MARCH QUARTER 2018 The Newgate Absolute Return Fund takes long and short positions in equity securities. We are a research and evidence based fund manager seeking to generate our investors absolute returns through the identification of incorrectly priced agents of change in companies and industries. QUARTERLY PERFORMANCE - FINANCIAL YEAR 2018 SEPTEMBER QTR DECEMBER QTR MARCH QTR JUNE QTR TOTAL FY RETURN 2018FY 7.22% 13.09% 7.39% - 30.23% There is nothing wrong with changing a plan - Lucius Seneca, Roman Philosopher, 60 AD If you are not confused you don t understand the situation very well - Charlie Munger, Berkshire Hathaway, 2014 FUND PERFORMANCE AS AT 31 MARCH 2017 TIME PERIOD RETURN 3 month return +7.39% 6 month return +21.46% 12 month return +38.23 Since Inception (total) +36.02% Since Inception (annualised) +20.49% Observed Volatility 11.4% QUARTERLY SUMMARY Over the March quarter, the Newgate Absolute Return Fund generated a +7.4% return, taking the rolling 12 month return to +38.2%. The Fund s positive return is in the context of an Australian equities market decline of negative 3.9% over the same period, taking the market s rolling 12 month return to a paltry 2.0% 1. This 12-month return compares to the average annual Australian equity market return of the past century of 11.9% per annum 2. AVERAGE FUND STATISTICS STATUS MOVEMENT Number of Positions: 38 positions + Cash Net Position: 137% (longs less shorts) Total Long Positions: 189% Total Short Positions: 52% Gross Exposure: 241% (longs plus shorts) NOTABLE STOCK CONTRIBUTIONS POSITIVE CONTRIBUTORS NEGATIVE CONTRIBUTORS Lynas Corporation (LYC) Orocobre (ORE) A2 Milk (A2M) Mineral Resources (MIN) GetSwift (GSW) Sims Metal Management (SGM) 1 ASX200 Accumulation Index, Bloomberg/IRESS 2 Triumph of the Optimists, 101 years of global investment returns, Dimson et al Emeco Holdings (EHL) NEWGATE CAPITAL PARTNERS PTY LTD. LEVEL 32, 8 EXHIBITION STREET. MELBOURNE VIC AUSTRALIA 3000. NEWGATECAP.COM
FUND OVERVIEW Why were markets weak? The primary reason global markets sold off over the quarter was due to concerns over rising inflation in the USA. The market is worried that if inflation breaches the Federal Reserve s target of 2% per annum they will have to increase interest rates more rapidly than expected to slow the US economy down. Higher interest rates and a slowing US economy would be negative for global equity markets. While we are watching this risk closely we highlight that the emergence of wage inflation in the USA is attracting more people into the workforce. This was clear from February s US payroll report which shows the participation rate 1 increasing from 62.7% to 63.0% after four years of little change. The rise in participation is keeping the US unemployment rate steady at 4.1%, despite exceptionally strong jobs growth. US Labor Force Participation Rate 70% 65% 60% The US participation rate has begun to rise. More people entering the workforce will help keeping a lid on inflation 55% 1950 1956 1962 1968 1974 1980 1986 1992 1998 2004 2010 2016 Source: Federal Bank of St Louis Even after adjusting for the ageing population, the participation rate could potentially rise by 2-3% over the medium term. This represents approximately 8 million workers, or about four years of rapid employment growth. This means the USA may not be at full employment as the Federal Reserve suggests, and the US economy can keep growing without wage inflation becoming a problem. Overall, our conclusion is that over the March quarter excessive inflation fears caused a long overdue share market correction. This has bought the market back to more 1 The participation rate is the number of people in the workforce
FUND OVERVIEW acceptable valuation levels and created an improved environment for generating returns. We remain optimistic over the coming 12 months. 3000 2500 S&P 500 Index The US market correction was long overdue after a period of very low volatility 2000 1500 1000 2010 2012 2014 2016 2018 Contributors Over the March quarter, the chief contributor to returns was rare earths producer Lynas Corporation (LYC). LYC s half year results were excellent with continued strong production growth, record profits and materially reduced debt levels. The outlook for LYC remains bright, demand for rare earth magnets from the electric vehicle industry will likely grow significantly, and LYC is well placed to grow production to meet this demand. LYC remains the largest position in the Fund. $2.80 Lynas Corp Ltd (LYC) $2.40 $2.00 $1.60 $1.20 $0.80 $0.40 Aug-2016 Nov-2016 Feb-2017 May-2017 Aug-2017 Nov-2017 Feb-2018
CONTRIBUTORS Getswift (GSW) Another major contributor was our short position in logistics software company Getswift (GSW). GSW listed late 2016 offering a software solution for the logistics industry. GSW claimed to have developed a leading global market position in last mile logistics software, suggesting their customers could: Dispatch like Uber, Track Like Dominos, Set Routes Like FedEx After just 12 months in operation, GSW asserted their application was used across the world. The GSW prospectus from October 2016 stated: The platform is currently used by businesses in over 200 cities throughout Australia, the US, Latin America, Europe and Asia and across a variety of different industry sectors Over 2017 GSW announced an array of high profile contract wins with major companies such as Pizza Hut, Red Rooster, Commonwealth Bank and Amazon. Over this period the share price rose from 20 cents to $4.00 - representing a market capitalisation of over $600 million. $4.20 Getswift (GSW) announced agreements and timeline Amazon Newgate initiates short position $3.70 $3.20 NA Williams $2.70 $2.20 $1.70 Commonwealth Bank Betta Home Living and Fantastic Furniture Pizza Hut AFR articles published $1.20 $0.70 Stock resumes from suspension $0.20 Mar-17 Apr-17 May-17 Jun-17 Jul-17 Aug-17 Sep-17 Oct-17 Nov-17 Dec-17 Jan-18 Feb-18 NEWGATE CAPITAL PARTNERS PTY LTD. LEVEL 32, 8 EXHIBITION STREET. MELBOURNE VIC AUSTRALIA 3000. NEWGATECAP.COM
