Quarterly Report September 2016

Dear Investor,

Almost seven years ago, I hoped to one day be able to write this letter to you. A potential investor at one of our first ever roadshows asked me how much money we thought we could effectively manage in Australia. My answer — $150m to $200m — seemed a long way from the $10m or so we raised in those first few months. It seemed even further away a few years later when the fund was still less than $20m and the return since inception had a minus sign in front of it.

Most funds management businesses fail. So I feel incredibly fortunate and proud to be writing to you telling you that those capacity constraints have started to bite. At the end of September, we were managing roughly $160m in ASX-focused funds.

The return to investors in the Forager Australian Shares Fund over the past five years has been 24.3% p.a., lifting the since-inception number to 167%. Someone who invested $100k with us when we first passed around the hat has $267k today, and that is a meaningful difference to many of our clients’ retirement plans.

Now, however, we have some important decisions to make.

Unfortunately, the Australian market is small. With $160m to invest in ASX-listed companies, we immediately cut the universe of potential stocks from 2,000 to less than 800 (using a cut-off of $100m market capitalisation). Less than 400 of these have a market capitalisation greater than $1bn, and the competition among fund managers for these small number of stocks is fierce. To be any chance of replicating historical performance, the Fund needs to stay small and nimble.

The second big decision is one for investors in the Australian Shares Fund to make over the coming months. We have put a proposal forward to convert the Fund to a closed-end trust and list it on the ASX. This would remove the existing ability for investors to redeem their units, instead allowing them to buy and sell units to and from each other on the stock exchange.

The Australian Shares Fund’s results have been stellar over the past five years but there are a number of funds management firms out there that have produced similar or better results. The interesting facet is how few of today’s exceptional funds were in existence prior to the financial crisis. Most of them are new, and have only operated in buoyant markets (particularly buoyant at the smaller end of the market).

I want this fund to survive and prosper in difficult and dysfunctional markets, too. In fact, our long term legacy will likely be defined by those difficult times.

Removing the risk of redemptions clearly enhances our ability to prosper in difficult times and removes the risk of the vehicle itself being vulnerable in extreme scenarios.

We have recommended this proposal to investors and, while this is not the place to re-iterate all of the pros and cons of the potential listing, it is my belief that there will come a day where we look back on this as one of the most important decisions we have made.

Some investors have suggested to me that restricting the size of the Australian Fund is a wonderful idea, as long as they are allowed to keep investing. Others have suggested we start another fund to invest in smaller companies. Nudge, nudge. Wink, wink: “just my money and yours”.

Hopefully you know me better than that. I’ve invested my money alongside yours since day one and that isn’t going to change. We won’t be running one fund for fees and another for returns. But we do have a problem.

I am 38 years old and want to grow my wealth for many decades yet. If we are already capacity constrained in Australia, how are we going to keep compounding our money?

The solutions are straight forward. Our expertise is in equities, which means there isn’t any point looking at other asset classes. So we can either find bigger companies to invest in, or find other markets in which to do what we have done historically in Australia.

Size kills performance in funds management. Even the greatest investor of all time, Warren Buffett, has seen his results revert closer to the market as he has been forced to buy larger and larger companies. If we are forced to invest in larger companies, our returns will almost certainly suffer.

But I am increasingly confident that the Forager International Shares Fund is a place where we can compound our money at attractive rates for many years to come. Yes, we have trodden carefully. Yes, we have owned some large blue chip companies where we are unlikely to have an advantage over competitors with armies of analysts.

Finding good ideas takes time, though. And the important thing is that, as we have found ideas where we think we have an edge — smaller, unloved and neglected ideas — the performance of those stocks has been extremely encouraging.

Indeed, the International Fund passed a small milestone of its own this quarter. The return since inception is now ahead of the index.

That might not sound like a lot in a world where you can get index returns for very low fees. But we held very high cash balances in those formative years, punishing during a raging bull market. We have caught up a lot of lost ground over the past couple of years. And, in stark contrast to Australia, it has been in a market where the vast majority of active managers are vastly underperforming the market.

