Our accountant has finalised our 30 June 2021 accounts and we will be sending out our FY21 financial statement to all shareholders shortly.
We are announcing an inaugural FY21 fully franked dividend of 19.4 cents per share (made up of 5.8 cents in franking credits and 13.6 cents in cash) which will be reinvested (or paid) before 30 September 2021. A dividend statement to all shareholders will also be issued.
The key reason we are issuing a dividend is to pay out our franking credits which have no value to CV Capital. Given our goal of harnessing the effects of compounding capital over a long period of time, our default position will be to reinvest the dividends. I will be reinvesting all of my dividends.
The reinvestment price per share (verified by our accountant) is $1.33, details as follows:
Should you elect not to reinvest your dividends, please inform me before 12 September 2021.
Feel free to contact me if you have any questions.
Illustration of dividend reinvestment Assuming a shareholder had 100,000 shares then he/she would be entitled to a dividend of $19,400 (19.4 cents x 100,000). Out of this amount, the cash portion is $13,600. Based on a dividend reinvestment price of $1.33, the shareholder would be issued 10,226 shares ($13,600/ $1.33).
The ASX 200 has closed the chapter on the pandemic. At the end of June, the index closed at 7,313 points which is higher than its pre-pandemic level. As I write this, Sydney, Brisbane and Perth are all in some form of lockdown due to outbreaks of Covid’s Delta variant. The difference in market reaction at the start of Covid lockdown last year and the current lockdown is stark notwithstanding the delta variant being twice as transmissible as the original Covid virus. Recently, a friend sent me a chart for the of 10 year Greek government bond yield which I found quite amusing. Back in 2012, markets were worried that Greece would default on its government debt which caused investors to dump Greek debt. Greek debt was then toxic, rating agencies downgraded them to junk and yields shot up to 35%. A default was avoided due to the EU and ECB stepping in to bail out Greece. Fast forward to the present and it appears that Greece is more indebted now than it was in 2012 as the government is running large fiscal deficits to support the economy through Covid (see here). Greece is more indebted than ever yet it’s 10 year government bond is trading at half the yield of Singapore, a creditor nation which is AAA rated. WTF?
We bought more shares in Boustead Projects, a company I previously discussed here. We also increased our stake in Boustead Singapore, the parent company of Boustead Projects. These two positions combined currently make up 23% of the portfolio.
Boustead Singapore’s history goes back 190 years as a British trading house operating in Singapore and Malaysia. In the 1970s, it separated from the Malaysian side of the business which had most of the tangible assets, leaving it with a smatter of different businesses. By 1996, when the current management took over, the company was a shadow of its former self and had a market capitalisation of only S$14 million.
Today, Boustead Singapore has 3 key divisions; (1) Boustead Projects (real estate) (2) engineering business and (3) geospatial division. They have recently acquired a health division and although the size of this division is currently not material, its growth prospects are reasonable. We made an investment in Boustead Singapore due to the following:
Top class management
Geospatial division is a gem of a business
On a sum-of-the-parts basis, it was very cheap
Top class management
Boustead Singapore is led by its major shareholder and CEO, Mr Wong Fong Fui. You can read about him here. His track record at Boustead Singapore is excellent, Boustead Singapore has paid a dividend every year since 2003 and compound shareholder returns since 1 January 2000 till today (21.5 years) is approximately 18% p.a. $10,000 invested in 2000 would have turned into roughly $368,000 today.
This performance is truly extraordinary and I would bet Mr. Wong would easily be in the top 0.1% of CEOs globally based on his track record for shareholder returns.
The geospatial division is the licensed distributor of Esri products in the region (Australia, Singapore, Malaysia, Indonesia, and other smaller markets). Esri is the global leader in geospatial software. Think of it as googlemaps on steroids for commercial customers. Australia is by far the largest market in this division, accounting for nearly 75% of the division’s revenue, which provides us with a partial currency hedge. Traditionally, key customers are government organisations but over past 20 years, more and more corporate customers are using geospatial software. This has translated to strong and steady revenue and profit growth over the past 17 years, as shown in the chart below. FY2021 revenue and profit bump was due to governments using Esri solutions in their fight against the Covid-19 (click here to learn more).
Software businesses are fantastic because their revenues are usually very sticky. Once a client has all their data stored on particular software, it is usually troublesome and risky to migrate to another vendor. Although this division is an exclusive distributor of Esri’s products and doesn’t own the IP, I think the risk of termination is actually pretty low due to these two reasons:
The relationship between Boustead Singapore and Esri goes back some 3 to 4 decades and the founder of Esri owns close to 12% of the geospatial division.
Due to the nature of these solutions and especially with government customers, there is typically a long lead time involved for a sale and both consulting and training are important aspects of a sale. So there is symbiotic relationship between Esri and Boustead as Boustead Singapore has the relationships with government which generate sales and can provide consulting and training to the customer.
I believe demand for geospatial technology will increase as we move deeper into the digital age with further development of virtual reality, autonomous driving, collection of geospatial data from internet of things for big data analysis, smart cities etc.
Besides the real estate division (Boustead Projects), the other big division in Boustead Singapore is the engineering division. The engineering division mainly designs and supplies waste heat recovery units, process control systems for downstream oil & gas companies. This business is global and cyclical as it depends on the capital expenditure cycle of their downstream oil & gas clients. The chart below highlights the cyclicality of its revenue and profits.
I calculate below the sum-of-parts intrinsic value for Boustead Singapore based on its 31 March 2021 financial results.
Our average purchase price was around A$0.78 cents which is significantly lower than my assessed intrinsic value (the A$ and S$ are nearly equal value). The paper gain on this investment is currently 49%.
In relation to securities sales, I trimmed our positions in Schaffer Corporation and Baby Bunting. The share price for Schaffer was approaching my assessed intrinsic value so I decided to offload some our holdings. At inception Schaffer was the largest position and is currently close to 7% of the fund. Our returns from Schaffer are circa 94% so it has been quite a good ride so far.
I sold 20% of our position in Baby Bunting when the share price hit $6 (our average cost price was $1.45). I trimmed the position because I felt the market was pricing perfection in Baby Bunting future results and I wanted to raise some cash to be a bit prudent in current market conditions. Overall, Baby Bunting is still our joint largest position (the other being Boustead Singapore) in the fund.
It’s the end of financial year and the accountants are currently preparing our financial statements and taxes. So the numbers presented below may change slightly, mainly due to tax. CV Capital return for FY2021 (1 July – 30 June) is 45.2% and since inception is 15.6% on an annual compounded basis.
The chart below shows our returns on $100,000 from inception to 30 June 2021 compared to our benchmark.
Our cash and cash equivalents position are circa 16.3% of the portfolio and the unit price as at 30 June 2021 is $1.65. I’ll update the table for the subscription and redemption prices once the accountant confirms our tax position. The share price can be broken down into the following:
We will be issuing our inaugural dividend this year. The key reason for issuing a dividend is to pay out our franking credits to shareholders. The franking credits have no value in the fund and our shareholders may be able to benefit from it depending on your individual tax position. Given the aim of the fund is to compound capital for the longest period possible, by default I will be reinvesting the cash portion of the dividend into the fund. The unit price for dividend reinvestment will be our unit subscription price at 30 June 2021 as calculated by the accountant. If you do not wish to reinvest the cash portion of the dividend, please advise me accordingly.
