I have not posted on this thread for some time but thought I...

I have not posted on this thread for some time but thought I would chime in given recent developments/market movements/discussion on the thread etc.

Full disclosure: I used to hold ALF, I do not anymore. But please don’t view this post as a biased viewpoint pushing some agenda. What I aim to do is present, in a logical and objective manner, aspects about ALF that either don’t appear to be fully appreciated or previously provided. My intention in posting is actually to ensure that those current holders understand FULLY what they hold. In all sincerity I mean well, and I say everything that follows with humility and respect to all readers and contributors to this great thread. It is not intended to be financial advice but just another poster wanting to help the community at large by adding their 2 cents.

Its a long one so thanks to those that read it.

Market Neutrality

If you view my previous posts I have written on the subject of Market Neutrality. Without wanting to repeat at length previous comments, I will note the key points again here.

Market Neutral DOES NOT equal Market Hedged. Please ensure you understand this. Hedging and Neutrality are very different things. I have provided comment to the ALF team in the past as to be careful not to misrepresent what is actually going on – especially after I saw their presentation in late 2014. “The fund is Market Neutral so we have your capital well protected and are well positioned for any possible correction”… this is not a true representation of what Market Neutral means or represents.

I have respect for each poster in this thread. I just worry, for instance when JUSTBOB (who has had some great posts on HC and clearly is a smart person and I enjoy reading his/her posts) writes:

“While the market is perceived to be over valued & in a negative mood ALF would have its long & short portfolios positioned that would be close to market neutral & once the market looks like increasing, Justin would be increasing the long portfolio & reducing the short portfolio. When the market starts a new bull phase ALF should start to report some outstanding results.”

Or another great poster and long-time contributor to the ALF discussion eerrtt writes:

“And yep, Market Neutral is good when ASX falls 10pc. Then they can go long, once they see a bottom. Justin has said the market is overvalued, whilst not in bubble territory, so neutral should be safe.”

If a fund is perfectly Market Neutral, all that means is that at that snapshot moment the market value of the longs equals the market value of the shorts. Now, should the market sell off and the longs fall proportionally the same amount as the shorts do, then in that case yes the NTA of that portfolio, all else equal, will not change – that is to say, the loss in value of the longs will be 100% offset by the “increase” in value from those shares sold short.

But if the longs fall proportionally MORE than the shorts, the fund will lose money. If the longs fall proportionally LESS, the fund would actually make money.

In reality, ALF is close to market neutral but as you all know is still technical net long – and that is why they will require their longs to outperform their shorts.

So, if for example, the market were to fall by 10%, the shorts would have to significantly outperform the longs (given they represent an overall smaller weight than the longs in the overall portfolio) to contribute to an overall gain in performance when the longs fall as well. In other words, and I just use random numbers to illustrate the point:

-> Market Falls 10%, Longs fall 12%, Shorts fall 15% equals GOOD for ALF and
-> Market Falls 10%, Longs fall 8%, Shorts fall 4% equals BAD for ALF

So you can see, it’s the RELATIVE size of the falls and the interaction BETWEEN the long and shorts that matter. In the second example, the longs actually fall less than the market so all else equal that is a relative outperformance and a good thing on its own, but the NTA would be hit as the shorts have not been able to offset this. To be fair (I did say I aimed to be unbiased), in both examples, the NTA would fall less than the fall in the longs alone as there is some offset with the shorts - but the point being its not hedged.

What you wouldn’t want is this

-> Market Falls 10%, Longs fall 8%, Shorts rally 4% equals VERY BAD for ALF

In this instance, the market falls, the longs fall, but those shares sold short actually rally. In this case, it’s very bad for NTA and a double whammy so to speak.

What this should make clear is that ALF is not hedged.

If Justin were to have purchased Futures or Options such that their delta (change in value) match that of the underlying portfolio one for one then it would be hedged. So irrespective of what the market did, the NTA would not change. The only technical detail with that, however, would be that hedging does come at a cost (either in the form of the premium paid for the options or when closing out the Futures contracts the price paid to close out will no doubt be different to what existed at the time of contract origination) … so just like house or car insurance, portfolio hedging costs money, but used with the proper purpose, that cost is seen as small relative to what the cost would be for not doing anything and then something going wrong. Thus, the NTA over time would be reduced by the cost of the hedge, but it would theoretically be made up by future profits made by investing at opportune times that Justin and co are no doubt waiting for.

ALF holders have all experienced over the last 12 months or so the perfect storm – the longs have sold off and the shorts have rallied. So of the 4 outcomes:

-> Longs up, Shorts up
-> Longs down, Shorts up (ALF have had this)
-> Longs up, Shorts down
-> Longs down, Shorts down

… we have had the worst outcome, which brings me to what is arguably the most important aspect of any LIC…

Management Skill

In situations like these what is extremely important is having confidence in the manager to work through the issues and correct them in a timely manner. What became clear from the presentations and Q&A sessions (recently but also last year) was that the team are struggling to think strategically in order to correct the positioning of the portfolio. The way in which the meetings were held and how questions were answered were less than encouraging. Examples such as not closing out short positions quick enough, and then having them rally against them over a period of a couple of months – in fund manager land that is unbelievably poor form – indeed, its greatest cost is that it makes one question the quality of underlying talent and is very hard to gain that trust back. Any manager can have a bad month, heck a bad few months – and the market isn’t being kind to many at the moment. But looking through those aspects, if the fundamental talent quality is lacking then there is a problem.

