Insufficient Capital March Update

This, Too, Shall Pass…

Performance Figures

The portfolio fell -41.4% over the March quarter, underperforming the ASX300 performance of -24.3% by -17.1%. We are very disappointed but always endeavour to allocate capital (according to our Ground Rules) to avoid underperformance during the 81% of years that markets rise. The quarter was dominated by three very distinct months: January – a continuation of the 2019 equities bull run, February – coronavirus (COVID-19) strikes equity markets, March – global monetary and fiscal stimulus disastrously fails to address fears of a pandemic-induced recession. Track the virus on this live dashboard

History tells us not to panic. 

The graph below reveals that one month after the declaration of an epidemic, the average performance of the MSCI World Index is +0.44%, while 6 month average performance is +8.5%. COVID-19 has been far worse because of the increased role of China in the global economy (China now represents around 20% of worldwide GDP) and the proliferation of global trade. Should we have acted? Everyone’s hindsight is always 20/20 and whilst it would have been nice to buy businesses at lower valuations, selling them because of pandemics is not our strategy. We buy and hold businesses. Eventually, the virus will pass and most people will probably wish they’d bought the dip. We’ll find out in the coming months.

The last time equities significantly corrected occurred from October-December 2018. The S&P500 fell 17.5% from top to bottom while the ASX300 fell 12.1%. At the start of the 2018 correction, our three largest holdings were: Cooper Energy (COE:ASX), Starpharma (SPL:ASX) and Afterpay (APT:ASX). Our monthly performance over the three months was: -9.4%, -0.5%, -6.6%. Our monthly performance during the 4 months following the correction was: +4.1%, +5.3%, +7.7%, +8.6%. Over the 7-month period from the ASX300’s peak to peak, we outperformed the index by +10.1%. We suffered a larger drawdown but recovered much more strongly. We believe that our portfolio consists of high quality businesses without exposure to areas facing the greatest earnings risks: education, hospitality and travel. 

The top contributor during the quarter was Stanmore Coal (SMR:ASX) – note: SMR is subject to a takeover bid announced on the 2nd of April – while the largest detractor was EML Payments (EML:ASX). The weighted average market capitalisation of our portfolio is $1.6 billion. The fund is currently fully invested and most heavily weighted to our ‘Structural Tailwinds’ strategy. 

A More Consolidated Portfolio

Over the quarter, we consolidated the portfolio more heavily towards our best ideas. It is common for portfolio managers to run a side portfolio of a handful of their best ideas. Whilst this may seem like a lack of manager alignment, very few investors will pay fees to managers who buy <10 stocks (particularly if they are household names like Facebook, Microsoft and Visa). A consolidated portfolio is inherently more volatile since it is driven by the performance of its few constituents. However, as discussed in our first newsletter, the volatility (standard deviation) of a portfolio approaches its limit very quickly as new investments are added. The average portfolio of 10 varied investments is only around 20% more volatile than a portfolio of 100 investments… and as one’s investment timeframe extends, volatility becomes less important. Should an investor with a 20 year investment horizon really care where their portfolio lies on the graph below? After a 10 stock portfolio, probably not.

We confess to running a small side portfolio of our best three (often less) ideas. This portfolio has doubled since inception (1 July 2017) with few portfolio changes. Its performance occurred despite three drawdowns of over 15% during the period (including the current sell-off). Unfortunately, we decided to align the two portfolios just prior to the most recent (and largest) drawdown. 

In future, three businesses will make up at least 40% of the Insufficient Capital portfolio. Whilst there will be increased volatility, its performance will now closely mirror the side portfolio through good times… and highly disruptive viruses. The three core businesses will always satisfy our ‘Ground Rules’ and vigorous fundamental research. 

Warren Buffett said that “Diversification is protection against ignorance. It makes little sense if you know what you are doing.” In a couple of year’s time, we (and you) will see if we are ignorant or add alpha. There is nowhere to hide. The returns are there for all to see. In line with a handful of long-term investors, including Christopher Davis (See the ‘Quip of the Month’ at the end of this letter), we focus on absolute returns rather than worrying too much about portfolio volatility. 

We recently enjoyed recording another podcast with Frazis Capital Partners. Check out the discussion on the coronavirus and two Australian burns innovators (Polynovo and Avita) on desktop here and on iTunes here

SmartPay Holdings 

During the quarter, we initiated SmartPay (SMP:ASX) as one of our three core businesses. Smartpay is Australia and New Zealand’s largest full-service EFTPOS provider / merchant payments business. They have 35,000 EFTPOS terminals outstanding across over 25,000 merchants. It is the largest direct connector of terminals to Paymark, one of New Zealand’s two central electronic payment processing platforms (known as ‘switch providers’) and has a 20% market share of terminals in the country. The New Zealand business is mature ($18M of annual recurring revenue) whilst the Australian business is just getting started.

