Value Investing

OC Premium Small Companies Mandate February 2016 Report

OC Premium Small Companies Mandate performance report for the month ended February 29, 2016.

OC Premium Small Companies Mandate – Performance review

February was a volatile time for equity markets with a sharp sell-off at the start of the month promptly followed by a commodity-driven rally which caught many investors, us included, by surprise. The S&P/ASX Small Ordinaries Accumulation Index (+0.9%) rallied hard after being sold off heavily earlier in the month with commodity stocks the key driver of performance. Indeed, the S&P/ASX Small Resources Accumulation Index was up a staggering 19.4% for the month versus the S&P/ASX Small Industrials Accumulation Index which was down 1.6%. Against this backdrop, the OC Premium Small Companies Mandate, which has no direct exposure to single commodity or single mine resource stocks, finished the month down 1.9%.

OC Premium Small Companies Mandate

During February, most ASX-listed stocks released their interim results (or final results for those companies with a December 31 financial year end). We cannot recall a results period in the past decade where so many smallcap stocks displayed such share price volatility around the release of their results. Certainly with the advent of continuous disclosure, share price reactions to results announcements have tended to be far more muted than those that we witnessed in February.

Although the Mandate does not invest directly into single commodity or single mine resource stocks, it does have exposure to the commodities thematic through two of the higher quality mining services names in our investment universe, namely Mineral Resources (MIN) (+55.3%) and MACA Limited (MLD) (+15.0%). Both companies currently earn the majority of their profits from crushing, screening and processing ore for quality clients across a number of different commodities and mine sites. Both have a strong reputation among their clients and typically operate under long-term contracts. Importantly, both MIN and MLD have strong net cash balance sheets that position them well to weather any protracted commodities downturn. We have lightened our holding in both companies into the strength of their first-half results, following their respective strong share price performance.

OC Premium Small Companies Mandate – Portfolio attribution

Costa Group (CGC) (+12.2%) – re-rated after delivering a strong interim result which reinforced our view that this is a quality company with less agricultural risk (~75% of the crop is weather protected) than most market participants would ascribe to it. CGC’s four key categories: mushrooms, berries, tomatoes and citrus have been growing at +10% over the past three years with the company also growing its market share. Management has a raft of domestic and international growth initiatives that ought to drive double-digit earnings per share growth over the medium term.

Burson Group (BAP) (+11.9%) – reiterated its credentials as one of the better managed growth stories in the Australian small companies universe by posting an interim result ahead of consensus expectations. Investors may recall the company purchased MAH (formerly Metcash Automotive) on 31 July 2015 which included the Autobarn, ABS and Midas store networks. Pleasingly, both the existing highly defensive Burson trade business and the recently acquired MAH stores delivered strong sales and margin growth and demonstrated an impressive ability to pass on supplier price increases (which were driven by the lower Australian dollar). In our post-result meeting, management articulated a clear strategy to grow each of its key business units and cement itself as Australasia’s leading provider of aftermarket parts, accessories and services. BAP remains a core holding of the Mandate.

Ozforex (OFX) (-38.9%) – early in the month, the Mandate was dealt a blow when OFX announced the termination of discussions with global payments suitor, Western Union, following an extensive period of due diligence. Concurrently, the company announced it now expected underlying EBITDA for FY16 of between $35 and $37m, down from previous guidance of between $38.5 to $40.5m. Management cited lower-than-expected customer acquisition levels and decreased volatility in foreign exchange markets leading to lower activity levels from both new and existing clients in recent months. Management distraction with the Western Union approach would likely have played some part as well. Our general rule of thumb is to sell operational downgrades when we are not anticipating them but the severity of the share price reaction has led us to retain our holding in OFX. Management remains committed to a target of doubling 2015 revenue by 2019 and we believe the strategy to reinvest into the business to accelerate growth remains sound.

Programmed Maintenance Services (PRG) (-34.8%) – announced a weaker-than-expected business update and provided earnings guidance for FY16 and FY17 which was below our expectations. While we had factored into our analysis lower demand from the resources sector, particularly oil and gas given the steep decline in the oil price, we had not anticipated the extent of the deterioration in the shutdown and maintenance business which we expected to be more resilient. Transparency in PRG’s key markets remains low and given the deterioration in the company’s earnings profile, we expect there will be a heightened focus on its debt profile given the lower guidance significantly reduces the headroom in its debt covenants. We exited our position in the company following the announcement.