I know I sound like a broken record when I say that I’m concerned about the strength of the stock market, but in the first quarter of 2021, the market climb has picked up pace. In fact, it’s not only the stock market which has been going up, bond prices are at all time highs, Australian house prices are rising at fastest pace in 32 years and even prices of 20-30 year old Japanese sports cars (e.g. Honda NSX, Toyota Supra, Nissan Skyline) have gone up 2-3 fold. So is the stock market (US market in particular) in a bubble? Let’s explore this a bit.
It is inherently difficult to identify a bubble before it burst. Most bubbles are only universally acknowledged as bubbles after they burst. But there are a few common features of a bubble, the first is overvaluation. Robert Shiller, the economist who famously picked the top for both the dot com and housing bubble produces the cyclically adjusted price earnings ratio (“Cape ratio”). Annual corporate earnings are unstable, so the Cape ratio uses the average 10 year earnings (inflation adjusted) to smooth out the earnings volatility to produce a more stable long term valuation metric. Although it has its issues, I believe it is still a better valuation yardstick than the simple price earnings ratio.
The chart below shows the Cape ratio for the S&P 500.
The S&P 500 Cape ratio is currently at the second highest level in 140 years. It is only eclipsed by the dot com bubble in 1999/2000. However, you’ll constantly hear punters play this down by arguing that the high stock prices are justified by the low long term government bond yields (long term interest rates). In fact, real long term government bond yields in the US have fallen to the lowest level in 140 years. Interest rates act like gravity on stock prices and when gravity is low, prices rise. To illustrate this point, the next chart shows the excess Cape yield which is basically the inverse of the Cape (1/Cape ratio) less the long term government bond yields (adjusted for inflation).
After adjusting for the current long term government bond yields, it appears that the excess Cape yield shows a far less extreme situation than just looking at the Cape level. However, that’s a relative way of looking at it and in my opinion, completely missing the forest for the trees. Bond yields are the inverse of their prices, so the reality is that real long term government bond prices in the US are at a 140 year highs and stock prices, relatively speaking are cheaper. It’s like saying a Porsche is cheap when compared to a Ferrari.
Looking at the Cape chart, the current situation looks to be the inverse of the situation in the late 70s/ early 80s, when prices of both stocks and long term bonds were very low (bond prices inverse of its yield) which was a great time to invest in both classes as prices rose over the subsequently decades.
The second feature of a bubble is euphoria and crazy investor behaviour especially on the part of individuals. Jeremy Grantham of GMO, a veteran market historian says that this is the single most dependable feature of the great bubbles in history (I encourage you to read his latest letter here). Some examples of current euphoric investor behaviours are:
The value of Bitcoin hit A$72,000 and is about the same value as a 1kg gold bar. It seems digital gold is as a good as the real thing.
Tesla Inc’s current market capitalisation is worth more than the world’s top 6 car manufacturers combined (Toyota, Volkswagen, Daimler, Ford, General Motors and Honda). In 2020, Tesla made 500,00 vehicles while Toyota alone made 8.8 million vehicles. But Elon is superhuman, no?
Coinbase, a Bitcoin exchanged closed on the day of its IPO at a market capitalisation of US$86 billion, making it as valuable as Intercontinental Exchange Inc, the owner of the New York Stock Exchange.
The $88 billion IPO boom in special-purpose acquisition companies (SPACs) so far in 2021. SPACs are shell corporations listed with the purpose of acquiring a private company at a future date (within 2 years). These are pure speculative vehicles as how can one possibly invest intelligently when one doesn’t even know what business the SPAC will end up acquiring? The last time we had a SPAC boom was in 2007, a year before the global financial crisis.
Explosion in US trading volumes in 2021. The average daily volume in 2019, 2020 and 2021 are 7 billion, 10.9 billion and 14.7 billion trades. The average daily trading volume in 2021 has doubled from 2019. This has coincided with the rise of Robinhood (trading app) and the retail investors who have enthusiastically jumped into the market (speculation frenzy).
The trillion dollar question is how much more can it rise and when will it burst? I’m afraid I have no idea and I don’t think anyone can answer this will a great level of confidence, that’s just the nature of bubbles, they are totally unpredictable. Jeremy Grantham believes the party can last till early summer in the US, we will see. Luckily for us in Australia, the ASX does not seem as overvalued as the US market which is a good thing in my opinion. But on the other hand, when the US market sneezes, everyone else catches the cold. So we will not be immune if the US bubble bursts.
So the next question is, does it matter for a long term value investor like CV Capital? I would say it does but not from trying to prevent our portfolio from going down along with the market. Some stocks we plan to hold for decades so what does it matter if the stock drops by 50% tomorrow? We won’t be selling anyway. So from a paper loss perspective, I don’t think it matters that much.
Where it matters is that if we go into a market meltdown fully invested (i.e. no cash), then we lose the opportunity to invest at bargain prices. So there is an opportunity cost for going into a market meltdown fully invested. One reason why we have outperformed the market is that we put some cash to work when the market crashed in March 2020.
Portfolio management is about balancing the known with the unknown. So we’re proceeding forward with even more caution than usual. Post March, I have been liquidating some of our positions. I’ve been selling positions where I believe the share price has reached or gotten close to its intrinsic value (which we normally do anyway but now I’m being a bit more conservative with my intrinsic value assessments) or selling positions for stocks which have too small portfolio weightings to make a difference to our overall returns (spring cleaning if you like). We will continue to stay invested in positions which we believe to be still undervalued and companies which we believe are long term compounders (companies with comparative advantages who will continue to grow their intrinsic value over time).
We have sold down our holdings in New Zealand Media and Entertainment (NZME). Overall, this has been a lousy investment and we lost 11.5% over 3 years. This was part of the group of stocks which I initially transferred into CV Capital at inception. NZME is the leading media company in New Zealand which owns newspapers, radio stations and some websites. My original thesis was that on a sum-of-parts basis it was cheap and although the newspaper part of the business was in decline, it was cutting costs, still had some growth assets (radio and home selling website One Roof) and was going to launch a paywall on its NZ Herald website, all of which could potentially offset the decline in newspaper revenue.
However, over the past 3 years, the radio business has declined rather than grown and both the paywall and OneRoof are starting from a very low base so it will take a long time before their earnings make a material impact on the group. So NZME’s management had to rely on cutting cost to preserve earnings and that is a very tough game as there is only so much fat you can trim. This has been a good lesson for me, that it is much better to buy a more expensive growing company than a cheap declining company.
CV Capital return for FY2021 (1 July – 31 March) is 36.5% and since inception is 14.7% on an annual compounded basis.
The chart below shows our returns on $100,000 from inception to 31 March 2020 compared to our benchmark.
