• Angus Crennan

Balmoral Fund 4Q19 Update

Hi all

Please see an extract from the investor update letter sent to you all earlier in January.



Executive Summary

Happy New Year! Our calendar year 2019 returns after all expenses were 17.1% which is a strong positive step towards our goal of compounding our investment capital over time.

This result was achieved with exceptionally robust risk management in place matched to the magnitude of risks in our current investing environment. We started the year, having taken advantage of the 4th quarter of 2018 sell-off, with our portfolio fully invested. 2019 then took off with a rocket and by end March we had sold some investments for strong gains and were at 37% cash, that moved to 70% cash by June. It was August before we found some good opportunities which took our cash levels back into the low 60% range which is where we stayed till December when we moved back into a little over 50% cash.

Our portfolio’s weighted average cash position over the year was 52%, a conservative positioning. With markets at all-time highs, and some noteworthy pockets of extreme valuations, it required more work to find good opportunities in 2019.

‘Heads we win and tails we don’t lose’ is the correct positioning for positive return seeking portfolios like ours because it’s the most likely to achieve our absolute return objective - We strive to make gains regardless of market conditions wherever that is possible.

Risk management has become extraordinarily important for our positive return objective given:

1. Late economic cycle risks are compounded by prolonged extraordinarily loose monetary policy concurrent with fiscal stimulus, and

2. Elevated geopolitical risk.

Overview of the key markets we operate in

The US is operating at full capacity: unemployment has hit a 50 year low of 3.5% supported by a cash rate of 1.5-1.75% and concurrent US Government stimulatory budgets. Many investment and sub-investment grade US companies have gorged on ultra-cheap debt, a currently sleeping but restless dragon to worry about another day. The US share market is expensive and some parts are extremely overvalued. To give you one example the value of Apple and Microsoft shares alone are worth more than all the listed companies in Germany combined. From late 2001 to late 2013 Microsoft shares traded in low US$ 30s range then they went exponential and finished 2019 at $158. Has Microsoft’s cash generation potential changed that much over the last few years? We had around 25% of our Fund invested in US companies at end of December and I will be looking to lift that allocation opportunistically when valuations are more attractive than at present.

A key change made over the last quarter is we have re-entered the UK market following developments around the Ireland border and a majority government forming. We are natural investors in the UK and it was a prudent shame for us to be avoiding it over these last few months. Like all developed markets UK prices are currently expensive. However, there will almost certainly be hiccups in the divorce with the EU, which I hope means there will be some good opportunities in the months and years to come. We have taken our first tentative steps back into the market (5.1% allocation as at end December) and we will certainly lift that allocation when it’s in our interests to do so.

Europe generally remains in a bit of a funk. An illustrative example is industrial powerhouse Germany’s manufacturing sector has shrunk for a second year in a row, that sector’s worst outcome in close to 20 years. We had 14% allocated to European companies at end December and would be happy to increase that if the right opportunities come along.

Although we currently don’t invest in China it’s relevant for global economic conditions and sentiment. Corporate debt levels are very high and a source of concern for their banking and capital markets particularly given changing global trade rules – somebody’s loan is somebody else’s asset. The key concern about China as a potential risk for me is an evolving perception of China as ‘competitor’ rather than ‘partner’, particularly in the US administration. I suspect this change will introduce all manner of new pressures on Chinese economic activity. Change requires initiative, correct incentives and access to capital all nicely aligned to blossom as opportunity and I am not certain how well that recipe for enterprise coexists with central planning.


Over the final quarter of 2019 our Fund increased in value by 0.4% reflecting our conservative positioning as well as increases in the value of the Australian Dollar.

Over calendar year 2019, including reinvested distributions, our Fund increased in value by 17.1%.

Since inception nearly three years ago on Australia Day 2017, including reinvested distributions and after all expenses, our Fund is up 31.7%. This represents a compound annual growth rate of 9.85%.

These are numbers I am proud to present to you, especially given the emphasis on risk management discussed in this and previous letters, and we remain on track with our purpose.