In Australia the indices have been weighed down by the largest stocks. The banks and large resources companies
have dramatically underperformed the rest of the market, meaning even the monkey with its dart board is showing outstanding relative performance. An equal weighted index has outperformed its market capitalisation weighted counterpart by 9% over the past two years. In the largest international market, the US, the opposite has been true. Significant outperformance by global tech giants Facebook, Amazon, Netflix and Google has meant the index left most active investors in its wake (as you can see in the chart below, equal-weighted has underperformed by 2%).

Along with some help from South32 and eBay, stellar results from small companies like El.En, Lotto24, Kapsch TrafficCom and Cable One (see Cable Blazes a New Trail below) has made our Fund one of the few doing better than benchmark over recent years. We need to find more of similarly attractive investment ideas but the evidence is growing that fear and greed are just as prevalent in the seven billion non-Australians on the planet. We need time and experience but when we find good ideas, the results can be just as good as those at home.

I don’t expect anyone to take my word for it. The proof will be in the pudding and the pudding won’t be baked for many years yet. I still expect it to take a decade to prove ourselves on the international investing front. Only three and a half years into that journey, you should still be sceptical.

The point is simply that the size of the Australian market is severely restrictive. If we are successful compounding wealth at a healthy rate over the next few decades, a good chunk of it is going to end up invested outside the ASX.

By the time we write the next quarterly report, I hope to be addressing unitholders in a listed Forager Australian Shares Fund. While it would be an important milestone, you should not expect anything dramatically different from us. We’ll be out there looking for ideas, trying to replicate the historical performance and communicating as clearly as possible what we are doing with your money.

Your support, patience and long-term focus have been instrumental in the success of Forager to date. I sincerely hope it stays that way.

In our annual performance report for the year to 30 June, we lamented the damage in inflicted by Britain’s vote to leave the European Union. That’s not because share prices had fallen— low prices are a good thing. Rather we felt that some of our most important investments had been performing exceptionally well, but that this was being masked by large falls in Brexit-exposed stocks.

All of that and then some was reversed in the September quarter, almost without assistance from the aforementioned Brexit stocks. We did add one new UK stock to the portfolio in the quarter that rallied strongly after we bought it, but Lloyds Bank (LSE: LLOY) is trading just 10% above its June lows. Countrywide (LSE: CWD) and Foxtons (LSE: FOXT) are still bouncing along the bottom.

Outstanding results being reported elsewhere, though, mean the portfolio is humming along. Highlights outlined in recent monthly reports included eBay (Nasdaq: EBAY), Sotheby’s (NYSE: BID) and Kapsch TrafficCom (WBAG: KTCG). The thesis on Cable One (NYSE: CABO) has been unfolding to plan and South32’s (ASX: S32) management team continues to show it has a healthy future as an efficiently run, low-cost miner.

A decent correction would still be welcome. As pointed out earlier, though, the gradual transition towards a more concentrated portfolio of mostly smaller stocks is working.

Providing cable service sounds like a boring business. It is a boring business. But one US company is shaking up the industry by doing the unthinkable: shifting focus from pay-TV. We bought shares in the company, Cable One, late in 2015.

Cable One provides a full suite of communications services to more than 400,000 consumers and business customers. It differs from most cable companies in the US in a number of respects. Due to the massive fixed cost investment required, most cable companies focus on selling into dense population centres. But Cable One has eschewed this strategy and focused on more rural regions. By doing so, it avoids competition with the telecom carriers who have ploughed into the city markets with their own pay-TV services.

More audaciously, Cable One is all but abandoning the traditional pay-TV business. This flies in the face of conventional wisdom. Management argues that its programming costs prove too great when selling to its more rural customer base. To combat these unfavourable economics, it’s been jacking up prices on its video service, knowing it will alientate many subscribers. It has also been unafraid to drop popular channels that have raised prices too aggressively.

For decades, cable television was a must-have in America. But the rise of digital video has dramatically altered the landscape for media consumption with far reaching consequences for companies providing the traditional cable bundle. Many Americans are choosing to cancel or shrink their cable subscription and many new households are avoiding signing up in the first place, favouring cheaper streaming services like Netflix.

Fortunately for cable providers like Cable One, pay-TV service is not their only product. They also happen to be the dominant providers of broadband internet, and that has given them a lifeline. Cord-cutters still need the internet, perhaps even more so, and the cable companies are figuring out how to shift the dollars they collect from video to internet subscribers.

