Insufficient Capital January Update

Performance Figures

The portfolio rose +9.67% over January, outperforming the ASX300 performance of +4.89% by +4.78%. We were very pleased with the result – a great start to the decade. Such strong index performance is incredibly hard to keep up with (let alone, outperform) when holding any cash or gold. We always endeavour to allocate all of our capital (according to Ground Rule #10) to avoid underperformance during strong months like January. However, we will only allocate capital when opportunities are sufficiently attractive to satisfy Ground Rule #12.

The top contributor during January was Afterpay while the largest detractor was Stanmore Coal. The weighted average market capitalisation of our portfolio is $3.3 billion. The fund currently holds 12% cash. 

At the end of January, the fund was most heavily weighted to our ‘Structural Tailwinds’ strategy. ‘Structural Tailwinds’ refers to areas of the economy which are growing at a faster rate than the national average economic growth rate. We note that these companies are not necessarily high-flying growth companies (for example, some non-bank lenders on PE ratios less than the market average fall under this strategy). Afterpay is the fund’s largest holding after its 30% appreciation over January and our decision to add to the position in November.

Going forward, we will release detailed newsletters every quarter (including a deep dive into a portfolio holding) and other updates when deemed appropriate. This will preserve a high level of quality content. 

(Another) Podcast with Frazis Capital

We recently thoroughly enjoyed recording another podcast with Frazis Capital Partners. Check out the discussion on “How We’re Different” on desktop here and on iTunes here. We provided details on Frazis Capital and its deep focus on the life sciences and technology in our last newsletter.

5 (more) Businesses on our CY2020 Watchlist

See the full CY2020 Watchlist on our website and analysis on the 5 other watchlist businesses at the end of our last newsletter.

Bank of Queensland (BOQ:ASX)Regional bank with fresh, proven management, driven to turn the bank around through competitiveness and technological advancement. Some painful writedowns may occur in the company’s troubled technology space before deploying newly raised capital to pivot the business back to growth.
 
Trades at 11.8X consensus forward PE multiple (consensus also presumes a -13% fall in EPS this year). All other major Australian banks trade at higher forward multiples: WBC at 13.0X, CBA at 17.4X, NAB at 12.2X, ANZ at 12.4X, BEN at 14.1X. Whilst the ‘big 4’ premiums could potentially be justified, BEN (another regional bank) appears unjustifiably expensive. We generally avoid speculating over potential M&A activity but believe that there is capacity for a regional bank deal.
Clover Corporation (CLV:ASX)Industrial manufacturer which utilises proprietary microencapsulation technology to deliver powders (both dairy and non-dairy) and oils (tuna). 
 
CLV’s microencapsulation technology (which removes any undesirable fishy odour or taste) gives the business an economic moat which supports long term compounding of capital (ROE is currently +24%). There are positive short-term tailwinds as Europe faces new DHA requirements.
 
At 24.7X consensus forward EV/EBITDA, +26% EBITDA growth and low leverage of 37% Debt/EBITDA, the business is attractively valued.
Resimac Group (RMC:ASX)Non-bank lender (which would fall under our ‘Structural Tailwinds’ strategy) with particular strength in residential mortgage backed securities (RMBS) origination. Specialising in prime mortgages, RMC carries far less default risk than other lenders.
 
At 11.6X consensus forward PE and strong double-digit growth in an industry where most businesses are struggling to grow their loanbook, RMC is a very attractive alternative to traditional bank stocks (which make up around 20% of the Australian market).
Universal Coal (UNV:ASX)South African thermal coal miner with a strong project pipeline and healthy balance sheet, paying a 12.5% yield (at a low payout ratio). 1.4X forward EV/EBITDA with positive earnings growth is a very low valuation even by thermal coal standards.
 
Eskom (state owned utility) has strong offtake contracts with UNV, with little risk that South Africa reduces its dependency on coal-fueled power generation over the midterm.
 
