In hindsight it has been nirvana for the unsophisticated investor. Those that piled into IPO’s and technology stocks in the last few years were unduly rewarded with spectacular returns. Those more discerning who avoided the speculative fervour, have been figuratively buried owning miners and unfashionable industrial companies. Ironically, it was only two years ago that Blackmores was one of those unloved companies in our portfolio. It could do no right. It had an aggressive competitor, was being marginalised by increasing power of the grocery channel and was seemingly directionless. But it had a number of significant positive attributes and was under earning on any simple benchmarking of its margins versus much lower quality brands in similar channels (e.g. Patties Foods). There was a sound margin of safety when we were buying shares below $20. Despite a meteoric share price rise since, it’s important to maintain perspective. Two years ago, the group had sales of $330m. If the CEO’s recent prognostications in the press are genuine it appears the group may reach the $1bn sales target this year or next versus market expectations of >$700m. Given the operating leverage in the business, a margin of 30% is plausible perhaps conservatively providing EBIT of roughly $300m. Based on its current market capitalisation, this places the company on a multiple of 12x EBIT versus high flying companies like Domino’s Pizzas on >38x EBIT, a company that has relied on acquisitions to drive growth, in this context it is hardly egregious. Where Blackmores’ market share of the Chinese supplement market stabilises is anyone’s guess, however, it’s not unreasonable to think it could be higher given the company has been grinding away at this market for a number of years with little to show until recently. It has not been an overnight success.
Anchoring to past share prices as a reference point for valuation when facts have changed is a constant battle particularly for the seasoned investor. In the past, we have taken profits too early in situations like Blackmores without adjusting to new learnings. As humans age we become more closed minded. On the other hand children have a predilection to open mindedness enabling their imaginations and ability to grasp new concepts. Bending our hardened minds is challenging but of great importance for second order thinking and therefore successful investing. Moving forward, what will be the next Blackmores? Well candidly we simply don’t know, however, prevailing market conditions appear conducive for discovering similar risk reward equations. Our preferred investments are those where risk is skewed predominantly in our favour. In small caps you find popularity waxes and wanes with share price ructions presenting plenty of scope in the long term for disciplined investors.
Many will wax lyrically about their winners. We spend a lot more time learning from our mistakes. By good luck or good management, the last year has been kind to us. There were just over thirty stocks in the Small Ordinaries Index in the past year that saw their share prices more than halve, we managed to avoid all of them. We remain of the view that small cap investing is to a large degree about minimising losses. Avoiding companies that underperform increases the probability that your portfolio on average will do better than the index, particularly when the variance of returns in small cap investing is large due to greater inherent volatility. This is where cash flows and balance sheets are critical to our process. The bottom thirty performers were littered with resource and energy stocks where quality is generally poor, at this end of the market, and hence makes avoidance easy. There was a smattering of industrials which were tempting headed by Bradken, Slater & Gordon, Dick Smith, Hills Industries, Capitol Health and Vocation. Eerily, all these companies (and in some cases over long periods) were market darlings in the small cap space, the “go to” and “go go” stocks. With the tide going out, the obvious flaws to us including weak free cash flows, off balance sheet debt and aggressive debt levels which are now obvious to all. We have already seen two of these companies fall into receivership. It’s highly probable they are not the last to do so from this list. We suspect most professional investors have now left these registers, replaced by retail investors that are anchoring to the illusion of past share prices that were not reflective of true value, instead of scrutinising financial statements to determine an intrinsic value. The parallels to the final days of Babcock and Brown, Allco Finance and MFS during the GFC are stark for those investors with only a modest corporate memory.
We feel the Australian share market is entering a treacherous period. Market participants are very complacent after a multi-year bull market for which it has been easy to ride themes and momentum with little rigour in the interpretation of financial statements. There are many highly rated companies that do not earn much money, particularly technology stocks that may never earn enough cash flow to justify market valuations. A market correction of some type feels likely which means funding might be tighter and therefore businesses that are self-funded and have little to no financial leverage (debt) may perform better. Within this framework we have been establishing positions in companies where valuations are attractive and are gradually cycling out of companies that have become overrated.
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