Intelligent Investor Equity Growth Portfolio - September 2018

The big contributor to this quarter’s performance was TPG Telecom, which justified its spot as one of the fund’s larger holdings.

As we explained in the monthly report, TPG is merging with Vodafone. The deal combines Australia’s third-largest mobile operator, Vodafone, which boasts 22m customers, with the country’s second largest broadband provider, TPG, which has 6m customers, including a wide range of business customers that Vodafone doesn’t have.

The combination has many benefits, such as being able to offer more attractive bundles for mobile and broadband services that reduce customer losses, and the company will pay half of its profits as dividends.

There are some negatives, though. TPG founder, and one of Australia’s most successful businessmen, David Teoh will be relegated to chairman with his shares escrowed for two years. The combined company also still has to spend large sums for items like spectrum to provide 5G services and access to the NBN to resell fast internet services.

The biggest negative, however, was that the share price appreciation bakes in very high expectations for the company’s future success. At a valuation comparable with US monopolistic broadband internet providers, we decided to sell.

We also sold our successful holding in Fleetwood, again due to valuation, and the only other sale was education provider Navitas. The company’s trend of falling earnings over the past four years was supposed to be rescued by the company’s big US push, which is showing increasing signs of failing.

Navitas fell 5% during the quarter before it was sold, while other detractors included Audinate, which fell 10%, and IOOF, which fell 9%. Sales of Audinate’s audio management products are growing quickly but the stock trades on a very high valuation, so the share price will be volatile from quarter to quarter even if there isn’t any change in the company’s prospects.

IOOF’s share price has languished as the headlines from the Hayne inquiry have grown louder. The worst outcome is IOOF being forced to separate the provision of financial advice from selling financial products (or ‘distribution’ in industry jargon). That’s unlikely in our view, so on a price-to-earnings ratio of 12 and 6.9% dividend yield, the current valuation is providing a large margin of safety against a worse than expected outcome.

The 13% increase in Trade Me’s share price lagged that of telecom billing company Hansen, up 19%, and Nanosonics, up 14%, but the New Zealand online classifieds business produced a 20% total return following the announcement of a NZD22 cent special dividend.

Trade Me justified its position as the portfolio’s largest holding after announcing an encouraging annual result following a couple of years of heavy investment that have pressured margins and profits.

Despite minimal increases in property, job and car listings, classifieds revenue increased 12% as customers spent more on premium ads. Though not before time, the company is following the hugely successful premium ad strategy used by REA Group. Customers will willingly pay more for premium ads provided it produces profitable sales. Trade Me is only just starting to flex its pricing power muscles, which bodes well for future profits and dividends. 

Spin-offs

Spin-offs occur when a company demerges a business division to be listed independently. Recent examples include Wesfarmers spinning off Coles and BHP’s spin-off of South 32.

Historically they’ve been wonderful investments, as the smaller stock often gets sold off heavily, as most investors are either forced to sell it due to liquidity restrictions or are only interested in owning the larger parent company. As newly motivated management releases the value in the business the returns can be astounding.

Though Clydesdale Bank was spun off from former parent National Australia Bank a couple of years back, we’ve recently added it to the portfolio. Clydesdale recently acquired Virgin Money, creating the UK’s sixth largest bank. The stuffy old Clydesdale brand will be replaced by the Virgin Money brand, which has more appeal to young customers.

Clydesdale Bank is trading around tangible book value (TBV) and is run by one of the most highly rated management teams in the UK. If management hits its 2019 aim of double-digit return on equity, then there is room for the multiple to expand over time if higher interest rates fatten profit margins, or as profits grow from a combination of attracting new customers and cutting costs. The company could also eventually become a takeover target, unlike the five major UK banks.