Our cash and cash equivalents position are circa 11.8% of the portfolio and the unit price as at 31 March 2021 is $1.55. The share price can be broken down into the following:
A very happy new year to all of you. Personally, I’m relieved 2020 is over and will be happy to forget last year. It has been a devastating year for me personally as I lost someone dear to me in my family. So I do hope 2021 brings better health, happiness and prosperity to everyone.
Financially, 2020 will be an unforgettable year given the wild roller coaster ride it has been. We started the year strongly with a compound return of 11.9% (since inception) and during the depths of the market falls in March, we basically gave up all the returns within a few weeks. But by the end of 2020 calendar year we more than made up for all of the lost ground and our returns now are greater than they were at the start of the year. Pretty wild ride but you do need a tough stomach to enjoy equity market returns.
Firstly, the June and September returns have been adjusted upwards slightly. Two reasons for this, (1) our accountant has calculated the tax position for financial year 2020 so this impacts the share price from the end of FY2020 (2) I mistakenly used a slightly higher share count to calculate the June and September’s share price. The good thing is that because the accountant independently calculates our share price, there is another layer of verification. This is one reason why I insist shareholders looking to exit do it after our financial close so that the share price can be independently verified. Moving forward, I intend to also get a second person to review my quarterly share price calculation to minimise the likelihood of mistakes occurring.
Taken together the share price has marginally increased for June and September as shown below.
I also want to touch a bit on subscriptions and redemptions prices. CV Capital as a company is an inefficient tax vehicle for making investments. However, what it lacks in tax efficiencies, it makes up for in low cost. Compared to a managed investment fund unit trust structure, our operating costs are miniscule. Given these tax ineffiencies, we have to make certain adjustments to our reported share price for subscription and redemption prices for it to be equitable for all shareholders. For example, if we paid a redemption price based on the reported share price (assuming we have unrealised gains) then the outgoing shareholder is potentially leaving capital gains tax on the unrealised portfolio gains for remaining shareholders in the fund to settle. Conversely, if new subscribers paid the reported share price then he/ she may end up having to pay capital gains tax on gains which they did not benefit from, being new shareholders. We calculate subscription and redemption prices as follows:
Subscription price = Share price less any franking credits and estimated capital gains tax from unrealised gains
Redemption price = Share price less estimated capital gains tax from unrealised gains
I will be sending out an information memorandum for the fund in the next few weeks which will provide further details.
Lessons from 2020
One of the key lessons for me in 2020 is to pay greater attention to events which have the potential to cause great economic and market turmoil and to understand these risks from first principles rather than relying on second hand (media) views.
Global stock markets were so optimistic in January 2020 despite Covid-19 raging in China. I suspect even a first year epidemiology student would have understood the grave risks Covid-19 posed to the world, yet the financial markets in developed countries were too busy hitting all time highs to take notice. I believe a key misjudgement was that investors used historical experience to project the future. They assumed that the authorities could get on top Covid-19 just like how Sars and Mers were tamed with little disruption to the economy. They also assumed that the health systems of developed countries were better equipped and organised to tackle the virus more effectively than China (which had to lockdown the entire country). How wrong the markets were on both counts.
Investors outside China had 2-3 months to see how contagious and deadly the virus was. The gravity of the situation was easily recognisable to those who had some knowledge of epidemiology and one had more than enough time to reduce equity exposure or put downside protection in place which a few famous investors actually did.
Last year also showed that financial markets are purely sentiment driven in the short term. Who would have imagined that despite the worst global economic contraction experienced since World War 2, both the US stock market indices (Nasdaq and S&P500) and US Covid-19 daily infection and death rates are currently simultaneously hitting all time highs. It is truly astounding to watch. There is a massive amount of capital riding on the speed of the global vaccine rollout. From my vantage point, the market appears to be pricing in a successful swift vaccination of the population in the developed countries and a quick economic recovery thereafter; lofty expectations perhaps.
Losers and winners
The biggest loser in the fund as at 31 Dec was Steamships Trading. If we sold the investment today we would cop a 35% loss. However, I do not deem our decision to investing Steamships to be a mistake. Instead, it was the disproportionate amount of capital allocated to this investment given its risk profile as a company based in PNG (a young country with an immature political system) that has hurt our returns. However, I am still optimistic for a recovery as the catalyst for growth (Papua LNG project) is still there albeit delayed by the current government. I have previously covered this in more detail here.
Another loser in 2020 was Kangaroo Plantations. Our thesis for investing in Kangaroo Plantations was that it had mature blue gum plantations on Kangaroo Island which was ready for harvest except that it was waiting for State government approval for construction of a wharf which would enable export of the timber off Kangaroo Island. What I didn’t predict was the intensity of the bush fires in January 2020 which ravaged all of their plantations across the island despite the plantations not being contiguously located. Although Kangaroo Plantations did receive insurance payout for the fire damage, it was significantly less than the market value of the timber destroyed.
If we sold the investment today we would incur a 37% loss and I regard this as a permanent loss of capital given the destruction of the timber assets. The company is still waiting approval for the wharf and so this loss may narrow once the wharf is approved (as they could potentially charge third parties for the use of the wharf). Fortunately, our allocation to this investment was circa 5% (based on cost) and the overall impact to the long term returns of the fund is currently 0.6%.
The biggest winner in the fund for 2020 calender year was Baby Bunting. As at 31 Dec, this investment makes up 15% of the fund and the total returns (including dividends) is circa 228%. I have discussed this investment in detail in previous reports (see here) so I won’t bore you again suffice to say the dumbest decision I made in 2020 also involved Baby Bunting. After rising to close to $4 pre-Covid it fell to circa $1.50 during the March market panic. I did top up our position by 20% but in hindsight it was such an obvious no brainer that we should have bought bucket loads of it. I understood the business well, it has virtually no brick and mortar competitors of significant size, it is selling essential goods for expecting mothers (so the lockdown affected it far less than other retailers) and it was going to double its store footprint over the next decade. The stock is currently trading close to $5. I deem our biggest winner for 2020 also to be my biggest mistake this year. In this game, mistakes of omission can hurt far more than mistakes of commission.
Another investment which materially helped our returns in 2020 calender year was Seek. We purchased this investment close to the lows in March which I regard as pure luck. Seek is the dominant job board site in Australia, New Zealand, South East Asia (via JobStreet), Mexico, Brazil and China (via Zhaopin). When we bought the stock at $11.75, the market was valuing Seek at $4.1 billion. Its average operating cash flows over the past 3 years was circa $350 million so we were paying about 12 times operating cash flow. Based on these numbers and the period when we bought it, it doesn’t look like an absolute steal. However, when you consider that the ANZ division (close to an unregulated monopoly) changed (Dec 19) its pricing structure to better align ad price to job value, and that its subsidiary Jobstreet will likely follow suit in due course then at $11.75 it’s starting to look like a significant bargain. The ability to charge higher prices for an unregulated monopoly is the ultimate no brainer investment.
