Portfolio Review – May 2018

Portfolio Review – May 2018

I recently (mostly) finished putting the final touches on the 10foot Google Sheets spreadsheet, which tracks my investments automatically, including cash holdings and relative to an index.

Before I get into it, something occurred to me recently which I feel deserves an additional disclaimer.

Although tracking my performance and my investment process is very important to me, from the point of view of an external investor, what is my primary motivation? It’s certainly not the money I earn from investing $10,000. I will be investing likely for another 40+ years, so far more valuable to me (at least right now) is how much I can learn from the portfolio, rather than how much I earn. I have found myself repeatedly breaking my own rules and going for complex or novel investments, or areas where I am inexperienced (like mining or Mayne Pharma) because they are where I learn the most. That is something I thought you should know, and you should keep in mind as you read my work.

Here is a brief recap of my holdings (as of 30 March 2018):

As I looked at my performance and my holdings I’ve been thinking a lot about themes and more complex topics like (forgive the lack of professional terminology):

• What is ‘driving’ my portfolio and the indices, and in what circumstances would my portfolio return above or below the index?
• What are the expected or likely returns of the stocks that I hold?
• What ‘themes’ does my portfolio contain?
• How much leverage is in the portfolio, and is this appropriate?

 

When I first began the blog I really just focused on trying to do good research and pick good or interesting opportunities. However, the more I track my performance, the more I find these ‘macro’ concerns become increasingly important. I also note here that I’m a bit behind when it comes to reporting my portfolio holdings, as I have made other purchases (but no sales) which have not been reported yet and are not featured in this post.

I have some preliminary thoughts on each point:

What is ‘driving’ my portfolio and its benchmarks?

Frankly I’m not sure what’s driving the benchmarks. ASX100/200 is obviously the resources and banks. The ASX Small Ords (XSO; the ASX300 ex- the ASX100) is smashing my portfolio by about 7% since inception however and I’m not sure what’s driving that – possibly also resources.

I am notably light on resources and banks, although I do own several foreign financial stocks, which should have somewhat lower correlation with our mortgage dependent banks. Still, I’m not entirely sure what’s driving the indices. Genuine question:  How do you tell??

My portfolio is very stock-driven, with my two largest positions Tower Limited and Probiotec driving almost the entirety of my performance. Of my remaining 5 positions, I am up 30% on one small position (NGE Capital), flat on my third largest position (Just Group plc), and down around 15%-25% on three other small positions.

The primary reason that performance is not stronger is largely the number of mistakes / detractor stocks that I have. I am already strongly concentrated in my best ideas and they are working out adequately. Early mistakes on Thorn Group and RNY Property Trust combined with being down around 15%-25% on 3 of my 5% positions works out to be a cumulative…. 5% or 6% (?) drag on performance since inception. Put it another way, if I’d never lost money on any of my stocks, I’d be up 14% instead of 8% currently. Irritating. A high historical cash holding with an average of 52% last year and ~25% currently has likely partly contributed to flat performance relative the index.

Overall, with less cash on hand these days I expect that portfolio volatility will increase.

What are the expected or likely returns of the stocks I hold? 

This is a very general and conservative range of expected returns for my stocks. I guesstimate expected return in a variety of ways but generally it’s earnings from the current business reinvested at a similar rate, plus possible modest growth at some investments and/or multiple expansion.

I stress that this isn’t guidance or a recommendation, just roughly what I think is achievable over the next ~5 years. Also note that 10foot portfolio returns may actually be quite different, as in many cases I purchased stocks last year at lower prices. These are my guesstimate expected returns as of today in May 2018:

• Eureka Group – expecting around 8% per annum over the next 5 years.

Eureka is earning around $8m EBITDA annually on $50m or so of book value. A fair bit of that goes to servicing debt so I expect the underlying rental yield is maybe 6%-8% per year. Reinvested in properties and with some potential property revaluation (from conversion or fixer-upper properties) and I expect the return to be around say 8% per annum, via a mix of earnings and book growth.

• Probiotec – expecting around 6% per annum including dividends from here

PBP is a capital intensive manufacturer going through turnaround. I originally expected to make around 10%-15% p.a., depending on how the turnaround went. However, shares are now up more than 100% in a year. At $1.30 or so I’ll have to consider if it’s close to IV and time to sell, especially given that management have a curious set of incentives suggesting at least $1.20 a share is achievable.  As a result I’d say the expected return from here over 5 years is fairly low. Wider margins combined with new business may surprise me however.

• NGE Capital – targeting around 15% per annum from here

To invest in NGE I would generally want to be getting around 15% per annum after fees (noting NGE’s small-cap focus), plus NGE also had a lottery ticket. I could earn up to ~27% extra over 5 years from a narrowing of the discount to NTA. Assuming a 15% return +4% per annum from a narrowing discount, this works out to be around 19% per annum, as I doubt the discount will fully disappear. NGE’s porfolio has changed due to takeovers and the discount has halved, which may materially change the risk-reward tradeoff. It’s still early days for NGE however and as it is still unproven, future performance is really unknown.

• Tower Limited – expecting around 10% per annum from here

I think Tower is worth around $1/share (33% more) after its turnaround, and it will likely be paying a 5% dividend yield, if not more, on my purchase price. Assuming it hits $1 in 5 years and starts paying a 5% dividend next year for four years, total returns are around 53% or 10%ish per annum. There is a blue sky scenario where I think it could be worth up to $1.50-$2, but I am not counting on that.

