Purchase #6: NGE Capital Ltd

Purchase #6: NGE Capital Ltd

Recently I made the 6th purchase for the 10foot portfolio, a small LIC known as NGE Capital Ltd (ASX: NGE), formerly New Guinea Energy.

It’s ultra-concentrated, with a market capitalisation of $18 million, and lead by an experienced manager with a solid track record. I’ve never owned an LIC of this style before, so I’m breaking new ground here. Here’s NGE’s top holdings:

What it holds	30 April 2017	30 June 2017	31 July 2017
Listed equities	43%	49%	54%
Unlisted equities	1%	17%	17%
Convertible notes	3%	3%	3%
Other	1%	0%	0%
Cash	52%	31%	26%

Direct holdings as % of NTA	30 April 2017	30 June 2017	31 July 2017
Mineral Deposits (ASX:MDL)	19%	–	24% (14.8 cents)
Eureka group (ASX:EGH)	13%	–	14.1% (8.7 cents)
Godfreys Group (ASX:GFY)	6%	~9% (estimate)	12.7%  (7.9 cents)
Peet  (ASX:PPC)	5%	–	3.2% (estimate) (2 cents)
Powerwrap Limited (unlisted equity)	–	–	15.3%  (9.4 cents)
Total	43%	49%	69%

Based on these weightings, NGE’s $0.619 in net tangible assets (NTA) works out to be:

• $0.334 in equities
• $0.105 in unlisted equities (predominantly Powerwrap)
• $0.019 in convertible notes
• $0.161 in cash
• NGE also owns half an oil rig, which may come in handy in the future – if only because it gives me the ability to say “So you’re looking for half an oil rig?  I know a guy…”

This means that NGE (at my purchase price of $0.4819) is trading at approximately a 21% discount to its Net Tangible Assets.

I’ve never made an investment like this before. There are 3 layers to it:

1. A bet on the companies that make up the LIC, and,
2. A bet on the manager, David Lamm, and,
3. A bet, or perhaps a free ‘option’ on the closing of the gap between share price and NTA

 

The thesis: 

The underlying LIC investments, although concentrated, are undervalued and have an attractive risk reward ratio, given the progress that is being made in their core businesses. The LIC allows me to indirectly take an interest in their future without having to make them full-size portfolio positions (due to the size of the funds I am investing, any $500 position is 5% of the portfolio). Because the LIC is so concentrated, it is simpler to analyse and I had a lower barrier to entry thanks to my previous research on Eureka.

David Lamm is a competent manager with a good track record at Kentgrove Capital. The LIC is buying back shares at a discount to NTA. I expect that over time the discount to NTA will narrow, possibly generating additional profit above what might ordinarily be expected from the investments alone. I like that Lamm adds to his positions as the thesis strengthens (see above tables).

I have formed the initial view that Mr Lamm is ambitious and will use the LIC to its full extent to drive his reputation for performance, rather than for asset gathering or leeching fees, however it will take time to form a full assessment. I did email Kentgrove Capital asking for a little context on a prior period where he under-performed, however they unfortunately did not respond.

If/when it gets to a point where the discount to NTA narrows and/or these companies prove their worth and are sold (i take the view that winning with the latter may lead to the former) then I will look to exit the investment.

Since NGE is a concentrated LIC, I felt that I needed to look at the underlying companies as if I were buying their shares directly.

In brackets I have included rough figures for what percentage of the 10foot portfolio they represent. E.g., I put 5% of my portfolio in NGE, which has 24% of its NTA (5 * 0.24) in Mineral Deposits = 10foot has a effective 1.2% position in Mineral Deposits.

Mineral Deposits Limited (ASX: MDL) (24% of NTA; 1.2% of 10foot)

MDL is a vertically integrated mineral sands miner. It owns a 50% stake in the Tizir JV, which has mining, furnace, logistics, power supply functions etc (i.e., most elements are within its control) and just reported 3 successive quarters of FCF. Tizir has a lot of expensive debt, but recently refinanced senior bonds out to 2022, and converted the Tizir iron and titanium smelter to a more economically attractive format. MDL itself carries no debt. I had to do extensive research on this one given the exposure to it, but in a nutshell, business is picking up, immediate debt pressure is reduced, prices are improving, and earnings could be set for a turnaround.

Eureka Group (ASX: EGH) (14.1% of NTA; 0.7% of 10foot)

Eureka is a part of the 10foot portfolio. In my opinion the downside is limited and the upside is meaningful. I am confident enough to (indirectly) own more shares at today’s prices. The total exposure will be approximately 5.9% of the 10foot portfolio at today’s prices.

Godfrey’s Group (ASX: GFY) (12.7% of NTA; 0.6% of 10foot)

Struggling retailer in turnaround. Cheap (EV/EBITDA of 4-5x forecast EBITDA) and the turnaround appears to be progressing; re-hired former founder/CEO, converting company stores to franchises (capital-light, better performance), cash flow positive, renegotiated loan terms (quit CBA, got new loan from major GFY shareholder).

Over a 10-year time frame I’m pretty bearish on Godfreys. I think that its proposition definitely adds value for customers, but I also reckon the standalone store format is not viable. In the near term (~3years) however the above drivers could contribute to a meaningful improvement in the company’s results and valuation.

