Insufficient Capital September Update

Posted On September 30, 2019

At the end of the September quarter, the fund was most heavily weighted to our ‘Net Cash Miners’ strategy:

The portfolio rose +9.25% over the quarter, strongly outperforming the ASX300 performance of +1.24% by +8.01%. We were very pleased to record outperformance over each month, most notably in August – a great start to FY2020. The top contributor during September was Afterpay (APT:ASX), while the largest detractor was Acrow Formwork (ACF:ASX).

Despite our tilt to value opportunities, most of our portfolio appreciation has recently been caused by growth investments (the majority fall under the ‘Structural Tailwinds’ strategy). We believe this has been caused by a momentum-loving, growth-hungry domestic equities environment, which seems ever more willing to disregard valuation for hockey-stick growth. In fact, Australian stocks with EPS growth greater than 20%/annum trade at double the valuation multiples of similar stocks listed overseas. We are confident that our value investments will have their time in the sun again (especially if economic conditions deteriorate).

At quarter end, the fund held 23% cash. The fund held an average cash position >25% during the quarter. This cash position greatly reduced our volatility and leaves further room for capital deployment. As we reiterated in our August newsletter, the fund generally refrains from holding large cash reserves (See Ground Rule #10) but we believe current market and economic conditions present a challenging environment to achieve our desired return target (See Ground Rule #12) without taking on excessive risk. 

During September, we initiated a small position in online sports betting company, Pointsbet (PBH:ASX). Pointsbet offers an innovative betting format known as “Spread Betting”, where winnings/losses are not fixed, instead depending on the accuracy of your bet (e.g. the bettor will win more if their team wins by a larger margin). Pointsbet recently entered the US market, starting with New Jersey, where recent sports betting legislation provides structural tailwinds to the industry. Google search traffic for Pointsbet in the US has more than doubled from August to September, while revenue is tracking at >240% YOY.

Similar to Afterpay and other Australian companies enjoying US tailwinds, Pointsbet is clearly gaining traction with American consumers and will be able to achieve strong lifetime value in future (let’s ignore the bottom line for now!). Pleasingly, our investment has already appreciated substantially and we look forward to further positive catalysts throughout FY2020 as Pointsbet continues its expansion into other US states (starting with Illinois, Indiana, Iowa and West Virginia). With 42 states having legalised, or intending to legalise sports betting, we anticipate a massive market prime for Pointsbet to exploit. We will discuss Pointsbet in depth in a future newsletter.

Rather than presenting a single stock idea, this newsletter will focus on a broader investment strategy – Buying Listed Investment Companies (LICs) at a Discount to Net Tangible Assets (NTA). Our management team regularly attends fund presentations as part of our internal research. Some of these funds are traded publicly (often as LICs) while others are private. It has become clear that some LICs are mispriced due to a few factors. After establishing the factors behind their discounts to NTA, this letter will set out the buy case for heavily discounted LICs using the example of a LIC we have previously owned and continue to find attractive.

Listed Investment Companies are closed-end public investment vehicles. Since they raise capital at IPO and investors buy/sell shares to each other, capital is permanent, removing the risk of redemptions. Further details on LICs can be found here. The largest LICs in Australia include Australian Foundation Investment Company (AFI:ASX), Argo Investments (ARG:ASX), Milton Corporation (MLT:ASX), Magellan Global Trust (MGG:ASX) and WAM Capital (WAM:ASX). 

Buy High Sell Low? Hmmm

LICs have the extra consideration of premia and discounts to NTA. For example, if a LIC raises $100M at $1/share (NTA/share) but is trading at <$1/share, the LIC is at a discount to its NTA (i.e. if its investments were liquidated and distributed to shareholders, shareholders would realise an immediate gain); when the LIC is trading at >$1/share, the LIC is at a premium to its NTA. 

Investor psychoanalysis reveals that most investors do the exact opposite of the famous adage, “Buy Low Sell High”. A very reliable cycle of emotions has dominated financial markets since the first pieces of stock paper were flying around in 16th Century England. This cycle of emotions has remained predictable ever since: Greed, Fear, Greed, Fear. There would be a lot less money to be made in markets if all investors adhered to Warren Buffet’s perhaps most famous adage: “Be fearful when others are greedy and greedy when others are fearful”. 

