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





 

Portfolio Performance

The aim of this post is to present the performance of the fund and discuss why some of the stocks in the portfolio have added or detracted from fund performance. I hope not to bore you with the details so I try and limit the discussion and analysis to a relatively minimal level given the purposes here. It is very important to understand that the quoted fund returns do not account for cash that is invested elsewhere - in term deposits for example. This overestimates the returns. If the cash return was factored in, the returns quoted below would be lower. I hope you enjoy it.

The preceding five months ending 22-7-16 have been interesting to say the least from a portfolio perspective. Stock specific news, market volatility and portfolio movements have led to a somewhat distinct result. Pleasingly, the portfolio added +19.46% in the five month period net of all fees and transaction costs but before taxes, representing an annualised return of +53.24%. If this theoretical annualised return were to eventuate, it would take the portfolio’s annualised return since inception (a 3 year period) to +25.97% per annum or a total return of +99.89%, net of all transaction costs and fees but before taxes.The actual return since inception to date (i.e. ~2.4 years) is +20.12% per annum, net of all transaction costs and fees but before taxes.

As usual, we will discuss the positions and actions which detracted value from the portfolio first. The biggest detractor from performance was selling out of Mineral Resources (ASX:MIN) too early. Despite it adding significantly to the performance, the detraction is derived from the fact that since selling out the price has risen substantially and so this represents an indirect cost. Unfortunately, the position got exited before the major rush of investor optimism toward the current fad, Lithium. While I believe the business is still undervalued, I made the mistake by giving into pressure and not controlling my temperament, costing the fund approximately 8% of gains (to the 22-7-16) on top of the aforementioned 19.46%. It’s important to reflect on mistakes in order to progress. The proceeds have been invested in a business which I believe offers significant risk-adjusted returns over the next three years. Despite this, it was a choice with which there is a high degree of discontent.

The other major detractor was Sirtex Medical (ASX:SRX). Earlier in the year, Sirtex made an announcement stating that it expects its dose sales growth to not remain at the near 5 year historical growth rate of ~19.7% but rather slow to 15-17% on the back of weakness in Europe and Asia despite strength in the US, which represents ~70% of its dose sales. EU and Asia experienced weakness as reimbursement funding was delayed. Subsequent to this market release, Sirtex confirmed actual dose sales growth of 16.4% for FY16.

I am still a believer in the long-term proposition of Sirtex, however, investing is expectations based and understanding why a stock trades at certain levels plays a role. Sirtex is a great business but it’s essentially a play on market opportunity, backed by outstanding management who continue to deliver. Sirtex has penetrated less than 5% of the salvage market which is continuing to grow. The business, however, does come with its fair share of risks. For example, a key risk I believe shorter-term, is the upcoming trial results which may see SIR-Spheres being used as a first-line treatment (or lack of) and thus lead to a quantum leap in market opportunity. Another risk is the fact that it’s a business with (currently) one product so obsolesce combined with a lack of product diversification is a real threat but one which I believe is not an issue just yet given the aforementioned market opportunity.

On the other hand, all other positions in the portfolio contributed to the positive performance. Key contributors were Enero Group (ASX:EGG), Mynetfone (ASX:MNF) and RCG Corp (ASX:RCG). EGG’s FY16 result will be of paramount importance to how it performs in the ensuing months and possibly, much longer term. The key for this one will be margin expansion driven by a reduction in the operating cost ratio and staff costs and strength from all regions. In my opinion, EGG remains priced for the direst of outcomes on a long-term view. I strongly believe the risk-reward for this stock is very favourable. The latter two stocks we’ll leave for another time.

Thank you for reading and the best of luck.

Yours faithfully,

Chadd Knights

Please note that this post may contain general financial advice that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking advice from a financial advisor if necessary. Moreover, the firm I work for and I personally have financial interests in at least some of the companies discussed.

Portfolio Performance Update - 22/02/2015 to 22/02/2016

The 22^nd of February marked 2 years since I made my first investment which was in Aveo Group (AOG) which unfortunately, I sold out of too soon. Since then, I’ve added and detracted from various positions. From 22-2-15 to 22-2-16, my portfolio increased by 10.6% post fees (12.3% pre-fees). This takes my annualised return since inception to 14.2% p.a. post fees (16.1% p.a. pre-fees).

My portfolio would be in a much worse off position if I didn’t make the large purchase Enero Group (EGG) that I made a few weeks ago which is up 22% (572% annualised). The portfolio was also aided by a late stage rally in Mineral Resources (MIN) which posted a strong result on the back of robust crushing volumes despite the slump in the iron ore price.

