Fairlight Alpha Fund Q3 2023 Letter

Pricey Companions,

Fairlight Alpha Fund’s third quarter 2023 returns had been -11.1% web of charges. This compares to -3.3% for the S&P 500 (SP500, SPX) Whole Return index. General, since inception the fund has returned 421.7% web of charges and 43.3% on an annualized foundation.

Efficiency vs. the S&P 500

We monitor the online asset worth of Fairlight Alpha Fund (the “Fund”) over time as calculated by our fund administrator primarily based on our portfolio positions and costs over time on a greenback foundation. The fund financials are additionally audited annually by an impartial auditor with the help of the Fairlight administration firm and the fund administrator.

The tables under present the S&P 500 complete return and partnership web returns, after charges, for annually 2019-2023, adopted by the compounded returns over the identical interval, in addition to the annualized good points.

Annual Returns

Yr

Fairlight Alpha Fund

S&P 500 (Whole Return)

Distinction

2019[1]

……………………………

38.1%

17.9%

20.1%

2020

………………………….

26.3%

18.4%

7.9%

2021

………………………….

146.5%

28.7%

117.8%

2022

………………………….

15.8%

-18.1%

33.9%

2023 (YTD)

………………………….

4.8%

13.1%

-8.3%

Compounded Returns

Yr

Fairlight Alpha Fund

S&P 500 (Whole Return)

Distinction

20191

……………………………

38.1%

17.9%

20.1%

2020

………………………….

74.4%

39.6%

34.7%

2021

………………………….

329.9%

79.7%

250.2%

2022

………………………….

397.9%

47.2%

350.7%

2023 (YTD)

………………………….

421.7%

66.4%

355.3%

Annualized Achieve

………………………….

43.3%

11.7%

31.6%

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1The S&P 500 returns symbolize the overall return index, i.e., with dividend reinvestment included. Will increase in worth come up from inventory value appreciation in addition to dividend reinvestment. This supplies a fairer comparability to the fund.

2The Fairlight Alpha Fund efficiency is proven web of partnership charges and bills.

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The fund, together with the general small-cap market, confronted a harder quarter this era. There’s quite a lot of dialogue round skews within the reported market returns attributable to the Magnificent Seven shares, however the correction in small-cap shares has created quite a lot of alternatives and there’s no scarcity of concepts that may be discovered which can be very low cost on an absolute foundation. As a measure of this the Russell 2000 index within the US has fallen by 17.6% since its peak on July 31. We keep away from speculating on macroeconomics, however it’s possible that the upper fee surroundings is now starting to have an effect on the financial system and lots of firms as a result of cash is now not free (or low cost). The good majority of the positions in our portfolio haven’t any web debt and often have massive web money or funding positions, and so might profit in the next fee surroundings and be shielded from monetary stress attributable to greater debt prices.

We have now been extraordinarily busy taking a look at quite a lot of new concepts and have discovered that the US markets are actually rather more considerable with potential investments than a yr in the past, or perhaps a quarter or two in the past. In related durations up to now, we’ve rotated out of some names which have held up higher into names which have fallen to extremes of valuation and this method has served us nicely over time.

Market and Portfolio Efficiency

There’s at all times dangerous information to stop buyers from being totally invested available in the market. Within the Seventies it was the vitality disaster and inflation (oil manufacturing per capita is estimated to have peaked round 1979). The Eighties noticed persevering with excessive inflation, then financial recessions, the chilly battle and a inventory market crash in 1987. Into the Nineteen Nineties it was the Financial savings and Mortgage disaster, Asian disaster, Russian debt default, LTCM disaster and dot-com bubble resulting in absurdly high-tech valuations and subsequent crash. The brand new millennium noticed September eleventh, a housing growth, hypothesis, and reckless lending culminating within the World Monetary Disaster. This led to the top of the bank-less dealer enterprise mannequin (Lehman, and Bear Stearns) and a interval of low rates of interest by the 2010s. There adopted the rise of ISIS and the Syrian civil battle, Russian annexation of Crimea in 2014, Brexit in 2016, market instability resulting from varied asset bubbles and tepid international development.

There are nonetheless many issues to be involved about: rising tensions and the chance of battle within the center east; the continuing Russia-Ukraine battle; growing Chinese language energy and affect inflicting uncertainty and concern within the West; growing chip wars and sanctions referring to semiconductor and know-how gross sales; spiraling US debt ranges; rising market inflation and financial instability; cyber safety threats; and job displacement and systemic shifts in society ensuing from the rise of AI. All these fears are sufficient to make buyers conceal of their shells and never look to tackle any danger. But when we have a look at inventory market returns throughout all of the earlier many years (utilizing the S&P 500 as a proxy) the image appears to be like very completely different.

