The WS Lancaster Absolute Fund was up 4% for September, bringing its year-to-date return to -4.7%. The fund has enjoyed a compound annual growth rate or 11.6% since its inception in May 2009.
During the third quarter, the fund's top long positions were Frasers Group, IWG, Jet2, Plus500, Ubisoft, Shell, BP, Vivendi, AO World and Natwest Group.
Q3 2023 hedge fund letters, conferences and more
The transition to Lancaster Investment Management
In their September letter to investors, which was obtained by Hedge Fund Alpha, portfolio managers James Hanbury and Jamie Grimston reported a robust third quarter for the fund with a return of 6.6%, versus the MSCI Daily Total Return Net World Index's gain of 0.7%. The Lancaster fund enjoyed gains on both the long and short sides.
Hanbury and Grimston clarified that their performance would've been even better if the fund hadn't been operating with reduced leverage for most of the third quarter due to some prime broker restrictions. However, they added that their financial third-party relationships were all "working normally" by the end of the quarter as the fund and investment team had successfully shifted from Odey/ Brook Asset Management over to Lancaster Investment Management.
More widely, the equity markets struggled to make progress during the third quarter amid the rising yield curves and weak macro conditions in China.
The Lancaster team said they hadn't made any material changes to their portfolio, although they will not reenter any of their previous micro caps. Additionally, they expect the fund's gross exposure to reduce structurally by around 10% as they "try harder than ever" to refocus purely on their highest-conviction ideas.
Hanbury and Grimston noted that the U.S. economy continued to surprise to the upside during the third quarter, resulting in a strong dollar, rising yield curves and rising real rates amid rapidly falling inflation.
Lancaster's long book
On the long side, the Lancaster fund's top contributor was Frasers Group, which revealed strong results and offered a promising outlook at its full-year update. The Lancaster team said Frasers Group found itself in "rarified company" among its larger Western retail peers as it guided for 10% profit before tax growth for its next fiscal year.
They would normally take "adjusted earnings" numbers with a grain of salt, but Frasers Group has some of the most conservative accounting they have ever seen. Hanbury and Grimston also noted that the retailer should benefit from quantitative tightening due to the higher cost of capital and tougher retail environment, which should enable it to stand out from the pack and win market share. They see a long runway for growth at Frasers Group.
The Lancaster team established a new position in Man Group during the third quarter. Of course, they know the business well and have owned shares several times over the last 10 years. Hanbury and Grimston have been impressed by Man Group's technology use and admire its excellent track record in capital allocations.
They expect the fund management industry to polarize increasingly between the larger firms that can invest in and engage with technology and the smaller, more-focused fundamental firms that are benchmark agnostic. As a result, the Lancaster team expects a virtuous cycle for Man Group as it leverages its central investments and rare diversity and sophistication to offer bespoke solutions to some of the world's largest clients. They expect all these trends in the fund management industry to enable Man Group to attract an even larger piece of the pie over time, adding that higher interest rates tend to be good for hedge funds, in general.
Other top performers
Hanbury and Grimston also highlighted Ubisoft as a strong third-quarter performer for the fund. They believe the market may be starting to view the developer's new game pipeline and strategic alliance with Tencent in a more positive light.
Earlier this year, the Lancaster team was encouraged by the feedback and levels of gamer interest from the large-scale public testing of Ubisoft's upcoming free-to-play title XDefiant. Additionally, they highlighted two other paid titles as signs that the company is again starting to deliver high-quality games consistently. Hanbury and Grimston also observed a windfall for Ubisoft as Microsoft signed a long-term deal to license the cloud-streaming distribution rights for Activision Blizzard's portfolio.
They also observed that their oil-exposed names recorded solid third-quarter returns amid the skyrocketing oil price, which soared about 27%. Lancaster's holdings include BP, Shell and Total, all of which were strong performers, while Valaris benefited from a boost in its share buyback target.
Key underperformer
On the other hand, Plus500 has had a challenging year, as evidenced by the 25% plunge in its stock price. The Lancaster team cited multiple drivers of that underperformance, emphasizing that none of them are concerning.
For example, they noted that volatility was low during the second and third quarters, and volatility is a key driver of activity and customer recruitment for Plus500. While they see low volatility as cyclical rather than structural, they still expected it to impact those quarterly earnings results.
The Lancaster team also recalled a regulatory change in Spain involving advertising prohibitions for CFD trading. They see a "reasonable chance" that this change will spread across Europe "in some form," warning that this change could be similar to the 2018 ESME regulatory changes, in that it tends to favor the better-positioned and larger providers.
However, Hanbury and Grimston noted that Plus500 is a multi-portal financial provider, so it will be able to continue advertising for its investing or futures division, unlike its competitors. They also clarified that they remain long on Plus500 and short on IG Group, just as they have been for many periods.
Opportunity in IWG?
The Lancaster team also highlighted IWG as a poor performer year to date. However, they feel the story with this stock has now become more compelling with three areas where the market is underappreciating the opportunity and value of its business.
Hanbury and Grimston noted that WeWork is close to entering Chapter 11 bankruptcy. On the back of a negative cost of capital, WeWork has disrupted pricing in the office industry over the last six years. In fact, they estimate that the company and other quantitative-easing-driven startups have slashed industry gross margins by about 300 basis points. Unfortunately, WeWork's market cap has plunged to $151 million, versus its $2.7 billion in net debt, making bankruptcy look inevitable.
The Lancaster team also believes the IWG capital-light model is beginning to gain traction as the company is now signing up around 100 new centers a month. They also highlighted Worka as a valuable business. IWG acquired 85% of The Instant Group in March 2022 and merged it with some of its own assets to create a leading brokerage business.
Although IWG is cyclical, Hanbury and Grimston believe higher rates are beginning to drive creative destruction among the company's lower-quality competitors.
Other underperformers on the long side were Vivendi and Jet2, which was the fund's biggest detractor during the third quarter despite its upgraded guidance.
Lancaster's short book
The Lancaster fund also enjoyed strong alpha and positive contributions on the short side. The fund's future short position in the Russell 2000 was its largest contributor, as the Lancaster team slashed the sizes of all their other shorts throughout the third quarter amid the migration from Odey/ Brook.
The fund's logistics property shorts did well during the quarter, although the market continues to struggle to digest changes. Despite their declines over the past two years, they've actually gotten more expensive compared to the risk-free rate's move.
Hanbury and Grimston explained that market is essentially saying the risk-free rate is wrong, or these companies have suddenly become less cyclical with more pricing power, which they don't believe is true. As a result, the sector remains a core short for their fund, with Segro and Prologis as their largest positions.
The Lancaster fund recently initiated short positions in Deckers and On Holding. Hanbury and Grimston believe Deckers' Hoka brand and the On Running brand have benefited from multiple significant demand tailwinds, including the running boom sparked by the COVID lockdowns. They also see the increase in runner interest in the ultra-cushioned running shoes offered by these brands as potentially cyclical. However, the Lancaster team remains concerned about the sustainability of these trends and thinks some of them may even turn into headwinds.
They also initiated a new short position in Rivian during the third quarter following the meaningful bounce in its stock. Finally, the Lancaster team covered their short position in Diageo as the market began to price in their bearish thesis.
