• Angus Crennan

Second quarter 2017 results – Balmoral Fund

Over the second quarter of 2017 the Balmoral Fund increased in value 3%, after fees.

Since inception on Australia Day 2017 our Fund has increased in value 6.9%. Given the fund had been investing for 155 days that represented an annualised rate of return, after fees, of 16.3%.

These are good results although it remains very early days for performance judgements.

Fund developments – Sold Positions

One position in our fund has been sold this quarter – TPG Telecom changed its business model and balance sheet profile over the quarter so much by bringing forward its mobile strategy that the original focus of the business has completely redirected. There is a good chance they will succeed although for now they are going through a major strategy inflection point and given a lot of capital investment projects taking place it will take time before we know if their new strategy, and all the capital they are investing in commencing the implantation of that strategy, is successful. The company’s mobile strategy follows the same thinking as their broadband strategy, being market share acquisition on low cost to deliver, although mobile coverage will be a key hurdle their low cost broadband offering did not have to overcome. TPG was the only Australian company in the Fund and so as at 30 June 2017 the Fund has no Australian investment exposure, only a small amount of Australian cash.

New Investments

DexCom is a global leader in blood glucose monitoring. This company is to diabetics what Gillette is to shaving – the quality of life afforded, and the gap between DexCom and the competition, mean it is well worth customers paying for the company’s product which is the foundation of sustainable attractive profit margins. It is early days for this company and this talented management team has produced something special, their product is excellent and their strategy has a lot of great momentum.

Kroger has been around since 1883 and is America’s largest retail chain. Kroger not only does supermarket format stores, like our own Woolworths or Coles, but also other format stores such as department and specialist spaces. They are a superb retailer routinely generating mid teen or higher returns on equity. We acquired this retail powerhouse after it reported disappointing results and Amazon concurrently announced it was becoming a grocery competitor through an acquisition which spooked investors. When our fund commenced earlier this year Kroger was selling for around $34/share; we acquired our shares at $22.50 in late June which equates to a price multiple under 13 times earnings. This is a screaming good price for a dominant US franchise with a wonderful business model and strategic store footprints consistently generating great returns.

LyondellBasell is one of the world’s largest plastics, chemical and refining companies which we acquired in late June at an average price of $80.39 which represents a price to earnings ratio under 9 times. Current debt levels are prudent at around 38% of total assets and recent results have amply justified such a cheap price.

Mattel is a US toy company boasting iconic brands like Fisher-Price, Matchbox and Barbie. The share price has taken a lot of punishment in recent years – the last time Mattel shares traded at US$21.87, which is the share price we acquired part ownership for, was 2010 coming out of the GFC. Despite the constant cash generation from key brands in recent years Mattel has exhibited poor brand franchise management with issues such as inventory control of new lines, and the market had punished that through the value of company’s shares giving us our attractive entry point. Senior management has recently changed, dividends have been reset at a sustainable payout level and the company’s new strategy to use more digital media to create more connected consumer experiences makes great sense.  This company just needs to do the basics well and it will deliver well for us.

Norcros PLC is a UK company focused on showers, taps, tiles and bathroom accessories. Their Triton Showers and Johnson Tiles both have excellent brand reputations built over decades and are each considered number one brands in their space in the UK market. We purchased this focused bathroom company at a GBP 1.73 which is around 12.5 times earnings. In addition to the enduring appeal of their dominant brands the UK’s recent initiative to lift home building to ease house prices (and perhaps stimulate domestic demand during the BREXIT process) plays well to this company’s strengths.

Sartorius Stedium is a pharmaceutical and laboratory equipment supplier. More than 85% of the company’s sales are from products which are dominant in their field (ie are top 3 brands globally) and the company is focused on high margin single use items (such as filters, bags and cell culture media) which of course means provided that provided the product is good the customer orders keep coming in. Profit has exploded in recent years nearly tripling from 2012 to 2016. From our acquisition of part ownership in early April at €58 per share this position has performed well for us. This company is a fabulous commercial operation and we have acquired our part ownership at a good price.

Existing Investments

Coty shares remained weak over the quarter reflecting the market’s uncertainty about the company’s transformation. The new management team remains focused on integrating the newly acquired brands and future positioning to a wider group of consumers. I like the cash generating capabilities of this business and although it bears close monitoring remain comfortable holding the position till the new management’s strategy can start to gather momentum.

Deutsche Bank share price rallied then returned to where we acquired our stake over the quarter. At present the company’s shares are trading at a price under 40% of its book value per share. Compare that with large peers trading 80-100% of book value, and our own CBA on around 220% of book value. You would think the market is pricing Deutsche cheaply because it has more risk in its business yet Deutsche’s ratio of loans to total assets is less than half CBA’s. In the worst months of the GFC Macquarie Group adopted a highly defensive balance sheet structure to get through periods of elevated risk and that same thinking is reflected in how Deutsche is currently positioned. I like both that Deutsche recently further firmed up its capital position and that it remains exceedingly well positioned for a recovery once sentiment in continental markets recovers and their interest rates normalise from extreme levels of monetary policy activism.