• Just Group plc – expecting above 10% per annum from here

Just Group grows essentially via investment returns on its book combined with the value of new business that it can write. Its European Embedded Value (EEV) implies a run-off value of around 228p per share while its net tangible asset value is around 165p. The current price is 142p, basically flat on my average buy price. Assuming the share price converges on book value (+16%), plus dividends of 2.3% p.a. at my purchase price, implied returns are around 5% per annum. However, Just is also growing its book value at a certain rate, depending on how much new business they write, which depends on how much business is available (they are focused on writing profitable business rather than volume). Book value grew 8% on the prior year, after dividends, so using that figure I guess that takes the expected return to around 13%p.a. or so, not counting possible multiple expansion. I think Just could conceivably be worth more than book value, but as with NGE there is always a risk that the discount doesn’t narrow.

• Undisclosed 10%-30% p.a.

This is a miner. I’m still working on my model, but assuming current prices hold up it has an EV/EBITDA of around 4x, and prices are strengthening. It is undervalued relative to peers that are on around 10x-14x, and I am looking to benefit from a re-rating over time. Assuming constant or higher mineral prices I expect to be able to at least double my money. However if prices suddenly collapse, I could still double my money – I’ll just have to wait 5-10 years for the cycle to swing up again. So the expected return is somewhere between 10%-30% p.a. over the next 3-10 years for a conservative maximum upside of 2x.

What ‘themes’ does my portfolio contain? 

I generally don’t try to get thematic investments just for the themes themselves, but I also think that there’s no reason not to target an attractive thematic, primarily because tailwinds are a nice bonus if they’re not already priced in. I think there are two primary themes in my portfolio at the moment. I’m ‘long’:

1. Old people (Just Group, Eureka Group)

Just Group and Eureka Group are both focused on older people and retirees. Eureka provides affordable accommodation for retirees with no assets, and Just Group sells reverse mortgages, annuities, and pension de-risking services. Both will be significant beneficiaries of an ageing population and several demographic trends:

• Land-rich and cash poor retirees (Just Group)
• Ageing population (Just Group, Eureka)
• Rising # of retirees with minimal assets and no income except the pension (Eureka)
• Outsourcing of defined benefit pensions (Just Group)

 

2. Interest rates (Just Group, Tower Limited)

• Rising interest rates and earnings on cash/debt instruments (Just Group, Tower)
• Rising demand for annuities due to higher yields (Just Group)
• Higher yields on reverse mortgages (possibly; Just Group)

 

Rising interest rates I feel may be an opportunity to benefit from a weaker AUD. I don’t know anything about currencies but about 14% of my portfolio is in GBP (Just Group) with another 20% in NZD, although that’s typically correlated with the AUD. I also have a bit of USD exposure which I’ll write about at another time.

With 40% of my portfolio in Tower and Just Group, I consider that I generally have decent exposure to rising interest rates. Eureka Group however will react fairly negatively to higher rates, and Just could expect to take some negative impacts, for example the face value of its loans will fall. Reverse mortgage demand might also slow somewhat due to higher rates but I doubt it will be a huge decline, as the pressure to get cash out of illiquid assets will be greater than the pain of paying 1%-2% more in interest. Probiotec and the undisclosed miner both have modest sensitivity to rising rates but I would not expect higher rates to be material to the thesis. I wouldn’t mind more exposure to rising rates if I can find the right investments.

How much leverage is in the portfolio, and is this appropriate? 

This is a good question. The only company I hold with a serious amount of debt is Eureka Group. Probiotec has a medium amount, which I am or am not concerned about depending on the phases of the moon, but it is adding debt and it has a working capital-intensive business model which means that debt is more of a concern than it appears.

I also have 40% of my portfolio in insurers which, while they aren’t conventionally indebted, contain sharp risks to the downside – especially Just Group. The insurers also have a degree of credit risk with bonds from commercial entities. This is particularly so with Just Group in the UK as it has a very large BBB exposure to companies that have been in a ZIRP environment for 10 years.

Ignoring position size, I rank the companies top-bottom in order of most-least concern in terms of leverage:

Just Group – changes in the underlying thing being insured can have a really bad impact in the worst case scenario, and the investor has minimal visibility into this. Just’s solvency ratio will also drop over the next couple of years as it expands. (14% of portfolio)

Eureka Group – a high level of debt and seemingly no intention to reduce it, capital recycling notwithstanding. Fortunately this is underpinned by its property assets and what should be long-term, fairly reliable and consistent cash flows. (4% of portfolio)

Probiotec Limited – As mentioned, debt is moderate but management is increasing it and it is possible the company will require significant working capital to expand its operations. The weighting of business to the second half creates risk of a cash crunch. (16% of portfolio)

Undisclosed miner – the company itself will be debt free in a year or so, but it has to pay around 10% interest and will have to take on a large debt facility if it decides to go ahead with its new mine. Debt here is actually a rapidly decreasing concern (chance of bankruptcy is virtually 0 at the moment), but will likely become a greater concern in the future. (5% of portfolio)

Tower Limited – Relatively unconcerned about Tower. The risk of natural catastrophes can’t be overlooked however. (23% of portfolio)

NGE Capital – Not a direct concern, although constituent companies such as MDL and Eureka (which I also hold) can have high levels of debt. Overall I would say NGE is a medium concern for indebted companies, albeit this should be somewhat mitigated by the manager doing the DD and carefully selecting the risks it takes. (6% of portfolio)

That about sums it up. Generally speaking I wouldn’t mind adding a little more interest rate exposure, old people exposure, and potentially some inflation exposure, but I won’t buy companies specifically for those reasons – as with the companies I already hold, extra thematic exposure is just a bonus.

I own shares in Probiotec, Tower, Just Group, NGE Capital, Eureka Group, and a sixth undisclosed company. I formerly owned shares in Mayne Pharma, RNY, and Thorn Group but sold them all some time ago. This is a disclosure and not a recommendation.