Insufficient Capital

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

At the end of the September quarter, the fund was most heavily weighted to our ‘Net Cash Miners’ strategy:

The portfolio rose +9.25% over the quarter, strongly outperforming the ASX300 performance of +1.24% by +8.01%. We were very pleased to record outperformance over each month, most notably in August – a great start to FY2020. The top contributor during September was Afterpay (APT:ASX), while the largest detractor was Acrow Formwork (ACF:ASX).

Despite our tilt to value opportunities, most of our portfolio appreciation has recently been caused by growth investments (the majority fall under the ‘Structural Tailwinds’ strategy). We believe this has been caused by a momentum-loving, growth-hungry domestic equities environment, which seems ever more willing to disregard valuation for hockey-stick growth. In fact, Australian stocks with EPS growth greater than 20%/annum trade at double the valuation multiples of similar stocks listed overseas. We are confident that our value investments will have their time in the sun again (especially if economic conditions deteriorate).

At quarter end, the fund held 23% cash. The fund held an average cash position >25% during the quarter. This cash position greatly reduced our volatility and leaves further room for capital deployment. As we reiterated in our August newsletter, the fund generally refrains from holding large cash reserves (See Ground Rule #10) but we believe current market and economic conditions present a challenging environment to achieve our desired return target (See Ground Rule #12) without taking on excessive risk. 

During September, we initiated a small position in online sports betting company, Pointsbet (PBH:ASX). Pointsbet offers an innovative betting format known as “Spread Betting”, where winnings/losses are not fixed, instead depending on the accuracy of your bet (e.g. the bettor will win more if their team wins by a larger margin). Pointsbet recently entered the US market, starting with New Jersey, where recent sports betting legislation provides structural tailwinds to the industry. Google search traffic for Pointsbet in the US has more than doubled from August to September, while revenue is tracking at >240% YOY.

Similar to Afterpay and other Australian companies enjoying US tailwinds, Pointsbet is clearly gaining traction with American consumers and will be able to achieve strong lifetime value in future (let’s ignore the bottom line for now!). Pleasingly, our investment has already appreciated substantially and we look forward to further positive catalysts throughout FY2020 as Pointsbet continues its expansion into other US states (starting with Illinois, Indiana, Iowa and West Virginia). With 42 states having legalised, or intending to legalise sports betting, we anticipate a massive market prime for Pointsbet to exploit. We will discuss Pointsbet in depth in a future newsletter.

Rather than presenting a single stock idea, this newsletter will focus on a broader investment strategy – Buying Listed Investment Companies (LICs) at a Discount to Net Tangible Assets (NTA). Our management team regularly attends fund presentations as part of our internal research. Some of these funds are traded publicly (often as LICs) while others are private. It has become clear that some LICs are mispriced due to a few factors. After establishing the factors behind their discounts to NTA, this letter will set out the buy case for heavily discounted LICs using the example of a LIC we have previously owned and continue to find attractive.

Listed Investment Companies are closed-end public investment vehicles. Since they raise capital at IPO and investors buy/sell shares to each other, capital is permanent, removing the risk of redemptions. Further details on LICs can be found here. The largest LICs in Australia include Australian Foundation Investment Company (AFI:ASX), Argo Investments (ARG:ASX), Milton Corporation (MLT:ASX), Magellan Global Trust (MGG:ASX) and WAM Capital (WAM:ASX). 

Buy High Sell Low? Hmmm

LICs have the extra consideration of premia and discounts to NTA. For example, if a LIC raises $100M at $1/share (NTA/share) but is trading at <$1/share, the LIC is at a discount to its NTA (i.e. if its investments were liquidated and distributed to shareholders, shareholders would realise an immediate gain); when the LIC is trading at >$1/share, the LIC is at a premium to its NTA. 

Investor psychoanalysis reveals that most investors do the exact opposite of the famous adage, “Buy Low Sell High”. A very reliable cycle of emotions has dominated financial markets since the first pieces of stock paper were flying around in 16th Century England. This cycle of emotions has remained predictable ever since: Greed, Fear, Greed, Fear. There would be a lot less money to be made in markets if all investors adhered to Warren Buffet’s perhaps most famous adage: “Be fearful when others are greedy and greedy when others are fearful”. 

