Perspective in a noisy market
For some perspective in a noisy market, I regularly go through the exercise of looking back a year at the worst performers in the Small Ordinaries Index. The index composition at any point of time is heavily influenced by prevailing macroeconomic themes. Last year, the resource sector still had moderate support but this has for the most part evaporated with eighteen of the bottom twenty performers over the last year being resource or resource related entities. All the small cap iron ore producers are trading at a pittance of their peak market capitalisations, with former market darlings BC Iron and Atlas Iron two of the biggest laggards. A year ago BCI Iron had a market capitalisation of $540m and was trading within 20% of its all-time high whilst Atlas Iron had a market cap of $830m; well down on its high of $3.6bn in the boom resource market of 2011 but still pretty relevant in scheme of the index. Lucky for shareholders of BC Iron, its balance sheet is flush with cash which should allow it to ride out the downturn in the iron ore price. Unfortunately for shareholders of Atlas Iron it is unlikely to see the other side with Term Loan B debt holders now controlling its destiny, when suspended Atlas had a market cap of $110m, illustrating a frightening level of complacency in the market. This is not dissimilar to the Forge situation from 2012/13 when its market cap was $79m before suspension and eventual administration. It would appear there is a false sense of security in this market, although it cuts both ways, with there being opportunities given the degree of mispricing of valuation and risk in a positive sense, we will happily prey on these opportunities to generate alpha over the long term, without it we would not be gainfully employed.
Actually, whilst writing this report I have noticed that four other companies in the index failed during the year including Red Fork Energy and Nexus Energy, neither of which had much market cap at the end. The two that did were Western Desert Resources (another iron ore producer) and NewSat, which had market caps of $90m and $74m respectively. Clearly risk assessment was not a high order priority for market buyers of these companies given the amount of equity value ascribed immediately prior to their demise. The frequency of failures, effectively five companies in the Small Ordinaries Index (if you include Atlas Iron) is contrary to what you would expect in an environment where funding markets are open and liquid. If the liquidity tap does tighten, it is possible there is a rash of failures. Clearly, risk assessment particularly balance sheet and cash flow remains critical to our decision making process.
Within the resource carnage there will be companies that have been indiscriminately sold down. Given a mean reversion philosophy, I suspect that something in the bottom twenty could actually be a top performer over the next year. The critical differentiator likely to be balance sheet strength, to firstly survive the downturn in commodity prices and the second order being the quality of the underlying asset/s. Based on this simple formula (i.e. crystal ball gazing) it would appear the primary candidates for outperformance over the next year are BC Iron, Silex and Mount Gibson. At this point I will declare that we own Mount Gibson and have bought more recently. It has been an unpleasant experience so far (discussed in a previous commentary) but we think there is significant value in the stub that all other things being equal should be crystallised in time. The steep market discount it trades to its cash backing (32cps vs share price of 22cps) seemingly premised on a perception yet evidenced that the cornerstone shareholders (couple of Chinese companies) will act to the detriment of minority shareholders. The fact the company has NOT bought back shares is of some concern given it would be highly accretive, and would vindicate our investment thesis in respect of major shareholders attitude and philosophical tendencies. Anyway I have probably devoted too much time to Mount Gibson in commentaries but it is a stark illustration of the irrational behaviour pervading the resource space and the iron ore sector, in particular.
On the other hand, historically I have struggled to glean much from the best performers in the Small Ordinaries Index, nevertheless it’s worth a look as it provides some insight as to what is hot. Fortuitously we owned four of top twenty performers over the past year – Dominos Pizzas, TPG Telecommunications, GUD and Retail Food Group – in our smaller companies fund, although we exited TPG (due to mandate restrictions) as it entered the top 100 and we sold Dominos way too early after some meteoric gains which have since continued. In terms of themes, there were a number of turnarounds with API, CSG, Nufarm, Codan and Transfield on the list - perhaps that’s a way to make money in small caps. And there were a number of perceived growth stocks that delivered stratospheric gains including Altium, Corporate Travel and Magellan Group. Surprisingly there were two gold stocks in the top twenty performers being St Barbara and Northern Star, illustrating our contention that companies in oversold sectors can provide opportunities, obviously gold was on the nose last year. In addition to TPG there were a couple of other telcos including M2 group and Chorus that delivered. Given the stellar performance of the top performing set of stocks – returns ranged from 50% to nearly 200%, we are happy to have outperformed the index over the past year, keeping in mind that we also reduced our underweight to resources during this period which at face value would have detracted from performance.
Moving on from index performance, we recently compiled a list of companies in the Small Ordinaries Index in the past year that were formally taken over. There were thirteen companies acquired with the surprising element being that ten were acquired by foreign companies. We are not sure what the long term trend is but that percentage feels unusually high. It would seem that global central bank money printing policies interspersed with a weakening Australian dollar are providing the impetus for expansion into Australia. We struggle a bit with activity in the industrial sectors given Australia’s relatively minor position in the world economic order, it’s difficult to envisage how much value some of these industrial assets will add to a large overseas player (perhaps desperate times call for desperate measures i.e. there is no growth in their home markets or perhaps it’s a holiday destination for senior management). Whereas five of the companies acquired were resource based, with the foreign predator potentially taking a longer term view on the commodity cycle. It may be there is more takeover activity in the resources space given depressed valuations. It might actually be a sensible counter cyclical strategy in that space, and a catalyst for the sector moving forward.
There are some relatively attractive investment opportunities in the small cap end of the market. We continue to add to positions where we think the companies are underappreciated, hence undervalued relative to our mid-cycle valuations, whilst providing some latitude for our better performers to run despite being priced at premiums to our valuations, we do have a tendency to sell early. Several of these companies are well managed and have enduring franchises that are difficult to replicate. Longer term these businesses will do reasonably well, although we would prefer to buy them more cheaply, albeit we are also mindful of the frictional costs of exiting and re-entering which can be prohibitive. Swapping out winners for losers is not always a wise course, unless the relative valuation differential is large and the underlying business quality differential narrow.
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