The Global Flexible Fund and its response to the crisis

Brian Selmo of First Pacific Advisors, the Portfolio Managers of Nedgroup Investments Global Flexible Fund, reviews the fund’s Q1 performance and some recent stock purchases.

Drivers of Q1 performance

Going into Q1, we were just under 60% invested with exposure to the areas that were most at risk in terms of this crisis, including oil and gas, aerospace and financials. These sectors had disproportionate negative performance, down between 50% - 70% in the quarter. Our gas exposure is via McDermott, which was clearly impacted by price of oil. With respect to aerospace, 5.5%-6% of the portfolio was in aerospace parts manufacturing with Howmet Aerospace being the largest position. When an industry seizes up very suddenly as has happened with air travel, those businesses face a very uncertain near-term window. All of the companies we own in this sector have strong balance sheets and we do not expect them to issue equity to get through this period, but the demand for their product is going to be materially impacted. 10% of the portfolio is in financials, of which 6% is in banks and 4% in a combination of AIG and Jefferies Financial Group, neither of which have lending operations, but are in the financial space. These holdings combined constitute 8.16% of the portfolio and together accounted for -6.51% in terms of performance in Q1.

Other holdings in the portfolio that were less impacted were businesses that are industrial and cyclical in nature, including large internet platforms, building materials companies, holding companies, etc. What we didn’t and still don’t have in the portfolio are consumer staples or naturally defensive business profiles. The reason for this is that over the next five years, these businesses will face some real challenges in terms of reaching their customers and also a long-term trend towards a healthier lifestyle. We view them as low-growth companies trading at healthy multiples into the 20s and not interesting long-term investment propositions.  We expect the names we own to grow more rapidly and command a less demanding multiple.

Early in January and February we were net sellers and then net buyers throughout March, which included adding to existing names and increasing the number of holdings. Our objective was to upgrade the portfolio by buying names that were higher quality businesses with better balance sheets and which would hopefully have stronger growth over time. We were therefore 66% invested in Q1 2020 compared with 62% at the end of Q4 2019.

The portfolio has become more international in nature over the last year or two, which really reflects the valuation opportunities around the world.

Portfolio activity in Q1

The companies that we exited or reduced include Ally Financial Inc, Mohawk Industries, Cabot Corp and Arconic Inc, all strong market share businesses, but all had concerns and were a little less certain than the ones we bought. Such as Wabtec Corp, Univar Solutions Inc, NXP Semiconductors NV and Bookings Holdings Inc, companies who have absolute dominant market share with nicely growing underlying businesses. We bought into some companies that were directly impacted by the crisis such as Marriott International and Air Canada. We think they’re the best in their industry worldwide, but will have a difficult couple of years ahead.

The portfolio’s position in AIG

AIG was one of the largest holdings and had an outsized fall in Q1, but we still see it as a really good investment. The thesis on AIG is that it is a multi-year turnaround of their general insurance business, the P&C business. The company has a few different parts being their life insurance business, which has been a strong performer for a number of years, the general insurance business, which has been underperforming and their legacy assets, which are in a wind-down.  There are some evidence points that give us a fair amount of confidence.  Firstly, a strong new management team, their changing portfolio of risk on the P&C side and how that portfolio is responding to shocks, such as typhoons and storms in Q4 of 2019. Given the data coming out around mortality rates from Covid-19, we don’t think we’ll be seeing the numbers initially predicted. There will also be lots of litigation regarding business interruption risk, which is unlikely to be an issue as their contracts do not cover pandemic-related business interruptions. We can say with relative confidence that this is very unlikely to be a capital event for AIG, but rather an earnings event.

Why buying Air Canada was a good idea

This is a unique airline in that it is one of two dominant players in the domestic flight market in Canada with 85% market share and we’re pretty confident that when domestic air travel returns in Canada, the market environment will be very favourable for them. It is also in a good international position with a strong domestic loyalty plan linked to a credit card. They get a share of the spend on the cards without putting any capital at risk. This is a revenue profit stream that should be less impacted and will be an advantage in terms of their share of flights out of Canada versus other carriers. They are also among the best capitalised airline balance sheet wise, so have a long period of time that they can survive without revenues. Clearly they can’t survive forever, so there is some risk and while we don’t hold a very large position, less than 50 basis points, we continue to evaluate it.

The Marriott International purchase

This was a less risky purchase. They are in the core bread-and-butter mid-scale hotel market so should only see a quarter or two of operations that are below free cash flow positive. Longer term, it is one of the great businesses in the world. Marriott and Hilton will dominate the pipeline for new hotels and in the fullness of time this is a growth business, growing on the back of someone else’s capital.

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