Investing in a world of options and asymmetry

“The secret to wealth is finding the asymmetric payoff—small risk, big reward” Nassim Taleb

Introduction

When this writer first set about a career in finance we were tasked with uncovering how much each ASX energy company was worth, with little more direction than a basic understanding of discounted cash flows and net present values. The task was easy enough; to develop an asset by asset model that delivered a valuation per share, but how do you consider:

• Potential changes in commodity prices like oil?
• Assets that have uncertainty in their delivery like Woodside’s Browse project?
• And massive binary exploration programs like Karoon’s? (it was affectionately called Kaboom back then)

A lot of it came down to pricing of options. We managed and believe this early entrée into markets has helped frame how we invest today. With a view to minimising risk and maximising returns, identifying the mispricing of options or asymmetric investing is a key part of what we now do on a day-to-day basis. It is similar thinking that has helped us: take positions in Austal, when the consensus at the time was that it faced extinction with key programs like LCS ending, load up on Origin at below book value when the market was capitalising trough earnings, and buy Stockland when it was one of the most hated REIT stocks in the market (among a litany of other examples). More than one observer has recently posited to us the thought that “valuations don’t matter anymore in markets… only narratives”. We don’t think this could be further from the truth.

Our experience in options analysis has been put to test in recent months, in more than just trying to back a Melbourne Cup winner. We have recently faced the questions does Chris Ellison (MIN) and Richard White (WTC) leave and what does that mean for their respective stock price? How fast do interest rates go down and what impact does that have on share prices? Who wins the US election and what is the result if they do?!

We continue to believe a flexible mindset with a focus on valuations (including option value) will be supremely important in 2025 as dislocation opportunities potentially present themselves. Within this article we explore our learnings in valuing options within equities, some historical examples of this and some further details on asymmetry in markets.

Exploration – EMV – Options Value

We start almost in chronological order with this writer’s journey in pricing options within equities. It was where this writer first heard the term ‘EMV’, at least I don’t remember it in the Uni textbooks. EMV stands for expected monetary value which is defined as “a statistical technique used to evaluate the potential financial impact of uncertain events on a project or investment”. So it was perfect this was one of the first things we learned in our first job in markets at Core Energy.

Specifically when it comes to oil and gas we were utilising it in the pricing of exploration plays. How does this work? Effectively it was asking the question: What is the cost of exploration? What is the probability of success? And, if it is a success what is the value of that success? Without introducing too much confusion the below is an example of how this works in theory.

It is saying if the mean potential accumulation is 100 million barrels of oil and we estimate the netback or NPV per barrel of oil at USD10/bbl with the play having a 20% chance of commercial success then the upside case is USD950m or risk weighted EMV is USD150m

What makes it an even more interesting exercise from a mathematically minded individual is a lot of these assumptions are/were prevalent in public announcements, particularly for the more junior companies, with exploration plays the geologists have defined what is the geological probability of success of the play and the mean expected recoverable size of the accumulation if successful. Hence these could be input into our models.

Note the art would often be translating a geological probability of success into a commercial chance of success and further translating what that mean in terms of netback value but it provided a useful framework for helping identify what exploration assets were potentially worth.

Individually pricing a portfolio of assets (Sum of the Parts Analysis)

Conjunctively with learning what an EMV was and what it meant for companies this writer was discovering that in resource investing it was most appropriate to price assets separately, i.e. calculate the collective value of a portfolio of assets by calculating their individual values and adding all of these up.

