Quarterly Review Q3 (March) FY2018

Quarterly Review Q3 (March) FY2018

This quarter marks the end of the first year for the 10foot portfolio, although I call it Q3 of FY18 because I want to align my reporting to the financial year.

Google closed down its Finance Portfolio function in the middle of this quarter and I recreated my portfolio in Google Sheets. It’s currently a 3 page spreadsheet tracking my performance and it is possible that there are errors. This quarter should be mostly accurate as I can compare the spreadsheet to the Google Portfolio data I have for half of the quarter, but in future quarters the chance of errors will rise.

The easiest way to measure my performance is to compare the value of the portfolio vs the value at inception (see table below) and then compare this to the value of the indices on those dates. This still raises the possibility of a ‘calculation error’ (if there are typos in the formula that draw my stock values from Google Finance) but it should be more accurate.

Relative outperformance was 3.7%, which is pretty good in the context of an average 52% cash position, but absolute performance was poor. Due to a lack of data points, the above chart also hides the fact that I underperformed for most of the year.

(Thank heavens I’m not benchmarked against the S&P500, amiright?)

10foot tells a story

I tweeted awhile ago that I was finally ahead of my benchmark for the first time in awhile. When I was asked to explain how/why, I created this chart. Although outdated and only a rough approximation, it is a useful visual representation of the year:

Given that I have a ~3% handicap in the form of brokerage fees, 5.4% performance is OK.  However, even 100% cash would have beaten the XNT in this 12 month period. For illustration, approximately 1.07% of my performance in the past 12 months came from interest on cash held. An additional 0.3% came from dividends.

Rather than calculate cash returns daily, I add a fictional 0.5% to the value of my cash holding on the final day of each quarter (approximating 2% interest p.a.). In some quarters this will penalize me and in others it will be a net positive, depending on the timing of trades.

	At inception (30 March 2017)	At 31 March 2018	Performance since inception
10foot portfolio	$10,000	$10,543.23	+5.4%
XNT	54422.6	55345.2	+1.7%
XJO	5896.2	5759.4	-2.4%
XSO	2396.4	2665.5	+11.2%

I spent $284.05 on brokerage in the year. For illustration, applying a 70% discount to the brokerage fee (to account for scale, making brokerage a lower % cost on each trade), I would have spent “$85” on brokerage. This would have added $199 or approximately 2% to my annual performance. That would have taken underlying performance to ~7.4%. (As a side note, underlying adjustments are totally awesome. Not hard to see why corporates can get a bit carried away…)

In the grand scheme of things, a 5.4% annual return is not special, and relative outperformance was aided by the recent shakiness in the XNT and XJO indices. I am at least partially insulated against these by my stake in UK-listed Just Group, as well as by having 32% in cash.

If you’re new to 10foot I disclaim that I am an amateur investor. I wrote when I began this experiment that I was targeting 8% p.a. after brokerage, because that seemed a reasonable approximation for long-term returns from stocks.

Having shown myself that I can generate ideas and defend them; I now feel less pressure to put money to work. Conversely, I am now thoroughly paranoid about my investments, which has lead to a heightened focus on risk.

When I started the blog I intended to just ‘dive in’ and work as hard as possible to get set up. I think feeling pressure to deploy money was probably a key element in the additional risk I took this year. Now that I am feeling a bit more established in my process – having learned a lot, also – I’m looking to sit back and make fewer, better decisions. As a result I’m now targeting performance greater than 8%p.a.

Selecting and identifying the really attractive risk-reward tradeoffs – and concentrating in them – is a work in progress. I recently read a great interview with Tony Hansen of EGP. In it he states:

“In simple terms, when the mid-point of our modelled expected range of returns exceeds 20% annually, we will buy.”

That resonated with me immensely and it is something I am looking to bring into my own process. With $10,000, I am limited to below 20 investments (I think I will end up probably with around 7-10 holdings), so the risks of concentration are heightened.

On marking to market

I had a bit of a ‘moment’ Thursday afternoon when some absolute [unsavoury epithet] dumped 20k Tower shares at 68 cents, which wiped 3% off my annual performance (!). I was extremely tempted to value shares at the midpoint of the market instead of the last traded price, but I was bailed out by a couple of trades at $0.76 just before close.

This does raise an interesting question of where to value shares if they are illiquid and there are wide gaps in the market. In some circumstances I think it may be totally legitimate to value at the mid-market level, or at the bid if bid/offers are well above the last traded price.

I may have to do this with some holdings in the future, but not this time.

