Please note: performance figures are annualised and the
figures are quoted net of fees and expenses but before taxes. All positions are
long positions. Inception date is 22/02/2014.
The preceding 6-month period (to 22/8/18) has been by far the best period for the fund since inception. My personal fund increased by +60.9% in the half. This takes performance since inception to +40.2% p.a. It may be a good time to reflect on this. When I started, I consistently read that the way to improve in the stock market was by making mistakes. My idea was to learn early, fail early, and fail with my own money so that later on, if I were in a position to manage other people’s money professionally, I wouldn’t need to start the process then. Early on, I made some shocking decisions such as investing in WDS Limited (ASX: WDS) which went broke, and Slater and Gordon (ASX: SGH) among others. On the contrary, I did very well out of Sirtex Medical (ASX: SRX), Mineral Resources (ASX: MIN) and Origin Energy (ASX: ORG). As my investment style has evolved, these businesses would unlikely be considered at present, but with the benefit of hindsight, they were trades that played out well. For example, when oil prices fell significantly (around 2015), I decided to go long. Numerous articles purported that oil would remain low for a long time and various “experts” had a similar view. These are telling signs to do exactly the opposite of what they’re saying. At around the same time, smart money such as Seth Klarman was also going long oil. I wanted exposure to the upside if oil prices came back but didn’t want to invest in a pure-play oil company, so I invested in ORG which I thought was a relatively safer bet. Within 18 months oil prices rebounded and the stock doubled over my holding period. Unfortunately, the experts got it wrong that time.
The ORG play was a trade with not much analysis. However, my
investment style has evolved. New ideas considered for the portfolio require me
to do copious amounts of work on each idea that is considered suitable, and
then to invest no less than 5% of the capital base in each idea. My investment
process starts with focusing on the management team – not the business. Because
the senior management team is responsible for capital allocation, they can
change the trajectory of the business. I will not invest in a business with a
management team that I believe are malicious, dodgy, or may act against the best
interests of shareholders even if I think I can do well out of it in the
short-term. In my opinion, basing a big part of your investment strategy on
trying to find ideas that are going to beat earnings guidance isn’t a strategy
that will likely outperform markets over long periods of time. One or a few people may do it well for a few
years, but over a multi-decade period, a more sophisticated strategy is
necessary.
When looking at a management team, I look at their history
both professionally and personally, how they’re remunerated, their shareholding
in the company and so on. I consider their integrity levels, how they view
their customers and whether they are passionate about what they do. The senior
management teams set the tone of the organisation and as a result, it’s
imperative they’re setting the right tone. I also try and speak to employees,
or even better, former employees. I want to know simple things such as whether
the CEO knows the names of their employees, how they treat their employees, what
the retention rate of the employees are and so on. Ever since I’ve started focusing
more closely on management teams and analysing managers who are extremely
successful, the commonalities are surprising. For example, many extremely
successful CEOs that I’ve looked at don’t have many hobbies outside of their
work. This is because they love what they do and everything else is merely
viewed as a distraction. To be clear here, I’m not saying good management teams
don’t have other hobbies. It just so happens to be that when I’ve looked at
certain successful CEOs, this is a common characteristic that continues to show
up. This may be by design, but people who are extremely passionate about their
business don’t really want to do anything else, but it’s not always the case.
Many good CEOs have outside hobbies and that’s fine.
After looking at the management team, I look at the
businesses competitive advantage and more importantly, whether the competitive
advantage is growing. A growing competitive
advantage is evidenced by things such as: a growing ROIC over time, expanding
GP margins, being able to increase prices above CPI and not lose market share and
so on. Having a competitive advantage now doesn’t mean you will have one in 5
years. You need to protect it and grow it so that the business continues to
become more valuable over time. Lastly, I focus on valuing the business. I am
willing to pay more than a bargain price for a high-quality business but not
for a mediocre business.
While the performance of my personal fund has been extremely
pleasing, these returns are not sustainable. Thinking such returns will
continue for a very long period of time would be naïve. Instead, I am gearing
toward a period of lower returns as the existing portfolio is unlikely to
maintain such returns and the market isn’t offering ample opportunity. However,
a few ideas have surfaced post the FY18 reporting season. The aim has and will
continue to be to target annual returns of 15-20%.
Turning to the preceding 6-month period, every position had
a positive contribution to the fund except for a new position which will remain
nameless for now. The majority contributor to the fund was my position in Afterpay Touch Group (ASX: APT) which
was up +151%. In terms of percentage gains, some other key contributors were: Infomedia (ASX: IFM) up +48%, Netwealth Group (ASX: NWL) up +44%, and
Redhill Education (ASX: RDH) up
+35%.
