A contrarian strategy, tasty stocks and a worthy cause

Q. How are you and what have you been up to over the past year?

I’m really well, thanks. My wife and I capitalised on my long service leave last year and took an extended holiday – we called it a ‘mini retirement’. We got to spend a lot of time in the UK with her family as well as my brother and sister-in-law who live there, too. We also visited a lot of friends in far-flung places, from Norway to Austria and Kenya.

Berkshire Hathaway’s annual meeting was another thing on our agenda and we attended it last year with Intelligent Investor member Mark of Canberra, who won our promotion 18 months ago. We had a great time in Omaha meeting up with a few Intelligent Investor members and, of course, experiencing the wisdom of Warren Buffett and Charlie Munger first hand.

Over the course of the past year we were also privileged to visit some really interesting operations like eBay in Silicon Valley, Google’s extraordinary new office in London and the Green Gecko Project in Cambodia. I personally learned a few things about leadership and organisational design from these interactions.

Q. How the other half live, eh? And, now you’re back in Australia, how are you seeing things on the investment front?

There seems to have been a noticeable change, in Sydney at least. The economy feels ‘over the top’ to me – and there are plenty of signs of slowdowns in both the business and property markets. Coming back from the US, Europe and the UK, they are much further along the correction path than we are. And as bad as people might feel things are here, there’s much worse occurring in those economies, particularly in regional areas.

In terms of the stockmarket, many large stocks strike me as being either around or even on the lower side of fair value. That’s a stark comparison to five years ago, when most prices had run way up. It seems like investors are being more appropriately rewarded for the risks they’re taking on.

Take the big bank stocks, for instance. I’m not buying them myself due to both local and global risks at this point but at least they’re mostly back on single-digit price-to-earnings ratios and attractive-looking yields. So those who are taking on those risks today are at least getting paid more for it.

Generally I’ve been building cash levels in the portfolios I run. I did a bit of buying back in the mini-panic of August last year but have taken some of those profits recently after they arrived ahead of schedule.

Q. Can you give us an example?

I bought some Perpetual shares down around the $21 mark in early August, received $1.40 in fully franked dividends and sold them around $25 in early May. Including the franking credits, the total return was around 28% over 9 months. That’s a much shorter time frame than I hold ‘core stocks’ for but I felt more comfortable cutting back on the financial exposure, the margin of safety had decreased and I have been building cash reserves for cheaper opportunities in the future.

Q. Have you been buying anything lately?

Along with Perpetual, I also sold out of Platinum Asset Management. It’s a fine company but, again, I felt the margin of safety had decreased in this environment.

I kept about half of those two sales in cash and re-invested the other half into shares of market operator ASX a couple of weeks ago at around $29. We’re about three months away from that stock going ex a fully franked dividend of more than 90 cents, and the yield at that price was well over 6% fully franked.

I feel more comfortable being in that business than the fund managers at this point, and ASX’s profits should increase if market activity picks up. The yield is great while I wait, so long as they’re able to successfully defend themselves from competitive threats. All of that said, it’s only a relatively small position – about 1.5% of the portfolio at this point. I’d look to double or triple that if the price fell another 5-15%.

I also bought some Platinum Capital securities (the listed investment company, as opposed to the fund manager Platinum Asset Management which I recently sold) in February, in the low 90-cent range. After trading at a premium to its net tangible asset backing for many years, this listed investment company is now available at a discount. And it provides some offshore exposure. That was partly in response to your repeated urgings to take advantage of the strong currency and diversify internationally, so thanks for that – and keep urging!

In fact, I think you and your team have done a terrific job recently of balancing specific stock research with more overall portfolio guidance regarding issues such as the currency and also portfolio allocation, so well done on that. I also got a lot out of Gareth’s excellent two-part report from the Grant’s Interest Rate Observer conference in April (see Grant’s conference notes).

Q. I know you allocate a part of your portfolio to more offbeat ideas. Can you share any of those with us?

Sure. Run Corporation (RNC) is a tiny stock I’ve had on my radar for several years – currently around $20m market capitalisation. It was floated in late 2005 at $1 per share and had some high profile backers like former National Australia Bank (NAB) boss Frank Cicutto and real estate mogul John McGrath. But it over-borrowed (from NAB) and wasn’t able to meet its original business plan. It’s limped along for many years trying hard to simply meet its interest bill.

Recent events have changed the situation. In December, a debt refinancing was announced under which NAB accepted a repayment of just $20m for the $36m loan it had made to Run. The $20m repayment was provided by Macquarie (with, unsurprisingly, $600,000 in additional costs). That created quite a bit more breathing space and a win for shareholders.

Then, on 11 May, the company announced that it had signed two conditional sale agreements, which valued the businesses being sold at more than $65m.

So taking those things together in very rough back-of-the-envelope terms – the $65m value of the transaction less $20m of debt – you can see the potential. If the sale goes through at that price, there’d be a substantial uplift from the $20m valuation the market is currently ascribing to the stock.

Another position I took recently was in the convertible notes of litigation funder IMF (IMFG). I don’t know the business all that well but I can see the way they run things and I think there’s a little ‘free lunch’ in the convertible notes. Here’s why.

