Small Companies Fund update for February

In February 2017, the first month of the fund's first year, we made an 8% return. Thus far, this stands as our most profitable month ever. This February, we set another record - a loss of 5.8%.

Not too much should be read into either of these figures as its the long-term results that matter. Investing is akin to walking through a financial minefield. One must take great care where one treads.

In the past year we avoided many bombs, including Retail Foods Group, Vita Group, Mutula Group and Bulletproof Group, which, it turns out, wasn't bulletproof at all.

It is, however, difficult to move forward without taking the odd hit. The two most costly have been telecoms virtual network operator Amaysim and CSG Limited, which provides print and business technology solutions in Australia and New Zealand. Both delivered disappointing first-half results that preceded sharp sell-offs.

Having completely sold CSG, let's take the opportunity to lay out our rationale for buying in the first place and then selling it within 12 months.

In the 2010 financial year, CSG made two acquisitions - Konica Minolta Business Solutions and Leasing Solutions - and was appointed by Canon as a new dealer, also obtaining the right to manage (under subcontract) 10,500 of Canon's service contracts.

CSG obtained three things in the process: the distribution rights for leading printing brands; a New Zealand-based captive finance company that could be expanded to Australia; and recurring service contracts attached to thousands of business machines in the field. Along with a stream of recurring revenue, the service business gave CSG a large customer list which it would later use to cross-sell.

The strategy was to become a one-stop shop for small businesses. Instead of using many disparate suppliers, small businesses could satisfy their hardware and software needs through CSG. The company's captive finance company could then transform the model from an upfront to a recurring monthly payment.

It looked like a good approach. Customers would appreciate the convenience and value-adding services, which could save them time and lower capital expenditure requirements. CSG, meanwhile, would have a bigger, better business. 

Needless to say, it didn't work out like that. Despite an apparently sensible strategy, the business had a number of false starts.

Management issued a series of profit downgrades between 2016 and 2017, knocking the share price from its $1.80 highs to around 40 cents. It was at this point we became interested.

With around $40m of tangible equity, CSG's captive finance business provided a backstop for a good proportion of its market value. The share price upside could come from the company cross-selling more technology products and subscriptions to its existing customer base.

The reality didn't match our expectations and a further profit downgrade with the first-half of financial year 2018's caused us to reconsider our view. 

Despite low barriers to entry and increasing competition, the opportunity for CSG to increase revenue from technology subscriptions and sales remains. The problem is in the company's print solutions division, which accounts for 58% of total revenue.

This business has been declining since 2015 and our expectation was that further declines would be gradual. This hasn't happened. In fact, the latest result suggests the decline is accelerating which means new technology sales must now run twice as fast if the company was to reach the hopes we had for it. We weren't prepared to take that bet and sold.

This is no disaster. Investing in declining businesses, even ones with growth options, is tricky. As Charlie Munger has said: 'It's hard to pay a low enough price for a declining business'. And when the facts contradict your expectation of how things will play out, it's better to change your mind and take the hit than hang on and hope that a deteriorating situation will improve.

To find out more about the InvestSMART Australian Small Companies Fund, view the Fund information page.

Note: The InvestSMART Australian Small Companies Fund owns shares in Amaysim.

Disclosure: The author owns units in the InvestSMART Australian Small Companies Fund 

Amendment: This article was amended on 4 Mar 18 to reflect the fact that Canon Australia was not acquired by CSG in 2010. Instead, it was appointed as a dealer, also acquiring the right to manage 10,500 Canon service contracts.