TOL - 15th Oct, 2024
4 lessons from our first year running an ASX small cap fund - and 3 stocks we now own as a result
We use three case studies to outline our key learnings from running the Seneca Australian Small Companies Fund over the past 12 months.
Since we launched the Seneca Australian Small Companies Fund in October last year, the fund has generated 28.4% returns after fees, outperforming the benchmark (S&P/ASX Small Ordinaries Accumulation Index) by almost 10%.
That result puts the fund in the top quartile of among peers, but what sets our fund apart from other top-performing funds is that we offer a unique fee structure: 0.00% p.a. management fee and a 20% performance fee on returns above the RBA cash rate (with a high watermark).
Managing a small-cap portfolio over the past 12 months has taught us a lot about our style and helped refine our investment process. Here are four case studies from actual investments we made during the year and four new companies where we are applying those same lessons to generate returns for investors in the future.
Lesson 1: Unloved, cyclical recoveries can make great investments
Example: MMA Offshore (ASX: MRM)
Return last 12 months: +110.2%
MMA Offshore provides the tugboats that service the offshore oil & gas sector. In 2014, when oil prices declined around 50%, MMA Offshore (then known as Mermaid Marine) found itself over-leveraged. The falling demand for its boats saw earnings plummet into loss, and the value of the equity cratered from a high of over $24.25 per share in 2013 to $7.34 by the end of 2014, before reaching a low of $0.24 in August 2020.
MRM 15-year share price chart. Source: Factset
Fund managers, brokers, and analysts alike were all scarred by the experience, with some vowing never to touch the stock again, while others guided against trying to “catch a falling knife.” Losing money due to an oil price shock is one thing, but buying an embattled, over-leveraged services company with a chequered history is harder to justify to your investors.
Leverage works both ways
…and therein lay the opportunity. MRM found itself over-exposed to the oil price on the downside, but after being properly recapitalised and making the requisite divestments, it would have complete leverage to any oil price rally and associated scramble for tugboats.
As with most commodity-market-driven companies, demand inevitably returned. However, this time, due to a lack of vessel investment between 2014 and 2020 and the 5 to 7-year lead times on new vessel production, MMA Offshore found itself operating at over 90% utilisation.
While we weren't fortunate enough to buy the stock at the bottom, we realised an attractive entry price in our fund, after we felt the risk of an earnings decline had largely passed and at a margin of safety to our assessment of fair value (which included replacement cost of the vessels in the fleet.)
MRM 2-year share price chart. Source: Factset
Cyan Renewables eventually took over the streamlined MRM business in a deal that was completed in July.
We mentioned MRM to the Livewire community here back in October 2023 here.
The Takeaway
What has happened, may not continue to happen. The narrative of the day will always dominate the headlines, but often, the best returns are made from looking past the share price to the underlying business drivers, management team and, in this case, the potential strategic value, hidden in plain sight. The temptation may be to attempt to repeat this investment play in 'the next MRM' with the recent IPO of Bhagwan Marine (BWN), we think the opportunity is in repeating the process, not the playbook.
Our pick for the next 12 months with this lesson in mind is Pointsbet Holdings (ASX: PBH), $222 million market cap @ $0.67/share.
After selling its US business, Pointsbet has been completely overlooked, despite the remaining business (Australia & Canada) inflecting into profitability on the back of exceptional revenue growth. It trades at a 40% discount to takeover valuations.
Pointsbet’s cash-burning foray into the US was carved out and sold to US-based Fanatics for US$225 million (A$333 million), with the proceeds distributed to shareholders, equating to $1.39/share.
That leaves the core Australian business operating profitably, growing at 10% annually. It now represents the majority of revenue, recording a turnover of around $2 billion in FY24.
And a Canadian business about one-tenth of the size of the Australian business (around A$200 million turnover in FY24). It's small but rapidly growing (around 50% p.a) with the adoption of sports betting in Canada (following the US sports betting legalisation path). This business unit is approaching breakeven and outperforming the market growth rate over the last 12 months.
At first glance, the share price chart of PBH looks terrible. But if you add back the capital returns, it has actually performed well over the last 12 months.
