Looking for nirvana
For those lacking a long term investment horizon, recent market volatility is probably a frightening experience given the relative calm since the GFC – has it really been 8 years? With momentum trades under pressure, valuation is becoming of greater importance as is the sustainability of cash flows and balance sheet strength. Given this bent, our portfolio has held up reasonably well and we are now finding increased opportunity to add to positions or find value in companies that have been discarded by the market due to a lack of positive momentum. For those looking for short term gratification, the markets are without a doubt a much more treacherous proposition. It would seem the days of buying companies at high multiples and hoping someone else then pays a higher multiple than you are now behind us.
During results season we witnessed little appetite for companies that were overhyped and could not deliver a quality result in terms of earnings and cash flows. Management platitudes of 2H improvement were blithely ignored particularly when valuation multiples were high or balance sheets stressed. The complacency of past results periods has been replaced by palpable nervousness. This generally happens when valuations are hyper stretched and impatient money abounds.
With a diversified portfolio of 50 or more companies, you are going to have something sour. Whilst we try to invest for the long term there are situations where the facts change and we need to determine swiftly whether the situation is structural or transient in nature. If transient it’s fine, but if structural and the risks outweigh the reward, it’s generally wise to make a change even it if means selling at a loss. One such company in the portfolio was Programmed Maintenance. We believe it definitively overpaid for Skilled Engineering last year, with working capital normalisation contributing to a blow out in the combined entities debt levels that was publicly revealed in a February trading update. Whilst in the long term the combination is logical, there is little margin for error in the short term given economic headwinds, heavy working capital requirements and the group’s aforementioned indebtedness. On the positive side, the CEO has an excellent track record of delivering cash backed earnings and was able to work Programmed out of an eerily similar situation after its merger with Integrated in 2007; quite ironically to the point where it was nearly debt free prior to the merger with Skilled. We will revisit the story down the track but for now are happy to watch from the sidelines despite it being fundamentally cheap.
The feeling amongst our team is that many of the acquisitions made during the recent bull market will meet an ugly end for the acquirers. Buying companies on single or modest double digit returns with debt is accretive to earnings per share but provides little margin for error if there is even minor earnings degradation. Recent examples where such acquisitions have gone pear shaped in the Small Ordinaries Index include Slater & Gordon, Cardno, Capitol Health, Bradken, Hills, Independence Group and of course Programmed Maintenance. In some cases the shareholder wealth destruction has been enormous. The next generation of serial acquirers (aka rollups) were en vogue going into result season. Most of them got the wobbles given lofty expectations. It will be interesting to see whether this is the start of the rot or an aberration, our inclination is clearly the former. There is a plethora of companies in the Small Ordinaries Index that have made significant acquisitions or many acquisitions that are significant to their valuation. The notable market favourites include Automotive Holdings, Bursons, Corporate Travel, Flexigroup, GUD, Spruson and Ferguson, Retail Cube, Vocus, Virtus and Webjet. Of these companies the portfolio has holdings in Webjet and Vocus, and therefore we clearly need to be vigilant on the potential risks facing these companies rather than riding them blindly in the good time and selling them in the bad times when they are washed out.
Not much has changed. We continue to invest in companies that we believe have long term franchise value which are unappreciated by the market. We are attracted to companies that generate strong free cash flow and have little debt. For a variety of reasons many of the companies we have taken significant positions in including Sigma, Western Areas, Cabcharge and Monadelphous are completely out of favour providing us with attractive entry points. We believe these companies could well prove to be the next Pacific Brands, Ridley’s, Reject Shop and Blackmores – companies that we bought when they were desperately out of favour that have subsequently significantly upgraded earnings and been strongly re-rated. This compound effect is nirvana for value based managers.
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