Milkwood Capital June 2016 Letter – Does Not Buy Brexit “Excuse”; Returns 15% YTD

Milkwood Capital letter to investors for the month ended June 30, 2016. First some accolades – Eurohedge says that the hedge fund is one the best performing LS funds around this year (+15% ytd as of today) according to a source with direct knowledge of the matter. Rhys, the PM remains is biggest investor with about $20m in the fund – he was previously the global head of EM equity research at Citi)

To our partners in the Milkwood Fund

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Milkwood Capital  – If you don’t buy now, when will you buy?

Investors have often heard the words of Warren Buffett “be fearful when others are greedy, and greedy when others are fearful”. Yet, when such occasions present themselves, this tried and tested advice ends up being disregarded. Why?

The answer is that investing is “simple, but not easy”. If it were easy, everyone would be successful at doing it. Of course, only a very few can be sustainably successful. We like the Charlie Munger saying “It’s not supposed to be easy. Anyone who finds it easy is stupid”.

Common phrases heard at times like these are “the market hates uncertainty” or “things have changed forever” and so forth. All magnify the perceived risk and uncertainty of the situation. Risk starts being measured again in terms of volatility of share prices, not company fundamentals or the risk of permanent capital loss as it should be.

Also, we don’t believe that investing on the basis of the next world catastrophe has ever generated permanent wealth. Think of the funds that accurately predicted the banking crisis in 2008. Most, if not all, have had terrible returns subsequently. Living in fear of the next crisis means lost opportunities, and being poorer for it.

So what is required? Contrarian thinking.

Howard Marks summarised it well when he said:

"It's true that the investing herd is often wrong. In particular, it behaves more aggressively the more prices rise, and more cautiously the more they fall — the opposite of what should happen. Contrarianism is most effective at the extremes, and then only for those who understand what the herd is doing and why it's wrong. And they still have to summon the nerve to do the opposite."

For long-term investors, times like these create the opportunities to invest in companies at even more attractive prices by taking a contrarian approach. There are two parts to this. Firstly, there are companies that we think have attractive fundamentals, but because of high valuations we have not bought them. Secondly, we already own companies which are now more attractively priced. We can deploy capital at more attractive prices than just a week ago. If the world was always perfect and smooth, the opportunity for outsized returns would be zero. Therefore, embrace unpredictable events such as Brexit and view it as an opportunity. Below is an example of an attractive company we have been waiting to buy.

Greencore - A Great British Sandwich

17 million British folks might not know how to vote correctly in a referendum on their future, but we are certain most of the UK population loves a good sandwich. Greencore makes sandwiches. Lots of them. In 2015 it produced 529m sandwiches in the UK (that’s 8 sandwiches per year for every man, woman, child and Brexit supporter). It also produces other basic food products. 215m cooking sauces, pickles and condiments. Both of these segments continue to grow in the UK as eating “on the go” becomes increasingly popular.

The more attractive part of this business (in growth terms) is the US, where Greencore is just getting momentum. It sells 175m sandwiches there, but is seeing growth of over 12% annually. There is a good chance that when you buy a sandwich at a coffee shop, it’s a Greencore product.

We haven’t owned Greencore before because it has been too expensive, on 20x earnings. However, Mr Market’s recent mood swing has resulted in a 26% fall in its value (in US$ terms), we think it makes sense to buy it now.

This doesn’t mean we are oblivious to the risks. Some of these are that there will be less money in people’s pockets. The retailers may exert more pressure on margins. The 10,000 workers employed by Greencore may end up being paid more. The cost of sandwich fillings may rise. UK companies are about to start issuing profits warnings en masse as they use the Brexit “excuse” to lower
expectations. All these things can be hiccups along the way.

But the question remains, if you aren’t going to buy now, when will you buy? When the outlook is rosy again and the price is back at 20x earnings?

What about our existing portfolio?

As of Friday evening - following sharp falls in much of the market and some of our largest holdings - our portfolio had outperformed the MSCI World index by over 800bps YTD and over 1400bps since the fund’s inception. Our exposure to the UK was somewhat mitigated by some selling prior to the referendum and currency hedges put in place (Andre dragged me kicking and screaming into putting this on, so any credit should go to him, not me).

We are bound to see further volatility in markets. Our exposure to banking shares will have a negative impact on the portfolio, as will the exchange rate volatility given that we are a US$ based fund. Nevertheless, we are well positioned to take advantage of this. Over the long term, the current market gyrations will be viewed as an opportunity to invest, not exit.

Ask yourself, if you aren’t going to invest now, when exactly will you invest? Or put slightly differently, if the best house in the street was for sale at 30% below yesterday’s value, would you be an interested buyer, or seller? We sit firmly in the buy camp. The outlook in the world is never clear. Fortunately, it does not have to be in order to achieve investment success.

We look forward to taking advantage of this market volatility which will enhance our long-term returns. Should you wish to increase your investment in the Milkwood Fund, please contact Andre or myself.

Cordially
Rhys Summerton