When investors in a LIC panic and fear poor future performance (of either the market, the LIC, or both), they exit their positions, potentially pushing the price of the LIC below NTA/share. We find this particularly astounding when LICs have large cash weightings in their portfolio. Imagine if the bank valued your savings account at 80c in the dollar! A fund manager (whose presentation we recently attended) said that no matter what, “People will always sell at a discount and buy at a premium (to NTA)”.

Current Investor Confidence

It is hard to read a financial paper without facing another article about Australia’s imminent recession. It is also becoming increasingly normal to wake up to >2% movements in US markets. Such pessimism and volatility contribute to capital outflow from LICs into lower risk investments (e.g. passive index funds, term deposits).

Investors also have increasingly distrusted expensive actively managed funds over low-cost passive index funds. With increased competition between passive funds and active managers, the days of a 2 and 20 fee structure (2% management fee and 20% performance fee) appear numbered. The underperformance (which is obviously not helped by high fees eroding gross performance) of active managers is more concerning. 

Since the GFC, a whopping 85.1% of actively managed funds have underperformed the S&P500 while 91.6% have underperformed over a 15 year period. There is no doubt that such widespread underperformance has contributed to discounts across the entire actively managed LIC space (even if all LICs cannot be painted with the same broad scathing brush). It has been difficult to outperform in the US without owning the famed FAANG stocks (Facebook, Apple, Amazon, Netflix and Google). They have now collectively grown to represent 35.3% of the Nasdaq100. Australia shares similarities with the WAAAX stocks (Wisetech, Afterpay, Appen, Altium and Xero), although these firms do not represent a large proportion of the index.

In 2008, Warren Buffett (our not so secret crush), made a $1M bet with fund-of-funds, Protege Partners, that an equally weighted group of 5 actively managed funds hand-picked by Protege would underperform the S&P500 (VFIAX – a 0.04% cost index fund tracking the S&P500) over a 10 year period due to the fees, costs and expenses associated with active management. 

By 2015, Protege co-founder, Tim Seides, acknowledged two years before the scheduled end date of the bet that “for all intents and purposes, the game is over. I lost.” By 2016, the index fund had returned 85.4% while the 5 funds had returned a comparatively dismal 22%. The result – Buffet’s chosen charity, Girls Incorporated of Omaha, had an extra $1M… and a crushing defeat for actively managed funds:

Underperformance >> devaluation of management expertise >> magnified discount to NTA

Liquidity & Risk Discounts

Some LICs (particularly those with <$100M of AUM) have little to no daily volume for extended periods. Such LICs should be discounted by at least the average buy/sell spread. If you have to take a 5% haircut just to exit a position, such illiquidity should be priced in

There are also quite a few of what we like to call, ‘YOLO (You Only Live Once) Opportunities’, out there. These funds take on excessive risk, sometimes even using internal leverage, or speculating on opportunistic mining explorers. Their discounts are justified. As an aside, some of these ‘YOLO Opportunities’ LICs have quite amusing names (perhaps inspiring our very own ‘Insufficient Capital’). Our personal favourite is “Fat Prophets Global Contrarian Fund” (ASX:FPC – Yes, it is real) – its discount, a whopping -24%. Buying high beta is all fun and games when the market is rising… until the market isn’t.

The Buy Case

If a LIC aligns with an investor’s personal strategy, sells at a discount, has reasonable fees and a reliable track record of creating investor value, it could definitely serve a place in a portfolio. If purchased, investors need to stay on top of the LIC’s major portfolio positions and its discount to NTA over time.

One of the greatest risks after purchasing a LIC is that an investor will become complacent and fail to update their research as the portfolio changes over time. Unlike an individual business, the thesis for a LIC must be updated regularly (usually on a monthly basis). We would never hold a LIC that trades at a premium to NTA.

