March portfolio update

A lot has happened in the first few months of 2022. Besides the war in Ukraine, there are rising concerns about inflation, and growth stocks and other long-duration assets have been punished by the market. 

While my investments have usually performed well during volatile periods in the market, this was not the case in the March quarter. My PA dropped 20.62% while my SMSF fell 9.91%. This is my worst quarter since I started tracking the portfolio, and it has been challenging. While I am confident about the prospects of my holdings, especially at their current valuations, I've spent plenty of time thinking about how I can improve my process.

My results for the quarter were driven by my two largest positions, Naked Wines and Haier Smart Home D. 

Naked Wines

Naked Wines was caught up in the growth sell off, and fell from 6.40 GBP to 3.60 GBP over the quarter (-43.75%). The result was exacerbated by the strong Australian dollar, which rose ~6% against the GBP over the quarter. There was no significant news from Naked. The market is clearly concerned about inflation and/or the sustainability of the business model. I am sanguine on both issues. While I expect Naked's growth to be constrained in the short-term, and customer acquisition costs to rise, I see no reason why Naked should not continue to grow as it has throughout its history. 

It is also worth noting that Naked is not an expensive business. Naked now trades at 0.77x LTM sales. Management has guided to 20% growth in sales over the medium term and 10% EBIT margins at maturity. This seems achievable as Naked increases its sales in the US (which are far higher margin than UK/Aus sales) and scales up. This seems cheap for a business that has historically generated very high returns on capital, has a dominant position in a structurally growing market (Naked is the #1 DTC wine player in the world) and has a long reinvestment runway. Naked remains my second largest position.

All that said, I made a mistake by repeatedly topping up my Naked Wines position on the way down. My initial position in Naked was bought at around 2.1 GBP prior to the pandemic. When topping up Naked, I was thinking more about portfolio sizing than simply valuation. This is not the right way to think, of course. If you keep topping up a falling position, you can blow up your portfolio. (John Hempton has written an excellent post about this.) This has been an important lesson for me, and it has been costly. I hope I can avoid making the same mistake again.

Haier Smart Home D

My largest current position is Haier Smart Home D (690.D), which I have written about in previous updates. Haier fell 17.75% over the quarter. Again, the result was exacerbated by foreign currency movements, as the Australian dollar gained about 6% against the Euro over the quarter. The war in Ukraine has led many investors to worry about China. That does not explain the curious situation with Haier's D shares. Despite ranking exactly the same as Haier's H shares, which are listed in Hong Kong, Haier's D shares trade at a 57% discount. Haier is the world's largest manufacturer of home appliances, with revenue split roughly half and half between China and the rest of the world. It owns Fisher and Paykel in Australia, GE Appliances in the US and a number of other major brands. Based on the current D share price, Haier trades at less than 6 times forward earnings and roughly 3.5 forward EV/EBIT. This seems extremely cheap for a company that has grown earnings per share at more than 11% CAGR since 2016. While Haier has not made any move to convert the D share to the H share, this is an option — as outlined in the H share prospectus — and there is no practical reason for the D share listing to exist. If D shares were converted to H shares today, they would be worth 137% more, yet investors are effectively getting this option for free. Again, if investors are worried about the China situation, the exact same risks apply to the H share. Whether or not conversion happens, investors should do well in Haier D, and I see no reason to change my position.

A note on portfolio construction

Historically, my PA has outperformed in periods of market volatility. One reason has been my holdings of small, unlisted companies in Australia which trade irregularly. These stocks often trade very cheaply in relation to their assets and earnings and pay large dividends. For tax reasons, I transferred these positions to my SMSF when it was established last year. As a result, my SMSF has performed better than my PA of late. Another issue is that, in the past, I have had a higher portfolio allocation to special situations that aren't correlated to the broader market. Besides Yorkey, which worked out very well, I had no real allocation to these sorts of investments in the quarter. Effectively, I was quite concentrated and there were correlations between usually uncorrelated stocks (e.g. Haier and Naked). While I'm happy to trade increased volatility for better returns, I'm going to place more emphasis on having different types of bets in the portfolio, especially in rising markets. I'm also going to put a hard limit on new positions of 10% of the portfolio at cost. This will give positions like Naked, which have good long term prospects, room to grow, while avoiding problems of over-concentration. Effectively, if you're taking a very large bet, say 20% of the portfolio, you are implicitly saying that a particular investment is far better than everything else in your investment universe. Historically, I haven't been very good at predicting which stock will perform better than another in the portfolio. For that reason, I am more inclined to size positions similarly rather than betting 4x position X on position Y. 

Finally, the drawdown has somewhat affected my confidence — as much as I try not to be affected by short-term results, it has been hard to watch the portfolio falling month after month. I've been a bit more cautious entering into new positions for the time being, and I've been doing a lot of work re-visiting my existing positions. Overall, I think the portfolio is very attractively priced. Both my PA and SMSF trade on a dividend yield of >5%, which is the highest in memory. Most of my holdings trade on single digit multiples and less than their net current asset value. I am confident that my holdings will continue to perform well over the next few years, especially from today's levels. 

I have added a small position in Countryside Partnerships (LON:CSP). Countryside is a capital light homebuilder in the UK that has historically earned > 40% ROCE. The company is currently undergoing a turnaround after poor operating results in the March quarter. Activist investor Browning West now has a board seat, and the company is buying back a significant amount of shares. While execution is a major risk, Countryside has a good business and a clear policy for capital allocation (any excess cash that isn't needed for growth will be used to buyback stock). I think the risk-reward here is attractive, but I need more evidence of execution before adding to my position.

The results of my private investment account and SMSF are summarised in the table below. The portfolios are constructed differently and performance will vary. 

My PA was down 1.69% in January, down 12.05% in February and down 8.19% in March. The cumulative return for the period was -20.62%. The S&P/ASX 200 Franking Credit Adjusted Annual Total Return Index (Tax-Exempt) gained 2.24% over the same period.

	August 3, 2017	March 31, 2022	Since July 1, 2021	Since Inception	Annualised
G&W Portfolio	1.0000	1.6790	-25.03%	67.90%	11.76%
Benchmark (SPAX2F0)	61,250.80	101,525.11	7.16%	65.75%	11.45%

My SMSF was down 0.75% in January, down 6.81% in February and down 2.60% in March. The cumulative return for the period was -9.91%. The S&P/ASX 200 Franking Credit Adjusted Annual Total Return Index (Tax-Exempt) gained 2.24% over the same period.

	August 4, 2021	March 31, 2022	Since July 1, 2021	Since Inception	Annualised
G&W SMSF	1.0000	0.9158	-8.42%	-8.42%	-12.57%
Benchmark (SPAX2F0)	98,123.18	101,525.11	3.47%	3.47%	5.34%