Buyer Beware

The bottom end of the ASX is a bad place to be. There is a huge party going on at the moment and it’s happening at the expense of household investors. I wanted to write something that I hope household investors (of which I am one) will find useful. My usual disclaimer applies here, I am not a professional investor, but once you have been investing for a few years you build a list of red flags and other things that you avoid in an investment.

The trouble is that an actual expert might see 5-10 companies with warning signs, discard them without a second thought, and not feel any compunction to write about them or actually do the hard yards to prove they are terrible. This is time-consuming, difficult, risky in several ways, and you don’t get paid for it, except in rare instances where you can build your rep/FUM like Forager Funds and Dick Smith.

There is a dearth of negative stock coverage in the market, and despite the huge proliferation of advisory services, there is no market for a service that points out bad stocks. Even short sellers do not do this work because there is often no borrow on the tiny stocks, and many of these stocks get priced on hype and/or are manipulated and can conjure a higher share price seemingly from thin air, making them dangerous to short. There are no formal warnings for the household investor in small-cap speculative shares, and no market for creating any. I have done my best to pull a few things together below:

Number 1: We’re at that point in the cycle

The first thing you need to know is that it is a really good time to be selling something. At this time in the cycle, although it does not look like it among the larger companies, money is falling from the sky. Anybody who can is building something to sell to the market; SaaS, baby formula, lithium, graphite, cobalt, blockchain, crypto, Internet of Things, or even just mediocre businesses cobbled together into an IPO. I joked about a 10foot IPO not long ago, but in today’s market I actually think it’s a possibility. And if that doesn’t terrify you, it should.

Fees (say around 6% of capital raised) are paid to the broker sponsoring the IPO, so if a broker can convince enough investors to pay up, they can earn millions in fees. I don’t think there is a huge problem with brokers per se, but there are issues with the companies being sold. Anyone who can is building stuff to sell, which is a sign that you should not be buying.

Steve Johnson of Forager wrote about this phenomenon just a few days ago.

Number 2: Do not touch Chinese stocks

I would hate to beat all businesses equally with the ugly stick, but if a company’s sole business is inside China, your default position when considering an investment should be ‘this company was put on Earth to fuck me’, because I shit you not, that’s what it’s here for.

Do Chinese companies IPO because they want to sell parts of their truly great business to gweilo, or do they sell because they want real money (AUD/CAD/USD) with which they can invest in overpriced property, send their kids to foreign schools, and earn an income outside the grasp of the shade of Mao Tse-tung?  I’m sure it’s probably the first one.

In my opinion, Chinese companies sell shares because buyers hand over real cash in return for worthless pieces of paper, i.e., assets whose ultimate ownership + cash flows will never be allowed to pass outside China. Many ASX-listed Chinese companies can’t get cash out of China, so you’ll never see a cent in dividends. Investors also need to watch for off-balance-sheet liabilities, like one company guaranteeing another company’s debts, although I’m not sure how prevalent that is amongst ASX-listed Chinese companies (by definition, it’s not easy to find).

Number 3: Dodgy LIC behaviour

This has become a bit of a hot issue recently too. Probably the most important thing to understand about LICs or similar vehicles is that they are what’s called ‘captured capital’. Once the cash goes into the LIC, e.g. via a capital raising, it does not come back out. The only way to realise your stake (unless the company gets wound up, which is out of your control) is to find another investor willing to buy your shares from you.  This is hard to do at the small end of the market, and gets much more difficult if the company changes management or establishes a bad reputation. If your investment gets frozen/ suspended, the manager can continue charging management fees while your investment is locked up and you are unable to sell.

SMH wrote about Naos/Contango

AFR wrote about Aurora misplacing a million bucks

There have been comments elsewhere in the media about Keybridge Capital, Molopo, and so on.

Number 4: Misconceptions about the role of regulators

Whose job is it to figure out if a company is kosher or not?  The answer is no-one:

ASX: Market operator. Their job is to monitor compliance with the listing rules and operate the market, not to police unconscionable conduct. The ASX gets paid to have lots of companies listed and to keep its costs controlled, so it is not in its immediate interest to be delisting companies or causing them problems.

