Quarterly Review: Q3 (March) FY 2019

Quarterly Review: Q3 (March) FY 2019

The end of March marks two years of the 10foot portfolio. It has not gone as expected and I have been doing a lot of thinking in the past few months. There are also some big changes to the portfolio, most notably converting it to a unit basis (measuring value per fictional “unit” instead of dollar value) and bringing my entire portfolio in, more on that later.

Before I get into it, for full disclosure I may decide to sell most or all of these positions to potentially make another investment in the near future. As a result I will not be adhering to my usual “I will not trade within 7 days of this post” rule.

The switch to a unit basis

I previously owned positions “outside” of the 10foot portfolio. At the start of this quarter I brought all of my positions “into” 10foot and converted it into a unit basis. Values are now measured on a fictional “per unit” basis with the portfolio starting with 10000 units at $1 at inception, and any further units added at NTA.

Performance

All these figures are post-consolidation (switch to a unit basis). The portfolio is currently ~94% invested with approximately 6% in cash.

The 10foot portfolio is up 8.3% since inception. It rose 12.5% this quarter to March 30, primarily due to the addition of Xero and Nearmap to the portfolio.

The benchmark XNT index rose 7.9%. The 10foot portfolio trails the index by 5% since inception:

The XJO and XSO indices are up 4.8% and 14.5% respectively since inception, vs gains of 8.3% in the 10foot portfolio.

It’s no longer possible to give a firm pre-consolidation figure but based on losses at Oliver’s, Just Group, and Experience Co I estimate the 10foot portfolio would be down around 8-10% since inception (pre-consolidation), trailing the XNT index by 25%.

With a portfolio of this size a key concern has been brokerage, with total brokerage of an estimated $500 (pre-portfolio consolidation) equating to about 5% of the initial capital invested (pre-consolidation). I suppose it could be thought of as a 2.5% annual MER. While that’s a meaningful chunk and certainly the friction does have some responsibility for poor performance, the core issues with the 10foot portfolio so far have been analytical/portfolio related, and I’ll go through those in a bit.

I have begun using Stake in the US, and when it goes live in UK later this year I’ll start using it there as well to defray brokerage costs.

High cash holdings (average of 50% cash in year 1 and 20% in year 2) have also had an impact on lagging the market, but again are not the core problem.

Current portfolio

Here is the current portfolio positions, cash holdings, and allocation via various currencies (based on listing location).

Losses at Oliver’s and Just Group in particular make those positions look smaller than otherwise. Nearmap is so large primarily because the stock rose 80% this quarter. For reference, Xero and Nearmap were my only two non-10 foot positions. I set their “buy price” equivalent to where the stock price was trading in January, rather than their lower historical cost (as I purchased them several years ago).

Analytical challenges

Portfolio performance has been poor. I think there are a few reasons for this and I’ll go through them one by one. Firstly a brief explainer of all of the positions I’ve previously bought and no longer hold.

Thorn Group – Consumer good leasing co. Industry consolidation not occurring, found out they were doing a lot of franchise leasing, competition intensifying. Sold correctly with minimal losses, avoiding a 50% decline.
RNY Property Trust – Liquidation play taken over well below purchase price. Conceivably unlucky (process was reasonable), but may have lacked sufficient margin of safety and too large a position size (function of small size of portfolio).
Eureka Group – sold due to relocating, minimal losses. Process was reasonable & I believe will play out in time.
Probiotec – sold due to thesis playing out. Correctly recognised underpriced business with persistent earnings, concrete improvements underway & optionality. Averaged up as thesis played out. Some luck involved, but I also nailed this one.
Crowd Mobile – quality of business lower than thought. Failed to recognise spruiker management (despite warnings) and failed to sell on a pump (would have doubled my money). Stupid all around.
Mayne Pharma – Generic drug co. Thought it was undervalued but realised it was beyond my circle of competence and sold for break even. Shares doubled and then halved again and now trade at where I bought it. Despite missed gains, probably made correct decision here.

