Monthly Letter August 2018

August Sector Comments
Madrague had a very disappointing month in August: -2.18% which takes the year to date figure to +0.43%. Sectors of note in August:

Chemicals: +0.59% 

The main contributor was our long position in Elkem. The company has exceeded all estimates since the IPO earlier this year. The Q2 report in August was another blow out report. Silicone prices are extremely strong due to robust demand and capacity is being restrained due to Chinese “Blue sky policy”. Furthermore, China has closed down inefficient and polluting plants to improve the air quality specifically and the environment in general. When we were in China and Japan on a chemical tour we met several of Elkems competitors. The message we get is unanimous: Capacity shortage will be solved, but it will take a long time, 1-3 years depending on who we speak to and demand assumptions. Before blue sky policy was implemented a lot of companies were starting construction before building permits had been approved. This shortened the time to market for new projects, but to a naïve western mind it seems very risky. This modus operandi no longer works according to the companies we met on our recent tour. If you “pre-build” before you have the permit you will be told to take it down if you get caught. This means that the shortage in Silicones will most likely be in the 2-3 year range rather than the 1-2 year. That in turn would mean that Elkem will continue to enjoy super profit for an extended period. We continue to be long and did not materially alter our position after the report.

Utilities: +0.24% 

Our long position in EDF was the source of the positive returns. EDF has benefited from rising power prices, rising CO2 prices and also a discussion about the possibility of a split of their distribution and generation business. The latter would be very good as it would crystallize value hidden in EDF. We also believe there is a growing awareness that nuclear is needed if the world is to move away from fossil based energy. We have been doing quite a bit of work on the sector lately as it has been and will be in big transformational phase in the next couple of years. We did not alter our EDF-position in August.

Financials: -0.98%

Our Financial sector experienced a very tough month in August. The short positions in Swedish Banks performed well while our longs in the rest of Europe were down. There were no disasters in either direction, but the overall performance of the sector vertical was not up to par to say the least. A couple of macro events played their part to maul the sector once again this year. It is one of the worst sectors even though results on aggregate has been more or less in line and consensus estimates has barely changed, i.e. we have seen an aggressive derating. On the macro front we would point to 3 worries that hits the banking sector a little bit harder than the rest of the equity markets: 1. Brexit and the back and forth with a looming deadline and a very real possibility of a no-deal Brexit. 2. Turkish economic problems coupled with sanctions from the US. 3. Italian budgetary discussions could potentially harm an already fragile economic recovery. All three worries are of course perfectly valid, but we would argue that they are not confined to the banking sector alone. It is as if risks are being priced into some sectors and not at all in other. We find that there is a dislocation that to some extent has persisted for many years. We think it is wrong, but struggle to find the trigger when it will change. Until then we monitor and look for opportunities to increase our positions. We closed our long in Credit Suisse, reduced our long position in Banco Santander and closed our short in ABN Amro as we reduced our gross and net exposure in the sector due to the poor performance.

Retail: -0.85%

The biggest drags on performance were our long position in British American Tobacco (BAT) and our short in Adidas. BAT was hit hard when they announced that they would follow Phillip Morris and Japan Tobacco with price hikes on cigarettes to compensate for upcoming tax hikes. However the company did not announce price hikes on their e-cigarettes, Glo, which made the market worried about possible price wars for market share grab. The valuation already before the latest news was in our mind very cheap and it got even cheaper in August. We kept our long position in throughout the month.. Our short position in Adidas was closed after the company reported figures that barely beat consensus, but where the market all of a sudden got convinced that the levers Adidas have to shrink the margin and valuation gap versus Nike can be achieved in the next few years. We closed our short in Adidas on the day of the report.

Basic Resources: -0.5%

Our short position in SCA and our long position in ArcelorMittal were the main source of negative performance. SCA is the pendang of what we see in Elkem. In SCA we have a company operating in an environment where the stars have never been more aligned: the Swedish krona is weak, the pulp prices are strong, interest rates are negative which pushes up the value of their forest holdings and the company is still valued at (almost) unheard of multiples of EV/EBIT of 20 for next year. We did not change our short position in August. We believe Arcelor was just dragged down by a poor equity market in August and hence did not change our position.

We decreased our gross exposure slightly from 155% to 145% in August and we also slightly decreased our net exposure from 48% to 44%. Our option protection shows the same characteristics as always, i.e. a gap move down 5-10% and we would have zero net exposure to the equity markets.

As always, you are more than welcome to contact us should you have any comments or questions on our investments or the views expressed in this letter.

Lars Frånstedt

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