ASX compliance officers I have found are generally well aware of shady behaviour, it is just hard for them to do anything meaningful about it. You will never see an ASX officer telling a company ‘you are full of shit’ which is unfortunate because this can be the truth. Instead, investors get a query between a disincentivised questioner (the ASX) and a self interested party (the company) that is professionally polite, reasonable, an exercise in political spin, and capable of lulling an investor (or allowing them to lull themselves) into a false sense of security.

ASIC: Market regulator. But hey, if you know what ASIC actually does all day, let me know. I follow them closely and they definitely have their finger on the pulse. However they are woefully inadequate when it comes to actually regulating behaviour. Are you a dodgy financial adviser/ salesperson? Expect to have your career ruined and be banned from finance for life (justifiably so). But are you a dodgy or fraudulent company? Insider trading? Front running?  Would you mind awfully much if ASIC gives you a $50,000 fine with no admission of wrongdoing, and consults with you first to see if you thought that fine was appropriate?

The problem is that ASIC regulates compliance with the law. Their job is not (well arguably it is, but they don’t seem to do a lot of it) to forensically pull companies apart and proactively act to prevent chicanery. There are huge grey areas in finance, especially around valuation, that can be easily exploited while still appearing reasonable.

Auditor: Checks compliance with company and regulatory procedures. Many times historically, auditors have been used to add authenticity to dodgy companies. Australian audit quality is appalling, according to the outgoing head of ASIC. Additionally, it is not the auditors’ job to forensically pull apart a company. They spot check transactions, check the cash at bank, and a bunch of other things, but they don’t appear to apply professional judgement in many cases. If they do, it’s in dry, formal language in the audit report that may be unintelligible to amateur investors without the time or knowledge to understand the implications of the auditor’s concerns. Audit firms are paid by the company and can simultaneously seek to do other business with the company (conflict of interest), can have long tenures, and there are historical examples of prominent auditors getting too close to their clients and being compromised by it. It is theoretically the auditor’s job to check valuations, but there are grey areas.

So whose job is it actually to establish that a company is a fraud (or whatever the problem may be)? The investor is on their own. Professionals have the tools, skills, and experience to make the necessary judgements, but they are not paid to point out bad stocks. Some of them make money by engaging in shenanigans themselves (see LIC articles above).

Additionally, unsuitable investments are increasingly being marketed directly at retail shareholders, bypassing the rigour of institutional investment checks and unintentionally (actually, I would argue intentionally) lowering the bar for a public listing.

There are also huge disincentives up and down the market that prevent people from criticising dodgy companies.

Number 5: Disincentives for pointing out dodgy investments:

  1. Career risks for analysts. You could lose your job, especially if you upset broker relationships (brokers are known to offer good deals to favoured clients). Finance is also a very small field where everybody knows and follows everybody. An analyst’s rep will stick with them.
  2. Business risk. This is a broad category, including the broker relationships I mentioned above, but basically if you are a fund manager/financial adviser you could lose clients, hurt your reputation, attract negative regulatory/legal attention (especially if you’re short-selling), and so on. The risks are doubled if you’re wrong, and dodgy behaviour is rarely unambiguous, exacerbating the risk.
  3. Litigation. I have not seen many Australian examples of this but it is not unknown for companies to send threatening letters and litigate against their critics.
  4. Personal risk. Expect blowback if you criticise a hot stock, and it is not unknown for people to receive threats and similar. US hedge fund manager David Einhorn was famously spied upon by Allied Capital, a ~billion-dollar company that illegally accessed his phone records, among other things.

Number 6: No-revenue hot stocks in Lithium, IoT, Crypto, Cobalt…et cetera

Where do I start?

I can’t tell you what to look for in an investment. But there are a tonne of things you should avoid, and you should approach all investments, especially in the smaller end of the market, with the assumption that you are the patsy at the table.

