July 2018 | Market Commentary
A lot of people know which are the good horses but the odds adjust such that the proceeds from wagering on those horses theoretically even out. In both cases the message is clear – valuation matters and it is possible to pay too much for a great business. In the short run many things drive share prices. It seems to us that earnings and price momentum have been the two dominant short term (voting) themes. This is hardly the stuff of weighing machines and is prone to dramatic sentiment change when the current investment climate abates and longer term drivers take over.
So how do you use the “weighing machine” to invest? We hold the view that investing in the stock market cannot be considered in isolation and needs to be considered against the back drop of all asset classes. Investors can freely switch between equities, cash, bonds, property and other alternatives. As such, the only way to properly compare all asset classes is from the cash flows derived from investing in each. There is a long history of the world’s best investors supporting this notion and it is the only one we are aware of that sifts out the rolodex of shorter term “voting machines” out there. If you think about your own business you don’t measure the number of likes, clicks or barrels of oil equivalent in the ground to determine how profitable it is – you measure how much cash you have generated in the bank at the end of the year. We use the same simple and repeatable method to evaluate shares in the smaller companies space to sift and sort the universe in order to try to find the best relative and absolute investments. Cash flows not only have the benefit of being measurable but they also enable companies to fund their own growth and avoid the use of external funding which is useful during times of market stress.
Given the strong run the market has had over the past year it would seem logical that some areas of the market might offer less compelling value – certainly than they did a year ago. We see two areas in particular which warrant caution – the larger end of the smaller companies index and wannabe disruptors. The larger end of the small companies index comprises many rapidly growing fintech type investments. The valuations of these companies would stretch any weighing machine type valuations to breaking point. Secondly, the smaller end comprising what is probably best referred to as the ‘wannabe disruptors’. These wannabe disruptors usually have a few things in common – little to no revenue, are rapidly growing (off a minute base), lose money, don’t generate cashflow and they usually have a hyperbolic sounding company name. We ran a screen on the number of stocks which fit this criterion and it peaked in January of this year at 56 companies (according to a Bloomberg screen of stocks with market caps greater than $100m and revenues less than $2m). This number has since declined to 42. Suffice to say we do not own any of these companies in the Fund.
During the month we had strong contributions from Technology One (TNE.ASX, +16%), Nufarm (NUF.ASX – not held, -19%),Mortgage Choice (MOC.ASX, +11%), Evolution Mining (EVN.ASX – not held, -21%) and Isentia (ISD.ASX, +12%). TNE typifies the style of business we like to own. Over its 19-year history as a listed company TNE has converted 96% of its EBITA (Earnings Before Interest, Tax and Amortisation) into free cash flows. The business has a strong net cash balance sheet and despite paying a healthy dividend also manages to grow organically by 10-15% pa. TNE had declined quite substantially after their first half results. Although the company had communicated that they were up against a tough comparator the market sold the shares down aggressively. We viewed the sell off as a misunderstanding and substantially increased the position in the Fund. Not only did we think there was substantial value in the shares as they sold off, but we also view the business model as becoming higher quality through time. TNE is migrating their client base onto a SAAS (software as a service) platform and changing the way they bill their customers. Around 25% of their client base is now on a SAAS hosted platform. As the company continues to migrate customers onto this platform, the amount of recurring revenue continues to grow. We expect this to increase from around50% of total revenues today to closer to 75% within a few years.
There were also strong contributions from we had strong contributions from Supply Networks (SNL.ASX, +18%), Gage Roads Brewing Co (GRB.ASX, +16%) and Isentia (ISD.ASX, +12%). SNL is the leading aftermarket supplier of truck parts to the independent truck mechanic trade in Australia and New Zealand. SNL has a long history of organic rollout which has meant that its return on capital is high and the balance sheet has remained virtually ungeared throughout its roll out. SNL upgraded its previous guidance from both a sales and earnings perspective. GRB is a boutique brewer based in Perth which is undergoing a shift from producing private label beer for Woolies to its own eponymous brands. This shift sees a pronounced improvement in margins and growth rates over the next few years. During July they announced a strong fourth quarter from both a sales and cash flow perspective.
Detractors included Class Ltd (CL1.ASX, -8.3%), Afterpay (APT.ASX – not held, +51.6%) and Specialty Fashion (SFH.ASX, -8%). APT warrants some comment although the Fund is restricted from owning it given the market cap >$3bn versus the limit of A$500m. APT came onto the scene two short years ago and offers consumers a novel lay-by facility in the form of four equal payment instalments over two months for relatively small purchases ($100 – $1500). APT have signed up many retailers in Australia and grown sales very quickly over the past two years – a credit to the founders’ entrepreneurialism and vision. Whilst the business is growing fast it is highly capital consumptive and reliant on third party debt funders in order to grow its business. APT also has a relatively short trading history and thus investors have little idea of how bad debts will look over a credit cycle and what a stabilised competitive environment looks like. It has been for these reasons we feel the business does not fit with our investment process, which has cost us relatively dearly versus the Benchmark.
APT warrants some comment given our underweight position. APT came onto the scene two short years ago and offers consumers a novel lay-by facility in the form of four equal payment instalments over two months for relatively small purchases ($100 – $1500). APT have signed up many retailers in Australia and grown sales very quickly over the past two years – a credit to the founders’ entrepreneurialism and vision. Whilst the business is growing fast it is highly capital consumptive and reliant on third party debt funders in order to grow its business. APT also has a relatively short trading history and thus investors have little idea of how bad debts will look over a credit cycle and what a stabilised competitive environment looks like. It has been for these reasons we feel the business does not fit with our investment process, which has cost us relatively dearly versus the Benchmark.
Other detractors included Sigma Healthcare (SIG.ASX, -40%) and Reliance Worldwide (RWC.ASX – not held, +11%). SIG declined almost 40% over the month as they lost a major client in the form of Chemist Warehouse and had a weak trading update. Chemist Warehouse represented close to 40% of SIG’s wholesale volumes and after protracted negotiations decided to change suppliers to EBOS. This was both a surprise and a disappointment to the market and the apparent pricing regime taken on by EBOS seems sub-economic considering the short-term contractual nature of the supply agreement. SIG will receive a substantial amount of working capital release (i.e. cash) as compensation at the end of its current agreement but nevertheless will be required to reduce costs and/or lift volumes to hold earnings to their new guidance. There is likely to be positive fallout for SIG given many EBOS pharmacists view Chemist Warehouse as the enemy. Given SIG was a relatively small position for the Fund before the update and valuation risk has lessened (i.e. exchanging cash for earnings) we have substantially increased the Fund’s weighting to SIG.
In spite of some pockets in our universe being highly valued we are still able to find good investment ideas that meet our process fundamentals. Markets are cyclical and sentiment – whilst powerful – is transitory over the long term. We believe our process positions us well for when markets inevitably return to the weighing machine (cash flow) valuations.