CONTRIBUTORS Despite the contract wins and staggering share price performance we were sceptical of GSW s product claims so undertook a detailed analysis of the company. Our work led us to conclude GSW s claims were preposterous. Apart from incurring almost no software development spending and a team with little experience in last mile logistics, we assessed their software product could not create the necessary network effect required to undertake cost effective last mile logistics. We explain the network effect below: Logistics is a highly complex activity Logistics is an applied science. It is a highly complex business involving an array of variables that conspire to make optimisation mathematically difficult. A logistics operation must decide the following: Where and when to pick up? Which route to use to deliver? Where and when to deliver? These decisions must be made considering the following variables: 1. Every customer s pick-up address 2. Every customer s drop-off address 3. Customer expectations around delivery time length and delivery window 4. The number of delivery assets available cars, trucks, motor scooters 5. Driver availability 6. Variance in package size 7. Weather and road works The diagram below illustrates the interaction between variables and outcomes: Complexity increases geometrically as the number of variables in an analytical problem increase. When a problem has four variables, there are six possible interrelationships. With eight variables there are 28 possible interrelationships Source: Psychology of Intelligence Analysis, Richard Heuer
CONTRIBUTORS The network effect is only available to logistics operations with scale Because of this complexity, the optimal decision on how to direct the logistics task is when all the relevant delivery variables are known by one central platform and when transport assets are centrally owned and controlled. It is this feature of the complex logistics industry that explains why it is concentrated across just a few firms. Major corporations such as Australia Post, DHL and FedEx hold a combined 80-90% market share in complex logistics, depending on geography. This market dominance affords these companies the scale and scope to centralise information about what needs to be picked up and where it needs to be delivered. It is an almost impenetrable barrier to entry. This fundamental nature of the logistics industry gave us confidence GSW were unable to deliver on their product claims. They had no scale and no point of centralised information to do what they said they could do. We entered a short position over December 2016. GSW eventually came undone after the Australian Financial Review revealed that many of the contracts that GSW had announced were not contracts but trials, and several companies had ceased using the product. This verified that the software was unable to do as the company suggested, and the share price fell significantly to reflect this. GSW is now facing numerous class actions because of its alleged misrepresentations. NEWGATE CAPITAL PARTNERS PTY LTD. LEVEL 32, 8 EXHIBITION STREET. MELBOURNE VIC AUSTRALIA 3000. NEWGATECAP.COM
RESEARCH NOTE Detractors The key detractor over the quarter came from our exposure to the emerging lithium industry, specifically Orocobre (ORE) and Mineral Resources (MIN). This significant correction was caused by several investment bank reports arguing the lithium market will be entering a period of oversupply and lithium prices will fall significantly. The chart below shows the extent to which global lithium companies have corrected on the back of this concern. $45 Global Lithium Exchange Traded Fund (LIT) $40 $35 $30 $25 $20 Jan-2017 Mar-2017 May-2017 Jul-2017 Sep-2017 Nov-2017 Jan-2018 Mar-2018 This type of volatility is to be expected around an emerging industry, where forecasts are long dated and subject to rapidly changing perceptions. But this does not mean the market is correct. We will argue the fundamentals do not support a lithium oversupply scenario and severe price declines. $25,000 Asia Lithium Carbonate Swap (USD/tonne) The debate is not whether lithium prices fall, but to what extent. $20,000 Those negative suggest $US8,000 per tonne. Our work points to $US10,000 to $US12,000 per tonne $15,000 $10,000 Our forecast range for lithum prices $5,000 The negative view suggests $US8,000 as a fair medium to long term price $0 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018