This approach was particularly useful given:

• Most companies had a combination of producing assets and development assets and it was inappropriate to assume the development assets had the same risk level of a producing asset, I.e. for Woodside pricing the North West Shelf and their other producing assets in a separate way to valuing Browse and Sunrise
• Differing ownership interests across a host of assets with that ownership interest sometimes changing over time
• Assets in various jurisdictions which attract(ed) different forms of regulation needed to be modelled with only those assets attracting that regulation I.e. Sunrise which probably has the same timeline to development now as it did in 2010 is subject to special Timorese government interest
• Exploration assets on top have an expected monetary value which can be calculated separately and thrown into the mix

This approach is not necessarily a revelation for any resource analyst, it is the accepted standard, but it is an approach that contrasts with the analysis of industrials where a companywide DCF is the norm. In some ways we get sucked into thinking there is a solitary base case for each company given there is consensus and most analysts just think in terms of being above or below that. Rightly or wrongly the sum of the parts approach, although not always appropriate can allow for the greater consideration of risk, cash flows and uncertain options and can hence provide asymmetric opportunities within industrial companies. It can allow for the pricing of binary options on top, which are largely excluded by the sell side unless they are a near certainty, even if, as we discuss for ASB and some biotechs below those options are extremely valuable.

Some examples beyond Austal and biotechs, that we have ventured away from the norm in this approach in industrial investing include: Blast Dog for Imdex, the Seeds business for Nufarm, land developments within Stockland and the Sum of the Parts within Aurizon. What are your favourite embedded options within stocks?

Some of the first observations we have made that we still reflect on today are:

• The larger the company the less value analysts generally add for exploration (and other options) particularly when contrasting more pureplay exploration companies, I.e. within commodity companies with producing assets development assets are often underpriced i.e. BHP, refer ROTE
• The same applies in biotechnology companies, which we explore looking at TLX, CU6 and NEU below

We further note that there is a certain asymmetry that comes from commodity company investing as the assets in the ground have exposure to a commodity price that can fluctuate and as we know with options the higher the volatility the more the option is worth. We explore the special case for gold equities at the end of this paper.

Austal Case Study

Austal (ASB) is a great example of this options scenario in practice. This writer first analysed Austal in late 2018 and we first invested in ASB during the early stages of COVID. It became quite a polarising stock during that time when in April 2020 they missed out on the large future frigate(s) contract to Fincantieri.

The narrative at the time was that ASB faced an existential threat with the run-off of their Littoral Combat Ship (LCS) and Expeditionary fast transport ships (EPF) contracts however, particularly once it was announced (in June 2020) that the US Government was granting them USD50m to expand capabilities into steel[1](1) for us it then became a matter of if not when they would win more work. Hence it became a great opportunity to put to work our learnings in Sum-of-the-Parts options analysis. Similar to valuing and then risking the individual assets of Woodside we set about determining the potential contracts ASB was vying for and coming up with a theoretical value of the company.

It took hours of reading but US congress papers are very detailed around the different contracts, including: number of ships, revenue per ship and deliveries per annum. Hence the assumptions we then had to make were average margin (US Shipbuilders including ASB historically average ~8% EBIT) and the probability of winning each contract. At the time our analysis looked something like this.

Hence the way we were viewing things it was a risked valuation of AUD3.30/share at a time the share price had gone <AUD2.00/share, but the NTA of the business was AUD2.05/share so it stood as a very asymmetric opportunity. Of course this analysis looks somewhat silly in hindsight as notably:

• ASB won the first of these options, the (USD3.3bn) Offshore Patrol Cutters (OPC) contract– 30/6/2022
• Less than 12 months after winning OPC, ASB won the T-AGOS contract – 19/5/2023
• ASB saw expanded programs with EPFs - medical ships – 21/12/2023
• Missed out on the Philippines OPV contract which we though was a high probability – 27/6/2022
• Has been announced as the exclusive manufacturer of ships for the Australian Government – 23/11/2023

