Quarterly Report – Period Ending 31 March 2015
TOP TEN HOLDINGS
The first quarter of 2015 has seen equity indices march on, albeit more slowly in the US, and bond yields fall to previously unseen levels. Oil prices have seemingly found a floor (at least for the time being), and the effect of monetary easing by the European Central Bank (ECB) is being felt in equity and fixed income markets – particularly in Europe. A number of the best performing stocks in the Elevation Capital Value Fund portfolio have been European, including Tod’s SpA, Heineken Holdings, Remy Cointreau and adidas AG, all of which have delivered returns of above +15% (in local currency terms) for the quarter.
In late January, Mario Draghi, President of the ECB, announced a comprehensive program of quantitative easing to counter the threat of deflation. This will involve the purchase of up to € 1.1 trillion (€ 60 Bln per month) worth of financial assets - primarily bonds – by the ECB. The move was largely anticipated by markets but this has not stopped a number of equity indices being pushed to new highs. The DAX, a German equity index, has risen ~ 15% since the announcement and the CAC40, a French equity index, has risen ~ 10.5%. In hindsight, the ECB’s decision to raise the refinancing rate (the European base rate, equivalent to the OCR in New Zealand) in April 2011 was very premature.
A discussion of easy monetary policy and its effects on asset prices leads us to the subject of residential property prices in New Zealand – particularly Auckland. New Zealanders have had a long love affair with property as an investment for various reasons. Property is more tangible than stocks and bonds (you can walk around and touch a home or a property), no taxes are imposed on capital gains and, perhaps most importantly, one can generally borrow a greater portion of the purchase price to finance the purchase of property. The rapid rise of residential property prices has largely been the result of the willingness of banks to lend large amounts to borrowers with minimal deposits. While margin lending for the purchase of stocks is capped, banks will allow you to leverage your property purchase many times over. A 10% deposit means you are leveraging your investment 10x, meaning the return on equity is significantly boosted by the use of leverage, enhancing risks as well as returns.
It is very difficult to argue against the returns Auckland property investors have experienced in the recent past which have pushed prices to among the most expensive in the world. A recent QV report on New Zealand residential property prices demonstrated a 17.9% year-on-year increase in the prices of property in Auckland City South, while Auckland City East and Auckland City Central showed gains of 15.4% and 11.3% respectively. Constraints impacting the property market do not help. One of the effects of provisions in the Resource Management Act has been to make it more difficult, time consuming and expensive to build a home, meaning that people are incentivised to buy existing homes, rather than increase the stock by building. As the American Economist Steve Landsburg said regarding the discipline of economics, “People respond to incentives, the rest is mere commentary”. Confusing the supply and demand equation further is the fact that demand is not restricted to the local market. Overseas investors who can borrow at lower interest rates see Auckland property as an attractive investment, with little paperwork and limited restrictions on foreign ownership of multiple dwellings, thereby increasing demand for properties. These buyers have played an increasingly large role in Auckland housing (albeit statistics are difficult to ascertain, which in itself is puzzling).
Given the rapid rise of property prices in Auckland, the investment case for property is, in our view, weak. Traditional measures of the fundamental value of properties such as price in relation to annual rental income (rental yield) and price in relation to median household income have increased to the extent that they are no longer predictive of property prices. Rental yields are historically low, while household incomes have risen only moderately in real terms. We interpret these two metrics negatively in terms of their implications for value in property markets at present. Rent can only be raised by so much in the face of median incomes which have only increased slowly.
‘The Economist’’ tracks residential property prices closely and New Zealand residential property prices (driven largely by Auckland) have been notable for their divergence from long term trends in both price vs rental income and price vs average national income (see charts below). It is worth noting that the red line in both charts represents the long term average. See the following link to The Economist feature: http://www.economist.com/blogs/dailychart/2011/11/global- house-prices.
