Mid March 2024 Newsletter
“Can we blame the weather?”
I was talking with a company recently, and they were explaining recent weakness in their share price. The utility company described that analysts were worried that the weather had recently been mild. This mild weather had weakened energy prices, prices that the utility’s cash flows are sensitive to. Forward markets for energy prices extrapolated the weakness forward, as has happened in previous weather driven softness. So forward expectations were also lower. The analysts downgraded estimates and price targets for the company. Ultimately the company had more levers in their toolkit than external experts anticipated, reported a strong set of results, and a positive outlook. The stock popped. This whole process started with weather, a highly unpredictable and volatile factor.
Here in Southern California, known for our mild weather, we have actually had surprisingly strong rain over the past six months. We’ve had drought for many years, so this was welcome. But some areas were able to handle this better than others. In Rancho Palos Verde (“RPV”), an area near my home known for its rolling hills, steep canyons, rock outcrops and bluffs, these rain events were not welcome. Even without the rain, RPV had tens of homes that as recently as last Summer were moving and collapsing under shifting ground. Landslides accompanied the heavy rains in February, and more homes in this area sadly collapsed. Besides the fact that the terrain is not flat, RPV has a particular issue with the soil beneath the beautiful views of the Pacific. Something called Benzonite Clay is highly present in the soil underneath RPV. And Benzonite Clay does not handle either being overly dry, or saturated with water, very well. In both instances it is likely to shift, and with it brings cracks in home foundations and buried infrastructure such as water and gas lines.
Source: Los Angeles Times
I thought about my conversation with the utility, as well as the vulnerable homes in RPV, when reviewing the last four to five months of performance for Ballina. To put it mildly, our strategies have struggled on a relative basis. We underperformed against markets that were reasonably positive. Stock selection has been poor. We’ve had stocks that have done well in this period. But we had more than one or two that were weak, against a rising market. Now, as many of you are aware, we have a sell discipline at Ballina Capital. We do not profess to be perfect on timing of stocks, so when one stock is hurting us quite a bit, we will take the perspective that the timing was poor, and trim or exit. This approach works fine when there are one or two stocks that are experiencing weakness. This sell discipline is less effective when there are five or six stocks experiencing weakness.
A weak period like this means that we have to roll up our sleeves and dig deeper on what is happening with the companies that have these ever more depressed share prices. Is their weakness due to transitory issues like the weather? Or is that too many of these companies have fundamental issues in their soil or foundation that will prove to be longstanding issues? We ended up reviewing fourteen different stocks.
What were the main takeaways from our work? 1) The vast majority of these companies, roughly 70%, were Small Cap (under our definition of less than $5bn Market Cap, USD). 2) Slightly less than half could be described as Emerging Market companies, 3) China and Hong Kong accounted for a little under 30% of the bad actors, 4) There was not one dominant sector but the pain sectors that were most common were Consumer Non-Cyclicals (specifically EM) and Financials. 5) More than 85% of companies had bottom line earnings downgrades in the past six months, and 6) A little under 2/3 of the companies were suffering from top and bottom line pressures. The earnings downgrades are the most clear takeaway. Avoiding them would clearly be preferred in all environments. But they happen. Reviewing the past five months for 6,109 international companies with FY1 earnings estimates in the Vanguard Total International Stock ETF (“VXUS”), 48.5% of them had their estimates move lower (source: Factset). 85% of our weak stocks having downgrades should maybe not be that surprising in this context, especially since the fourteen companies we reviewed are the bottom performers across more than 60 stocks held across our strategies, i.e. the bottom 25%? Also important to note that two of the Ballina holdings that were reviewed that had earnings downgraded were energy companies, and energy companies typically have their estimates move with the commodity price. And this was the case as nine of the ten largest energy companies in VXUS had their earnings estimates trimmed in this period.
Returning to our painful stocks, what did we end up doing with them? We have trimmed the number of shares we hold in more than half of them. We exited six entirely. Those six will likely be joined by at least one more. We actually found that in almost ½ of the companies, despite the weaker profits that some of them were having, the valuations were very defensible (i.e. weak earnings have not driven them to more than 25x current earnings). But solid valuation is not enough for us to keep the stocks. There are plenty of cheap international stocks in our universe and in our rank sheets. I would offer that just two of the remaining eight weak stocks that we reviewed are “safe”, i.e. we do not believe we will exit. Those happen to be the two technology stocks, but that is just a coincidence. Those two “safe” stocks are some of the names with defensible valuations, even if on depressed earnings. But what is most distinctive is that these “safe stocks” happen to have perhaps the most solid balance sheets and cash flow profiles of the whole group. It is difficult to give up on businesses of redeemable quality that have fortress balance sheets. Even when the earnings are less than you expect, the balance sheet strength is still very much present. Benzonite clay is not underneath these companies.