That bet got even more asymmetric when after the first two of these points our probabilistic valuation had increased closer to AUD4.00/share and NTA of the business had jumped to AUD2.67/share however ASB had experienced some near term earnings headwinds, associated with the T-ATS contract which saw the share price drop <AUD2.00/share and trade at ~70% of NTA. At ~AUD3.20/share today, after a failed takeover bid from South Korean shipbuilder Hanwha and the award of a USD450m contract / grant from General Dynamic Boats / the US Government, for the building of submarines (SIB contract); and exclusivity for the building of ships for the Australian government; ASB is once again trading at an extreme level of upside asymmetry. Our understanding is that management is still determining the exact accounting treatment of the SIB contract but it has the potential to either a) be added straight to the asset base once complete, taking pro-forma NTA to AUD4.50/share or b) amortised over the medium term i.e. 10 years in which case USD45m would be added to earnings every year. Both of which are pretty bullish outcomes - either 70% upside to NTA or earnings!

Although there is uncertainty remaining about ASB’s ability to execute on steel shipbuilding contracts. If they can and their portfolio options doesn’t push out to the right ASB is destined to produce FY2030 EBIT of AUD250-300m, which would have the company trading at <4x EBIT vs global shipbuilders trading on 15-20x (refer below). All this for 70% of pro-forma NTA means ASB remains one of the most asymmetric opportunities for us on the ASX.

Orora Case Study

Another recent example is Orora (ORA), where like many in the market during 2024 we were asking ourselves how much is too much on the downside?

Below is some of our analysis from July 2024 when 8 months after the Saverglass acquisition completed we calculated you were effectively paying 25% of the Saverglass purchase price within ORA, in what was reported as a fairly competitive process.

Or looking at it another way, ORA took on additional debt to finance the deal which saw net debt (ex leases) increase ~AUD900m and the EV rise to AU3,572m from AUD2,972m (AUD600m). With Saverglass contributing ~AUD280m EBITDA to ORA (pre AASB116) Saverglass was being valued at ~2.1x EBITDA.

If you continued to believe in the quality of the rest of the business (and the management team), what should it have been down? This is not a perfect science but we inferred share price performance using ORA comps, remembering there were effectively downgrades to Saverglass and to OPS[2](2) while Australian earnings were maintained in 2HFY24

• Saverglass has some decent peers (refer below)
• For ORA’s Australian division we used the ASX300 (for want of a better comp)
• For ORA’s North American division BUNZL and Ball Corp were considered, note per Bloomberg both had seen downgrades similar to ORA’s North American division

Our analysis pointed us to the conclusion that per ORA’s peers it should have been down a lot less (4%) than it was

In rounding out the exercise we had to ask ourselves were Saverglass’ earnings overstated and was Saverglass’ downgrade in line with peers? To that point we noted that between 2019 and 2023 Saverglass’ earnings increased from EUR100m to EUR168m. Volumes during that period were up 13%, meaning price/mix/margin accounted for ~50% of the increase. Over that 5 year period ~EUR270m of capex was spent on growth projects. If we assumed a ROIC similar to ORA’s (15%) that equates to EUR40m of EBITDA. (EUR100m x 1.13) + EUR40m ~ EUR153m. Hence our bush maths didn’t point to massive overearning - maybe ~EUR10-15m. But with 11% volume decline in 2H24 the destocking set up a more reasonable base to consider going forward. Furthermore per the table below margins assumed are ~ 2.5% under at Saverglass vs peers if we consider accounting differences i.e. AASB16[3](3).

Furthermore on capex we noted that In the prior 5 years Saverglass’ capex had been ~EUR450m on sales averaging EUR560m, equating to 16% of sales. Peers are investing ~9% of sales in capex. Hence it appeared to us, that if anything previous owners were overinvesting in Saverglass reducing, our suspicion of dubious private equity practices. We also came to the conclusion in July that Saverglass’ depreciation was potentially more aggressive than ORA’s, which when adjusted could provide a buffer to insulate further earnings downgrades, which proved to be the case in August.

Hence the Saverglass acquisition was poorly timed (unlucky is one word) but it did come from private equity. However there was enough evidence to show that comps had faced similar challenges and with the limited data we had there could be an interpretation that Saverglass outperformed peers in FY24, making the old adage applicable that management were “doing well in a tough environment”.

