Value Investing

OC Premium Small Companies Mandate January 2016 Commentary

OC Premium Small Companies Mandate commentary for the month ended January 31, 2016.

OC Premium Small Companies Mandate – Performance review

Following a broad-based sell-off in global equity markets in January, the OC Premium Small Companies Fund finished the month down 6.2%. This was behind both the S&P/ASX Small Ordinaries Accumulation Index and the S&P/ASX Small Industrials Index which returned -5.1% and -5.2% respectively. The Fund has a strong long-term track record having returned +12.5% p.a. over the past five years. This is well ahead of both the S&P/ASX Small Ordinaries Accumulation Index and the S&P/ASX Small Industrials Index which returned -3.1% and +7.3% respectively over the same time horizon.

The OC Premium Small Companies Fund has typically held up well in falling markets due to our heavy focus on risk management and our aversion to investing in speculative stocks which tend to fall disproportionally more in an equity market pull-back. However, the January sell-off was broad based and a number of our high-quality names were sold down during the month on no news flow (as most of our companies were in “black-out” ahead of the February reporting season). We do, however, have to confess to a couple of “own goals” in the form of earnings downgrades during the month from portfolio holdings, namely Lovisa and Simonds Group. This dragged the performance of the Fund below the benchmark for January.

While we are never happy when one of our companies releases an operational earnings update which is below the market consensus forecast, it can happen from time to time. Under our disciplined investment process, we will typically exit the stock unless the downgrade can be explained by an abnormal or one-off event or it has already been factored into our modelling and valuation.

OC Premium Small Companies Mandate

OC Premium Small Companies Mandate – Portfolio attribution

Lovisa (LOV) (-38.9%) – a specialist retailer of fast fashion women’s jewellery, released an unexpected earnings downgrade which was approximately 14% below our internal forecasts. The downgrade was largely driven by gross margin pressure which came about due to several product lines selling below expectations and needing clearance sales to clear the excess inventory. This was exacerbated by the impact of a falling Australian dollar on cost of goods sold with price rises unable to fully offset the impact of the currency hit. We were surprised by the announcement given our recent contact with management pre-earnings “blackout” was quite positive, particularly with respect to the company’s offshore operations. While we are attracted to LOV’s fast fashion model and still see strong potential for offshore expansion, we have taken the conservative approach of exiting the stock, preferring to wait and see if management can steady the ship and restore credibility before we would consider the company for the portfolio again.

Simonds Group (SIO) (-54.3%) – released the results of its previously announced strategic review and underwhelmed the market by disclosing that its core homes business had significantly underperformed market expectations. The company confirmed it was closing its Madison Projects division which was foreshadowed in the December quarterly investment review. Both the quantum of the write-down associated with the closure of Madison Projects and the deterioration in the core homes business underwhelmed us. Additionally, the management of the company remains in limbo as the search for a permanent CEO continues and we have begun to exit our stake in the investment.

Equity market leverage works to the upside as it does to the downside for funds management stocks so it was not surprising our listed fund managers, namely Magellan Financial Group (MFG) (-16.5%), Henderson Group (HGG) (-13.3%), BT Investment Management (BTT) (-17.2%) and Pacific Current Group (PAC) (-14.2%), were all sold down during the month. These companies continue to have sound thematics underpinning their growth including strong underlying products, excellent distribution channels and credible brands. They remain core portfolio holdings for the Fund.

Baby Bunting Group (BBN) (+10.5%) – there were some bright patches during the month including the performance of recent portfolio addition, BBN, which continues to re-rate as the market becomes more familiar with its business model. BBN has an established brand and a current footprint of some 33 stores. We expect BBN management to roll out six stores per annum over the next six years, effectively doubling its presence in the Australian market and driving significant scale and synergy benefits for the group. The competition continues to struggle with large NSW competitor My Baby Warehouse’s NSW division entering administration in December. Though BBN is now trading at a significant premium to the market PE multiple, we believe the medium to long-term growth prospects of the business are outstanding and we remain comfortable holders of the stock.

M2 Communications (MTU) (+10.0%) – portfolio stalwart, MTU, enjoyed a strong month which culminated in shareholders’ overwhelming approval of the proposed scheme of arrangements in relation to the merger with Vocus Communications. We remain optimistic about the prospects for the merged group which will result in the creation of a full-service vertically integrated, infrastructure-backed trans-Tasman telco. The combined management team led by MTU CEO, Geoff Horth, is highly regarded by the market and we expect strong revenue growth and cost synergies to be extracted in the coming years. The merged group will be in a strong strategic position to capitalise on the NBN in Australia and UFB in New Zealand and has a suite of products that are relevant to the consumer, corporate and government markets.

OC Premium Small Companies Mandate

OC Premium Small Companies Mandate – Outlook

A raft of earnings downgrades from companies in late January and early February added to recent global macroeconomic concerns and exacerbated investor nervousness ahead of the February reporting season. In late January, the International Monetary Fund again downgraded its forecast for global growth this year (down 0.2% to a forecast of 3.4%), warning that economic turmoil in China and potential contagion throughout emerging markets could derail global growth.

The domestic economic environment remains challenging and, outside of a buoyant labour market, there is little evidence the Australian economy will rebound any time soon with the transition to east coast-led growth continuing to lack meaningful momentum.

As flagged in the December quarterly review, the era of zero interest rates in the US finally came to an end in December. The US economy remains broadly on track, although the strength of the US dollar is impacting the competitiveness of the country’s exports which is likely to constrain growth in the coming year. We have little exposure to US exporters in our portfolio and the stronger US dollar ought to be a net positive for several of our holdings due to the translational impact of companies’ offshore earnings (e.g. Hansen, Fisher & Paykel Healthcare, Ardent Leisure, Pacific Current Group, Servcorp).

In recent commentary, the US Federal Reserve has cast doubt over the speed at which interest rates will be normalised with concerns about the global economy front of mind. Given the tightening in financial conditions in recent weeks, we now expect the Fed to leave rates on hold in the coming month and possibly even return to zero rates if things deteriorate further.

China remains a key focus with investors continuing to be worried about the Central Government’s ability to transition the economy from one based on investment and external demand to one driven by domestic consumption. While this concern is not new, there is an increasing belief the government may soon embark on a further round of more aggressive devaluation of the renminbi in a bid to stem the outflow of capital and make China’s exports more globally competitive. The concern is that this could lead to so called ‘currency wars’ where other major central banks retaliate with their own currency adjustments, a game in which there are likely to be few winners and could amplify global financial instability.

According to the IMF’s chief economist, Maurice Obstfeld, there hasn’t been any significant shift in the fundamentals of the Chinese economy over the past six months. Rather, it is the environment of uncertainty about the health of the Chinese economy that is fuelling market volatility. According to Obstfeld, markets “are very spooked by small events that they find hard to interpret”.

The falling oil price continues to drag on markets as the price of WTI Crude approaches US$28 per barrel with little evidence the global supply glut will dissipate any time soon. While a lower oil price is a positive for Australian consumers and other countries that are net oil importers such as the US, Japan and most of Western Europe, oil is increasingly being viewed as a proxy for global growth and its decline is weighing heavily on global stock markets.

In times of heightened volatility we try to look through the noise in the press and from economic commentators and focus on our own views of the macro-economic environment and the fundamentals of our portfolio in order to draw our own conclusions. We remain comfortable with our positioning ahead of the February reporting season and will report back to our investors on the performance of our companies and their outlook in our next monthly review.