Commentary
account for around 50% of operating profit and are historically stable businesses which have grown at mid-single digit rates per year over the last decade. Beauty makes up the other half and has grown at 19% per year in the five years preceding COVID, driven primarily by its luxury skin care brand Whoo in China.
A large part of Whoo sales are to Chinese consumers through duty-free stores in Korea. This channel has been hit by COVID related travel restrictions as well as recent rebate negotiations between Korean duty-free stores and resellers, which has also impacted peers such as Estée Lauder and Amorepacific. These effects led to a decline in Beauty sales of over 30% between 2019 and 2022. As travel between Korea and China returns to normal, we expect to see sales recover.
The current valuation of the ordinary shares is at 15 times forward earnings – near the lowest levels in the company’s history. Its long-term average is at 23 times and its peers currently trade on around 30 times earnings. The preference shares, which were purchased for this strategy, trade at a 60% discount to the ordinary shares despite having marginally better economic rights (a slightly higher dividend). Therefore, the preference shares are effectively valued at around six times earnings – a bargain based on our view of the company’s solid HDB and Refreshment businesses recovery potential in Beauty and net cash balance sheet.
We also purchased North West Company (NWC) during the month. NWC is a leading retailer to rural and under-served small population communities primarily in northern Canada and rural Alaska. NWC operates more than 220 stores primarily through its banners Northern, Quickstop and Alaska Commercial Company. The communities served have populations which are often less than 1,000 people. Most of NWC’s customers are dependent on government transfer payments and the purchases are mostly non-discretionary (80% of sales are food products).
Due to the vast geography of NWC’s store network, we believe its main competitive advantage is logistics. In Canada, most of NWC’s stores are inaccessible by roads and all the Alaksa stores are serviced by air or water transportation. As an example, NWC owns a cargo airline used to bring products from its fulfilment centres to these remote locations. Due to the complexity of serving these small populations, NWC is often the only retailer in its communities and is insulated from online competition. As a result of these favourable competitive dynamics, NWC generates highly attractive returns (10-year average ROE is 22%) despite very modest leverage.
The main challenge for NWC is growing its store base due to the rural nature of the communities served. This is somewhat mitigated by NWC historically generating low single-digit same store sales growth (pre-COVID 10-year average of c. 2%). Due to low capital requirements for both new and existing stores, NWC has historically returned c. 80% of earnings to shareholders through dividends and, more recently, buybacks.
Overall, NWC has several fundamental characteristics that we like: strong competitive position, low disruption risk, non-discretionary purchases, high returns on capital, same store sales growth and a strong balance sheet.
Businesses with these characteristics are usually not available at attractive prices. However, NWC has de-rated in recent months due to operating margin pressure. In the most recent quarter, operating margins dropped to 5.7% from 7.5% in the previous quarter. The decline was primarily due to cost inflation impacts including higher staff costs and fuel-based utility expenses. We believe NWC will be able to pass on these cost increases to customers albeit with some delay. This temporary headwind allowed us to buy NWC at what we believe is an attractive price.
On consensus estimates, NWC currently trades at 12x FY1/24 earnings compared to its historical average above 15x earnings. Assuming margin recovery, continued same store sales growth and 15x P/E, we see more than 70% upside to the current price. A big part of the upside is from dividend income due to the high payout ratio.
The final change during the month was a switch of Synchrony Financial into Ally Financial. The trigger for the switch was Synchrony, the US Credit card business, is facing the possibility of having late fees on credit cards capped at $8 a month by the US government. This would have a large impact on revenue and a much larger impact on profitability, possibly around 50%. Although Synchrony can take actions to offset the impact, we feel that there is too much regulatory uncertainty to own the shares today. We continue to like Synchrony’s business model and we believe the company is well managed and attractively priced. In our view, Ally shares these characterises but without the regulatory risk which made the switch attractive. Since purchase Synchrony has provided a negative attribution of -1.7%.
Ally has been through a material change over the last decade and a half. In 2009 it was rebranded as Ally, having previously been GMs lending business, and listed in 2014.
Today Ally has c.$135bn of loans outstanding split $95bn in auto loans ($80bn of auto consumer loans, $15bn of auto floorplan loans), $20bn of mortgages and $10bn corporate finance loans. There are also a further $10bn auto leases and $35bn of investment securities, of which $5bn are for the insurance business. 87% of Ally’s funding is deposits, 92% of which are insured.
The most recent wave of improvement to net interest margin (NIM), the difference between what a bank earns on loans and pays on interest on deposits, has been hidden by the increases in the Fed Funds rate. Ally has a duration on its assets of 2-3 years which means it takes time for increased rates to filter through to the loans. Given the sharp rise in interest rates, Ally has seen NIM pressure to around 3.2%. Currently Ally is writing new business with a NIM above 4%.
Other than the NIM pressure the biggest issues facing Ally today is the price of used cars, the possibility of a credit cycle and the increased risk of regulation of liquidity and capital. All of these are understandable and manageable risks. They are also unlikely all to play out simultaneously, i.e. if there is a slowdown in the economy then the risk of a credit cycle rises but some of the NIM and capital issues go away. Furthermore, FED stress test show that Ally can withstand a severe downside scenario like 2008-09 without new capital.