PBH share price chart vs total return (indexed) last 18 months. Source: Factset
By FY26, we expect Pointsbet to generate $31 million in operating profit, demonstrating significant operating leverage, which is not currently priced into the stock. If that forecast is correct, it's on 6x FY26 EV/EBITDA. For context, Sportsbet-owner Flutter (LON: FLTR) trades on 14x EV/EBITDA.
We expect PBH to follow in the footsteps of US gaming peers DraftKings and Rush Street Interactive in re-rating upon achieving sustainable standalone profitability.
Like MRM, we think PBH's real value is hidden in plain sight, with its Australian gambling license, under-appreciated technology stack, and established customer base. Global gaming giant Stake.com popped up on the PBH register as a substantial 5% holder and is reportedly looking to gain a foothold in the Australian market.
Lesson 2: Just because you spot value today, doesn’t mean everyone will agree with you tomorrow.
Example: GQG Partners (ASX: GQG)
Return last 12 months (incl. dividends): +100.7%
We thought global fund manager GQG Partners was cheap at its $2.00 IPO price. Unfortunately, the company listed near the top of the IPO market in 2022, and negative sentiment towards the funds' management sector (largely on the back of Magellan’s fall from grace) saw shares down to a range of $1.25 - $1.75 over the next two years. I thought to myself:
Am I going crazy???
We couldn’t understand the decline in GQG’s share price. While we understood the negativity towards Magellan (ASX: MFG), who lost key personnel and clients and suffered significant reputational damage – all of which resulted in the only thing that matters walking out the door… fee-earning assets under management, GQG had outperformed and generated significant inflows. We couldn’t quite square why the market was being so irrational.
Source: GQG Partners, Seneca Financial Solutions
Subsequently, we bought GQG shares at the inception of our Seneca Australian Small Companies Fund in October 2023. Our thesis was simple: we were confident we’d get paid the circa 8% dividend yield as a worst-case scenario, which, in a small-cap bear market, was a solid result. Best case, the market eventually figures out that GQG and MFG are different businesses and re-rates GQG to a fair multiple for a fund manager doing consistent positive net inflows and generating strong relative returns for investors.
It took roughly six months for GQG to surpass its IPO price and hit highs above $3.00 per share in July, with around 15% of the total return to shareholders coming via dividends.
We could have easily bought another fund manager, Platinum Asset Management (ASX: PTM), at the same time. Before the takeover, Platinum suffered a fate similar to Magellan's. Although the recent takeover bid resulted in a ~30% sugar hit to the PTM share price, zooming out to the prior 12 months, you wouldn't have made money if you bought PTM shares last year.
You'd be 96% better off if you bought GQG 12 months ago relative to PTM (yes, that includes dividends). And you'd be 102.7% better off having bought into the GQG IPO, even though you would have been underwater for the first couple of years.
GQG vs PTM total return (incl. dividends) since GQG IPO ~3 years ago. Source: Factset
Despite the opposite direction of net flows, GQG still trades on a high dividend yield of 8.8% (compared to PTM's 6.8%), much of the GQG share price growth has been driven by organic earnings growth, not valuation multiple expansion.
We mentioned GQG to the Livewire community here back in October 2023 here and in July 2024 here and here.
Our pick for the next 12 months is Catapult International (ASX: CAT), $622 million market cap @ $2.40/share.
Sports technology company Catapult is seemingly nothing like GQG. Catapult provides sports wearables and software to professional sporting organisations.
However, we see parallels in how the two businesses are perceived. Despite a marked acceleration in profitability, the market perception of Catapult as a cash-burning, upfront one-off revenue business has been slow to adapt to the reoccurring nature of its sales, as evidenced in its 3.5x EV/Sales multiple.
Catapult is now the clubhouse leader in the high-growth (around 20% p.a.) sports technology and analytics market. However, CAT only has a circa 17% share of that market, meaning the runway for growth and expansion is very long.