An example of a stock that we decided to keep is Gungho Online Entertainment (TSE ticker: 3765). It is a Small Cap Japanese video game developer. Video game sales can be hit driven and lumpy. It can be hard to know what the pipeline will bring in 2-3 years time. Small size and limited visibility are enough reason for Japanese companies to keep the balance sheet strong, and this is what Gungho does. See Cash as % of sales below. Gungho did experience a surge of revenue growth in FYE Dec 2023, but in the 2H of the year the sequential picture deteriorated. Together with more dire news and performance from the sector, this was enough to drive the share price down. While we wish that the immediate outlook for Gungho was brighter, we did not own the shares because we were certain the short term was perfect. We like the properties they hold, and we like the sector’s long term demand outlook. We’re also very attracted to the aforementioned balance sheet, which holds almost enough Net Cash to equal the market capitalization of the company. And then there is valuation. Yes, earnings estimates were cut for FYE 24, but on that low figure, Gungho only trades hands for 10.5x earnings (source: Factset). This is roughly 40% of the sector average (source: Factset). We do believe that Gungho can do better in terms of financial performance. Essentially the place we’re in right now was within the range of outcomes that we expected for Gungho. The stock continues to rank well (as is often the case with stocks that have declined). While a strong ranking doesn’t guarantee that we retain a stock, in this case we have decided to keep it (for now).
Source: Factset
A stock that we decided to exit is Flow Traders (“FLOW”), a Dutch Financial Services company. FLOW has an interesting business where they provide liquidity in markets, mainly to Exchange Traded Products (“ETP’s”). FLOW has a strong presence in their market, but there are not many other publicly traded peers. Investors have to invest time to understand the company. While the underlying business is a good one, the monthly revenues for FLOW are largely out of their control. If markets become super volatile, and spreads for ETP’s expand, even for a week, FLOW has historically reaped large benefits. (This occurs even in a declining equity market, so FLOW is an interesting diversifying stock given that it would likely be going up when other shares are declining) In our initial analysis of FLOW, we believed that volatility would not remain suppressed (as best reflected in the VIX[1] index). Eventually volatility would return to markets, and FLOW would benefit. But this has not occurred (see chart below). We’ve begun to believe that the methods by which investors hedge risk has changed. Options spreads, as reflected in the VIX, perhaps do not need to expand to the same levels that they did previously? In addition, our analysis embedded a baseline, i.e. steady state financial performance for FLOW. But our analysis was not holding. FLOW’s baseline financial performance was worse than expected. 2023 produced the lowest annual results in the history of the company as a listed company (listed in 2015). While the market expects a rebound in 2024, it is only to a level 40% below where we would have previously expected “normal” to be. The sector also has regulatory risk, or at least cost of complying. And they would always be subject to a detrimental trading error. While the company has a merit approach to pay, retaining good people will be tough and costly in this period. For all of these reasons, FLOW was a stock we felt that we had to exit. We’ll have to be comfortable with the risk that we sold near the bottom.
Source: Factset
Conviction can be a tricky thing as an investor. We want maximum conviction. And we want to place our largest weight in the high conviction names. But then the real world happens, prices move, and conviction can be either reinforced or damaged. As mentioned, balance sheet strength, and reasonable valuations of depressed earnings were capable of reinforcing conviction in the face of a weaker share price. The least difficult stocks to exit are usually the ones where the conviction was never as high to begin with. And this is what we experienced recently. The shares that we ended up exiting were smaller positions.
Weak performance requires self exploration. Decisions are required. Doing nothing is a decision. Ideally, the situation will look significantly brighter when the weather turns. Our perception of the current situation with Gungho is that their recent weakness is like arriving home to discover rainwater on the driveway. It will dry, and none will be the worse for it. With Flow, our review led us to feel it was a bit more like driving home and finding large unexplained cracks throughout the property. We believe the situation FLOW has is more like the Benzonite Clay derived issues in RPV. The weather can improve, but the potential negative surprises are likely to keep returning.
