Monthly Letter May 2018

Europe Again. Italy this time (again)

At the start of 2018 the Italian election in March was deemed to be one of the biggest risk events for the coming year. The outcome didn’t disappoint those looking for a little bit of chaos. The outcome was more or less as “bad” as the worst fears in the market. One of the best gauges of confidence in a country is the yield of the 10 year government bond. The last day of trading in March the yield had dropped (i.e. the value of those bonds had risen) by 17 basis points from 1.95% to 1.78%. The spread vs. Germany was virtually unchanged so for someone looking at Italy from the moon and with no knowledge of the election would not have perceived any increased risk. We find this a bit strange given the very difficult outcome of the election with no clear majority in either direction. We were bound to get either a very weak government or a marriage made in hell. Maybe we got the latter. At Madrague we try not to put our own political beliefs into the investment equation.

Our job is to gauge what investment implications we get from changes in the political landscape. Very much like how we argued about the European crisis in 2012, 2014, 2015 and so on we are of the belief that the most likely outcome is that Italy will not crash the fizzling party this time around either. If they do, the consequences for Italy will be just as bad as for the rest of Europe. We recently attended a high profile CIO conference where the topic of Italy was hotly debated. One of the smarter attendees asked one of the speakers what chances he thought there were of an Italian policy mistake. The question certainly sounds smart, but we think it is posed the wrong way for 2 reasons: firstly senior European Commission members never admit that there can be or will be policy mistakes. Secondly we believe that the real risk lies in deliberate blackmail from Italy. The Italian government debt is the biggest in absolute numbers in Europe. This gives them an enormous bargaining chip vs. the rest of the European Union. The rest of Europe simply can’t bail out Italy just because the debt is too big. So maybe we should be worried about both policy mistakes and policy tactics. We do know though that marriages are made in church, but you divorce in court. The European marriage might have been pushed slightly closer to court after the election and the government that was finally formed.

As a side note on Italy and the European economy we note that activity is still good on the GDP side (even though momentum has faded slightly) and more specifically the Italian debt market is improving fast. In the first half of 2018 both Intesa and Banco BPM have sold substantial parts of their NPL (non-performing loans) portfolios at levels which are not eating into their capital base. So the micro environment is improving as the political situation is worsening. As one of our trusted friends in the investment community put it in a rather laconic statement: Italy is a master at managing chaos. 66 governments since the Second World War.

Madrague had a disappointing month in May: -1.93% which takes the year to date figure to +0.48%. Sectors of note in May:

Chemicals: +0.5%

This is one of our smaller sector verticals, but with our biggest single position: Elkem. The company was recently listed by China National Bluestar. We believe it is totally misunderstood and under researched. It is followed by 5 Nordic brokers and 1 international (Morgan Stanley who took the company public). The company reported its first quarterly figures as a listed company in May. Earnings were revised up by 25% for 2018 even though the company cautioned that q1 most likely would be the best quarter in 2018. So far in q2 the Silicone prices in China have continued higher and we see a potential for further positive surprises short term coupled with longer term improvements coming from higher production and high-grading of products.

Financials: -1.0%

Long positions in Banco BPM accounted for almost 80% of the losses in our financial sector. We clearly underestimated the significance of the new government in Italy. The outcome should have been fairly expected after the election in March. We cut part of the position with the intention of re-engaging in Italy as the political turmoil softens. As stated previously in this monthly letter we see clear signs that the markets for bad loans are improving.

Telecom: -0.8%

Out long position in Hellenic Telecom was the main detractor accounting for 80% of the net losses in the sector. We did not change our position even though the stock was down 15% in May. The stock took a large hit in May because of the heightened risk in southern Europe. The company is virtually unlevered and has been improving operationally throughout the European crisis. This is not the time to sell Hellenic Telecom.

Retail: -0.3%

Long positions in Pandora and Oriflame were the biggest detractors with our short in Clas Ohlson the biggest positive contributor. We cut our positions in both Pandora and Oriflame as there were new disappointing findings when they reported q1 numbers. In Pandora like for like sales in physical stores declined 8% and the 2018 earnings estimates are down 25% since the beginning of 2017. Oriflame showed both disappointing sales and earnings numbers with cautious comments about the future adding fuel to the fire. Consensus earnings estimates for 2018 have come down c8% since the report. Clas Ohlson is really struggling with the competition from online competitors while they continue to increase store space. Visitors and sales per sqm are down 30- 35%. Online sales are just 3.5% of sales and as they invest to change that their margins will continue lower. The dividend which currently yields more than 7% will be severely cut in the coming years.

We increased our gross exposure slightly from 147% to 152% in May and we also slightly increased our net exposure from 42% to 46%. 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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