Cable One’s management has invested heavily over the past several years in one of the most powerful digital networks in the country. As recently as 2015, the average speed of its network was 50Mbps. After completing its upgrade, it now offers speeds up to one gigabit per second. It’s impressive, especially for small-town internet. We expect its customers will be willing to pay more for faster, better internet over time. They’ll need it for their Netflix. As a quasi monopoly within most of its geographies, Cable One is optimally positioned.

Besides securing its future, the transition from pay-TV to internet will benefit Cable One’s financials as well. The company enjoys healthy double-digit margins already. But providing internet service is around four times as profitable per dollar of revenue when compared with pay-TV distribution. As revenue shifts to this more profitable product, the improved cashflow will be good for shareholders.

Cable One also represents a strategically valuable asset. In most markets in which the company operates, it competes only with the local telecom provider in offering broadband internet. But it typically dominates market share with a much better, faster service. We think owning the internet connection direct to the consumer should become more valuable over time.

In addition, the cable industry has seen major consolidation as the big operators look to capture greater economies of scale. Cable One should prove an attractive target.

This is a steady, predictable business that has stood the test of recessions past. It’s backed by a bold and creative management team. The stock is up 34% on the Fund’s average purchase price but even from here the stock is likely to deliver an attractive return for the risk involved.

When the diamond market suffered a mini collapse in 2015, we snapped up shares of the global leader in diamond processing technology. Sarine Technologies (SGX: U77) is headquartered in Israel and listed in Singapore. It sells machinery and related software involved in all facets of processing rough stones into polished diamonds.

Sarine traces its roots back to the 1980s when a group of gemstone traders formed a company aimed at bringing automation to the gem processing industry. Historically, working out the most efficient and profitable way of cutting a rough diamond was a manual process, dependent on many hours of labour by a highly skilled technician. Over the years, Sarine’s technology has reduced the reliance on human labour while substantially improving manufacturing yields. For example, whereas a top-notch diamond cutter could harvest two or three polished diamonds out of an average rough stone, the company’s machines can get between ten and twelve.

Sarine sells its products into a highly fragmented market of over 5,000 businesses around the world. Its most important product line, the Galaxy system, performs a scan of a rough diamond mapping all inclusions in the stone. As part of Sarine’s service, the scan is analysed and a plan is designed that maximises the value of the diamonds to be cut from the rough stone. Every time one of its customers processes a diamond with one of its Galaxy machines, Sarine earns a fee. We were highly attracted to this aspect of the business model — the recurring, fee-based revenue is exceptionally profitable.

Sotheby’s competitive advantage in art auctions arises from its client lists, brand name and expertise, none of which are accounted for on its books. So those tangible assets looked superfluous and potentially able to be returned to shareholders.

We also believed that the shrinking margin was self-inflicted and easily fixable as a result. And that the business’s flexible cost base meant it could withstand a severe correction in the art market. The $400m excess over its tangible assets looked a steal for such an entrenched business.

The stock was clearly cheap. Nevertheless, a low valuation never guarantees a great investment return (though it usually helps). For the investment to succeed, we needed Sotheby’s management to lift its game. And for the board to consider capital management actions.

We took a measure of confidence from the involvement of two activist funds, Third Point and Marcato Capital, which collectively owned 20% of the company and were pushing for board and management change. That confidence was well founded.

Since June last year Sotheby’s has repatriated some of its overseas cash to the US and suspended its dividend to focus on an accelerated share buyback. The company had to pay some tax, but the share count has decreased by a whopping 22% as a result. Concurrently, activist-backed CEO Tad Smith seems to have put an end to the abuse of auction guarantees. The commission margin has recently recovered to 16.4%.

The combination of a lower share count and margin improvement enabled Sotheby’s to earn a profit of $1.52 per share in the second quarter of 2016, well above Wall Street’s expectation of $1.05. As a result, Sotheby’s stock price has recovered significantly. The Fund recently crystallised a 65% return on its investment in just over six months.

More Activism is Welcome

Learning from mistakes is important. It also isn’t as straight forward as it sounds for long-term investors. We often have to wait years to get feedback on our investing decisions. And once we have that feedback, it is fiendishly difficult to separate skill from luck.

Was buying Whitehaven Coal (WHC) at $0.39 in January a good investing decision? Was selling it at $0.78 a few weeks later the right thing to do? The share price closed at $2.45 on 30 September, so the former looks like a stroke of genius and the latter an act of stupidity.