Desk 1: US market returns by decade (S&P 500).

Interval

Change

Compound Return

1970-1979

17.2%

17.2%

1980-1989

227.4%

283.9%

1990-1999

315.7%

1,496.0%

2000-2009

-24.1%

1,111.3%

2010-2019

189.7%

3,409.4%

2020-YTD

30.7%

4,489.5%

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Apart from the 2000s within the wake of the World Monetary Disaster every decade produced constructive returns. And publish 2009 the market reached new highs by early 2013. Staying invested available in the market over these many years even in a market index tracker would have produced a really wholesome degree of returns.

A latest space of concern amongst market observers is the US banks, notably following occasions in March/April. This era noticed elevated apprehensions round US regional banks, in addition to group banks. Considerations embody financial institution runs, undisclosed know-how or crypto exposures, additional losses on Mounted Price US Treasury and Company positions held in Obtainable-For-Sale and Held-to-Maturity portfolios, and the looming prospect of a recession. Nonetheless, an in depth examination of economic statements from varied US group banks reveals minimal indicators of stress in lots of circumstances. Particularly, we like banks equivalent to Residents Bancshares Company (OTCPK:CZBS) and M&F Bancorp, Inc. (OTCPK:MFBP). Each banks have a historical past of successfully managing their mortgage books and took part within the ECIP program. Each are MDIs (Minority Depository Establishments), which were given investments through most well-liked shares on favorable phrases, enhancing their potential to develop domestically and supply credit score to native areas. Furthermore, massive US banks, like Financial institution of America and Citigroup, are supporting them when it comes to workers, steering, and participation in syndicated loans (see the NFL press launch[2]).

The valuation of those banks has declined over the past quarter, in step with the development noticed in lots of different small and microcap shares, making them much more compelling investments than earlier than. They nonetheless have an extended runway of development forward of them, notably excessive regulatory capital ratios and their fixed-rate investments are held in Obtainable-For-Sale portfolios, which have already been mirrored of their monetary statements underneath AOCI. Rising rates of interest have additionally boosted their earnings and notably for Residents Bancshares which has managed deposit prices successfully, boasting one of many lowest deposit price bases amongst US banks. Given their deep-rooted connections to their communities and sturdy stability sheets, we anticipate they may enhance deposits over time. In flip, as their mortgage portfolios broaden, we mission their earnings to no less than double within the upcoming years. They’re additionally nicely positioned to climate a recession or financial downturn. We at the moment estimate that Residents Bancshares is priced at a present a number of of 4.8x and M&F Bancorp is at 5.9x, with each holding money reserves exceeding their market capitalization (practically twice as a lot for M&F Bancorp). We’re additionally exploring different alternatives amongst non-ECIP US group banks (and in a single case constructing a place in) that we’ll focus on additional in future letters.

Past the US, there are some names in East Asia that we like (and have talked about earlier than), equivalent to Pax World (OTCPK:PXGYF). Regardless of a decline in earnings this yr, with Pax incomes HK$650.6 million in H1 2023 versus HK$699.8 million in H1 2022 the long-term development is one among development. We consider Pax World’s enterprise stays robust and is basically ignored by the market. This rising enterprise, buying and selling at a 4.8x a number of, holds money reserves equal to virtually half its market cap. Moreover, it is usually returning capital to shareholders with a 6.5% dividend yield over the past two reporting durations and has accelerated its share buyback efforts, having purchased virtually 1% of shares excellent over the previous couple of months.

All year long, we’ve reviewed hundreds of firms, together with many within the oil sector. Whereas we’re typically cautious about commodity-based companies the place the corporate lacks management over the worth of what it produces, the valuations in a number of circumstances have reached extraordinarily compelling ranges. For instance, Petrobras (PBR) and Ecopetrol (EC). Petrobras has distributed dividends of over $2.30 paid this yr[3], whereas Ecopetrol has traded as cheaply because the $9-$10 vary (near our buy value) and is paying roughly $2.50 in dividends this yr.

We issue within the potential price of FX actions over time, however even underneath probably the most pessimistic situations the investments ought to work out nicely. We initially got here throughout these concepts whereas taking a look at South American shares usually. We noticed that many market commentators had expressed issues that Ecopetrol’s dividends is perhaps halted, particularly following the election of Gustavo Petro as president of Colombia in June 2022. Equally, there have been reservations concerning the sustainability of Petrobras’s dividend. Nonetheless, the federal government owns substantial controlling stakes in these firms and can be a recipient of their dividends. For Ecopetrol, the Colombian authorities owes cash to Ecopetrol because of the Gas Value Stabilization Fund (FEPC). This fund goals to stabilize gas costs for Colombian shoppers. It bridges the hole between worldwide and nationwide Colombian shopper costs by compensating producers and importers for this value distinction. The first objective is to cushion the influence of world oil value fluctuations on the Colombian market. That is achieved both by money cost or by forgoing dividend funds due from the federal government’s stake in these firms. In Ecopetrol’s case, the dividends paid (or people who can be paid to the federal government) are utilized towards the excellent balances.

