Insufficient Capital August Update

The fund rose +3.73% over the August reporting period, compared to the ASX300 performance of -2.97% (+6.7% outperformance). At August end, the fund held 27% cash. The top contributor was Afterpay, while the largest detractor was Acrow Formwork.

Positioning Changes

We recently exited a long-term core position in natural gas producer, Cooper Energy (COE:ASX). We bought Cooper in late 2017 at 2.2X 2021 forecast EV/EBITDA. There are four key risk areas to investing in energy: Funding, Exploring, Extracting, Selling. When we invested, Cooper had already completed all required funding and exploration. The firm had take-or-pay contracts with AGL Energy, Alinta and Energy Australia on the vast majority of future production throughout the 2020s. This significantly reduced natural gas price risk (Selling Risk). The only remaining major risk associated with Cooper was extraction (the physical process of laying pipe and transporting natural gas). We did not believe that a 2.2X forward multiple (albeit, 3 years out) was appropriate for Cooper’s risk profile given comparable firms are valued at around 5-6X forward EBITDA. We believed that what appeared to be short-term thinking investors would only appreciate Cooper’s cashflows when they begin occurring in 2021. Pleasantly, Cooper’s multiple has expanded earlier than expected. This reduced our expected return below the return target set out in our investing Ground Rules, prompting the decision to exit the position at a 91% profit.

We added 20% to our Afterpay position after a meaningful pull-back provided the opportunity prior to its reporting. In addition, we added 20% to our Stanmore position after a similar pull-back. We also initiated a small position in card-issuer and platform, EML Payments. Further details regarding the results of the three will be detailed below.

Stanmore Coal (SMR:ASX)

Details about our investment in Stanmore Coal can be found in a previous newsletter. The company is our largest position. Stanmore received a non-binding, indicative proposal from Winfield (a private group with experience in the Bowen Basin via a shareholding in Glencore’s Rolleston mine) for between $1.50 and $1.70/share. Winfield’s 4 week due diligence period is due to end imminently. This comes after a $0.95 offer from Golden Investments in November 2018. We continue to hold the position and believe there could be competing offers in future due to Stanmore’s high quality of assets.

Annual results were presented on 22 August:

The company announced a final 8c/share dividend, taking the full year dividend to 11c/share). This represents a 7.9% yield. We decided to reinvest the 3cps interim dividend earlier in the year, following Ground Rule * #9. This proved to be a very lucrative decision for the fund. Unfortunately, Stanmore is not offering a reinvestment plan for the final dividend.

Despite the company’s superb performance, Stanmore continues to trade at 2.4X forward EBITDA, a 40% discount to some of its larger peers. We believe Stanmore should also be trading at 4X forward EV/EBITDA due to its strong cashflow generation, asset quality, operational expertise, deleveraged balance sheet (SMR’s cash position is now 25% of its market capitalisation) and consistent upgrades to mine development.

A valuation of 4X forward EV/EBITDA would be significantly higher than the upper bound of Winfield’s offer.

EML Payments (EML:ASX)

We initiated a position in EML during the month, seeing great opportunity in its prepaid stored value products. EML is a principle member of MasterCard in Australia and Europe, processing and authorising card transactions across 21 countries on MasterCard, Visa, Discover and Eftpos.

Whilst EML faces strong competition from US payments heavyweight Stripe (who are rolling out an issuing API [a set of tools for building software applications] which is heavily discounted), we still believe there is midterm upside for EML. EML is valued far more cheaply than other financial services firms at 25X EV/EBITDA, growing topline revenue by 37% during FY19 and EBITDA by 38%. The company is well-positioned for further investment in its engineering team (a key weakness vs the new breed of fintechs) with $18.1M of net cash.

The investment has appreciated +25% since our initiation. We will update our subscribers with more details on EML in a future newsletter which will follow our usual format.

Afterpay Touch (APT:ASX)

We first invested in Afterpay at a $1.3B valuation (EV/Sales circa 40). The company is now worth over $8B (EV/Sales of 23.2) but is around 2X cheaper based on EV/Sales multiple. Despite the incredible appreciation, we believe the company now carries less risk than at our first entry due to its foothold and scalability in Australia and the US. There has also been strong initial growth in the UK, with over 200,000 customers onboarded in the first 15 weeks:

Annual results were presented on 28 August:

Gross losses as a proportion of income should continue to fall in future since Afterpay’s algorithm locks out any customer who fails to pay on time from future purchases. This will boost future profitability and reduce exposure to credit risk.

Afterpay remains on track to deliver on its mission to be the world’s most loved ‘buy now pay later’ platform. We found one statistic particularly compelling. New US customers could be purchasing 5X more frequently in two years if they remain on Afterpay’s platform and follow Australian customer behaviour.

Unlike most funds which reduce positions as they grow, we will only reduce positions when we no longer believe they meet our investing criteria.

Acrow Formwork (ACF:ASX)

Acrow was covered in more detail in a previous newsletter. The company is effectively transitioning from residential scaffolding (a very competitive, cyclical and fragmented market) to value adding civil formwork solutions focusing on infrastructure projects.

Acrow’s annual results were presented on 30 August:

We continue to maintain high conviction in the position as a core holding, despite its poor performance for the fund, and believe it is a superb countercyclical opportunity due to its infrastructure focus. Acrow trades on a PE of <7 and pays a 7.4% dividend. Despite our large position, we will reinvest all dividends if they are offered at a discount to the share price according to Ground Rule * #9.