Price vs Rental Income:
Price vs Average National Income:
In the event that property prices suffer a decline, the effects on the banking system and individual borrowers may be unpalatable. The implications should be obvious to most investors – diversification is key. Having exposure to different markets, not just property and not just New Zealand, is important for investors seeking to minimise risks. Although property has been a good performer for investors in the recent past, this is no indication that it will continue in the future. To quote Babe Ruth, “yesterday’s home runs don’t win today’s games”.
We are increasingly cautious regarding debt levels in New Zealand. Within New Zealand at present we fear significant complacency amongst the broader population in the face of key commodity price deflation. It seems that debt fuelled property price appreciation has put the blinkers on to the possible misallocation of resources. Time may prove us wrong, but borrowing more to spend more on houses is not the same as earning more to spend more. Economic history is replete with large groups of investors who believed in mathematically unsustainable trends. We doubt this time is any different - despite what the wider real estate industry will tell you. Additionally, low interest rates are likely to moderate or even reverse course in time - we are circumspect as to whether higher interest rates in the future are being factored in by current buyers.
Looking forward in equity markets, the possibility of rising interest rates in the United States is likely to lead to increased volatility in the months ahead. Markets which have been supported by accommodative monetary policy (the bull market has been charging ahead for five years now), may be volatile in the face of rising interest rates. More generally, market conditions are clearly developing pockets of complacency. One area of particular concern is the bond market. Bond yields have been pushed to previously unseen lows by increasing prices as investors seek safety. The risk to equity markets is fundamental – in the event of a bond market bubble bursting, the weighted average cost of capital for firms increases on a forward basis. It is easy for firms to generate a positive net present value on projects when capital is costing them 3%-5%, not so easy when it is costing them 7% or above. Famed investor Julian Robertson acknowledged the link between the equity and bond markets in a recent interview, saying that a bursting bond bubble would have a serious impact on stocks.
In mature bull markets it is always prudent to have an eye on the possibility of a correction in equity prices. This is important for both buy and sell decisions and emphasis should rest firmly on value rather than price as multiples become further stretched. Seth Klarman of Baupost Group sums up his mindset as a value investor in a mature bull market – “Stick to your knitting. Avoid portfolio leverage. Maintain sell discipline. Hold some cash in reserve to take advantage of future opportunity.” As with all fund managers, we have views on likely macroeconomic outcomes in the future. However, making investments based on macroeconomic views often leads to binary outcomes. Instead, we take the approach of bottom up, fundamental valuation, basing our decision to purchase a share on our view of the fundamental intrinsic value of that share. As we screen hundreds (perhaps thousands) of companies per year, assessing the multiples they trade at against their peers and where they have traded historically, our approach is moving towards one of caution. We are seeing shares trading at multiples which are significantly higher than their historical averages. Our cash balance is +24% (as at 15 April 2015), which is indicative of our cautious outlook (we expect this balance to move to over 30% on forecast new inflows in May 2015).
Broader equity valuations are stretched in a number of markets, increasingly the US. Our view of Europe differs slightly, in that we believe there is still room for further earnings growth and multiple expansion (particularly with the advent of quantitative easing). A recent Financial Times (“FT”) article highlighted this point eloquently, saying that the Eurozone stock market is valued at 52% of the region’s GDP, versus the US stock market which is valued at 138% of US GDP. Even accounting for regional differences in the proportion of listed versus private firms, this highlights how far behind the Eurozone has been in terms of both real economic recovery and equity market recovery. Our bottom up fundamental analysis supports this view and Europe currently accounts for approximately 35.6% of the portfolio as at 31 March 2015.
While we are increasingly cautious of elevated market multiples, this is largely driven by a few sectors (eg. Technology, Healthcare, Biotechnology etc.). We are not suggesting there are no opportunities at present. To once again quote Seth Klarman on the opportunities available in both bull and bear markets:
“It’s crucial to remember that a bear market is still a market. Markets are driven by supply and demand, and greed and fear. They constitute, as Benjamin Graham noted, a voting machine, not a weighing machine. Emotion-driven individuals dominate markets and just as no bull market goes on forever, nor does any bear market. To take advantage of the low prices in a bear market, you have to have been buying on the way down, perhaps all the way down. There is no way to perfectly time the bottom, and no other way to put substantial capital to work”.
