Following a minor market correction early in the year, the fund posted good absolute and relative NOK-denominated returns until well into the third quarter. A disappointing finish resulted in the fund posting negative returns for the full year, although we take some comfort in the fact that the fund outperformed its benchmark. Measured over three and five years, annualised returns are well ahead of its Nordic benchmark and most major indices.

As of end 2018. *Fund launched 6 July 2012. Sources: AFM, Bloomberg.

As of end 2018. *Fund launched 6 July 2012. Sources: AFM, Bloomberg.

We were disappointed to see that the fund underperformed the market during the market turbulence in the final quarter of the year. Moreover, we also witnessed a burst in relative volatility compared to Mr Market (in this respect the VINX Nordic Index). Annualised standard deviation based on rolling 36 months’ returns was 11.0% by the end of the year, more or less in line with the market index. Weak performance in the final quarter can largely be attributed to significant declines for a few holdings. A weaker Norwegian Krone also contributed negatively to relative performance towards the end of year, but had a minor effect for the full year. From a factor perspective, we note that quite unusually – considering the weak market development – leverage, value and size (large cap) outperformed in the fourth quarter.


INTRINSIC VALUE AND PORTFOLIO VALUATION

When analysing value creation in the portfolio, we turn to our holding company approach (thinking of the fund as an industrial holding company where accounts are consolidated on a proportionate basis). We believe that value creation over time will be expressed by growth in book equity, earnings and dividends. This, in turn, is likely to drive stock price performance over the long run.

On a preliminary basis (based largely on Q3-18 financial statements as year-end reports are not yet published) the fund’s earnings measured on a unit basis was up by 7% last year. Dividends received increased by 11% whereas book values increased by 22%. Intrinsic value, a composite of these three (earnings, dividends and book value) was up by 13.0% last year. As our net asset value declined by 3.6%, the logical, and presumably correct, conclusion is that the portfolio during the year became significantly more attractively valued.

The market’s (as defined by the VINX Nordic Index) increase in intrinsic value was 5.5% last year. Hence, an interpretation is that the fund’s excess value creation (7.5%-p) was larger than its excess price performance (2.3%-p) – implying that also relative valuation improved. Since July 2013 (one year after fund inception) intrinsic value for the fund is up by 100% compared to an increase for the market index of 51%. This excess value creation, of 49%-p, compares with excess portfolio returns of “only” 31%-p during the same period.

Over the course of the year, the fund’s price to book ratio went down from 2.3 to 1.8, while the market’s ratio fell from 2.5 to 2.2. The fund’s realised (12 months’ trailing) price earnings ratio decreased from 17.4 to 15.6 (the market’s fell from 20.3 to 18.0), while the forward-looking (based on analysts’ estimates) price earnings ratio decreased from 15.0 to 11.2 (market from 16.4 to 14.1). Realised (trailing) dividend yield went up by 0.4%-p to 3.6%. At the end of the year, portfolio valuations were at their lowest levels for more than four years. Moreover, the discount to the market index was also at its widest level for four and a half years.

It should be noted that growth in intrinsic value and the improvement in absolute and relative valuation over the last year to a large degree stems from portfolio rotation (i.e. selling “expensive” holdings and buying “cheap” ones).


PERFORMANCE ATTRIBUTION, CONTRIBUTORS AND COMPANY DEVELOPMENTS

Even though we fully agree with Anthony Bolton’s view that one should not spend too much time on attribution analysis, it is important to understand the drivers of performance. Below we will first briefly go through sources of relative contributions (i.e. sector attribution) and then move on to the more interesting part of the analysis, focussing on performance contributions from our stocks.

Looking briefly at industry sectors (as defined by GICS level 1), we find that security selection within the sectors contributed positively to relative performance in 2018. The strongest selection effect came from industrials where many of our “defensive” names like Tomra, Valmet, Bravida and Kongsberg gave positive contributions in a sector that significantly underperformed the broader market. Furthermore, the consumer staples sector, driven by our seafood holdings, posted strong absolute and relative returns. The same goes for health care, due to strong returns from Elekta.

Sector allocation contributed negatively to performance. This can largely be attributed to technology and consumer discretionary. The fund had small exposure towards the tech sector which was the market’s best performing last year, driven by bouncing share prices for Ericsson and Nokia. Moreover, we had a high relative exposure towards the diverse consumer cyclical sector, which was the worst performing market sector. 

Furthermore, there was a positive interaction effect, due to the fact that our portfolio outperformed in all the sectors where we had larger weights than the benchmark index.


Sector attribution for 2018. Fund returns in NOK measured against VINX Nordic benchmark. Numbers not fully consistent with actual performance. Sources: AFM, Bloomberg.

From a geographical point of view, we note that the analysis shows that our results in Norway and Finland stand out positively, while our stock selection in Denmark was poor last year. Analysing performance and market cap, it turns out that the fund posted strong returns in the mid cap segment (market cap EUR 1-5 bn.), whereas our small cap bucket (consisting of companies with market capitalisation below EUR 1 bn.) had an overall poor showing.