When investors in a LIC panic and fear poor future performance (of either the market, the LIC, or both), they exit their positions, potentially pushing the price of the LIC below NTA/share. We find this particularly astounding when LICs have large cash weightings in their portfolio. Imagine if the bank valued your savings account at 80c in the dollar! A fund manager (whose presentation we recently attended) said that no matter what, “People will always sell at a discount and buy at a premium (to NTA)”.

Current Investor Confidence

It is hard to read a financial paper without facing another article about Australia’s imminent recession. It is also becoming increasingly normal to wake up to >2% movements in US markets. Such pessimism and volatility contribute to capital outflow from LICs into lower risk investments (e.g. passive index funds, term deposits).

Investors also have increasingly distrusted expensive actively managed funds over low-cost passive index funds. With increased competition between passive funds and active managers, the days of a 2 and 20 fee structure (2% management fee and 20% performance fee) appear numbered. The underperformance (which is obviously not helped by high fees eroding gross performance) of active managers is more concerning. 

Since the GFC, a whopping 85.1% of actively managed funds have underperformed the S&P500 while 91.6% have underperformed over a 15 year period. There is no doubt that such widespread underperformance has contributed to discounts across the entire actively managed LIC space (even if all LICs cannot be painted with the same broad scathing brush). It has been difficult to outperform in the US without owning the famed FAANG stocks (Facebook, Apple, Amazon, Netflix and Google). They have now collectively grown to represent 35.3% of the Nasdaq100. Australia shares similarities with the WAAAX stocks (Wisetech, Afterpay, Appen, Altium and Xero), although these firms do not represent a large proportion of the index.

In 2008, Warren Buffett (our not so secret crush), made a $1M bet with fund-of-funds, Protege Partners, that an equally weighted group of 5 actively managed funds hand-picked by Protege would underperform the S&P500 (VFIAX – a 0.04% cost index fund tracking the S&P500) over a 10 year period due to the fees, costs and expenses associated with active management. 

By 2015, Protege co-founder, Tim Seides, acknowledged two years before the scheduled end date of the bet that “for all intents and purposes, the game is over. I lost.” By 2016, the index fund had returned 85.4% while the 5 funds had returned a comparatively dismal 22%. The result – Buffet’s chosen charity, Girls Incorporated of Omaha, had an extra $1M… and a crushing defeat for actively managed funds:

Underperformance >> devaluation of management expertise >> magnified discount to NTA

Liquidity & Risk Discounts

Some LICs (particularly those with <$100M of AUM) have little to no daily volume for extended periods. Such LICs should be discounted by at least the average buy/sell spread. If you have to take a 5% haircut just to exit a position, such illiquidity should be priced in

There are also quite a few of what we like to call, ‘YOLO (You Only Live Once) Opportunities’, out there. These funds take on excessive risk, sometimes even using internal leverage, or speculating on opportunistic mining explorers. Their discounts are justified. As an aside, some of these ‘YOLO Opportunities’ LICs have quite amusing names (perhaps inspiring our very own ‘Insufficient Capital’). Our personal favourite is “Fat Prophets Global Contrarian Fund” (ASX:FPC – Yes, it is real) – its discount, a whopping -24%. Buying high beta is all fun and games when the market is rising… until the market isn’t.

The Buy Case

If a LIC aligns with an investor’s personal strategy, sells at a discount, has reasonable fees and a reliable track record of creating investor value, it could definitely serve a place in a portfolio. If purchased, investors need to stay on top of the LIC’s major portfolio positions and its discount to NTA over time.

One of the greatest risks after purchasing a LIC is that an investor will become complacent and fail to update their research as the portfolio changes over time. Unlike an individual business, the thesis for a LIC must be updated regularly (usually on a monthly basis). We would never hold a LIC that trades at a premium to NTA.