This implies the federal government can scale back the stability owed to Ecopetrol for its contribution to the Gas Value Stabilization Fund. For instance, in Q3 2023 this amounted to greater than 8 trillion COP or US$2 billion. On the finish of July 2023, the stability of the Gas Value Stabilization Fund stood at round 22 trillion Colombian Pesos, equal to $5.4 billion.

Continued excessive oil costs, further oil manufacturing, systemic regional significance and current money reserves reinforce our perception within the attractiveness of those investments. Although Petrobras amended its dividend coverage in July, from a minimal of 60% to no less than 45% of free money stream, this can give the corporate further room to carry out further share buybacks. Judging by what has occurred so far, and the precise remedy of shareholders (quite than speculated actions) we are going to keep and monitor a holding in these shares at present valuations.

Shifting consideration again to the US, the microcap now presents some compelling alternatives throughout quite a lot of sectors. We’re within the course of of buying stakes in a number of concepts and so we are going to focus on these additional in future letters. Given the illiquidity in a few of these investments, our objective is to determine a significant degree of funding earlier than we write these up or publish particulars.

Historic Efficiency of Small-Cap, Illiquid and Household Shares

The comparability between the efficiency of small-cap shares versus large-cap shares has been a frequent subject, however different metrics can be indicators of potential swimming pools of upper performing investments. Liquidity is a vital issue that’s usually perceived as a detrimental attribute, however extremely researched, well-chosen shares can outperform. This concept is assist by the seminal paper of Amihud and Mendelson (1986) on liquidity and inventory returns[4]. Equally, in non-public markets the returns of Non-public Fairness (“PE”) could be partially attributed to the private, illiquid nature of their investments[5]. We understand the investments we’ve made up to now as benefiting from an illiquidity premium, akin to PE returns, however with the expansion upside of Enterprise Capital returns.

We additionally got here throughout one other research referring to family-owned companies which aligns with the type of shares that the fund invests in. The quick Credit score Suisse research: “Belief: the alpha issue for household owned firms” examined the outperformance of those sorts of companies in comparison with the broader market[6]. Notable examples of such firms embody large-cap entities like Hermès, Merck, and L’Oréal. The outperformance of family-owned companies is claimed to be 4% from 2006 to 2022.

These sorts of research function helpful pointers, guiding us as to which a part of the lake we must be fishing in and function an extra issue to consider when reviewing companies. Household-owned companies and proprietor operators (that perform in an analogous manner) usually exhibit behavioral qualities much less frequent in different publicly owned companies: superior capital allocation and extra favorable remedy of frequent shareholders. When it comes to “liquidity alpha”, this phenomenon arises from outdoors the enterprise itself, stemming from components like inventory value actions, broad bid/supply spreads, or durations of illiquidity that can lead to substantial gaps between an organization’s market value and its intrinsic worth.

Outlook for the The rest of 2023

The persisting turbulence within the markets has created many new alternatives. One of the best companies and shares are like resilient bubbles in an unlimited ocean, and regardless of being tossed by the waves of market sentiment, they’ve an inherent buoyancy that guides them to the floor, manifesting the underlying worth that we acknowledge in calmer waters.

This has been an exceptionally busy interval for us, as a result of there are an enormous variety of concepts to investigate and sift by. And we purpose to stay optimistic for the long run, even in these tough and unsure instances. However we endeavor to recollect that there’s each that: “there may be at all times one thing to fret about” (Peter Lynch); but additionally that: “there may be at all times one thing to do” (Peter Cundill).

We’re regularly grateful for our companions’ assist and understand how valuable time is for everybody. And so, we search to maximise returns, and develop the dimensions of every investor’s allocation throughout the fund over time. And at all times being vigilant to take greatest benefit of the market’s swings of pessimism and optimism.

Yours,

Andrew Martin, Chief Government Officer | Michael Saunders, Head of Advertising and Investor Relations

Footnotes

[1] The Fairlight Alpha Fund was launched on 01-Mar-2019 and so the 2019 efficiency and returns are introduced for a 10-month interval.

[2]https://newsroom.bankofamerica.com/content material/newsroom/press-releases/2023/06/the-nfl-secures–78-million-in-loans-from-minority-banks–streng.html

[3] Utilizing the Brazilian Actual-to-dollar FX fee as of every pay date.

