Quarterly Review: Q1 (September) FY 2019

Quarterly Review: Q1 (September) FY 2019

This quarter turned out better than I thought. I tweeted a month ago that it had been a bit rough- down 12% QoQ and down 5% since inception. However, when I was updating my spreadsheet to include my latest sales of Probiotec (after quarter end – more on that below) I noticed that a previous sale had not been accounted for.

Accounting trickery

I had removed the shares that I had sold from my active holdings listed, and posted them in the “sold positions” list (this tracks profit and loss on closed positions). The sale had correctly registered as reducing my current holdings, which correctly reduced the value of the portfolio. However, the sale had not registered in my tracking of profit and loss, which incorrectly reduced the amount of cash that I hold.  Let me explain it this way:

Imagine I hold 1200 shares worth $1 each. These are worth $1200 and thus the value of the portfolio is $1200.  I sell 600 shares at $1, receiving $600 in cash.

I now hold $600 worth of shares, and $600 worth of cash, and the portfolio is still worth $1200. However, in my case, the cash had not registered – a simple error where I’d forgotten to drag the Google Sheets formula down one line.

It is ironic that 10foot is reporting accounting issues after excoriating many companies for same. The difference between they and I of course is that a) I am honest and b) I am happy to admit that I make it up* as I go along (*my reporting, not my results – also unlike some). Full disclosure it is possible there are still errors in my performance numbers.

The value of shareholdings are almost certainly correct but the value of cash in the portfolio may be a bit iffy as it relies on a long list of cells (recording dividend payments etc) interacting with each other correctly.

Here is a chart of performance vs the benchmark XNT index:

In my earlier erroneous tweet, I said that I was down 12% for the quarter (from $10,700 to $9500),  trailing the benchmark by 16%, and down 5% since inception (from $10,000 to $9500).  After the corrections detailed above, I’m actually down ~8% on last quarter, trailing the benchmark by ~12%, and down ~0.5% since inception. This is an understandably happier state of affairs.

And vs the secondary indices of XJO and XSO:

You’ll see that the charts themselves have improved since previous quarters as I have now rebased them both to 100 at inception, for easier comparison, although this no longer shows $$. The dollar value of the portfolio was $9945 at the end of quarter, including $2510 cash, vs $10,000 at inception.

If investment performance matched the index, then some underperformance over the long run would be expected due to cash holdings (and brokerage), with cash holdings averaging around 25% since inception. My goal with this portfolio is to either beat the XNT index or exceed 8% p.a. over the long term regardless of cash holdings. With regards to underperformance, I feel that I generally own a reasonable group of stocks with decent core opportunities, and I’m not in a rush to make changes to it.

Before I get into commentary, there are some housekeeping things I want to address.

Relocating 

As I disclosed recently on Twitter, I’m moving to Sydney for work. As part of this, I’ll be potentially selling some of my stocks. I will not however be disclosing these until well after the sale goes through, so you should consider all of my positions “held for sale” (as they may well be, if unexpected expenses arise). I’ve already sold all of my Probiotec shares and I have an open sale order for some Tower shares in the market. Were I to sell more shares, I would generally aim to sell in this order:

First, Eureka Group and then NGE Capital, as these are asset management firms that tend to trade at around book value, so I expect to be able to sell and buy at around “fair value” most of the time.

After that I would likely sell some Tower Insurance, for a similar reason (trading around book value). After that, probably Greenlight Re, Base Resources, then in no particular order – the remaining Tower, Just Group, Oliver’s, and Experience Co.

Changes to the 10foot portfolio 

I’ve mentioned this previously, and it’s taken me a while to figure out what to do and how I’m going to do it, but in the next few months I’m going to make some changes to the 10foot portfolio. I’ve enjoyed laying out my thinking and publicly tracking all of my decisions, and this has brought an integrity to my process that I didn’t know I was missing. In the future I would like to bring all of my holdings into the 10foot portfolio. I’ll also change the way that I track performance – I’ll issue “units” and track growth in the value of the units over time rather than tracking the $ value of the total portfolio.

I think tracking unit value will be more useful because, as a young person trying to grow assets over the long term, the amount of dollars I deploy into investments overall (and performance on these) is far more important than artificial distinctions like how much % of my portfolio they currently consist of.  The way i think about it is, over a life time I will hopefully invest something like $500,000 of actual earnings, excluding investment performance. So if I have only $10,000 now, does it matter if I put it all in two or three compelling opportunities? That makes my portfolio look super concentrated and volatile in the short term, but if I’m adding 10 grand the next year, and another 10 the year after that, in time the % allocations of those initial positions becomes insignificant.

