The lesson of the Hindenburg
Being a fund manager can be a humbling experience. You can do all the research, stick to your tried and tested investment process, only to be felled by the seemingly innocuous. Aah such is life too. The Hindenburg disaster of 1937 is an event that has always resonated with me. For those who have never heard the story, the Hindenburg was a large passenger airship flying the transatlantic route that suffered a catastrophic accident, shattering confidence in this mode of transport and marking the end of the airship era. Back then, you either travelled by sea or airship. The airships were quicker and statistically safer, making them the preferred passenger carrier, particularly for the wealthy. Whilst there are a number of hypotheses as to what caused the crash, the one certainty was the use of hydrogen as the lifting gas versus helium as it was initially designed, contributed to the severity of the crash. Helium is not flammable whilst hydrogen is highly combustible. Unfortunately, helium was relatively expensive at the time being the by-product of natural gas reserves in the United States, whereas hydrogen was produced cheaply. The large quantity of helium required for the Hindenburg would have been incredibly costly and given the depressed economic environment the Hindenburg was switched to hydrogen – essentially it became a flying bomb. Anyway the moral of the story here is that our mantra of avoiding losers (rather than picking winners) is appealing given the high dispersion of returns exhibited by index constituents, invariably though companies we believe are essentially safe (full of inert helium) can on the rare occasion be chock full of combustible hydrogen. We found this out in October when one of our smaller positions, a mining contractor (“Oh the humanity!”) suffered a similar fate to the Hindenburg. Given we are unlikely to eliminate all extreme events our aim is to minimise their potential impact by running a diversified portfolio. One lesson re-etched into our investment psyche is that in the contracting sector you are only one poorly structured contract away from a “Hindenburg”.
When snake oil salesmen are abundant our best advice is … ‘en garde’. There is no better example of this than the Vocational Education and Training (VET) sector, where we saw a number of IPO’s in the past year. Victoria and South Australia led the way by opening the previous inefficient TAFE based system to competition, allowing fledgling operators to absolutely mint it over the past few years. With other states set to follow, it seemed like the VET sector was about to print money across the country. It was a big picture, easy sell story for the vendors and the spruikers (and there definitely was substance). However, delineating between the quality operators and those simply taking advantage of the system was a difficult exercise. Alarmingly, many of the businesses vended to the market had no more than three years earnings history and most were cobbled together immediately prior to listing (some even contingent on the raising) so as to attract enough market capitalisation to be meaningful to the investment community. The lack of track record and potential abuse of government funding were red flags to us. The fallout from Vocation Ltd’s recent travails (share price down 62% in October) will ultimately lead to greater scrutiny of the industry, with government agencies now acutely aware of some of the less desirable activities. For example, I thought channelling was a ‘divine art’ but in the VET industry it refers to signing up students to qualifications they don’t necessarily require, with majority of it funded by the government. Unfortunately, the legitimate providers in this space are likely to be dragged into this mess and might actually present some investment opportunity, although we suspect there is a lot more water to flow under the bridge. Our tendency to invest against the grain generally leads us to buy early however engaging a modicum of restraint is probably a wise course of action. Much of the market has apparently been caught up in the hype meaning that the list of marginal buyers for these stocks is potentially, to quote Monty Python’s Mr Creosote, ‘wafer thin’. As noted in previous commentaries, the chasm in ratings between the ‘haves’ and ‘have nots’ is widening such that we can spend more time on companies that have a verifiable history and are cheap versus investigating companies that have ‘six month half-lives’.
A concerning trend that may mark the beginning of the end for this bull market is the numerous public to private deals that are falling over. The trigger more recently apparently being a tightening of the Term Loan B (TLB) market in the US. These TLB’s don’t require regular balance sheet checks, have maturities up to 7 years and a bullet payment schedule with minimal amortisation and covenant lite structures, essentially junk bonds. Apart from being a favourite funding source for private equity led buyouts in recent years, they have been increasingly used by highly indebted listed companies to avoid dilutive capital raisings. Could it be the fabled canary in the coal mine? Perhaps, however the transmission effect from debt to equity markets and then to the real economy could be a lengthy process.
In the meantime, the sharp retracement in the S&P/ASX Small Ordinaries Index and global share markets that was evident from early September to mid-October seems to be yesterday’s story, with the index bouncing through to the end of the month. Interestingly, the industrial component of Small index rallied 5% from its lows (to the end of October) while the resources component has continued its descent. Commodity prices particularly oil, gold and iron ore have fallen precipitously without corresponding relief from the Australian dollar. There is near universal bearishness on the Chinese economy, apart from the Spanish CEO of Ferrovial, Mr Inigo Meiras, believing Australia will continue to benefit from the “Chinese boom”, then following this with an indicative and non-binding proposal to buy Transfield Services (TSE). Hopefully he is right. Otherwise, the Australian economy is in a spot of bother. With indiscriminate selling in the small miners and mining service space, one of our key criteria remains balance sheet strength such that the company has the ability to ride out a transient period of negative free cash flow, which seems increasingly likely at spot commodity prices and exchange rates.
There are some decent opportunities now appearing in the small end of the market, with several former glamour stocks retracing sharply in recent months. We have a tendency to buy early with the allure of value and a falling share price, usually too hard for us to ignore. In fact a number of these stocks are now close to our valuations after trading at significant premiums in the not too distant past. The bigger the discount the more we like them.
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