RESEARCH NOTE Summary To meet the stated requirements of electric vehicle manufacturers, lithium production must grow from current levels of 300,000 tonnes to two million tonnes by 2030. Our analysis, supported by interviews with independent industry specialists concludes the lithium price needs to stay in the $US10,000 to $US12,000 per tonne price range to incentivise this growth. We provide eight (8) arguments supporting our view that not only is an oversupply situation unlikely, but lithium prices will have to remain at levels to incentivise the large supply requirements: Supply side issues 1. Supply growth will be slower than expected Creating fresh lithium supply is technically challenging. It is highly probable that supply growth will disappoint and there will be disruptions to existing operations. To give you an example, in 2012, the market expected global lithium supply to more than double from 175,000 tonnes to 400,000 tonnes by 2016. By the time we got to 2016 it had only grown to 200,000 tonnes 1, a paltry 15% increase in four years. 2. Forecasts for supply costs are inaccurate in a growth commodity industry like lithium, the cost of new production is highly influential in setting price. The cost forecasts from some investment banks are inaccurate. They have not considered sales commission, regional development contributions, impurity removal, correct royalty levels, contributions to local communities, research and development costs, freight charges, working capital costs and a proper return on the capital that needs to be spent to generate new supply. In our opinion, this was the major analytical error in their work. 3. Industry structure suggests a rational market Because the industry is in its infancy, projects are only receiving debt and equity financing if they have offtake agreements with buyers. This naturally keeps new supply in check. Further the major existing lithium producers are stating they will be disciplined about supply growth: We will only build capacity to meet long term commitments from our customers, we re not in the business of speculating that demand will materialise Leading lithium producer, Albemarle, March 2018 4. Concerns about oversupply helps prevent it The negative investment bank report has caused significant uncertainty in an emerging industry in the process of organising finance for high risk mining and processing projects. This report in of itself has probably delayed some lithium supply by 6-12 months. 1 Lithium industry journals, Orocobre results presentation, 2017
RESEARCH NOTE 5. Buyers of lithium are locking up supply as they scale up ahead of demand Because of the significant growth expected within the electric vehicle industries, battery manufacturers are building capacity well ahead of market forecasts for demand 12. To ensure these plants run optimally these companies require specific lithium chemistry as well as secure, long-term supply. Reflecting this need they are locking up most of the available new supply by entering into sizeable long-term contracts from reliable lithium producers Panasonics battery manufacturing plant in the US. Source: Panasonic 6. Inventory levels need to be built along the supply chain there is a significant time lag between lithium production at the mine to an electric vehicle being purchased by a consumer in a dealership. We estimate 10-15% of lithium supply to be tied up along the supply chain as working capital. This industry feature was a material omission by those arguing for an undisciplined lithium oversupply scenario. 1 The four major battery manufacturers are expected to expand production capacity from 60Gwh to 200GWh by 2020 for a cost of $US10 billion. Source: LG Chemical disclosures 2 The estimated capital costs of the expansion capacity for battery manufacturers to meet the demand by 2030 is $US200 billion. Source: Credit Suisse, March 2018
RESEARCH NOTE 7. The forecast period used by analysts is flawed For no good reason the market is fixated on the electric vehicle penetration rate in 2025 and the resulting lithium demand and supply balance in that year. This is the wrong way to think about it because based on the plans of the major car manufacturers, the penetration rate in 2025 will be 10-15%, but just five years later in 2030 is likely to be 50-75%. This growth trajectory reflects how new technology adoption rates follow a typical S-curve, pictured below. To meet this demand lithium supply will need to double over this five-year period. For this enormous supply growth to occur post 2025, the lithium price must remain at incentive levels to keep encouraging new supply. These incentive levels are $US10,000- $US12,000. 8. There are new sources of demand for lithium In our base case analysis for lithium demand growth we have only considered the demand stemming from electric vehicles. We have ignored the prospects for demand from battery energy storage. Demand for lithium from battery energy storage could be at least as great as that from electric vehicles Conclusion The market sentiment towards lithium stocks is poor at present on the back of misplaced oversupply concerns and worry that lithium prices will fall further than expected. We remain long Orocobre (ORE) in the portfolio and will be looking for opportunities elsewhere in the lithium sector to capitalise on our work. NEWGATE CAPITAL PARTNERS PTY LTD. LEVEL 32, 8 EXHIBITION STREET. MELBOURNE VIC AUSTRALIA 3000. NEWGATECAP.COM
