March 2017 – chasingvalue

I apologies for this post being somewhat late. As I have anticipated, the resolutions to turn CMI into a listed investment company went through which means that Glennon Capital (GC) is currently responsible for CMI’s cash hoard of over $20 million or $0.57 per share which is more than half the current share price.

What was relatively a safe asset (cash) is now at risk. The value of the cash is now in the hands of GC. Although future investment outcomes are nearly impossible to predict, we can form some views on the manager based on another LIC that they manage, GC1. In assessing a manager, I put them through 3 important tests:

Whose interest is being put first (managers or shareholders)
Approach to risk and investment philosophy
Track record

The first one is a no brainer, if the manager is putting his or her interest ahead of the shareholders then good luck to the shareholders. Secondly, I prefer a manager who puts risk management first ahead of investment returns. I don’t like a manager who aims for the highest returns. Howard Marks gives a good example of his client who over a 14 year period consistently had returns between the 27^th and 47^th percentile of all managers at the end of the period ended up with returns at the 4^th percentile of all managers. It’s no use having the top investment returns 1 year and then blowing up the next and if you take risk and shoot for the stars, you’re likely to blow up big.

I’ve attempted to put GC to the above test based on their history, which is only over two years and in terms of track records is rather short. To illustrate some points, I have inversed the test from least important to most important.

Track record
GC1’s investment track record is only for 1.5 years years so I also had reference to a 5 year track record another fund managed by GC (Glennon Capital Small Companies Portfolio) which was illustrated in GC1’s prospectus.

As you can see, the above after fees performance of Glennon Capital Small Companies Portfolio has outperformed its benchmark (ASX Small Ordinaries Index) over 5 years by 11.4% (annualised basis). The chart below illustrates the investment performance of GC1. According to it’s February 17 investment report, since inception the fund return (before fees) is 22.33%. The after fees annualised returns were not disclosed.

Based on the above returns, GC’s investment record appears to be quite satisfactory.

Approach to risk and investment philosophy
Based on GC1’s propectus, GC’s investment philosophy is to invest in companies outside of the ASX S&P 100 who have:

Superior management and sustainable business that operate in industries with barriers to entry and growth prospects;
Undervalued
Do not use leverage
Long term focus

A review of GC1’s portfolio as at June 2016 shows that the portfolio is made up of 41 stocks with their individual weights ranging from 8.05% (maximum) to 0.02% (minimum) and the average weight being 2.05%.

Since inception till 30 June 2016 (FY2016) and 28 February 2017, GC1’s portfolio returned 15.86% and 22.33% respectively. This compares with it’s benchmark S&P ASX Small Ordinaries Accumulation Index return of 18.89% and 24.36% respectively over the same periods. GC1’s returns doesn’t appear to vary too much from the index which is not surprising given the number of stocks invested. The advantage of having 40 stocks in a portfolio mean that potential for material underperformance against the index is unlikely but on the same token, the potential for material outperformance is also unlikely.

Whose interest is being put first
Now this is where things get interesting. Based on the FY16 and HY17 financial reports, the fees paid out to GC are as follows:

Since inception, GC has earned $1.1 million in fees.

The chart (click here for better view) below shows both the performance by GC1’s shares since inception against the S&P ASX Small Ordinaries Index Fund ETF. As illustrated, the benchmark far outperformed GC1’s shares.

GC1 is currently trading at 94 cents and has paid a total of 4.75 cents in dividend over its listed lifetime. Therefore, an investor who invested $1 at the IPO is about break-even at today’s share price.

How is this so you may ask? Why didn’t the share price track the 22.3% portfolio returns earned since its inception to February 2017?

There are a few reasons for this.

The fund is trading at a slight discount to its NTA. Based on it’s NTA at the end of February, it is currently trading at a 5% discount.
The reported portfolio returns are gross. Fund manager fees and other fund overheads would have eroded the gross returns.
However, the main culprit is the options that were granted to shareholders during the IPO to entice subscriptions. At IPO, one option was given “free” for every share subscribed.

These IPO options were actually bait on a hook, read this great write-up on LIC options.

These “free” options created a huge overhang over the share price due to the potential dilution they represented. Even if the options are exercised, they reduce the percentage returns for an investor than compared to a situation where the options were never issued.

In GC1’s case, more than 60% of the options were not exercised at the maturity date. What did GC1 do? It went into an underwriting agreement with a broker for the unexercised options. So this meant existing shareholders were not only diluted but probably copped the underwriting fee as well.

At the IPO, GC1 had 21.69 million ordinary shares and as at 31 December 2016 (afterthe options were all exercised) it had 46.95 million shares outstanding. This gives you a sense of the magnitude of the dilution. Nearly all of the portfolio returns have been diluted away.

So who wins from these options? Well, given the typical fund manager fee structure, the winner is always the fund manager as options generate more FUM and more FUM means more management fees.

Conclusion

It is quite tricky to balance out the advantages and disadvantages for CMI at this juncture. On one hand, you have the good points which are that its cheap, has a good electrical business and exposed to what is probably a low point in the coal mining cycle.

On the other hand, you have equity investments which are hard to quantify and a major shareholder whose interest may not be fully aligned with the minority shareholders.

So on balance, taking into consideration all the facts, I will hang on to the shares due to:

Leanne as a major shareholder has both plus and minuses in my opinion. She has the largest interest in CMI and will act against any indiscretions against shareholders interest.
Historically, the cash balance earned next to nothing due to the low interest rate environment and it would not take much to increase this return. If GC adopts a similar portfolio diversification strategy to GC1, then I think over the longer term our cash should generate near market returns. The only issue is timing and equity market risk (systematic risk).

For my original CMI post, click here.

The results for this half year were much better than pcp but was not unexpected given the full year contribution of the WA routes. An interesting development which management pointed out was that the downturn in the traditional network appears to have bottomed. Although still very early days (we had false starts before), this is great news if the passenger numbers on the traditional network can recover after 9 consecutive years of decline.

My takeaways from the half year are as follows:

Both the WA and traditional network are performing well. The half year presentation showed that the passengers on the WA routes made up 9.7% of the traditional work which on the surface doesn’t seem surprising given the historical passengers numbers. However, we do know that Rex increased the WA route service by 35% over the previous operator and therefore for the passenger percentage (10%) to remain consistent, passengers on the traditional network must have increased as well. I’ve analysed the comparable monthly passenger data for year to date (YTD) FY17 and FY16.

As shown above, YTD17 passengers are up 12% but more interesting is the strong pcp growth from November to January. Another indicator that passengers are increasing is that the HY load factor has increased by 2% (54.8% to 56.6%).

Now that Rex has established itself in WA, the natural progression would be to expand operations there to spread the overheads. Like the eastern states, WA has some regulated and unregulated routes which Rex could expand into. The closest competitor to Rex (besides Qantaslink) is Skippers Air which has the rights to some regulated routes. Rex’s entry into WA can’t be good news for a small operator like Skipper and I won’t be surprised if they end up selling to Rex.

Pel-air have started medivac operations out of Singapore with 2 aircraft. Currently it is likely to contribute immaterially to earnings and therefore no breakdown was provided, however it is a nice toehold into a new market.

On the cost front, cost have gone up (Flight & port operations and also salaries) which management have said were due to the new WA routes and medivac operations in Singapore.

Based on the half year result, I forecast net profit after tax to be circa $8 – $12 million with recurring capital expenditure being less than depreciation at the current fleet size. The recent developments are positive and I believe when the dividends are started again, the stock will move higher.