Why rehash old news? Because the thinking is still valid today, particularly now that ORA have agreed to divest OPS to Veritiv[4](4). we once again have to ask ourselves if trading at ~net cash and ~6x EBITDA or 9.5x EBIT is the right multiple for a global beverages company? We (and Lone Star) might argue it is at least one turn too low.

Biotechnology Companies

EMV options, as described above, are everywhere we look in finance, but none more so than in Biotechnology. This writer has recently been fascinated by this space and highlights a few particular names we have been exploring for asymmetric opportunities.

The calculations for these are in some ways very similar to the EMV calculation presented above for oil and gas with some slight differences. Replacing the size of the hydrocarbon accumulation however and the price of oil are estimates around: the total addressable market a drug addresses (TAM), the take-up rate and persistence of users and the price of a drug. A key determinant of persistence can often be if insurers or other entities cover the drug and hence there is limited gap for the patient.

Probability of success factors, similar to a hydrocarbon accumulation, are somewhat idiosyncratic but in the absence of this analyst having the scientific background to assess these applications on individual merit we revert to historic probabilities of success and commercialisation. Hence at a general level we start with the question, what has been the probability of success of different trials, and what can that impute about stocks?

From our reading including the National Library of Medicine paper from which the image above is lifted a drug that has completed phase III successfully has historically had an 88% chance of approval and a drug that is at a Phase III gate likely has a ~60% chance of being successful in that trial and passing to the approval stage. Hence we frame our thinking on biotech options around these cases (i.e. 50% for phase III trials and ~30% for phase II). We adjust this factor based on evidence that the drug has been successfully approved in another jurisdiction or has been pre-approved for critical use prior to final approval.

Also noteworthy is the likelihood of a drug progressing from Phase I to final approval is about 8%. Success rates can also differ notably depending on the therapeutic area they are associated with.

Telix

The best example of a portfolio of different biotechnology assets is Telix Pharmaceuticals (TLX). For those unfamiliar with the company they are a biopharmaceutical company that focuses on the development of diagnostic and therapeutic products based on targeted radiopharmaceuticals or "molecularly targeted radiation" (MTR). The products in their pipeline are intended to address major unmet medical needs in oncology, particularly in prostate, renal, and brain cancers. The first of these products Illuccix is a diagnostic imaging agent developed by Telix after it acquired TheraPharm in December 2020. It is used for the imaging of prostate cancer using Positron Emission Tomography (PET) scans. The diagnostic agent targets the prostate- specific membrane antigen (PSMA), which is overexpressed in prostate cancer cells, allowing for a more precise localisation and visualisation of the disease. This can assist in better patient management and can influence treatment decisions. Telix is partnered with radiopharmaceutical giant Cardinal Health for distribution of Illucix in the US market.

TLX has also developed drugs for the imaging and therapy of renal cancer (TLX-250) as well as brain (TLX-101) and multiple other applications such as rare diseases and bone marrow as well as an exciting portfolio of prostate therapeutics products TLX-591 and TLX-592.

Analysing TLX can be somewhat complex but we have tried to (dangerously) simplify our detailed model below i.e. we have attempted to impute potential market share of key drugs below and risk each of those products based on stage of development (without a scientific overlay). The outcome to us suggests bias to the upside on revenue and hence earnings on a 5+ year basis. However, we appreciate that this is assumption heavy and will be more binary than this exercise suggests, particularly with the uncertainties RFK Jr brings to the US healthcare space and the intricacies of CMS payment changes.

