Portfolio Update & Other Miscellaneous Thoughts

Note: performance figures are quoted net of any fees and transaction costs but before taxes. Performance figures are annualised.

Usually the stocks mentioned are relatively brief, but I wanted to change it up and talk about a particular company in some depth. So hopefully you can make it to the end and that you enjoy it!



Since inception (22/2/14), my personal fund has produced a positive return of +23.63% p.a. This compares favourably to most (if not all) of the major Australian equity indexes. The performance can be dissected into two distinct periods. The first 18-24 months were characterised by various failures but there was one standout which I invested aggressively in and it paid off. This stock was Sirtex (ASX:SRX), which I initially bought for $20 per share and later sold a large portion of it for $40 per share. This gain significantly offset the losses in the other positions while the other non-negative contributors led to a net positive performance. Sirtex has now been liquidated from the fund. More recently though, the story has been a little different. The positive performance has not come from one strong outlier, but rather, relatively consistent contributions from various positions combined with fewer failures. This combination has led to quite pleasing performance. Failures are hard to earn back as it takes a stock to double after halving just to break even. For example, if you bought a stock at $100 and it halves to $50, it will have to double just to return to your break even price. While stating the obvious, I believe avoiding losses is so crucial to producing abnormally high returns. Hopefully the performance in the latter period is because I have improved.

I want to discuss one stock in some depth and then just mention some other contributors which haven't been mentioned before. My highest conviction stock this year has been Redhill Education (ASX:RDH) which I've invested aggressively in (20% of the fund size). I've been quite vocal about this one but it has been very controversial. Almost everyone I have spoken to thinks it's an absolute rubbish investment. The people that I have spoken to (being over 15 good money managers and investors) have all said they wouldn't go near it. To be fair, no one has really looked at this stock in detail though but I beg to differ with them. I truly believe many have simply just not looked at this one in enough depth, because they think the industry is in poor shape or other impediments get in the way, such as the stock having virtually no free float, the company being too small or for whatever other reason. I truly believe the industry dynamics as they apply to RDH have been misunderstood but the market has begun to correct this. This is coupled with the stock being very illiquid and lacks analyst coverage - typically a very good combination if you think you're on the right side of the trade.

RDH are a for profit education company, providing English language courses and management courses under the Greenwich English & Management business, vocational and higher education technology courses under the Academy of Technology business, a computer coding diploma via the Coder Academy businesses, interior design and styling courses through its International School of Colour and Design and student recruitment services via its Gostudy business. I believe a key to the misunderstanding here is that some of RDH's revenues are in the Vocational Education and Training (VET) space which has come under immense pressure recently and has had the budget for such education companies reduced significantly. However, RDH has <5% of it's revenues exposed to VET fees (both historically and now) and so it's reliance on this funding is immaterial at best. RDH generates most of it's revenue from international students who are full fee paying, while domestic students pay some upfront and then rely on either VET FEE-HELP (now VET Student Loans) or government subsidies for degrees and other longer courses. VET funding peaked at over $1bn when there were hundreds of private providers relying on this funding a few years ago, but has now been reduced significantly to under $100m with less than 30 credited companies, with RDH being one of them. This is a direct result of some unscrupulous education providers who took advantage of the government budget and incentivised anyone off the street to sign up to their courses. They offered students laptops and promised good job outcomes upon completion of their courses. Many of these providers had failure rates in excess of 50% and many went out of business before the students even completed their course. It's safe to say, many of these poor students didn't get a good job upon completion. There were hundreds of these providers and now many have been wiped out. RDH didn't engage in any of this. While other competitors were taking in students from anywhere, RDH stuck to their strict process which is now paying off.  The "strict" criteria that an education provider now needs to meet to be a credited provider has meant that there are now only about 30 serious players left. However, this has now put immense pressure on TAFEs who have had an influx of students. Therefore, I think funding will come back sooner rather than later, the extent to which is unknown. RDH will stand to benefit from this being one of the credited providers and the new "strict" criteria will make it more difficult for new entrants to enter into the market and obtain access to government funding.