While Afterpay didn’t report its FY18 results until after
the funds reporting period, they gave a detailed business update in July which
included FY18 guidance. The update showed continued strong success in
Australia, and early signs of good results in the US. More recently, Urban
Outfitters (a large US retail firm) have stated that since offering Afterpay to
its customers a few months ago, the results have been very pleasing. Having an
organisation of this size talk up the service provides me with significant
confidence going forward.
Recently, I took to the streets and went and spoke to a
number of retailers in Sydney and got their views on Afterpay. What I found (and
subsequently confirmed on retail blogs) is that if you’re not offering a buy
now, pay later service, you may be severely disadvantaging your business. The
retailers who use the service continue to see very similar results which is,
average order values of about 15-20% higher than basket sizes checking out without
Afterpay, and higher conversion rates. Many of Afterpay’s customers (of which
there are now ~2.3 million) will not shop with you if you do not offer it. If
you’re a retailer and your target market is females aged 18-35, and you’re not
offering the service, you’re at the greatest risk of losing potential sales
where the increased sales much more than offset the reduction from Afterpay’s
transaction fee.
Afterpay have managed to turn the idea of spending money
(which no one likes) into an “enjoyable” thing because people enjoy using Afterpay.
The people I spoke to on the street who use the service light up when they talk
about it. “Just Afterpay It” has become a trademark. Afterpay is unique because
it’s growing by word-of-mouth and as a result, the cost to acquire new
customers is extremely low. As more retailers and customers use the service, the
network effect becomes ever more powerful. Being the first mover (in other
markets) is important to ensure that the momentum continues.
Credit risk is one of the biggest risks surrounding this
business. The credit environment in Australia is good at the moment.
Delinquencies are low and as a result, many are paying their obligations (including
Afterpay) on time or even early. The impressive statistics such as low average
basket sizes (~$150) and the fact that less than 10% of users have an
outstanding balance of over $500 imply credit risk of any particular person may
be low. However, these statistics are in light of a favourable economic
backdrop and it’s unknown how the total customer base would react if the
environment were to shift the other way. Especially given the relatively benign
consequences if defaults were to occur. You can model out various scenarios but
no one really knows. Another risk is regulation, but I am a little more
reserved on this. The evidence isn’t clear for them to be regulated. However, I
get comfort that both the credit risk and regulation risk are increasingly
mitigated as the geographic expansion continues. The management team are
proactive on the regulation front and are doing the right things to ensure they
are completely compliant. While the regulatory risk might pose short-term share
price pressure, this isn’t a concern.
A key issue is to determine the correct valuation multiple for
a business which is simultaneously a fast growing fintech disruptor, and a
consumer finance company which requires its balance sheet to grow in order for
the business to continue to grow. On a global basis, the fintech’s that do
generate an EBITDA trade anywhere between 50-100x EBITDA, while the consumer
finance companies trade on about 10x EBITDA. Obviously, the right multiple sits
somewhere in between 10-100x EBITDA. After considering the growth trajectory,
the risks and the fact that I prefer to be on the conservative side, the
multiple I have used is much closer to the 10x than the 100x. Even so, over my
investment horizon, there is potential for meaningful upside here. You can’t
view this business on a 1 year forward PE and make a judgement based solely on that.
This is not a traditional industrial company where most of its valuation comes from utilising its existing asset and client base. It’s not trading on 15x earnings
growing in the single digits. I’ve spoken to many investors and read some
articles which make me believe that whether they know it or not, people may be
comparing Afterpay with the types of businesses they more often deal with, which
tend to trade on comparatively much lower near-term multiples. However, such businesses
would not have the same growth levels or unmet addressable market sizes.
Bringing all the analysis together, I believe the business
offers compelling risk-adjusted returns. Despite modelling out different sets
of assumptions, at the end of the day, I’m backing Nick and Anthony and every
single employee to continue to execute. This ties back to analysing the
management teams (where the details are kept confidential unless publicly
stated).
A company which did report its FY18 results prior to the
funds end reporting date was IFM. IFM reported a good result which were ahead
of my expectations. They grew despite a major contract rolling off. Moreover, a
telling sign of IFM’s growth is how much of their development costs they are
capitalising. The balance has increased significantly increased. One may believe
this is driven by artificial reasons, but it’s not the case. IFM increases
development costs when work is committed to them. So, the capitalised costs are
underpinned by future improvements in revenue and the evidence points to this
as well.
Thank you for reading,
Chadd Knights
This article is general advice and is not
intended to be personal advice. Before making any decisions, consult a licensed
professional.