Peet (ASX: PPC) (3.2% of NTA; 0.1% of 10foot)

Peet is outside my circle of competence. I’m not super keen on it as it is a property developer, already paying a high interest rate on the funds it raises from the market, and has just 3 year average debt maturity. However, it’s got market NTA of $1.13/share (which may be understated due to exclusion of several things including the fund management business), strong pipeline of contracts, 10% of mcap in cash. I think I can see the thesis here (undervalued on sum of parts valuation) and as it is a small part of the portfolio I’m happy to hold.

Powerwrap (15.3% of NTA; 0.8% of 10foot)

Powerwrap is a company I found myself wishing I could invest in a while ago, but never could as it is unlisted. I was a bit dark about that and I went on to talk myself out of owning peers like Hub24 (ASX: HUB) and Praemium (ASX: PPS). Hub’s returns have subsequently been triple-digits starting with a ‘5’, but you know what they say about birds in the bush….

Powerwrap has $6 billion in funds under administration and is possibly heading to IPO later this year. It is a good business and I think being unaffiliated with a major product provider could be its ace in the hole if it can compete. However, as a private business it is opaque and difficult to value, despite the fairly good standard of news updates on their website. In this case I am relying on David Lamm’s (and other Powerwrap shareholders) experience to make this a worthwhile investment. Lamm appears to have previous experience with unlisted investments at Kentgrove Capital, and I have seen Kentgrove crop up occasionally providing financing to certain listed companies.

How the thesis could play out: 

I think there are 5 basic outcomes from this investment over my intended timeframe, which is the next 3-5 years:

1. The companies outperform and the discount to NTA narrows (complete win)
2. The companies outperform and the discount to NTA does not narrow (partial win)
3. The companies do not outperform but the discount to NTA narrows (partial failure)
4. The companies do not outperform and the discount to NTA widens (total failure)
5. The companies get sold and NTA discount hasn’t narrowed (time to re-think)

 

In my view I have done my best to account for the likelihood of #1 via research. As to #2, the discount should narrow either via buybacks or performance, or at least company performance (if good) should deliver market beating results even if the LIC discount remains constant. Outcomes #3 and #4 would essentially reflect an investment failure, and I would likely sell. The discount to NTA is useful primarily for the potential for extra ‘juice’ on top of the investment.

As to #5, I would have to consider this when it happens. Some of Lamm’s previous investments with NGE (see recent investor presentation) have been pretty quick trades so he’s not averse to selling fast. My timeframe may be totally out of synch with his, which would raise issues especially if I’m not keen on his next purchases. I don’t really have an answer for this possibility, but I spent some time doing DD on Lamm and Kentgrove and I think he has a repeatable process (+ a track record of same) which ameliorates a good part of this specific uncertainty.

I would consider doubling down if the discount to NTA stays the same or widens, although it would depend on the assets in the portfolio (% of cash and unlisted assets), the progress at the companies, and the implications for my intellectual independence. If I doubled down on NGE it would be a 10% position, meaning I’d essentially have 10% of the portfolio being managed by someone else, which kind of defeats the purpose. So I would have to think on that.

A note about the manager and intellectual outsourcing

I’m into a bit of a grey area here – one of the things about the 10foot portfolio is that I want the intellectual ‘ownership’ of the investment ideas to be mine (getting ‘tips’ is okay, but buy ‘theses’ are not). If I wanted to outperform by investing $10,000 in a top-notch manager, then I would have done that and there wouldn’t be a blog. That said, having Mr Lamm supervising the investments is a definite plus, and I wouldn’t be in NGE if there wasn’t a quality manager running it. Regular readers will know that there are certain other investment vehicles that I would not invest in regardless of the manager or the discount to NTA…

The risks

There are so many company and LIC-specific risks that it would be counterproductive to go into them all. The obvious one is probably that I’ve been too cute with my thinking with trying to benefit from both the companies and the discount to NTA. I’ve never tried to benefit from an LIC closing its NTA discount before. This is new ground for me, but I expect that the LIC structure adds ‘inefficiency’ to the investment. This could be good or bad, although I believe the underlying equity investments are essentially sound.

I’d love comments below if you have a view on the way the LIC structure could be a benefit or a drag in this circumstance.

The bottom line

There are a few moving parts in this one, and it’s hard to say how it will go It is possible that improvement in some companies is offset by underperformance at others for example, with the investment going nowhere.

However, by watching for two months before purchasing, I was able to see progress on the theses at MDL and EGH, as well as some anecdotal improvement at Godfreys (of which NGE and Kentgrove own a combined ~21% of the company). I am confident that the turnarounds are already turning, and I think the risk reward is quite attractive. The prospect of a free +20% on top from a narrowing of the NTA discount would be a pleasant bonus, if it happens.

I was probably a shade too quick to buy, with the result being that I paid a fraction more than I needed to. Some shares have changed hands 5%-10% below my buy price in recent days. I try not to care too much about a few cents here and there, since I’m usually aiming to multiply my investment, not just pick up 30%-50%. However, on these companies with the lower share price I have to keep reminding myself that 1 cent is equivalent to 2% or more of performance.

I don’t want to pinch pennies and miss the darn investment, but equally I think that, especially with illiquid micro-caps, patience can pay for itself. Hopefully i’ll get better at striking a balance between haste and price in the future.

On 2 August 2017, I purchased 1054 NGE shares in a frustratingly not-round-numbers block at an average price of $0.475, for a total of $515.60 including brokerage ($0.4891 per share).

I directly own shares in NGE Capital and Eureka Group. This is a disclosure and not a recommendation. I typically won’t disclose my indirect interests via the LIC, as I can’t reasonably keep track of every change, especially since some of the positions are not publicly disclosed.