Aurora Investment Trust (ARR) has announced its annual results for the year ended 31 December 2022. During what was a difficult year in global markets, ARR provided an NAV total return of -17.4% (2021: +17.1%) and the share price total return was -16.3% (2021: +13.5%). ARR says that, in comparison, its benchmark All-Share Index provided a total return of 0.3% (2021: 18.3%), predominantly due to the c.25% weighting in energy and mining stocks which performed strongly after the Russian invasion. The Mid Cap index, where ARR is focused, is less exposed to those sectors, and saw a fall of 20% for the year. [QD comment: perhaps ARR would be better served by comparing its performance to a UK mid cap benchmark.]
ARR says that the strongest contributor to its performance was the inflation hedge put in place in 2021 and sold early in 2022, while the weakest contributor was Barratt Developments, where the proceeds from the inflation hedge were invested. The chairman, Lucy Walker, comments that, while the board recognises that this was a disappointing performance for shareholders, concentrated portfolios of undervalued holdings are not immune to short or medium term market volatility.
Fee clawback kicks in for 2022
2022 was the seventh year of Phoenix’s management of ARR’s portfolio, which began in January 2016. Phoenix receives no annual management fee and is solely remunerated from an annual performance fee, equal to one third of the outperformance of ARR’s NAV against its benchmark, the FTSE All-Share Index (total return). The performance fee is paid by issuance of ARR ordinary shares, which are subject to a fixed three-year clawback period (the issued shares are returned in the event that any outperformance versus the index reverses on the third-year anniversary and, if outperformance fully reverses, the manager will receive nothing). In the years ending 2019, 2020 and 2021 the manager was awarded shares in settlement of a performance fee. However, in 2022, instead of paying a performance fee, ARR clawed back 530,311 shares from Phoenix. These were delivered to ARR and held in Treasury at the year end, but were cancelled shortly after on 9 January 2023.
Share Premium/Discount and growth ambitions
During 2022, ARR saw its discount to NAV narrow from 7.6% at the end of 2021 to 4.4% at the end of 2022 and, on occasions during the year, the shares traded at a small premium.
Growing the trust remains a key objective of the board, with a medium-term target of £250. Unfortunately, progress was set back during 2022 with the market capitalisation falling from £179m in January 2022, to £148m at the year end. The only shares issued in the year were issued to Phoenix in relation to the 2021 performance fee. The board comments that growing the company will only be possible with ARR’s shares trading at a premium to NAV, and therefore the first objective is to close the discount.
Investment manager’s performance review
“From a performance perspective, 2022 was dominated by concerns over higher inflation and the impact of higher interest rates. The war in Ukraine was also a significant factor as it led to an increase in commodity prices, which added to the existing inflationary forces.
“The first half of the year saw falls across the portfolio, with the NAV down 16.6% versus 4.6% for the benchmark at 30 June 2022.
“The year ended slightly weaker with the portfolio down 17.4% whilst the Index recovered to end the year up 0.3%. Within the second half of the year, Q3 was weak as the NAV fell a further 9.7% before a 9.5% recovery in Q4.
“It has been a tough year in which to beat the UK indices. The main UK indices have, unusually (from a global perspective), returned a positive performance in 2022, largely owing to the weighting in energy and miners, whose prices jumped in response to the elevated profit opportunity that followed Russia’s invasion of Ukraine. Between them, those sectors make up c.25% of the market and they are up 42% and 23% respectively in 2022. We do not have any ownership in those areas.
“The Mid Cap Index, which has a lower exposure to those sectors and is more domestically focused, fell 20% in the year.
“The 17.4% decline in Aurora was after a positive 6.5% contribution from a hedge against inflation, through put options on a short sterling future contract, which was disclosed in detail in the Company’s last annual report.. The biggest contributor to our decline was Barratt Developments where we re-invested the proceeds of that hedge, it was down 41% in 2022, which results in a -5.4% effect on the return. Castelnau Groupcontributed a -4.3% effect after it declined by 35%.
“The other stocks to make negative contributions of over 2% were Randall & Quilter and easyJet, which were down 3% and 2.8% respectively.
“Last year’s biggest riser, Frasers Group, the Company’s biggest holding, fell 8% in 2022 (having risen 71% in 2021). When combined with its large weight, this had a -1.5% effect on the Company for the year.
“The best performer in the portfolio in 2022 was Netflix, rising 50% from when we purchased it and making a +1.3% contribution to the overall performance.”
Investment manager’s activity review
“In the June 2022 monthly factsheet, we highlighted the valuation opportunities afforded by the fall in the NAV during the half year. This piece was titled “Christmas in Valueland”.
“Please refer to the June factsheet on our website for the full details, but it highlighted the counter intuitive thinking of value investors as bad fundamental news can often provide good investment opportunities. The essence of “Valueland” is the ability to buy the future for less, and it follows that the less you pay the higher the return you will enjoy in the future.