I'm having fun here so lets continue! Congratulations if you've read this far and haven't completely zoned out yet. No hard feelings if you have though, I understand :).  Let's look at one of RDH's fastest growing businesses - the Coder Factory. The Coder Factory provides Silicon Valley bootcamp style coding courses. The diplomas are usually 6 months in duration and are full time (9-5, Monday-Friday). Many of the domestic students doing this course are younger workers who are looking for a career change. Or in some cases, accounting students/graduates who found out that debits and credits weren't for them. Starting salaries for web app developers (a job for which a graduate of the Coder Factory can apply for) can be in the order of $65,000 and will increase from there. One counter-argument to this business in general is that people can teach themselves to code and so there is an increasingly reduced need for such a provider. However, by doing this, you won't get the piece of paper at the end and a key selling point of the Coder Factory is the fact that they put students into internships and many of these students obtain full time jobs at the same organisation after completion of their course. 90% of the most recent cohort of students in Sydney (about 30 in total) found full time work relatively quickly after completion of their course. This is up from about 85% from the cohort before - so there is no sign of saturation and there shouldn't be given that their software developers and the industry has a shortage of talent. RDH has recently launched this service in Melbourne and Brisbane with great success. In fact, they had so much demand for it in Melbourne, they had to sublease space from a competitor. This has now been resolved with a doubling in capacity. In the US, there has been a few similar businesses that have gone under, but this is because of funding issues as a result of not understanding the economics of the business from the beginning. There are only 3 main players in Australia while there are many, many more in the US even after adjusting for population differences. This geographic expansion, while has come at a cost to previous reporting periods profits, has now started to drive strong top line growth and profitability and should continue to do so with expanding margins as the operating leverage begins to have an impact from increased utilisation of space in the short to medium term.

I can't end the discussion without talking about their largest business (the English language business). Given that their management business is linked to the English business we'll view them as one business and call it Greenwich English and Management College (GE&M). GE&M represents about half of the groups revenues and was the fastest growing segment in FY17 but this was largely driven by the expansion into Melbourne and the new Management College which is a great initiative (we'll explain why in a second). The organic growth of the original business is still strong and there is scope for it to continue. While Sydney is nearing capacity during "normal" hours, they can increase utilisation by offering night and/or weekend courses. Alternatively, they can just get more space. The English language business at any one time has about 1,600 students in it and is one of the largest private providers of English Language Intensive Course for Overseas Students (ELICOS) language courses in Australia. English language courses for international students in Australia can typically be grouped into 3 distinct groups. Universities (top-tier), mid-tier and low-tier providers. On average, universities usually charge about $365 per week per student, while a mid-tier provider charges about $230 per week per student. But the best mid-tier providers such as Greenwich typically provide a quality offering that is at least on par with universities despite a large pricing differential. The low-tier providers charge about $120 per week per student but generally provide a low quality service. Undoubtedly, universities get a lion share of the international market, but the subset is still large and growing. More recently, there has been a change in the English requirements for students hoping to study at a vocational education provider. Without going into the details of this, the net effect of this particular change and other similar ones on Greenwich is unknown as there are both positives and negatives and some of the regulations are still subject to potential changes before they come into effect. The rationale behind the implementation of the Management business is coherent. The average stay of an international student at the Greenwich English business is about 3 months. However, the average student stays in Australia for around 2 years. RDH recognised that many of the students were then leaving to other organisations offering services that RDH weren't offering at the time. Many of them progress to study managerial type courses and/or higher education courses upon completion of their English studies. RDH are looking to capitalise on this 21 month differential by trying to get students to stay with RDH longer by providing the services that the students typically progress toward. More time is needed to assess this initiative but the initial outcomes look very promising. If they can pull this off, the business will grow substantially from here. The industry is also benefiting from a tailwind with Trump in the US turning international students away from the US. While the EU & Canada are strong competitors for international students, Australia is still a top destination for international students.

