February 2019 Investment Update

Dear investors and well-wishers,

The Fund returned +8.74% over January 2019, ahead of the S&P 500 (+7.8%) and ASX 200 (+3.9%).

As we wrote last month, the ingredients were all in place for a rally, and it has been a curious one. ETF data suggests there has been continued selling by discretionary investors, but corporates resumed record buybacks. One assumes there has been plenty of short covering. We reduced our short positions significantly early in the month, but they were our largest detractors.

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It’s not clear how this will resolve. There is clearly a lot of cash on the sidelines, and managers have reduced their total and net exposures significantly. Our personal view is that the past quarter was the liquidation event, with lower prices causing more selling and even lower prices.

That has now flamed out, and our view is that it will take a negative GDP or employment growth for a resumed sell-off to reach new lows.

Portfolio Update

Stanmore Coal fell after a ~$240 million takeover bid failed, which was our preferred outcome. The firm made $46.5 million of EBITDA in FY18, and management forecasts EBITDA of over $140 million for FY19, so this would have been an absolute steal.

Management initiated a special dividend and committed to a buyback of 10% of the firm’s share capital, and the stock has since rallied well past the takeover price.

We exited Samsung above our purchase price. Samsung generates the bulk of their profits from memory, and a multi-decade period of consolidation that left three dominant players looks to be over, and new state-backed competitors are set to add capacity. One of the reasons we underperformed over the past few months was our exposure to the global smartphone sector, and this was a way of correcting this. We have maintained a 4% holding in Apple and a ~3% holding in Sunny Optical, which makes lenses for smartphones and the auto industry, where Sunny has a 30% market share. After a strong rally, Sunny Optical remains on an 11x 2019 PE.


In past letters we have drawn a parallel between 2016 and today. The missing piece was the reaction from Chinese authorities. Well, they have now acted, with measures equivalent to 5.5% of GDP. This is actually ahead of 2016, where measures equalled 5.4% of GDP, and since Chinese GDP has expanded since then, the total amount is actually 35% more.

Much of this is orientated towards tax cuts, which seems wise. We have maintained exposure to Chinese tech stocks, and expect these to benefit from the stimulus as it makes its way through the economy.

Some decades ago Stanley Druckenmiller said that one of the best environments for stocks is a weak economy with a central bank trying to stimulate. That seems to fit the current situation.

The equivalent stimulus in 2016 reversed falls in PMIs (which have given plenty of false signals over the past decade), and led to a bull market in global stocks. While off their lows, our US-listed Chinese stocks remain significantly below their 2018 highs, unlike US stocks which have largely recovered.

We are also paying close attention to the balance sheets of our portfolio companies. More than 63% of our portfolio is invested in companies with net cash on their balance sheet, and going forward we plan to increase this proportion significantly.

Without downplaying the risks, we now have:

1) A more accommodative Fed

2) Significant amounts of cash on the sidelines

3) An investor community that has dramatically cut gross and net equity exposure

4) A stimulus measure equal to over 5% of Chinese GDP

5) Continued employment strength in the US, Australia and China.

Record high liquidity in China

And to top things off:

6) The US is running record deficits and spending.

Irrespective of your views on the consequences and politics of Government deficits, this undoubtedly serves as an enormous, often unacknowledged fiscal stimulus.

Furthermore, in the lead-up to October 2018 oil and interest rates surged higher. These are prices paid by almost everyone. The US 10 year has come down around about 50 basis points from its high, and oil remains well below its lows, so these are also positive changes.

Pleasingly, our top energy pick, Lundin Petroleum, has recovered its losses, despite the dramatic fall in crude. Any further upside in crude, while risky for the global economy, should significantly benefit this investment.

What would change our view?

We are watching employment around the world very closely. Purchasing Manager Indices have turned sharply down around the world, but these are notorious for giving false signals. Often they bottom at the best times to buy equities, such as 2011 and early 2016, rather than the worst. Many key data points, be they Chinese auto sales or US housing starts, will reach the 12 month point later this year, and may inflect strongly positive off low bases, at the same time as stimulus measures take effect.

We have taken a close look at US rates. Treasuries generally have a negative correlation with equities, however they are not a perfect hedge. The January/February and October sell-offs in 2018 were accompanied by falls in both stocks and treasuries.However the one situation that will cause the largest derating in equities – an extended recession – will almost certainly be accompanied by lower rates and strong returns for portfolios of US bonds. The US 10 year currently yields over 260 basis points, which is substantially above the rest of the world, and likely a core reason for the global slowdown. There is a long way down from there.

The risk to such an allocation is that inflation returns, which would trigger higher rates, lower bond prices and almost certainly lower equity valuations. While a valid concern, this has not been the modern experience in the US, Japan, or Europe, where recessions have been accompanied by deflation. So far, as growth in the US has slowed, inflation expectations have dropped accordingly, so inflation is behaving as expected.

Most importantly, bonds are the direct beneficiaries when central banks try to stimulate through QE or by cutting rates. Clarida, a Fed official, this week announced that further measures, like capping the 10 year rate, are also on the table.

The early 1980s show a period of high inflation and recession. Equity returns proved excellent over the subsequent decade, despite the nearly 2 year period of negative returns.

No doubt there were plenty of reasons found from 1980 to 1982 to sell stocks, but those who congratulated themselves on catching 10-20% of the bear market move may well have missing the ~300% return that followed.

We have made plenty of mistakes over the past year. We had a large hedging profit early in 2018 that was fully invested by the time markets turned. But as we intend on being in this business for +50 years, it behooves us to limit the amount we pay in short interest, borrow costs, transaction costs and hedging costs. In the future we will focus more on using cash and bonds, which are positive yielding and have positive expected returns, to reflect cautious views.

We recently recorded a podcast with Eti Amegor, Associate Director at Axius, a firm who partners with leading fund managers, discussing volatility and the Australian landscape. In other podcasts we discussed Fiat, our US tech stocks and Australian investments.

Our Australian stocks have now significantly outperformed our global investments and are now some of our largest positions, with Afterpay at 7%, Stanmore Coal at 6% and Cooper Energy at 6%. We wrote about Afterpay here, and Cooper and Stanmore Coal here.

If you would like more detail on the portfolio, please get in touch.

Best wishes


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