June 20, 2022
Due to Fairlight’s long term investing horizon we prefer to analyse performance on an annual basis and avoid short term commentary where possible. That said, there is no avoiding the fact that 2022 performance to date has been disappointing on both an absolute and market relative basis, which we believe warrants further explanation. In this piece we will highlight the headwinds currently facing the portfolio, explain portfolio changes and provide an update on the recent reporting season and the current outlook for the portfolio.
Historically the Fairlight Fund has proven to be relatively defensive in difficult markets – as was the case in late 2018 and early 2020 – but in 2022 the Fund has for the first time underperformed a falling market.
Earlier in the year we outlined the two primary reasons for this relative underperformance and they remain true still through to the end of May:
1. The only industries that have delivered positive returns year-to-date have been energy, metals, infrastructure and utilities. Fairlight’s investment process is focused on high-quality businesses that can generate consistent and high returns on invested capital – which in practice means the Fund will typically have very low exposures to these sectors which are commonly associated with either low or inconsistent returns. Fairlight’s preferred industries of consumer, industrials, commercial services, healthcare and technology have all delivered negative returns year-to-date which the Fund has not been immune from.
2. Fairlight’s investment style is anchored in the blending of small and quality styles of investing. Year-to-date both these styles of investing have underperformed the broader market. It is very unusual for both small and quality styles of investing to underperform at the same time and historical record suggests that it would be surprising if this was to persist for an extended period of time.
While significant price declines have been widespread across the portfolio, Fairlight has been encouraged by the strong earnings growth delivered in the recent reporting season. Despite the markets well-founded concerns on the impact of inflation, so far we have witnessed our companies leverage their strong competitive positions and pricing power to successfully pass on cost inflation to protect margins. As we reach the midpoint of 2022, our estimates indicate the portfolio is on track to maintain flat operating margins year over year (at 27%) and deliver 15% EPS growth. Our strategy remains unchanged and we have not made wholesale changes to the Fund in response to recent performance with the turnover in line with its long term average.
That said, the disconnect we are witnessing between fundamentals and the market’s current perception of future prospects has provided opportunities to increase our investments in many high quality businesses we believe are trading at substantial discounts to our view of fair value. In 2022 we have made the following portfolio changes:
• Sales: In total 6 investments have been sold. Three where Fairlight identified an error and exited the position, two where management made large, unexpected acquisitions and one on valuation grounds.
• Purchases: Only one new investment has been introduced to the portfolio. The majority of capital has been directed towards increasing our holdings of existing investments, generally where we have seen confirming evidence of our investment thesis build over several years. So far in 2022 we have increased our investment in 18 different existing portfolio holdings.
Given the attractive opportunities we see across the portfolio and our bench of ideas, the Fund is currently fully invested.
We recognize that negative returns are painful and this pain is shared by the Fairlight team who are all substantial investors in the fund. However negative returns do come with a silver lining – the prospect for higher future returns. The returns that investors will make over the next few years are a function of three variables:
1. Valuations today: Figure 1 shows that currently the global small and mid cap universe is trading at its most attractive valuation since 2013. Somewhat surprisingly the global small and mid cap market is even cheaper today than was the case in March 2020 at the peak of concerns around COVID-19. The current valuation of 13x next twelve months earnings is very attractive in the context of the history of the asset class.
2. Earnings growth: The Fairlight Fund has since inception delivered 13% annual earnings per share growth. While there is always some uncertainty when it comes to forecasting, our current best estimate for 2022 is for the Fund to deliver 15% earnings per share growth which is in line with the longer-term history.
3. Valuations in the future: This is ultimately unknowable today, but one can highlight that today’s valuation of 13x appear conservative when compared to the median historical valuation of the global small and mid cap asset class of 16x.
It isn’t just the view of the Fairlight team that our portfolio represents very good value today – it is also the opinion of the management teams of our portfolio holdings. Figure 2 shows the change in the buyback yield of the Fairlight Fund over the past year and compares this against our benchmark. The current trailing weighted average buyback yield of the fund is 3% which is the highest it has been since the inception of the fund. Management of our portfolio companies clearly view current prices as attractive and have been buying back their company stock.
The Fairlight View
The philosophy with which Fairlight manages the portfolio is well established, and we continue to manage the portfolio with the view that a sufficiently diversified collection of high-quality growing businesses purchased at reasonable prices will outperform over the long term.
Figure 1. Valuation of the global small and mid cap universe
Figure 2. Buybacks have accelerated in the Fairlight portfolio this year