Two new exposures to the value rotation

Twelve months on from the COVID-19 led market correction, the rotation to value stocks has continued as further economic re opening beckons. Locally, Consumer Discretionary and Financial stocks took the lead alongside Resources. The US 10-year bond yield continued its solid rally, rising to 1.7% by the end of the month as the US passed its mammoth $1.9 trillion stimulus package. For now at least, ongoing concern about the size of the stimulus has been offset by ongoing economic expansion and the continued rollout of COVID-19 vaccinations around the world.

There were some signs of market stress though. The first was the bankruptcy of Greensill Capital, an apparent global success story built around supply chain financing. The withdrawal of insurance coverage and then finance for Greensill’s activities sparked a dramatic collapse in the business in a few short days. It also raised the prospect of financial difficulties for some of Greensill’s creditors, including GFG Alliance, owner of steel mills including at Whyalla in South Australia. 

At the end of March, the market also saw the sudden collapse of US hedge fund Archegos Capital, managed by Bill Hwang, an erstwhile Tiger Cub protégé. Both collapses, bookending the month, highlighted the fragility of seemingly successful financial entities and also beg the question of how many other financially risky entities are yet to face a reckoning. As always, a critical first step in our investment process is to screen companies for quality, including the robustness of their balance sheet and financial resources to survive the ups and downs of the economic cycle.

In regard to PIC’s portfolio performance in March, the top absolute contributors to performance were Flutter Entertainment Plc (LON:FLTR), Crown Resorts Limited (ASX: CWN) and Bluescope Steel Limited (ASX: BSL). 

In March, FLTR reported its results for the period ending 31 December 2020 with its core business exceeding market expectations by 6%. Importantly, we believe FLTR has demonstrated a willingness to take COVID-19 windfalls and prioritise the growth in the business over the long-term. This includes increased marketing in the core Paddy Power brand in the UK and the PokerStars business. We continue to believe that companies that are willing to invest, rather than cut back, during challenging conditions are the ones that have a greater chance of emerging as long term winners in their markets.

The portfolio’s position in Crown Resorts Limited (ASX:CWN) soared in March as The Blackstone Group Inc (Blackstone) launched a bid to acquire all the shares in CWN by way of a scheme of arrangement. Blackstone first purchased a 9.99% stake in CWN in April 2020. Despite the troubles surrounding the CWN’s gaming licence in Sydney, we have always considered Crown’s underlying assets (entertainment complexes, its hotel business, apartment residences and gaming licences in major cities) to be high-quality and well supported by a strong balance sheet. We also note the improvements to CWN’s corporate governance of late. The Blackstone bid is vindication of the value we've seen in the stock.

Bluescope Steel Limited (ASX:BSL) also delivered for the portfolio in March with the market pricing in the surge in steel prices as stimulus has accelerated economic recovery. In 2015, BSL acquired the remaining 50% of North Star Bluescope Steel from Cargill Inc to move to full ownership of the business. BSL is now hurrying to finish the expansion of its American North Star business in Delta, Ohio.

The number of US steelmakers have consolidated dramatically in the past 20 years in the US but North Star has continued to grow its market share even as some of the larger players fade or leave. The completion of the North Star expansion would enable it to deliver additional steel into the market which is expected to remain strong for years to come as the new US government focuses on infrastructure spending in the years ahead.

Lloyds Banking Group (LON: LLOY)

We re-initiated a position in Lloyds Banking Group Plc (LON: LLOY) in early February 2021 following its exit in LLOY as a result of COVID-19 led volatility last year.

With Brexit largely out of the way (although finer details are still to be agreed upon) and the UK Vaccination program gaining traction, we believe the economic outlook in the UK has been improving. Anticipation of better economic conditions have resulted in higher inflation expectations and steeper government bond curves. It is our belief that LLOY is the UK’s premium domestic banking retail franchise and will be a key beneficiary of the improving economic environment in the UK. With that backdrop, we re-initiated a position in LLOY based on its view that LLOY was trading well below book value while offering considerable margin of safety on account of its strong capital position and level of provisioning.

We considered LLOY’s results for the 4th quarter for financial year 2020 to be very good with net interest margins (NIMs) surprising on the upside and credit costs trending towards mid-cycle levels. In our view, LLOY has been very proactive in managing its NIMs and one of the biggest headwinds to Net Interest Income (NII), its hedge book, will benefit from the increasing bond yields and steeper curves. LLOY is currently trading below book value while its Australian counterparts are trading above book value and offering similar through-the-cycle return profiles. We believe that LLOY offers value on an absolute and relative basis compared to the Australian banks and should significantly benefit from the improving economic conditions in the UK. The business has been setup well and while there is some risk of a new CEO reset later in the calendar year, the overall macro improvement should trump any of these headwinds.

As at 31 March 2021, LLOY comprised 2.7% of the PIC portfolio.

Select Harvests Limited (ASX: SHV)

Over the past two months, we have re-established a position in Select Harvests Limited (ASX: SHV) for the PIC portfolio. SHV is an Australian based grower, processor and marketer of almonds and almond based value-added products. The business owns and leases over 9,200 hectares of almond orchards across New South Wales, Victoria and South Australia and has two processing facilities located in Victoria. The PIC portfolio previously held SHV in 2018 and 2019 before fully exiting the position in early 2020 as the share price reached our valuation.

2020 was a tough year for SHV. The global almond price fell to its lowest level in 9 years due to a combination of COVID-19 related demand shortfalls and a record crop out of the key Californian market. SHV exports most of its almonds and therefore the price it realises for the sale of its crop is highly leveraged to global almond prices. As a result, SHV’s FY20 Net Profit After Tax (NPAT) fell 53% during the period as the realised almond price fell from $8.60 per kg in 2019 to $7.50 per kg. Whilst an ugly headline result, SHV pleasingly delivered production yields well above industry standards and disciplined cost control across both farming and processing.

The weak almond pricing environment has seen the SHV share price fall from approximately $9 in late 2019 to a low of approximately $5 in early 2021. We value SHV based on an assumption of mid-cycle almond pricing and believes the stock has recently been trading at a material discount to fair value. Whilst the short-term pricing outlook remains challenging, we are closely monitoring the intensifying Californian drought and 2021 Californian crop which early indications suggest will be smaller than the 2020 crop. We have observed that in past cycles almond pricing conditions can change very quickly.

Putting short-term price movements aside, we have a constructive view of long-term almond prices underpinned by favourable demand and supply dynamics. Global consumption has grown approximately 6-8% over the past 5 years (excluding the impact of COVID-19) as consumer focus continues to shift towards plant-based diets. We also see pressure on global supply, particularly in California as increased regulation on water usage increases the cash cost of production. The combination of slower supply growth with the possibility of supply reductions is supportive of higher almond prices moving forward.

As at 31 March 2021, SHV comprised 1.9% of the PIC portfolio

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