Letter to Shareholders 2023

Dear Shareholders

With this first letter we inform our shareholders about the performance of the Keynote – Spin-Off Fund since its launch on 21 July 2023.

From its inception on 21 July 2023 to 29 December 2023, the Keynote – Spin-Off Fund achieved a performance of 8.88% in USD (share class IK-USD) and 9.22% in EUR (share class IK-EUR). This compares with the performance of the global equity markets as follows:

Five months is a short period for performance comparisons. We regard three years as a more meaningful time frame for drawing relevant conclusions. Above all, it is important that such a period encompasses both strong and weak market phases. The reason we will regularly list the equity indices here has more to do with the objectivity and continuity of our reporting than with any particular conviction about the merits or drawbacks of any one of these indices.

This is also a good opportunity to revisit our investment strategy in more depth alongside the performance. It is important to us that our investors understand our approach and can follow what we do and what we refrain from doing.

One characteristic that distinguishes Keynote is the fact that we do not think in terms of equity indices. We have no intention of "playing the market". The portfolio is determined by the attractiveness of the individual companies and not by index constructions. On the contrary: the Keynote – Spin-Off Fund is rather the "anti index fund".

Spin-Offs – A Segment with High Inefficiencies

In the theory of the efficient market, economics assumes that the investment markets are always perfectly transparent. This makes it very difficult to beat the market. On the other hand, the long history of recurring stock manias, booms and busts, cult stocks and valuation anomalies contradicts this theory.

In our view, the market repeatedly behaves irrationally, even though under normal conditions it should tend towards rational behaviour. The difference between perfect efficiency and a "certain" efficiency offers enormous opportunities. Many market inefficiencies occur without a clear pattern and can vary greatly in their magnitude, from a general market panic to sector- or country-related irrationality through to company-specific mispricing.

We therefore engage in an area of the market where structural inefficiencies offer greater potential for outperformance. In other words: we fish where the fish are and not in the overfished oceans of the well-known equity indices. To this end, we deliberately seek opportunities off the beaten track in the spin-off segment.

The scientific evidence for the outperformance of spin-offs is unequivocal: numerous independent scientific studies over the past five decades confirm that spin-off situations offer attractive investment opportunities. Over the first 12 to 36 months, spin-offs achieve significant excess returns both relative to their respective industry groups and relative to the overall markets (see table below). It makes no difference whether an inflationary or deflationary regime prevailed, whether growth or value stocks were in vogue, or whether small caps were favoured over large caps.

The reasons for the outperformance are manifold and have already been set out in detail here (see Keynote Insights, Part 1: Why demerged business units offer attractive investment opportunities and Part 2: Indicators of attractive spin‑off situations). What is important for the investor is the fact that a high probability of excess returns is virtually built into this segment through the spin-off mechanics.

This is because a spin-off gives rise to two or more new companies that were previously never traded in isolation on the stock exchange. This creates inefficiencies due to incomplete data and leads to mispricing. In an initial phase, selling pressure usually arises because certain shareholders of the combined company do not want to, or are not permitted to, hold one of the two new business units. Index funds, for example, are forced to sell, regardless of price, if the spin-off is too small or comes from a different sector. Every time investors sell without a fundamental reason, opportunities can arise to acquire shares in high-quality companies at attractive prices.

While the short-term success of spin-offs has much to do with the disappearance of the conglomerate discount, what matters much more for medium- to long-term success is whether the demerged business unit receives the resources, capital and talent that were lacking within the conglomerate. When a company is released into its new-found freedom, a host of interesting projects with high returns on capital often emerge that should already have been tackled within the conglomerate and can be realised in the first one to two years after the demerger: from the launch of new products, the consolidation of factories, the focusing of marketing efforts and cost savings through to value-enhancing acquisitions. Interestingly, many studies concluded that the greatest gains for the spun-off company were achieved not in the first year, but in the second or third year.

If the management team comes from within, this also increases the motivation to work at the demerged company. For as a separately listed public company, the spin-off is responsible for its own destiny and is no longer treated as a "second-class passenger" within the conglomerate. When a company and its management are freed from a large parent company, pent-up entrepreneurial energies are released. The combination of accountability, personal responsibility and more direct incentives (via shares and/or share options) thus takes its natural course.