Portfolio Holdings

At the end of December 2019 we are part owners in 14 businesses:

1. Villeroy & Boch - German fine china and bathroom interiors.

2. Hugo Boss - German corporate and smart casual clothier

3. Sartorius Stedim Biotech - French pharmaceutical and laboratory equipment supplier

4. Kroger - US retailer

5. H&M – Swedish fashion retailer

6. Mattel – US toy and entertainment company

7. Telstra – Australian telecommunications

8. Euronext – European securities market exchange (headquartered in France)

9. Biogen Incorporated – US biotech

10. Cheesecake Factory – US restaurant chain

11. Go Ahead Group – UK passenger transport group

12. Norcros – UK bathroom products

13. Cummins Inc – US power products and solutions

14. A.O. Smith Corp – US water management products

There are four new names which were added since end September 2019:

Go-Ahead Group is a UK passenger transport company founded in 1987. We have twice owned part of this company before, the first time making 17% on our holding and the second time making 15%. The business is very competitive in its space consistently generating cash and returns on equity over 30% whilst using modest leverage.

Norcros is a UK company focused on showers, taps, tiles and bathroom accessories with strong brands that dominate their respective segments in the UK and South African markets. We have previously part owned this company and made 20% over an 8-month holding period. Like any company leveraged to an extended real estate cycle there are risks however the valuation we paid was attractive, the business is well placed and it has been consistently generating strong returns on equity and free cash using modest leverage.

Cummins Inc is a US business founded in 1919 that designs, manufactures, distributes and services diesel, natural gas, hybrid and electric engines as well as battery, fuel and electrical power generation, air handling, filtration and emission systems. The company’s business model aligns to its competitive advantages (technology, scale and strong relationships) which has driven impressive momentum in earnings and cash generation. Best of all we acquired our stake in this business at an attractive valuation.

A.O. Smith is a 146-year-old US based provider of water management products with dominant brands in water heating and water treatment across 60 countries. Strong and consistent returns on equity and cash generation were the cornerstones of our buying into this business. As a plus we can confidently expect the water industry will be around for the foreseeable future. The valuation we paid for our stake was full but not excessive, a sign of the times, so we are placing trust in management to continue its successful trajectory into future years.

Investment Commentary and Outlook

We are late in an extended credit cycle. That means:

1. Asset prices are expensive yet memories are short, faith in central banks’ high and the general chorus is that asset prices can only go up, and

2. Availability and appetite for debt and leverage is high.

To give you one example of how expensive shares are, according to Bloomberg, the value of all global shares was around $87 trillion US dollars at the end of December which is equal to the value of all global goods and services produced. This ‘excessive valuation’ metric was made famous by Warren Buffett although to my knowledge he only applied it to the domestic US market.

Leverage is high not just in Australian households. China is already mentioned above and in the US market the net leverage ratio of bond issuers is as high as it was at peak market euphoria just before the Tech Wreck. The credit spread, or additional interest cost, which sub-investment grade companies are paying for debt is the lowest in two decades – this means the credit cycle is still going strong and large lenders (such as banks and insurance companies) are competing to lend to borrowers. This usually places pressure on both underwriting standards (who can borrow and how much) and lender covenants (protections for the lender) meaning loans are likely being written which would not have been approved several years ago.

The dangers of leverage

Consider a company which has 80% of its assets financed with debt. $100 of assets represented by $80 debt and $20 of equity belonging to the owners of the company. Now assume the value of assets fall 10% to $90, hardly a stress event. In that scenario the value of the company’s debt remains the same, $80, meaning the value of the owners’ equity has to cushion the $10 change in the value of assets and has therefore been crunched 50% (ie the $20 of book value equity is now only worth $10 when marked to market).

Continuing this example assuming a lender agrees to continue lending the same $80 to that company (it might not) then the credit spread the company will need to pay going forward will increase to represent its added risk (its equity cushion has halved). This was exactly the behaviour we saw from the Australian banks during the GFC – large real estate owners like REITs had their loans extended however the credit spreads they paid the banks increased substantially. In an environment where markets are already making life difficult for a highly leveraged company it also has to contend with higher debt costs.

The way out of stress events like these is either to raise more capital (which owners will not like), or sell assets and repay some of the debt. Selling assets quickly becomes painful too however because markets often deteriorate faster than de-risking is possible in some asset classes. For example there is significant due diligence and legal processes that need to be completed before a commercial office building can be purchased or sold. Buyers observe the falling prices, get anxious and decide to wait out the sell off. As a result the prices for less liquid assets falls further and the most leveraged owners who purchased at peak cycle valuations face the discipline of capitalism. At some point lenders cut their losses and call in their loans to recover what they can. This means forced sellers who have to contend with the natural potential owners of their assets already licking their wounds.