Cadence Capital 

One of the LICs we have previously owned is Cadence Capital (ASX:CDM). Over the last 14 years (since inception), CDM has returned +11.7%/annum after fees and including dividend franking credits (outperforming the All Ords by +3.1%/annum). This is a cumulative return of +355.6% vs +211.5% (as at June 30).  We have kept on top of their portfolio ever since our investment and share the value-driven strategy of the portfolio manager, Karl Siegling. We even share some past and present positions: Stanmore Coal, Bingo Industries, Shine Corporate, Select Harvests, Westpac Banking Corporation, Telstra Corporation

Cadence currently trades at a very high 22.7% discount to NTA post tax obligations. This is particularly astounding considering the LIC’s 32.6% cash weighting (as at 30 September)… So CDM’s riskless cash at bank is being discounted to less than 80c in the dollar. Just to put that in perspective – if we buy CDM, which has around 2% of its assets in Stanmore Coal (our own largest holding), we are effectively paying 87.3c (22.7% less than the current market price of $1.13/share) for the Stanmore stock. This would be a PE ratio of 2.4X and a dividend yield of 14.9%. Or we could buy it in the market at 4X and 11.5% (both are cheap nonetheless).

The market is clearly expecting Cadence’s significant cash weighting to be allocated terribly. Looking at Cadence’s FY2019 performance, it is easy to be forgiven for this belief. Cadence’s net performance was -20.5% during FY2019, while the All Ordinaries appreciated +12.5%. The largest detractors included: ARQ Group, Emeco Holdings, Navigator Global Investments, Shine Corporate and Teva Pharmaceutical. Most notably, ARQ (formerly known as Melbourne IT) collapsed around 90% from its peak in December 2017 to now representing only 2.4% of the fund. Siegling has gone onto the board of ARQ in an attempt to steer the ship. We strongly believe that he is doing everything in his power to recover value for all ARQ shareholders.

At the annual roadshow, it was clear that Cadence’s board is desperately trying to close the discount to NTA. The LIC has undertaken a buyback of approximately 10% of its stock, immediately accreting value to shareholders. Additionally, the portfolio manager is buying stock almost daily and reinvesting dividends. 

Until October 2018, Cadence had traded at a premium during the vast majority of the past 5 years. The LIC even reached a 20% premium in 2016. In the depths of the GFC, it reached a 40% discount. We believe that only another recessionary period could warrant such an extreme valuation dislocation.

We are particularly attracted to Cadence’s positions in Macquarie Group (4.9% of the LIC’s assets), Resimac Group (4.1%), Rio Tinto (1.9%), Stanmore Coal (1.8%) and BHP (1.6%). That’s not to say our team is attracted to all of Cadence’s positions, with a handful raising concerns. Nonetheless, we continue to evaluate Cadence’s portfolio and would not be surprised if it became a future position of ours. Ideally, we would first like to see the deployment of some of its large cash position.

Quip of the Month

“The time to buy is when there’s blood in the streets” – Baron Rothschild

Rothschild made a fortune in the panic that followed England’s victory at the Battle of Waterloo against Napoleon. Using a network of agents across Europe, Rothschild learnt of Wellington’s victory on June 18 1815, before other investors. He heavily sold British stocks and pound sterling, with the other investors following suit, effectively creating an environment of spilt blood. Later that day, Rothschild bought all of it back before the news emerged publicly and the market surged. This sequence of events is also said to be the source of the maxim, “Buy on the sound of cannons, sell on the sound of trumpets.”

Buying a discounted LIC is a contrarian investment, epitomising the notion of investing after ‘blood’ (losses) has been shed. Another great example of contrarian investing would be the purchase of Bingo Industries (ASX:BIN) on 18 February 2019 (the stock’s all time low) when concerns regarding stagnating growth for the waste management giant were echoing throughout Sydney’s Martin Place. Despite this, some contrarian investors recognised a sound underlying business facing short term headwinds. They realised a >100% return in 4 months.

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

Kind Regards,
Insufficient Capital

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

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