August 2018 | Market Commentary
Results season seemed more volatile than usual with sharp moves on little new information. Interpretation of near-term earnings direction seemed to be the major share price driver. Interestingly, in the month of August thirteen companies in the S&P ASX Small Ordinaries Index rallied more than 20%,. Also, there were thirteen companies that declined greater than 20%, we owned one of them being ISD. Given we run a portfolio and our weightings are based on risk as well as return, overall, we managed to generate a strong return for clients despite a couple of big negative moves.
The Moneyball Strategy
“People are overlooked for a variety of biased reasons and perceived flaws: age, appearance, personality. Billy, of the twenty thousand notable players for us to consider, I believe that there’s a championship team of twenty-five people that we can afford because everyone else in baseball under values them – like an island of misfit toys.” Quote from Moneyball (the movie version) on how to build a team on a limited budget that can achieve consistent success.
We never expect a perfect scorecard at results, as it’s mathematically implausible. In fact, professional fund managers on average get only 52% of their calls right in the long term. Given the number of companies in our portfolio and the fact that businesses are volatile and operate in industries that are cyclical. it is inevitable that not everything is going to go right at the same time. But the losers of this round in many cases are winners in future rounds. Like Moneyball, our portfolio looks like “an island of misfit toys” but we feel this is due to misconception, which lends to mispricing, which can be exploited to achieve consistent returns over various cycles. Adopting a Moneyball strategy to investing means having a defined process and that often means investing against the grain.
“Billy, this is Chad Bradford. He’s a relief pitcher. He is one of the most undervalued players in baseball. His defect is that he throws funny. Nobody in the big leagues’ cares about him, because he looks funny. This guy could be not just the best pitcher in our bullpen, but one of the most effective relief pitchers in all of baseball. This guy should cost $3 million a year. We can get him for $237,000.” Quote from Moneyball on how baseball scouts are obsessed with appearances rather than the statistics which tell the true story.
We have discussed Vita Group (VTG) before. Yes, it has one supplier in Telstra, but it had the same one supplier when it was trading at a share price of $5. Now it trades just above $1. It is highly cash generative and at last balance date had $18m of net cash on its balance sheet. Its contract with Telstra has been renewed, earnings rebased and its now trading on only 4x pre-tax free cash flow. Meaning a 4-year payback period. Apart from valuation, it is strategically important to Telstra given it influences around $1.5bn of revenue. The productivity of the stores it runs for Telstra is excellent and it is less prone to competition given its store footprint is skewed to regional markets where Telstra’s network is superior. The one supplier issue is more than compensated by the price.
ISD looks like a dud rather than a stud. In all seriousness though, Meltwater’s (its main competitor) aggressive pricing has led to significant price erosion and effectively a race to the bottom in the industry. How long they can continue with super low prices is hard to gauge given the dearth of publicly available financial information. Any relief on this front will be positive for ISD. According to market sources it will be hard for Meltwater to service the NSW government contract (won recently) which has complex requirements. In saying that, cost savings at ISD failed to eventuate which was a massive own goal. The company needs to reconfigure its business and work out what client’s value in an evolving media monitoring landscape. We will give the new CEO time given he is well credentialled and the business remains highly cash flow generative albeit at lower levels than we had forecast.
Just like the Chad Bradford example in Moneyball, we believe the companies discussed above were significantly marked down due to obvious issues such that the risk seems skewed to the upside based on simple maths. The issues discussed are knowns which are ignored when share prices are going up but amplified when they go down. At some point valuation will matter for these companies, but in the meantime, they will produce a cash flow stream that in most cases will provide quick payback for shareholders.
In conclusion, we continue to seek out high cash flow companies with predictability in earnings based on competitive position, and most importantly where the valuation makes sense. Buying hyper popular companies on enormous multiples has worked in this market for a long period. At some point we believe this nexus will break and break badly. The dot-com bust of 2000/01 is a stark reminder that even the most celebrated companies can be cut down to size. Harking back to those days, high quality companies including CSL, Computershare and Technology One all fell by more than 80%, simply because they became way too expensive.