Insufficient Capital June Update

Posted On June 30, 2020

Welcome to our first end of financial year newsletter. 

We are very proud to have completed our first full year of operations, achieving significant outperformance (+24.96% vs ASX300 performance of -10.81%).

The structure of this newsletter will be: 

1. Thank You
2. Performance Figures
3. Quarterly Portfolio Changes (including our favourite new opportunity)
4. Performance of our Corona Watchlist vs the ASX300
5. Podcast with Frazis Capital Partners
6. Quip of the Financial Year

Thank You

When we launched our newsletter, we never anticipated the reception it has received. Primarily through word of mouth from you, our readers, we now connect with north of a thousand market participants – we’re always striving to improve our content, and hope that we can continue to share ideas with many more investors in the future.

Performance Figures

The portfolio rose +90.1% over the June quarter, outperforming the ASX300 performance of +16.5% by +73.6%. The top contributor during the quarter was Afterpay (APT:ASX). There were no detractors during the quarter. The weighted average market capitalisation of our portfolio is $2.9 billion. The portfolio currently has 8.6% cash and is most heavily weighted to our ‘Structural Tailwinds’ strategy. 

Quarterly Portfolio Changes

There were three major portfolio changes during the quarter. These were: 

1. Full exit from Stanmore Coal Ltd (SMR:ASX)
2. Partial sale of Afterpay Ltd (APT:ASX)
3. Purchase of Cadence Capital Ltd (CDM:ASX)

Stanmore Coal Ltd (SMR:ASX)

On 2 April, Golden Investments Pte Ltd (Golden) announced an on-market offer of $1.00/share for SMR – their second bid for the company (having had an off-market $0.95/share offer rejected 13 months earlier). At the time of the announcement, Golden already owned 31.5% of SMR. Golden returned to SMR during the depths of coronavirus despair. We initially viewed the $1.00 bid as highly opportunistic when considering that Stanmore received a non-binding, indicative proposal from Winfield (a private group with experience in the Bowen Basin) in August 2019 for between $1.50 and $1.70/share. Whilst this unfortunately fell through, as discussed in our End of Year Update, the proposal indicated the potential value of the firm and the stock hit $1.50. Unfortunately, we did not take the exit opportunity.

It was clear that $1 (market capitalisation of A$270.4 million) was the highest price that would be achieved (although, there was also a 1 for 33 bonus issue). Muscled out during a time of opportunity, we exited the position. We first entered the position in November 2018. Overall, we made +5.8% from the investment (beating our ASX300 performance benchmark over the same period by +8.7%). Whilst it is always pleasing to beat the benchmark, there was no ‘warm fuzzy feeling’ in letting this company go. Golden has benefited from a highly opportunistic bid. 

Taking a glass half full view… whilst we lost out on one opportunistic coronavirus acquisition, we have benefited from another. The coronavirus provided an opportunity for EML Payments Ltd (EML:ASX) to renegotiate their acquisition of Prepaid Financial Services (Ireland) Ltd (PFS). PFS was fundamental to EML’s strategy of transitioning from a company deriving the majority of its revenue from gift cards, to one deriving the majority of its revenues from less cyclical general-purpose reloadable programs. The acquisition will allow EML to build a larger competitive moat around their business and better compete with $43 billion payments giant, Square (SQ:NYSE). On 31 March, EML completed the acquisition, paying A$252.3 million (reduced from the previously negotiated A$433.6 million). The renegotiated acquisition has ensured that EML remains in a position of fiscal strength throughout the current period of economic uncertainty, with in excess of A$125 million in net cash. The combined group has a total cash overhead expense rate averaging between A$5-6 million per month so there will be no need to raise capital at today’s heavily depressed valuation. We expect that EML will build its cash pile until it can justify another earnings-accretive acquisition. 

Afterpay Ltd (APT:ASX)

In May, we exited over half of our Afterpay position. We have often said that if nothing fundamentally changes within a business, there are very few reasons to trim its portfolio weight. There were a few key reasons why we trimmed this one:

