Quarterly review September: Q1 2018

So ends the second quarter of 10foot’s short life so far. On balance, I should have underperformed, given that I blew 4% of my capital on RNY Property Trust and lost a little bit on Thorn Group Ltd (ASX: TGA), plus I pay 3% in transaction fees, so I am behind from the get-go. The 10foot portfolio was mediocre but, lo! I am 65% in cash and the market was worse.

I am thinking that I would like to up the 10-foot portfolio size to $20k and switch brokers as the transaction fees will prove quite a hurdle – and so will the minimum 5% positions. That’s something I will consider for the next little while. Anyway here’s how I performed:

10foot versus the ASX200 net total return index since inception. Performance as of market close on 30 September.

Here is performance vs secondary indices, XJO (ASX 200) and XSO (ASX300 excl ASX200):

10foot portfolio vs its secondary indices since inception. Performance as of market close on 30 September.

I forgot to add my interest on cash for the quarter, so performance above is slightly understated. To calculate interest, I simply add 0.5% to the value of cash remaining at the end of each quarter, as a way of approximating a 2% annual interest rate on cash. Interest ‘payments’ were $32.45 in the September quarter, which would have added 0.3% to performance.

It is too early to make any judgements about relative performance. However I am primarily buying small caps so I should really be outperforming the small ords index also (yellow line above). I will continue to report performance vs all 3 indices, although Google Finance is making major changes or closing its portfolio feature in November, so I may have to find an alternative solution for the next quarterly. Sharesight sadly does not have the features I need, like a cash-linked transaction function.

My current allocation to shares at market values vs cash:

The 10foot portfolio.

Note that some of the cash is fictional as I am still saving for the portfolio, but the fictional amount is much lower than last quarter. 

And here are the positions themselves:

10foot positions as at 30 Sept 2017. Note that RNY + Thorn show their last close price per share, not the price I sold at. Loss percentages are accurate, however. Data via Google Finance Portfolio.

I pay $14.95 to my broker each time I buy and sell, which equates to a 3% fee on a $500 (5% of capital) position. Originally I thought that I would be holding companies for 3-5 years, so the transaction fees would be mostly irrelevant. That is still the goal, but the way the 10foot portfolio has shaped up so far there has been more activity than I thought.  So transaction fees are too high and I may change broker.  Here are my latest thoughts on each of my positions:

RNY Property Trust (ASX: RNY) – sold for loss of $401.90 which is 76% of the position, or 4.01% of capital

I sold RNY for a hefty loss for reasons I detailed here.  While the outcome was not ideal, on balance I think I had a reasonably good process. The key issue is that RNY was too large, and should have been a 1% or 2% position. Given the 10foot portfolio’s size, I can’t have a position smaller than 5%. At the time I purchased I thought ‘well, this is a good opportunity, let’s buy it’. But for the relatively binary events like RNY, 5% is too large.  If a stock should be a 1% position, but can’t be because 10foot has a 5% minimum, then I shouldn’t own it. (blindingly obvious) Lesson learned.

I was probably lazy with position sizing as 10foot is not my entire wealth, and I was sizing to risk/reward me not 10foot. More on that below.

Thorn Group Ltd (ASX: TGA) – sold for loss of $45.26 which is 8.6% of the position, or 0.45% of capital.

I sold Thorn Group for reasons I detailed here, but in essence I lost confidence in it. I still think it’s probably undervalued given the one-off regulatory charges. But the key thing is that for it to be undervalued, it has to be able to keep making new leases to customers, and I’m not very confident about Thorn’s customer demographic, and competition is increasing. To consider buying Thorn again I’d want a fatter opportunity, something like if it were trading below book value and/or at the bottom of the cycle, not the top like we’re at now.

Eureka Group (ASX: EGH)

Eureka had a strong report, with a big leap in revenue that was overshadowed by the huge blowout in costs. At least part of the cost increase was due to investment in Terranora which should unlock considerable value when sold, but I was expecting that costs would rise slower than revenue. It is hard to tell though, as acquisitions (esp. of vacant properties) cloud the picture. With the empty properties it’s been acquiring, Eureka wears all the operating costs plus advertising, transaction fees etc up front before it can earn rent to offset the fixed costs. This could be a recurring issue while the company is small, but equally, I expect to see progress made on costs as % of revenue in the coming year. I would be glad to see them offload the nursing homes, because that sector is nothing but trouble.

On balance I think if Eureka can keep costs in line and continue acquiring properties with 11%+ rental yields like they’ve been doing, they should turn out OK. I am unsure about management’s idea of potentially lifting rental rates, which reduces stability and increases uncertainty for tenants, potentially reducing the overall appeal of Eureka’s affordable accommodation. Still, I am happy to hold while I see how it progresses.

Probiotec Limited makes an acquisition (ASX: PBP)

Probiotec had a solid result, but its recent acquisition of South Pack has slid it quite significantly up the risk scale, and it is no longer a candidate for becoming a larger position. I think there’s a risk the company may have to raise capital or take on more debt at some point. I did some quick numbers regarding the acquisition:

Probiotec had 52,929,356 shares on issue.  Add 7.9m new shares issued for South Pack = 60.8m Probiotec shares on issue @ 0.54 = $33m market capitalisation. (market cap is now more like $40m due to price rise post- end of quarter.)

Add $6.3m in debt, plus another up to $8m in debt for South Pack ($14.3m debt total) = $47.3m Enterprise Value. Total debt of ~2.1x EBITDA. PBP debt is limited to 2.5x EBITDA, not the 3.5x commonly seen, so as you can see Probiotec does not have a lot of headroom for adverse circumstances.