Acrow invested heavily in its people during FY2019. We are excited to see continued development of in-house engineering expertise, which could be a lucrative revenue stream for the business. Acrow also revealed it was in negotiations to acquire Unispan, a highly complementary business – we expect multiple synergies to be realised should the transaction occur. Similar to the Natform acquisition at around 2X EBITDA, Unispan would likely be purchased at a low multiple of earnings through debt funding.

Aurelia Metals (AMI:ASX)

We entered Aurelia due to its attractive cost of production, diverse base metal production and healthy balance sheet. Aurelia follows our 1st Ground Rule *, with a large cash balance available to fund further exploration and development. Since our first entry, the company has faced a number of shocks:

  • Blowout AISC cost of production (doubling to $1,045/oz in 2019 from $509/oz in 2018)
  • Exit of Glencore from register and failed transaction to buy Glencore’s CSA mine
  • Departure of a respected CEO over unclear reasons
  • Increasing concerns over remaining quality and life of assets

Despite these shocks, the company has a very strong balance sheet with $104 million cash (just under 25% of its market capitalisation) – more than enough to fund further exploration around the Federation project and future capex for mine development and upgrades. Furthermore, the company’s base metal mix is attractive (our views are in line with Glencore’s regarding the future demand/supply conditions for zinc and copper), with the Pb/Zn circuit upgrade, as well as the mining shifting to a more base metal rich area, expected to boost these outputs.

We believe the market has overreacted to Aurelia’s shocks over the last year and that the company has now made a fresh start. Although Aurelia has indicated that its outlook is rather positive due to its base metal mix, the company continues to trade at a low forward EV/EBITDA of 2.9X.

Aurelia declared a maiden dividend (2c/share), delivering a 4% yield. Returning capital to shareholders will have a minor impact on Aurelia’s significant cash position. We are excited to see Aurelia continue to develop itself as a mid tier gold and base metal producer.

Quip of the Month

“All you need for a lifetime of successful investing is a few big winners, and the pluses from those will overwhelm the minuses from the stocks that don’t work out.” – Peter Lynch

Lynch achieved a return of 29.2%/annum for Fidelity Investments between 1977 and 1990.

One of the many struggles that fund managers encounter is the pressure to sell positions as they grow to reduce volatility and short-term downside risk. This has become more relevant recently, particularly in relation to our growing positions in Stanmore Coal and Afterpay. The tendency to trim positions is much more common when managers deploy outsiders’ capital (rather than only their own capital). Following the common practice of trimming positions makes it very difficult to follow Peter Lynch’s advice since big winners which are continually trimmed will never be allowed to grow to their full potential. Although Insufficient Capital only manages the capital of its team, we hope that taking on outside capital in future would never result in portfolio trimming for any reason other than investment quality.

Australian REITs

At Insufficient Capital, we do not profess to own a macroeconomic crystal ball. We focus entirely on the company level. This means that we often fail to discover companies which follow macroeconomic trends unless they meet our other investing criteria. However, we recently researched one of the most lucrative recent macroeconomic trends – the ‘yield play’, whereby the falling cash rate results in huge capital flow from bank deposits to other yielding assets, particularly property, resulting in yield compression.

The A-Reit Index (Australian Real Estate Investment Trusts are its constituents) appreciated around 14% (excluding dividends) during FY2019, outperforming the broader ASX200 by over 7%. Australian REITS have had their prices pushed up further and further by capital inflow hunting for yield, particularly from superannuation funds. While there will likely be further upside if rates fall to the lower bound of 0%, we caution that the Australian economy would be in a poor position (with diminishing consumer spending and investment) to warrant further RBA cuts to 0% (however, the RBA has indicated that further cuts are quite likely). Investing in property as a bond proxy is great when cash rates fall… until tenants can’t pay their rent.

In saying that, some of our subscribers have reached out to us asking which property trusts present the best value. We believe BWP Trust (BWP:ASX) and Charter Hall Long Wale Reit (CLW:ASX) best mitigate the key risks associated with a (potentially) deteriorating economy. BWP was spun out of Wesfarmers (the owner of Bunnings) in 1998 as a sale and lease-back. BWP owns 265 stores leased to Bunnings nationwide. The trust yields 4.75% and has returned 15.5%/annum in the last 10 years. The portfolio WALE is reasonable at 4.4 years and gearing is low at 17.3%. Wesfarmers owns 25% of the trust. BWP offers investors a yield which is superior to any deposit rate without exposure to economic vicissitudes due to the defensiveness of its major tenant. Charter Hall Long WALE appears to be the most attractive REIT available on the ASX when considering the ‘yield play’ because it most resembles a long duration bond. CLW’s WALE is 12.5 years, with 91% of tenants being government-associated or ASX-listed. The REIT yields 5.2%. During August, CLW announced that they would buy a portfolio of Telstra assets on a 4.4% yield. This transaction represents around 18% of its market capitalisation. We believe that CLW’s total yield could easily compress to around 4.4%, representing 15% capital upside.

If subscribers would like further details on our portfolio positions and strategies, we are always happy to discuss.

Kind Regards,
Insufficient Capital

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