1. As we said in our last newsletter, three businesses will always make up at least 40% of the Insufficient Capital portfolio. Prior to the partial sale, Afterpay was our largest portfolio position and is still included in our top three positions after the sale. 
2. The coronavirus has provided many new investment opportunities. Afterpay has recently surged to an all time high valuation, gaining well over 500% (yes, 500% with two zeroes) from its COVID-19 low. Was it oversold at a valuation of A$2.38 billion? Evidently. However, many businesses have recovered less strongly. Some of these are justifiably low. Others are not and we believe that capital should be allocated to these opportunities (many of these opportunities can be found in our various watchlists, available on the website). If Afterpay successfully executes in international markets and continues to execute domestically, we value the business at A$31 billion at the end of FY2024 (approximately 2X above today’s valuation). If we were not in a severe bear market, with many opportunities available and potential second-order impacts on unemployment, we would not have cut our position. We believe that over four years, opportunities to more than double our money are available elsewhere, with a lower risk profile.
3. As we alluded to above, potential second-order impacts on unemployment (structural unemployment in particular) are yet to be seen. Afterpay provides short-term credit to its customers… even though it claims otherwise to some government regulators! If many of Afterpay’s customers remain unemployed for longer, they will spend less on discretionary goods and services. It is truly impossible to grasp the economic outcomes of today’s never-before-seen unemployment benefits, and ultimately, the higher future taxes required to fund them. The only (rather obvious) fact we know is that consumers with less after-tax income will spend less on discretionary items. With increased unemployment comes the risk of a higher default rate (Afterpay’s current default rate is 1.0%). The short duration loan book allows Afterpay to react swiftly to economic threats, quickly lowering spending limits, increasing credit checks and adjusting other variables. The firm is yet to face a full credit cycle. This uncertainty makes a very large position size uncomfortable. We like to sleep well at night.
4. We are hearing the bullish case for Afterpay in media and investment channels more than ever before. Many people are using this bear market as an opportunity to invest for the first time. The bear market opportunity is compounded by global social distancing measures which promote staying at home to research the market and/or day-trade (most studies show that around 95% of day-traders lose capital… but that’s another story). The chart below reveals that US trading volumes have quadrupled since the start of the equities tumble. Many first-time investors buy well-known brands, such as Google, Apple, Facebook, Coca-Cola, Starbucks, Disney… and Afterpay. We believe that a vast amount of valuation-agnostic, short-term capital, is flowing into well-known brands such as Afterpay. When considering this extra variable, we are reminded of our 7th Ground Rule: “Be fearful about any investment being hyped in the media and market”

Despite the above points, we remain very positive on Afterpay’s business and management’s ability to execute. According to its 14 April announcement, March 2020 was Afterpay’s third largest underlying sales month on record, behind the Christmas months of November and December 2020. Q3 FY20 underlying sales increased 97% on Q3FY19. We would not be surprised if June 2020 is now Afterpay’s third largest underlying sales month. The business has only scratched the surface and we are very happy to retain a top three portfolio position. 

Cadence Capital Ltd (CDM:ASX)

We first discussed CDM and Listed Investment Companies (LICs) more broadly in our September 2019 newsletter. Since then, we have continued to monitor CDM, recently adding it to our Corona Watchlist and finally, our portfolio. This demonstrates the significant amount of work we put into analysing an idea before we add it to our portfolio. Whilst we generally prefer to choose the businesses we own, sometimes there are significant price dislocations which present opportunities in listed actively managed funds such as CDM. 

In September 2019, we wrote: “we continue to evaluate Cadence’s portfolio and would not be surprised if it became a future position of ours”… well well well. Fortunately, we did not purchase Cadence in September. At the end of September, Cadence’s post tax net tangible assets (NTA) was $1.048, whilst trading at $0.810 (a discount of 22.7%). As at 30 May 2020, post tax NTA was $0.979, whilst trading at $0.595 (a much steeper discount of 39.2%). The  end of June NTA and portfolio update will be released around 13 July. We believe that CDM’s portfolio has never looked better and is full of very high quality businesses that we love to own at the current discount. Our favourite Top 20 Cadence holdings (see entire list below) are: Resimac Group (RMC:ASX), EML Payments (EML:ASX), Macquarie Group (MQG:ASX), Facebook (FB:NASDAQ) and Credit Corp Group (CCP:ASX).

Cadence has moved from trading at a premium to NTA to trading at a discount to NTA over the last seven years. Does it surprise us? Not at all. Even Cadence’s founder/portfolio manager, Karl Siegling, said (at an annual general meeting) words to the effect of: “People will generally always sell at a discount and buy at a premium”. This was seen recently, when raw panic drove CDM down to $0.49 on 31 March 2020 despite net assets of $0.881/share (a huge discount of 44.4% made even more incredible when considering that the fund held $0.497/share of cash at the time, effectively valuing its equity holdings below 0). 

We’ve looked back through Cadence’s past newsletters to see how its premium/discount has changed since January 2013. The average discount over the entire period is 3.67%, while the average discount over the past two years is -21.58%. CDM’s current portfolio is full of well-known brands (aligned with Ground Rule No. 5) and is highly liquid. We believe that the extent of the current discount offers a tremendous opportunity when looking beneath the hood at Cadence’s individual portfolio constituents. 