However, risks arise from recent scrutiny of Eskom’s supply contracts (and Eskom’s shaky financial stance), as well as general negative sentiment towards thermal coal. There is also a low proportion of revenue generated through exports, with reliance on South Africa’s economy.

Terracom (TER:ASX) recently took a 20% holding in the company in return for cash and scrip, at an implied valuation premium of roughly 50%. 
Viva Leisure (VVA:ASX)Leading Australian gym/health club operator with many membership options across 7 brands, as well as a history of earnings accretive acquisitions in strategically significant areas.
 
Viva’s gyms are well regarded in the industry, and its investments in technology are helping to develop a stronger brand with stickier customers than most gyms.
 
Valuation Risk?
Run rate guidance for $85M of revenue and $21M EBITDA (current market capitalisation is around $170M). Despite the company’s internally forecasted revenue growth rate of 77% (much of which is inorganic) and EBITDA growth rate of 97%, gyms often sell on EV/EBITDA multiples of <3X (around ⅓ of VVA’s current valuation) due to lack of loyalty and virtually non-existent customer satisfaction in the industry over the long term.

We have already dipped our toe into the watchlist, moving Clover Corporation from the watchlist to the portfolio during January as a small position. We like the area of the supply chain in which the business operates and believe it can generate alpha over the long-term. 

Quip of the Month

“We don’t have to be smarter than the rest. We have to be more disciplined than the rest.”– Warren Buffett

There has never been a better time to be a retail investor. In developed markets, strict laws and the proliferation of tech-driven financial products has given retail investors the tools to compete with any city-centre analyst or portfolio manager… yet retail investors almost always underperform the market. We covered one of the key reasons for this underperformance in our September newsletter when discussing why LICs often trade at discounts to net tangible assets. The clashing basic human emotions of greed and fear destroy returns for both retail and professional investors. In September, we revealed that a whopping 85.1% of actively managed funds have underperformed the S&P500 since the GFC while 91.6% have underperformed over a 15 year period. Unlike actively managed funds, retail investors do not face pressure to lock in performance fees by selling positions as they grow (reducing volatility, short-term downside risk… and returns). We discussed the difficulties facing actively managed funds to take a long-term view in our August newsletter.

There is only one reason to invest in a business – to make a profit. But there are many reasons to sell a business (with varying degrees of justifiability) – life’s needs; life’s wants; something materially impacts future earnings; everyone says you’re wrong; bearish broker reports; online investing forum advice; your partner’s cousin’s dad claims to know something he shouldn’t; tomorrow’s recession; divorce; and more and more. With vast amounts of information available now, more than ever before, and user-friendly trading platforms, it has never been more compelling to press the sell button. Investors continue to do so at the worst possible times.

As we said in our End of Year Special, we use fundamental analysis to buy and hold core portfolio businesses (we always think of our position as if we are owning the whole business rather than just some of its ‘stock’). In our opinion, it is critical to lock out all other noise in the market to avoid buying high and selling low, as well as general overtrading. Such discipline ensured that we never sold any of our top 3 portfolio performers during 2019: EML Payments, Afterpay, Pointsbet. These 3 investments continued to be our top performers in January, all appreciating over 10% during the month.Trading out of the market can be a very costly mistake when considering that the broader Australian index (most other major global indices have produced similar results) has generated a positive return in 81% of years since 1900, with an average gain of +13.2%/annum:

In fact, missing the top 5 best days on the Australian market over the last 20 years would have cost around 40% of return. The losing battle of market timing is further explained here

The S&P500 tells a very similar story. The graph below shows just a handful of reasons to sell equities since the GFC. The general result of doing so – disastrous.

Remaining disciplined is key. There must always be a set of compelling and justifiable reasons to press the sell button. 

If you would like further details regarding our activities, we are always happy to discuss portfolio positions. We encourage you to follow us on Instagram and Twitter, where we share more regular bite-sized commentary.

Kind Regards,

Insufficient Capital

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