Cover-more (CVO) (-23.0%) – travel insurance and medical assistance provider, CVO, was another high profile name to disappoint the market during reporting season. The key issue in CVO’s result was a $5.6m increase in claims costs largely brought about by currency movements, which was only partially offset by a $3.8m increase in insurance growth. The company has flagged a change to its pricing model and will aim to transition to a “generalised linear model” which it claims will reduce volatility, smooth out margins and should result in a return to growth. Most investors, us included, had believed the current pricing model already allowed for the recovery of most of the currency risk. We have sold our shareholding but note the company has been sold down a further 15%+ since our exit. If the company can successfully implement a new pricing model that will reduce margin volatility, it would be a catalyst for us to revisit the stock as a potential investment.

OC Premium Small Companies Mandate – Outlook

Commodity stocks rallied hard in the back-half of February and have continued to do so into March with the commodity bulls now in full voice. Equity markets are being swept along on the back of a resurgent oil price with Brent crude, the global benchmark, now 50 per cent above the 12-year lows it had plumbed in January. Strong price gains in other key commodities, such as iron ore and copper, have added to the euphoria.

This is in stark contrast to the prevailing sentiment we witnessed earlier in 2016, when concerns about slowing global growth, tightening financial conditions in the US, economic instability in China and an oil price rout had investors firmly in “risk off” mode.

We all know markets can be somewhat bi-polar but has anything really changed to warrant this new found commodity-driven optimism?

Oil prices have climbed on the expectation the major global oil producers may soon reach agreement to control levels of output following decisions by Russia, Saudi Arabia, Venezuela and Qatar to freeze production at January levels. But we are still a long way from reaching an equilibrium point in oil markets, which are still heavily in oversupply. Moreover, other large cashstrapped producers, such as Iran, may be tempted to boost production to raise revenue to help balance their budgets.

Likewise, the longevity of the rally in iron ore and copper will likely depend heavily on resurgent demand out of China given it remains the key consumer of these commodities. Anecdotal evidence suggests overall Chinese demand for these metals remains unchanged. The Chinese government appears committed to policies geared towards transitioning the economy from one based on investment to one driven by services and domestic consumption. Should Beijing continue on this course, as we expect, the rally in iron ore and copper may prove short-lived.

Given the market’s current fixation on resource stocks it might be timely to remind investors why we don’t invest in single commodity or single mine resource stocks in the OC Premium Small Companies Mandate:

  • Mining companies outside the S&P/ASX 100 are often single mine owners, typically exposed to one commodity and have a volatile (or nil) earnings stream. We therefore consider them risky investments that are difficult to forecast.
  • The earnings of these companies (where they exist) is usually heavily reliant on commodity prices and currency movements. Many merely own a resource that is undergoing feasibility and is yet to be mined or even proven.
  • Two key drivers of share price performance for small mining companies are typically exploration success and commodity price movements, leading to a greater level of risk from uncontrollable factors. As longterm investors would be aware, we do not invest in companies where the key drivers cannot be reasonably forecast by our analysts due to the excessive risk this entails.

The Mandate instead gains exposure to the commodities cycle by investing in quality companies that can service the mining sector. In particular, companies that can enter long-term or take or pay services contracts with a diverse client base that operate across multiple commodities, mine sites and projects. Current examples in the portfolio include Mineral Resources and MACA Limited.

Overall, we remain bearish on the commodity space including most mining services companies in the Australian small-cap space. Most mining services stocks currently have limited work in hand, they face fierce competition on projects up for tender and are battling negative fixed-cost leverage as much of their equipment sits idle. Moreover, most of them have too much debt and will face ongoing issues if the commodity cycle doesn’t turn in the medium term.

We acknowledge our aversion to investing in single commodity or single mine resource stocks means there may be periods in which we underperform the S&P/ASX Small Ordinaries Index. We point to our proven ability to deliver investors strong long-term returns as validation of our philosophy and investment process.

March promises to be a busy time for the investment team with many meetings scheduled with company management post reporting season. Next week, we have analysts heading to the UK and Asia for a series of meetings with Australian-listed companies (and their peers) operating in those regions, as well as industry and regional experts who will deepen our understanding of our investment universe. We look forward to reporting our findings back to investors in our March report.

OC Premium Small Companies Mandate

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