Q3 2015

The third quarter saw heightened volatility in global markets as investors became increasingly concerned by the prospect of a slowdown in China and the impact it would have on the rest of the world. This was further fueled by the Chinese Central Bank – People’s Bank of China (PBOC), devaluing the yuan which triggered further weakness in commodities and emerging markets more generally. More specifically, Chinese industrial companies reported an -8.8% year-on-year decline in profits in August. At a corporate level, Longmay Mining Holding Group, the largest coal miner in China’s northeast announced 100,000 layoffs. Global Bio-Chem Technology, the largest corn refiner in China and the third largest in the world suspended operations. Even beer production in China fell 4% year-on-year! One could be forgiven based on all the headlines that China was not only important to New Zealand, Australia, Brazil and Germany but also to the US. The facts are actually quite the contrary. Total US exports to China are US$ 165bln, less than 1% of US GDP according to James Surowiecki at The New Yorker. Goldman Sachs estimates that just 2% of the S&P 500’s revenues comes from China at present.

When the facts are accurately presented and considered opportunities arise. Typically, when the markets experience a sell-off as we saw during the third quarter we are seeking to “upgrade” the portfolio where possible. You can see on page four of this report that we added a number of new positions and added to a large proportion of the existing portfolio. During the third quarter, we invested NZ$ 10.0mln versus divestments of only NZ$ 1.98mln. We exited several positions, which had contributed meaningful positive returns (STW Communications and Vivendi), positions which frankly were disappointing albeit not loss making (Kirkcaldie & Stains, & BP plc) and several smaller positions where we simply recycled the capital. We have also being “blessed” with strong inflows from clients during a period of market weakness, which placed us on the front foot, something that should not be under-estimated in a pooled vehicle like the Fund. “Having great clients is the key to investment success.” – Seth Klarman – Baupost Group Our cash balance at the end of May 2015 was 31.2% of the Fund, with a total Net Asset Value of NZ$ 17.74mln. Our cash balance at the end of September 2015 was 7.60% of the Fund, with a total Net Asset Value of NZ$ 21.60mln. Inflows remained positive during October and our cash balance is approximately 12.1% at the time of writing with a Net Asset Value of approximately NZ$ 23.6mln. Reminder: Our long-standing fee reduction mechanism, kicks in at NZ$ 25mln of Net Asset Value. This sees the management fee of the Fund decrease from 1.25% per annum to 1.20% per annum and continue to decrease with each NZ$ 5mln of Net Asset Value growth up to NZ$ 50mln where the fee will be 0.95% per annum. The whole objective of this mechanism is to share the benefits of scale with our clients in an open and transparent manner. As “bottom-up” stock investors, we do not target sectors specifically but negative headlines tend to affect a cohort and the media sector this year has been swamped with negative headlines – “cord-cutting”, “skinny bundles” and further audience fragmentation. These headlines and the negative stock price performances have garnered our attention and we have accordingly added a number of new holdings to the Fund. In each case we have selected the company based on their individual merits but the opportunity has been presented by widespread despondency on the sector and the perceived threats facing the industry. To provide some colour around the industry terminology: “Cord Cutting” is the term used to define the number of households that have dropped pay-TV. The “Skinny Bundle” is a phenomenon borne of the fact that households (particularly in the US) have been paying for an average of 194 channels while only watching 17 of them according to Nielsen. Consumers are now questioning why they do not just pay for what they actually watch – hence the popularity of such services as iTunes, Netflix & Hulu. The negative headlines in the sector have led us to invest across the sector on a stock specific sum-of-the-parts basis. One of our largest media holdings today where we believe there is compelling long-term value with multiple mechanisms to realise fair value overtime is Discovery Communications Inc. which we have provided a brief summary on the ensuing page.


Discovery Communications Inc. is the world’s #1 pay-TV programmer, based on cumulative subscribers of 2.8 billion in more than 220 countries. It provides non-fiction media and entertainment programming to pay-TV distributors through network brands such as the Discovery Channel, TLC, Animal Planet, Velocity and ID. The Company also recently acquired Eurosport to enter the non-football sports programming market in Europe.

The real attraction to Discovery is their content library and international footprint which we expect will allow the company to adapt, evolve and ultimately thrive in a changing media ecosystem. Discovery owns the majority of its content and this content is relatively low cost to produce. Gabelli Research suggests “the typical discovery program costs $300K per hour versus scripted programming which can cost $2-5 million per hour”. The content can also be easily transferred across markets with a sound overlay to change languages and largely does not date. This creates an enviable business model for Discovery where 50% of revenue (est. + US$ 6bln for 2015) is generated from long-term agreements with pay-TV distributors and the Company is exposed to secular growth in the international pay-TV industry. Discovery accordingly has industry leading margins and reliably returns capital to shareholders through share buybacks. Discovery currently trades at a meaningful discount to its slower growing peers, which attracted us to the Company. We believe Discovery is positioned well as a standalone business, but we also believe the Company has a number of strategic options due to:

(i) Discovery having a leading network of international channels that would be attractive to other large media companies;

(ii) Discovery’s US business would benefit from being part of a larger media complex; and/or

(iii) Discovery could also be a candidate for a tax inversion which could add significant value for shareholders. (It just so happens that the master of tax strategies Dr. John Malone is the largest voting shareholder of Discovery.)

We plan to release a detailed presentation on Discovery in the New Year.



The world’s finances continue to be manipulated by central bankers utilising their monetary policy levers. Interest rates have been driven to levels not seen for hundreds of years, and the impact of low rates can be seen in asset prices across the world. We are extremely conscious of this fact and that the unintended consequences of this unprecedented monetary intervention are unknown and largely unquantifiable. As we highlighted in our last quarterly report we are attune to the prospect of widespread deflation. Jim Grant - Historian and Monetary Economist recently stated “There’s nothing wrong with falling prices if the cause of the decline is wholesome gains in productivity. There’s everything wrong with falling prices if the cause is un-payable debts.” In our minds low interest rates (discount rates) lead to the potential for erroneous investments. This comment extends not only to international commodity trading houses like Glencore who utilise vast amounts of debt within their business model, but also to real estate investment trusts (“REITs”) who equally are using cheap debt to fund development pipelines, and also potentially captures the average house purchase today in Auckland. Accordingly with conservatism in mind, our portfolio consists of companies that provide everyday necessities, aspirational luxury goods and entertainment. The majority of our investments have pricing power by virtue of the brands/content they own, the services they provide or they are simply worth more in pieces than the current whole or to competitors/fellow industry participants. We only hold two commodity producers within the portfolio at present – Chesapeake Energy and Anglo American plc – both companies on a sum-of-the-parts basis we believe are worth more than the current share prices imply but to date have been disappointing investments as our forecasting ability on commodity prices has been limited at best and both these holdings have accordingly been a drag on the Fund’s performance. However, we are reminded by the October rally in global markets whereby most of the year’s losses have been erased as can be seen by our recent returns that it is important to continue to focus on the long term and try to reduce/eliminate the short-term noise. The Chinese authorities have a novel approach to reduce/eliminate the “noise” with their domestic media as shown below which we have sourced from the Financial Times (31 August 2015): “Do not conduct in-depth analysis, and do not speculate on or assess the direction of the market,” it reported an official directive as saying. “Do not exaggerate panic or sadness. Do not use emotionally charged words such as ‘slump’, ‘spike’ or ‘collapse’. Needless to say we do not own any Chinese shares in the Fund – the market in our view is currently uninvestable. Thank you for your continued interest, long-term mindedness and collective positive response to recent market volatility.


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