I have no financial interest in any company mentioned. This is a disclosure and not a recommendation. 

Picture sourced from the New York Bar Picture Book.

10foot Scuttlebutt – November 2017 edition

Back with another version of scuttlebutt, and a few things I’ve seen or thought about recently. As usual, you are agreeing to my disclaimer, and the following represents some idle thoughts I’ve had about various businesses in recent times:

Oliver’s Real Foods (ASX: OLI)

Oliver’s is working smart financially. The company is selling and leasing back properties for 10-15 years with 2 x 5 year lease extension options . This has excellent implied value over the long term (if the business itself is a success), because they can recycle the cash to keep expanding. Recent transactions suggest a new site could be acquired for as little as ~$200k net or so (before fitout, inventory, startup costs etc). This has alleviated some of my concerns about how capital intensive their growth is, and I think the target of 60 restaurants (~23 currently) is looking more feasible. Execution remains a key risk and cash flows were weak at the recent quarter.

Getswift (ASX: GSW)

Getswift is a high risk proposition at today’s prices in my opinion. Hockey-stick implied revenue growth, minimal staff, minimal R&D expense, several competitors in adjacent fields with no barriers to entry, and indeterminate locked-in revenues or switching costs. Additionally, the company appears limited to small-scale customers in my opinion – anyone with serious software needs could develop an in-house solution that is cheaper and tailored to their specific requirements. Getswift has:

  • Fully diluted market cap of over ~$400m (more than 400x annualised revenue)
  • Management implying potentially 1.15bn transactions in North America due to one deal with NA Williams (UPS delivered 4.9bn parcels globally in 2016)
  • Getswift spent $0.92m annualised on staff based on recent quarterly. ~$600k of this goes to exec remuneration. (apparent limited development capability – implies only a handful of non-exec employees doing R&D, sales, support, IR etc, for a $400m company).
  • Getswift is growing deliveries aggressively but $ per delivery is declining precipitously with recent deals like NA Williams (has negative implications for lifetime value of deals + new customers)
  • Almost zero development/marketing/advertising budget (look at what comparative – or even smaller – companies spend on these things in the USA…millions of dollars every year)

 

I also note this quote from the recent announcement from the company (14 Nov):

The Company is taking a measured approach in ensuring that only quantifiable and impactful announcements are delivered to the market. With that in mind it has chosen to announce 9 of these integrations once they have all been completed rather than individually.”

To me that implies either a) uncertainty regarding the likely amount of deliveries conveyed by recent deals (given the implied 2.5 million stores integrated), and/or b) an awareness that the company is quite hyped and a reluctance to contribute to any further hyping. Either interpretation speaks volumes to the company’s current situation.

Lastly, a Dun & Bradstreet credit report from 3 November 2017 suggests that N.A. Williams has $21m in annual sales, $5.5m in assets, and 130 employees. I do not understand the means by which a deal with a company with 130 employees could convey up to 1.15bn transactions to Getswift when ‘fully captured’. I think this is an area to watch and it is important to keep the sceptical part of your brain engaged, especially in light of Getswift’s ~500% price rise YTD.

Myob Group Ltd is in trouble (ASX: MYO)

I have had an eye on Myob as a turnaround ever since it listed (it hasn’t gone anywhere since it listed, but it should have gone one way – down) but I think there is a lot of pain to pass under the bridge between now and then. In my opinion, Myob is sowing the seeds of its own destruction. Rather than investing in its product to draw customers from their old (free) desktop solutions to paid, modern solutions with greater functionality and scalable revenues, the company is a) focusing on paying dividends and b) levering up further to buy things that it doesn’t need. There are low hanging fruit that both it and Reckon (ASX: RKN) could pluck by reinvesting in the software business over the next few years, but both companies are over-indebted (well, Reckon won’t be after this transaction) and in my opinion without serious reinvestment, Myob will be consigned to mediocrity and eventually, irrelevance. Could be a cigar butt in a few years, once Bain gets off the register and if it pays down its debt .