The Australian market opportunity is around 1 million terminals. Although SmartPay only has 0.4% of the Aussie terminal market (4000 terminals), it grew revenue by 32% last quarter. Australia’s big four banks are SmartPay’s key competition and continue to dominate national terminal count. They overcharge merchants, have terrible customer service, bear the cost of managing their own switches, lack focus on the business segment and have a poor reputation following the Australian banking royal commission. Tyro (TYR:ASX) has 45,000 terminals, while US payments giant, Square (SQ:NYSE), recently broke into the Australian market by targeting micro-merchants. 

Australian terminal and revenue growth:

In Australia, Smartpay initially offered merchants single-charge terminals with $35/month terminal rental (comparable to the New Zealand rental driven business model), running that product for 6 months. The business recently developed a zero charge terminal for the Australian market, with no monthly costs to the merchant and unlimited fee-free transactions – no scheme fees, interchange fees, acquirer fees, terminal rental fees. A 1.5% surcharge is added to each transaction and paid by the customer. The merchant does not pay anything but reserves the ability to transfer the customer’s cost to themself (e.g. for high spending and loyal customers). Smartpay offers free add on features including contactless payment, Alipay, WeChat cash out, tipping and MOTO. The key point of difference is cost. A typical Australian small business doing $25,000/month of transactions saves around $3,000/year using Smartpay over its competitors.

Smartpay avoids industries with prepayment risk such as travel agencies. They are very strong in small-medium enterprises in the hospitality industry. Large businesses demand lower prices from their payments provider. The banks focus on them with the hope of offering other financial products (e.g. debt facilities). Tyro now focuses on banking products rather than pure payments, using their banking licence. Smartpay is the only major operator with a complete focus on the payments business. No significant competitors (other than Square) have entered the market because there is a high moat. It takes at least 6 months of work to connect a new switch so switch providers tend to avoid talking to new entrants if they’re small operators.

Smartpay received a $70M offer from Verifone for its New Zealand business in November 2019. The New Zealand Commerce Commission’s decision on whether to approve the acquisition is due on 15 May. The $70M offer was double the market capitalisation of the entire company (including the Australian business) at the time. 

There could be a bidding war because all NZ transactions go through only two switch providers (Paymark – owned by Ingenico, Eftpos NZ – owned by Verifone). These market dynamics make Smartpay a very important asset for Ingenico. If the offer succeeds, Paymark would likely lose the significant 20% terminal share to Eftpos NZ since Verifone would change Smartpay’s switch provider from Paymark to Eftpos NZ post-acquisition. Ingenico paid $190M for Paymark in 2018 and risks losing a key revenue stream if Smartpay redirects transactions to the Verifone-owned switch provider.

Taking out the NZ business (presuming the $70M buyout goes through), the Australian business is currently valued at a measly $7.5M. Pre-COVID-19, it was on track to record $14M of annual recurring revenue this year. The current valuation appears very low when considering the high growth of the Australian business and its superior margin (over the NZ business). Smartpay intends to spend the sales proceeds on debt repayment, Australian growth and a significant dividend (or equivalent share buyback). Smartpay is currently valued at 5.2X consensus forward EV/EBITDA. However, this valuation will be even lower after the sale of the New Zealand business.

It is important to note that disruptive businesses like Tyro and Smartpay have flourished off the high fees and immobility of Australia’s big four banks. Smartpay could suffer continual margin erosion due to competition and ultimately have a low valuation multiple ascribed to it. 

Quip of the Month

“In a sense, we start with this mindset of building wealth over the long term. And in this way, we always say that we are absolute investors. We view it as if we are buying the entire business. We look for the returns to be driven by the cash the business produces over a long period of time.” – Christopher Davis (Davis Funds)

During times like these, it is easy to forget that long term returns are always sourced from future cash flows. Whilst the coronavirus will impact short-midterm cash flows, all portfolio businesses will make it out the other side (perhaps a little battered). 50% of our portfolio is debt-free with significant net cash. We are almost certain that none of our portfolio holdings will be forced to raise capital at their current low valuations (unlike shareholders in Webjet [WEB:ASX] who will bear the brunt of a recapitalisation 90% below its peak). Cash is king.

The eternal growth vs value debate is irrelevant to our portfolio construction. Faster growing companies (such as EML Payments) deserve higher valuation multiples and will return cash to investors as dividends at a later date. Slow growing companies (or those with mature assets) are already returning cash to investors (e.g. Stanmore Coal). There is always a fair price to pay for any company if its future cashflows can be forecasted.

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 (recently, commentary has focused on the impact of the coronavirus on equity markets). 

We also recently published a coronavirus watchlist, where we highlight a handful of attractive businesses that we are looking at during this sell-off. Don’t get too excited – it is just a watchlist.

Remember to stay indoors, wash your hands and keep the most vulnerable of our community protected. #investfromhome

Kind Regards,

Insufficient Capital 

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