CV Capital

CV Capital September 21 quarterly update

To my fellow shareholders,

In our March 21 update, I spoke about the bubble in the US stock market. Since then the stock markets in US and Australia has strengthened. The ASX 200 hit a high in mid-August before closing Q3 at similar levels to Q2. This is despite numerous economic events which could have affected investor sentiment, i.e. ASX reporting season in August and September, iron ore price falling 50% between July and September.

I came across a very interesting chart in GMO’s Q2 report which reinforces my view of the current bubble in the US stock market. The chart below shows the percentage of US stocks whose market capitalisation is greater than 10x revenue.

Source: GMO

There is nothing magical about 10x revenue being a yardstick for a stock market bubble. Just that it was famously quoted in a 2002 interview with Scott McNealy, CEO of Sun Microsystems after the bubble where he said:

“At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?”

So what to do?

We pick stocks, we do not bet on macroeconomic events. Whilst I may have a view on the market, I know that 1) there is a significant probability that my view is incorrect and 2) even I’m right, I have no idea when or how the bubble will burst.

The idea that one is able to liquidate his/ her portfolio just prior to the bubble bursting and then pick up stocks at the market lows is a fallacy. Even if one is able to time the peak correctly (which is nearly impossible), I have observed the last two market meltdowns closely and I can say that buying during a market crash when volatility is at its peak is emotionally very hard to do. In a meltdown stock prices are very volatile and falling fast which cause buyers to hesitate as they can’t help but think that the stock may be cheaper tomorrow. So they keep hesitating but once a low is set, the price rebounds can be very strong but buyers are anchored to the previously low prices which cause them to further hesitate. These emotions can cause a cashed up buyer to completely miss out in a market meltdown.  

Whilst we will not materially change course given my views on the elevated stock market levels, we will be more cautious than normal.

  • We may sell positions more readily where we believe it’s fully valued or even slightly undervalued by the market. In less bullish times, we may hold on to them until we find another opportunity to redeploy the capital.
  • We may raise the bar for selecting new investments.
  • We’re less likely to be 100% invested. However, if a no brainer high quality opportunity emerges, we will not hesitate to put all our capital to work.

In a market meltdown I fully expect our portfolio to fall by 30% or more. For a long term investor without a crystal ball, this is still a better strategy than trying to time the market. The great investor Peter Lynch once said “far more money has been lost by investors preparing for corrections, or  trying to anticipate corrections, than has been lost in corrections themselves”.

Fund Activity

We increased our holdings in BFL, a holding which was previously undisclosed. BFL is the ASX ticker for the Bank of South Pacific, a PNG based financial institution which is the largest bank in the South Pacific Islands. The key reasons we invested are:

  1. It is highly profitable
  2. Has a dominant market share in its home market
  3. Cheap and trading at a lower valuation level than compared to its weaker competitor, Kina Securities (KSL)
  4. Earnings growing at approximately 11% p.a.

BFL provides traditional banking services to PNG and other pacific islands. It’s market share in PNG is 65%, dwarfing its main competitor KSL at 13%. The remaining market share is held between ANZ (institutional) and Westpac who are more focused on servicing Australian companies operating in PNG. Competition is light in PNG, as this AFR article quoted “Of the 80-odd bank branches and sub-branches BSP operates across PNG, three quarters face no immediate competition from a rival lender in the town or region”. The lack of competition makes the bank hugely profitable. Over the last decade BFL reported the net interest margin (NIM) of 6% and return on equity (ROE) in the mid to high 20% as compared to Australian banks who typically report NIM of 2% and ROE in the mid to low teens.

A major risk of banking is poor lending standards. In the context of PNG, in my opinion is BFL does not have a risky financial position as:

  • Out of the K$27 billion of assets in FY20, loans make up about 49% of total assets. Cash and investment in PNG treasury and central bank bills make up 21% of the total assets.
  • It has a high Tier 1 capital ratio of 20%.
  • Given the low level of competitive and its market dominance, it does not need to target poor credit customers. The current CEO was previously head of risk management which in my opinion is positive for a bank.
  • FY20 bad loan provision of circa 5.8% of total loans is also higher than KSL at 2.1%. This suggests that BFL is more conservative managed.

Over the past decade, the net profit and dividends grew by approximately 11% and 8% per annum respectively.

Comparing the metrics between BFP and KSL, it is obvious that BFL is a much stronger company.

Despite this, KSL trades at a higher price earnings ratio (7.7x) compared to BFL at (6.9x). This makes little sense economically given BFL’s higher return on equity and shares the same risks. It is like akin to investors paying more for a 5% term deposit than compared to a 10% term deposit.

I believe the reason for this is illiquidity and ignorance. BFL did a compliance listing on the ASX in May 2021 (it was already listed in its home market). As it did not raise any capital, it did not issue shares onto the ASX so trading has been very illiquid. In fact for many weeks after the ASX listing, there were no trades and only recently has a few trades occurred as shareholders transferred their holdings from PNG to ASX. The illiquidity means that many large investors are unable to buy the stock.

At 6.9x price earnings ratio, it is very cheap considering its dominant position, ROE and past growth rates. As a point of comparison, each of the Big 4 banks have lower market share in Australia, are less profitable on a NIM and ROE basis and trade at a price earnings ratio of 16x to 21x.

The key risk for BFL is sovereign credit risk. It has a significant exposure to the PNG government through loans to various government entities. The PNG economy has been struggling for the last few years and the government has been running a fiscal deficit which was made worse by Covid-19. The government debt to GDP is circa 50% and expected to grow in the short term. The good news is the economy is likely to improve next year with the current high LNG prices and progress on Papua LNG, the next mega LNG project in PNG. PNG is also benefitting from renewed Australian assistance (financial and otherwise) to counter China’s growing influence in the Pacific. However, this sovereign credit risk means we have to size our position accordingly.

Fund performance

CV Capital paid a 13.6 cent fully franked dividend in September and all dividends were subsequently reinvested. Including dividends, CV Capital’s share price fell by 3.6% from June 21 to Sept 21. A key reason for the fall is the payment of the performance bonus in September (details disclosed in the FY21 financial statements sent to all shareholders). Our returns (post performance bonus) since inception to 30 September 2021 is 14% p.a.

Note 1: Total returns are calculated by including dividends, franking and other tax credits. The benchmark return calculation does not assume reinvestment.

Note 2: There was an adjustment to June 2020’s unit price for franking credits which caused an increase in return compared to prior reports

The chart below shows our returns on $100,000 from inception to 30 September 2021 compared to our benchmark.

Our cash and cash equivalents position are circa 14.8% of the portfolio and the share price as at 30 September 2021 is $1.40 with the subscription price being $1.34. Details are as follows:

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