Dear investors and well-wishers,
The Fund returned -14.5% net in October. This was a disappointing result in tough markets.
Broadly, the underperformance was due to our exposure to Asia, technology, a sharp contraction in biotech, and a fall in energy prices. This was the sort of month where any weakness in earnings was punished harshly.
While it’s never pleasant to have a down period, the past five or so years there have been four occasions where we’ve contracted a similar amount, and each case our long term returns remained solid. It’s not uncommon for multiples to contract across the board, though this time felt a little more severe as the move occurred over a single month, by some measures the worst since September 2008.
Our process is consistent in times like these. We will remain invested in businesses at low valuations, and hold them while our thesis remains intact. We believe the best approach at times like these is patience, and a steady hand.
We generally invest on a 3+ year basis, so hold our positions through times like these, rather than exiting due to negative movements in sentiment. As such, we’ve taken the opportunity below to outline our portfolio positioning, core holdings and the thesis behind them.
Changes to the Portfolio
We reduced two positions after the firms reported poor results. These were AAC Technologies and Adaptimmune. AAC Technologies is a smartphone supplier. The firm lost market share, as well as being caught up in the jitters over global smartphone sales. As an Asian supplier, AAC was also at the center of trade war concerns. We purchased AAC ahead of an upgrade cycle next year, but broadly, we were too early on this theme, and AAC's loss of market share suggests it may not be the best beneficiary of the theme. We still expect weak iPhone sales this year to lead to substantial growth next year. Adaptimmune announced Phase 1 trial data, which demonstrated safety, but not efficacy, which was enough to prompt a dramatic slide. The stock had rallied up until the trial result, so the total loss was less than the monthly contribution, and we exited our entire stake.
As you might expect there are opportunities amongst the market turmoil. For much of the past few years, it has been difficult to justify the valuations of the world’s leading technology businesses, many of which have carved out monopolies and invest billions, or tens of billions to maintain their positions.
Tech was the center of this sell-off, and the weakness has continued in November. However, the long term prospects of the sector are as promising as ever.
The risk in these stocks is often lowest when they are moving by +3% a day, but trade at low valuations, rather than in periods of high valuations and low volatility (such as January this year). We took the opportunity to add to our portfolio, buying Google at a little over ~10x forward EV/EBITDA.
The real disappointment this month was the minor contribution from hedging, which we were hoping to generate greater returns in markets like these.
Going into the month we had actually increased our hedges substantially, only for the relevant indices to end roughly where our strikes were. The VIX peaked at 26, with the front futures trading lower. An equivalent move to February, where the VIX peaked at over 50, would have netted over 10% to the fund, but the nature of this sell-off was different, marked by a low volatility leg down in markets. We still hold these positions, and they may yet yield a significant return, should the market panic.
A significant part of our portfolio (~31%) was invested in Asia, and much of this in technology and consumer stocks, which bore the brunt of Red October.
October was a brutal month for the region, and some indices sold off to 20 month lows.
Asian equities now trade at a ~30% discount to US equities. Foreigners withdrew from the
market en masse, and this time we were on the wrong side of these flows. Often flows like this bode well for long term returns, and indeed in November so far, Asian stocks have outperformed.
Over the long term we believe there is a great investment opportunity here, as:
Valuations are low
Policy responses have begun in earnest, for example the Chinese Government is now:
1. Allowing the use of buybacks
2. Easing financial conditions
3. Working towards relisting foreign-listed Chinese firms on Chinese exchanges
There is strong underlying performance in the companies we hold.
We have high conviction in our portfolio companies, however, given we have the tools to short companies, it was a mistake to fail to pair some of these up. Tencent was always more richly valued than Alibaba, for example, with a far lower quality income stream (gaming vs Alibaba’s advertising), and JD.com would have fared even better, given that it’s structurally unprofitable.
With the exception of AAC technologies, discussed above, our Asian stocks reported strong results.
Alibaba, for example, posted 54% revenue growth year-on-year, and was rewarded with a 14% drop in price over the course of the month.
We initially bought the stock at $76, an effective EV/EBITDA of 10.8x on today’s prices. We diluted this down as the price rose, but re-entered over the past few months, building the position back up to its original 5% weight. At one point in the month Alibaba’s valuation multiple contracted to 14x forward EV/EBITDA.
Alibaba’s core e-commerce business remains incredibly profitable, at a 41% EBITA margin. The firm is investing heavily in other businesses, so group level EBITA margin is lower, at 27%. Some of these investments, such as the firm’s VC-style investments in delivery and media and so on, seem unlikely to create significant amounts of value in the near to mid term.
However others, such as their physical-store roll-outs, cloud computing and payments processing, are already bearing fruit. Cloud computing revenue grew 90% year-on-year, while their payments arm, Ant Financial, was most recently valued at US$150 billion
(Alibaba owns 33%, representing a significant part of Alibaba’s $380 billion dollar market cap).
Alibaba recently hosted ‘Singles Day’ and recorded record sales, 27% higher than the year before, a strong performance amidst considerable macro tension.
Weibo posted ~68% organic growth year-on-year, then corrected substantially. The stock is now firmly in value territory, irrespective of growth (which we expect to continue). Assuming a near halving of growth over the next year to 34%, the firm trades on a forward EV/EBITDA of 7.8x.
