Dear investors and well-wishers,
The Fund returned -8.37% net in December, while S&P500 dropped 9.2%.
The moves seen in December were fairly exceptional. It was the worst December since the Great Depression, and for many markets that was the worst quarter since the GFC.
This capped a disappointing year. We started well, catching the end of the bull run and the VIX implosion, but the fund was invested in Asia, technology, energy and biotech stocks, which bore the brunt of the most recent sell-off. Our hedging made only a minor contribution over the past few months, but was a benefit over the course of the year.
One of our local companies, Stanmore Coal was subject to an opportunistic bid at 0.95c by a Chinese group. The stock is currently trading at 96c, and the bid substantially undervalues the company, in our view. The firm has a market cap of A$242 million, with $20 million of cash, no debt, and is expecting to make $139 million of EBITDA in the year to June 2019.
We added Amazon at a 15x forward EBITDA at a price of around $1350, more or less at the December lows. We used profits from our hedges and shorts to fund the new position.
We also added a small position in Aurelia Metals, a gold miner that netted $151 million of operating cash flow in the year to June 2018, on a market cap of A$685 million. Aurelia Metals has quite a different set of risk/return factors to the rest of our portfolio, and we sold a US cyclical to make room.
The firm recently bought Peak Gold, which runs a neighbouring mine. In its first year as part of Aurelia, Peak returned the entire purchase price, from cash on the balance sheet and its first year of free cash flow, an indication of the strength of management.
Aurelia has $71 million cash, and no debt. The core task of management is now to increase the firm’s reserves, and they have the balance sheet to do it. Gold has performed in a risk-off fashion lately, and if the global downturn intensifies, we expect the gold price to perform well, particularly denominated in Australian dollars.
As an example of how our year played out, Fiat reported unit sales up 7% year-on-year in a weak global auto market, with 17% growth in its core US Jeep brand. EBIT rose 13% year-on-year, and the firm moved from net debt to a net cash position, which should enable the company to survive the next auto downturn.
But over the year the firm sold off by 19%, to a valuation of 1.8x EBITDA, and 5.7% dividend yield.
Situations like this where fundamentals improve and the stock price declines, are like compressed springs. When sentiment returns the fundamental improvement will be reflected in price. In the meantime, it makes little sense to sell quality assets at low prices in the middle of a market panic, and we have no intention of doing so.
The question of the day
The most critical question in markets today is whether the past few months were a dip to buy, or whether we're facing a multi-year bear market like 2000-2002, or 2007-2009. Both of these were gruelling, multi-year affairs with ~50% falls peak-to-trough across equity markets, whereas the numerous other sell-offs and panics over the past decades have been excellent buying opportunities.
A curious aspect of the current situation is the continued strength of the US labor market.
In both fore-mentioned bear markets, the initial market falls coincided with job losses and a weak labour market. In the GFC, the first negative payrolls came in June 2007, very close to the equity market top. In 2000, the first job losses came in June 2000, again close to the top. We are in the fourth month of this particular market storm, and job losses have yet to appear, in either Europe or the US.
In fact, in December US job growth actually accelerated, and unemployment rose (a rise in unemployment is good here as the it gives the Fed room to pause rate hikes).
Examining previous sell-offs, the falls over the past three months were similar in magnitude to those of 1987, which also coincided with concerns that the Fed was going to over-tighten and cause a recession. The past quarter and 1987 involved declines of around 20%, though 1987 occurred much faster.
1987 proved to be an excellent buying opportunity, with no job losses until 1990, when the first round appeared in that year’s recession. In between, the market recovered all its losses and rallied 10% further. And when the recession did finally come, years after the crash, anyone who sold out missed an incredible decade of returns.
