Monthly Letter March 2018

Mathematicians’ approach and Bear Markets

The year so far has been characterized by higher volatility, more sentiment swings, question marks on several established themes (electric vehicles, FAANG, scarce materials to name a few), expectation of rate normalization and a harsher tone between global leaders. We would argue that the higher volatility is a
return to a more normal environment. Volatility is good, it creates opportunity and it should change the investment landscape back to an environment where companies are allowed to fail and where the easy way to get rich is not just to gear up an asset with borrowings that imply zero default risk. An interesting train of thought was pushed to us from a US equity strategist in early January. This is an equity strategist that has never bought a single share in his life.

We found it a bit odd given that he was supposed to be an expert on equity direction and allocation. Anyway, as a mathematician he had a bit of a different approach to the current environment. Where he differed from what we would say is consensus view was that he believed that the equity market would react negatively to a US tax cut. We now know that the market reacted quite well,
but with a subsequent sell-off. His argument was pretty basic (but he did of course build his case on numbers and statistics) that what the tax cut does is that it accelerates the current economic expansion which in turns gets us closer to the next recession. Hence the market should go down. We would not completely
say that he has been proven correct, but we cannot disregard the fact that the market has been moving more or less sideways with higher volatility since the start of the year. We are also seeing signs that cyclical stocks are derating, economic growth numbers are losing some momentum from high level. If our strategy friend is correct we have most likely seen the high of the year already. Madrague’s base case scenario, though, is that volatility has increased which has widened the range of outcomes for corporate profits. This in turn should increase the risk-premia which should result in lower equity prices. Our train of thought is that we have already seen the rebasing of equity prices and that we will have an upward trajectory until we get “closer” to the next recession. As we are not a macro fund we will not wager a bet on when that moment might be. We always keep in mind what our friends at Gavekal has said about bear markets: “The purpose of a bear market is to return assets to its rightful owners”. Our aim is to preserve capital when we get there and then pick up cheap assets in that part of the cycle.

Madrague had a poor month in March: -1.97% which takes the year to date figure to -1.64%. Sectors of note in March:

Capital Goods: +0.4%
Short positions in Wärtsilä, Caterpillar and Dometiq were the main contributors to the positive p&l. In a month where the main indices in Europe and the US were down c3% our shorts in the cyclical space underperformed the general market. The three stocks were down between 5% and 11%. We covered our
Caterpillar and remain short in Dometiq and Wärtsilä. We have been managing this sector from the short side up until March when we neutralized the exposure. Our biggest longs are Schneider and SKF. We believe that Schneider is well on track to over-deliver on their productivity targets. SKF is valued too cheaply
vs. peers given their market position.

Basic resources: -1.0%
This was a bit of a perfect storm for the sector in March. The biggest detractor was our long position in Outokumpu. Outokumpu has been a very poor performer for us in 2018. In theory Outokumpu should have been a great stock in this part of the cycle. They are a domestic US producer and should not be negatively affected by the announced steel tariffs. If tariffs do materialize with negative effects for the European producers, we would expect EU to respond which would then protect Outokumpu. Hot rolled coil prices have soared in 2018 with spot-prices up by c30%. Outokumpu is also vertically integrated with 60% Ferrochrome.

They should be the perfect play on stainless steel. Those are the external factors. Internally they have been having operational problems with production outages. In Q4 2017 they delivered an EBITDA/tonne of just EUR47 vs. competitors at EUR235. We believe that the company is at an operational low point and that the stock is as well. We continue to be holders, but keep monitoring the company with a critical view.

Oil: -0.3%
The sector has been a real struggle for us in the last few years. We have underestimated the negative sentiment towards the rig companies. Our firm belief is that we will see a recovery in the segment. We are of course not talking about getting back to boom levels pre the US shale production increase, but the world will need Deep-water oil to be able to meet demand in the coming years. There are no credible estimates for fossil fuel demand destruction that will make the world non-dependent of Deep-water oil in the next decades. The main source of losses in the sector for Madrague in March were Ensco, Noble and Saipem.

We cut the rig exposure as they have been too volatile for us, but kept the exposure to the subsea service segment.

We decreased our gross exposure slightly from 168% to 144% in March while we increased our net exposure from 39% to 50%. 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
Chief Investment Officer

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