Valuation dichotomy between growth and value reaches a level not seen since 1999

During September the Fund reported a loss of -2.94% on an absolute basis. Spie was the largest monthly contributor to the Fund’s performance, followed by Albioma and Befesa.

Fund Commentary
24 Oct 2018

During September the Fund reported a loss of -2.94% on an absolute basis. Spie was the largest monthly contributor to the Fund’s performance, followed by Albioma and Befesa.

During the month, there was limited significant news regarding Spie and Albioma. Spie rebounded following a local broker adding the stock to its selected stock list, as well as a come back from mediocre performance during the summer period.

On 26th September, Albioma confirmed the long-awaited commissioning of “Galion 2”, a 100% bagasse/biomass plant in Martinique, securing a sizeable EBITDA and cash flow stream for the next 30 years. The Galion 2 will triple renewable electricity production on the island (from 7% to 22%), contributing to the shift towards a lower-carbon energy mix on the island.

Befesa has recently been added to the portfolio, immediately contributed to its performance. The Company IPOed in November 2017, with the Investment Adviser having met management three times since, once in April and twice in September this year. Befesa is a market leader in steel dust and aluminium salt slags recycling services in Europe, with a market share of ca. 45-50%. It operates in a niche market with solid underlying trends, underpinned by 1) growth in the European electric arc furnace (EAF) steel production, 2) increasing recycling activity driven by regulation, and 3) positive demand and price outlook for zinc, its main product output. Befesa’s plants are located in close proximity to its longstanding clients, achieving high, resilient utilisation thanks to entry barriers via permits, know-how and upfront capital requirements. According to the Investment Adviser, stable service fees and a conservative zinc hedging policy result in a highly visible business model.

The decision to invest was made following Befesa’s decision to expand into China as a first-mover, which was announced on 24th September. Befesa has signed an agreement with the Jiangsu Changzhou Economic Zone (on China’s eastern coast) to develop the area’s steel dust recycling services business. Under this new agreement, Befesa will acquire a land use right in Changzhou to build a steel dust recycling plant. Initially, the Company will construct a 110Kt plant, which management expects to ramp up from H2 2020. The team believe that a plant of this magnitude could contribute ca. EUR 15m to EBITDA at current zinc price levels, costing ca. EUR45m to construct, which is cheaper than prior expansion projects. In the mid-term, management believes the steel dust recycling market in China could be over 4x larger than in Europe. In the team’s opinion, Befesa has the ability to double in size before 2025 through the opening of the Chinese market and its demonstrated technological knowhow.

At the other end of the spectrum, Jacquet Metal, Akwel and were the three main detractors in September. In spite of very compelling H1 results published on 6th September, Jacquet Metal’s stock price pulled back in September due to a local broker downgrade. On the one hand, this broker acknowledges the quality of the results, and even upgraded the results’ expectations for the year, on the other hand however mentioning: “Escalating protectionism prompts fears of a global economic slowdown, and thus weakening demand for industrial metals. A negative price effect at JMS could appear in two or three quarters if current metal price trends continue”. The Investment Adviser fundamentally disagrees with these arguments, which in their view fail to capture the evolution of metal prices ever since and, more importantly, if this scenario ever were to materialise, the cash flow generation potential this would entail. According to the team, the Company is as such naturally hedged against metal price risks, as in case of a fall in metal prices its own cash flow dynamic would trigger a significant cash inflow derived from its working capital.

Akwel’s investment case was well documented in the July commentary. Things remain absolutely identical regarding the investment thesis, i.e. Akwel is still a Company trading at book value in spite of a 15%+ ROE. It is nothing else than a financial instrument with a 15%+ coupon offered by the market today at par value. Finally, was penalised during the month by a clean-up placement from one of the venture capital funds still invested in the Company, creating a typical flow back mechanism.

The Fund’s performance year to date is a source of frustration for the Investment Adviser, and for the people invested in the vehicle. Multiple articles have been written about the valuation dichotomy in the market between growth and value, with some statistical studies showing that it has reached a level not seen since 1999. This said, it is always difficult to call an inflection point in such a trend, with the team refraining from doing so.

The Investment Adviser has always stressed that the Fund’s performance is a reflection of the value created by the companies in which it is invested. This has always been the case, not only since May 2015 when the Fund was launched, but from July 2002 onwards when the team started managing third party assets. It is unfortunate that this year it is not the case that markets are reflecting the value created by companies. Some quality companies producing excellent results this year have seen their stock price fall by 30% or sometimes 40%, even if it is true that:

  • Growth in Europe, and in general, was lower than expected at the beginning of the year;
  • Cash outflows from European equities have been sizeable this year;
  • Trade barriers and protectionism create a wide range of uncertainties and an inevitable pull back in investments;
  • Turkey, Italy and emerging market economies create an unpleasant and constant background noise.

According to the Investment Adviser, the reality is that the companies the Fund invests in have the ability to sustainably create value for their shareholders, measured through their free cash flow generation streams. This is true today and will continue to be true tomorrow, even if the world enters a period of slower growth for a certain period of time. The Fund’s companies have the resources to adapt in case this scenario materialises, be it through the soundness of their balance sheets, through a reduction of their variable cost base and capital expenditures, or through cash coming from a deflation of their working capital.

As illustrated in the Akwel’s investment case in July, the gap between market prices and fundamental valuation of the portfolio has widened to a level not seen since the inception of the Fund. According to the Investment Adviser, the value created by the Fund’s investments in 2018 is not questionable, it is a fact. The team are convinced that the time will come when this value will be reimbursed to its shareholders through a substantial share price appreciation.

The views and statements contained herein are those of Pascal Investment Advisers SA in their capacity as Investment Adviser to the Fund as of 12/10/18 and are based on internal research and modelling.