Fundamentals have gone missing in 2022

In this article, we have a look at a way of assessing the valuation fundamentals of a fund.

We thought it might be useful to share some analysis we did last month. This June was a memorably bad month and there was very negative price action across global share markets, the bulk of which dropped solidly into bear market territory (-20%) as the month progressed. Our flagship Ranger fund picked a bad year to have a poor first quarter, 3 holdings delivered disappointing news to the market and were summarily sold off which dragged the fund down over that quarter. That meant that when the broad risk-off “sell everything” mode really kicked off in the second quarter and reached its crescendo in June, Ranger, also hit hard, was down around 30% for the year.

Clearly, this has been an unpleasant and challenging situation for investors. It’s a significant drawdown, and one of the largest we’ve experienced. Especially when you consider that at the beginning of the year we were convinced that all of our circa 20 holdings in the fund were already trading significantly below their medium-term intrinsic value and represented great value. Nonetheless, they got a lot cheaper as the year progressed, as share markets across the globe de-rated significantly.

Drawdowns happen, the key consideration for investors is whether they hold an interest in a substantial business that will survive and in due course thrive. Or do they hold an interest in a highly speculative business whose future is very uncertain? In a sharp “sell everything” indiscriminate share market drop, it can initially be difficult to tell which is which because the price action of both can look very similar, they can both be down a lot. The difference of course is that the investor holding a business of substance will see their investment recover, due to its strong fundamentals, while the investor that invested in a speculative venture may never see their investment recover, due to its lack of good fundamentals.

So how can investors tell which camp they are in? There are a few fundamentals that give a strong indication of whether you own a business of substance or an expensive speculative venture. And this is the exercise we did in June, we calculated statistics for the Ranger fund as if it were a single business that owned circa 20 companies, essentially looking at the fund as if it were the “Ranger conglomerate” that owned and ran these companies. The numbers that exercise generated strongly indicated that the “Ranger conglomerate” was a substantial business that generated significant revenue and was priced at a very attractive multiple with plenty of scope to further improve its profitability. The table below summarises our analysis.

The first row highlights that the Ranger conglomerate generates a healthy level of sales. For every $100 of Ranger conglomerate $250 of revenue is generated by the business. This is a significantly higher level of sales than an investor receives from other broader share market exposures, for example $100 invested in the S&P/NZX 50 index sees you earn just $50 in revenues. That’s a mere fraction of $250.

The next row looks at the amount of profit the Ranger conglomerate delivers from those sales. This statistic is a little less sparkling as its profit margin in 2022 is a modest 4%. As mentioned, a couple of divisions have struggled in 2022, however it still generates a little over $10 of earnings for every $100 of Ranger conglomerate. That is still significantly higher than the $7.35 that the $100 in the S&P/NZX 50 index will generate in 2022.

Optimism is in very short supply this year, but our view is that the Ranger conglomerate can significantly improve on that 4% profit margin in 2023 and beyond. And the one plus of such a modest current profit margin is that even improving it to 6% is a 50% increase in earnings. Such a level is one we believe can and will be achieved and exceeded, that is because we believe that the investments in the fund have strong fundamentals which will see them not just survive 2022 but thrive in the future. 

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