I acquired ALF back in 2013. The track record to date was strong and all indications were that they had exhibited true alpha generating ability and the future looked bright. Analysis at the time suggested they had typically traded at a discount to NTA for much of its listed life, but the small premium at the time was justified as one was paying for the experience of the management team. I ended up selling out recently after seeing many months of mtm losses (both in terms of my holding but also that of the fund itself).

As an aside, those that talk about buying based on the fact that its trading at a discount would be served well looking at historical charts depicting the premium/discount relationship. For most of the period between 2006 and 2010, it traded at between a 15% and 20% discount. The premium really only came about in 2013. Between 2004 and the start of 2013 it would always trade at a discount.

All that premium has now been taken out of the price and it’s now pricing at a discount once again, but the magnitude of that discount is not historically out of order.

Given the behavioural attributes I have seen exhibited by the team over the last 12 months, and mixing that in with the experience that I have from previous situations with fund teams, I am concerned that the 2009 to 2012 period was a case of a “rising tide lifts all boats” rather than genuine ability. Time will tell, but if we see the other side of Christmas and the HC threads contain themes not much different from today, I think that question will have been answered definitively.

Also, if one looks at the data, what seems to have occurred is that 2009 was an amazing NTA growth phase (but recall, the market as a whole bounced back during 2009). Over 2010 to 2013 the NTA did have growth but nothing like that seen in 2009. Now, admittedly it was payng good franked dividends over this period. Thus, I think it’s fair to say overall, the market environment was helpful but there were some great calls by the team. I mean heck, I bought in right

The way in which the presentations were conducted most recently, just have me concerned that the team is not up to the challenge facing them. The hit to NTA is massive, don’t underestimate how much damage to the portfolio has been done. It’s not the end of the world, but it’s a mammoth task in front of them. You need to feel confident that Justin and co are up to correcting that.

Liquidity

Liquidity is an issue with this stock.

If a large holder sells down, it can move it 5+ cents. Something for current holdings to think about is how they play their holding AFTER the next dividend. As others have noted, the last dividend and the next one are being paid from profit reserves and are NOT special. BUT after that, if the NTA reports continue as is, it will be difficult to maintain 10c/year and even a dividend at all. The registry is full of SMSF’s holders which on the one hand can be a positive as they don’t tend to transact as much as others (or sell out at will) BUT the cost is that if the income stops, they will likely exit and given the liquidity one can imagine what will happen to the price – sub $1 will come swiftly and will may very well be seen as a good exit in 6 to 12 months. I don’t mean to be doom and gloom – just think about it logically. ALF pays the next dividend, the dividend in 2016 is reduced or suspended who will be the marginal buyer of ALF and with WAM et al readily available why should SMSF ABC hold ALF anymore. As a holder, do you want to wear this risk?

Closing remarks

The question one must ask themselves is that, given all the above, “am I as a holder being duly compensated for all the above risk?”. It’s a personal question, and not one that I can answer for anyone other than myself, but overall I didn’t feel that I was. Hence I moved on. I still watch out of interest, as markets are a forever evolving beast that can teach us all a lesson every day.

Perhaps, at $1 or $75c or $50c a buyer will feel that over a 3 to 5yr horizon, that entry point does provide enough potential upside to compensate for those risks. But for someone who purchased at $1.30 or $1.50 or above, will the performance of the NTA over the next few years reward that holding. As noted above, but I will elaborate here, the reason why the damage to NTA is so huge is because the performance required to get the fund back to an NTA of $1.50 to $1.60 and still have enough for dividends would require such market outperformance that either (i) they get lucky or (ii) Justin is the best fund manager in the country. Both possible, but based on probabilities and performance over the last 12 months the data would make it difficult to argue that case.

Also remember that with any investment, any full analysis needs to take in the opportunity cost. If you continue to hold ALF, what are you forgoing holding. ALF vs VHY vs WAM etc.

For me, what ALF represents now is two things (i) seeing truly how good the management team is – does the NTA turnaround in the next 12 to 18 months and it hits $1.50 to $2 so they are a great team indeed etc. (and for the share price to follow I think they will need VERY STRONG NTA performance) and (ii) a lesson in investor psychology should the NTA reports continue to disappoint – that is to say, when does capitulation really kick in – clearly holders are selling out, but the real deep flush hasn’t occurred yet – does it actually occur and what does the share price look like in 12 months’ time.

And so those comments given as examples above from the two posters (and why I chose them) imply a heavy reliance on management being able to time the market into the future and to not lose money with the market neutral positioning in the meantime. To emphasise this point further, even if Justin had perfect stock picking skill in the future and the market does fall 10% or 20% or whatever % in the near term, you want him to arrive at that point cashed up and with the war chest fully loaded – but if the relative performance of the longs/shorts continues to eat into the value of the capital available to invest, then at that point, the ability for Justin to turns things around becomes even that much harder. Thus it's a vicious cycle if you will - think of it this way, if you lose 50% on an investment you then need to make 100% to get back to breakeven. In fund land a cheeky way around that is external cash injection to bring the 'funds under management' size back to what it was prior and then deploy that fresh capital.

And so that is why each month of further degradation in NTA is harder to absorb because it becomes exponentially harder to then make that back up in the future and provide a dividend overlay on top of that. I have seen cases of fund managers taking extreme positions in the hope that “the Hail Mary” play will come off and make them square again or at best a little positive and then after THAT they can then start rebuilding. I would not say we have reached that point with ALF, or indeed may never, but it’s something to watch out for.

It’s admittedly a difficult trading environment out there at the moment, and unlikely to get easier in the foreseeable future. I wish Justin and the team well. I wish all current holders well. I really do – I get no joy from reading posts by eerrtt saying I have just bought more, and then the price falls another 5% over the week.
  
The very best to all of you.

Jam