January 7, 2021
2020 was a successful year for the Fund, delivering investors an 11% return, exceeding the MSCI World SMID Index by 6 percentage points. These returns were achieved in a year that clearly illustrated the full range of market sentiment; firstly, the extreme risk aversion on display in Q1 followed by unbridled enthusiasm in the succeeding three quarters. It is instructive to view the performance of the Fund in terms of the two distinct periods of market behaviour. In Q1, the Fund declined 10% compared to a 17% decline for the Index. In contrast, the Fund appreciated by 24% in the remainder of the year versus an increase of 28% for the Index.
Whilst the absolute returns achieved in the latter half of the year are notable, it was the Fund’s ability to protect investor capital during times of stress that was most pleasing. Fairlight’s quality-focused investment philosophy is predicated on the notion that compounding over the long term works most effectively when losses are minimised. This concept is neatly illustrated by the fact a 50% loss requires a 100% gain on the next investment just to break even.
Winning by not losing
A useful metric in illustrating the profile of returns for an investment is the Upside/Downside Capture. This metric splits returns into performance in months where the Index has appreciated versus performance in months where the Index has declined. In 2020 Fairlight delivered a Downside Capture Ratio of 0.85 (for each 1% the Index declined, Fairlight declined 0.85%) and an Upside Capture of 1.05. Since the inception of the Fund the Downside Capture has been 0.72 and the Upside Capture 1.07, a profile that is in line with the intended defensive nature of the strategy. Over the long term Fairlight aims to win by not losing. That is, if the Downside Capture delivered so far can be maintained and combined with an Upside Capture of only 1.0, the nature of compounding illustrated above means the Fund should handily outperform without needing to outpace the Index in times of ebullience.
Unpacking Fairlight’s performance
Fairlight entered 2020 with 34 stocks in the portfolio, made 14 new investments during the year and exited 14 positions, leaving the portfolio with 34 stocks today. Of the 48 stocks owned at any point during 2020, 26 outperformed the MSCI World SMID Index, a Hit Rate of 54%. Of the 22 that underperformed, only 13 delivered an absolute negative return.
From a Win/Loss perspective, the 26 ‘winners’ outperformed the index by 23% on average, compared to an average underperformance of 12% across the 22 ‘losers’, equating to a Win/Loss Ratio of 1.9x.
Another useful tool to visualise the Fund’s performance for the year is Figure 1, which plots the absolute return of each stock in the Fairlight portfolio against its average holding weight. There are two areas on the chart which warrant an explanation:
Firstly, the two large weights in AUTO and CDW which delivered a negative return. Fairlight has not identified any changes in the investment thesis for these stocks, instead it is important to view 2020’s performance in context with 2019, where CDW appreciated 78% and AUTO 38%.
Secondly, the three largest detractors of HXL, KAR and EQN:
· HXL: Hexcel derives 68% of its revenues from the Commercial Aerospace market which has been heavily impacted by COVID-19 related shutdowns. Fairlight believes these issues are temporary and that the investment thesis remains intact. As a result, Fairlight took advantage of share price weakness during the year to add to the position.
· KAR: KAR Auction Services is a provider of wholesale auctions of used/salvaged cars. It was unclear whether heavy investment in a new business line would eventually prove successful and the business was also losing executive talent. As such, during March the decision was made to exit the position.
· EQN: Equiniti is a provider of share registry services in the US and UK. Fairlight underestimated the business’ reliance on interest rate related income on its float and its negative operating leverage. With interest rates approaching zero for the foreseeable future the earnings power of the business looks to be permanently impaired. Investment thesis drift was identified and the position sold.
The Fairlight View
Looking to 2021, we believe the Fairlight portfolio is well positioned to deliver on our aim of a 10% - 12% p.a return after all fees through the market cycle with lower volatility than the index. We continue to believe a portfolio of the highest quality businesses, purchased with valuation discipline will outperform over the long term whilst protecting and preserving client capital.