Beware of falling knives
Before moving forward, it’s always good to look back and reflect on the year past. The strategy performed well overall up 15% before fees versus the Small Ordinaries Index which was down 4%. The index return debased by its small resource component which was down 28% for the year. Statistically, the index again exhibited significantly high return variance ~44% versus the top 100 companies ~30%. Of the bottom five performers, four officially were handed to the undertakers (i.e. administration); and one, Mirabella Nickel, was suspended indefinitely after it was resurrected briefly after a surge in the nickel price that was only partially sustained. First to the undertaker was Forge Group, which was unsurprising given the volume of chatter in the industry in relation to a number of problem contracts and magnitude of potential losses. Similar chatter continues in respect of other contractors in the small cap (and large cap) universes that still have juicy market capitalisations – a couple more Forge type situations appear a genuine possibility in 2015. Remarkably, many are seemingly ignoring this credible industry feedback, the parlous financial strength of these contractors and the absence of cash flow, and instead focussing on management rhetoric, a dangerous strategy when the tide is clearly going out in the contracting space. The other key traits shared by the five companies that are now defunct include the fact that they were all resource companies or resource related, financially leveraged and were negative cash flow generators. Again, we reiterate one of our key disciplines in small cap investing is avoiding companies with too much leverage and a lack of free cash flow to sustain themselves in a down cycle. If it’s not generating free cash flow in the good times, how will it in a downturn?
Outside of the defunct, a scan of the bottom decile of performers is littered with high flyers from the resource boom. Several were victims of circumstance to some degree (e.g. Mount Gibson) seawall collapse) while others were flights of fancy (e.g. Sundance Resources’ Congo iron ore project). Unfortunately, we were figuratively caught in the sea wall collapse at Koolan Island, with our backstop being a tonne of cash and franking credits which underpins our current investment thesis. Let’s hope the Mount Gibson board act rationally in releasing most of that inherent value via a distribution to shareholders. To date despite expectations to the contrary, the board have been overtly shareholder friendly. Spending a lot of money remediating the sea wall in the current pricing environment with no guarantee of enduring success would seem an exercise in futility. An acquisition is a possibility and pricing might actually be favourable, however, the scarcity of low cost / long life mines is the limiting factor, with board unlikely to buy an asset with unfavourable economics in the current climate.
On the whole, we managed to avoid most of the bombs in the small resources component over the year, with moderate damage inflicted by Mount Gibson and Horizon Oil, more than offset by strong performances in key resource positions of Independence Group, Western Areas and ROC Oil. Like our large cap brethren we are looking for opportunities in this space given the improved valuation appeal. To that end we are now overweight the gold sector, although the significance of this is somewhat marginal for the strategy given the sector is now only around 3% of the index versus >10% at the peak. The Australia dollar retracement to US$0.80 or thereabouts is nearing our long held US$0.75 assumption. As such many of the Australian based gold miners that have completed significant capex campaigns will generate sound levels of cash if the gold price holds around current spot price which is not too dissimilar to our mid-cycle gold price assumption of US$1250/oz. A falling oil price is positive for the economics of high volume open pit miners (e.g. around 35% of Regis Resources cost base is diesel fuel). Balance sheet strength and low cost operations are particularly important when buying gold miners due to the speculative forces ultimately determine the gold price, given its limited use in industrial purposes and the existence of significant above ground supply.
The last domino to fall amongst commodity complexes was clearly the oil price. This began midway through 2014 and accelerated aggressively in the last quarter. After seeing nickel, coal, gold and iron ore fall in a similar manner one after another over the past two years, the toppling of this last domino was not a major surprise. Fortunately, our largest position in the energy sector, ROC Oil, was taken over in August leaving us significantly underweight the sector (sometimes it’s better to be lucky than skillful). An additional constraint on our weight was finding assets that met our quality criteria. Most of the oil/gas plays in the small cap universe have a strong bent towards exploration. Given our predisposition to free cash flow and return based valuations, this precludes many of these stocks from investment. Nevertheless, we will maintain a watching brief on this space as the oil price is intrinsically self-correcting in that reserves deplete and the marginal cost of replenishment and extraction is rising which ultimately determines the price absent changes to the demand profile. Instinctively, our short term concern is that consensus is very much trying to catch a falling knife premised on a $100 oil price that the investment community was conditioned to and is now psychologically anchored to. Until the investment world divorces itself form this anchor and the last vestige of optimism is extinguished there is a significant risk of investing prematurely, a common sin that we have experienced too numerous times in the past to repeat again.
As usual we have spent a disproportionate amount of time discussing the negative. Looking on the positive side of the ledger for 2014 there appears little discernible trend within the index, with a mishmash of stocks from various sectors outperforming. Yes, surprisingly four resource names made the top ten performers including Northern Star Gold, Indophil Resources, Panoramic and Western Areas. Sirtex Medical was the best performer over the year, up a staggering 143% followed by the much maligned APN Media which was up a lazy 98%. As usual there were a number of takeovers in the small cap space during the year and outside of ROC (already discussed), we benefited from Oakton, Wotif and Goodman Fielder being acquired.
There were over seventy floats in small and micro-cap space during calendar year 2014. Schroders’ smaller companies fund and micro-cap funds both participated in six floats, not necessarily the same given mandate and liquidity constraints. Generally, we avoided floats that were private equity led, preferring those where management and existing owners kept the majority of skin in the game. In hindsight it would have been easier ‘buying and stagging’ everything that floated but that is not our mantra with our preference to be long term shareholders where possible, assuming the valuation remains realistic. It would not surprise us if some of the gloss starts fading fast on a chunk of floats from 2013 and 2014 given many of the prospectus forecasts looked aggressive given challenging economic and competitive conditions, and the overzealous multiples paid for assets with a fictional growth story bound within an officially signed document called a prospectus - caveat emptor.
Another year of statistics suggests that in small cap investing its best protecting downside risk in stock specific selections rather than chasing alpha, the dispersion of returns and the number of failures in small cap universe over the past year support this thesis. Risk mitigation therefore remains paramount with balance sheet and free cash flow generation the foundation of our portfolio construction. We feel the next year will provide some opportunity to diversify away from our large overweight to consumer discretionary which has been valuation led. The Australian dollar retracement is clearly very positive for primary industries. To date it has been largely ignored as the market is fixated with China’s economic woes and falling commodity prices the severity of which has seemingly abated in most instances.
Opinions, estimates and projections in this article constitute the current judgement of the author as of the date of this article. They do not necessarily reflect the opinions of Schroder Investment Management Australia Limited, ABN 22 000 443 274, AFS Licence 226473 ("Schroders") or any member of the Schroders Group and are subject to change without notice. In preparing this document, we have relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources or which was otherwise reviewed by us. Schroders does not give any warranty as to the accuracy, reliability or completeness of information which is contained in this article. Except insofar as liability under any statute cannot be excluded, Schroders and its directors, employees, consultants or any company in the Schroders Group do not accept any liability (whether arising in contract, in tort or negligence or otherwise) for any error or omission in this article or for any resulting loss or damage (whether direct, indirect, consequential or otherwise) suffered by the recipient of this article or any other person. This document does not contain, and should not be relied on as containing any investment, accounting, legal or tax advice. Schroders may record and monitor telephone calls for security, training and compliance purposes.