To imagine the possible impact from a price hike, we can look to realestate.com, the leading online real estate advertising company in Australia which is comparable to Seek. In FY2015, realestate.com started its journey to market based pricing for its Australian business which basically meant charging ad prices based on property values (which is essentially the same thing Seek is currently doing). This change in pricing method helped realestate.com to increase revenue from $477 million in FY2015 to $874.9 million in FY2019 (before Covid), an impressive 83% growth for an already mature market leader. Realestate.com didn’t disclose ad volumes growth over the period but it couldn’t have been anywhere close to 83%, it could have even been flat over the period given the slump in property prices for Sydney and Melbourne in the first half of 2019.
In the last quarter we purchased a 5% position (based on cost) in Gowings. This investment is basically an asset play. Gowing is primarily an investment holding entity with a majority of its assets tied up in regional shopping malls alongside some equity investments. It owns Coffs Central and Port Central which are shopping malls located in the CBDs of Coffs Harbour and Port Macquarie making them the prime shopping and lifestyle destinations for both regional towns. There is development potential at both locations with approval given for the 7 storey hotel on top of Coffs Central and the potential to develop 12,000 sqm car park in Port Macquarie’s CBD. The managing director owns 39% of the company and has a good long term investment track record. It’s net asset per share was $3.64 as at 31 July 2020 and we purchased the shares at $1.51 after shopping malls lost favour amongst investors due to the Covid-19 social restrictions. As we have a large margin of safety, I see this as a low risk investment.
We sold 25% of our holdings in Schaffer Corporation. We sold the shares at $18 which I deem to be still slightly below its intrinsic value. I sold it to raise some cash as I believe that there are other better opportunities currently in the market which have more upside (and comparable risk) than Schaffer at $18. Our return on the sale of this parcel of shares was approximately 85% over the 3 year holding period.
As at 31 Dec, our top 4 holdings and cash accounted for circa 52% of the overall value and are as follows:
Cash and cash equivalents include cash and securities that currently have received a friendly takeover bid which is supported by the company’s board.
CV Capital return for FY2021 (1 July – 31 Dec) is 28% and since inception is 13.5% on an annual compounded basis.
The chart below shows our returns on $100,000 from inception to 31 Dec 2020 compared to our benchmark.
Our cash and cash equivalents position are circa 13.8% of the portfolio and the share price as at 31 December 2020 is $1.46. The share price can be broken down into the following:
It appears that the economy is recovering from Covid-19. As I write this, the long talked about Australia-New Zealand travel bubble is finally happening and some state borders are also reopening. NSW has not had a single locally transmitted case in the past 7 days and even Victoria has gotten its local transmissions down to single digits. Relatively speaking, Australia is doing well.
Earnings season has just ended and overall earnings were pretty good given the backdrop of Covid-19. Based on the reported earnings it appears to me that the worst case predictions for the economy during the lockdown did not materialise. Don’t get me wrong, there are some sectors like travel and hospitality which have been completely decimated and the economy is still very weak but we did not go into a depression and it appears that the worst has passed (unless of course we get another outbreak ala Melbourne).
The performance of some companies really surprised me despite being in the direct line of fire. Take for example Motorcycle Holdings (a national motorcycle distributor), Breville Group (manufacturer of small kitchen appliances), JB Hifi (consumer electronics retailer), Adairs (home furnishing retailer), all consumer discretionary companies whom you’d think would have been badly hit from the lockdown but instead reported revenue growth in FY2020. The lockdown has spurred some surprising trends. Even shopping malls were pretty resilient, Scenter Group’s (Westfield) revenue only fell by 16% for the half year despite 3 out of the 6 months being in the most acute phase of the social restrictions.
No doubt Jobkeeper has played a huge part in keeping employment and spending ticking along in our consumer driven economy. In tourist hotspots like Byron Bay, 67% of all businesses are reliant on Jobkeeper. Whilst I’m sure there are alot of rorting going on, on balance Jobkeeper was the right move by the government which saved many businesses from going under. The alternative could have been a much deeper recession. The next test for the economy would be when we roll off Jobkeeper in April 2021.
The share market has been more or less flat since June. It’s been a two speed market with the technology companies (Saas, cloud, AI) and “buy now pay later” (BNPL) stocks being the market darlings where no price is too high and other sectors being priced much more modestly. Below are some of my observations which highlight the market exuberance for these stocks:
Afterpay is now marginally more valuable than the Coles Group. A company whose revenue is less than half the net profit of Coles and has yet to post a profit in its entire history is more valuable than the Coles Group, a behemoth who services 21 million Australians every week and has a competitive advantage so huge that it’s near impossible to dethrone in my opinion.
Excluding Afterpay, the next 5 BNPL stocks have a combined worth of $6.3 billion and based on their latest annual reports, reported a combined net loss of $127 million. For $6.3 billion, one could buy all of these Afterpay copycats or a Crown Resort or JB Hi-Fi or Ampol (Caltex) with change to spare.
Then there is Brainchip. Quoting from their website “Brainchip is a global technology company that is revolutionizing Edge AI applications with our event domain neural processor and comprehensive development environment”. Got it? In its FY2019 annual report, it posted $75k of revenue (that’s right, k for thousand) and on its website lists its product applications as “coming soon!”. In early September, this company was valued by the market at close to $1.2b (that’s right, b for billion).
In America, Tesla announced a 5:1 stock split on 11 August which was set to take place on 31 August. Tesla market capitalisation between 11 August and 31 August increased by US$223 billion, (compare this to CSL, the most valuable company on the ASX worth A$130 billion) going from US$275 million to US$498 million. As there were no other major announcements between these dates or just prior to 11 August, the stock split is the most likely catalyst for the valuation uplift. Logically this makes no sense as a stock split only cuts the cake into more slices, it doesn’t add to the overall size of the cake. But more than two CSLs were magically created just by cutting more slices.
I could go on with more examples of market exuberance but let’s move on to the fund’s activity and performance in the last quarter.
We purchased more shares in Boustead Projects (a company I previously discussed here). My thesis has not changed and I think they will unlock the value of their real estate portfolio possibly in the next 12 months as management indicated in the recent annual general meeting (AGM) that they are still pursuing this option. I suspect if not for Covid-19, the monetisation of these real estate assets could have already taken place.
We took some profit from Baby Bunting, we sold the stake we bought during the March sell off. Baby Bunting’s stock price had gone up 2.7 times from the March lows and I wanted to trim the position as it was becoming a very large position in the portfolio. At Baby Bunting’s current price, I believe there are more attractive opportunities in the market. Time will tell whether this was a good decision.
Our Salmat (I previously wrote about here) investment also finally came to a close with a final distribution paid to shareholders in August. I’m quite pleased with this trade as we made a good return without taking much risk. The return we made was purely from cashflows generated by the business and not from selling our shares at a higher price. We made 58% over a 23 month period.
With regards to our share purchase plan (SPP) side hustle, we have so far participated in 8 share purchase plans capital raisings and got full allocations for 2 SPPs. I believe this low hit rate is somewhat indicative of the high level of liquidity in the system driven by low interest rates and central banks pouring money into the system. I’m certainly not complaining as we have netted close to $14k profit from a cost base of less than $200.