Investment Objectives of the Keynote - Spin-Off Fund

The fund's investment focus is on the divestment of one or more organisational units from existing corporate structures through the formation of an independent company or the spinning-off of an existing subsidiary. In doing so, the shares of the new or newly independent company are usually distributed free of charge to the shareholders of the parent company and listed on the stock exchange (Spin-Offs). Variants of such transactions are Split-Offs (shares of the subsidiary are exchanged for a defined number of shares of the parent company), Equity Carve-Outs (the parent company sells part of the subsidiary via a partial IPO) and Reverse Morris Trusts (a business unit or other assets are demerged into a separate company and then merged tax-free with another company). In addition, the fund can also invest in the parent companies (Parent) or in those companies where a spin-off has been announced (Pre-Spin).

The Keynote – Spin-Off Fund has different objectives from most benchmark-oriented equivalents. It is a unique fund with a clear focus on spin-off situations and pursues the following objectives:

1. Generating high, absolute, asymmetric returns in a benchmark-oriented world
2. Preserving shareholders' capital over the medium term (typically 3 years)
3. Achieving high risk-adjusted returns over an equity market cycle (typically 5 years)

In today's benchmark-driven investment world, most funds orient themselves towards an index when it comes to portfolio construction. We neither replicate an index nor try to minimise the "tracking error", i.e. the deviation from an index. The term itself virtually implies that such an approach is a mistake ("error"). With us, a large part of the decision-making is determined by the absolute Internal Rate of Return (IRR) that an investment can generate over a period of three to five years. The asymmetry of returns – little downside potential, high upside potential – plays an important role here. In doing so, we try to exploit the spin-off inefficiencies mentioned at the outset: the selling pressure and missing data create opportunities to acquire high-quality companies with sustainable competitive advantages at attractive valuations. For each company in the portfolio, we use our 50-point checklist to establish a five-year internal return expectation. This means that we look at the enterprise value, the level of debt, the margins and the earning power today, consider the potential in five years and assign the company a conservative valuation in absolute terms and relative to the market. In addition, the particularly promising characteristics of spin-offs are taken into account: demerger from a conglomerate, incentivisation of management, inside CEO, low analyst coverage, insider buying. In this way we play an entirely different game from most market participants.

To achieve the second objective – preserving capital over the medium term – the primary task is to exclude companies that display characteristics preventing longer-term outperformance: these include structural risks that will place a business model under pressure (among others, companies in retail, old technology firms, banks or commercial real estate), firms that achieve low returns on capital employed, companies with poor capital allocation or shares with an excessive valuation. Spin-off specific exclusion criteria relate above all to excessive debt and problematic assets. Put simply, the exclusion concerns companies that are unlikely to generate value over the coming years and for which time is not our friend.

The final objective – achieving high risk-adjusted returns over an equity market cycle – means nothing other than generating as much positive return as possible while minimising the downside risk. Such characteristics are found in quality spin-offs. That is why this is the area which always carries the highest weighting in the fund. Quality spin-offs exhibit high inefficiencies, since they have neither a growth nor a value bias. These companies increase their profits or cash flows faster than the market, have lower cyclicality and less downside risk. The low initial valuation is a temporary phenomenon, i.e. because of these characteristics the share should be valued higher over a three- to five-year horizon.

Our historical spin-off selection has clearly outperformed the overall market, and that at much lower downside risk: in rising markets we participated by 115%, but in only 85% of the downward movements.

The Portfolio of the Keynote - Spin-Off Fund

At the end of 2023, the majority (73.0%) of the portfolio consisted of spin-offs, while the remaining part (parents) accounted for 17.3% and pre-spin situations for 9.7%. The greatest inefficiencies are found in spin-offs, and therefore the fund will structurally always have the largest weighting in the demerged companies. Yet more interesting opportunities are often found in the remaining part or in the companies ahead of the spin-off.

This is the case, for example, with our investment in General Electric (see case study on GE), where the massive conglomerate discount had already narrowed ahead of the spin-off, as the split into three companies gave the market an increasingly clearer picture of the value of the individual business units. GE has an outstanding business (GE Aerospace), a very good segment (GE HealthCare) and a below-average division with improvement potential (GE Vernova). At the start of 2023, the healthcare division GE HealthCare was demerged, and in view of its mid-single-digit organic growth rates, margin potential, double-digit earnings growth and strong free cash flows it is now regarded by the market as an attractive health care play. The energy and renewable energy division remaining in GE (GE Vernova) will be demerged in April 2024. The market capitalised the losses in the renewable energy area practically indefinitely. Yet the chances are good that this business will experience a mid-single-digit operating margin and a re-rating in 2025/26. The remaining division (GE Aerospace) offers by far the most attractive business model, which, given the young engine fleet (many engines have yet to undergo their first or second overhaul), should be equipped for more than a decade of excellent growth.