Adhering to these wise words, we believe our collective patience, coupled with our cash balance, will afford the Fund opportunity in the future.
Portfolio Review – Q1 2015
Below we have detailed the five largest contributors/detractors from Fund performance during Q1 2015:
During Q1 2015 we undertook the following portfolio movements:
We have exited two positions during Q1 2015:
1 In the holding’s local currency including dividends
2 Gale Force Petroleum (“GFP”) was exited at a loss which amounted to ~0.43% of Net Asset Value (as at 31 March 2015). It was a very small position within the portfolio which totalled only ~0.51% of Net Asset Value - our average position size as at 31 March 2015 was 2.16%. GFP was a small capitalisation oil company based in Canada which was best described as a special situation investment which failed to fulfil the prospects for capital return via asset realisation despite trading at a significant discount to stated Net Asset Value (proven reserves). Clearly, not every position goes to plan and thankfully in this case the position was sized to reflect the risks inherent in small capitalisation companies (which are increasingly a rarity in our portfolio as highlighted by the portfolio detailed on the front cover to this quarterly report.) However, losses (on occasion) are an inescapable fact within this business and one has to place these examples in the “never forget” file/ledger and learn from them.
New Position Acquired During Q1 2015
De La Rue Plc
During the most recent quarter we established a new position in a company called De La Rue. Based in the United Kingdom, De La Rue is the primary private sector currency printer globally. The Company’s main activity is printing bank notes for central banks in over 150 countries. It also produces other documents including security paper, passport and identification documents as well as software. Its two biggest contracts are with the British government (to produce British passports, a 10 year contract it renewed in October 2014) and the Bank of England (to produce the British Pound bank note, a 10 year contract renewed in 2014).
De La Rue has a venerable history. Established in 1813, De La Rue (Thomas De La Rue as it was called then) began as a printer and a stationer. In 1831, Thomas De La Rue was awarded a Royal Patent from King William IV for the manufacturing of playing cards. In 1846, the Company invented the first envelope folding machine, producing 2,700 envelopes per hour. In 1860, De La Rue produced its first paper money – the Mauritius £ 5, £ 10 and 10 shilling notes. De La Rue also developed the first fountain pens considered to be practical in 1881. In 1914, the UK treasury commissioned Thomas De La Rue to print £ 1 and 10 shilling notes at the outbreak of the First World War. The company’s factories were destroyed during the blitz in 1940 but arrangements were quickly made to resume printing elsewhere and De La Rue was able to honour all arrangements. Innovation continued in 1957 when De La Rue first began marketing its highly successful banknote counting machine. In 1967, De La Rue developed (jointly with Barclays Bank) the world’s first through-the-wall ATM machine.
De La Rue currently trades at £ 5.55 per share (as at 31/03/2015), having fallen 48% from a high of £ 10.73 per share in October 2012. In September 2014, the dividend was cut and earnings expectations revised down in an announcement which induced a ~37% fall in the share price. This saw De La Rue move into an attractive price range in terms of the multiples it trades at. Speculation has mounted that a takeover offer from Oberthur (a French competitor) and an undisclosed private equity partner (likely Bain Capital) may be forthcoming. Oberthur has previously made an offer for De La Rue and, based on our analysis, we believe that any offer would likely be in the price range of £ 7.50 and £ 8.13 per share. De La Rue operates in a truly niche industry, in which it is one of only a handful of participants, with high barriers to entry. It has an illustrious history dating back to 1813 and there is, in our view, a reasonable prospect that it will be acquired by a competitor. In the meantime, we receive a dividend yield of 4% - 5% to wait patiently.
A presentation on De La Rue will be released in Q2 2015.
Thank you once again for your continued support and interest in the Fund and the trust you place in our firm. Respectfully submitted,
Elevation Capital Management Limited