CV Capital return for FY2021 (30 Jun – 30 Sept) is 9.5%. A big driver of this return was Baby Buntings and Schaffer Corporation, two of the biggest positions in our fund. Baby Bunting reported an excellent result for FY2020 which showed continued revenue growth from new stores and same store sales and the market reacted with a 40% increase in share price from June. Schaffer showed a pretty resilient result despite their key European customers shutting operations from March to May.
Since inception our return is 7.4% on an annual compounded basis (21.4% on a non-compounded basis) and so far we have outperformed our benchmark by 4.0% p.a. Our cash and cash equivalents position are circa 10% of the portfolio and the unit price (including franking credits) as at 30 September 2020 is $1.21.
Since my last report, the market has staged a remarkable rebound from the March lows. At the end of June the ASX 200 is up close to 30% from the low set on 23 March 2020. It is fascinating to watch optimism return so quickly in spite of:
RBA projecting GDP to fall by 10% in the first half of 2020;
RBA estimating unemployment rate to rise to 10% by June 2020;
In 2019, 8.7 million international tourists visited Australia and spent $45 billion. It is now down to zero with no firm date for reopening of borders. It is same with international student education which in 2018/19 contributing $37.6 billion to the economy.
The chart below shows the ASX 200 index (market) and its price earnings ratio (P/E ratio). The P/E ratio is calculated by using the market capitalisation and divided by earnings.
At the end of June 2020, the market’s P/E ratio was 19.5x, which is roughly 8% lower than where it was at the end of January 2020 before Covid-19 hit Australia. I find it remarkable that the market is just 8% lower despite the unprecedented economic headwinds we are currently facing. On a forward P/E basis (taking current market capitalisation and divided by future earnings), the market is likely to be trading on higher levels now compared to pre-Covid 19 as corporate earnings (denominator in the P/E calculation) are very likely to fall more than 8% in FY2020 and possibly into FY2021 in comparison to earnings in FY2019.
It appears to me that the market is pricing in a “V” shape economic recovery and corporate earnings to return to pre-Covid 19 levels relatively quickly. A major hurdle to this is of course the trajectory of the pandemic and humanity’s efforts to develop a vaccine. I am neither an epidemiologist nor vaccine expert but I’ve read enough to know that the besides the technical challenges in developing a vaccine, it must also be produced in large enough numbers (billions of doses) and at a low enough cost to be able to provide herd immunity for the human species. Even if a vaccine was rolled out today, there is still an economic anchor of a high unemployment rate (7.4% in June 2020) and risk that it may go higher once the Jobkeeper and other government assistance programs end. Of all the possible future scenarios, a quick recovery in corporate earnings feels quite optimistic to me.
In the short term the stock market is an unpredictable animal and over the long term it usually goes up. So even if corporate earnings turn out to be dismal it does not automatically mean that the stock market will fall. From my vantage point, there are many powerful forces driving the market higher such as the historically low cash rate and very low bond yields (for e.g. the 3 year Australian government bond yield is at 0.29% and 3 year A rated corporate bond yield is at 1.32%) which forces investors searching for yield (cashflow) into the stock market due to the higher dividend yields.
This is my long winded way of saying I think the market has run ahead of itself and I believe the probability of a correction is elevated. However, since I can’t predict market movements, my strategy is to move forward with caution. We will stay invested in good quality companies but keep a prudent amount of cash to take advantage of potential market falls.
We sold our position in Capral (3.5% position in March). Overall we made a 7.5% loss (inclusive of dividends and franking credits) on this investment. Whilst I still believe that Capral is trading below its intrinsic value, I decided to sell for the following reasons:
It was not a high quality business and I felt that there are currently better opportunities in the market and if the market does fall there will be even better opportunities then.
Capral is a building products supplier and the demand for housing in the short to medium term looked pretty lacklustre given the near close to zero immigration and international students arrivals coupled with a 20 year high in unemployment. Cheap import competition has negatively affected Capral’s earnings for the last decade and coupled with the housing downturn, I believe the the outlook for earnings is poor.
We participated in 4 share purchase plans (SPP) as part of the strategy laid out in the March 2020 report. These were very profitable trades from a percentage return point of view. So far we have made about $9.5k from a cost base of $100. These are very low cost trades with potential to earn an outside return but there is some luck involved as a few ducks must line up. Therefore, due to the “long shot” risks associated with this strategy, it only makes sense to put a small amount of capital to this strategy. It’s more of a side hustle than anything else.
We raised some capital in May 2020 at $1.031 per share.
I have decided to change the financial year for the fund to align to the Australian tax year. This will reduced our accounting fees moving forward. Given this change, 30 June 2020 will be the end of the new 2019/20 financial year (roughly 6 months) and 1 July 2020 will be the start of the 2020/21 financial year.
CV Capital return for FY2020 (14 Jan – 30 Jun) is (11.3%) and since inception is 4.4% on an annual compounded basis. Our cash and cash equivalent positions are circa 18% of the portfolio and the unit price (including franking credits) as at 30 June 2020 is $1.11.
The world has been turned upside down from a microscopic parasite since my last update so there is plenty to discuss and I will break down this report into the following sections; coronavirus epidemic, market reaction, portfolio performance, fund activity and near term strategy.
Following on my 31 Dec 19 quarter report, I would like to provide a quick update on the FY2019 results (our 2nd year milestone was passed on 14 Jan 20). Last year has been a fantastic year for stocks. Most major stock markets in the world experienced eye-watering gains and the local market was no exception. The table below shows the returns of some major global markets (in no particular order).
The gains across the ASX 200 were very broad based. Out of 200 constituent stocks in the ASX 200 index, 154 (77%) stocks went up in value in 2019. To put the 2019 gains into perspective, the 20.3% price return achieved in 2019 was the best return for the ASX 200 over the last decade. Ranking returns over the past 20 years, 2019 was the third best year. The only materially stronger year was 2009 when the market recovered from the global financial crisis in the previous year. I wouldn’t count on a few more consecutive years of 20%+ gains in the immediate future.
Our performance trailed our
benchmark in FY2019 and although it would be nice to beat the benchmark every
year, in reality this is extremely difficult to achieve over a long period of
time. We do not aim to beat the benchmark annually but rather to beat the
market over the long run (3 – 5 years with preference for the latter). In any
given year, our investment philosophy of selecting beaten down unfavoured
stocks generally leads to underperformance in bull markets and
outperformance in bear markets.
An underappreciated fact which
is rarely a topic of discussion is portfolio risks. It is obvious to me that if
earnings are at similar level then the index at 7,000 is inherently riskier
than when the index is at 3,500. As compared to returns (which always gets the news
headlines as it is easy to measure), risk cannot be measured (I do not believe
price volatility to be a true measure of risk but that discussion is for another
time) and therefore much harder to illustrate in a simple manner.
I define risk as the probability of a permanent loss of capital which is fundamentally different than the risk of a share price falling purely based on market sentiment.