[4] Liquidity and Inventory Returns, Amihud and Mendelson, 1986: Liquidity and Inventory Returns on JSTOR

[5]https://viewpoint.bnpparibas-am.com/the-illiquidity-premium-in-private-asset-markets/#:~:textual content=Thispercent20outperformancepercent20canpercent20bepercent20seen,illiquidpercent20assetspercent20overpercent20prolongedpercent20

[6] https://am.credit-suisse.com/content material/dam/csam/docs/equities/lux-european-entrepreneur-ef/marketcommentary-ch-eng.pdf

THIS IS NOT AN OFFERING OR THE SOLICITATION OF AN OFFER TO PURCHASE AN INTEREST IN FAIRLIGHT ALPHA FUND LP (THE “FUND”). ANY SUCH OFFER OR SOLICITATION WILL ONLY BE MADE TO QUALIFIED INVESTORS BY MEANS OF A CONFIDENTIAL OFFERING MEMORANDUM AND ONLY IN THOSE JURISDICTIONS WHERE PERMITTED BY LAW.

AN INVESTMENT IN THE FUNDS IS SPECULATIVE AND INVOLVES A HIGH DEGREE OF RISK. OPPORTUNITIES FOR WITHDRAWAL, REDEMPTION AND TRANSFERABILITY OF INTERESTS ARE RESTRICTED, SO INVESTORS MAY NOT HAVE ACCESS TO CAPITAL WHEN IT IS NEEDED. THERE IS NO SECONDARY MARKET FOR THE INTERESTS AND NONE IS EXPECTED TO DEVELOP.

THE FEES AND EXPENSES CHARGED IN CONNECTION WITH THIS INVESTMENT MAY BE HIGHER THAN THE FEES AND EXPENSES OF OTHER INVESTMENT ALTERNATIVES AND MAY OFFSET PROFITS. NO ASSURANCE CAN BE GIVEN THAT THE INVESTMENT OBJECTIVE WILL BE ACHIEVED OR THAT AN INVESTOR WILL RECEIVE A RETURN OF ALL OR PART OF HIS OR HER INVESTMENT. INVESTMENT RESULTS MAY VARY SUBSTANTIALLY OVER ANY GIVEN TIME PERIOD.

THE PERFORMANCE DATA SHOWN HEREIN REPRESENTS THE PERFORMANCE OF THE FUND. THE RESULTS REFLECT THE DEDUCTION OF: (I) AN ANNUAL ASSET MANAGEMENT FEE OF 2%, CHARGED QUARTERLY; (II) A PERFORMANCE ALLOCATION OF 20%, TAKEN QUARTERLY, SUBJECT TO A “HIGH WATER MARK;” AND (III) TRANSACTION FEES AND OTHER EXPENSES ACTUALLY INCURRED BY THE FUND. THE RESULTS REFLECT THE IMPLEMENTATION OF THE INVESTMENT STRATEGY DESCRIBED IN THE FUNDS’ OFFERING DOCUMENTS AND APPLIED IN THE FUNDS’ TRADING ACCOUNTS. ALL INVESTMENTS INVOLVE RISK, INCLUDING THE LOSS OF PRINCIPAL.

RESULTS ARE COMPARED TO THE PERFORMANCE OF THE S&P 500 TOTAL RETURN INDEX (THE “COMPARATIVE INDEX”) FOR INFORMATIONAL PURPOSES ONLY. THE FUND’S INVESTMENT PROGRAM DOES NOT MIRROR THE COMPARATIVE INDEX AND THE VOLATILITY OF THE FUND’S INVESTMENT PROGRAM MAY BE MATERIALLY DIFFERENT FROM THAT OF THE COMPARATIVE INDEX. THE SECURITIES OR OTHER INSTRUMENTS INCLUDED IN THE COMPARATIVE INDEX ARE NOT NECESSARILY INCLUDED IN THE FUND’S INVESTMENT PROGRAM AND CRITERIA FOR INCLUSION IN THE COMPARATIVE INDEX ARE DIFFERENT THAN THOSE FOR INVESTMENT BY THE FUND. THE PERFORMANCE OF THE COMPARATIVE INDEX WAS OBTAINED FROM PUBLISHED SOURCES BELIEVED TO BE RELIABLE, BUT WHICH ARE NOT WARRANTED AS TO ACCURACY OR COMPLETENESS. UNLESS NOTED OTHERWISE, THE RETURNS OF THE COMPARATIVE INDEX PRESENTED HEREIN DO NOT REFLECT FEES OR TRANSACTION COSTS, BUT THOSE RETURNS DO REFLECT NET DIVIDENDS, IF ANY.

PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.

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Authentic publish

Editor’s be aware: The abstract bullets for this text had been chosen by searching for alpha editors.

Editor’s Notice: This text discusses a number of securities that don’t commerce on a serious U.S. change. Please concentrate on the dangers related to these shares.