CV Capital

CV Capital March 2020 – quarterly update

To my fellow shareholders,

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.

Coronavirus epidemic

As of the time of writing, most of the world’s developed economies are successfully “flattening the curve”. Each country is at a different stage of the pandemic but nearly all the developed countries are on the right trajectory. Through high testing rates, having no land borders and luck, Australia currently appears to be further ahead of most countries in the fight against coronavirus. Over the past week, daily new cases as a percentage of total cases have fallen to below 0.5% compared to early March (before the lockdown) when this ratio was 20% – 30% a day which meant that the total population infected doubled every 3/4 days.

So from the data, it appears that the social distancing measures taken have successfully suppressed the first wave of this pandemic. The last time a global pandemic occurred on a similar scale was the Spanish flu. In the US this occurred in three waves during 1918 and 1919. The first wave hit during spring and summer of 1918 and the second and third wave occurred in the fall of 1918 and spring of 1919. The Spanish flu killed an estimated 50 million worldwide. I found an interesting chart which I thought I share. It shows weekly death rates in 36 US cities after a 24 week duration during the Spanish Flu pandemic.

I make two observations:

  • Social distancing appeared to be effective in 1918 in reducing the death rate after they were implemented and at the end of 24 weeks, the worst of the pandemic had past for most cities. This may provide a clue to how long the current pandemic will last.
  • In contrast with 1918, the current death rate per 100,000 persons currently for USA and Australia is around 17 persons and less than 1 person respectively. Through advancements in healthcare etc, we are managing the current pandemic much much better than in 1918 despite living in a more urban and globalised world today.

Stock market response

The lockdown measures will inevitable extract a huge toll on the economy and optimism in mid February turned into panic by March.  The stock market fall from peak to trough was one the fastest in recent history and the selling was indiscriminate.

The overall peak to trough during the GFC was 54% and this occurred over a 16 month period from the peak in 1 November 2007 to the bottom in 6 March 2009. During the most acute phase of the GFC (Lehman Brothers bankruptcy period), it took the ASX200 index about two months to fall 34.7% from 29 August 2008 (5,135 points) to bottom in 20 November 2008 (3,352 points). This time, the market took half that time for a similar size fall. The ASX200 index fell 36.5% from 20 February to 23 March, a period marginally exceeding one month.

Portfolio performance

Overall the portfolio fell 20% from our last report to 31 March 2020 which is only slightly better than the market (ASX200 fell 27% over same period) and is disappointing as I expected the portfolio to do better in a downturn given our conservative stock picks and cash position. Although we had 16.7% of the portfolio in cash and a further 6.8% in near cash equivalent security (Salmat which is currently a cash box) coming into the downturn, we had falls in our concentrated positions which offset some of the benefits of our cash holding. The positions which accounted for the largest falls from our last report (in order of magnitude) are as follows: Baby Bunting, Schaffer, Donaco and Link. These accounted for circa 60% of the change in our portfolio value from the last report.  

Brick and mortar retailers have all been sold off in response to the coronavirus lockdown and Baby Bunting’s (12.9% position) share price have fallen more than the market. However, its stores are still trading as it sells many essential products for families who are expecting a baby and has an online presence which is growing in the current environment. From a liquidity perspective it has low debt levels (debt to equity ratio of 23%) and has significant headroom on its debt facility (used less than 50% currently). It also has the ability to preserve cash by temporarily shutting unprofitable stores and standing down staff if necessary so I believe it can ride through the current lockdown.

Schaffer Corporation (12.4% position) also fell more than the market as it was forced to stop its European automotive leather operations in response to the closure of its customer’s automobile factories in Germany. Besides the automotive leather operations, it has real estate and financial assets valued at $106 million (after tax and debt associated with the real estate) and has net debt of $27.1 million which is low relative to its assets. Schaffer is in a strong financial position and with the German automakers currently re-opening their factories; it should be able to re-start its leather operations soon.

Prior to the pandemic, we purchased more shares in Donaco (3.5% position) which I previously described as a mistake in 2018 (read here). However, two events changed my view. First, a change of control event occurred with a Hong Kong private equity firm becoming the largest shareholder and taking over management of the company (previous management lost focus). Second, all of the legal disputes with the Thai vendor were settled and this removed the imminent risk of losing its key asset, the Star Vegas casino. So I figured it was worth adding to our positions because:

  • The share price at the time was trading at a value lower than the construction cost of the Aristo casino and Aristo is actually smaller and less profitable than Star Vegas.
  • The HK private equity firm bought in at a price which was significantly higher than the share price at the time of purchase and I believe one of their potential strategies would be to sell the casinos and liquidate the company for a quick profit and this would be a catalyst for the stock.
  • After settlement with the Thai vendor, the company was de-risked and could start to rebuild the Star Vegas business. Star Vegas is still one of the premier casinos in Poipet.

Aristo and Star Vegas rely on foreign gamblers and the current coronavirus border closure at Cambodia and Vietnam has decimated business at both casinos. As a result, Donaco has shut both casinos to preserve cash. Although Donaco is able to fund overheads until the end of 2020 (it has US$11.6 million in cash and its cash burn rate is around US$900k a month), it is due to pay $17 million in loan repayments before the end of 2020. Donaco and Megabank are currently in negotiations to restructure the loan and I’m optimistic Megabank will support Donaco as it has not missed a single debt payment in the last 5 years and considering the current unprecedented environment. If it is unable to restructure/ refinance the debt then Donaco will have to raise equity capital to shore-up its cash position.