Conceptually, risk adjusted return is the best measure to compare investment performance. However as risk cannot be accurately measured, the risk adjusted return concept is limited to being a mental framework. In terms of our risk profile, I believe our portfolio risks to be moderate given:
Our average cash position was 20.4% throughout FY2019 and cash remains our largest position at the end of FY2019.
I believe the market has yet to appreciate the inherent value in the majority (circa 70%) of the positions in our portfolio.
On our large positions such as Baby Bunting and Schaffer, I believe Baby Bunting will become the “Bunnings” of their segment and it still has a long runway of growth ahead. The sum-of-the parts valuation of Schaffer is, in my opinion higher than the current market price. It has significant real estate value which is not being recognised.
I selected our benchmark purely on the basis of it being an opportunity cost. Our portfolio looks nothing like our benchmark. At the end of FY2019, our portfolio has 16 positions with only a single position being a constituent of the ASX 200 index. Given such little overlap between our portfolio and the benchmark, there is little value in analysing difference in performance other than to say we could have gained X% if we invested in the benchmark.
These are the top 6 positions of our portfolio at the end of FY2019 and they account for circa 69% of our portfolio’s value:
CV Capital returns for FY2019 and since inception was 16.4% (to be verified by our accountant) and 11.9% respectively. Given the market’s sensational return in FY2019, I think trailing our benchmark marginally after two years is not such an unsatisfactory outcome. The table below shows out performance (before taxes). Our cash position is circa 16.7% of the portfolio and the unit price (pre-tax and including franking credits) as at 14 Jan 20 is $1.25 (rounded).
We are fast closing in on our second anniversary of CV Capital (our financial year end is 14 January). As we come to the end of our second year, I would like to detail key mistakes and successes in 2019 which I have not previously covered.
There are two types of mistakes in investing, mistakes from action and mistakes from inaction. One of the biggest mistakes in 2019 was inaction on my part. My friend and teacher, Tony Hansen of EGP Capital invited me to a meeting with the CEO of a payment processing company which was growing strongly and was quite cheap. I thought it looked like a good opportunity but a sharp uplift in the share price within two days of the meeting caused me to wait. Mentally it is hard to buy a stock after seeing it go up 20% but about a week later, the company announced that it sold an overseas business resulting in the doubling of the share price. The lesson is that what happens in the past doesn’t really matter, if we understand the business and if the stock is cheap, we should at least buy some immediately.
The other mistake which I actually made last year but is now acting like an anchor on our returns was over weighting our investment in Steamships. Based on cost, we allocated 13.4% of the fund into Steamships. My investment thesis was that this was a “blue chip” company trading below the book value of its investment properties whose earnings would be getting a massive tailwind from the development of large gas fields in PNG (namely Papua LNG and P’nyang) and other big mining projects. The chart below shows the expected capital expenditure for mining projects in PNG including Papua LNG.
When we made the investment, the government under the leadership of Peter O’Niel was very supportive of these projects. However in May 2019, Peter O’Neil was replaced as prime minister by James Marape. After taking over leadership the new PM shored up public support by stirring up nationalist sentiment with slogans such as “take back PNG”. This led to the government attempting to re-negotiate the Papua LNG deal with the project owners. After months of negotiations, the new government finally backed down and agreed to honour the terms of the Papua LNG agreement. As a result of “losing face” over the Papua LNG re-negotiations, the government is now trying to play hard ball in the P’nyang negotiations (which has not been signed). As P’nyang is integral to the overall Papua LNG project, the entire project is now in limbo as the negotiations between the project owners and the government appear to have come to a stalemate. Given my thesis had assumed that the economic stimulus from the project would have started by end of 2019/ start of 2020, that assumption has now gone out the window. Even though I still believe we will make money from Steamships over the medium term (even without these LNG projects Steamships has property development pipeline which should grow their asset base and contribute to future earnings growth), it has acted as an anchor on the overall portfolio return given its significant weighting (our paper loss as at 31 December 2019 is circa 22%). Given the uncertain nature of PNG politics, it was a mistake to have put so much weight on this investment.
Moving onto our wins, I’ve previously discussed Baby Bunting in our September 19 report and how it has greatly contributed to the returns for this financial year. I’ve got nothing to add but to reiterate that I believe Baby Bunting is fast on its way to become as dominant in its category like Bunnings is in theirs.
Another win has been Salmat. We acquired the shares at 55 cents in the last quarter of 2018. At the time, the Company had about 40 cents of cash per share and two business segments. The catalogue business was in structural decline but the managed solutions business was growing. I figured that both businesses were worth $120 million in total (60 cents per share) and that it was a possibility that the company would divest all its assets and shut shop. Therefore, at 55 cents it was trading below its intrinsic value of $1 (cash plus value of businesses) with a possible future catalyst. Fast forward to today the Company has sold both businesses for $125 million and will no longer have any operations come end of Februray 2020. I’m quietly confident that Salmat will distribute most if not all the remaining cash to shareholders over the next 6 months. Although it looked like my valuation of the business segments were spot on, in reality I overestimated the value of the catalogue business and underestimated the value of the managed solution business. Revenue for the catalogue business fell more than my forecast and due to its fixed cost its earnings declined at an even greater pace. With the conclusion of the sale of the managed services business in February 2020, the Company should have circa $174 million in cash and 20 million of franking credits. Therefore, before closure costs and other statutory expenses, it could potentially distributed 97 cents to shareholders (cash plus franking credits). With the shares trading at 81.5 cents as at 31 Dec 2019 and including dividends received, our return has been 57% over a 14 month holding period.
We also had success in an investment which I’m not yet ready to disclose. It is a financial institution operating in a frontier market, let’s call it Bank XYZ. I was attracted to this investment because it had close to 60% market share in its home market, growing its net profit at low teens, generated returns of equity (ROE) close to 30% which is unheard of in Australia for a bank but more importantly did not earn those high returns by lending to high risk borrowers. It could make those returns because of its dominant position in its home market coupled by a lack of competition. When we made the investment, it was trading on a price earnings multiple of 6x and was paying a dividend yield of 10%. Its valuation is cheap because it is listed on its home stock market which has poor liquidity, unsophisticated group of local investors and hardly any foreign investors. Management is aware of the problems with its local stock market and have told me a future option is to get a secondary listing in a more sophisticated stock market. If that happens, then I believe that its price earnings multiple would get re-rated to 12x instead of the current 6x. While waiting for that to happen (fingers crossed), we’re getting paid a 10% dividend yield which is not bad. Even without a secondary listing and assuming the price earnings multiple of 6x remains constant, my valuation calculation suggest that this investment could yield a 400% return over a 10 year holding period (equivalent to a 22% compound annual return). We’ve own the investment for more than 18 months and our total returns (including dividends) up to 31 December 2018 is 40%.
In my last quarterly report, I
mentioned that we were casting a wider net in search of undervalued securities.