This mix of valuation and growth is often very hard to find, but in October investors couldn’t seem to exit fast enough from US-listed Chinese stocks. It behooves a patient investor to take the other side of those flows.
The price has contracted to February 2017 levels, when the company was a third of the size by revenue. We maintained an average purchase price of $79, and in October the stock fell to $59, well below the February peak of $139.
After increasing in price by more than 3x, Afterpay was our largest position going in to the sell-off. After some initial weakness, the stock fell significantly after the announcement of a Senate inquiry, which lumped the firm with payday lenders.
In our opinion Afterpay is one of the friendliest forms of lending available, with customers paying nothing for the service, unless their payments are late and even then, late fees are capped. We’re not aware of any credit card or loan product which is as forgiving.
The firm uses a simple algorithm - if you default you are no longer allowed to borrow. This incentivises users to make repayments, and also ensures that Afterpay’s customer list is steadily improving. From a business perspective, the firm lends small amounts, for short periods of time (4-6 weeks on average, depending if first payment is made at purchase or not).
The lending economics for Afterpay are excellent. 4% for short term lending exceeds the rate earned by banks on credit cards. In this case, however, the cost lies with the merchant, not the customer.
Fortunately Afterpay has achieved considerable traction in the United States, accumulating 300,000 customers since May, adding to its existing 2.5 million customer register.
iQiyi is a firm in investment phase - and fell significantly in this kind of market. The firm recently announced it had increased paying subscribers by 89% year-on-year, adding 13 million subscribers over the quarter (for comparison, Netflix added 7 million). This was a solid result, but the high levels of investment required to generate the user growth, as well as comments stating that any price rises were unlikely in the near term, disappointed the market.
iQiyi has 546 million monthly active users, and 124 million daily active users, a strong outcome for a business that is less than 8 years old.
For comparison, Netflix is growing at 34%, and trades at an EV/Sales of 8.4x. iQiyi is growing at 48% and trades at an EV/Sales of 6.1x.
Both firms are strategically underpricing their offering and investing in content, aiming to build as large a subscriber base as possible, after which they will be able to justify steady price rises. This strategy is hard to value on traditional historic metrics, though even the most cynical value investor should be able to see there’s some value in a business with 89 million paying subscribers, growing at 89%.
Lundin Petroleum is a Swedish-listed oil and gas producer and represents our direct exposure to oil prices. Over the quarter WTI crude slid from $73 to $65 (and since to $56) Lundin Petroleum fell accordingly. Despite a dramatic fall, Lundin remains above our entry price, though crude prices are lower.
The firm is in the process of doubling production, and has a marginal cost of less than US$10 per barrel. Broadly, this is what we like most in commodity companies - firms that use existing production to fund step-change increases in production. The firm is dependent on oil price, but the self-funded production increase and low marginal production cost offers a strong margin of safety.
HCA was one of the few outperformers this month. The firm runs 178 hospitals and 120 surgery centers across the United States and London, with a US market share of 24.5%.
The firm has grown revenue at 5.7% per annum over the last five years.
We initially purchased the company in our old fund at $73, reflecting a 2018 EV/EBITDA of 5.0x. This is right in line with the metrics that we like - real estate backed businesses trading at 20% EBITDA yields.
HCA has appreciated significantly, and now trades at 8.5x forward EV/EBITDA, with highly favourable cash flow management, steadily purchasing new hospitals, paying a dividend of 1.1% and using the residual to buy back stock.
As an update on Fiat’s valuation, the firm now trades on an EV/EBITDA of 2.4x, and a 2018 PE of 4.8x. These numbers are likely to improve substantially, as Fiat is selling its parts business, Magneti Marelli, to a KKR-owned entity for US$7.2 billion. Magneti Marelli only contributed about $1.1 billion of EBITDA, so this is highly accretive for Fiat, and will reduce EV/EBITDA to 2.1x.
The core business is performing well, with Fiat’s most important brand, Jeep, recently announcing its 10th consecutive month of sales increases in the US.
The outlook is fairly mixed right now. In Australia, regulatory tightening has intensified as the Royal Commission put the spotlight on lending. House prices are falling in all major cities, as tighter lending standards have cut swathes of borrowers out of the market. Housing is now more affordable, but no more attainable, to those who can’t meet the new standards.
In the United States, the Fed remains intent on tightening, as a tight employment market outweighs pockets of distress in the economy.
The dramatic fall in crude is one of the few positive macro developments of recent weeks, alleviating the burden on consumers around the globe.
We generally invest on a 3+ year basis, so when market multiples de-rate like this it can be something of a test of conviction. Ultimately, monthly returns are dwarfed by years of fundamental performance, and we are focusing carefully on maintaining our exposures and focusing on fundamentals, while ignoring short term price action.
Where necessary, be assured we will exit positions when evidence turns against our investment thesis to protect capital. We are working hard to test and retest our underlying assumptions, to ensure that macro volatility remains that, and doesn’t convert to capital loss.
We are currently 96% long, and 27% short. We have hedges covering an additional 57% structured through options, as well as VIX optionality. As always, I'd be happy to discuss the portfolio in person.
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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