Matthew Booker, Senior Portfolio Manager, Australian Smaller Companies argues it is imperfection that germinates opportunity.
In the movie “The Last Samurai”, Katsumoto sought the perfect cherry blossom. It was only at his dying, as he looked up at the cherry blossoms above him that he said, “Perfect. They are all perfect.”
It’s not our job to find the perfect business in the perfect industry and injudiciously pay the perfect price. It is imperfection that germinates opportunity. In most circumstances this means we buy in the face of conventional wisdom and for the most part in times of uncertainty and fear. This can result in bouts of short to medium term underperformance in the portfolio as investment decisions are typically unfashionable, however in theory should generate a superior outcome over the long term for our clients.
For this reason we have been tilting the portfolio in recent periods to sectors and therein companies where we see pockets of mispricing, where vagaries of human emotion are overriding logic and value. For example we recently initiated a material position in Monadelphous (MND) - an engineering and construction company servicing the mining and energy sectors. Clearly this is a counter-cyclical play due to the negative sentiment in the mining sector, and in particular oil and gas capex declining from unsustainable levels. There is an expectation that MND will be collateral damage due to its perceived reliance on construction, however, we note the industry is morphing from construction to an operating phase. Its main competitors in the latter field being UGL and Transfield, now called Broadspectrum (BSR) are struggling under the burden of heavy indebtedness and legacy contracts afflicting cash flow generation, the lifeblood of a contracting business. MND on the other hand generates strong cash flow (always has) and is regarded as having the best risk management practices in the space. Competitor issues could be a boon for MND with potential for it to take considerable market share if there are any missteps. The increased skew of earnings to operations and maintenance we think provides a more sustainable and lower risk earnings profile that has greater intrinsic value than in its previous cyclical construction led earnings. MND is without question the best managed company in the sector and its healthy balance sheet accords it a significant competitive advantage that is unappreciated. In recent periods we have benefited from owning against the grain positions in SMX Technologies, Pacific Brands, Reject Shop, Regis Resources and Webjet. We are hoping that MND follows in a similar vein, albeit we risk being early given the machinations currently driving sharemarkets i.e. momentum.
With AGM season now mostly behind us - we saw a number of profit downgrades, deferrals and some surprising upgrades. The deferrals historically turning into whopping downgrades in the 2H.
The two most notable downgrades being former market darlings – Dick Smith (DSH) and Capitol Health (CAJ) in the small cap universe. The Dick Smith story we failed to understand from the outset and being simple people if we don’t understand something we don’t buy it. I remember shopping at the flagship DSH store at North Ryde in the 1980’s - it had the largest Australian flag on record for many years and it was ahead of its time. However somewhere along the way, probably after Aussie Dick sold it to Woolworths, it lost its mojo and became an also-ran behind JB HiFi’s emergence and now thorough domination of the sector. Having a large store network doesn’t necessarily equate to success, and could be the millstone around DSH’s neck in the future as negative operating leverage bites and the cost of exiting onerous leases is borne by fourth generation shareholders. No better examples of this than Myer recently and Billabong before that. It looks like the only winners from this debacle are Aussie Dick (many moons ago), private equity and senior management who crystallised gains on listing and subsequent share sales.
For CAJ shareholders the large profit downgrade is worrisome as the rationale beggars belief with the company indicating that doctors are providing less referrals for diagnostic imaging due to regulatory uncertainty given recently announced Government review into the Medicare Benefits Schedule. Usually earnings downgrades occur after November 2015 funding cuts are implemented not before. We suspect there might be broader issues at play for CAJ. It has been a serial acquirer in recent years which all things considered probably increases its risk profile. It’s also very possible the halcyon days for the diagnostic imaging sector are past given significant consolidation has transpired and recent rebirthing of assets on the sharemarket. The industry has shown cyclicality in the past with DCA group’s (DVC) woes in 2006 being an example of what can go wrong with these kinds of businesses.
On the deferrals side, we saw Godfrey’s (GFY) and GWA Group (GWA) state that first half earnings would be weaker than expected. Unfortunately only the minority will deliver on the old second half skew to earnings. Management teams are naturally overtly positively disposed, intrinsic to their core belief system and probably a significant reason for their success to date. Others in the second half club include GBST and Nearmap. Of these companies, we own GFY however it is a minor position and valuation multiples are muted (5x EBIT). We believe its balance sheet is strong enough to weather operating pressures and the risk from significant lease exposures.
Surprising upgrades included old media company Southern Cross Media (SXL) and APN Outdoor (APO). It wasn’t long ago that outdoor media was viewed as the ugly duckling of the media sector. It was death by a thousand cuts owning Eyecorp (part of TEN group) with cyclical revenues driving earnings volatility (generally down) and landlords dialling down returns on contract renewals. With the implementation of MOVE (audience measurement system) a few years ago, digitisation of billboards and the perceived fragmentation of eyeballs it would appear the sector has undergone a renaissance which is expected to be structural in nature with multiples now extrapolating the good times. On the other hand SXL is heavily exposed to Radio which like its outdoor comrade was expected to die an ugly death. So far not so with the radio market growing strongly in recent periods, and delivering double digit growth in the September quarter. At this point the market is disbelieving of this medium with SXL and APN who are heavily exposed to radio, trading at inferior multiples to their outdoor peers.
With AGM season ongoing, we would expect further profit updates to drive share prices. It would seem anything with a positive read is quickly re-rated, and anything negative quickly dealt with the other way. The more crowded the trade the more reactive the share price has seemingly been. Anything that is under-owned is exhibiting only moderate movements.
We remain cautious on the outlook for the market given the macroeconomic backdrop is unconvincing. Putting that aside we are finding decent opportunities from a valuation perspective amongst companies that are unpopular due more to perception than reality. Most of these companies like the aforementioned MND have strong balance sheets and a history of strong free cash flow generation that provides a lot of comfort they will be around in the long term. The optimal situation for us is when these companies have pragmatic management teams that you know are working hard for positive outcomes for their shareholder constituents. We remain wary of many of the market darling companies that are seemingly reliant on positive news flow to continue their share price success. Many of these companies have turned to acquisitions to drive share prices. This presents risks from a number of perspectives 1) they are nearly always ROIC dilutive and 2) they generally use debt to fund them. History suggests bearish outcomes in the long term for companies employing these tactics. Value driven managers end up picking over the pieces after the catastrophe.
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