This search took me to places like Hong Kong and Russia where we have made some
small investments. I would like to provide a quick summary of the criteria’s
used in selecting our overseas investments:
I mostly limit my selection of opportunities to stocks which are profitable and in mature industries that are not in structural decline. I avoid any turnaround stories, companies with no track records of earnings and companies which are not conservatively leveraged.
Given the higher risks associated with some overseas markets and my lack of local knowledge, I try to select stocks whose valuations are so cheap that there are unavailable in Australia. As an example, I screen for companies whose market capitalisation are below their current assets (cash, stock, trade receivables) less total liabilities value (known as net nets). These net nets are so cheap that if the carrying values of the current assets approximate their market values, an investor would make money by shutting the business down. And if the carrying values of the current assets are overstated, there are usually some fixed assets (non-current assets) which could potentially be monetised at a value greater than zero (given the market assigned no value to these assets). These net nets are extremely cheap and at this point in the cycle they rarely show up on the ASX. Ones that do show up are usually high risk, overleveraged or have dodgy management etc.
A net net which we recently discovered and invested in is a company listed in Hong Kong called Chow Sang Sang Holdings International (CSS). CSS was founded in 1934 and is the 7th largest jewellery company in the world (by revenue). Based on Deloitte’s Global Power of Luxury Goods 2019 report, the top 8 global jewellery companies are as follows:
When I was researching the industry, I was surprised that a Hong Kong company took top spot and that Hong Kong companies dominated the list. The rise of the Chinese middle class and growth in their jewellery consumption over the past two decades has made China the largest jewellery market in the world and these Hong Kong companies have exploited this trend by expanding their retail footprint into China.
CSS’ shares suffered a 30% drop between April and Oct 2019 mainly due to the protests in Hong Kong. This resulted in its market capitalisation falling below HK$6.5 billion which looked very attractive when compared to the value of its current assets less total liabilities of HK$7.3 billion. At this level it was trading at price to earnings ratio of 6x, paying a 7% dividend yield with the share price being at a 10 year low. In my opinion, CSS is an unbelievably high quality net net for the following reasons:
Its brand has a long history in Hong Kong associated with quality and trust. Most Hong Kongers would know this brand and consumer trust is essential when selling expensive jewellery.
Culturally the Chinese have an affinity for gold. Not as much as the Indians but gold is traditionally given at weddings and births. I believe the demand for gold jewellery is likely to increase as the Chinese middle class expands and becomes richer.
The last financial report shows CSS had cash and gold inventory worth HK$9.4 billion and debt of HK$2.2 billion compared to market capitalisation of HK$6.5 billion.
The management team is made up of descendants of the company’s founder and has jewellery retailing in their DNA. They are also the largest shareholders which suggest that their interests are closely aligned with minority shareholders.
Over the past 9 years CSS has grown their footprint in China by 130%. As of June 18 they had 534 China stores vs 87 stores in other locations (HK/ Macau and Taiwan). The chart below shows revenue growth from CSS China stores vs HK/ Macau stores over the past 8 years.
My thesis is that even in the very unlikely event that Hong Kong doesn’t recover from recent events, over the next 5 – 10 years, revenue from China will eventually dwarf HK/ Macau as the Chinese middle class expands and becomes richer. CSS has no plans to increase their HK/ Macau footprint but is focusing on opening 50 new stores in China annually. Although the Chinese stores on a per store basis currently generate significantly less revenue than HK/ Macau stores (as they sell products at lower price point), their profit margins are higher due to the lower rent and wage cost. This investment provides a cheap entry point for exposure to the fastest growing middle class in the world.
We did make a few more smaller investments which I’m looking to buy more of and once we’ve finished buying I’ll talk about these in more detail in the next report.
The portfolio appreciated marginally by 1.4% in the December quarter. There were ups and downs in the portfolio. Given that we are nearing our second year anniversary, I’ve decided to change how we present the results and show the returns both on an annual basis and since inception.
CV Capital’s objective is to beat the benchmark over the long term (3 – 5 years) and although some of our early investments are now coming to fruition, there are still many investments which has not played out yet. Therefore, I’d prefer to form a more concrete judgement of our performance after our third year anniversary. The table below shows out performance (before taxes). Our cash position is circa 12% of the portfolio and the unit price (including taxes) as at 31 December 2019 is $1.24 (rounded).
In my last report, I said that
it was a challenging period to find bargains. My definition of a bargain is a
stock that has very little downside but has significant upside potential (i.e. low
risks and high returns).
Traditionally, an easy way to
spot a potential bargain is to look for statistically cheap stocks,
these are stocks selling at low valuation benchmarks (e.g. low price to
earnings or low price to book value). Although there are many statistically
cheap stocks on the ASX, nowadays these tend to be companies which are: (1)
operating in sunset industries with declining revenues and earnings (2)
undergoing restructuring exercises (3) highly leveraged (4) facing a threat to
its business. Stocks like these do not fit my definition of a bargain.
Spotting a bargain on the ASX today usually requires insight which is much harder to achieve than compared to looking for statistically cheap stocks. An example of insight was when we bought Baby Buntings last year (I discussed Baby Bunting in the 2018 annual letter). The stock was trading at around PE of 14x when we bought the shares in June 2018, which is not by any measure cheap. I had some insight into Baby Buntings as I have young kids and frequently visited the stores. Their main brick and mortar competitors were closing down which reduced future competition and at the same time Baby Buntings’ share price had fell 50% from 12 months prior due to both the general retail sector being re-rated downwards and their margins being eroded because of their competitors’ closing down sales. The combination of these factors meant that the risk reward ratio was very good and we took a large position. As of 30 September, the return from this investment is 159%, by far the highest return in the portfolio. Unfortunately, I can’t seem to find these opportunities very often.
It’s probably not that surprising that bargains are harder to spot on the ASX given where we are in the cycle and the existence of many smart investors constantly hunting for undervalued securities.
In relation to searching for opportunities, Charlie Munger has previously said “fish where the fish are” which I believe is very true. Many a time, it is not necessarily the smartest who makes a fortune but the first. Therefore, moving forward I intend to expand our search for bargains in foreign markets with less demanding valuations or where pricing is less efficient. For illustration, I list below a few valuations benchmarks across various markets around the world.
Based on just a few valuation benchmarks, these suggest that there may be better value outside of the Australian market. As an example, I have uncovered some companies listed on the Russian stock market that are trading at low single digit PE multiples with dividend yields in the teens. If we invest in markets like Russia, given the risks involved, my strategy would be to allocate no more than 10% of the portfolio to that country and spread our bets across say 10 securities so that we don’t concentrate our exposure to any single company. I see these markets as both an opportunity and also a potential substitute for cash as their dividend yields are high.
In terms of activity in the
last quarter, we exited a position and we entered into a new position.