Combined with my current positions above, those comments will give you a brief look at the portfolio for any errors you might identify (and if you spot some, do shoot me an email or comment below with your feedback). Here are my thoughts on the core errors so far:

Microcaps

One key problem has been to do with business quality. Some of that is due to intentionally experimenting in the microcap end of the market (Eureka, Crowd, Probiotec and RNY were all <$40m mcap). I’ve realised that my process and mindset are not well suited to investing in microcaps. I’m not currently equipped with the right mix of credulity and willingness to sell early that in my opinion is required. On the credulity part I’m not sure of the precise areas where I fall short, but I generally highly mistrust microcap management (correctly, I believe) and struggle to identify genuine operators. As a result I also struggle to identify when a company is improving.

Probiotec is a classic example. Some people make money on co’s like Probiotec because they believe management when mgmt says there are XYZ improvements in the business coming. I did not believe Probiotec’s mgmt and found it hard to average up at 80 cents when management was talking about buybacks and strategic options. I did however think I would make money in a wide variety of circumstances by buying shares at ~40 cents even if management commentary was not accurate.  I should emphasise this is not a comment on Probiotec management, as I have never met them. This simply reflects my bias that makes it hard to invest in companies where business is improving and to believe that business is improving without external corroborating evidence, which can be hard to source in microcaps. (with Probiotec I was able to source external evidence of business improvement from numerous sources). So that’s the credulity part, and indeed in Probiotec I made money despite my internal biases.

The second thing I struggle with is the willingness to sell. Microcaps simply have a more tenuous existence than established companies and their earnings are less persistent, funding is tighter, and success less assured. As a result you need to be prepared to sell more quickly when a thesis breaks. Given the choice between selling or holding a stock I generally (intentionally) choose to hold, and this is how I prefer to invest. Additionally microcaps have greater uncertainty (+ cash flow volatility due to investing in growth etc), are more affected by sentiment, and the fluctuations make it harder for me to know when to sell or when to buy. Other things like the decision to average up or average down looks very different in microcaps due to these issues.  I’m pretty sure I have the knowledge/ experience to adjust for these issues better than I have been, but it hasn’t worked out that way.

For these reasons there are likely fewer microcaps in my future.  The good thing is that by broadly avoiding microcaps in the future, mistakes in Crowd Mobile, RNY, and maybe Oliver’s (more on this later) are unlikely to be repeated.

My ideal size company is around the $100m-$1bn mark, once a business has a well-established formula, but this is a story for another time.

Portfolio sizing

Another key concern and contributor to poor performance has been portfolio sizing. I have generally tried to minimise transaction costs by not churning/ sometimes by taking a larger position up front, and also I have tried to overall take a larger position (within reason) up to a hard cap of 20%. Minimising transaction costs is straightforward but the position size has been tricky. Generally I have wanted to have a meaningful amount of money invested in a position, and have taken the approach that a larger position is “better” – or at least not that important. E.g. what is the difference between a $1000 and a $1500 position when I hope to save several thousand dollars a year (i.e. the size of the dollars invested should grow rapidly, minimising the position sizes naturally). That’s true as far as it goes but it also has been suboptimal from a portfolio perspective because the portfolio has been skewed heavily by the sizes of positions taken. I.e. I was measuring the portfolio as a discrete construct (quarterly performance measurement) but investing it in a way that ignored that fact.  This was exacerbated by the desire to have a meaningful amount of money in dollar terms invested in each stock.

In a way being index unaware could be seen to be a positive, but large positions in companies that have gone down has been the primary driver of poor performance in the 10foot portfolio. In future I think the best approach will be to invest based strictly on current portfolio size. I also think this will be partly simplified by moving my entire portfolio to 10foot and not managing it as a separate construct.