In relation to the above:

• We have chosen to only compare revenue but note Illucix at present has a GM currently of 65% and we assume a similar margin for most products
• Illucix is the base product for Telix, by estimates off the back of theirs and competitor Lantheus’ most recent quarterlies they already have ~30% market share in the US of PSMA PET however this is expected to increase further with a confirmed (40%) CMS pass-through price drop for Pylarify and the commencement of TLX-007 for Telix
• Global sales are more opaque but it is seen as a ~USD1bn TAM opportunity and within 3 years TLX could be doing ~1/3 of their US sales from the rest of the world. Illucix globally (like almost all drugs) is anticipated to have a lower average selling price (ASP) but similar gross margins to the US
• TLX250 (Zircaix) for kidney cancer, they have a 4 year head start on the competition. Although there was a slight delay after TLX’s submission to the FDA, announcements appear to suggest technical hurdles have been passed and only administrative hurdles remain. It is likely to be priced at a higher ASP to Illucix and if successfully approved TLX could achieve material early market share in an uncontested market
  
• TLX-101 Pixclara (F-FET) is a brain cancer imaging agent, PET agent, for the characterisation of progressive or recurrent glioma. It has been granted priority review and we note already included in international clinical practice guideline the imaging of gliomas. TLX see it as strategic as it potentially paves the way for TLX-591. So, if the trials are successful for Pixclara than it somewhat derisks their Therapeutics
  
• Therapeutics prostate products TLX-591 and TLX-592. Prostate TAM is USD8-10bn and TAMs for all cancer therapeutics is ~USD40bn. Hence why TLX want to play in that market but it is competitive. ProstACT GLOBAL Phase III trial is progressing but will be a prolonged process

In summary for TLX, based on our analysis we believe there are potentially further upgrades implicit in earnings projections as:

• Global PSMA PET markets are penetrated
• TLX-250 and TLX-101 are commercialised
• Application of imaging products expands as the number of scans increases
• TLX progresses its Therapeutics business and TLX-591 and 592 are commercialised and scaled
• Further applications are progressed and developed such as Musculo-skeletal

Chester CY2027 earnings and beyond remain meaningfully above consensus

Clarity

When we talk about TLX we are often asked what we think about Clarity (CU6). CU6 is a clinical stage radiopharmaceutical company developing next generation theranostic (therapy and imaging) products based on platform SAR technology, ideally suited for use with copper isotopes which is said to enable superior imaging and therapeutic characteristics. Their products are hence likely to play in the same space as some of TLX’s products (notably 591 and 592).

As noted above we do not have a medical background and hence assess the economic payoff at an information disadvantage to other market participants but note that unlike TLX, CU6 doesn’t have a base level of earnings but 2 Phase III trials currently related to Cu-SAR-bisPSMA. Hence by the maths of above we would have to assess their value at 50% of their estimated share of TAM. We have heard glowing commentary on the potential of their product however for us without the requisite skills to assess the science, we would class the economic payoff as too binary for us to entertain. That’s not to say that it isn’t the right investment for others with the requisite skills. I.e. if it was potentially going to capture AUD10bn of value and had a 50% chance of payoff at <AUD2bn market cap that payoff is undervalued. However for us its binary not asymmetric. It does highlight maybe similar to resource companies the market may be willing to recognise these options in pure development companies rather than companies producing earnings, which is highlighted in the example below.

Neuren

Neuren (NEU) is an Australian biopharmaceutical company specialising in developing therapies for neurodevelopmental disorders that emerge in early childhood. Their lead product, DAYBUE™ (trofinetide), is approved in the US for treating Rett syndrome in patients aged two years and older. NEU is also advancing NNZ-2591, currently progressing to Phase 3 clinical trials for conditions including Phelan-McDermid (PMS), Pitt Hopkins (PTHS) and Angelman (AS). The company has granted Acadia Pharmaceuticals an exclusive worldwide license for trofinetide in Rett syndrome and Fragile X syndrome, while retaining rights to NNZ-2591 for other indications. We have recently been fascinated with NEU of late given it is a self-funding clinical research company with this portfolio of attractive options. Although there are a host of factors impacting the short term view of NEU: change in US administration and management change at distributor Acadia we are increasingly gaining conviction the share price is underwritten by DAYBUE’s value and the potential of NNZ-2591, despite being extremely material under a successful commercialisation, is being priced at near zero within the share price.

