The reckless pursuit of gratification
Unsurprisingly the successful after market performance of early IPO’s including Ozforex, Steadfast and Virtus Health has kick-started a frenetic period of private to public listings in the smaller cap market. The magic elixir of leverage, easy money and high multiples has provided a narrow window for owners to make off like bandits. Quality of listings is generally deteriorating with reconstituted wrecks slapped together with chewing gum and string, paraded as new shiny vehicles with a splash of new car smell to disguise the underlying lemon. Pro-forma three year historics with hockey stick like prospectus earnings forecasts are the norm. Investors so overwhelmed after a long drought of new listings and a declining universe, that anything half-baked is finding a home as long as it’s not mining services related. Those days are over; it is the new era of anything but mining services. How the tide has turned. However, like that era, the end game is eerily similar, a transfer of wealth from the everyday worker’s super fund to the minority, primarily private equiteers and bankers with a smattering of entrepreneurs prospering from simple roll-up strategies underpinned by central banks eagerness to print unlimited supplies of funny money.
Amongst the throng of clamouring masses we stand railing against the madness, the ill-discipline and, the greed. Instead, focussing on the facts, reading prospectuses particularly the risk section (yes there is one) and assessing businesses on their merits. There is no obligation for us to participate and we are willing to skip a listing we think has merit but is not appropriately priced. We think discipline during this stage of the cycle will hold us in good stead. We suspect that many of these listings will be underwater in the not too distant future and perversely will have produced financials of greater substance (undoubtedly doused in red) providing a second round opportunity. The intense focus on ‘shiny and new’ has created a vacuum of demand in the existing universe, a clear manifestation being a 5% decline in the small ordinaries index. As opportunists we are finding emerging value in some of the tried and tested businesses. Whilst not without warts (they never are) these businesses have real track records, produce strong cash flow, generate decent returns and have sound balance sheets, and yet are trading at discounts to the ‘shiny and new’. We suspect at some point the pendulum will swing back in favour of the ‘dull and old’.
Our bearish view on engineering and mining service companies played out in a brutal manner during November with two companies suspended from trading for big chunks of the month due to problem contracts necessitating emergency capital raisings. Whilst one raised equity, the other is now surviving at the benevolence of its bankers. It appears inconceivable that the latter will win new business given reputational damage and its dire financial position. Further problem contracts will be the death knell – those speculating on a recovery in the business appear misguided. Given the extent of shareholder wealth destruction and the suddenness that balance sheets have shifted from net cash to net debt, we assumed a high degree of caution would materialise in a deeper selloff amongst the peer group. This has not been the case. The sector broadly appears protected by an invisible force field. The three things to be learned from recent shenanigans are:
- Avoid buying companies in this space that feel it necessary to announce regular contract wins. These companies are clearly self-centred share price promoters that have little concept of risk.
- Free cash flow is king in this sector. If companies are not converting earnings to operating cash flow or plough operating cash flow back into the balance sheet through the capex line then at some point something’s going to give.
- These companies cannot carry much debt, if any, given bonding requirements and inherent risk in fixed price contracts. Sadly, many of these companies are not just moderately geared; they are geared to the proverbial eyeballs.
Undoubtedly, the dominoes will continue to topple in the mining service and engineering sectors. Unfortunately, the better managed companies will be dragged into the vortex as the market re-assesses the intrinsic risk in this opaque space. For now complacency reigns, we suspect in part due to growth of passive investment funds and the rise of quantitative funds that generally rely on unreliable consensus expectations (analysts tend to punch in management guidance as forecasts particularly if they have ‘sell recommendation’ as a profit downgrade essentially vindicates their call). Invariably, avoiding this space will see active small cap investors once again outperform the index just as systemically underweighting small resources proved successful in the last few years. How illogical is the efficient market hypothesis.
The reckless pursuit of short term gratification pervading the market scares us. We feel a subdued period or a downturn in the small cap space is a strong possibility as cash has been siphoned from the system. We have rotated out of stocks where extreme valuations more than reflect the perception of quality, into companies that we believe are relatively durable and defensive. We might be early, but a contrarian approach generally yields better returns in the long term.
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