We believe the company has earnings power at least as good as history which we assume is around $1.5bn. With 300m shares outstanding, earnings per share is c.$5.2 implying a low to mid teen return on equity. At 10x PE, fair value is around $50 a share, 90% upside and the company pays a dividend of over 4%.
The upside of the portfolio is 75% up from 65% last month because of the opportunities we are finding. This compares favourably with the long-term average of 40%. In terms of valuation, only two of the current holdings have an upside below 40%. The fund is trading on a price-to-earnings multiple of 10x on forward earnings compared with the MSCI World on 19x and provides a dividend yield of nearly 3%.
Russian holdings
Please note that on 3rd March 2022 the Fund’s investment in Lukoil ADR listed on the London Stock Exchange (LSE) was suspended from trading. Our Valuation Committee considered it was in the Fund’s best interests that the holding of Lukoil ADR be fair value priced (FVP) at zero. In June 2022, we elected for the holding to be converted into local shares (Lukoil PJSC).
Given the current international sanctions on Russian securities and cash balances, we believe that if lifted and the Fund was able to access the local market, the holding in Lukoil PJSC (with a current FVP of zero) would represent 13% of the Fund and cash dividend of 2.0%. On 22nd August 2023 a Reuters article suggested that Lukoil was planning to repurchase 25% of its shares from foreign shareholders. The repurchase price would be at least a 50% discount from the quoted price. We continue to monitor the situation closely.
Commentary
The fund fell 0.7% in August while the MSCI World High Dividend Yield Index fell 0.8%. The largest negative contributors to performance were, in order of impact, Allegiant Travel (-27.8%, total return in local currency), Alibaba (-7.5%) and Samsung Electronics (-4.2%).
Allegiant performed poorly on the back of increased concerns about falling ticket prices in the US market. Allegiant has executed substantially better than peers over the last twelve months, despite this the shares languish near their Covid lows. Currently the company is trading on 8 times 2023 earnings guidance compared with a long-term median of 17 times. As an airline the earnings per share are volatile but these have grown at close to double digits over the last ten years. Sales per share, which excluding Covid are less volatile, have grown at over 10% per annum over the last decade. We took the opportunity to increase the holding and funded it with a sale of the remaining position in easyJet. We still believe easyJet is attractively positioned among European low-cost airlines with protected positions in slot-constrained airports, a strong balance sheet and attractive valuation. Allegiant shares these characteristics but has better growth prospects, better management alignment and a more attractive valuation. Since the time of purchase easyJet has provided a negative attribution of -1.5% and Allegiant a negative attribution of -3.1%. Hence, the switch reflects our positive view on Allegiant rather than a negative view on easyJet.
The largest positive contributors to performance were IWG (+17.2%), JD Wetherspoon (+7.0%) and Fairfax (+5.9%).
Other than the disposal of easyJet to increase the holding in Allegiant it was a busy month for the portfolio. We sold the remaining positions in Siemens and Colliers as they had relatively limited upside, from the point of purchase the two holdings provided a positive 4.1% and 1.3% attribution respectively. Siemens has been held since the inception of the fund 12 years ago. The proceeds were invested in the preference shares of LG Household & Healthcare (LG H&H). LG H&H is a Korean consumer goods company with three core businesses: Home Care & Daily Beauty (HDB), Refreshments (primarily Coca-Cola bottling) and Beauty (skin care). Since its IPO in 2001, LG H&H has grown revenues per share by nine times, improved its balance sheet from net debt to net cash and provided a total shareholder return of 20% per year. HDB and Refreshments
Commentary
account for around 50% of operating profit and are historically stable businesses which have grown at mid-single digit rates per year over the last decade. Beauty makes up the other half and has grown at 19% per year in the five years preceding COVID, driven primarily by its luxury skin care brand Whoo in China.
A large part of Whoo sales are to Chinese consumers through duty-free stores in Korea. This channel has been hit by COVID related travel restrictions as well as recent rebate negotiations between Korean duty-free stores and resellers, which has also impacted peers such as Estée Lauder and Amorepacific. These effects led to a decline in Beauty sales of over 30% between 2019 and 2022. As travel between Korea and China returns to normal, we expect to see sales recover.
The current valuation of the ordinary shares is at 15 times forward earnings – near the lowest levels in the company’s history. Its long-term average is at 23 times and its peers currently trade on around 30 times earnings. The preference shares, which were purchased for this strategy, trade at a 60% discount to the ordinary shares despite having marginally better economic rights (a slightly higher dividend). Therefore, the preference shares are effectively valued at around six times earnings – a bargain based on our view of the company’s solid HDB and Refreshment businesses recovery potential in Beauty and net cash balance sheet.
We also purchased North West Company (NWC) during the month. NWC is a leading retailer to rural and under-served small population communities primarily in northern Canada and rural Alaska. NWC operates more than 220 stores primarily through its banners Northern, Quickstop and Alaska Commercial Company. The communities served have populations which are often less than 1,000 people. Most of NWC’s customers are dependent on government transfer payments and the purchases are mostly non-discretionary (80% of sales are food products).