“Those “Valueland” type opportunities persisted for much of the year and even after recent positive performance valuations remain at an historically attractive level.
“We took advantage of the opportunity set and instigated 4 new holdings. We reported in detail during the year on two; AO World and Netflix, a third, Hotel Chocolat recently went over 3% and we will be formally introducing it in the next monthly factsheet. A fourth, Wayfair, remains below our 3% disclosure level and will be introduced when it exceeds that 3% threshold.
“The investments in Netflix and Wayfair are outside our historic focus on UK listed equities, but if they sit within our circle of competence, they are investable, and the Company’s mandate allows up to 20% of the portfolio to consist of non-UK holdings. Ryanair for example is another member of the portfolio from outside the UK. When we stray outside of the UK, it is to multinational businesses where we think we bring some initial knowledge and insight. Unilever is listed in the UK and Proctor & Gamble in the US, but the expertise required to understand one is highly applicable to the other.
“The rationale behind the purchase of Netflix was also outlined in the June factsheet, and it is repeated below:
“Rather than cover the story of Netflix, which you probably know and has been covered well elsewhere, including in founder Reed Hasting’s book collaboration with Erin Meyer called “No Rules Rule”, which is written up in the Phoenix Reading Room, we thought we should explain why we have invested in it.
“Long-term holders will remember that we have owned media production broadcast businesses before, initially Carlton Communications and then, following its merger with Granada, ITV. At the time of that merger in 2003 the competition and media regulators decided that ITV would have too much power, and so restricted their ability to change their business and capped their prices and advertiser contracts at 2003 levels. This hobbled them in a changing world. They tried something called ITV Digital, which was a failure, but even in 2008 when this was reviewed by Ofcom, they were still thought to need restrictions. In that report streaming, though mentioned, was not expected to be significant. What they called Broadband TV, or internet TV, was held back because only two thirds of households had access to the internet at the time.
“The internet itself was underestimated because they said it didn’t allow the same ability to target audiences the way broadcast TV did.
“We sold our ITV and our WPP viewing that the world was changing fast in a way that undermined both those businesses. All this time later, ITV trades 40% below where we sold it and whenever we have reconsidered it as an investment, for example in 2018 when Carolyn McCall moved there from easyJet, the fear of Netflix has undermined its attractiveness. A show like The Crown would have been a natural for ITV before the emergence of Netflix.
“Now, 43% of UK households subscribe to Netflix, streaming services are in 59% of households and Netflix dominates the Top 10 list of most enjoyed titles watched according to Kantar. ITV finally got together with the BBC, and in 2017 created something called BritBox to compete. Currently Netflix has 100 times more subscribers.
“What has been playing out in the UK has been going on everywhere at different paces and in different ways. Streaming is a superior way of receiving media content. To young people who have grown up with it, the idea of scheduled linear timed broadcasting is quaint, anachronistic, and not the way they tend to consume media unless it’s a live broadcast. Around 300 million households around the world now utilise a streaming service and we think over the next 10 years that could grow to a range of numbers averaging about 1 billion. Netflix, as the first and biggest, we expect to lose share as others get up and running, but they will have a smaller share of a much bigger market. Their growth trajectory will be different to newcomers because they have reached points of deep penetration in many markets. The pandemic has distorted numbers and made trends harder to discern, but it seems reasonable to assume that lockdown had a positive impact upon them and so the end of lockdown should be negative. They entered the lockdown with 167m subscribers and have emerged with 220m. Netflix is not just the UK’s no.1; it is the World’s. Whilst many focus on Netflix versus Disney, we think the real pain points will be with the likes of ITV and their ilk around the world.
“Netflix has built this business whilst charging for it. ITV is free. ITV doesn’t have churn numbers because it is free, and advertisers pay for it. This dynamic gives Netflix a great opportunity to vary its business model to reduce subscription price as a point of friction. Netflix is already the streaming service that consumers say is their favourite and would be the last one they cancel. As Netflix experiments with the advertiser funded model that has served Google, YouTube, Facebook and most of the world’s commercial broadcasters well, we believe it will increase its competitive advantage.
“Netflix has a founder led culture that is always adapting and evolving, using trial and error combined with a good understanding of data to develop. We see this in many successful businesses and so when we consider the management team and culture at Netflix, we think it will outcompete its rivals.
“There are many scenarios you can model at Netflix. Our base one gives a value of well over $500, and our downside stress test comes out around $200. We have now invested 3% of the portfolio at an average price of $211.49 and, given that it represents a new area for us, we will restrict ourselves there until we believe we have developed our expertise further. In the past, that cap has taken years not months to lift.
“In January 2023, Phoenix Asset Management Partners, through Castelnau Group Limited, launched an offer for Dignity PLCin conjunction with Sir Peter Wood. For full details of that Offer, please refer to the Castelnau Group website www.castelnaugroup.com.”