Aurora has announced its results for the 10-month period from 29 February 2016 to 31 December 2016. Its chairman, Lord Flight (pictured), explains that reason for the ‘short year’ is to align Aurora’s accounting period with that of its Investment Manager, Phoenix Asset Management Partners, who have been in place for approximately 15 months, following their appointment on 28 January 2016.
During the 10-month period, Aurora saw its NAV rise 6.38%, whilst the share price increased by 9.8%. Aurora says that these underperformed the company’s All Share benchmark (total return), which rose by 19.5%. The share price of Aurora traded at a premium to NAV for substantially all of the period (an average premium of 2.9%), which enabled the company to issue new shares. The board says that its intention is for the shares to continue to trade at a small premium to NAV.
An important consideration for the Aurora Board in appointing the new Investment Manager was the extent to which they would be able to grow the size of the Trust and, therefore, improve its economic viability. The board says that Phoenix were confident that by marketing their track record, they could attract new investors to the Trust. An initial placing in March was the first of several, which, together with the sale of 4 million shares that had previously been held in Treasury, resulted in approximately £32 million of new money being raised between 1 February and 31 December 2016. Consequently, the market capitalisation of the Trust, which had been £15m in January 2016, finished the year at £52m. Since 31 December the Company has raised a further £6 million, increasing the market capitalisation to £62 million. The board says that the growth in the size of the Trust has come from two main sources. Firstly, from existing clients of Phoenix and secondly Phoenix has attracted investors previously unknown to them by holding a number of “roadshow” events across the UK over the last 12 months. In last year’s statement, the chairman said that the objective was to increase the size of Aurora to £100m over the medium term. He says that this continues to be the case.
The manager says that whilst delivering a substantial return for investors and earning no fees at all is disappointing (they charge a zero management fee), the performance fee structure sets quite a specific expectation to investors that Phoenix will deliver a better return than the stock market. The manager says that definitively remains its belief but says that in some individual years this will not happen. However, the manager says that it draws considerable heart from our 19-year track record of managing the Phoenix UK Fund (which has a very similar portfolio to Aurora). Over that period of time, the manager has beaten the All Share by an average annualised 4.5% per annum, after all fees. It says that this has been achieved this by beating the market considerably in some years and lagging it in others.
Looking at individual holdings, the manager says that the investment that looks the worst, in several respects, is Sports Direct. The share price fell by 31% over the course of the year as the business: issued a profit warning; was subject to what the manager describes as ‘a dogged campaign by the Guardian newspaper that unearthed some slightly rum working practises’; parted company with the longstanding CEO and the head of finance; announced a change of property strategy in the core UK business; halted attempts to expand in Europe until the operating model has been proven to be sustainably profitable. The manager says that it has considered each of these issues in some detail. It says that it has been invested in Sports Direct to varying degrees for nearly ten years and has followed the business and management closely all that time. Today, in 2017, it doesn’t think that Mike Ashley has gone from being a great retailer to a twit in less than a year, although it says that the press reports and share price might give you cause to think otherwise. The manager says that its national store visits and web-site monitoring suggest that Sports Direct currently retain their competitive advantage of being the lowest cost producer in the sector and the core UK business seems to be in fine shape. The manager says that it will pay close attention to the new property strategy, which favours freeholds over leaseholds and to move part of the estate upmarket and that it will watch how the in-store offer develops, given Mike’s intent to sell more expensive lines from the large third party suppliers such as Nike and Adidas. Above all, it says that it will look for signs that Mike remains the completely rational businessman that it says it has found him to be over the last ten years. The manager says that, if it is right, there is plenty of reason to be excited about the investment, which it thinks is worth more than twice the current share price and is also why it increased the portfolio weight over the course of the year. Moreover, for all the bad publicity the Company has had recently, it says that it believes that the management team has integrity and wants to do the right thing.
The manager says that the positive tailwinds detailed in last year’s statement regarding large housebuilders in the UK are all still blowing and those businesses (Barratt Developments and Bellway) are now valued at roughly eight times earnings. Their share prices fell sharply in the wake of the Brexit vote and haven’t yet fully recovered and the manager says that it leapt at the opportunity to buy more shares at much lower prices, adding to both holdings.