Three catalysts for Cadence’s discount to NTA closing include: 

1. Strong portfolio performance – Investors generally value a high-performing management team. For example, WAM Capital (WAM:ASX) trades at a 13% premium to NTA and has returned 15.7%/annum since August 1999, outperforming its benchmark by a phenomenal 8.0%/annum.
2. Regular dividends – In a world where 0% returns are the new normal, Cadence and other LICs are a compelling investment proposition, particularly for retirees.
3. Share buy-back schemes – These indicate to the market that the LIC’s board believes the fund is materially undervalued. They also effectively increase the LIC’s NTA whilst it is trading at a discount (see below for details regarding Cadence’s share buy-back).

We formed a view that Cadence satisfies all of our LIC investing Ground Rules (not to be confused with our general investing Ground Rules): 

1. The LIC must have a significant discount to NTA 
2. Investment strategy must align with our general investing Ground Rules
3. Reasonable fee structure
4. Strong track record (particularly during downturns)
5. Management alignment and significant personal investment
6. Share buy-back schemes are preferable  

Cadence’s founder has been buying shares nearly every day (this is not an exaggeration) and owns just under 8% of shares outstanding. Siegling backs himself. Recently, two other directors joined Siegling and purchased units. The company proceeded to announce an extension of the existing market share buy-back (on 20 May) of up to 10% of ordinary shares outstanding. This should increase the fund’s NTA per share whilst it trades at a discount as the portfolio is effectively rebought at a discount.. We believe that Cadence’s active capital management is prudent and value-accretive in this current environment. 

Cadence has a long history of dividend payments (see below) and has historically targeted a fully franked dividend yield of 6-8%/annum. Whilst trading at a discount, Cadence is not offering a discounted dividend reinvestment plan. This would have the opposite effect of a share buy-back, decreasing the fund’s NTA by issuing shares at a discount. Returning capital to investors in the form of dividends (with franking credits) is highly tax-effective for Australian investors. As yields continue to fall globally, CDM’s target yield is difficult to maintain (although the current discount is definitely helping!) 

Cadence is currently our favourite COVID-19 opportunity. The position has appreciated significantly since our purchase (outperforming the ASX300 by +3.5% over the quarter) but has trailed the rest of our portfolio. We believe that there is low downside risk for the position with so much fear already priced into the discount. Our simple calculation for the expected return of our investment in CDM is:

1. Performance of underlying portfolio (NTA growth), which has been negatively impacted by COVID-19
2. Reduction in discount to NTA as panic clears and greed returns (the panic-greed cycle in markets is almost as certain as death and taxes)

Performance of our Corona Watchlist vs the ASX300

Our Corona Watchlist and its performance as an equally weighted index are available here. Cadence is the only watchlist member which has been added to our actual portfolio. Whilst the other 10 constituents have not yet made the portfolio, they remain our favourite opportunities (and areas of research) during this downturn. As an index, the watchlist has outperformed the ASX300 by +11.7% since 1 April. The weighted average market capitalisation of the watchlist is $23.1 billion.

Podcast with Frazis Capital Partners

At the end of June, we recorded another podcast with Frazis Capital Partners on “Plug Power, Solaredge, and a market update”. The podcast (and all prior podcasts recorded with Frazis Capital) can be found here.

Quip of the Financial Year

“Wall Street never changes, the pockets change, the suckers change, the stocks change, but Wall Street never changes, because human nature never changes.” – Jesse Livermore (Livermore was the basis for the main character of ‘Reminiscences of a Stock Operator’)

COVID-19 was the defining moment of FY2020 for both society and financial markets. The virus may go down in history as the defining moment of the decade, bringing forward long-term structural shifts such as working from home. We believe that our world has materially changed, but we won’t know the full extent of the changes for many years. Looking into the future (and as a reflection of our commitment to being an active investment company) our FY2030 newsletter will likely reflect these structural changes… although we aren’t buying Zoom (NASDAQ:ZM) and Peloton (NASDAQ:PTON) just yet.

Livermore invested through the turn of the 20th Century, WWI and The Great Depression. One thing that has not been changed by COVID-19 is human nature. In the depths of despair, investors sell their shares at the worst possible time. Money market fund assets have ballooned by around 30% since the coronavirus struck down equity markets in March. The perpetual cycles of ‘Buy high/sell low’, ‘Greed/Fear’, ‘Exuberance/Panic’ were alive and well when Livermore made his first $5 bet on Chicago, Burlington and Quincy Railroad in 1892. 

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