Unfortunately, the market had a tumultuous CY15 and this has continued into CY16. We are at a time where global growth and inflation forecasts are below trend in most regions, commodity prices have collapsed, global trade has slowed and margins are peaking. On top of all of this, corporate and government debts are at heightened levels and riskier assets have been bolstered by credit pumping Central Bank’s around the globe.  

Interestingly, returns in the ASX have been flat but volatility has surged. This begs the question: are we getting paid to move to riskier assets such as shares? Maybe, but maybe not. It appears we are operating in an environment where value investing isn’t working and momentum investing is. Investors who prioritise the mitigation of downside risk over upside return aren’t being rewarded in the current market environment.

If we look at stock specifics of the market, some performed tremendously most notably: Ballamy’s, Blackmores and A2 Milk – the Chinese story was a hit with investors. However, some performed terribly - essentially anything tied to commodity prices took a hit except in some rare occasions. Bellamy’s stock value grew from about $1.65 at the beginning of 2015 to about $13.61 by the end of 2015 – a rise of about 725%. At (almost) the same time between FY14-15, Ballamy’s book value per share changed from $0.22 to $0.51, representing a respectable 132% increase but when compared to its share price appreciation, something just doesn’t add up. The recent Stock price performance of these “hot stocks” have increased risk and diminished prospective returns. Contrastingly, returns on book have risen in companies such as BHP and at the same time, their risk has reduced and their prospective returns have strengthened.

This is by no means a distraction from the fact that I didn’t reach my performance target of 15%, but just some commentary around the current market environment. There will come a point in time when valuations will again be prioritised.

Enero Group – ASX:EGG . A Summary Of The 1HFY16 Results.

Enero Group – ASX:EGG

1HFY16 Results – A Summary

A flattening revenue line, record breaking profitability, strengthening margins and 40% of its market value backed by cash does not set the stage for basement level market prices.  

Enero Group (EGG) reported strong 1HFY16 results which saw net revenue rise 3% to $57.6m (helped by a FX tailwind of ~$4.3m) and operating EBITDA by 57% to $7.2m compared to the pcp. Driving this strong operating EBITDA performance was robust margin expansion from 8.2% to 12.6% over the same time period last year as a result of a resilient revenue base and cost management. Operating costs as a percentage of revenue continue to decline as a result of stricter cost controls.

Marketing budgets are generally one of the first budgets to get culled when times get tough. Despite this, EGG delivered a strong result from all three key operating hubs. Australasia saw revenue decline 21.8% to $22.9m and operating EBITDA fell by 25.0% to $3.3m. However, EGG was able to arrest a material decline in margin erosion which fell by a mere 0.6% to 14.4% on the back of cost control measures. I do not expect revenue declines in Australia to continue into 2HFY16.

Robust performance in the UK & Europe region was helped by a recovering economy and the resurgence of marketing spending by companies and led to some significant client wins such as Ebay. Revenue in the region was up 13.1% to $27m and operating EBITDA increased 63.9% to $6.7m. All of which helped boost the operating EBITDA margin from 16.7% to a respectable 24.8%. I expect strength in this facet of the company to continue its momentum and deliver a good 2HFY16 result. 

The turnaround in the USA is gaining traction but it’s still sub-scale. Revenue grew by 6.0% to $7.7m and operating EBITDA rose 59.8% to $0.7m. Given the size of the US market, it represents a large opportunity going forward. Given the large cash balance and need to grow scale, M&A activity may seem appropriate.

On almost any measure, this stock appears undervalued. Barring upside (downside) from revenue growth (decline), continued focus on cost management, the expansion of margins,  and momentum in key agencies will see continued profit growth. With almost half of its market value backed by cash (which continues to grow), and trading on about 3x EV/EBITDA  (FY16e) and a FCF yield of ~17% FY16e, such a risk-reward is extremely favourable.

Background Information

Enero Group (EGG) is an integrated marketing and communications firm with a portfolio of 10 companies. EGG operates from three primary locations – Sydney, London and New York with Australia being the largest by revenue and exposure. EGG’s key services fall into three main categories including advertising and production, public relations and research.

Please note that this post may contain general financial advice that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking advice from a financial advisor if necessary. Moreover, the firm I work for and I personally have financial interests in the company discussed.

