LHC has emerged as the top performing hedge fund in 2018-19, but now it’s selling some of its hottest stocks because prices are too high.

LHC Capital, the Sydney-based hedge fund which topped the returns table in 2018-19, says it is responding to a “valuation conundrum” caused by lower interest rates by selling its winning trades.

The $400 million fund’s chief investment officers, Marcus Hughes and Stephen Aboud, told investors in the LHC high conviction fund that the strategy returned 24.8 per cent after fees over the financial year, including 8.5 per cent in the fourth quarter.

That would make LHC the best performing Australian hedge fund strategy, exceeding the top-ranked long-short investment manager as measured by Mercer.

The fund manager is taking advantage of the strength in markets to offload its holdings in Pro Medicus and IPH, which it said were now “more than fully valued”.

Low interest rates have created a “valuation conundrum” and it was not clear if declining cash rates were in fact a buy or sell signal, Mr Hughes and Mr Aboud explain in their investment letter.

“With cash at such low yields, the temptation for savers to chase riskier higher yielding assets grows by the day,” they wrote.

But they conclude that equities may not perform, even if interest rates keep falling.

“Interest rates are not known to be lowered because an economy is going along strongly, and the valuation of companies whose earnings are under pressure from a weakening economy ought not simply rise!”

“However, there is a valuation limit where perfect future execution does become priced into equities.”

That, they explained, is why they were selling their winners.

Priced for perfection

The fund first bought shares in medical imaging software company Pro Medicus in late 2015 for $3 and bought more stock at $8 about a year ago.

The company, they said, had “executed flawlessly” to become the dominant player in the US private hospital market.

But a key contract win has lifted its current valuation to 35 times expected 2021 revenues.

LHC doubted whether the $14 million in additional revenue justified its market capitalisation doubling to $3 billion over the quarter, and decided to reduce its position.

“We believe that the current price of the equity is pricing in perfect business execution and successful market dominance into perpetuity.”

LHC told its investors it had also sold out of IPH Limited, the intellectual property law firm. It bought into the business at the 2014 float price of $2.10, and bought more shares 18 months ago at $3.50 after a downgrade.

The stock has rallied to $8 despite “no material change to forward underlying earnings since we made this stock purchase”, referring specifically to earnings of an organic nature.

During the quarter, IPH announced a merger with Xenith IP. LHC said its position in IPH assumed it would lead a consolidation in the industry that would increase its earnings by 20 per cent.

But it has progressively sold its shares as sell-side analysts upgraded their earnings on the deal.

“We believe that at current prices the market has priced in the successful integration of this acquisition and significantly re-rated the underlying earnings stream.

“We are also mindful that the post-merger IPH will have closer to three quarters of its earnings coming from the mature Australian market which will dilute the exciting growth option from the Asian business.”

Among the positions LHC has added to are its holdings of Servcorp, which provides workspace and IT solutions in 54 cities worldwide.

The fund concluded that its extensive $50 million refurbishment program has weighed on occupancy rates, and consequently its share price, but it is now positioned to benefit from that spending.

“Whilst SRV has recently bounced off its 52 week lows, British competitor IWG plc trades at all time highs.

“We find it hard to reconcile why IWG trades at double the SRV valuation multiples despite having more aggressive accounting, a more geared balance sheet, lower organic revenue growth, weaker cash generation and a poorer customer offering.”

At an “ungeared” 15 per cent free cash flow yield, LHC said there is a “strong margin of safety for an enduring and highly cash generative and dividend paying business”.

Conservative positioning

LHC Capital’s own investors are mainly family offices and high net worth individuals. It is closed to new investors.

LHC’s performance over the financial year bettered every Australian long-only and long-short fund in the latest Mercer survey. Since inception, it has delivered an annualised return of 16.61 per cent after fees. It also bettered known high-performing strategies which fall outside the scoper of Mercer’s survey.

LHC has a total gross exposure of 130 per cent (the sum of its long and short positions) and a net position of 45 per cent (its long positions minus its short positions).

This low market exposure means that should markets run, it would underperform, but it expected to do better in weaker markets.

Among LHC’s shorts are Afterpay, the buy-now-pay-later firm facing questions about its path to profitability; Lend Lease, on account of issues with fixed cost contracts in engineering unit; IOOF in the face of regulatory challenges; and Link Market Services, predicated on worries about its UK unit.

LHC is also shorting the Australian banks due to “declining return on equity in a low credit growth environment with unsustainable payout ratios”.

Other long positions include ASX-listed payments company iSignthis, and high flying tech stock Altium.

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