RESEARCH NOTE Resource companies and inflation The market is prepared for a gradual rate hiking process from the Federal Reserve, and over time expects other development market central banks to follow suit. As discussed earlier in the newsletter there is also the risk inflation does rise above target levels and rates must be increased more than expected. We highlight that history shows commodities perform very well in this environment. The chart below illustrates that industrial metals and energy prices rise significantly during the rate hiking process. 60% Average Annualised Daily Returns During Fed Hiking (data from 1984) 50% 40% 30% 20% 10% 0% Industrial Metals Energy Precious Metals Livestock Agriculture Source: Goldman Sachs Conclusion Whilst we do not hold our resource positioning as an inflation hedge, it does provide the portfolio with this potential benefit. If inflation surprises to the upside we expect commodity prices to increase to benefit commodity companies. FUND PROFILE Investment Objective Generate returns of between 12-15% per annum over rolling three year periods with target volatility of less than 15% Fund Inception 7 August 2016 Trustee: Newgate Capital Partners, AFSL 478 388 Fund Manager: Custodian: Administrator: Auditors and Tax Legal: Regulator: Tim Hannon Macquarie Bank Fund BPO PricewaterhouseCoopers DLA Piper, CNM Legal ASIC
IMPORTANT DISCLAIMER This may affect your legal rights: Because this document has been prepared without consideration of any specific client s financial situation, particular needs and investment objectives, you should consult your investment adviser before any investment decision is made. While this document is based on the information from sources which are considered reliable, Newgate Funds Pty Ltd, its associated entities, directors, employees and consultants do not represent, warrant or guarantee, expressly or impliedly, that the information contained in this document is complete or accurate. Nor does Newgate Funds Pty Ltd accept any responsibility to inform you of any matter that subsequently comes to its notice, which may affect any of the information contained in this document. This document is a private communication to clients and is not intended for public circulation or for the use of any third party, without the prior approval of Newgate Funds Pty Ltd. This is general securities advice only and does not constitute advice to any person. Disclosure of Interest: Newgate Investment Management Pty Ltd, Newgate Capital Partners Pty Ltd and its associates may hold shares in the companies recommended. The individual fund performance figures are based on an investment in the Fund s August 2016 units, the date of the Funds inception. The performance numbers are based on the net asset value of the Fund and are calculated net of management fees, brokerage commissions, administrative expenses, and accrued performance allocation, if any, and include the reinvestment of all dividends, interest, new issue income or loss, and capital gains. The Firm and the Fund have a limited operating history. This report is not an offer to buy or sell any security. Offering by private Information Memorandum only. Investing in hedge funds such as the Newgate Absolute Return Fund is risky and investors are exposed to capital loss. Investors should review the Information Memorandum for the Fund, which contains a complete description of the investment program and its risks, in its entirety before investing. The Fund invests in listed securities, which can be volatile and subject to market factors beyond the control of the manager. Certain information provided herein is based on third-party sources, which information, although believed to be accurate, has not been independently verified. The Firm assumes no liability for errors and omissions in the information contained herein. This report is for informational purposes only and may not be reproduced or distributed without the prior consent of the Firm. Volatility is calculated by using the annualised standard deviation of monthly returns since inception of Newgate Real Estate and Infrastructure Fund. Standard deviation measures the distribution of returns around the mean return. Low standard deviations reflect low variation in monthly results; higher variability is usually interpreted as higher risk. Standard deviations are based on monthly results, and then annualised. The Sharpe Ratio is the ratio of excess return to volatility. Excess return is defined as the annualised rate of return less the risk-free rate, using monthly returns since inception. The volatility measure is the annualised standard deviation of monthly excess returns since inception. Any investment in the Funds is speculative and involves substantial risk, including the risk of losing all or substantially all such investment. No representation is made that the Funds will or are likely to achieve their objective, that any investor will or is likely to achieve results comparable to the estimated performance shown, will make any profit at all or will be able to avoid incurring substantial losses. Past performance is not necessarily indicative of future results. Comparisons of the performance of actively managed accounts such as the Funds with passive securities indices involved material inherent limitations. Performance estimates are presented only as of the date referenced above and may have changed materially since such date. Newgate Capital Partners Pty Ltd, ABN 32 606 357 831, AFS Licence Number 478 388 NEWGATE CAPITAL PARTNERS PTY LTD. LEVEL 32, 8 EXHIBITION STREET. MELBOURNE VIC AUSTRALIA 3000. NEWGATECAP.COM