February 2018

February 2018 Month End Investment Letter

We aim to build diversified, low risk portfolios at Ballina Capital, LLC ("Ballina"). What we will not do is invest in overvalued securities under the guise of lowering risk. There are several sectors that are found to be more defensive for equity portfolios – specifically Telecom, Utilities and Packaged Consumer Staples companies. Current Ballina portfolios have very modest exposure to these sectors. For the latter group, packaged Consumer Staples Companies, we find the recent divergence of fundamentals from valuation to be quite startling, thus feeling justified in the lack of exposure.

Kraft Heinz, Unilever, Nestle, Proctor & Gamble, General Mills, Reckitt Benckiser – these are Large Packaged Good Companies that sell around the world. Their goods can be found center of the store in virtually every major market. Investors that look admiringly at such companies do so for their consistent growth, stable yet high margins and lack of substantial sensitivity to economic activity. In the last decade, the stocks of such “Consumer Staples” were found to be in increasing appeal because of their “bond proxy” like characteristics. The thinking went that in a day where high quality fixed income traded so dearly, the equities that were most “like” bonds could also be justified to be more expensive than history. And this played out. Multiples expanded. According to Factset, the Major Developed Diversified Food companies were valued at Enterprise Value to Sales of 2.48x at the end of 2017. As recent as 2012, that metric was 40% lower. In the Household/Personal Care sector, this metric had expanded by 45% over the same timeframe.

These stocks had been appreciating. This was occurring with presumably lower risk. The volatility of the group remains undoubtedly low. The diversification benefits are valid when compared with high beta shares. However, something has changed in the fundamental picture, and the market is catching on. The companies are finding it tremendously difficult to grow sales. With sales reports over the last few quarters, the market is disappointed. The 3G Private Equity model and other scale efficiencies have already led to high margins. Without sales growth, however, could those margins be under threat? Threats seem to be aplenty in that the modern consumer seems to have little respect for the brands trusted by their parents and grandparents. A brand today can gain traction digitally and distribute through ecommerce without ever having to slog through the expensive supply chains the packaged good companies built sturdy walls of competitive advantage around.

While the performance of the Global Equity market is barely positive year to date, the shares of Consumer Staples Companies (Food, Beverage, Home and Personal Care) are negative (see table below). Irrespective of a fundamental view on whether these companies can be innovative enough to compete, these stocks do not screen for Ballina because they are simply too expensive. The road to a fair valuation for companies that are overvalued can be a long one. Despite the possible benefits to portfolio risk and diversification, this is a path that Ballina is currently willing to steer clear of.

Strategy Performance

International All-Cap Value returned -4.7% (gross basis, -4.78% Net) in February 2018 versus -5.24% for the benchmark. Year to date performance was 3.07% (gross, 2.9% Net) versus 0.18% for the benchmark.

Global Small Cap Value returned -4.82% (gross, -4.9% Net) in February 2018 versus -4.14% for the benchmark.[1] Year to date performance was -1.5% (-1.66% Net) versus -0.78% for the benchmark.

[1] Benchmark for Global Small Cap Value comprised of 50% weight iShares Russell 2000 Index (IWM) and 50% weight Vanguard FTSE All-World ex-US Small-Cap ETF (VSS)

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