April 8, 2020
Whilst it gives us no joy to deliver a negative absolute return to investors (-10.4%), the Fairlight strategy outperformed the MSCI Global Small and Mid Cap index (-14.9%) for the month by 4.5% after all fees. Our one year rolling return is +8.0% as compared to -6.8% for the benchmark.
“Wisdom comes to us when it can no longer do any good”.
Gabriel García Márquez, Love in the Time of Cholera
Whilst predictions do not often come to fruition, there is wisdom in preparation. Just one month ago it was challenging to identify a catalyst to end the longest bull market in history; although valuations were generally expensive, consumer confidence was high, global macro indicators had stabilised after some softness in Q4 2019 and monetary policy was accommodative due in part to benign inflation. Over the ensuing month, the tragic outbreak of COVID-19 has led to the fastest S&P500 bear market in history.
Although Fairlight moved to preserve capital during the early onset of COVID-19, we certainly didn’t foresee the event, and we rate our odds of predicting the next major macro shock as equally woeful. So, whilst we feel most headline grabbing predictions turn out to be incorrect, we continue to minimise the impact of inevitable economic surprises through process design.
Fairlight employs the following measures to reduce risk within the portfolio:
Opportunistically increasing the quality of the portfolio
It is our intention to exit the current downturn with a portfolio in better shape than it was when we entered. Since inception, the Fund has tracked at approximately seven new investments per annum. However, since the beginning of the pandemic related market declines began a month ago, we have initiated new investments in six companies as market conditions provided an attractive opportunity to increase the quality of the portfolio. During the sell-off we purchased predominately “business-to-business” enterprises that are critical to customer operations and typically have client retention rates of 95%+, modest leverage and high returns on invested capital.
Businesses sold are those generally serving consumers, especially those exposed to the auto market – a sector we observe to be facing similar challenges to 2008/9. We have also recycled capital from defensive names that have performed comparatively well, in some cases delivering a positive return over the past month, into growth businesses that sold down by 35% or more.
The Fairlight Global Small and Mid Cap portfolio metrics remain attractive with the aggregate cash return on capital invested currently 64% and net debt to EBITDA (a proxy for cash flow) currently 1.0x. Our debt levels compare favourably to both the US small cap market (Russell 2000) and large cap market (S&P500) as we have largely avoided highly acquisitive companies or those that have leveraged their balance sheets to excessively repurchase shares (see Figure 1). The investment team continue to be in close contact with investee companies and feel confident they have sufficient liquidity to weather a range of economic environments.
The Fairlight View
It is important to remember the outlook for markets is not the same as the outlook for the economy. The US had one of its worst recessions in history in 2009, and yet most indices had one of their best years in history at the same time. In fact, when evaluating bear markets from 1932 – 2009, the average annualised S&P500 return from the bottom of the bear market to the end of the recession was 66%. Generally speaking, waiting for economic data to improve before investing in equity markets means waiting too long.
We expect media headlines to deteriorate over the coming months, and we have not yet seen the full extent of earnings downgrades by sell side analysts. However, we also see compelling opportunities to own businesses previously deemed to be forever excluded on valuation grounds. Interestingly, US company executives and founders see value in their respective share prices also, with the ratio of companies with insider buying the highest it has been since March of 2009. The team is confident in the 3-5 year outlook for our recent additions, and for our fund in aggregate.