January 14, 2022
2021 was a successful year for the Fund, delivering investors a 31% return, outpacing the MSCI World SMID Index by 7 percentage points. The year began with financial markets focused on stocks exposed to the ‘COVID recovery’ theme and the long-awaited return of ‘value’, ostensibly a difficult environment for Fairlight’s quality approach given much of the portfolio sailed through 2020 largely unaffected. As the year progressed focus shifted to concerns on the rising spectre of inflation, new emerging coronavirus variants, China sovereign risk and the timeline of Fed tapering/rate hikes (the list goes on). While these risks are worth considering, the Fairlight investment strategy is predicated on assembling a portfolio of businesses that can prosper in any market environment. Fairlight’s experience is that while market sentiment can sway from week to week, the price of quality businesses will inevitably march to the quarterly cadence of their earnings reports. In 2021 the Fairlight portfolio in aggregate grew earnings per share by 24%, building on the resilient 1% growth delivered in 2020.
Measuring Our Performance
In 2021 the Fund celebrated its third anniversary, meaning the performance track record is now approaching a duration which we believe contains some information value (the Fairlight investment time horizon is 5+ years). The team believes the below table provides the best clarity on performance for investors and we commit to reproducing it in each annual review going forward.
Other metrics we believe provide insight into the performance of the Fund are the Upside/Downside Capture, Hit Rate and the Win/Loss Ratio (for detailed discussion on these metrics please see 2020 in Review and 2019 in Review). In 2021 the Fund delivered:
• Upside capture of 134%
• Downside capture of 147%
• A relative outperformance Hit Rate of 65% and a positive absolute return Hit Rate of 81%.
• A relative outperformance Win/Loss Ratio of 1.1x and an absolute return Win/Loss Ratio 2.2x.
Contributors and Detractors to Return
Of particular interest in the contributors/detractors is the tenure of the largest contributors. CDW and Techtronic have both been owned since the inception of the Fund while Morningstar and Constellation were first purchased in 2019. We have discussed the surprising notion that the outperformance of quality companies tends to persist for longer than expected in further detail in Why Does Quality Investing Work.
In relation to detractors:
• Angi: The core marketplace business was challenged by a shortage of service providers in the US and the costs associated with consolidating three different consumer properties into the new unifying Angi brand. The Fund continues to hold a position because of the opportunity presented by the fast-growing fixed price offering which is a unique solution for bringing the home services market online.
• Ritchie Bros: The performance of Ritchie Bros in 2021 needs to be viewed with consideration to 2020 and its counter cyclical business model. RBA was the largest contributor to portfolio return in 2020 with the stock appreciating 47%, however as the economies rebounded the availability and sourcing of second hand inventory became a key issue. In late 2021 the business made a relatively large, debt funded international acquisition which has introduced new risks. The position is still held given the long growth runway, albeit at a lower position size to reflect the new risk profile of the business.
2021 was a particularly fertile period for new ideas, with the Fund entering 2021 with 34 stocks and exiting it with 38 today. In total there was 14 new investments, one spin-off received as a dividend and 11 divestments (one of which was the result of a takeover bid). The average P/E of the new investments made was 25x, compared to an average P/E of 39x for the stocks sold during the year.
The Fund is managed with a focused eye on minimising costs and maintaining tax efficiency where possible. Turnover in 2021 was 40% with the total cost paid in brokerage for portfolio changes equating to just 0.02% of the Fund.
The Fairlight View
As we enter 2022, the Fairlight portfolio in aggregate boasts an operating margin of 26%, returns on capital of 30%, cash conversion of 108% and Net Debt/EBITDA of only 0.6x. In terms of valuation, the forward P/E multiple today is 26x, compared to 31x at the beginning of 2021 (this is a function of the earnings growth and capital recycling mentioned above). Our strategy remains unchanged, believing that a portfolio of the highest quality businesses, purchased with valuation discipline will outperform over the long term whilst protecting and preserving client capital.