Crowd Mobile (ASX: CM8)

After the rumours of a share price pump I see that the Crowd CEO has sold 5.6m shares to extinguish a personal liability. Cause and effect or fooled by randomness? This is probably pretty close to the 3-month VWAP, i.e., a fair sale price. Still, I don’t understand why Crowd shares would suddenly go to $0.24 (up 70% in a few months) right before the CEO sells. Fundamentally, if the company can maintain this level of cash generation, it should prove quite cheap. Even so, I will be looking critically at Crowd over the next couple of months especially in light of what the upcoming half year might look like.

An interesting pairs trade in gold? 

I think there may be an interesting pairs trade in gold miners, for those interested in that sort of thing. It looks as though you could short Newcrest Mining Limited (ASX: NCM) at ~35x earnings with some debt, and go long something like Resolute Mining Limited (ASX: RSG) at 5x earnings with minimal debt and a fantastic CEO.  I reckon a Resolute long and a Newcrest short are interesting on their individual merits, with commodity price (+ interest rates, etc) and its correlation with the share price the obvious risk.  By shorting one and going long the other, theoretically you would be closer to gold price neutral and could look for the value of both companies to converge. I haven’t done a lot of work on NCM but I had a very good look at Resolute a few months ago for 10foot. (I was going to post about it but it got trapped in writer’s purgatory).  Just an idea that occurred to me.

If you know stuff about gold miners, get in touch. I quite like Resolute but can’t get a grip on its likely value through the cycle.

Wesfarmers Ltd as a sum of the parts (ASX: WES)

I have jumped on the Wesfarmers-breakup story bandwagon. With seemingly every fund manager in Oz looking at the company from a sum of the parts perspective, given the rumoured sale of Kmart, Officeworks, and/or Target, I spent a couple of hours looking at it over the weekend.  If you assume that every business could be stripped down and sold off at a top price; 16-18x P/E for Officeworks, 22-24x for Bunnings, etc (or equivalent high multiple in EBITDA) then you could probably squeeze a few extra billion out of Wesfarmers.

If, however, the businesses sold for what I would be willing to pay for them, which is more like 12x for Officeworks/Coles, then really Wesfarmers’ needs to be 30% cheaper to even get a look in. It would be pretty interesting as a levered buyout target, especially if you could rip some capital out of the company.  However, right now, a breakup story looks like a ‘greater fool’ investment to a mug punter like myself.

Until next time.

I own shares in Crowd Mobile and Oliver’s Real Foods. I have no financial interest in any of the other companies mentioned. This is a disclosure and not a recommendation.

The Gig Economy, Round 2

I saw the gay marriage result today and that got me thinking about the gig economy and working conditions. What do gay people have to do with the gig economy? Not sure – but AMP’s Shane Oliver asserted on Twitter that workforce participation would likely pick up now that gay people can marry.

Why would gay people be more likely to work if they’re married? Again, not sure – the converse of this would almost be to argue that workforce participation should decline because the marriage rate among hetero couples has been falling over the past 20 years. Actually, workforce participation has declined since 2008 (except for very recently), and you would probably get a reasonable correlation between workforce participation and heterosexual marriage rate, but that is a pretty edgy connection to make. But that’s why I’m a hack with a blog and Oliver’s the guy getting paid big bikkies.

Extemporaneous rant aside, I am in the early days of an (undisclosed) 10foot investment that will work out extra-well if a stack of people lose their jobs. Management is pretty friendly but I think if a tech-savvy version of Carl Icahn came in, perhaps up to 30% of this company’s workforce could be cut. I was thinking about the difficulties of losing your job in a corporate restructure, and following this line of thought I foresee two big problems for society:

  • Lots of jobs are being destroyed. Heaps of people will be obsolete by 2030. This is often touted as the problem du jour, but I think that’s inaccurate. Plenty of new jobs will be and are continuously being created.  Jobs being destroyed is not actually the problem.