From a first principles perspective, how many people should realistically have 15% of their portfolio in a single stock? I think the answer is “very few” (I thought this even before I started 10foot) and I’ve noted, for example, many times in my quarterly updates that a key risk with NGE Capital is its 15% positions in cyclical stocks and other risky situations.

Investing based on current portfolio size with some stricter position size limits will likely mostly solve the problem of having too much invested in stocks that go down. It will not solve the problem of stocks that go down (more on this later) and it will also not solve the precise problem of exactly how much to invest in each position (5%? 6%? 7%?), but overall it should improve things.

Deciding exactly how much to put in a stock (discriminating between, say, making it a 5% or 6% position) is a relatively small concern that has not had a meaningful impact on performance, and may even be an unanswerable question. That said, I’ve begun using Stake for US brokerage, which has made it easier to take smaller positions in US stocks, and this would have saved me some money on Greenlight Re (which was too large, at 5%).  New positions in lower-conviction ideas (Despegar, Scorpio Tankers) reflect more disciplined position sizing.

In summary; even if I picked exactly the same stocks, I could have improved performance by avoiding the issues mentioned above.

Picking stocks that go down

“Find some good stock and hold it til it goes up… if it don’t go up, don’t buy it.”

There has been a mix of luck and (lack of) skill involved in performance of the portfolio so far. I’ll have more detailed thoughts on my current holdings below, but the three biggest analytical drivers of poor performance so far have been Just Group, Oliver’s, and Experience Co, so it might also be worth examining these stocks for specific errors.

Just Group

From my perch Just Group looks to have executed reasonably well. The JR and Partnership merger just before I purchased led to greater cost synergies than were forecast and the company has been selling decent volumes at a decent rate of return. Overall I think Just is a well established company (around a $1bn mcap) with a good process/DNA and a decent rep in a growing market with a high probability of its products remaining in demand for at least a decade. I thought the company just needed to keep doing what it was doing in order to grow and perform.

There was an element of bad luck (and perhaps lack of information) with the regulator raising capital requirements in a way that will be fairly punitive to Just and has already pummelled the stock price (currently 65p vs 150p I first purchased at). I don’t believe I was ill-informed with Just, indeed I think I may have been one of the first people in the world to become aware of the new capital requirements (I tweeted about the changes about two weeks before the market reacted). Whether I was correctly estimating the probability of higher capital requirements however, is uncertain.

The proposed regulations aren’t in place yet but the likely impact is meaningful, and Just Group just raised 375m (1/3rd of its market cap) at a 50% discount to book – which has probably meaningfully impaired the value of its shares and future earnings.

Management has been quoting low double digit rates of return on new business for a while now and industry pricing has reportedly picked up to offset the higher capital requirements (which are an industry phenomenon, not unique to Just), but we’ll see. Was I just unlucky? Perhaps there was an element of luck, but I also knowingly bought a business that at some point may have needed to be recapitalised. Many businesses can need recapitalisation and still be good investments (e.g if highly indebted or cyclical) but that risk was compounded here by Just being a 15% position.

Olivers Real Food

To give a quick recap I first bought shares in Oliver’s at 22 cents and sold at that price a few months later after problems in the business were not acted on. I ultimately repurchased at 28 cents (stupid) when new management set out their plan for the turnaround, and I purchased more shares at 10 cents after that. Ugh. Position sizing again rears its ugly head (as with Just) although this was contained to a 10% position until recently (I bought more at 2c – more on this later). Primarily I may have overestimated the ability of management to turn the business around. A key risk was the attractiveness of the concept ( I remember my Peter Lynch and Bildner’s)  and whether a wider footprint of stores would resonate with customers outside the home area. I knew this was a risk but I may have overestimated the importance of competitive position and having a differentiated offering vis a vis McDonalds and KFC, versus the importance of having a standalone attractive proposition and good operations. I did note in my blog posts at the time that I had questions about the menu and operational efficiency.

