The odds change based on what's to bet
“The measure of intelligence is the ability to change” - Albert Einstein
The first quarter of the year started with a bang with the Small Ordinaries Accumulation Index (the Small Cap Index) up 7.68% in just 3 months. Most of the trends we spoke of over the past 12-18 months continued to manifest with earnings upgrades driving aggressive share price performance in an increasingly narrow band of industrial stocks. Small resources slightly lagged the industrials though not by a wide margin. Within the resources sector gold stocks performed well and oil stocks got sold off aggressively on the back of the continued reduction in the oil price. There’s nothing like price momentum to give you guidance on where to invest at the moment. We still hold dear the notion that, in the long run, the stock market more resembles a weighing machine than the voting machine does, in the shorter term. Little has changed in our view of the broader markets. Shares have become more expensive as their returns have far exceeded underlying earnings growth – a simple but effective parameter to measure intrinsic wealth creation. On the flipside, there will usually be good investments in any market whether the broader index is high or low, and we believe our clients have employed us to try to find these worthwhile opportunities.
A share investment comprises three things : 1) a company – these can be good or bad, 2) the management of the company – these too can be good or bad and have as one of their most important roles - the allocation of the company’s capital and 3) a stock price which purports to factor in the market’s view on (1) and (2). Whether a stock is a good or bad investment doesn’t always depend on the stock being a good business with a good management team, but rather on the total price you are being asked to pay for this in a free market. Charlie Munger referred to the stock market as being like the pari-mutuel wagering system; the odds change based on what’s to bet. As more money is invested in a stock, its PE ratio rises making it a more expensive relative investment (all else being equal) and a potentially less attractive investment return. As good businesses with sound management teams gain broader recognition, their share prices will rise to levels that don’t necessarily make them good investments at the higher levels. The reverse is also true subject to sensible risk parameters.
Small cap investing isn’t for the faint of heart. There is a greater breadth of stocks and greater breadth in potential outcomes than in larger cap stocks. Over the previous rolling 12 months for example, the return spread on the best and worst stocks in the small ordinaries index was to -92% to +491% compared to -65% to +189% for the ASX 100. With market capitalisations being smaller, values can also be more distorted by liquidity movements – money flows – than with their larger counterparts. Whilst this can cause what are politely termed “dislocations” in stock prices from underlying fundamentals, it is generally a safe bet that things like a lack of cashflows, and over geared balance sheets will come back to haunt. Exhibit A of this type of thing is the now famous ABC Learning a few years back or more recently Forge in the mining services space. Agreeing to build a power station for a lot less than it costs turns out to be a bad idea for a viable business. If you added "Pro Forma” earnings to the list you are starting to build a good check list of things to avoid. Exhibit B here is Vocation Limited (VET) which had cobbled together 3 disparate businesses and did not even integrate them when it floated. This is all leading to the point that in the current market, we are seeing a number of smaller cap companies with a dangerous lack of real cashflows trading at multiples not reflective of this. This is particularly the case in the legal services sector where WIP or Work in Progress changes absorb most of the underlying cash generation. This is all dandy when the market is prepared to pay for growth but the only way shareholders are going to see genuine cashflows is when the business ceases to grow or goes into run off – neither implying a good outcome for growth oriented investors who own these stocks currently.
I mentioned earlier that management teams can dramatically alter the fate of a company and assist with making it either a good or poor investment. This is even more so the case with smaller cap companies as capital allocation decisions can be significant relative to the size of the base business. Founding entrepreneurs are usually very passionate about their business, capital deployment and are active on this front. A good deal of their wealth is often tied up in their business in a very direct way not merely via potential “upside” in the form of performance rights or options but also on the downside since they have current capital invested in the business. This symmetry of risk is important as it helps us avoid the “traders’ dilemma” which fosters overly courageous bets in a heads I win, tails you lose type arrangement.
In the smaller companies space there have been a great number of success stories over the years where founders have grown their businesses to be great investments – MFG, DMP, CRZ, TNE, TPM, IIN and VOC are all good examples of this. We have benefitted greatly from this style of investment and continue to look for them. A case in point this month is the footwear franchise and brand importer RCG which is owned in both our small and micro-cap funds. RCG is acquiring the Accent group which owns several other footwear retailers and the brand rights to Dr Martens, Sketchers and Vans in Australia and New Zealand. Not only did RCG buy Accent at a significant discount to its current valuation, it should also gain the benefit of cost synergies, growth opportunities and add depth to its management talent. The allocation of capital also involves mental agility and a flexibility to adapt to market conditions. Growth via acquisitions or aggressive capital investment doesn’t always make the best sense for shareholders. For example, many management teams we speak to seem to have a constitutional aversion to share buybacks fretting that they will only further reduce liquidity in their shares and, heaven forbid, shrink their market cap. They also worry that this would somehow take away their strategic ability to make acquisitions. On this front, it is worth praising the team at Seven Group Holdings who have completed a 4% buyback over the previous 6 months only to reload with an additional buyback for up to 6% of the company. Deploying capital into a business when your share price is trading at a steep discount to tangible asset backing is tantamount to building a higher dam wall when you have leaks at the bottom – and about as effective at building shareholder wealth.
Further examples of management significantly influencing an investment outcome can be found in other service companies we own. In the microcap space we have been very fortunate to have owned the telco retailer Vita Group. Whilst telco retailing would normally be considered a difficult place to make returns, this stock has provided an outstanding outcome and returned close to 200% over the past 2 years. What is their secret sauce? They take care of their staff well, who in turn look after their customers which drives repeat purchases and customer loyalty. Vita invests heavily in their staff’s training and seeks to enhance their skills in leadership, selling and customer service. It sounds simple but they clearly execute on this effective strategy exceptionally well.
Investing is an unusual process of iteration, comparison and creative thinking – not necessarily in that order. In spite of our views on market levels we have been able to find ways of investing capital that match our criteria which seeks to find good businesses with sustainable ROIC trading at reasonable discounts to assessed value. Our funds have also been the beneficiaries of a high proportion of corporate activity which we suggested would be a driving theme in a low rate, low growth, high corporate confidence environment. These trends seem likely to continue and we will continue to pick stocks that also match our need for cashflow generation in case markets enter a period of rougher waters.
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