Cadence Capital 

One of the LICs we have previously owned is Cadence Capital (ASX:CDM). Over the last 14 years (since inception), CDM has returned +11.7%/annum after fees and including dividend franking credits (outperforming the All Ords by +3.1%/annum). This is a cumulative return of +355.6% vs +211.5% (as at June 30).  We have kept on top of their portfolio ever since our investment and share the value-driven strategy of the portfolio manager, Karl Siegling. We even share some past and present positions: Stanmore Coal, Bingo Industries, Shine Corporate, Select Harvests, Westpac Banking Corporation, Telstra Corporation

Cadence currently trades at a very high 22.7% discount to NTA post tax obligations. This is particularly astounding considering the LIC’s 32.6% cash weighting (as at 30 September)… So CDM’s riskless cash at bank is being discounted to less than 80c in the dollar. Just to put that in perspective – if we buy CDM, which has around 2% of its assets in Stanmore Coal (our own largest holding), we are effectively paying 87.3c (22.7% less than the current market price of $1.13/share) for the Stanmore stock. This would be a PE ratio of 2.4X and a dividend yield of 14.9%. Or we could buy it in the market at 4X and 11.5% (both are cheap nonetheless).

The market is clearly expecting Cadence’s significant cash weighting to be allocated terribly. Looking at Cadence’s FY2019 performance, it is easy to be forgiven for this belief. Cadence’s net performance was -20.5% during FY2019, while the All Ordinaries appreciated +12.5%. The largest detractors included: ARQ Group, Emeco Holdings, Navigator Global Investments, Shine Corporate and Teva Pharmaceutical. Most notably, ARQ (formerly known as Melbourne IT) collapsed around 90% from its peak in December 2017 to now representing only 2.4% of the fund. Siegling has gone onto the board of ARQ in an attempt to steer the ship. We strongly believe that he is doing everything in his power to recover value for all ARQ shareholders.

At the annual roadshow, it was clear that Cadence’s board is desperately trying to close the discount to NTA. The LIC has undertaken a buyback of approximately 10% of its stock, immediately accreting value to shareholders. Additionally, the portfolio manager is buying stock almost daily and reinvesting dividends. 

Until October 2018, Cadence had traded at a premium during the vast majority of the past 5 years. The LIC even reached a 20% premium in 2016. In the depths of the GFC, it reached a 40% discount. We believe that only another recessionary period could warrant such an extreme valuation dislocation.

We are particularly attracted to Cadence’s positions in Macquarie Group (4.9% of the LIC’s assets), Resimac Group (4.1%), Rio Tinto (1.9%), Stanmore Coal (1.8%) and BHP (1.6%). That’s not to say our team is attracted to all of Cadence’s positions, with a handful raising concerns. Nonetheless, we continue to evaluate Cadence’s portfolio and would not be surprised if it became a future position of ours. Ideally, we would first like to see the deployment of some of its large cash position.

Quip of the Month

“The time to buy is when there’s blood in the streets” – Baron Rothschild

Rothschild made a fortune in the panic that followed England’s victory at the Battle of Waterloo against Napoleon. Using a network of agents across Europe, Rothschild learnt of Wellington’s victory on June 18 1815, before other investors. He heavily sold British stocks and pound sterling, with the other investors following suit, effectively creating an environment of spilt blood. Later that day, Rothschild bought all of it back before the news emerged publicly and the market surged. This sequence of events is also said to be the source of the maxim, “Buy on the sound of cannons, sell on the sound of trumpets.”

Buying a discounted LIC is a contrarian investment, epitomising the notion of investing after ‘blood’ (losses) has been shed. Another great example of contrarian investing would be the purchase of Bingo Industries (ASX:BIN) on 18 February 2019 (the stock’s all time low) when concerns regarding stagnating growth for the waste management giant were echoing throughout Sydney’s Martin Place. Despite this, some contrarian investors recognised a sound underlying business facing short term headwinds. They realised a >100% return in 4 months.

If subscribers would like further details on our activities, we are always happy to discuss portfolio positions.

Kind Regards,
Insufficient Capital