CV Capital – Year end FY2018 shareholder letter

To my fellow shareholders,

CV Capital has recently completed its inaugural year on 14 January 2019. The past 12 months has been a story of two halves for the stock market. In the first half (15 Jan – 30 Jun) the ASX 200 accumulation index (ASX 200 index including dividends) appreciated by 4.1% and in the second half (1 Jul – 14 Jan) it reversed course and depreciated by 4.7%. A combination of US-China trade war fears, rising interest rates in the US, sharp decline in FAANG stocks (Facebook, Apple, Amazon, Netflix and Google) all contributed to the second half being disappointing one for the market.

All in all, the ASX 200 accumulation index finished down 0.8% for our financial year (15 Jan 18 – 14 Jan 19). Our benchmark (ASX:STW) did better, ahead by 0.5% over the financial year. One reason our benchmark did better than the ASX200 accumulation index is because it includes returns from franking and foreign tax credits, whereas the ASX 200 accumulation index only includes cash dividends. As CV Capital also reports franking credits as part of its returns, the STW ETF is a better yardstick than the ASX 200 accumulation index.

Before I delve into CV Capital’s performance for FY2018, I would just like to reiterate that we are investing for the long term and that the focus on 12 month returns as a measure of success is foolish. As Warren Buffett once wrote, “why should the time required for an investment to payoff synchronize precisely with the time it takes the planet to go around the sun?” 

Given this backdrop, our 12 month return was 7.6% after costs (8.2% before costs). The main expenses was compliance (tax and accounting) and travel cost for attending AGMs. I will continue to keep costs as low as possible and as the company grows its asset base, the expense ratio (expenses as a percentage of assets) will further decline.

Although we did generate excess returns of 7.1% (7.6% minus 0.5%) over the benchmark, we gave back close to 9.5% of the gains from August 2018, which is disappointing. The paper losses we suffered since August was primarily due to 1) my stupidity and 2) random market movements (in combination these spoke for 90% of the losses from August).

My stupidity

My biggest folly for the year was Donaco. Donaco is a gaming company and operates two casinos, one in Lao Cai, Vietnam and another in Poipet, Cambodia. It acquired Star Vegas (Poipet casino) in 2015 from a Thai vendor with an arrangement where the Thai vendor would manage the casino for two years and be paid a success fee upon achieving specific earnings targets.

Once two years was up, Donaco decided to take back management of Star Vegas and during that period in mid 2017, there was a falling out between Donaco and the Thai vendor.  Donaco alleged that the Thai vendor breached the non-compete agreement by operating two casinos in the Poipet area. Business at Star Vegas slumped as the Thai vendors poached the VIP junkets. Donaco then proceeded to sue the Thai vendors in Cambodia and Singapore.

We purchased the shares in Feb 2018 after the shares fell more than 50% due to the problems. The shares were cheap and I believed that the problems faced by management were surmountable. However, the extent of the trouble was not fully disclosed by the company and some of the details only emerged much later from a recent article published in the SMH, an extract which I’ve included below.  

“According to the court documents, on the afternoon of June 30, 2017, all the slot machines at Star Vegas were turned off and the gambling tables closed. Around 4pm an announcement came over the speaker system within the casino that the Star Vegas had ceased operation and all players were required to move to the “Star Paradise”, the new casino next door. The Thai vendor allegedly took computers, kitchen equipment and corralled about 550 staff to the new casino. He also told VIP junket operators he would not extend credit to their clients and could not guarantee their safety unless they started visiting Star Paradise casino instead.” – smh article on 12 Jan 2019.

Both parties are now suing each other and the biggest risk for Donaco is if the Thai vendor (as landlord) manages to terminate Donaco’s 50 year lease on the Star Vegas land. The shares were trashed as institutional investors fled given the uncertain outcome of the litigation proceedings and potential for further underhanded tactics by the Thai vendor.

At the end of the financial year, we recorded a 70% paper loss on this investment which reduced the portfolio returns since August by 2.6%.

One of the principles at CV Capital is that success is not measured by winning or losing on a single investment but rather having a robust process that identifies low risk investments with favourable wininng odds. A simple analogy is that every bet we make, we want casino odds rather that player odds. Therefore, my folly was not that we lost money on this but the fact that I was aware of the risk of operating in a frontier jurisdiction with potentially shady characters but still overlooked it.