 

The problems are:

  • An inability to access the new jobs because of difficulty retraining

Education is gradually being wound back and more of the cost is being passed on to students. For example, universities are now allowed to levy a student services + amenities fee (SSAF) to fund extracurricular activities + services at their uni. This is an additional ~$300 per year. Not much, but as a full-time student that could be 2%-3% of your annual wage. The threshold for paying back your loan has also reduced. Previously it was more or less non-recourse debt, but it is increasingly becoming recourse and you can start paying your debt back once your salary exceeds approx $53,000 (not sure exact figure). Instead of being a tool to improve yourself and earn a higher salary, now degrees are becoming mandatory for jobs (at the same time as attaining a degree is getting more expensive) and with the lower salary required for repayment, it’s almost like an additional tax.

A technical degree could cost north of $50,000. Yes, the cost of HELP-debt is low and the person will (should) get paid more yada yada, but universities + the economy are absolutely appalling at allocating students to industries in demand, so a degree far from guarantees a job. Plus, that is an astonishing liability to land on someone and it nibbles away at your income for the rest of your life. HELP debt is also not available to all equally. Some will be unable to retrain either due to their citizenship or family status (unable to afford to work part time while they study, for e.g.).  In my opinion there is a definite class of people that will struggle to access retraining services, for several reasons. New migrants are severely disadvantaged because even if they can afford education (they are not eligible for HELP), the cost for ‘foreign’ students (including recent migrants) is prohibitively high, up to 2x or more the cost of a Commonwealth Supported (i.e., subsidised) Position.

I think that greater effort needs to be made to make retraining services accessible and affordable. Additionally, the need for retraining should probably be taught as early as high school. The one-career-for-life Australia of our parents is irrevocably gone and I would suggest that many of our politicians – who grew up under this model – are woefully out of touch and verging on incompetent when it comes to this issue. If you plan to retrain and consistently set money aside for this purpose, it is not infeasible to do so, but many people are not aware of the need and do not save appropriately. Additionally, the increasing erosion of working rights, including the minimum wage, is going to make it more difficult to save, in my opinion.

  • Distribution of wealth being affected by erosion of worker protections (via gig economy, Uber, and indirectly, corporate tax avoidance, trust structures for wealthy, etc)

I have written about this previously in my post on The Gig Economy. I won’t repeat that post, but underclass roles are growing in their prevalence. When you are in a role that is dependent on constant output from you (e.g. Uber) with no holidays or sick days, it is extraordinarily difficult for you to take a risk on education and a lower income when you have no margin of safety – especially if you are supporting a family. It is also becoming increasingly difficult to build a safety buffer in the first place if you start your working life in an unskilled job. This is exacerbated in Sydney due to property prices but I believe it is a serious problem elsewhere as well – rent might be cheaper outside of Sydney, but unemployment is higher.

In line with this, I think we are seeing the increasing erosion of conditions for workers over time, a process ironically hurried along by some of the more militant unions. You can see snatches of this erosion in the corporate restructuring on the ASX and changes to worker incentive programs. (The cynic in me notes that the CEO remuneration machine chugs along undisturbed…)

The problem is not that jobs are being destroyed, workers are becoming more flexible, or even that the nature of work and employment conditions are changing.

The problem is that many workers appear to increasingly lack a safety net, and this is occurring at the very same time that retraining appears to be getting more difficult due to higher costs of education and so on.

Tangential to this:  There are loads of immensely valuable courses on the web that can be accessed for free and are very flexible. However, an inflexible hiring regime that places emphasis on qualifications rather than achievement or capability is a double whammy – operating deleverage – for those needing to retrain at the same time as retraining services are becoming more inaccessible.

I do not know how to resolve this, but I think that as a country we are at a crossroads on this issue. The next 10 years will decide whether we degenerate into more of a US-style wage-slave corporatocracy, or whether we take a higher road like the Euro countries. I acknowledge that neither is perfect, but I think in a society as prosperous as ours, high standards of social mobility, and a life of dignity for the least of us, should be our hallmarks.

Disclosure:  I don’t have any personal or financial interest in or relationship with either AMP or Shane Oliver.