I rationalised that improving operations would lead to improved performance but that so far has not proven the case. If the product does not resonate with customers, then logically, improving the speed of delivering the service that people don’t want, may not necessarily help much. Ultimately my core analysis was not as sharp as it could have been – not as sharp as it should have been in the areas that were most important.

There may also have been an element of bad luck here, especially with founder Jason Gunn returning so soon after I’d purchased more shares at 2.2 cents, given that I am not overly optimistic about Mr Gunn’s return based on Oliver’s historical performance. Still, re Oliver’s it’s possible that stricter rules around position size may have led to a more optimal outcome from a portfolio value perspective.

Thirdly, a small issue, I overlooked that with a troubled operating history to date, any problems with the company (even ordinary problems such as higher costs and temporary unprofitability due to investments made by CEO Madigan) would lead to a sharp sell-off in the stock, which is what happened. Generally I try to sail towards where I think intrinsic value is going to be in 5-10 years, ignoring the storms along the way, but I could have been smarter and more patient re market sentiment in this situation.

Probably I was wrong on Oliver’s. I think it probably could have been turned around (and it may surprise me yet) as fundamentally all of its problems look solvable, but we’ll see. I plan to wait 6 months or so to see Mr Gunn’s reforms, but unless there is an improbably sharp turnaround, its days in my portfolio are numbered.

Experience Co

I feel a little stupid on Experience Co frankly. I conservatively assessed its intrinsic value as being around 66 cents or so, prior to first purchasing shares at 58 cents. I made an error here – I noted at the time that weather was likely to become substantially worse over the next few years due to the turn of the El Niño – La Niña cycle that would lead to storms (and indeed severe floods in NQ earlier this year). Yet I did not correctly handicap for the probability of wet weather, likely due to attempting to ignore short term concerns (weather) to focus on intrinsic value, again to my cost. Arguably I also should have aimed for a higher margin of safety in my discount to IV, but I try to use very conservative valuations to account for that problem, and I don’t believe the limited discount to IV per se was itself an error.

Anyhow, I purchased shares at 58 cents and purchased more at 38 cents or so when shares were sold off. Despite the weather and tragic death during a skydive I felt that EXP’s intrinsic value remained fairly consistent. I purchased more shares at 19 cents when the stock collapsed on a pre-results downgrade early this year. I thought 58 cents was a decent price, 38 cents was cheap, and 19 cents was stupidly cheap (and I think I’ll be proven right on the latter one at least… with emphasis on stupid, maybe! Ha. ). However the same issue appears yet again in having too large a position (20%) in a stock that’s down 75%.

Analytically I haven’t come across any major errors in my Experience Co process yet. Broadly I think the company’s business is attractive, it’s an oligopoly in some areas, aggregating a fragmented industry in others, and in yet other places it has some permit-limited businesses that will likely prove very favourable from an ROI perspective. If it goes on to acquire further businesses where capacity or the number of operators are limited by regulation or similar I think it will do well and enjoy a fairly strong persistence of earnings over the long term.

I estimated around a 1-2% increase in pricing, similar growth in volume and some other minor misc benefits from scale (slightly lower CAC, lower cost to serve for e.g. due to cluster strategy). One possible risk that was pointed out to me was that growth estimates do not include capital raised to grow the business (new share issuance) and this is true, I have not really factored in new shares issued as I assumed future growth comes only from reinvested cash and a moderate level of debt (equivalent to current levels of ~1.3x(?) EBITDA). However I don’t see this as being a major risk especially given there will be no shares issued at these prices.  An Australian recession or an event that disrupts tourism is a meaningful risk as a great amount of spending comes from locals.

That said, if you’d asked me a year ago I would have said I was broadly optimistic on both Just and Oliver’s, and I feel the same way about Experience Co. So I am looking to identify possible errors in my thinking and I am open to hearing your thoughts, dear reader. Better to establish that I am wrong sooner rather than later.