Due to the vast geography of NWC’s store network, we believe its main competitive advantage is logistics. In Canada, most of NWC’s stores are inaccessible by roads and all the Alaksa stores are serviced by air or water transportation. As an example, NWC owns a cargo airline used to bring products from its fulfilment centres to these remote locations. Due to the complexity of serving these small populations, NWC is often the only retailer in its communities and is insulated from online competition. As a result of these favourable competitive dynamics, NWC generates highly attractive returns (10-year average ROE is 22%) despite very modest leverage.
The main challenge for NWC is growing its store base due to the rural nature of the communities served. This is somewhat mitigated by NWC historically generating low single-digit same store sales growth (pre-COVID 10-year average of c. 2%). Due to low capital requirements for both new and existing stores, NWC has historically returned c. 80% of earnings to shareholders through dividends and, more recently, buybacks.
Overall, NWC has several fundamental characteristics that we like: strong competitive position, low disruption risk, non-discretionary purchases, high returns on capital, same store sales growth and a strong balance sheet.
Businesses with these characteristics are usually not available at attractive prices. However, NWC has de-rated in recent months due to operating margin pressure. In the most recent quarter, operating margins dropped to 5.7% from 7.5% in the previous quarter. The decline was primarily due to cost inflation impacts including higher staff costs and fuel-based utility expenses. We believe NWC will be able to pass on these cost increases to customers albeit with some delay. This temporary headwind allowed us to buy NWC at what we believe is an attractive price.
On consensus estimates, NWC currently trades at 12x FY1/24 earnings compared to its historical average above 15x earnings. Assuming margin recovery, continued same store sales growth and 15x P/E, we see more than 70% upside to the current price. A big part of the upside is from dividend income due to the high payout ratio.
The final change during the month was a switch of Synchrony Financial into Ally Financial. The trigger for the switch was Synchrony, the US Credit card business, is facing the possibility of having late fees on credit cards capped at $8 a month by the US government. This would have a large impact on revenue and a much larger impact on profitability, possibly around 50%. Although Synchrony can take actions to offset the impact, we feel that there is too much regulatory uncertainty to own the shares today. We continue to like Synchrony’s business model and we believe the company is well managed and attractively priced. In our view, Ally shares these characterises but without the regulatory risk which made the switch attractive. Since purchase Synchrony has provided a negative attribution of -1.7%.
Ally has been through a material change over the last decade and a half. In 2009 it was rebranded as Ally, having previously been GMs lending business, and listed in 2014.
Today Ally has c.$135bn of loans outstanding split $95bn in auto loans ($80bn of auto consumer loans, $15bn of auto floorplan loans), $20bn of mortgages and $10bn corporate finance loans. There are also a further $10bn auto leases and $35bn of investment securities, of which $5bn are for the insurance business. 87% of Ally’s funding is deposits, 92% of which are insured.
The most recent wave of improvement to net interest margin (NIM), the difference between what a bank earns on loans and pays on interest on deposits, has been hidden by the increases in the Fed Funds rate. Ally has a duration on its assets of 2-3 years which means it takes time for increased rates to filter through to the loans. Given the sharp rise in interest rates, Ally has seen NIM pressure to around 3.2%. Currently Ally is writing new business with a NIM above 4%.
Other than the NIM pressure the biggest issues facing Ally today is the price of used cars, the possibility of a credit cycle and the increased risk of regulation of liquidity and capital. All of these are understandable and manageable risks. They are also unlikely all to play out simultaneously, i.e. if there is a slowdown in the economy then the risk of a credit cycle rises but some of the NIM and capital issues go away. Furthermore, FED stress test show that Ally can withstand a severe downside scenario like 2008-09 without new capital.
We believe the company has earnings power at least as good as history which we assume is around $1.5bn. With 300m shares outstanding, earnings per share is c.$5.2 implying a low to mid teen return on equity. At 10x PE, fair value is around $50 a share, 90% upside and the company pays a dividend of over 4%.
The upside of the portfolio is 75% up from 65% last month because of the opportunities we are finding. This compares favourably with the long-term average of 40%. In terms of valuation, only two of the current holdings have an upside below 40%. The fund is trading on a price-to-earnings multiple of 10x on forward earnings compared with the MSCI World on 19x and provides a dividend yield of nearly 3%.
Russian holdings
Please note that on 3rd March 2022 the Fund’s investment in Lukoil ADR listed on the London Stock Exchange (LSE) was suspended from trading. Our Valuation Committee considered it was in the Fund’s best interests that the holding of Lukoil ADR be fair value priced (FVP) at zero. In June 2022, we elected for the holding to be converted into local shares (Lukoil PJSC).
Given the current international sanctions on Russian securities and cash balances, we believe that if lifted and the Fund was able to access the local market, the holding in Lukoil PJSC (with a current FVP of zero) would represent 13% of the Fund and cash dividend of 2.0%. On 22nd August 2023 a Reuters article suggested that Lukoil was planning to repurchase 25% of its shares from foreign shareholders. The repurchase price would be at least a 50% discount from the quoted price. We continue to monitor the situation closely.
Commentary
Commentary
Commentary
Commentary