August 2017 | Market Commentary

Overview

As usual, company profit announcements dominated headlines in August causing significant volatility in share prices. It was typically a mixed bag although there were some high profile misses, particularly in the mid-sized market with Domino’s and Bluescope underwhelming lofty expectations.

A quick scan of the S&P/ASX Small Ordinaries Accumulation Index for August illustrates the disappointments with Mayne Pharma (MYX.ASX), GBST (GBT.ASX) and CSG (CSV.ASX) share prices all falling by between 30% and 43% during the month. The Fund did not own these companies.

Our process precludes us from owning MYX and CSV due to their poor cash flow generation when including capitalised costs and expenditures. GBT on the other hand generates solid free cash flow and expenses all its technology R&D. The issue with GBT being underinvestment in their wealth management system under former management team. The rectification of which is budgeted to cost $50m over three years, which is significant spend relative to a market capitalisation of only $130m. On the positive side, the best performers in the Benchmark were Blackmores (BKL.ASX), Highfield Resources (HFR.ASX) and Starpharma (SPL.ASX), which rallied between 27% and 37% during the month

Blackmores Limited (ASX:BKKL)

We have been a long term investor in BKL, although the position until recently was small in context of the Fund. Pre-reporting, we elected to increase our weighting as we believed risk was skewed to the upside. Our view is the company is significantly “under-earning” versus its scale and relative to its peer group. For example, in FY14 it generated $350m of sales and an EBITA margin of 11%. In FY17, it doubled sales to $700m and yet the EBITA margin increased only slightly to 12%. The company therefore exhibited nearly zero benefit from its significant increase in scale.

BWX which owns the ‘Sukin’ skincare brand and has similar channels to market highlights the issue. In FY17, BWX had $72m of sales and an EBITA margin of 35%. Even Goodman Fielder in its second tenure as a listed company averaged EBITA margins of 13%. Whilst comparing BKL to BWX is probably unfair as it likely BWX is “over-earning”, it’s abundantly clear that the truth should be somewhere in between for BKL. We are hopeful that the new CEO can find the right balance between investing or the long term and short to medium term returns for shareholders…. that deserve better. BKL was the largest contributor to Fund performance in August, followed by Adairs (ADH.ASX) and Class (CL1.ASX)

Adairs (ADH.ASX)

We have followed ADH since its listing in mid-2015 but only recently invested in the company with our average entry price below $1. It has rallied off a low base in July which continued into August after another positive sales and profit update, in addition to the one in July. We believe ADH has a solid formula and franchise that was tested by transient issues which the market mistook as structural. We still believe it is inexpensive based on our view of sustainable long term margins.

Class (CL1.ASX)

CL1, a long term holding for the Fund also performed well after another strong result. It continues to take market share in the SMSF space and its product is being evolved for use in the family trust space. It is possible this product develops well beyond expectation given its architecture appears well ahead of its legacy competitors in various verticals. Unlike other upstarts, CL1 generates significant profits and free cash flow that also limits downside risk.

Isentia (ISD.ASX)

Isentia (ISD.ASX) was the largest detractor in the Fund over the month with the share price falling just over 20% after a profit warning. It effectively retraced to our average entry price after a positive rebound in the previous month. Whilst disappointing we believe the outlook for ISD has substantially improved as its market share has stabilised, and its main competitor having lost some credibility and cost advantage given publicly announced legal action by ISD in regards to copyright.

In Summary

Overall, where nothing has fundamentally changed with a business we have looked to opportunistically build our position before and during reporting season. Fortuitously, market volatility has helped our cause. We have also added several new positions in recent months with one such being the aforementioned Adairs.