If I have a strong tolerance for volatility (I do) then over a 1-3 year timeframe the movements in my positions, while potentially uncomfortable, should be insignificant over the long term. I would be interested to hear arguments for or against this approach as I am not an expert on portfolio management (reader beware).

The second element is I want to focus more on companies that I can legitimately own for 10 to 20 years. I’m sure there will still be some cyclical/turnaround investments with a 3-8 year horizon, but the concentrated, volatile approach mentioned above should be far easier if I hold companies that are a) likely to be worth more in the future, and b) almost unquestionably not a zero.

The 10foot portfolio has been an experiment that was mostly successful I think, mediocre performance notwithstanding – and the average holding period is only a year so far, so I am not reading too much into the performance number. More importantly, I learned how to test my thoughts independent of professional investor recommendations, and I think I’ve performed respectable analysis despite several mistakes. I’d like to make this approach somewhat more professional and permanent.

Portfolio commentary

Back on investing now, I’ve (mostly) successfully resolved to stop checking the portfolio values every day, as this was interfering with my thought process. In the previous quarter or two I was checking almost daily, to get an idea of the impact that various share price movements had on the overall portfolio, and to make sure that the automated tracker I use was working accurately.

Ironically, since I stopped checking it daily, or even weekly, I’ve become a lot more happy about the companies I hold. Of course, while I wasn’t looking they’ve all gone down. This quarter shows what happens when you have a concentrated portfolio and two of your biggest positions halve on you.

There are two elephants in the room, Just Group, and Experience Co, which I will address at some length below.

Performance aside, I’m overall pretty happy with the portfolio and if I were forced to hold these companies for 10 years I think I could do that – except for Probiotec which is on its way out, as I’ll note below. These companies are generally cheap, and generally have a decent set of opportunities in their core businesses, which I think will be reflected in earnings and the share price in time.

Several of the companies I hold I think are potentially “growth” or growing businesses that are neither viewed nor priced as such by the wider market, which is an attractive prospect if they can each deliver on some of their opportunities. Here is a quick portfolio overview:

Eureka Group	Priced at ~NTA. Owns aged care properties yielding around 10-12% gross rental. Opportunities to free up additional capital not being used productively.
Probiotec	Sold
Tower Insurance	Insurer priced at 1x book. Legacy IT systems and years of mismanagement have left it a very large number of opportunities for improvement; great brand but weaker operating metrics than peers.
Base Resources	Mineral sands miner priced at ~3x EV/EBITDA. Prices have grown at ~20%+ p.a. for last two years, industry supply appears tight. Beneficiary of strong USD.
Oliver’s Real Foods	Marginally profitable restaurant operator priced at ~0.6x sales.  Substantial opportunities for biz improvements and SSS growth could lead to earnings growing much faster than revenue.
Just Group plc	Complex insurer (DB pension derisking, annuities, equity release mortgages) priced at ~10x earnings. Consistently strong and/or growing demand for its products offset by spectre of higher capital requirements.
Experience Co	Tourist business on ~10x estimated NPAT with 20%-30% returns on tangible capital and several opportunities to unlock synergies, create new products, and claim market share.
NGE Capital	LIC trading at 0.7x book with several concentrated positions in (potentially) undervalued companies.
Greenlight Re	Long/short insurer LIC led by smart investor that has been a perennial underperformer due to short positions against bull market stocks. Likes short shorts. Interesting play in a potential downturn.

The 10foot portfolio’s average P/E is somewhere around 9x or less, excluding NGE and GLRE as these are LICs.  NGE and GLRE both trade at around a 20% discount to book value. Tower, Eureka, Oliver’s, Just Group, and Experience Co (40% of capital) each have favourable long-term tailwinds as well as concrete plans for growing the business.

As I have noted earlier, I may end up selling some or all of my positions to fund my relocation. Most of the below commentary was written before I decided to move, so you need to be aware of the potential dislocation between bullish commentary and the fact that I may conceivably be selling these stocks shortly. I ordinarily do not trade within 7 calendar days of commenting on a stock but as my move is quite soon I am temporarily suspending that rule. I could conceivably sell these positions tomorrow, caveat emptor.

Some commentary on my positions:

Eureka Group

I have nothing to add on Eureka Group other than to (again) note that it is going to take a while to play out and that patience is a virtue.  NGE Capital has provided some commentary on the company which pretty much sums up the opportunity. Notably Eureka is another company using a cluster strategy, like Experience Co, but benefits have been minimal to date.