My View On The Australian Economy As 2015 Draws To An End

I think throughout my posts, my concerns over the Australian economy permeate throughout my posts over time. It may be hard to follow when they appear all over the place. This post is to summarise my current thoughts on the Australian economy in a more concise form. Please note that it is not an exhaustive list and that little of what follows would crystallise into my thinking when picking stocks (however it may help me identify potential bottom-up candidates) I still think it’s important to stay on top of it all – or as much as you can. 

My View On The Australian Economy

The economy is transitioning from mining investment-led growth to a broader-based form of growth. With the RBA cash rate at record lows, the intentions of the low interest rates have not had the desired outcome as business investment has not been ideal. This comes at a time when above average economic growth is tapering off as the investment boom comes to an end. Consensus economic growth for 2016 sits at around 2.5-3.0%. However, there is downside to this forecast and economists are consistently revising their numbers.

Secondly, the economy is undergoing a “wage growth” recession. As the mining boom continues to taper off, highly paid mining jobs are being replaced with lower paid roles putting downward pressure on income growth. Recent consumer sentiment & retail sales numbers have been "steady" but this has been supported by the “wealth effect” whereby increasing asset prices (especially house prices) have meant people are feeling richer and so are dipping into their savings which is stimulating consumer spending. You can see this by noting that the average household savings has fallen. This trend is expected to continue as long as asset prices continue to rise. However, with the ASX achieving relatively flat results for 2015 (which is expected to continue short-term) and house price appreciation forecasted to fall by about 7.5% in 2016, it is hard to see how the consumer (in at least the short term) will contribute to GDP growth.

Lastly, the labour market has held up well in recent times with net job ads improving but not impressive. In order to fill the gap between the fall in mining investment related jobs and the broader economy, the job ads will need to improve.

The Australian Economy More Closely

There are several key headwinds that the Australian economy is facing. The lower A$ hasn’t yet sparked a strong surge in non-mining exports, we should at some point see this trend turn though. The most recent GDP growth number for the September quarter of 0.9% was particularly surprising and was primarily driven by strong net exports. Whether or not this continues, I cannot say much but as the A$ comes off, you should see non-mining exports pick up. Major detractors of growth were the sharp decline in mining capex and investment, the stubbornly resilient A$, and cuts to government expenditure. As China’s demand for key commodities continue to decline and our terms of trade with it, it is constraining income growth which is constraining domestic demand growth.
As noted above, it is expected that consumer spending will grow but correlate with growth in asset prices, not wage growth. However, consumer spending should be supported by population growth.

My Take On The Equity Market

I’m treading in uncharted waters here, but what I’m seeing is that the Australian market is diverging. However, with this divergence the risk-reward trade-off is not really justifiable. Many sell-side analysts are recommending the same longs, as they do so, it’s driving the prices up and so newcomer’s returns are not as appealing. As a result, buying into the “consensus growth” is reducing in its attractiveness. Similarly, in the value end of the market (dominated by miners & energy related companies) it isn’t any easier to buy given their inherent business models are dependent on commodity prices and resulting lack of accuracy in forecasted figures.

According to Robert Buckland, chief global equity strategist of Citi in an investor presentation said that the recent market correction has removed EPS growth expectations and the market is now fairly valued. Put differently, Robert believes that the market was pricing in a circa 10% EPS growth, however, the recent correction has wiped this out and now the market isn’t pricing in any EPS growth or falls in EPS. Thus, the market isn’t overvalued nor is it undervalued. I believe there is little reason to make a call that P/E multiples should expand in the near term as the fundamentals don’t look strong enough. The funny thing about markets though is that anything can happen, be mindful.

Earnings are expected to grow in the low single digit (pulled down by resources). The same trend of 2015 has continued and it appears as though will continue into the start of 2016 – slow revenue growth and margin expansion driven by cost out and restructuring.  As a result, we should expect only very modest growth in the Australian equity market in 2016 (other things remaining equal). However, the low interest rate environment and strong dividend yields should support the market.

A key question now is how you should translate this (top-down) thinking into portfolio positions. I would argue that banking should be a beneficiary as their dividends should support their prices, despite ROEs falling as a result of capital raisings on back of new regulation introduced by APRA. Alternatively, US$ exposure is also attractive. Lastly, lower A$ exposed industry’s also look attractive, such as tourism, education and so on. On the other hand, as a sector I’m bearish on materials. While there is value there, it’s a hard game to play. Oversupply of key commodities and demand side pressure from China and other key emerging markets signals more risk for the sector.

The fundamentals of the economy suggest that it is hard to see why the Australian economy will continue to grow at above-average levels in the near term. Rather, it is expected that the economy will continue to grow but at a more “normal” rate in line with the long-term average.