With private equity investments, streaming, e-Sports, sports betting, women's sports and the professionalisation of college athletes driving more money into the sports business, team owners are more incentivised than ever to use data science to optimise how they allocate resources, manage their assets (players) and invest in winning.
With Catapult now operating on over 40% incremental margins, we see a substantial opportunity for investors to generate outsized returns from a $2.40 share price.
Catapult free cash flow per share (trailing). Source: FactSet.
We mentioned CAT to the Livewire community in June 2024 here on Buy Hold Sell.
Lesson 3: There are no shortcuts. You must do the work.
Example: Global Data Centre Group (ASX: GDC)
Return last 12 months (incl. dividends): +72.0%
GDC is a listed investment company that holds stakes in data centre assets globally. It was a foundation holding in the Seneca Australian Small Companies Fund.
Having followed GDC for some time, we were attracted to its exposure to data centre assets with exposure to high-growth segments across under-serviced geographies. However, the most exciting feature of GDC was the steep discount to peers like NextDC (ASX: NXT) and Macquarie Technology (ASX: MAQ). We valued GDC conservatively at ~$3.00, believing that book value was understated.
However, this valuation was unlikely to be realised without a catalyst (identifying catalysts is a critical part of our investment process across all products at Seneca). For GDC, this catalyst became clear when management overhauled their incentive structures – meaning they would make millions in the event assets were sold and the resultant capital returned to shareholders.
Source: GDC company announcements.
Show me the incentive, and I'll show you the outcome.
GDC share price. Source: Factset
The asset sales then began:
April 2024: GDC first sold its data centre in Perth for $39 million.
May 2024: Etix edge data centre business sold for 52% premium to book value.
September 2024: the well-publicised, blockbuster sale of hyperscale data centre giant Airtrunk completed for $24 billion. GDC owned a 1% stake in Airtrunk, equating to $1.59 per share after fees.
In 2022, GDC was unloved, suffering from interest rate hikes (lower cap rate valuations for data centres) and a spike in European power prices (key cost input for data centres). It was only through individually valuing the parts of the business, repeatedly meeting with management, and gaining an understanding of the incentive structures that we were able to build sufficient conviction to keep buying GDC shares.
To uncover opportunities like this, a $146 million market cap company that doesn’t need to raise capital, it’s unlikely you’ll find analyst research coverage to rely on (except maybe here). You need to be willing to do your own work and develop your own conviction.
We briefly mentioned GDC to the Livewire community here in June 2024 here.
Our pick for the next 12 months is Ingenia Communities Group (ASX: INA), $2.02 billion market cap @ $4.95/share.
Ingenia operates retirement villages, land leases and holiday parks. Land leases are targeted at downsizing retirees, providing people with a vibrant community to live in, while saving them money. In short, it costs people about 20% less than owning outright, can free up equity in the family home, and provides additional social benefits.
Like GDC, we think the sum of the parts at Ingenia is worth more than the whole. Supported by declining bond yields (lowers the cost of funding for developments), Ingenia looks primed for a significant re-rate and/or a spin-off to realise the true value of the business.
To build conviction here, you need to do the work to ensure that Ingenia is not plagued by some of the problems that have befallen former market darling and competitor, Lifestyle Communities (ASX: LIC), which we have long been sceptical of.
The LIC share price has come under pressure after a July Four Corners report on Lifestyle Communities' excessive fees, specifically the deferred management fee (4% p.a. capped at 20%). Without a significant turnaround in demand, LIC may end up breaching its debt covenants.
While certainly not a positive for the sector, we think this could actually benefit operators like Ingenia and Stockland (ASX: SGP)’s Halcyon, with more transparent fees and stronger reputations.
Ingenia is growing organically. Its FY24 result beat earnings expectations, reporting +17% EBIT growth, above guidance of 10-15%. We think along similar lines to major shareholder HMC Capital and believe a spin-off of the holiday parks business, to leave a pure-play retirement communities business would be highly accretive for shareholders.
We see upside up until around $7.00 for INA.
Lesson 4: Your network matters
Example: Sun Silver (ASX: SS1)
Return last 12 months (incl. dividends): +300.0%
We were fortunate enough to get on the best-performing resources IPO of the year, Sun Silver. SS1 listed at 20c, opened +150% at 50c, and trades at ~80c currently, up 300% since listing.