We fully exited our position in Bounty Mining with a loss of 36%. We were fortunate not to have lost more as we trimmed our position by a third earlier in the year. Coming into this investment, I already knew that mining was a risky game and we invested because I thought the odds were in favour of Bounty given the favourable circumstances. Bounty listed (IPO) in June 2018 at a price of 35 cents or a market capitalisation of circa $120 million and its key asset was the Cook Colliery, a coking coal mine under care and maintenance at the time. Bounty purchased Cook Colliery from Caledon Coal which had gone bust after investing hundreds of millions into upgrading the existing mine infrastructure. So I figured the opportunity was good because:
Cook Colliery had plant and equipment worth a few hundred million which meant that there was no major capital expenditure required to restart operations.
Coking coal prices were trading at $260/ton and at Bounty target production rates of 1 million ROM tonnes, the revenue potential was substantial.
The managing director at the time was a 30 year coal mining veteran who also had a significant stake in Bounty.
When we invested in November 18, the share price had halved since the IPO. At 16 cents or a market capitalisation of $60 million, I felt it was very cheap relative to their potential revenue and earnings if they could achieve their target production. All that was needed was to mine the coal.
So why didn’t this investment work out?
The main reason was the challenging mining conditions at Cook. Bounty is still only mining 600 tonnes of coal (far short of their target production) on an annualised basis and the low volumes are causing Bounty to lose money on every ton of coal mined. To fund these losses, Bounty had to borrow from their major shareholder. Although the latest June quarterly report showed that production is on an increasing trend, albeit very slowly, I decided to exit our position because the Company was running out of funds again and the latest funding proposal by the major shareholder was in the form of a convertible note where once exercised would double the ordinary share count and significantly dilute the minority shareholders. So even if Bounty succeeded in increasing production and profitability, minority shareholders were not going to see much of it.
Before this experience, my view
was that mining was a very difficult sector for a value investor but now I
think it is near impossible territory. The risks surrounding commodity prices, operational
and geological risks mean that for an outsider it is near impossible to tell
whether a margin of safety truly exists.
On a brighter note, we bought a
new position in Link Administration Holdings. Link has a few business lines but
the main ones are fund administration and corporate share registry services. They
also own a 44% stake in PEXA which is Australia’s premier electronic lodgement
network operator (ELNO) for real estate transactions. The share price fell
nearly 40% from May to August, (due to a profit downgrade announced at the end
of May) which is when we took a position.
When we acquired our position, the enterprise value (total value of the company including its debt) was $3.1 billion which included the value of their interest in PEXA, which was valued on the balance sheet at $715 million. Link’s core businesses in FY18 (excluding PEXA) were spitting out free cash flows (FCF or cash that is available to be paid out to shareholders) greater than $200 million a year and with 80% of the revenues being recurring in nature (due to its contractual nature), this suggested that the $200 million FCF is sustainable. I also believe the revenues from the fund administration business to be relatively sticky because of how they integrate their systems and people into their customers operations. As an example, one of their key clients AustralianSuper has 2.2 million members who are all serviced by Link. Link calculates the balances in their super accounts, handles correspondences and operates the AustralianSuper call centre. It would not be easy for AustralianSuper to migrate the systems and people to a new provider.
In addition, the fund
administration and corporate share registry services businesses have large
economies of scale benefits. The investment (sunk cost) into the systems and
software development cost hundreds of millions and it would be very difficult
for a competitor to compete on price as Link is already the market leader in
fund administration and has the second largest market share (after Computershare)
in corporate share registry services. This means that they can spread the sunk
cost across more clients/ members than a smaller competitor or even the super
fund themselves (if they wish to DIY) so in theory should enable Link to have a
competitive advantage by being the lowest cost provider.
Removing PEXA’s value from Link’s
enterprise value implies a $2.4 billion ($3.1b – $715m) valuation for Link’s business.
For now let’s assume the value of PEXA is about right. Based on a FCF of $200
million, this implies that the market is valuing the business at a FCF multiple
of 12x ($2.4b/ $200m), which is a relatively low multiple to pay considering
the quality of the business. Just as a point of reference, I calculated that
Computershare, a key competitor is trading at a FCF multiple of circa 24x.
PEXA is very interesting and is potentially the jewel in the crown. PEXA was formed in 2010 to fulfil the Council of Australian Governments’ initiative to deliver a single, national e-conveyancing solution for the Australian property industry. Fast forward to 2019, PEXA has invested millions to develop its platform and is currently the only licensed national ELNO. PEXA has significant market share in real estate transactions in those states where e-conveyancing has been made mandatory. The chart below shows the take up by the states for all types of property transactions.
PEXA is currently processing 2 million (annualised basis) real estate transactions from a total market size of circa 3.5 million transactions. Once SA and QLD make e-conveyancing mandatory (which is only a matter of time), it wouldn’t surprise me if PEXA’s market share increased to over 90%. On average PEXA charges $60 per transaction so its potential future revenue from e-conveyancing services could be over $190 million. FY2019 financial information presented by Link suggest that the operating expenses are circa $100 million per annum with R&D expenses being significant (>$20 million) in FY2019. This suggests that its operating income from e-conveyancing could reach $100 million once e-conveyancing becomes mandatory across all states.
The e-conveyancing fees are mandated to escalate at inflation (CPI) and growth in construction of new properties should provide strong tailwind for revenue growth. With a largely fixed cost base future price increases should largely flow to the bottom line. In addition PEXA is also developing tools to provide add-on services such as title searches and e-contracts. This provides opportunity to further grow ancillary revenue and earnings.
Although a competitor has emerged (Sympli), I think that it will be very difficult to compete given the first mover advantage (my understanding is that Sympli’s platform is still under development), market share (PEXA already has close to 80% market share in states which have mandated e-conveyancing) and network effect that PEXA commands. The network effect is significant because at the moment, there is no interoperability between the ELNOs and PEXA already has 8,218 solicitors and 149 financial institutions as subscribers. This means that in a property transaction, both the vendor and purchaser’s solicitors have to use the same ELNO.
PEXA’s average cost of $60 is insignificant relative to the size of a property transaction and since these fees are passed on to the solicitor’s client there is not much incentive to switch to a cheaper provider from the solicitor’s perspective. Once a solicitor learns how to use PEXA’s platform, the human condition generally dictates that he/she would be reluctant to learn a new one.
Link’s carrying value for their
stake in PEXA implies a 100% value of $1.6 billion. In my opinion, this does
not appear to be a stretch given the monopolistic nature of the business. One
potential strategy for Link is to list PEXA in the next 2 – 3 years and by then
it is possible that the business could be worth between $2 – $3 billion.
Moving onto the September 2019 quarter results.
Since June, the portfolio has
appreciated by 11.2% and we have managed to recover lost ground and pull slightly
ahead of the benchmark. A key reason for the satisfactory performance over the
last 3 months is the appreciation in Baby Bunting’s shares and given the
concentration of our portfolio, movements in our large position have a big
impact on the overall returns.
CV Capital’s objective is
to beat the benchmark over the long term (3 – 5 years) and although we are
approaching the 2nd year milestone, I am still not placing too much
emphasis on the current performance. The table below shows out performance
(before taxes). Our cash position is circa 21% of the portfolio. I’ve added a
column to show mathematically how long it will take to double the value based
on the current rate of return. It is for illustrative purposes only.