At times, we have been able to hedge the various market downdrafts. September 2015 was positive for us, but we missed Jan 2016. We caught Jan/Feb earlier this year, but missed October. We were positioned for it, but took profits after the first 4% fall, and invested much of that in VIX premia. VIX futures which reacted so explosively in the past, spent most of the sell-off hovering around their long-term average. Now that the data comes out, much of the selling was done by momentum following CTAs and risk parity funds which reduce exposure after market falls. This perhaps broke the link between the equity indices and the options market, where discretionary managers typically look to hedge in sell-offs.
Irrespective of the causes, we have since diversified our set of hedges.
This left us exposed to the worst performing sectors globally - which were among the best performers sectors over the past few years. In many ways this seemed to be an ‘innovation sell-off’, focused on technology, biotech and growth. Betting against emerging markets is now one of the most crowded trades, according to Bank of America.
We are firm that these remain the best places to be invested, and the sharp falls of 2018 are likely to be dwarfed by the 3, 5 and 10 year returns, if not sooner.
The Fed is now on pause, and Powell’s comments on QT that triggered the worst of the December sell-off are at odds with the transcript, as it turns out that there was plenty of discussion over quantitative tightening. Powell was arguing against QT as early as 2013, so Trump has perhaps unwittingly appointed a hawk to the Fed. Nevertheless, in his latest comments he stuck to a script that reversed the comments that caused so much angst.
2018 was the year China planned to deleverage after the stimulus of 2016. This turned out to be mistimed, coinciding with Trump's imposition of tariffs. Authorities have begun to reverse the negative credit impulse in China, and have announced an additional $125 billion of railways, as well as tax cuts, and have injected funds in to the system, all over the past few weeks. They say to buy when central bankers panic.
If you combine: - a Fed Pause, - Chinese tax cuts and additional spending, - potential trade resolution, - record outflows flows from equity funds and into money funds, - an active manager underweight to technology, - a crowded global short/underweight in emerging markets, - short positions in US stocks at double the two year average, - a sharp contraction in valuations, and - sentiment that swung to a bearish extreme not seen in a decade...
and you have all the ingredients for a fairly sustained rally, though I doubt anyone wants to hear about it right now.
We are well aware of the bricks in the wall of worry, but now that positioning has shifted from a positive to a negative extreme, we believe further index falls to retest the December lows will require a deterioration in actual fundamentals.
As a point of interest, the following chart models how risk parity funds are positioning. These are some of the ‘computers’ everyone likes to blame. You can see that equity exposure was reduced significantly over the past few months.
When markets are quiet, these strategies increase their positions, and when markets start moving, they reduce them. The effect of this is that a single bad day can cause a massive unwind of positioning. Many use a 30 day window, in which case the extreme vol of December will already be starting to roll off.
If the rally continues, these strategies will be left with an up-trending market and low volatility, which will cause them to add to their positions on the long side. These kinds of buy high / sell low strategies have a persistent kind of appeal. They certainly seem to exacerbate sell-offs, but can also extend rallies. This kind of buy high/sell low reminds us of portfolio insurance, a further analogue to 1987, rather than 2007.
Similarly, using moving averages as a proxy, trend following funds will still largely be short US equities, and should the recent rally continue, the position will be reversed and the firms will be actually buying as prices rise.
Irrespective of the these positioning moves, it's the performance of our companies over the coming years that matters most. Our stocks are, on average, over 50% away from their 52 week highs, and the median is over 40%. We've been able to add to our long term investments at market lows, so the past few months have not gone to waste. We will always have a hedge part of our portfolio, even if small, so will always have at least some cash to invest when the market breaches new lows.
While our underlying companies continue to perform we'll hold our positions, and as the last couple of weeks have shown, markets can surprise to the upside, as well as downside.
Frazis Capital Partners Pty Ltd is a corporate authorised representative (CAR No. 1263393) of Lanterne Strategic Investors Pty Ltd (AFSL No. 238198). The Frazis Fund is open to wholesale investors only, as defined in the Corporations Act 2001 (Cth). The Company is not authorised to provide financial product advice to retail clients and information provided does not constitute financial product advice to retail clients.
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