November 2017 | Market Commentary
“Serious investing consists of buying things because the price is attractive relative to intrinsic value. Speculation, on the other hand, occurs when people buy something without any consideration of its underlying value or the appropriateness of its price, solely because they think others will pay more for it in the future.“ Howard Marks (Oaktree Capital)
Overview
The Spheria Australian Opportunities Fund was up in November while the S&P/ASX Mid – Small Accumulation Index rose. We are unequivocally – in our view – in the latter stages of a bull market. You have to look no further than the meteoric rise in Bitcoin to get some sense of the use of speculative instruments. Whilst it is entirely possible that Bitcoin is the instrument of some new fiscal reality our strong suspicion is to the contrary. If the level of knowledge displayed by the investors we’ve met rushing into Bitcoin of late is anything to go by our slightly cynical views are likely to be vindicated. The small cap market is typically where the crossroads of entrepreneurialism and capitalism meet. It is where companies seeking capital to expand their business list and almost all of the M&A activity occurs. As a result there are a relatively large number of newer style business models many of whom have now well and truly joined what we have dubbed the “400 and 0 club” – $400m of market capitalisation and $0 of earnings.
It is little wonder that people have embraced these type of investments – many have been truly stellar performers in share price terms but truly woeful performers in terms of fundamentals. A lot of these highly rated newer business models do have high revenue growth rates but typically off infinitesimally small bases. Whilst investors in Australia look longingly at the Googles, Facebooks and the rest of the canines (commonly referred to as FAANG’s) it is drawing a very long bow to assume that everything in Fintech in Australia is likely to become a disruptor and therefore worth $400m in value when it earns nothing in cashflow or earnings. You have to look no further than 1page (ASX: 1PG) which peaked at over $700m of market cap in August of 2015 and yet generated just $400,000 of revenue on a cost base of over $19m in FY 2016 to see proof of this misplaced exuberance in action (there is 26m cash in business after raising money at top – suspension reflects sale of US business). 1page is now in suspension and any investor who clamoured over themselves to buy shares at their peak at $5.44 has lost almost all of their money. The only disruption occurring there was to their bank account!
We are prepared to buy innovative and disruptive investments for clients as long as the fundamentals or likely fundamentals back up the investment case. In other words, as long as the cash flows or highly prospective cash flows can support an argument for the investment. The other driving theme in small caps lately has been the M&A cycle. The combination of cheap capital and high levels of corporate confidence has been a heady mix. To justify the M&A activity management teams will often refer to a deal being “eps accretive”. We can’t think of a less useful metric to assess an acquisition and feel the term should be permanently banished from the investment lexicon. All that “eps accretion” means is that the returns on the acquisition exceed the cost of funds (typically debt costs) used to acquire the acquisition target. We think a better metric should be whether the deal is value accretive (in NPV terms) over the medium term not whether something covers the cost of debt funding in the first year. It could in fact be argued that in many cases cheap and available acquisitions are likely to be value dilutive over the longer term despite being “eps accretive” in the first year – after all how often are quality assets available at low multiples in a low interest rate environment?
Key Drivers
The Microcap and Smaller Companies fund benefitted from corporate activity during the month with Reckon Ltd (+28%) (RKN.AX) receiving a bid for its practice management accounting software division from MYOB (MYO.AX) and AWE (+31%) (AWE.AX) receiving an indicative proposal from China Energy Reserve (CERCG) at 71c. Likewise, The Opportunities fund benefitted from some recovery in the share price of Isentia (+28%) (ISD.AX) and strong performance from Monadelphous (+10%) and Reece (+8%) during the month. We continue to believe takeover activity will remain a strong theme as we are in the later stages of the market’s bull run. Globally M&A is also back at levels not seen since 2007 (at around US$5T) with each of the last 3 years exceeding the 2007 former peak. Australia has also seen a sharp rise in M&A activity although the deal tally has not surpassed its 2007 peak yet.
On the negative side of the ledger Class Software (CL1.AX) (-9%) detracted from performance as noise from their key competitor around market share spooked investors. We remain of the view that Class offers accountants a superior product based on numerous channel checks during a recent round of marketing we undertook.
In Summary
As we have stated in previous commentaries we believe the market is now in a highly speculative phase. This means investors are overly risk prone and are chasing ‘investment themes’ and investment stories without undertaking the usual amount of due diligence or fundamental analysis before investing. We know that in these type of markets it is even more important to adhere to our long held views that cash flows and valuations remain key to longer term investment success.