Link’s (6.2% position) share price fell more than the market as it lowered its earnings guidance for FY2020 just prior to the market meltdown. We purchased more shares in Link over the quarter as I believe it is cheap in relation to its current cashflow and future growth potential. Whilst it has moderate levels of debt, 80% of its revenue is recurring. The current lockdown has also quickened the adoption of e-conveyancing and South Australia recently announced mandatory use of e-conveyancing for property transactions by August 2020. This should provide a boost to Pexa volumes once the pandemic is over. I think Link has enough liquidity to meet all its commitments as it paid a dividend in April. In addition, the CEO and chairman made on-market purchases of $459k and $980k respectively in March 2020.

Fund Activity

We have made a few purchases over the last quarter as the market was going down. We topped up on some existing positions and bought a new position in Boustead Projects.  Boustead Projects is a company listed in Singapore with two business units; construction and property management. Construction business is usually not appealing to me because its competitive and tough competition sometimes leads to poor pricing of contracts making them unprofitable. So why do I like Boustead Projects?

  1. Management appears to be selective about tendering for work and has pricing discipline when tendering for projects. The construction division has been profitable every year since FY2012. It helps when the major shareholder, Mr. Wong Fung Fui adopts a long term perspective. Their order book has increased from S$233 million (FY2018) to S$600 million (FY2019). This suggests that earnings will increase in 2020 and 2021 assuming no adverse impact from coronavirus.
  1. It directly owns a property portfolio worth S$366 million and reported an occupancy rate of 93% in FY2019. In addition, it also has 40%-50% interest in property joint ventures worth S$80 million (after deducting debt) based on my estimates. The property portfolio is carried on the balance sheet at historical cost so this removes the incentive for management to show revaluation gains.
  1. In prior years, the company said that it will have to reach a certain size to be able to monetise its property portfolio and in the latest 2019 annual report, it said that it had reached a stage where it is reviewing various monetisation options. My guess is that they will transfer their property portfolio into a newly created real estate investment trust. This will be the catalyst to unlock value from the property portfolio.   

When we purchase the shares it was trading at a market capitalisation of around S$280 million and had net cash of S$50 million. It was basically trading at levels below the value of its wholly owned property portfolio with the interest in joint ventures and construction business valued effectively at zero. Boustead Projects pays a small dividend, so we’ll cash our dividend cheques while patiently waiting for the catalyst.

Lessons from the market meltdown

Whilst we were relatively cautious going into this market crash (given my views that the US market was very expensive), with cash being our largest position and owning securities with low debt, generating cashflows etc; this was still not enough to prevent a material fall in our portfolio value. So there is no really place to hide in a market rout. In fact, the less liquid cheaper small caps sometimes fell more than the expensive big caps. Although paper losses are somewhat disappointing, they are actually less of an issue if we stick to a long term horizon and own strong companies which can come out the other side intact.

However, a market meltdown presents a wonderful opportunity to acquire quality companies at marked down prices and without significant levels of cash it is difficult to fully take advantage of the situation. We have a buy and hold strategy and since I don’t believe in market timing, we are very unlikely to find ourselves in a position where we have say 50% of the portfolio in cash during a market crash. So I think a strategy of buying some insurance (say out-of-the money put options) when the market is bullish is worth considering. Although it’s near impossible to time a market crash, we do know that history suggest that they typically come around every 7-10 years so I think it’s prudent to buy some protection when market valuations are high. Not so much to protect the value of the existing long positions but to generate cash to exploit the available opportunities in a market crash.

Near term strategy: share purchase plans

Given the looming economic crisis, many companies have raised capital in the past month and I believe many more companies will have to come to market to shore up their balance sheets over the next 12 months. So I’ve been positioning the fund to be able to participate in share purchase plans (SPP) that have large discounts to the underlying share price.

Share purchase plans are offered to eligible shareholders to purchase up to a maximum $30,000 in shares at a discount to the market price. Typically it is offered concurrently with an institutional placement and it allows retail shareholders to participate. It can be done quickly without a prospectus which is why companies like it. The great thing about share purchase plans is that eligible shareholders usually get about 3 weeks to decide whether to participate. This window of time is very beneficial to the eligible shareholder as he/ she can wait for the share price to rise before deciding to participate. It is essentially a free call option. The only disadvantage is that the company can scale back the SPP which means the shareholders may not get their full application. Some recent examples of potentially profitable SPPs.

Not every SPP will be as profitable as the ones above and given the lucrative returns, I suspect there will be scale backs due to oversubscription.

To be eligible for these SPPs, one has to be a shareholder prior to the announcement of the SPP. Therefore, I have purchased a minimum number of shares in many companies which I think will have to eventually recapitalise their business due to their debt levels and being in sectors that are directly hit by the coronavirus lockdown (retail, hospitality, travel etc). At the moment, we have close to 100 companies in our potential SPP basket. Not every company in our basket will do an SPP nor will each SPP provide a good trade opportunity, but I believe for a very small outlay the potential payoffs are worth it.

We’ve already gotten 2 SPPs and I foresee we will get many more. During the GFC, companies were raising capital from 2008 and into 2010 so I think we are only at the beginning. We will need liquidity to participate in these SPPs so I will be opening up the fund for new subscriptions on 8 May 2020. I will investing more into the fund.  

The table below shows our performance up to 31 March 2020. Our cash position is circa 6.2% of the portfolio and the unit price (including taxes) as at 31 March 2020 is $1.00 (rounded).

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

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