We preface this analysis by saying we aren’t experts on the science of their assets and have leveraged off the work of some of the covering analysts to gain views on success, but NEU are currently the leading drug contender for the indications of Phelan McDermmitt and Pitt Hopkins disease. They are potentially third in the case of Angelman but their progress potentially provides them with 3 lucrative shots on goal.

Key things we don’t know are:

• Whether Phase III trials will be successful – but refer averages from the studies noted above (we have assumed 50% in the US for PMS and PTHS)
• Potential level of market penetration – we have assumed similar stabilised levels for DAYBUE which is arguably conservative given the lower levels of side effects noted to date
• How much NNZ-2591 will cost - however we have used DAYBUE (gross USD575k) as somewhat of a guide. And despite higher potential efficacy, lower side effects + rarer diseases potentially suggesting a higher price than DAYBUE the RFK Jnr factor, and average of other orphan drugs as a guide has led to us reducing this almost by half (gross USD300k) as well as a similar gross to net factor as DAYBUE and a global discount factor of 30-40%
• Timing of roll-out. We have assumed consistent 1 January 2028 for all markets and geographies – however note that a 6 or 12 month delay to that matter doesn’t make or break the point of the exercise
• The Commercial model – We have assumed DAYBUE is the only drug that is under licence to Acadia and 2591 they distribute themselves. Notably 2591 could cannibalise DAYBUE for Rett but we have assumed no change here.
• Whether they will achieve comparable economics globally to the US. We have assumed a lower level of economics

The net effect of all of these assumptions is an EMV Sum of the Parts that looks like the following

I.e. our analysis suggests that NNZ-2591 is being priced at close to zero within the NEU share price. We have to ask ourselves if NNZ-2591 was sitting as the sold drug within a company would it be valued at <AUD150m? Asymmetric?!

Botanix

Botanix Pharmaceuticals Limited (BOT) is an Australian dermatology company focused on developing and commercialising treatments for prevalent skin diseases and infections. Its lead product, Sofpironium Bromide (Sofdra), targets primary axillary hyperhidrosis (excessive underarm sweating). In June 2024 Sofdra received FDA approval to be distributed in the US which sets them on the path to commercialisation and ultimately free cash flow.

BOT will be employing a direct to consumer telehealth model to distribute the product and have already signed agreements with (including with Ascent) covering over 40% of the US TAM ‘commercial lives’. There are currently an estimated 10m people with Hyperhidrosis in the US with the disease obviously a global not just US opportunity. Sofpironium Bromide is being distributed in Japan by Kaken Pharmaceuticals in a product called Ecclock.

We invested in BOT prior to it receiving FDA approval when it was priced like this was a meaningful risk. We saw the opportunity as somewhat asymmetric vs the risk implied by the share price at the time due to:

1. The fact it had previously been approved yet there was a check of its packaging
2. The product (with a slightly different formulation) had been distributed in Japan Ecclock meaning it already had market validation

Furthermore once FDA was approved we further strengthened our resolve on the name after

3. Dr David Nayagam at E&P conducted a survey of the (US) Hyperhidrosis Society which highlighted some key facts about the product including propensity for sufferers to try the product (high at 95% of patients likely or highly likely to try SOFDRA) and required improvement on current condition (~50% which is low) indicated high penetration and persistence rates. The survey also indicated potential patients love the idea of telemedicine and direct shipping; and

4. Now more recently the announcement, that insurers will cover the product eliminates what we had heard from others was seen as the key risk

Note it is difficult to determine what is the appropriate ramp-up of the product but again we have an addressable TAM, a price and economics of comparable companies to provide some assumptions to assist us in determining commercial value.