At the end of our financial year, the market capitalisation of Donaco is slightly above $50 million. I believe that the market has more or less fully discounted the value of Star Vegas so there is no point selling at current prices (Donaco also operates the Aristo casino in Vietnam). In the event Donaco is able to get a favourable outcome in the lease arbitration case in February 2019, this would remove a huge cloud of uncertainty over its future. 

Random market movements

Our largest position in CV Capital is Schaffer Corporation. The shares were transferred into CV Capital at $11.10 per share at the beginning of the financial year. On 15 August, Schaffer reported a 174% increase in underlying profits for FY2018. Investors responded to these solid financial results by driving up the share price to $17.05 by the end of August. From September onwards, the shares then reversed course into a declining trend and by the end of our financial year the shares were trading at $13.06.

There was no fundamental reason for this decline. In fact at the AGM in mid November, the Chairman broadly confirmed that the first half results for FY2019 would be similar to the first half results for FY2018. Nonetheless, the share price still fell and is currently trading at a level lower than where the shares were trading two weeks before the company reported their strong results for FY2018, which doesn’t really make much sense to me. Since August, the decline in Schaffer’s share price has shaved off 6% gains in our portfolio.

However, I continue to believe that the shares are undervalued and have elaborated more on this below.

Top holdings

At the end of the financial year, our top 3 positions including cash accounted for 69% of the value of CV Capital.

No.InvestmentWeighting
1Schaffer Corporation18%
2Steamships Trading13%
3Baby Bunting11%
4Cash27%
 Total69%

 Note 1: Returns include unrealised capital gain, dividend and franking credits

I am quietly optimistic about our three largest investments and have given a high level summary of each one below.

Schaffer Corporation

At current prices, I believe Schaffer is undervalued by the market. The entire company is being valued by the market at $181 million and it has no net debt. It has a property portfolio worth $84.6 million net of capital gains tax.

Schaffer has two operating businesses, Automotive Leather and Building Materials (which is insignificant relative to the Automotive Leather division). The Automotive Leather division reported net profit after tax of $23.7 million in FY2018 and is expected to report similar levels of profit in FY2019.  

Backing out the value of property from Schaffer’s market value, it implies that the market is valuing the Automotive Leather division at $96.4 million ($181m – $84.6m and ignoring the Building Materials division) or at a price earnings multiple of 4 times ($96.4m/ $23.7m). I believe this is a very low valuation for the Automotive Leather business given:

  1. It has secured multi-year supply contracts with Land Rover, Audi and Mercedez Benz.
  2. It has the opportunity to increase volumes after being awarded new contracts to supply leather for Mercedez’s electric cars commencing in early 2021.
  3. Similar businesses have been sold at much higher price earnings multiple. 

In addition, Schaffer owns two development sites whose which can add significant value in the medium term. The first is a large development site for industrial use in Jandakot, Perth which is adjacent to an established industrial zone with links to a major freeway. The second is a residential development site approved for high density apartments within the Cockburn coast redevelopment project (just south of Fremantle, WA). This redevelopment project will create a township for 12,000 residents over the next 20 years. I believe the development risks are relatively low given the sites are located in already established areas and without any debt associated with the sites, it has the advantage of waiting for the right market conditions to launch the developments.

For the above reasons, I believe Schaffer to be undervalued at current market prices. FY2019 dividend is forecast to be at least $0.60 per share fully franked which represents a gross dividend yield of 7.7% based on our cost per share. I’m happy to collect the dividends whilst waiting for the market to realise its intrinsic value.

 Steamships Trading

Our second largest holding is Steamships. Steamships is the leading logistics, hotel operator and property developer in PNG. Steamships is not only undervalued by the market at current levels but it also has the potential to double its earnings over the next 3-5 years.

Steamships’ market capitalisation was $580 million (14 January 2019) and it had net debt of $133 million, valuing the company at $713 million or PGK1.7 billion (exchange rate of 1A$:PGK2.4). It owns investment properties valued in the range of PGK$1.6 billion to PGK$2 billion. Therefore, the market is only placing value on its investment properties and ignoring the value of its shipping business, land transport business and hotel business.