We detailed our SS1 thesis before its listing in a comprehensive note to the Livewire community here back in May 2024 here.
Sun Silver has the Maverick Springs project in Nevada, USA. Proximal to the Carlin Trend, which is prolific for low-cost gold and silver mining, Maverick Springs hosts one of the largest silver JORC resources on the ASX and was initially offered at a fraction of the price of comparable peers.
The important lesson here is Sun Silver was bought to market by a small, largely unknown corporate adviser from Perth with no broker support and limited roadshow – there was only a handful of funds who had the opportunity to bid and as far as we know, we were one of two or three who invested.
Accessing deals in 2024 is not that difficult. If you’ve got the right-sized chequebook and know enough brokers, you’ll see plenty of off-market deal flow. The problem arises if you bid into a good deal, you’ll likely get scaled back heavily. And if you don’t get scaled back, chances are you’ve bid into a deal you’ll soon wish you hadn’t.
The real money is made when you can secure a substantial allocation to a deal that’s so good, that it doesn’t need a broker. For that, you probably need a personal network of friends who are at the age when they are starting businesses, pegging ground, listing vehicles and raising money for projects.
I just happen to be in that age range, and growing up in Perth (as well as working in the mining industry) means sometimes I get access to unique, mispriced opportunities. It’s not the first time. It probably won’t be the last.
While we won't name any specific picks here just yet, we're starting to see several transactions of interest in the pipeline. And given we're seeing cyclical, ultra-bearish headlines like this one in the AFR, we think this is time to start doing the preliminary work because when the IPO window opens, it tends to open hard and fast.
In Summary
A single year does not make a top-performing fund. While we are pleased with our results and for our early investors, we fully expect to be running this Small Companies Fund for decades to come.
The fund is currently invested across 35 small and mid-cap companies on the ASX. The fact that our highest expected return positions in the portfolio have yet to eventuate leaves us excited for the year ahead.
Click here to access the monthly performance update on our website.
Thanks to Ben Richards for his contributions to the fund and this article.
If you'd like to discuss this article, investing with Seneca or your portfolio, feel free to book a free consultation with me.
Never miss an update
Enjoy this wire? Hit the ‘like’ button to let us know.
Stay up to date with my current content by
following me below and you’ll be notified every time I post a wire
Luke is the trusted financial adviser to some of Australia’s most successful families, professionals, and business owners. At Seneca, Luke is the portfolio manager for the Seneca Australian Shares SMA and Australian Small Companies Fund. Prior to co-founding Seneca in 2017, Luke worked for Vale (NYSE: VALE), Deutsche Bank (NYSE: DB) and at Shaw & Partners.
........
The information contained in this article is general in nature and does not take into account your personal situation. You should consider whether the information is appropriate to your needs, and where appropriate, seek professional advice from a financial adviser.
Luke Laretive, Seneca Financial Solutions, its Directors and its associated entities may have or had interests in the companies mentioned. They also may have or have had a relationship with or may provide or have provided capital markets and/or other financial services to those companies mentioned.
Although every effort has been made to verify the accuracy of the information contained in this article, all liability (except for any liability which by law cannot be excluded), for any error, inaccuracy in, or omission from the information contained in this email or any loss or damage suffered by any person directly or indirectly through relying on this information.
2 topics
11 stocks mentioned
1 contributor mentioned
Luke is the trusted financial adviser to some of Australia’s most successful families, professionals, and business owners. At Seneca, Luke is the portfolio manager for the Seneca Australian Shares SMA and Australian Small Companies Fund. Prior...
Expertise
Luke is the trusted financial adviser to some of Australia’s most successful families, professionals, and business owners. At Seneca, Luke is the portfolio manager for the Seneca Australian Shares SMA and Australian Small Companies Fund. Prior...
Expertise
Comments
Comments
Sign In or Join Free to comment
most popular
Equities
Why "buy and manage" is the better way to invest in stocks
Livewire Markets