There are however a number of factors (but not limited to) which may shake or permute my reasoning. The following factors are important considerations:

1. Firstly, changes in the RBA cash rate should change the dynamics by bolstering business investment, support the construction sector, and unfortunately support riskier assets such as shares among others. The strong GDP number in the September quarter suggests rate cuts are unlikely until early-mid 2016.

2. Sustained strength in the A$ will also put pressure on non-mining exports. A sharp decline in the A$ might see key export services flourish with key beneficiaries being tourism, education, agriculture and so on.

3. Uncertainty around the 2015-16 federal budget. Given that government expenditure has come off, a change in this may boost growth or have an alternative effect if the political party in charge decides to tighten fiscal policy further.

4. Business & consumer confidence levels are key to our growth. With the evidence suggesting downward pressure on consumer confidence, business confidence might pick up in 2016 on the back of low interest rates and low A$.

5. Lastly, China’s economic slowdown is also another key factor for our markets. Any shifts here will also shift our growth story.

Portfolio Performance

As I didn’t do a 6 month portfolio review I’ve decided to do something a little different and do a 9 month review (of my performance) instead.

My Personal Account (PA) which I refer to as my “Growth Value Fund” posted returns of 6.3% after transaction costs for the 9 months (to date). This takes my annualised return since inception to 12.3% p.a. (post all costs - which are quite high given my transaction costs as a % of transaction value is high. Performance before this cost is about 15%). Over the most recent 9 months, major detractors included WDS Limited (ASX:WDS), Slater & Gordon (ASX:SGH) and Arrium (ASX:ARI).  I have sold out of all of these positions except for WDS. Although these stocks fell significantly, the impact was subdued due to their small weightings – I held small positions relative to my other, high conviction calls. On the other hand, major contributors were Sirtex Medical (ASX:SRX), RCG Corporation (ASX:RCG) and Molopo Energy (ASX:MPO). These three stocks have done the majority of the lifting in both performance and dollar gains. I sold out of Molopo Energy realising a c. 26% capital gain (104% annualised).

Over the most recent quarter I added significantly to my Mineral Resources (ASX:MIN) holding and bought into MNF Group (ASX:MNF) which is now my largest holding. While both are only up c. 2-4%, the dollar gains are substantial as they are big holdings of mine (about 50% of my portfolio in fact – a serious level of concentration). People question why I have bought into Mineral Resources and I’d like to offer some insight. Many have ditched the company and there has been immense short selling pressure. My best guess would be because of the impact of the iron price on the business. However, what many don’t talk about is its extremely high quality iron ore crushing business which operates at a 29% EBIT margin and has a high level of contractual (recurring) revenue. Furthermore, the revenues are generated on a volume basis, and so are not as responsive to price as many believe – the majors are still pushing volume through via MIN.Yes, the earnings have re based downward, but the share price depreciation has been too aggressive and not justifiable in my opinion.  

Brief Market Review

As financial markets continue their wild gyrations, the most recent quarter was not easy with the MSCI AC World ex-Australia falling about 9.2% (USD) but this was offset by changes in the Aussie dollar.  Growth concerns over China and the rising expectations of the US interest rate hike were key themes shaking markets.

Domestically, the ASX200 Accumulation Index fell 6.6% in the most recent quarter – mostly driven by a sell-off in the banks and materials.  More specifically, the resource sector came under immense pressure as the iron ore price and oil price continue to set new lows. On the other hand, investors rewarded the industrials sector.

Brief Market Outlook

The Australian economy continues to shift away from the mining sector. With the AUD coming off we have seen tourism and services reduce the unemployment rates for these sectors. With the RBA cash rate at 2.00%, it remains expansionary. There is also a growing concern over the Australian GDP growth rate in the medium term. In one of my recent posts titled “General Commentary” I talked about how each RBA rate cut is having less of an impact on investment. I’d like to add to this. What’s happening is that with each RBA rate cut, you’re seeing more money pour into equity markets, driving up prices. Companies are using the lower rates to pay higher dividends to attract this new money, driving their share prices higher at the cost of investment into the future. This, I believe is a serious issue which needs a solution. It has come to my attention that many of the beloved blue-chips are operating at unsustainable payout ratios which I believe will come under threat.

In terms of the market outlook over the short term I cannot add much value here as quite frankly I have no idea. However, while many are focused on the daily moves of markets, I am confident that the ASX will continue to grind up over time as the economy continues to grow.

I will attempt a more elaborate post at my yearly review covering most of the year which may see some overlap with the material posted in this review.  

I hope you all enjoy your Christmas & New Year.