The manager says that the supermarket businesses, Tesco and Morrisons – whose share prices rose 15% and 16% respectively during the period – both made fundamental progress during the year. The manager says that, in its view, both firms lost sight of how to delight their customers and then egregiously compounded the error by making some dubious capital allocation decisions that they would later reverse. Also, as most UK domestic food retailers were taking their eye off the ball, the formidable German discounters, Aldi and Lidl, were taking market share from everyone else. So, 2016, whilst not exactly the year that Tesco and Morrison’s began to fight back (the competitive response to the Germans was earlier than that), it was the year that the manager says that it started to see meaningful results from their efforts.
The manager says that Lloyds is an interesting case because it thinks that the business fundamentals have been on the turn (i.e. improving) for some time and yet the shares remain cheap. Since 2010 the balance sheet has improved considerably and the manager says that the Group now has a class-leading capital ratio, far fewer unwanted legacy or “run-off” assets and much less reliance on wholesale funding than in the past. The management team have been reducing the cost base (by closing underperforming branches for example) and simplifying the operating model. Meanwhile, the business continues to enjoy high market shares and strong underlying profitability. For example, they have 25% of UK current accounts, 23% of UK retail deposits and 22% of UK mortgage balances. The manager says that its monitoring research continues to support the hypothesis that customers in the UK are very loyal to their bank, often ignoring indifferent customer service and high product fees. It has been this way for many years despite it being relatively easy for customers to switch banks. The manager says that, over the coming years Lloyds will be a high dividend payer and that it will soon have returned to full private ownership as the Government selling will soon have concluded. The manager thinks that Lloyds’ shares (that fell 10% over the period) are worth more than twice the current share price and added to the holding following the Brexit vote. It believes that, eventually, the strong underlying business fundamentals will weigh on the valuation of the business but it says. Just don’t ask it when!
The manager says that JD Wetherspoon had a year of steady, modest progress against a backdrop of increasing costs, most notably rising wages. They continue to open new pubs (951 and counting) in areas where the economics of doing so make sense, and to close pubs that are not pulling their weight. The intention over the long term continues to be to increase the proportion of freehold rather than leasehold properties. Ten years ago this split was 42/58 in favour of leasehold and today the mix is 51/49 in favour of freehold. One of the consequences of this strategy has been for the debt level to gradually rise. Founder of the business, Tim Martin thinks that a higher freehold mix gives the business greater flexibility to add value from property development such as building hotel rooms above pubs in space that would otherwise be redundant. The manager says that it continues to rate the pub operating business very highly and its research consistently reveals high standards of pub-keeping including clean toilets and food that, once ordered, arrives promptly. The share price increased 25% over the period and we watch with interest for signs that sufficient returns are being generated on the capital being deployed within the business.
A study of the history of the pharmaceutical industry, shows, among other things, a perpetual cycle of drug discovery and then, eventually, patent expiry; although the world’s great pharma businesses tend to endure, their most important products (almost) never do. It is therefore fitting that Glaxo continues to reshape itself, as a suite of new products replace those of the past. During the year, the Group reported ongoing progress as a broader portfolio of new drugs and vaccines replaced lost revenue from “blockbusters” such as Advair. Also during the year, CEO Andrew Witty announced his retirement. He is to be replaced by Emma Walmsley, the current head of Glaxo’s Consumer Healthcare business. The shares continue to trade significantly below our estimation of their intrinsic value.
In terms of outlook, the manager says that a foreseeable short-term factor that does merit a mention is the likelihood (in some cases imminence) of currency related inflation. For Tesco and Morrison’s it says that this is likely to be positive and reverse a relatively persistent recent trend of food price deflation. It says that, all other things being equal, a bit of inflation is probably a good thing for these businesses although it isn’t a good thing for housebuilders, who will be seeing the price of some of their materials, such as timber (sourced in Euros, paid in sterling), increase substantially overnight. The impact will have been cushioned until now by long term supply agreements but at some point they will start paying higher prices. The manager says that the good news is that the affected materials are a relatively small part of the overall cost base and that the rate of labour cost inflation (which, with land, are the most significant costs) has been coming down. The overall result is likely to be that build costs rise three to four per-cent this year, which won’t have a material impact on profits.
Regarding Brexit, the manager says that, for at least the last 500 years (and arguably much longer than that) Britain has managed to be one of the world’s 10 largest economies even though it has only enjoyed membership of the EU since 1973. He says that history suggests therefore, that Britain is, eventually, likely to make a relatively decent fist of things outside of the EU.
Aurora’s manager gets behind Mike Ashley : ARR