Based on data from CVC Ltd‘s (ASX: CVC) report (who owned 48% of South Pack and now owns 8% of Probiotec) I estimate that Probiotec paid between 8x and 14x earnings for South Pack, probably towards the top end of that range. Probiotec says they acquired it at about 5x EBITDA, which is about what PBP shares are priced at. This is not too bad although CVC looks to have made a nice profit on its stake in a short period of time. I doubt there will be much in the way of synergies, although head office costs/mgmt salaries will get spread out a bit.

My main concern is now about Probiotec’s higher levels of debt, especially given a prior blowout in receivables (since rectified) I mentioned when I first purchased PBP. It is not hard to see a similar thing happening in the future, with suppliers being late to pay, and Probiotec having to take on more debt or raise capital just to keep business moving in the cyclically weak first half. On the plus side it looks as though CVC may once again be a Probiotec shareholder, which could imply a vote of confidence if they stick around.

I estimate Probiotec has an enterprise value of ~$54m, pricing it at estimated ~5.4x EV/EBITDA and/or P/E of ~8ish before any growth this year. My estimate of fair value is above this, depending on how the acquisition pans out, and I continue to hold.

Crowd Mobile Ltd (ASX: CM8)

Crowd Mobile had a decent result too, albeit with greater than expected growth in Q&A being offset by a decline in Subscription, which now looks distinctly like a melting ice cube. This is a concern. My thesis called for flat overall revenues and consistent cash earnings – which is what happened, but I think risks have increased a bit. In either event, Crowd’s price is no longer a great opportunity, although I still think it is trading somewhat below intrinsic value. Huge volumes of Crowd shares have changed hands recently and the price rocketed before falling back somewhat, perhaps lending credence to recent rumours of a pump.

I am currently ascribing no value to the company’s digital influencer business, because while digital influencing will become increasingly important, in my opinion it will be tough to monetise and tough to add value. It is an open question as to whether an agency like Crowd or the influencer/ advertiser themselves will hold the economic power. Plus, Crowd is keeping its influencer earnings hidden in the Q&A business, making it difficult to evaluate costs, progress, and success.

There are many things that can affect digital influencing’s viability (not least of which, changes to social media algorithms) and in my view authenticity + natural-ness, not just pure number of followers, will increasingly be a driver of social media engagement in the future. This may make it tough for advertising companies to run concerted campaigns via influencers and thus tougher for both influencers and companies like Crowd to make a buck. The most effective influencers are already people that engage authentically with a platform (think: Forager Funds on Twitter/blog) and occasionally make recommendations for other content (think books, new funds etc) that followers will jump on. Having said that I am not a marketing or social media expert, so these are just my preliminary thoughts which will evolve over time.

NGE Capital (ASX: NGE)

I have no new thoughts on NGE, but I did note that it has established a website during the quarter. I emailed management asking for some insight on costs and strategy, and they replied that there would be more info on these things at their next market update. I have observed progress at NGE’s major holdings Eureka Group, Mineral Developments, and Godfreys, and am happy to continue holding NGE. I actually suspect NGE has been selling some Eureka Group, but that’s pure speculation and we’ll find out soon enough.

There are some insightful comments about NGE and LICs in general at the bottom of the this post which prospective NGE investors may find worthwhile.

Mayne Pharma Group Ltd (ASX: MYX)

I just purchased Mayne Pharma and have nothing to add at this point, other than noting with some satisfaction that Donald Trump continues to be unable to legislate his way out of a paper bag, perhaps mitigating some of the regulatory risks. Regulatory/structural upheaval in the pharma sector both on the drug/IP side and the pharmacy side remains a concern.

Just Group plc (ASX: JUST)

I only just purchased Just Group shares.

A note on position sizing

One thing I struggle with is that 10foot is not my entire wealth. I am trying to manage it as though it is the only portfolio I own, but it is hard because I do not feel the visceral fear that I would if I were putting an actual 5% of my wealth in each of these positions. As a result, I may be more comfortable with the risks than is ideal and RNY would tend to confirm this.

(This is a vivid lesson on why you should expect your investment manager to have a majority of their wealth in their funds.)

This is one of the primary reasons I’m considering doubling the portfolio size, because it would sharpen my focus on risk, as well as make a starter position a more palatable 2.5%er instead of 5%.

The portfolio in general

I’m now about 35% invested, in line with my 30%-50% guestimate for how much cash I would deploy in the first year. I have two possible acquisitions on the horizon and possibly 1-2 double downs, depending on what crops up. I guess I could end the year around 50%-55% invested, approximately in line with expectations. I’m feeling a bit more certain of how much cash I’d like to hold, and I think somewhere around 20%-30% once the portfolio is built would be ideal. I will sketch out my thoughts on this in a later post.

I had wanted to rank my investments by order of risk + reward like I did last quarter, but I’m out of space.  Maybe in the near future.

One thing I have realised is that, if I am slow to build the portfolio, my first year’s performance will basically just reflect the cash I hold (as we saw this quarter). I may try accelerate the pace of investment (actually, the pace of research) somewhat, although I’ll never buy just for the sake of deploying more cash.

I have some uncertainty around positions in Crowd Mobile and Probiotec, as they feel less of an opportunity (CM8 on valuation, Probiotec on debt risk) than they did at the first time I purchased. This has created some confusion because, as the old adage goes, ‘if you wouldn’t buy more today, you should probably sell’. I’m comfortable with PBP and CM8 for now because I think on balance there is still likely improvement on the way.

The portfolio continues to be a mix of misfits and turnarounds, although Just Group I consider a high quality business and at least one of the companies I’m looking at now is a genuine growth prospect.

These results are not audited. I own shares in Eureka Group, Probiotec, Crowd Mobile, NGE Capital, Mayne Pharma, and Just Group. This is a disclosure and not a recommendation.

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(And if you’re my loyal reader in Colombia, I no hablo de español, but do feel free to ‘hola’ at me)

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