Small Companies Fund - April Update
The resources sector has driven the index higher and we have an interesting exposure to it.
Is the mining boom back? The signs are all there; employment and wages in the sector are growing; capital expenditures are normalising and mineral prices are higher.
If that doesn't convince you, simply take a look at the equity market where mining stocks have charged higher.
From heavyweights like BHP to second tier firms, all the way down to small caps, the mining sector is hot. The boom, it seems, is indeed back.
Why does this matter? Mining happens to be the largest sector constituent of the ASX Small Ords Index and it explains why that benchmark has charged ahead this year, rising 2.75% during April. In comparison, the InvestSmart Australian Small Companies Fund rose by 1.3% during April.
Part of that deviation is due to our 34% cash weighting which, when the index is flying, does nothing to aid performance. Yet cash creates opportunity. Given cash and patience, our portfolio will be well served over time.
Another part of the performance difference comes from our mining exposure or, more accurately, our lack of it. Among our few exposures to the sector is Matrix Composites and, unlike almost every other mining stock in the small caps index, it has barely moved.
Matrix was one of the first stocks we bought when the small companies fund was born and the investment case is simple.
A one time market darling, Matrix manufactures and sells riser buoyancy modules, the materials that help deep sea drilling equipment stay afloat and stop it getting crushed by high pressure ocean depths. It is a vital part of extracting oil from deep water.
When oil prices were high, capital expenditure in the sector flowed freely and Matrix expanded, building the world's largest, lowest cost manufacturing facility for syntactic foam, the stuff buoyancy modules are made of, in Western Australia.
Like so many ambitious expansions, this one happened at the cycle's peak and falling prices have devastated the industry.
Revenue, which peaked at $175m in 2011, collapsed to just over $20m last year; pre-tax profits, which peaked at $45m, have turned negative. So why are we interested in a barely profitable manufacturing business whose customers have their wallets firmly shut?
Because the world continues to consume over 90m barrels of oil per day and, eventually, barrels consumed will have to be replaced.
Oil producers have delayed or cancelled $1tn of exploration and development projects since the oil price collapsed and much of that has been concentrated in the deep sea drilling space. This is one of the most cyclically impaired markets anywhere.
As the cycle turns
Matrix is unprofitable not because it is a lousy business but because it is a cyclical business in the depths of a cyclical funk. With net cash on the balance sheet and low capital expenditures that only need to be spent with new orders, Matrix can comfortably sit out the storm while the industry recovers.
When it does, today's price might just look a bargain. Matrix's market capitalisation of $45m is less than half net tangible asset backing and it retains a cash-rich balance sheet and low spending requirements. On offer is a world leader in its field that continues to develop productivity-enhancing products at the lowest cost.
This isn't an all or nothing outcome and we aren't accepting outsized risk for an outsized return. We think this is a genuine mispricing.
If Matrix were to utilise its facility at full capacity, we think it could make up to $100m in EBITDA. That's probably an unlikely scenario but it's equally unlikely to think the world will give up on deep sea oil production.
This is typical of the kind of investments we look for in the Small Companies Fund. Matrix is deeply unloved, attached to a narrative that excites few and it doesn't have the attractive PERs or ROEs that many investors crave. Yet here lies enormous latent profitability.
Note: The InvestSmart Australian Small Companies Fund owns shares in Matrix Composites and Engineering. For more information on investing in the fund, click here.
Disclosure: The author owns shares in Matrix.
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