Probiotec

I sold 2/3rds of Probiotec during the quarter. As I wrote in that piece it was essentially the “perfect” investment. However while I was lucky to see it play out quicker and more successfully than expected, I also partly missed one aspect. I think here there were/are essentially two theses:

One is the manufacturer cutting non-economic contracts and improving profitability. That is the one I recognised.  Second is the private equity style separate the sum of the parts to maximise the value of each – by selling off the brand, selling property to lease it back and so on, this can also improve corporate performance by focusing the company and realising undervalued assets.

I did not spend much time on the second part of the thesis, despite the involvement of a private equity firm which I have commented on previously. However, the involvement of the private equity firm has been key to the rapid realisation of the full value of Probiotec. While I recognised the size of the likely impact, I incorrectly underweighted the probability that this corporate activity would occur or succeed. Overall i’m pretty happy with the investment and I continue to hold shares while I see what plays out. It is possible I will buy more if the share price falls.

Subsequent to writing the above paragraph, and after the end of quarter, I sold all of my remaining Probiotec shares at $1.53.

Tower Insurance

Not much is new for Tower other than the appointment of two execs to lead changes in the business. Tower has appointed an IT leader to oversee replacement of its ad-hoc legacy systems, and he is hopefully more forward-thinking than those in the past that created those ad hoc systems. Second is appointment of a People and Culture manager, which is a curious position. Still, there is likely to be substantial change going on behind the scenes in the way that Tower does business so I think that both appointments could be valuable. Now I just have to wait and see if they can deliver improved business performance. Tower will likely take several years to play out from here, although I think a takeover remains a possibility, and would be sensible.

Base Resources

Whichever way I slice it, Base Resources looks very cheap and zircon & rutile pricing is going bananas. Base benefits from a lower Australian dollar and will probably also benefit from rising inflation, if that happens. I think it’s an interesting position for a company on 3x EBITDA, albeit with a short mine life of ~6 years.

While I think there will definitely be a supply response, as new mines are very attractive at these mineral prices, it is hard to identify where the supply will come from and I think there will likely be a lead time of a couple of years. Industry publications also forecast a coming supply shortfall, for whatever that’s worth (I don’t assign much value to that prediction).

I have modestly lowered my mental estimation of the chances of Base being able to expand its Kwale resource, but this has never been a core part of the investment thesis. Overall it is likely that slightly more of the investment case rests on the new mine at Ranobe. It is plausible that the Base shares will not begin to revalue until more progress is made on the new mine.

I purchased more Base shares during the quarter. Previous purchases & sales to get the right position size were, in hindsight, unnecessary fidgeting, especially given my obvious tolerance for volatility in other stocks.  Base is now a 9% of capital position. I note that NGE Capital (below) has also purchased Base Resources shares and their stake works out to be roughly 0.6% or so of 10foot. NGE has published commentary on their thesis here.

NGE Capital

NGE has published an interesting event-driven thesis in Russian aluminium company Rusal which was recently hit by Magnitsky sanctions against its controlling oligarch, Oleg Deripaska. I think this is a very interesting thesis and well worth a read.

On a separate note, it is starting to look as though NGE does have some kind of edge or process that is potentially market beating. I am not in love with every company NGE owns, but I find it very easy to pick up one of their positions and see the thesis, which to me tends to confirm that there is a method at work (this being a vital assessment to make when researching any investment manager). The MILs and the GFYs of the world are part of this process and I am happy to hold. Several 10foot positions such as Base Resources and Eureka Group continue to unintentionally overlap with NGE’s portfolio.

The risk of NGE struggling is also pretty decent, for example I think the above Rusal thesis is red-hot, however the downside is conceivably grim (a zero) and it is a 14% position. I do wonder whether a sequence of successive large bets on Rusal-like situations would be a winning strategy over the long run, given the impact that one blow-up could have. That might be a question for management.

I’ve written previously that I thought takeovers made it harder to discern manager skill, because the business gets removed from play before the investment manager’s thesis plays out. Thinking about it more now, I think that is slightly incorrect – as with everything in investing, there is nuance that does not lend itself to broad commentary. A takeover removes the business from play before the business thesis (Ie “we are going to do XYZ which will grow our profits”) plays out, so it is harder to know if the investment manager was on track there. However, irrespective of business thesis, if a company gets taken over, the investment manager still correctly identified that a situation is undervalued. Whether that was luck or skill is a separate question, but overall I now think it is usually correct to give some credit to an investment manager for good investment selection, if a company gets taken over.

It is likely that NGE is going to be a long term position for the 10foot portfolio. A key risk over time now will be watching that key personnel don’t start to benefit disproportionately from performance or growth in the company’s assets.

