John Hempton’s Bronte Amalthea Fund commentary for the month ended September 30, 2016.

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The Bronte Amalthea Fund is a global long/short fund targeting double digit returns over the long term, managed by a performance orientated firm with a process and portfolio that is genuinely different. Objectives include lowering the risk of permanent loss of capital and providing global diversification without the market/drawdown risks typical of long-only funds. A highly diversified short book substantially reduces risk and enables profits to be made in tough markets. The fund is an alternative to equity investing, and complement to most portfolios, and is typically an excellent diversifier which may lower overall portfolio risk.

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Bronte Amalthea Fund – Commentary

Global markets were down when measured in Australian dollars and the fund also declined this month. The present environment looks to be a great time for short-sellers. We observe many low-quality stocks trading at high valuations that we believe will eventually trade at low valuations. We have made money on shorts and we expect to continue to make money on shorts.

Bronte Amalthea Fund

Bronte Amalthea Fund

Alas it’s a difficult time for value investors. Finding good companies trading below their true value—the daily business of a value investor—has not been easy. And by-and-large our value-oriented longs have not performed.

And we only have a partial solution.

But let’s outline the value problem.

Steven Bregman of Horizon Kinetics gave an interesting presentation at a recent Grant’s conference (of Grant’s Interest Rate Observer fame). He noted that the returns for taking risk are not high and shared this list of bonds and their returns:

Bronte Amalthea Fund

This is not encouraging. For holding US 10-Year Treasuries, one can earn 1.7 percent. That is better than most European bonds which are negative yield. But the returns for taking very large and very real risks are not good. Russian Federation bonds yield only 60 basis points more. Taking “Vladimir Putin risk” for the princely sum of 60 extra basis points of return looks like a bad trade to us, but it is where markets have been forced for lack of obvious values.

The stand-out high return asset there is Wendy’s CCC+ ten year bonds for 6.9 percent – giving you an extra 5.2 percent over Treasuries for carrying the risk of a hamburger joint. Hamburger risk, if you’ll pardon the pun, sounds more digestible than Putin risk—until you look at the balance sheet of Wendy’s, which is very highly levered largely from company stock repurchases. Historically, credit ratings in the single-B and double-B range are given to debt instruments that should repay you provided nothing within the usual range of expectations goes wrong. Credit ratings in the CCC range are reversals of that – holders get paid only if something goes right. Risking a substantial loss of principal to earn a 5% extra return does not seem sensible to us. Ultimately we have little solution for this other than to observe that value stocks are getting a little cheaper.

Our longs have mostly been “value stocks,” which have generally underperformed the broader market. We got some longs sort of right (without any hits and more than a few small losses) and our shorts have made some money. The result is very small net losses, a result we think acceptable but not good. We are unwilling to take a lot of extra risk to receive only a little extra return. A good business can be a losing investment if purchased too dearly. We would of course be better off had we owned only the hottest momentum names – but we will never chase momentum this late in a business cycle. It’s a strategy that works well until it doesn’t and we doubt our ability to “jump off” momentum-driven stocks better than others3.

At some point our shorts will work extremely well. We are short what we believe to be some truly awful companies, and we are proud of our ability to unearth them, and we are investing in tools to improve this process.

We continue to actively search for quality stocks to buy at the right price. One option would be to simply hold cash until the time when valuations are more appealing. But as we can find what appear to be highly attractive shorts, we much prefer these as they can actively generate cash when the market turns. The goal is to be well positioned when stocks become cheap. Whilst we find this market difficult as value investors, we remain convinced of the attractiveness and eventual success of the strategy.

Still the main purpose of this note is to share some stocks we have been buying. This should tell you how we spend our days.

Albany International

John blogged about this company but did not give away the whole story. The original blog post is here.

Background

Albany is a high-tech weaving company whose main business (where it is the world leader) is machine clothing: the fabric used as a conveyor belt in paper mills. Paper is formed from pulp slurry spread on a belt that allows the water to be drained away. Each of the process stages in which paper is rolled between large rollers and the conveyor belt that carries it requires a tailored type of machine clothing.

This is naturally a pretty good business, as better machine clothing makes better or cheaper paper, and switching one’s supplier is difficult once a paper plant is optimized. Moreover, machine clothing is a consumable, and is thus not hugely vulnerable to the paper capital equipment cycle. Alas there are competitors – most notably the papermaking machine OEMs – but even the competitors we find seem to have sustainably high margins.

This sounds attractive to an investor, but the paper industry is in decline, and thus machine clothing is a good business in decline. In the past Albany has guided for the (very slow) decline in this business, and their numbers are consistent with guidance. Some paper sectors, like tissue, are not in decline, and to the extent that Albany can steer away from newspaper and office paper they should manage. But the company explicitly says that their job is to run this business at as slow a decline as possible.

Albany International had lots of other businesses in the past but sold them all to focus on machine clothing and aerospace. Albany’s aerospace business comes from weaving carbon fibers. In the carbon fiber business there are a few dominant fiber providers (Toray in Japan, and Hexcel in Stamford for aerospace carbon fiber) and a few resin companies (e.g. Hercules).

The carbon fiber fabrics are mostly made by formerly high-tech fabric makers. Almost all carbon fiber weaving companies started at the technical end of fabric manufacture.

Albany’s position in aerospace looks good – but there is almost no revenue now (about $100m), and it runs at a loss. They have projected $450 million in revenue in a few years.

Our work program consisted of verifying that revenue guidance and estimating the associated margin.

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