There is also an analogue for Sofdra with Ecclock in Japan but notably their healthcare system is very different to that of the US and has meaningful friction points that limit the ability to easily refil a script. The upside on this though is that with our understanding that patients in Japan average only 1.5 fills on average the sales data out of Japan is indicating a potentially extreme penetration rate for sufferers willing to try Ecclock[6](6). The trouble is however the lack of refills.

Hence assumption heavy but we have been able to develop the following scenario table with the results of the study and the Ecclock example potentially skewing our thinking towards the higher end of the potential scenarios, up from our initial base case.

Imricor

Imricor (IMR) Is a relatively recent addition to the Chester cares list. IMR produce MRI compatible catheters and systems to enable cardiac ablation procedures to treat cardiac arrythmias (irregular heartbeat). The catheters developed by IMR are a world first, other manufacturers only have capability for X-Rays but given the heart is a muscle, use of 2D X-Rays for these ablation procedures (minimally invasive procedure to normalise heartbeat) is not optimal. MRI procedures are more accurate, quicker and IMR believe economic, hence present as a more effective outcome for both patients and cardiologists. The business similar to BOT is founder-led by Steve Wedan, who first designed MRI and ultrasound systems at GE and has painstakingly developed the full suite of products to make cardiology labs MRI compatible over the course of 20 years.

Although IMR is a Medtech not a biotechnology company we feel it has a similar setup to Botanix (BOT) in that it is subject to an FDA trial for Atrial Flutter (AFL) that is somewhat derisked given pre-existing approvals in Europe and the Middle East and a history of performing heart flutter procedures almost without fault in Europe. The trial is for up to 91 patients with an early exit at 76 patients, hopefully in early 2025.

Similar to BOT there is also granular detail on the expected number of procedures to be performed in a lab each year, the cost of equipment, catheters and hence what the opportunity available to IMR is if they can achieve FDA approval and penetrate the US cardiology industry.

Despite the prescriptive nature of these elements there is still risk to the downside that FDA approval isn’t received for AFL, VT or AFIB particularly because to date there hasn’t been a VT (Ventricular Tachcardia) or AFIB (Atrial Fibrillation) procedure performed with MRI devices, with which we hold our breath in anticipation of an imminent VT procedure in Europe.

Given this risk and the more assumption heavy nature of this valuation we utilise a higher cost of capital to discount potential cash flows and determine low, base and high scenarios. Differences in the assumptions include the number of labs they ramp up to, hence the number of procedures performed per annum and the number of catheters reordered.

Notably X-Ray Catheter players (BioSense, Webstar, Medtronic, Boston Scientific) are operating with GMs of 80% and potentially EBITDA margins of 40%.

Book Value Asymmetry

Of the examples above we believe set-ups provided/provides asymmetry from a value perspective but we get the most comfort, as is the case with ASB when the stocks trade below book value. ASB is a great example of value asymmetry. Some of our more recent successful investments have come from investing in companies trading below book value with the market missing an element of the mark-to-market of those assets. As we have previously noted the biggest issue with this type of investing is that often in this situation, after identifying and purchasing an investment at below book value there is an impairment of that company which invalidates the book value of those assets. Hence it remains important for us that this isn’t the sole purpose of investing in the business but rather one prong of the investment thesis. And on a further note the asset we are investing in is somewhat of an essential service and not a discretionary item or a mine. We recently heard the quote “In mining there is no asset backed lending only cash based lending”[7](7). I.e. if a mine doesn’t produce the cash it will be shut down and also value potentially lost. Notes where we have previously highlighted this in more detail include:

• Not A Sequel but an Origin Story
• Hidden Property value within a property stock

Earnings Expectations Asymmetry

As part of the work we do at Chester, we compare our projections of modelled companies with that of the market to identify if the market is mispricing earnings. Although this can at times be a challenge given most stocks have multiple analysts covering them when these situations are identified they can be extremely lucrative. We recently read a great research note by Harris “Kuppy” Kupperman titled “What’s Driving Stocks”, reproducing some work by the Macro Tourist Andrew Muir considering some of the negative aspects of this phenomenon but it really is a powerful force particularly when combined with a lens of stocks that are underappreciated or unloved and hence (cheaper than average). We could list a bunch of names where we have done this internally but some of the public examples are:

• Select Harvest
• Austal
• Imdex and ALQ
• Nufarm

What we like about these situations is we can be wrong but it increases the chances of asymmetric returns, that if the company beats expectations the stock price will follow by at least the extent of the earnings beat, but often more as the stock experiences somewhat of a re-rate. The article does a better job of explaining why EPS expectations = share price movement. Below we discuss how the ASX listed gold stocks could be the perfect set-up as being relatively cheap but subject to longer term earnings upgrades based on the gold price.

Information Asymmetry

Information Asymmetry is also worth mentioning here and the work we do in reviewing annual reports (Why it pays to read the Account Notes) and insider activity (Why it pays to follow the insiders - Part 2) to gain any form of informational edge and tip the scales in our favour. We particularly note the section in the article linked above titled ‘The Book Deal Trade’ as one of the more asymmetric opportunities we can think of. We have been working on one particular Book Deal Trade for the better part of 2024 and hope to inform of our efforts here early in 2025. We are super excited by it but acknowledge there are no guarantees in markets.

The case for Gold Equities

Last but not least we want to mention the asymmetry available in gold equities. We are well known at Chester for always having investments in gold equities at ~5-10% of the portfolio. We won’t rehash our investment pitch but essentially we are attracted to the defensive characteristics of it within our portfolio almost like an insurance policy. By its very definition however insurance is usually something that loses you money but you pay to have the protection. In the case of gold we don’t believe that to be the case.

At Chester we don’t try to make commodity price calls, we rely on consensus prices for the commodities that we model, the primary exception being gold in which case we utilise a price more aligned with spot (or the futures curve), the lags in any period usually only represent the timing differences on when we last completed our detailed update and the gold price at the time (and also our desire to use a round number). The broker that is most closely aligned to this way of thinking is Canaccord Genuity but outside of that the street appears to use a commodity price assumption meaningfully below spot on a long term basis.

Above is a sample of long term (LT) gold prices assumed by the sell side. In response to these differences we have asked a few select houses as to why and the responses are often a combination of: “that’s what we’ve always used”; “we are told to use that price"; or “higher costs will offset any differences in gold price” … But what if they don’t? Based on average all-in-sustaining costs (AISC) of the ASX gold companies of circa AUD2,000/oz it works out that they generate ~40% margins, providing ~2.5x leverage to the gold price. Putting it another way if the average (particularly ex Canaccord) were adjusted to spot there would be up to 100% average valuation increases or 65% to adjust to our most recent assumption of ~AUD3,600/oz. We don’t know where the spot gold price lands under a Trump Administration but we continue to contest that the spot price is as good as any other arbitrary number. DOGE may do their thing and potentially reduce US Government deficits but turning them into surpluses is another thing.

Should gold price hold spot, and we don’t see a meaningful ratcheting up in opex and capex, the upgrades to long term free cash flows of these businesses are going to be material and maybe enough to get the pod shops involved. On this basis some gold equities are extremely cheap and getting cheaper.

We show an example for WGX from September below (acknowledging some changes to WGX and consensus since) but the information is still valid. Notably WGX is the gold stock we have chosen to show but this is prevalent across most of the ASX names we look at, largely due to the gold prices assumed by the sell side.

I.e. WGX’s leverage to the gold price is 2.5x

The above has shown to translate into higher FCF estimates of Chester vs the street.

Closing

Much like the holiday season, investing with options and asymmetry is about finding the gifts hidden beneath the surface. The right strategy can turn a modest outlay into a spectacular surprise—or at least save you from ending up with coal. Here’s to a happy holidays for all and uncovering some more asymmetric opportunities in 2025.