Taken together its unsurprising that history shows us prices fall a lot faster in hard times than they went up in good times. Most importantly when asset prices are falling it is not just the buyers of the actual assets which start to pull back. At a certain point the lenders of debt start scaling back their risk appetite.

Falling prices after a long bull market are ultimately the preconditions for a turning point in a credit cycle.

The Bullish States of America

The US equity market at present is a bull in its prime. It has been going up for 126 months which is the longest and most glorious run up in its history. US equity indicies are at all-time highs while other asset classes concurrently also bask in glory: rates are low, credit spreads are all time lows, US house prices are at all-time highs. US market confidence goes even further than its bullish capital markets - US unemployment is at 50-year lows and US jobs growth has been positive for the longest period in US history.

With such strong economic conditions its unusual that the US Federal Reserve cut interest rates three times in 2019 and markets are expecting it to cut interest rates further in 2020. More fuel for the inferno. On top of easy money comes US fiscal largess - the US Government’s budget deficit jumped 26% in the 2019 fiscal year, close to US$ 1000 billion of newly borrowed money injected into the US economy.

For investors this symphony of heavenly music is a paradox – expensive valuations have in the past always resulted in bloody noses. Unless ‘this time is different’ from all the glorious bull markets that died in the past, which it’s not, we should be extra cautious paying high prices. Yet the key lesson this last decade has been to take into account how powerful Central Banks are, and the Federal Reserve has clearly shown it is supportive of asset price inflation, so should we just have faith and overlook the lessons of the past?

Ben Graham wrote:

“An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.”

In our current investing environment I believe expensive valuations are less likely to go up even more than they are to go down. If I am wrong and prices do continue going up I draw some comfort from an additional belief that the magnitude they can go up is overshadowed by the magnitude they could go down.

If you had perfect market foresight, which would be nice, and knew that global equity markets had a 30% probability of going up 10% but 70% probability of going down 30%, then the only logical portfolio positioning would be a conservative one.

Are we close to the end of the cycle?

We cannot know. However there are indicators which we would be foolish to ignore.

As recently as September we saw the exceedingly deep US repurchase or ‘repo’ market start to freeze up. There is a big problem in US credit conditions when short term lending secured by high quality collateral dislocates. To remedy the situation the US Federal Reserve announced it would do a ‘one-off’ liquidity injection – which quickly evolved to the US Fed adding additional liquidity every few days. Despite how strong conditions are in the US in the last third of 2019 the US Federal Reserve expanded its balance sheet as fast as it did when it was undertaking formal quantitative easing during the dark days recovering from the GFC.

Consider this disruption in the US money market, and some of the general market conditions I have mentioned in this and past letters, against the following quote from George Soros writing about a previous equity market collapse:

“In retrospect, it is easy to reconstruct the sequence of events that led to the crash. The boom had been fed by liquidity; it was a reduction in liquidity that established the preconditions for a crash. In this respect also 1987 resembles 1929, it will be recalled that the crash of 1929 was preceded by a rise in short term money rates.”

It’s certainly a warning to keep our guard up and be judicious committing our precious investment capital at stretched valuations.

So what now?

As an old cricket coach used to say ‘play the ball on its merits’; these market conditions merit caution. We will remain patient knowing opportunities will come. Recall in the recent past we have taken both company specific opportunities (such as LyondellBasell last quarter) and systemic opportunities (final quarter of 2018). We have a good tool kit and a wide investment universe – I don’t believe it will be long till better opportunities will be made available to us.

The near-term outcome I am looking for us to achieve is some gains – we want to make an adequate return - whilst avoiding risk concentrations. If I can achieve that with our portfolio’s construction it will mean that when markets sell-off we will weather those conditions well. This in turn means when the selling is done, and opportunities have improved because the prices of the investment assets we want to own is lower, we can acquire the assets we want at attractive prices. Such a sequence of events both minimizes the risk of us facing potential losses in the near term and sets us all up for future years of compounding our capital, an attractive mix which justifies our short-term restraint.

As always please contact me if you have any questions or would like additional information about our portfolio and how it is positioned.



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