Oliver’s Real Foods

I have no real comment on OLI but the recent annual report to me suggests that management has a good handle of the business. There are several more opportunities in there that I was not aware of. I have approached the CEO for an interview and he has agreed, although he is busy in the leadup to the AGM so perhaps in December I might have an interview to put up. I hope to be able to attend the AGM in a few weeks.

Just Group

Just Group.  I have a longer post waiting in the wings about its capital requirements, I kind of don’t want to steal its thunder, but it may be a while before it gets published (I have since published it here) so here’s a brief summary:

The English central bank thinks that insurers need to hold more capital in reserve to cover property valuation risks in equity release mortgages. Insurers, naturally, think that the central bank should duck right off. The proposed changes to capital requirements would require Just to hold substantially more capital and it has been punished on these concerns. This risk is somewhat offset by management’s statement that they have been able to adjust pricing to compensate, but nevertheless the situation is fluid. I have been tackling this risk from the viewpoint of “does this change the long term demand for these products?” and I think the answer is emphatically not. Annuities I could take or leave, but I don’t see equity release mortgages or pension de-risking services going anywhere for at least a decade (indeed both are growing industries).

The biggest issues to my mind with Just Group currently are

a) is this higher capital requirement likely to damage the business?   (conceivably not given that pricing can apparently be increased to compensate, but the extra capital will be costly to raise and will keep the share price under pressure for now)

b) What form is the capital raise going to take – equity, debt, or reinsuring away some of the contracts?  I think management may be overoptimistic on the reinsurance potential as other insurers will be in a similar boat with capital requirements. An equity raising would be ugly at this price. This is the biggest question currently, in my opinion, and while I was keen to invest more at 72p recently, I have been patient while I wait to see what the likely route for capital raising is.

Experience Co

Experience Co in this quarter is essentially a story of multiple contraction. Instead of 25x when I bought it, it’s now priced at a P/E of 10x. Anecdotally I have heard that this contraction is largely due to fund managers selling in the belief that a lower multiple now means that the roll-up story, i.e., acquire businesses on 5x with shares priced at 20x, is broken. Whether that is accurate or not, it is true that 25x is not an appropriate long term multiple – I estimate 12-14x is more realistic.

Either way I think the selling overlooks substantial opportunities within the business itself, and for claiming higher market share within the industry. I thought EXP was a decent opportunity at 58 cents and I made it a 10% position at that price, which has been a substantial detriment to performance given that EXP now trades at ~35 cents. I purchased more shares at 38 cents, and I frankly hope that the share price keeps going down, as I would like to buy more around 30 cents or below.  There is a set of circumstances in which EXP could become >30% of the 10foot portfolio; that might not be likely but it is a non zero probability.

While nothing I write on here is a recommendation (and you implicitly agree to this if you use my website), I would especially exhort readers to not ever follow my position sizing, especially not with the entirety of their wealth. Copy my ideas at your own risk, but not my position sizing, which is a function of the small size of the portfolio and its experimental nature.

It is unlikely that I purchase more EXP for the time being due to the relocation mentioned above.

Greenlight Re 

GLRE performance continues to be poor, and I am losing money on this position which I expect to continue for a while. However I think it is a decent opportunity, run by a manager whose past success I do not think was due to luck. During this quarter, Greenlight was around 30-35% net long the market and now, as of 30 October, Greenlight is currently around 25% net long the US market. This is bearish positioning and it’s become sharply more bearish in the past few months. We’re yet to see if Einhorn will be right this time, and it will mean more pain and higher losses if he’s not. The bull case is a downturn (of whatever cause) and a rotation into companies with modest valuations and strong brands and cash generation capabilities. I think that this is a “valuation” bull market, where investors are paying increasing multiples for the same earnings, and attaching a high multiple to anything with revenue growth. I think eventually the focus has to switch back to cash flow at some point, because low interest rates have led to a lower cost of money that I think can’t continue.

GLRE is by far the most experimental of my positions and it is one that I would suggest readers avoid. My 5% position is possibly too large.

(As an aside I sometimes think that somebody should confiscate Einhorn’s short-seller license, but that’s why he gets paid the big $ and I do not.)

I own shares in Oliver’s, Tower Insurance, Eureka Group, Just Group plc, Greenlight Re, Experience Co, NGE Capital, Base Resources. During the quarter above I owned shares in Probiotec, but I have since sold my entire holding. As mentioned earlier in this post, I am relocating and if I require extra money I will be selling 10foot positions. You should consider all of my stocks to be “held for sale”, bullish commentary notwithstanding. This is a disclosure and not a recommendation.