The portfolio:

The current value of the portfolio is $10,543, compared to $10,000 at inception.

Currently I’m 68.1% invested with 31.9% in cash:

This is on an actual market price basis, previous charts have been on a cost basis. I personally find the cost base more honest and I generally consider my investments on a cost basis rather than a market price % of portfolio basis.

Here’s what I think of my stocks:

Eureka Group Holdings

Down around 13% since I purchased, progress continues on the Terranora conversion, management is exiting most of the aged care homes, and looking to recycle capital into higher yielding opportunities. Eureka recently purchased 5 Tasmanian villages from Ingenia for $18 million.

I’m uncomfortable with Eureka’s debt position but coming sales and cash realised from Terranora should improve the balance sheet considerably and allow the company to continue acquiring. I think of Eureka as basically a capital-intensive roll-up with minimal operating leverage.

That doesn’t sound great, but it’s in a growing market and I think its strategy of buying in regional areas should allow it to maintain high occupancy and retain a decent ROI – it should have visible and highly consistent cash flows, and it’s hard to imagine a lot of competition in this low-cost part of the market.  I would consider buying more shares at a major discount to Eureka’s NTA of ~30 cents, but otherwise I wait patiently.

I have additional exposure to Eureka, I estimate another ~0.6% of my portfolio or so, via my holdings in NGE Capital (below).

Probiotec Limited

Probiotec is an interesting one and I am up 58% on average, making it my largest winner and driver of much of the portfolio’s performance to date.  First half results were strong and as I have noted previously, management has put an interesting set of incentives in place.  Directors continue to buy more shares on market and so do significant private equity shareholders CVC Limited (ASX: CVC).

I am stuck with the vague feeling that there are forces at work (corporate dealmaking) that I don’t understand or have visibility into, but with holders putting their money where their mouth is, and business performance strong, I continue to hold my shares.

Mayne Pharma – sold for break-even

I sold my Mayne Pharma shares during this quarter. It’s hard to escape the feeling that this was a poorly put together investment idea from the start and I am glad I sold.

NGE Capital 

NGE currently trades at about 44 cents, a 27% discount to its NTA of ~60 cents, both of which are essentially flat since I purchased. It has at least one potential catalyst via its unlisted investment in PowerWrap, which may IPO this year.

It’s early days yet and I have not put NGE under as close a microscope as I do with my other companies. I view this part of my portfolio as ‘outsourced’. NGE took substantial losses on Godfreys, went backwards somewhat on Eureka Group (which I also hold), made a lot of money on MDL, still hold PowerWrap (unlisted equity) and took a few early hits on their new investment in Millenium Services.

(I recently published an interview with NGE Exec Chairman David Lamm which is relevant to those interested in this company.)

NGE first year performance was decent and I am happy to hold. While management has stated otherwise, and while there is obvious upside here, I continue to believe that NGE ‘fair’ value is a ~20% discount to NTA. An investor I follow, Steve Green, has commented that communication can help LICs narrow their discount to NTA, and given the recent interviews and presentations by NGE this is a possibility. However it is not part of my base case.

I have no real comments either way other than to say that I keep an eye on the companies NGE owns to maintain a view of the kinds of risks that are being taken, and to avoid too much overlap with my portfolio.

Speaking generally – this is not a comment on NGE – I believe if you follow and judge every decision a manager makes, you will quickly talk yourself out of their fund because their decisions will not always agree with yours, and once you see 4-5 decisions that don’t align with your views, you start asking “well, wtf are these people doing?” It is important to remember that the investor is buying a process and as long as the process is viable and repeatable then the performance and the risks, rather than the investment decisions per se, are the key thing to watch.

With this in mind, I have a multi-year timeframe for NGE and I don’t expect to make any further trades in NGE shares.

Crowd Mobile – sold for a 50.6% loss on the position, or 2.6% loss of capital

I sold my shares in Crowd Mobile for reasons I detail here, and I ain’t goin’ back. I ain’t goin’ back!

Oliver’s Real Foods – sold for a 0.8% gain on the position, and immaterial impact on the portfolio

I sold my shares in Oliver’s (to IOOF, it turns out) for reasons I detailed here. I like the company and I’m keeping an eye on it but the uncertainty was too high for me. I am not sure the business is progressing the way that it needs to in order to succeed. Given the choice I would have reduced my position rather than sell, but I didn’t have that option.

Oliver’s has just replaced its CEO, and I am quite interested in potentially buying back into this company. I think the new bloke has his work cut out, and I am nervous about whether the brand is really hitting the spot for customers, but I am watching closely.