In order to analyse the fund's performance to date (period: 21.07.2023 to 29.12.2023) more closely, we consider below the three stocks that most strongly affected performance positively and negatively. Let us begin with the problem cases:

After the shares of Match Group had lost more than three quarters of their value since the spin-off, we established a position. The company operates four of the five largest dating platforms globally, including the market leader Tinder, and it was attractively valued. Yet the expectation of a turnaround proved premature. The foundation of any value creation of a digital consumer model is a healthy and growing user base, but the steps initiated by management are likely to prove rather counterproductive. The business model undoubtedly offers potential, but for the time being the motto for us with Match is "better safe than sorry": the Match share was sold from the fund portfolio.

After the spin-off of Veralto, we sold the position in Danaher. Although we are convinced by Danaher's business model, the management team and the longer-term margin potential, the bioprocessing division and the China business will remain a drag until mid-2024. We therefore see greater potential in the spin-off Veralto for the time being.

Atmus Filtration Technologies was brought to the stock exchange in 2023 via a partial demerger from the diesel engine manufacturer Cummins. Atmus is a leading provider of filtration products for on-highway and off-highway commercial vehicles and equipment, and we liked its high aftermarket share and steady cash generation. However, the cyclical growth slowdown and the emerging share exchange that Cummins plans in order to divest its remaining stake of 80.5% are likely to prove a sword of Damocles for the time being and represent a drag on the share. With the exit of the position, we remain on the sidelines in order to conduct a reassessment in 2024.

It can be a mistake to hold underperforming companies. As Warren Buffett and Peter Lynch have already noted, one should not pull out the flowers and water the weeds. We therefore let the winners run and cut off the losers.

What has gone particularly well for us since the fund's launch at the end of July 2023? Quite a lot, but the following positions deserve special mention:

ZimVie was demerged from Zimmer Biomet in 2022. Zimmer Biomet wanted to align its own business with the higher-growth orthopaedic core business and leave the lower-growth spine and dental areas in a separate entity (ZimVie). Yet the spin-off was poorly structured: Zimmer Biomet initially retained a 19.6% stake in the spin-off but entered into a forward sale agreement with investment banks to sell its holding in ZimVie. At the same time, management had to revise its guidance downwards. The result: a nearly 80% decline in the share price by March 2023, in which almost 100 million shares changed hands, equivalent to four times the total ZimVie shares. With a normalised 2025e free cash flow yield of over 30%, Mr. Market offered us attractive price levels in October 2023. In December, ZimVie then announced that it will sell its spine business for USD 375 million (of which USD 315 million in cash, USD 60 million in a note) to the investment company H.I.G. Capital, whereupon the share reacted with a marked jump in price. The deal will have a positive effect on the company's growth and will contribute to stronger revenue growth, higher EBITDA and cash flow conversion and a better balance sheet. The re-rating of ZimVie will continue – the share will transform from a volatile turnaround candidate into a defensive medtech company with a correspondingly more stable price trajectory.

The Crane Company (Crane Co), demerged from the multi-industry conglomerate Crane, comprises the aerospace and electronics business units as well as Process Flow Technologies (valves/pumps). Crane Co has a stable business (40% aftermarket share) with high FCF conversion (90-100%). The above-average organic growth combined with the margin expansion potential will bring double-digit annual earnings growth and a re-rating. Thanks to its solid balance sheet, Crane also has M&A potential. Crane's CEO, Max Mitchell, and CFO, Richard Maue, both of whom moved to the spin-off, are also convinced by the prospects.

Alleima is a classic spin-off situation which we were able to acquire shortly after the fund's launch at an FCF yield of 15.5%. The manufacturer of special steel and alloys was demerged from the industrial company Sandvik in 2022 and was for a long time under selling pressure, because many funds are not permitted to hold small caps and investors with an ESG mandate sold Alleima on account of its exposure to the oil and gas industry. In doing so, not only was the fact ignored that this business is booming, but, ironically, it was also overlooked that Alleima operates in ESG-compliant growth markets (hydrogen, renewable energies, medical technology) in which new orders are continually being won. After a price gain of over 70% since purchase, we parted with the share four months later, as the discount to fair value had narrowed.

The Keynote - Spin-Off Fund invests worldwide in the most attractive spin-off situations. At 76.1%, the USA formed the largest country weighting, followed by Canada with 6% and Switzerland with 5.1%. Most spin-off situations take place on the other side of the Atlantic, and therefore the fund will always hold a high proportion of US equities. But to emphasise it once more: we invest in companies, not in countries or indices. The country in which a company is listed is largely irrelevant, provided it has a well-regulated equity market.