IMF needs to finance its business conservatively. A poorly-funded, publicly-listed litigation funder would expose a weak flank to legal adversaries. The company has no bank debt and if you look at its latest quarterly report (for March), it had cash of $48m. But things are even better because the company has received several cash settlements since then (more than $17m). IMF’s clients have also won the largest class action settlement in Australian history in the Centro case, so a decent amount of that will eventually find its way into IMF’s coffers.

One blip on the radar is a foray into the US, which, thankfully, has taken a lot longer than expected. I say thankfully because convertible note holders want to minimise any risk and cash outflows at this point.

Q. Tell us about the case – pardon the pun – for the convertible notes.

IMF issued $39.9m of convertible notes on 13 December 2010. Each note has a face value of $1.65, pays a 10.25% fixed interest rate (on a quarterly basis) on that face value and is convertible at the holder’s election into one IMF share before it matures on 31 December 2014. The alternative is to receive the $1.65 repayment in cash.

Another clause (3.5, for those who’d like to do their own research) gives IMF the ability to force holders to elect to convert or be repaid cash from December this year. And I think that’s rather likely.

Business has gone very well for IMF over the past 18 months and the cost of debt has fallen over that time. The 10.25% coupon on these notes now look exceedingly expensive. There’s every chance they’ll force holders to choose conversion or repayment in seven months’ time.

If that happens, holders will be repaid the $1.65 face value plus a penalty, spelled out in clause 3.6 of the prospectus: ‘The early redemption penalty is that amount determined by multiplying the face value of each Convertible Note by 2.0% per annum compounded quarterly for the period commencing on the date the voluntary redemption takes place.’

My calculations put the potential December repayment amount at almost $1.72 per note. In between, the notes are due to make another three quarterly interest payments (in June, September and December) of a little more than 4.2 cents each.

So buying the notes close to $1.72 before the June interest payment should provide an annualised interest return of around 9%. That’s not bad, but then there’s the free option of the IMF share price going above $1.72 by then. While it’s not looking likely, stranger things have happened.

If management doesn’t convert (or repay), then you’ll own a convertible note in a rather liquid company paying a healthy income return for another couple of years (with the option on the share price extending over that period). You’d then just need to hope that they don’t do anything seriously risky in the US before December 2014 (which I don’t think is likely given their track record).

Q. Is there anything else on your mind that you’d care to share?

I always like to keep a close eye on things heading into the June tax-loss selling season. It’s important to have watchlists set up so you can see at a glance any unusual trading and be ready to take advantage of it. You can generally find one or two opportunities each June out of this tax-driven quirk of the markets.

Also – and this might be a bit ‘out there’ – I’ve been developing a little contrarian strategy around highly-leveraged stocks. A lot of people have got the message that debt can be dangerous. And, for 95% of the investing population, that’s a great message; get rid of those margin loans, steer clear of companies with high debt and be aware of other types of leverage. For example, shareholders in retailing companies are currently learning a difficult lesson in the meaning of ‘operational leverage’ – how lease payments can behave in a similar manner to long-term debt.

That said, I believe there’s a price for everything. So with everyone shunning companies with significant leverage, I’m in the throes of putting together a mini-portfolio (say, 10-15% of the overall portfolio) of such stocks.

Run Corporation fits in to that and I’ve also dipped my toe into Collins Foods recently around the $1 mark – a real stinker of a float and a stock where the market has not yet seen a full set of accounts, so it’s currently trading in a bit of an information vacuum. It may end up a more resilient business than jaded float investors are giving it credit for. If it can avoid a capital raising there’s the potential for good gains from here.

I’ve also put a cheeky below-market bid in for some shares of Coffey international – another company to stumble following a debt-fuelled international acquisition strategy. But they have a strong position in their core geotechnical business and, again, if they can avoid (another) dilutive capital raising, there’s good potential from today’s price. But I suspect things might get worse with this one before they get better (which is why I’m not bidding aggressively).

Any of these might go wrong. Run’s transaction may not settle and Collins and Coffey might need to raise equity, but I like the idea of looking for opportunities in areas where the crowd is looking the other way and these stocks fit the bill.

Q. You’re not rejoining the Intelligent Investor team in an official capacity, so are you doing anything aside from investing at the moment?

Does enjoying the vestiges of autumn sunshine count? Only kidding. I’m actually in the early stages of developing a potential new service that I think Australia is crying out for. The values and untainted approach our group has brought to value investing, funds management and now self-managed super fund investing (through the Walnut Report) is exciting to be part of and extend into new areas.

It’s only very early days so I won’t say too much at this point about the new project but it’s exciting to be able to have moved from one job I was passionate about into developing something new that’s also very close to my heart.

Q. Thanks for your time.

You’re welcome. And if you’re looking for a worthy cause to make a tax-deductible donation to this June, please consider the Green Gecko Project. I’ve visited there twice now and it really is a unique situation, which is changing hundreds of lives for the better.

Oh, and keep up the great work Nathan!

Note: None of the stocks mentioned are official recommendations from Intelligent Investor.