Hugo Boss has performed well over the quarter. Corporate sales are supporting the launch of a new Hugo branded smart casual line. The excellent reputation of the brand for high quality and its establishment image have driven the success of this franchise for decades and moving to carve out an attractive share of an adjacent, complimentary market makes great use of their existing expertise and culture.

Inwido share price performed well over the quarter. The company’s high quality windows and doors, proven over decades in harsh Scandinavian winters, integrate easily into development projects and therefore will continue to enjoy support from designers, architects and developers.

Prada SpA share price rallied then fell away over the quarter reflecting weak investor confidence the management can deliver. News from Milan fashion shows is Prada continues to differentiate – the flair, creativity and drive remain in the business, as investors we await the inevitable alignment of the creative with the economic results – which we will see come through as rapid, high margin sales growth – which in turn will quickly drive the share price substantially higher. To get economic traction from the strong creative elements which have always been there and unquestionably remain today the distribution channels need to work more effectively, which is really a generic management skillset requirement and a problem I would expect is remedied well within our investment horizon.

Villeroy & Boch has had a stand out quarter with the share price substantially higher than our acquisition price. The company’s high quality product and excellent reputation is being complimented by smarter distribution.

Portfolio Construction Comments

Our portfolio was just under 90% invested in great assets as at end June, which is fairly close to fully invested without using the freedom to use leverage.

Cash offers us very little return potential given central banks have used significant monetary policy actions to stimulate economic activity so it has been a priority to get invested although clearly not until good investments at good prices had been identified. Even if asset markets are reasonably expensive overall the relative returns from bonds and cash remain unattractive meaning I don’t expect to be changing that asset allocation in the near term. Further, given we have good investments at good prices, there is little incentive to move capital from our current positions.

Considering diversification, our asset class level diversification remains negligible with around 90% equity and 10% cash. The justification very simply being the relative appeal of alternate asset classes is so poor. A high grade bond earning a lower yield than inflation is detracting from our ability to reach our compounding capital investment objective, we have no reason to be there. Within equities we have geographic diversification, size and life-stage diversification, as well as industry diversification within our portfolio. Some investments have been purchased using a value lens (for example Deutsche Bank acquired on a very low price to book value) while other companies we acquired parts of were purchased on grounds of their latent growth potential – this can be summed up as style diversification.

A final but key point about diversification relates to our objective in this fund. Our fund’s objective is simply about maximising the rate of compounding of our capital. Diversification can reduce volatility however the compounding gods are not diversification but rather portfolio concentration and owing great assets at good prices. Buying a $20 note at $10 is still a great bet even if a greater fool subsequently offers it to you at $8.

One derivative was used over the quarter which would have increased in value had the market fallen. This derivative was purchased when news was announced that the US President had fired the FBI Director James Comey and was held for approximately 6 hours until the US market had been open for approximately 30 minutes. When it was clear the US equity market would not react negatively to this news the position was disposed of. The cost to the fund of holding this protective derivative was negligible although its benefit in the event the market panicked would have been substantial.

Our fund currently holds no Australian investments (other than limited Australian cash). Because our investments are all offshore this means we will benefit if the Australian dollar weakens against other currencies, in particular strengthening Euro and US Dollars relative to Australian Dollars are favourable to our fund’s value. Given all investors in the fund already have the majority of their assets and income in Australia I am comfortable with that positioning.

Current positioning is roughly 41% European companies (48% if we include Prada which is Italian although listed in Hong Kong), 36% US companies and 7% UK companies. Of our cash we hold around 7% in US Dollars, 3% in Australian Dollars with very small amounts in Euros and Great British Pounds.

As at end June the fund had no active derivative positions and was using no leverage.

World View Comments

Markets are expensive relative to history primarily due interest rates being exceptionally low for prolonged periods. To maximise our chances of achieve the compounding rates we are looking for I have used artificially high discount rates to ensure we not only buy our investments based on a robust valuation but also at a target price building in a substantial margin of safety.

European assets have been increasing in value this quarter, which was expected at some point given the undervaluation in those markets vs clear overvaluation in the US. We have purchased some great European companies which should do nicely for years to come. More importantly Europe is not what it was a decade ago – although the multiple national governments finding common ground for reform inevitably slow change down, Europe now has a generation which has done it tough for a prolonged period and an establishment that has BREXIT shocked into understanding change is needed. Although risks remain, including the looming Italian election, the preconditions are in place for Europe to do well economically for the next decade. Europe’s great companies, some of whom we now part own, should benefiting disproportionately.

Australian household debt continues to represents a risk to our domestic outlook. In committing to high levels of mortgage debt Australian families have taken on very long life and substantial liabilities which significantly impairs those households’ ability to manage unforeseen difficulties. A recession, whether catalysed internally or via external events, could place significant stress on households, which are Australia’s foundational economic unit. Given our economy is not complex the obvious catalyst would be a terms of trade shock echoing out of issues in Asia and transmitted through our key exports.

Please contact me if you would like more information.


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