InvestSMART Australian Small Companies Fund Update - June 2018
A soaring small cap index has left us behind, but our focus is on the long term and we're finding good opportunities which we hope will change that.
We're under no illusion: cash is a terrible investment over the long term. A small, nominal return is eaten away by inflation, even at 2%, erroding purchasing power. An overpriced investment, mind you, which bakes in a poor return from the outset, is even worse. That's part of the reason we've been hoarding cash and exercising patience.
Portfolios underperforming benchmark
Investments in 3PL, HSN and UBI
Focus on long term
This month that patience was rewarded with three interesting, attractively-priced opportunities, two of which will be familiar to fund investors and one that won't.
The first was 3P Learning, which owns the Mathletics brand of educational software. With a scalable software-as-a-service product enjoying strong domestic penetration and a large opportunity overseas, 3P has good bones. After a tumultuous start to life as a listed company, it took a management change in 2016 to add the flesh.
New management has steadily executed its strategy of eliminating distractions, investing in core products and repositioning the business to be more globally scalable. The final major piece in that plan was the sale of 3P's 40% stake in Learnosity, offloaded earlier this month for $25m.
The figure was in accordance with our valuation but appears to have upset investors with higher hopes, who have sold off their shares to a point where it's attractive once again.
We’re excited about 3P’s prospects. Educational software offers many advantages over traditional learning methods, including the ability to adjust questions based on students' abilities as well as automated marking and analytics for teachers. We believe it will play a bigger role in classrooms over time.
3P's highly profitable domestic operation bankrolls the development needed to compete on the international stage. Having toiled overseas for years, 3P’s international divisions could be on the cusp of making a meaningful contribution. We're pleased to be able to top up our holding at attractive prices.
Tall, dark and Hansen
Another old favourite is Hansen Technologies, maker of billing software for utilities. Hansen’s software is at the heart of its customers' businesses, managing cash flow and customer relationships. The centrality of its role delivers very sticky customers because switching is so fraught with risk. Contact Energy, for example, took six years to switch from Hansen’s competitor, Gentrack.
|Period to 30 June 2018||1m|
|Australian Small Companies Fund||–2.44||–0.71||3.73||10.65|
|S&P/ASX Small Ordinaries Accumulation Index||1.06||7.67||24.25||19.63|
|* 1 Feb 2017|
|**Performance is after fees and expenses|
This makes Hansen an attractive business with steady, recurring revenue, high returns on capital and plenty of free cash flow. This stifles difficulties without eliminating them, as a recent announcement shows.
This year’s profits are lower than expected and a slower growth outlook lies ahead. Investors were taken by surprise and acted savagely in response. The lower share price gave us an opportunity to build our holding in an appealing business at even more appealing prices.
Old dogs don’t learn new tricks
Ever since its painful foray into equipment hire, investors have feared Global Construction Services’ next capital allocation mistake. If you're in search of an explanation for the company's juicy free cash flow yield this is it.
When we initially built a position we thought management had learned from its mistakes. There was a careful expansion into the east coast, the sale of underperforming assets and the recommencement of dividends. But the merger of equals with SRG Limited, announced earlier this month, suggests GCS's old, tired tricks are back.
Joining the two businesses has strategic appeal but comes with an unsavory price tag. GCS’s large cash pile and valuable tax assets have been lost in the transaction. The deal is not a disaster but its terms remove some of the upside and we’ve substantially reduced our position as a result.
Sensing value in UBI
The final opportunity this month is less familiar but, if anything, more attractive than 3P or Hansen.
That opportunity is Universal Biosensors (UBI), an owner of specialised intellectual property (IP) used in diagnostic tests. It’s only a small company worth around $40m, but that hasn’t stopped it from commercialising its IP with big pharma.
|Note: holdings in alphabetical order|
|Number of holdings: 23|
|Top 5: 27%|
UBI’s IP is currently used in two applications - the first a royalty for every blood glucose testing strip sold by Johnson & Johnson, the second a similar arrangement with Siemens for blood coagulation testing. But its IP has far more potential than that, with new ventures with Siemens and a self-testing device in the pipeline.
This gives it plenty of upside if things work out, but what attracts us is its downside protection. UBI's contract with Johnson & Johnson allows a lump sum to be paid to UBI in lieu of future royalties which was recently estimated to be worth $40-45m, but there's a chance it could be much more than that.
Johnson & Johnson had every incentive to pay the lump sum as soon as possible - as long as royalties continue the greater the eventual sum paid - but now that they're selling their blood glucose division their incentives have changed. Investing for the long term is out, sprucing the business up for sale is in, and that means delaying capital expenditure like the lump sum to UBI.
This could work out even better for UBI shareholders, as if sale completion is delayed until next year, UBI will be entitled to another $20m or so of royalties.
Heads I win, tails I don't lose much, if at all. Plus, recent board changes, and insider buying, also suggest the company is likely to behave in a shareholder-friendly manner with its big cash pile.
Each of these situations shows our opportunistic, value-based approach to investing in small companies. All we ask of our investors is the patience to ride out periods like this and see things through to fruition.
Find out how you can invest directly in these and other Intelligent Investor and InvestSMART portfolios by clicking here.
Disclosure: The author owns many of the stocks mentioned, via his holding in the InvestSMART Australian Small Companies Fund. He also owns RPMGlobal and Thorn Group directly.
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