By this point, you've probably asked yourself "but what about the financials?" RDH has been reinvesting in the business significantly, and the benefits have now started to come through. The FY17 result and especially 1H17 was impacted by reinvestment costs. FY17 EBITDA came in at $3.9m but 2H17 saw the benefits flow through with EBITDA being $3.3m or $6.6m annualised. I expect EBITDA of $7.5m in FY18 and $10m in FY19. How will they get there? FY18 and FY19 will see the benefits of the recent geographic expansion coupled with expanded course offerings (for example, RDH have little to no exposure to the hospitality or healthcare spaces) and stronger margins as utilisation rises. Moreover, they have about 50% of revenue growth embedded in their balance sheet already, for which they have not booked any revenue for yet. This is an important point which isn't easy to deduce from the disclosures of the company.As RDH offer degrees and other pathways for international students to study longer, these students are required as part of their visa application to pay one third of the total cost for these studies upfront. So, when a student locks in a 3 years course with RDH, they pay one-third upfront and that down payment gets recorded on the balance sheet. They receive the cash but it's not booked as revenue so the income statement isn't artificially inflated. The one third down payment gets booked as cash flows and the revenue will get recorded over time. So there is some good revenue visibility. The impact of this is significant. The incremental EBITDA RDH can realise on this ~$20m revenue is around $3m. If we assume they will realise this evenly over two years to FY19, it's not hard to see how they can get to $10m EBITDA quite easily. On top of this, RDH are also looking to continue to expand offshore and open a new student recruitment agency and potentially launch the Coder Factory in Asia. The business has a significant cash balance of $6.3m and no debt. Barring any acquisitions, this is expected to grow as the business generates good cash flow and working capital requirements remain tight. Essentially, the business trades on about a 5x FY19 EV/EBITDA multiple or on just under an 8x FY19 cash adjusted P/E. This is backed by a very prudent and proven management team which has continuously delivered. I believe the stock is still significantly undervalued. While this stock has been a strong performer benefiting from both multiple expansion and earnings growth, the underlying business has also increased in value significantly. Another near-term catalyst is the implementation of a dividend policy. Given the incremental returns on capital are relatively high and the opportunities relatively vast, I hope that if a dividend policy is announced, it's one with a low payout ratio. I trust the board will make the right decision here. The biggest risk to this stock is regulatory risk, which by nature, is a tough external risk to manage. However, given education is Australia's third largest export sector and that both political parties appear to want to capitalise on the strong international student market trend, I believe the risk is not substantial in the near to medium term. While I believe it is still undervalued, many disagree and as Warren Buffettt says, If you have been in a poker game for a while, and you still don’t know who the patsy is, you’re the patsy. But how do you confirm whether or not you're the patsy? The market will tell you. Over time, the stock price will reflect the fundamentals of the business and the stock price will rise or fall accordingly. And how long is over time? 2 years is more than enough time in most circumstances.

Other good contributors to performance which I haven't mentioned before have been NAOS Emerging Opportunities Company (ASX:NCC), Macquaire Telecom (ASX:MAQ) and Origin Energy (ASX:ORG).


Thoughts on Market Valuation & The Plethora of New Fund Managers

My personal trading account is becoming less of a "personal account" as I am increasingly investing my money into the funds which my place of employment run and so over time, my performance will increasingly mimic the returns of these Listed Investment Companies (LICs) and less so in response to my direct decision making. But at the same time, my cash balance has increased (not necessarily due to selling positions but by not injecting excess money into the equity market). This is a reflection of my view that there are not many quality bargains in the domestic equity market. It is truly a stock pickers market and it is very stock specific. I am of the view that there has been a big influx of money into the smaller end of the market recently both directly and via fund managers. This new money has led to many high growth stocks and resource companies being bid up aggressively and as a result, are now very hard to justify on valuation grounds. Despite this, they continue to rise. I believe some investors and fund managers are assuming more risk than they otherwise would under more normal circumstances.This increasingly frothy market combined with the plethora of new money into the small caps space may lead to trouble down the track. Some funds probably won't grow to the scale necessary to operate a funds management business successfully which by nature, has a very fixed cost base. As a result, you may see consolidation in the space. In response to the lack of quality bargains (but also to build out my knowledge base), I have begun looking at international equities. The US market is interesting given its size but also the way in which it can present opportunities. I believe some industries in the US market are more volatile than their Australian equivalents. For example, there is a big emphasis on quarterly earnings which isn't present in Australia. Moreover, the response to short-term revenue and earnings misses are more pronounced in the US relative to Australia. This is a blessing for me given it will present more opportunities but it can be a curse if you're a fund manager who's judged on monthly performance.