Just Group plc 

Just Group released its preliminary results during this quarter and I thought they were solid. I bought 400 more shares at 139 pence, or A$2.54 after brokerage. This was a slight discount to my initial purchase at A$2.63, and I am down approximately 3% from my average buy price.

Just’s results were padded by reserve releases but even so, Just Group now trades at approximately a 15% discount to book value and about 8x its net profit after tax of 155m.  On an underlying basis excluding the favourable assumptions impact, Just is priced at about 10x profit, I estimate. Or alternatively, it’s priced at about 9x new business profit.

It’s a complex business and I don’t want to oversimplify it and say “hey this is cheap”. Still, with a discount to book value and a ~10%(ish) earnings yield, combined with an approach that focuses on writing profitable business rather than volume & competing on price, I find Just Group very interesting.

Interest rates are going up which I expect will lead to some changes in consumer and business behaviour, and it is hard to know if these will be net positive or negative. One possibility is that higher rates make it easier for corporates to meet their pension return requirements, reducing DB outsourcing demand. I am also concerned about possible credit risks in Just’s bond portfolio as rates rise and the ECB tones down its bond buying program.

One major concern I have is that Just’s Solvency II ratio will shrink over the next few years as Just grows with new business, before it should start to expand again in the early 2020s. This creates risk given that solvency and the availability of capital are the lynchpin from which all else flows. I am looking for alternative views on Just, so if you have one, please get in touch.

Tower Limited

I think Tower Limited shares have probably run a bit ahead of themselves following the recent AGM update that revealed a 14% increase in GWP to date. I continue to think Tower is worth around $1, and potentially more if it can grow market share; recent GWP growth would suggest that it can. Bain Capital recently bought Vero’s 20% stake at above market prices.

Bain buys Vero’s 20% stake in $TWR. Interesting move. If I had $50m I would have bought it myself. (held)https://t.co/dQgmbIec58

— 10foot dog (@10footinvestor) March 8, 2018

I note that Bain’s move and Vero’s (presumed) influence on the capital raising price – which was ridiculously low – enabled Vero to exit at a profit to itself. That says to me that this is a game of larger corporates now and the individual shareholder will have to be a bit more wary when it comes to looking out for his interests. Best guess; there’s another bid for Tower in the works.

A key risk for me is that Tower is cutting prices to grow market share. Management states that they will start to use risk/address- based pricing, but they say that less than 1% of customers will receive a significant increase in their premiums. So less than 1 percent of customers will have higher prices, but that will let Tower slash prices across the board for all its non-earthquake risk customers? What if the majors join the race to the bottom?

This may be a prudent decision, or the 1% figure might exclude customers that don’t renew due to the now-higher prices, but shareholders have to trust that management will only be insuring the low risk areas (which could mean the lower prices are ‘safe’).

While I think he is a great CEO, I am fairly critical of CEO Harding’s remuneration package because it is 100% cash, he owns sweet F-A shares and the requirements for his cash STI bonus are not clearly articulated. Still I think that in the past this has been beneficial because he has been incentivized to stabilize the business rather than grow accounting profit, for example. I have approached Tower to get more clarity on executive compensation.

I am generally in favour of the company’s push for risk-based pricing – but I am watching the risks very closely. I sent a number of questions to Tower around 1 month ago for publication on my blog; IR indicated that they would respond but I am still waiting. For now I remain a believer in the turnaround strategy and continue to hold.

Undisclosed

I recently purchased shares in a resources company. I’m down 2% which had an immaterial impact on portfolio performance. This is a high risk business with a lot of future execution risk, but it has been consistently profitable even through a down cycle, and will soon be debt free. I think there is a good case to be made that it is mis-priced and that recent developments have alleviated a lot of the market’s concerns.

I am looking to benefit from a stock price re-rating, rather than from the underlying value of the business, as all cash earnings will be reinvested in developing new resources for the next 3-5 years. This lack of cash flow carries obvious risk. I am currently modelling these new resources in greater detail and will consider my investment in light of the results of that. I likely will not disclose this position until after I’m comfortable with my model, which could take a while as I am not skilled at modelling.

And if you’ve read this far…

If you’ve read all the way to the end, thank you. I know that this was a ridiculously long post, but I had a number of important things that I wanted to record for future reference.

Of the companies mentioned, I own shares in Eureka Group, Probiotec Limited, NGE Capital, Just Group, Tower Limited, and a sixth undisclosed company. This is a disclosure and not a recommendation.