The Keynote – Spin-Off Fund invests broadly across all sectors. Nevertheless, the industrials and healthcare sectors play an important role, since many industries within these two sectors offer compelling, relatively stable growth potential and there are traditionally very many attractive spin-off situations here.

In the industrials sector, General Electric, Crane as well as ESAB and Veralto are among the largest positions. The protracted challenges of the aerospace industry following the Covid crisis are easing, and therefore GE and Crane, driven by the growing middle class and the improvement in quality of life, will record secular growth by the end of this decade. The aerospace industry has very high barriers to entry, based on scale, capital, technical competence and regulation, and behaves rationally from the perspective of a pure industrial cycle. ESAB, a world-leading manufacturer of welding and cutting equipment as well as welding consumables, was demerged from Colfax in 2022. The company is well positioned and will drive margin expansion thanks to the simplification of its product line, the consolidation of production and the shift towards higher-margin equipment sales. In this way, ESAB is developing into a "high quality compounder" and is likely to record annual earnings growth in the mid-teens through to 2028. Veralto, the former water business of Danaher, offers instruments, tests and software to ensure water quality. The company has attractive defensive qualities, as more than half of its revenue is attributable to recurring revenues. Veralto generates high free cash flows and will drive growth over time through acquisitions.

In the healthcare sector, GE HealthCare, alongside the dental company ZimVie and the generics and biosimilars manufacturer Sandoz, represents a core position. GE HealthCare manufactures and services imaging technologies for diagnostics (among others, computed tomography scanners and ultrasound technologies) and is the market leader in contrast media and radiopharmaceuticals. GE HealthCare will use its high FCF conversion (85%+) to reinvest in its own business and make acquisitions with faster organic growth, which will bring a better growth profile and higher multiples. The combination of mid-single-digit revenue growth and 75-100 basis points of margin expansion per year will bring double-digit earnings increases and a re-rating of the share. As mentioned at the outset, this re-rating process is also in full swing at ZimVie. The Novartis spin-off Sandoz met with much scepticism ahead of the demerger, for Sandoz was regarded as a problem child within Novartis on account of a declining business and low margins. Yet the prospects of a Sandoz released into freedom are better than the market currently assumes, and we consider the share attractive over the longer term (see Deep Dive Sandoz).

The consumer goods sector, too, has offered an attractive environment for spin-off situations in the past. However, many consumer goods companies are confronted with challenges, including consumers' changing preferences towards healthier, more natural foods and beverages. With Bellring Brands, demerged from the consumer goods company Post Holdings, we backed a firm that holds a leading position in ready-to-drink protein shakes and protein bars with brands such as Premier Protein, Power Bar and Dymatize. Bellring Brands' products are popular and their pricing power is durable: despite price increases in the mid-teens, sales volumes rose by 5%, whereas at most competitors in the consumer goods industry price pass-throughs come at the expense of sales volumes.

At the end of 2023, the portfolio comprised 21 holdings. Listed below are the five equity holdings that had the highest weighting at year-end:

Summary and Outlook

A little over a year ago, market expectations leaned strongly towards a global recession triggered by the central banks, while we regarded a severe recession as unlikely. Following a strong year for the equity markets, optimism towards a soft landing now prevails, with correspondingly positive return expectations for the investment markets. This scenario may well be correct, and in view of the increased valuations it probably has to be, in order for the broad equity markets to continue rising.

The mass of investors generally tends to fixate on the current conditions and extrapolate them into the future. Yet history has shown that the economy and the markets tend to revert to the mean. Put differently: whether times are good or bad, they do not remain so forever. Against the backdrop of a shifting market sentiment that is very much focused on macroeconomic narratives, many investors tend to concentrate on the short term when assessing the economic outlook and the prospects of individual companies.

We, by contrast, continue to try to identify spin-off situations with excellent risk-adjusted return potential over the next three to five years. The fund portfolio of the Keynote – Spin-Off Fund is, on the whole, well diversified, robust, and delivers growth with investments in high-quality companies with a strong market position, which are also less severely affected by poorer economic factors such as a recession. The shares in the fund are thus less dependent on the movements of the broad equity markets and more strongly driven by company-specific fundamental developments. As a result, the Keynote – Spin-Off Fund, with a focused portfolio of companies away from the mainstream, offers interesting diversification effects for any equity portfolio.

The Board of Directors and the Portfolio Management

KEYNOTE (SICAV)

KEYNOTE - SPIN-OFF FUND