General thoughts on positions:

This post has already been long enough so I am just going to do a very brief update on each of my current positions.

British American Tobacco (LSE:BATS) and Altria (NYSE:MO) –

Long teen smokers, short regulation (I joke). I think the dwindling volumes and rising prices game has quite a way to run, especially given the cost of a pack of smokes is only a couple of dollars pre-tariffs. I doubt smoking will be outlawed entirely and MO/BATS are in enough countries that being put out of business is very unlikely. There are also some “options” on vaping and marijuana due to investments each company has made. BATS has a huge collection of Asian smokers (who account for two thirds of its volume and one third of revenue) and Altria is doing a lot of work on vaping and marijuana, as well as owning 10% of Anheuser Busch.  I think the biggest overlooked risk is actually that smoking/nicotine volumes move nonlinearly once volume drops low enough (the population of smokers drops below sustainable level; not enough new smokers being brought in to offset) but that’s a way away and I’ll write separately on that at some point.

There is a blog post on smoking and BATS by Lyall Taylor here which prompted my initial interest.

Just Group plc (LSE:JUST):  Nothing to add on this one other than it is not inspiring to own a co that’s had to raise capital at a fraction of book value.

Greenlight Re (NYSE:GLRE): Still waiting for Einhorn to make some money. I think he/the portfolio will come good eventually, wish he’d stop shorting tech stocks though.

Scorpio Tankers: I’ve written on Scorpio here. I think it’s conceivably a 3-bagger if and when rates normalise to their 15 year average. The risk is that could still be several years away, if it doesn’t go bankrupt first.  There are also some possible corp gov concerns re relationships between Tankers and Scorpio Bulkers.

Despegar: I continue to do some work on Despegar. I’m waiting for its upcoming annual report before I make a decision. I really would like to own it but its cash flow looks ghastly and investor relations has not been able to explain it to me why that is. Later this year I’m hoping to go to Argentina so if I’m still interested I may even try to meet with the company.

Nearmap (ASX:NEA) and Xero (ASX:XRO): You can read public theses on these in so many places, and my rationale was/is similar. Am not a buyer at these prices. As noted above I added NEA and XRO to the portfolio based on their share price at 10 Jan 2019, not my historical cost.

Experience Co (ASX:EXP) – thought it was cheap at 58c, 38c, and stupidly cheap at 19c ¯\_(ツ)_/¯.  I still get an IV for it around 60 cents, so we’ll see. Tourist numbers so far this year have been weak due to weather.

Oliver’s (ASX:OLI) – Waiting for Mr Gunn to work his magic. But frankly I’m just going to be quiet about this company for a while, I have spent enough effort on it. We’ll see what happens.

Base Resources (ASX:OLI) – showing a profit on Base for the first time, given that it’s now got a net cash position and trading on something like a 30% cash flow yield – albeit that cash will all go back into building its next mine. Next step will be to seek funding for the mine and it will be interesting to see what approach they take; it appears clear that the company will definitely require external funding in addition to internal cash flow.

NGE Capital (ASX:NGE) – no real commentary on this one.

Tower Limited (ASX:TWR): Tower is making good progress with volumes and pricing picking up and cost ratio continuing to fall. I hold patiently and am glad management has been smart enough not to pay a dividend. The key question remains if the company is large enough to actually be independently profitable, because even relatively small weather events wipe out a year’s worth of profits.

4100 words later, that brings me to the end of another quarter.  Fortunately I am enjoying the blogging process as much as I was when I started if not more. If you’ve read this far, thanks for sticking with me. Cheers.

I own shares in JUST, BATS, MO, STNG, DESP, GLRE, XRO, NEA, OLI, BSE, NGE, TWR, EXP. For personal reasons, I will not be following my usual trading rules for this blog post and may buy or sell more (or all) of any of these stocks at any time without notice to readers. This is a disclosure and not a recommendation.