Passive Vs. Active

This is a hot debate at the moment and has been going on for some time. The shift from active investing to passive investing continues to gain strong traction. Essentially, the crux of the argument is that many fund managers haven't kept up their respective benchmarks on a post-fee basis. So investors are shifting money from active fund managers toward passive vehicles which have next to no human judgement involved. This trend towards passive investing has progressed much further in the US relative to Australia but it's not just restricted to these two markets - it's a global phenomenon. Passive investing would benefit the vast majority of regular investors but only to a certain point. When you invest in the index, you should get an average return. The more your portfolio deviates away from the index, the more your returns will move away from the index in either a positive or negative direction. I am against this trend as it goes against the long-term interests of investors but my view is biased as I work for an active fund manager. Why? Because traditional passive vehicles don't take valuation into account and the strong inflows these vehicles are receiving are promoting a momentum based investment strategy.  When one buys stocks without valuation in mind, this is dangerous. As Howard Marks has said, some of the few times he has witnessed the investor mentality of no price being too high was during the boom of the Nifty Fifty and the tech boom beginning in the early 1970s and 1997, respectively. They both had strong runs but both subsequently crashed and with the former, it took a long time for many to make their money back and in the latter, the money wasn't made back at all in many cases as many of the businesses didn't have any revenue! So am i implying that this will occur with the trend of passive investing? No, but I will reiterate, when one buys businesses without valuation in mind, it is dangerous. Yes, there are "semi-passive" strategies that blend a passive strategy with an active but as this continues the fee differential will continue to close and the cost advantage that passive vehicles have will diminish. Another issue with the rise of passive investing is that active fund managers, especially activist ones,play a key role in keeping senior management and boards in check. Imagine a situation in which the register of each company in the S&P500 or the ASX200 was 80% held by passive vehicles. They would control the decision making. But how can one make decisions when there is no one there to make them? If profits begin to fall, it's easy to vote a manager out, but what if management teams get more creative by changing accounting treatments, make acquisitions to hide poor organic growth or other mischievous ways to keep a job? I don't have answers to many of these questions, but it's something I will continue to think about. How can active managers defend themselves? Well apart from the obvious which is to maintain outperformance, many have done it to themselves by being closet index huggers. But, when investing in the ASX200, having an edge is difficult. I believe you must provide a niche offering such as specialising in small caps. The herd continues to run towards passive investing but I am of the view this can reverse. It might just need a significant market correction.





Thanks for reading and all the best,
Chadd Knights



This article is general advice and is not intended to be personal advice. Before making any decisions, consult a licensed professional.

3 Year Performance Update

Note: All performance figures quoted are net of fees and transaction costs but before taxes. 

I am not going to waste too much of your time and so I'll keep this very brief.

Given that some of the positions within the portfolio have had a rough ride of late, it would be a good idea to update the actual figures for the 3 year period (from the 22/2/14 to the 22/2/17).

The 22nd of February 2017 marked 3 years of investing in the stock market. Reflecting on what was, it has been a tumultuous ride marked by both winners but also many, many losers (especially in the beginning). Some of the worst investments were in SGH and WDS (which went broke). On the contrary, some of the better investments included MIN and SRX among others. It is well understood that SRX has recently halved in value, but please keep in mind it has also halved and doubled a few times in the past and I have been fortunate enough to favourably capitalise on the swings. I have doubled down on SRX.

Several months ago I mentioned that the theoretical 3 year annualised return was +25.97% p.a. While this return didn't eventuate, i am not disappointed with the end result. In the end, the actual figure was +17.69% p.a. (or a total return of 60.31%). However, the first month of the 4th year (i.e. from 23/2/17 to 22/3/17) the portfolio was up 6.70% and it's up about 2% this month so far. In other words, it's been a good start and key to this, was good 1H17 results by some positions underpinned by better than expected FY17 outlook statements.

A few months ago, I removed RCG from the portfolio. I learnt a good lesson from this one. Namely, that retail is very, very hard. In particular, I underestimated how quickly the rate of organic growth can change in just one season. I still have faith in the management team there but taking a 2-3 year view on the business, the risk-reward isn't there from my perspective. Earnings growth is under more risk than I initially assumed, more investment will be needed and the threat of Amazon will weigh on the multiple. Fortunately, I broke even on the investment but there was an opportunity cost involved. Going forward, there has been some new additions to the portfolio that I believe offer good risk-adjusted returns over a 3 year view. Unfortunately, I am not in a position yet to be able to name these stocks.

Analysing companies and finding undervalued businesses not yet discovered by the wider market is my passion, and I am very fortunate that my passion coincides with my pay slip. While it is early days and barring unforeseen circumstances, I have made the decision to devote the rest of my life to becoming the best version of myself and hopefully in the process, a very successful capital allocator.

In life, some are more fortunate than others. I hope that if you are on the fortunate side, you use your resources wisely, namely, by giving to those less fortunate in some way. This doesn't necessarily mean you have to hand out money. It could be that, you share your knowledge with others or you lend a hand to others when needed. Either way, I hope the actions are underpinned by good intentions. Intelligence, integrity and energy as Warren Buffett says, are key to a successful life and success in business.

Thank you for reading.

Yours faithfully,

Chadd Knights