Strategy Performance
International All Cap Value returned 0.34% on a gross basis, and 0.26% on a net basis, in February 2024 versus -2.91% for the benchmark. Year to date performance was -2.70% on a gross basis, and -2.86% on a net basis, versus 1.15% for the benchmark.
International Small Cap Value[2] returned 1.02% on a gross basis, and 1.01% on a net basis, in February 2024 versus 1.57% for the benchmark. Year to date performance was -2.12% on a gross basis, and -2.22% on a net basis, versus -1.61% for the benchmark.
International Developed Market Value[3] returned -0.51% on a gross basis, and -0.59% on a net basis, in February 2024 versus 2.99% for the benchmark. Year to date performance was -3.11% on a gross basis, and -3.27% on a net basis, versus 2.53% for the benchmark.
International Developed Market Small Cap Value[4] returned -1.18% on a gross basis, and -1.25% on a net basis, in February 2024 versus 1.56% for the benchmark. Year to date performance was -1.98% on a gross basis, and -2.11% on a net basis, versus -1.05% for the benchmark.
Top Contributors and Detractors
International All Cap Value’s top contributor in February was JNBY Design. The Chinese clothing retailer reported strong growth in 1H results, and a positive outlook for the full year. The strategy’s top detractor was Nexity. This is a French property developer, and the 2023 full year results confirmed that profitability is significantly challenged in the current environment.
International Small Cap Value’s top contributor in February was JNBY Design. The Chinese apparel retailer reported strong growth in 1H results, and provided positive guidance for the full year. The strategy’s top detractor was Gungho Online Entertainment. This is a Japanese video game developer. The company reported Full Year 2023 results that were uninspiring. Global video game sector sentiment is also poor as many larger companies have released bearish commentary and laid off workers.
International Developed Market Value’s top contributor in February was Mercedes-Benz Group. The German auto producer reported Q4 results that were ahead of expectations. They also announced a continuation of their share buyback. The strategy’s top detractor was Japanese video game developer Gungho Online Entertainment. The company reported Full Year 2023 results that were uninspiring. Global video game sector sentiment is also poor as many larger companies have released bearish commentary and laid off workers.
Disclosures:
The opinions expressed herein are those of Ballina and are subject to change without notice. Past performance is not a guarantee or indicator of future results. Returns are presented gross and net of fees and include the reinvestment of income. The benchmarks being shown for comparison purposes are: a) for International All Cap Value - the Vanguard Total International Stock ETF (VXUS), b) for International Small Cap Value - Vanguard FTSE All-World ex-US Small-Cap ETF (VSS), c) for International Developed Market Value – the iShares MSCI EAFE ETF (EFA), and d) for the International Developed Market Small Cap Value – the iShares MSCI EAFE Small-Cap (SCZ) . The information contained herein is not investment advice. The information contained in this commentary represents the opinion of Ballina Capital and should not be construed as personalized or individualized investment advice. You should not consider the information and commentary published herein as a recommendation to buy or sell any particular security. The securities identified and described do not represent all the securities purchased, sold or recommended for client accounts. You should not assume that any of the securities discussed in the commentary published herein are or will be purchased for your account, or are or will be profitable, or that recommendations we make in the future will be profitable or equal the performance of the securities listed in commentary. Consider the investment objectives, risks, and expenses before investing.
For the Top and Bottom Contributors: Contribution reflects the impact of performance and the portfolio weight to total portfolio return. Data show is from a representative account of the International All Cap Value and International Small Cap Value. All returns are Gross of Fees. Timing differences of purchases and sales may have a modest impact on the actual contribution numbers presented. The calculation methodology along with detail on all holding’s contribution to the overall accounts performance during the measurement period are available upon request.
[1] The CBOE Volatility Index (“VIX”) is an index that represents market’s expectations for the relative strength of near-term price changes in the S&P 500. It is driven by the prices of S&P index options with near term expirations, and generates a projection of 30 day forward volatility.
[2] On October 17, 2022, the Global Small Cap Value strategy transitioned to the International Small Cap Value strategy. From this date forward the focus of the strategy will be on International Small Cap stocks. The benchmark changed on 10/17/22 to Vanguard International FTSE All-World ex-US Small-Cap ETF (VSS).
[3] International Developed Market Value is a new composite. The strategy funded during June of 2023, and July 2023 was the first full month of performance.
[4] International Developed Market Small Cap Value is a new composite. August 2023 was the first full month of performance.