Looking at companies’ contribution to fund performance, Amer Sports stands out. The company has been in the portfolio since inception in 2012 and has posted 550% accumulated returns during the period. Following strong price performance from early in the year, a bid from a consortium led by Chinese sportswear firm ANTA Sports, propelled the stock price further. This holding will most likely be exited over the next few weeks. Apart from Icelandic Hagar, we note that all of the ten best performers have been in the portfolio for more than three years. The list features three aquaculture names, two of which were among our negative contributors in 2017. A strong market development, good operations and a multiple rerating – the latter leading us to divest a significant part of our holdings – are explanatory factors. Elekta, also one of the funds’ losing stocks in 2017, had a strong showing on the back of a completed turnaround, good order intake and high expectations for its recently introduced MRI-linac. Aker BP, once again delivered a rock solid year operationally and made it into the top ten list for the third year consecutive year, and most of the holding was divested.

We witnessed that four holdings deducted more than 1%-point from performance in 2018 and they all fell in excess of 40%. The share price of Danske Bank was seriously hit as the Estonian money laundering scandal unfolded. Obviously, our investment hypothesis of the bank as a blend of good management, reasonable valuation and strong yield has now been turned into one of excessive pessimism and deep value. Pandora failed to deliver on its revised strategy and can now be considered a turnaround case.

There now is a quite precise diagnosis of the challenges the company is facing, but the medicine prescribed will take time to have effect. LeoVegas, our best performing stock in 2017, witnessed its share price decline heavily last year as growth decelerated and compliance related costs mounted. Sports retailer XXL was added to the portfolio in August last year following a poor quarterly report and lacklustre share price development. However, things turned for the worse as the company in December warned of a very weak development in the seasonally important fourth quarter.


PORTFOLIO ACTIVITY AND CHARACTERISTICS

We made ten new investments during 2018. Three of them, ABB, Telenor and JM, have previously been in the portfolio. Silicon and material producer Elkem was taken into the fund during its relisting on the stock exchange. The company has so far delivered strong results, but the company’s end markets are subject to significant cyclical headwinds. Finish power and marine technology company Wärtsila and packaging company Huhtamäki are both considered quality companies with strong market positions and attractive cyclically adjusted valuations. Danish kitchen producer TCM Group is an attractively valued small cap with a good management and track record. Sweden-based window producer Inwido, like JM, were taken into the portfolio following widespread housing market pessimism and a significant share price decline. In retrospect XXL was taken into the fund too early, while gaming company Better Collective has delivered as expected.

We exited four companies. Finnish telecom operator DNA, Austevoll Seafood and Ekornes were exited on valuation grounds. Solstad Offshore was divested due to its excessive debt and uncertain market outlook.

22 new investment candidates made it through the investment funnel to a very detailed analysis, slightly lower the 24 in 2017. Needless to say, improving research productivity is a top priority.

By the end of the year we had 42 companies in the portfolio, up from 36 a year ago. During the last five years the number of holdings has varied between 36 and 46. The ten largest holding accounted for 40% of the portfolio (excl. cash), down from 48% last year. Active share decreased from 83.3% to 79.1%.

There were moderate changes to the industry composition of the portfolio. Exposure towards consumer staples (seafood) and real estate (Entra) was scaled back, while it increased somewhat for materials and consumer discretionary. Industrials and consumer discretionary combined made up 51% of the portfolio at the end of the year. Measured by market cap, we note that the share of the portfolio invested in small caps increased by 6%-p to 23% over the course of the year, while there was a reduction in the share of mid caps of roughly the same magnitude to 37%. Weighted average market capitalisation for the portfolio was down 4% to NOK 126 bn., while median market cap rose by NOK 5 bn to NOK 27 bn.

The financial leverage in the portfolio was fairly flat throughout the year and aggregated net debt to equity (excluding financials) stood at 44% at the end of last year, compared to 42% a year ago. Realised return on equity for the aggregated portfolio was 14.4%, more or less the same level as in 2017. Forward-looking (as given by analysts’ consensus) ROE decreased sligthy to 20.4%.

 

Sindre Sørbye
Portfolio Manager and Partner
January 2019

Arctic Nordic Equities is an equity fund investing in «high conviction» Nordic companies. The fund is run by Sindre Sørbye, Tore Mengshoel and Ole Dahl, who has been a joint investment team since joining Orkla ASA, later Solsten, now Arctic Fund Management. Together with analyst Thomas Rasmussen, the team is responsible for Arctic Norwegian Value Creation II and Arctic Nordic Equities. The latter was launched in 2012, while the Arctic Norwegian Value Creation was launched in 2014.

Past performance in Arctic Nordic Equites is no guarantee for future returns. Future returns depend on the market, fund manager skill, fund risk level, costs, among others. Performance may at times be negative and may vary within periods.