As Steamships is one of the largest conglomerates operating in PNG, its fortunes are very much tied to PNG’s economy. Over the last few years, PNG has been in an economic slump due to low commodity prices and cuts in government spending. However, there are huge resource projects in the pipeline with the most significant being the Papua LNG project, which once developed would be PNG’s second LNG project.

The first PNG LNG project commenced construction in 2010 and was completed in 2014 at a cost of US$19 billion. This provided a massive stimulus to the economy which resulted in profits for Steamships nearly doubling from PGK96.5m in FY2009 to PGK177.7m (FY2012).

The Papua LNG project is expected to cost US$13 billion and if history is any guide, during its construction phase it should provide an economic tailwind to Steamships similar to the first LNG project. Of course there is risk that the Papua LNG project gets delayed or does not proceed. However, with the company’s market value backed by its property assets, I see this bet as heads I win and tails I don’t lose.

Baby Bunting 

Our third largest security holding at year end gave us the highest gains in FY2018 (total returns 48.6%). Baby Bunting is the leading baby product retailer in Australia. Calender year 2018 was a watershed year for Baby Bunting as many of its key competitors including Baby R Us shut shop leaving Baby Bunting as the sole national bricks and mortar baby store retailer in Australia.

Baby Bunting has doubled its store footprint in the last 5 years to 50 stores. The company has plans to expand their footprint to 80+ stores and I believe with the closing down of its key competitors it has further scope to enlarge their footprint. It has a successful store format so replicating it into new locations should generate similar success.

The biggest threat to Baby Bunting is online shopping, i.e. Amazon. However, there are still some advantages that Baby Bunting has over its online competitors, such as:

  • Baby products are an emotional purchase so new parents would want to touch and feel the product first.
  • For first time parent (I should know) buying big ticket items such as strollers and car seats is daunting mainly because of the extensive range of products with different features, types, brands etc. Having someone explain to you the differences and the pros and cons of each product is extremely helpful.
  • Proper installation of a car seat is important. Baby Bunting provides baby car seat installation service which an online retailer would not be able to provide.
  • Some products are exclusive to Baby Buntings. For example, they have their own private label products or exclusive colours on branded strollers (very important for the stroller to match mommy’s handbag!) etc.

In addition, for big ticket items such as strollers, baby seats and cots, Amazon Australia currently only has a fraction of the product range sold by Baby Bunting. It appears to me that Amazon Australia’s baby segment focuses more on smaller items whereas the bulk of Baby Bunting’s revenue come from the big ticket items such as strollers, car seats and cots.   

So I’m quite bullish about the prospects of Baby Bunting given advantages of scale in being able to negotiate prices (higher margins) or exclusive products from its suppliers, potential growth from new store rollout and population growth. In my view, Baby Bunting is on its way to becoming the “Bunnings” of the baby speciality retail segment.

Cash

Our largest holding at the moment is cash. The current levels of cash is not 100% intentional, we had two takeovers in this financial year (Watpac and SVWPA) where we generated returns between 25% to 29% on each investment and have not been able to fully redeploy the cash. Although we are not trying to time the markets and in general prefer to be fully invested at all times, I do believe there are reasons that justify a bit of caution in today’s markets.

There are risks such as Brexit, fallout from the China US trade wars, slowing economy in China, fall in Australian house prices, sell-off in the US high yield bond market etc.

So at the moment, we’re still investing but being more cautious and selective in our investments.

The remaining 31% of the portfolio is made up of 7 securities. At 14 January 2019 we have a portfolio of 10 securities.

Overall

This first year has been a learning experience for me and I think I’m a better investor now than at the same time last year. Whilst it would have been nice to report double digit returns for the first year, 12 months is still a very short period in investing and we did manage to generate some excess return which is nice. Even though we have generated excess returns of 7.1% over our benchmark, we have decided to waive the performance fees this year given it was our inaugural year and to show appreciation for the trust that you have placed in us.

I’m optimistic about the portfolio because there are some investments which have the potential to do really well in this year. We will continue to turn over as many stones as possible to look for mis-priced bets.

Thank you for entrusting us with your capital.

 15 Jan 1814 Jan 19Gross
dividends
Return (incl franking credits)
CV Capital1.001.076nil7.6%
Benchmark - STW56.753.783.2080.5%
ASX 200 accumulation index60,54560,043n/a(0.8%)

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