Whitehaven is a highly leveraged coal miner. Our view in January was that it may go bust, or it may be worth a lot of money, but on a probability weighted basis the low share price was an interesting opportunity. The coal price has doubled in the six months since (see chart 5) and, if it stays at these levels for a couple of years, Whitehaven could repay a lot of debt very quickly.

The upside case is playing out, for now. But did we get the probabilities right at the time? We don’t know. You never do.

Which brings us to the Fund’s mining-related investments. Over the past six months, investor optimism has returned to the sector. Share prices are up a long way and, on average, the Fund has made excellent returns. It’s an appropriate time to reflect on what lessons, if any, should be learned from our foray into this previously unloved sector of the market.

The Bad

Both companies have significant insider ownership, which shows that skin in the game won’t always save you. But they do show how important management is in this business. Understanding return on capital is paramount. And it is a business where one bad contract can send you broke, so having the right person signing deals is more important than usual.

Reiterating the management lesson, one of the best examples of success is MACA (MLD). We acquired a stake in MACA in June last year, paying $0.81 per share. The company performs contract mining for small to mid-tier miners mostly in gold and iron ore. Driven by negative sentiment on a falling iron ore price, MACA’s share price collapsed well before its results deteriorated.

MACA has been able to replace some of that with work from small and mid-tier gold miners. At its 2016 financial year result in August, revenue was some 20% lower than its record 2015 financial year, but MACA has been able to stabilise the business at that level and maintain margins.

This year’s share price performance is a testament to the company’s management team’s ability. It’s navigated the business through the downturn while maintaining a $42m net cash position and generating $40m of free cash flow in 2016.

During the quarter the investment in MACA was completely exited. Its valuation was no longer compelling, with the stock looking fully priced. It was sold at levels that were roughly double the Fund’s entry price last year.

If MACA was the good, Hughes and Brierty the bad, then Macmahon (MAH) would be the ugly. Macmahon remains one of the largest investments in the Fund. It’s very cheap, on both an earnings and an asset basis, but the business still has its problems.

It is probably the best example of the cash these mining services businesses can generate as they shrink. Our thesis here was that the accounting profits would be woeful but that, given it didn’t need to buy any new equipment for several years, Macmahon would generate oodles of cashflow. That has largely played out and the company balance sheet now shows net cash of $56m, compared with net debt of $56m at the end of the 2014 financial year.

Unfortunately, that cash isn’t coming out to shareholders any time soon. Over the past year Macmahon lost $13m on a new contract at Newcrest’s (NCM) Telfer mine and expects to lose another $10m over the next six months.

Telfer isn’t Macmahon’s only problem. It is currently losing $0.5m per month in Nigeria. While management wants to leave this region, it could incur a $2.5m exit payment. On top of this, adverse currency movements would result in a further $8m of plant and equipment write downs.

One of the Fund’s most recent investments in the mining services industry, was in GR Engineering (GNG). It is turning out to be an excellent business.

GR has been able to carve out an attractive niche for itself within the highly competitive engineering sector. The company specialises in designing and building mineral processing plants for a fixed price. Most of its clients are junior miners that happily outsource these risky projects to a specialist. Even if that means paying a bit more.

Drawing on decades of experience, GR has been able to consistently avoid cost overruns and time delays. And, so far, it hasn’t had to deal with any contract disputes, mediation, arbitration or litigation. Thanks to this excellent track record, the company often wins additional work from old clients to carry out plant modifications, upgrades and expansions at a later date. The only major competitor in Australia is Sedgman, now owned by CIMIC. Market shares vary year by year depending on contract wins, but generally the two companies have a 25% share each. While Sedgman dominates the coal segment, GR dominates the gold segment.

As Chart 3 shows, revenue can swing wildly depending on the state of the mining sector and large contract awards. Since listing in 2011, annual revenue has ranged between $110m and $217m. But despite this inherent volatility the business has proven resilient. Since bottoming at $10m in 2013, profits have averaged $18m per year and have been increasing despite a weak mining environment. Importantly, contrary to the other mining services businesses in the portfolio, GR doesn’t require much capital to grow. Since 2011 GR has outlaid only $6m in capital expenditure and paid $77m, nearly all of its profits, to shareholders in dividends.