Insufficient Capital April Update

Welcome to the first monthly newsletter for “Insufficient Capital”, the name applied to a long-only equities portfolio. The name applied to the fund is a self-deprecating jab at the fund’s relatively small pool of capital. The newsletters aim to analyse the portfolio as well as general market/economic conditions.

About the Portfolio Manager

The portfolio manager is studying a degree in Civil Engineering (Hons) and Commerce (Finance) at UNSW. Some of the harsh lessons learnt through past investments manifest in the “Ground Rules” available here.

During the month of April, Insufficient Capital appreciated +8.56% compared to the ASX300 Performance of +2.43%. The rationality behind benchmarking against the ASX300 will be explained at the end of this newsletter. The greatest performance contributor was Starpharma Holdings (SPL:ASX) while the largest detractor was Aurelia Metals (AMI:ASX).

As the first monthly newsletter, it is pertinent to set up the Ground Rules for the fund, the disclaimer being that the fund reserves the right to break the rules in special circumstances. Any amendment to the Ground Rules will be noted in future letters.

Our Ground Rules are available here.

These letters will discuss specific stocks, typically portfolio positions, and topics relevant to investing. When investing, nearly all learnings occur when money is lost so it is fitting in this first newsletter to discuss the largest monthly detractor: Aurelia Metals.

Aurelia Metals

Aurelia fell around 16% during the month, primarily due to a disappointing quarterly result. Gold production of 23,323oz was down due to the underperformance of gold grades (less gold was in the ore mined than expected) while the all-in sustaining cost (AISC) was $1302/oz, up significantly from $733/oz recorded last quarter. However, the gold price achieved of $1821/oz demonstrates the significant margin Aurelia has as one of the lowest cost Australian gold producers. Cash conversion was strong, with Aurelia’s quarterly sales revenue of $67m resulting in net site operating cashflow of $25.6m. Net cash increased marginally from $107.9m to $108.6m. Although underwhelming, Aurelia is taking the measures required to continue doing what it does best – low cost gold production.

Concerns have been raised over Aurelia’s mine life, dampening the EV/EBITDA multiple applied to the company. The company’s Hera asset has a mine life of 4 years and contains 7 ore bodies. The current program for the asset is focused on near term drilling. After Hera, Aurelia will begin mining Nymagee which also has a life of 4 years. Aurelia’s Great Cobar asset has a potential mine life of 6 years and will add significant resources and reserves. Aurelia’s strong free cashflow from operations will likely enable it to fund Nymagee and Great Cobar without taking on debt.

A note on Aurelia’s hedging

In the past, hedging was required by lenders. The company’s healthy balance sheet has allowed hedging to run off, leaving the firm more exposed to movements in the gold price. When prices are above $1600-$1700/oz, Aurelia has stated they will hedge up to 50% of their gold production. This was reiterated on a private call the portfolio manager had with the CFO.

Why does Insufficient Capital hold Aurelia?

Insufficient Capital has a pessimistic outlook for the Australian economy over the short-to-midterm due to persistent levels of household debt (190% debt to income ratio is now the highest in the world), the increasing cost of credit impacting consumer spending and the wealth effect of falling house prices in Australia’s two major urban centres. It should be noted that Australia recently fell into a per capita recession for the first time since 2006, meaning that the economy relied on population growth to support the economy.

Gold is famously a poor long-term investment but performs well during challenging times and volatility due to its underlying value. Investment in a low cost gold miner like Aurelia effectively combines two hedges:

  1. Gold as a store of value
  2. Owning a business with high free cashflow from operations and a strong balance sheet (See Ground Rules 1 and 4)

Aurelia is valued at a favourable consensus forward EV/EBITDA multiple of 2.8X for the year ending June 30 2019. This compares to a global peer average of 9.4X (seekingalpha). If Aurelia continues to increase its cash balance rather than engage in capital expenditure, its EV/EBITDA multiple would likely continue to fall. It is significant to note Aurelia’s low EBITDA multiple despite a 3350% valuation gain since 2015 – debt-financing works wonders.

Aurelia recently disclosed it is in preliminary discussions regarding the potential acquisition of CSA Mines (a copper mine also in the Cobar region) from Glencore. The fund believes that this is an exciting earnings-accretive opportunity and efficient use of Aurelia’s substantial cash position.

Aurelia has made an astounding transition from carrying significant levels of debt to net cash within 4 years. This has led some to believe that new investors are late to the party. The fund does not believe the expected return is as high as it was in FY15, but the risk profile is now lower.

Benchmarking against the ASX300

Insufficient Capital will be benchmarking performance against the ASX300 index because there will be a strong portfolio weighting towards its constituents. Most companies with strong balance sheets and low leverage are towards the bigger end of town. Sometimes the fund will find companies which have lower capitalisations that are viable investments if they meet the criteria outlined in the Ground Rules (for example, Acrow Formwork – ACF:ASX). These will often be traditional operating businesses in retail, construction and broader industrials.

During the month, Warren Buffet’s perhaps most famous adage strongly resonated:

“Be Fearful when Others are Greedy and Greedy when Others are Fearful.”

This rings true for both the largest contributor and detractor for the month. Investments trading off fear often generate the greatest alpha opportunities. In this month’s positive case, the contrarian view is that Stanmore Coal offers great value with fears that coal has peaked pushing EV/EBITDA multiples very low. On the flip side, when staring into the abyss (for Insufficient Capital, this takes the form of a large red number), it is pertinent to recall the thesis behind the investment and remind oneself that the market is often irrational in the short term but a great weighing machine in the long term.

We look forward to future correspondence and would appreciate any constructive criticism going forward.

Yours Truly,

Insufficient Capital

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