Forager Funds

Feasting on the crumbs of passive giants

Passive flows and opportunity

Passive funds are the giants of modern markets, and they are here to stay. At Forager, we have taken the view that it is best to work with, not against, these funds. Therefore, long may they expand their footprint in equity markets.

Low-cost passive funds—and I’d include Australia’s superannuation giants in this category—are largely a force for good. Their relentless focus on costs has saved investors billions in fees. Given their enormous size, it’s entirely logical for them to stick to large, liquid companies. Take Australian Super as an example. As of 31 March this year, it had $367 billion in funds under management.

There’s simply no need—or point—for a fund of that size to venture into Australian small caps. Even if it invested $100 million in Forager’s

Australian Shares Fund, our 18% outperformance, would have earned its members just an extra 0.0049% for the year. Count the decimal points yourself.

Yet what’s logical for them creates opportunities for us. Think of it like the crumbs from a giant’s sandwich. For the giant, those crumbs are inconsequential. For a nimble ant, they can represent an enormous feast.

Over the past year, passive trends have helped us in three important ways.

Price-agnostic sellers

First, we’ve seen plenty of forced, price-insensitive selling at the smaller end of the market. This happens when stocks become too small for the giants’ portfolios, or when fund liquidations occur because super funds have given up on active small-cap managers.

Several high-profile small-cap fund closures occurred over the past 12 months as super funds pulled mandates. This created opportunities for us to add to existing investments at attractive prices—for example, in MotorCycle Holdings.

Companies at the bottom end of indices often experience sharp price declines as an initial, fundamentals-based drop is exacerbated by waves of passive selling. ASX-listed Johns Lyng, for instance, had a market capitalisation above $2 billion in mid-2022, enough for inclusion in the S&P/ASX 200 Index. By 31 March this year, it had been deleted from that index, with its share price down more than 75% from its peak(it bottomed, not coincidentally, on 9 April).

The business isn’t as good as investors thought when the share price was north of $9. But in our view, it’s not as bad as a $2 share price would suggest either. Most value investors would agree. Yet much of the price movement reflects passive investors who haven’t given valuation a moment’s thought.

Thematic waves

Another source of returns has come from the growing influence of thematic exchange-traded funds (ETFs). These funds allow investors to target sectors linked to themes like defence, cybersecurity, or artificial intelligence. While gaining popularity in Australia, they’re already significant players in US markets.

I’m far less convinced that thematic funds are a force for good. The whole point of index funds is to acknowledge that beating the market is difficult—and that keeping fees low matters most. Thematic funds charge significantly higher fees than broad index funds and appeal to investors who want to punt on the next hot sector. Almost by design, they attract a surge of money near the peaks and lose much of it at the lows.

That can create buying opportunities for us. Take Comfort Systems. I first met the management team of this NYSE-listed company at a broker conference in Chicago in November 2023. They provide a wide range of mechanical, electrical, and plumbing contracting services, specialising in HVAC systems.

My notes at the time read: Nice business, good management team, not sure about the special sauce, probably not cheap enough for us.

Forager’s International Fund Portfolio Manager, Harvey Migotti, met them again in November 2024. His assessment: Very good business, great management team, and strong long-term tailwinds from data centre construction and manufacturing returning to the US. The share price had doubled in the interim, but Harvey returned to Sydney convinced we needed to complete our research and be ready to act.

Then came Donald Trump’s renewed assault on global trade. Between 22 January and 4 April, Comfort Systems’ share price fell 46%. This company carries net cash on its balance sheet and has years of work locked into its order book. Yet when money flows out of the market, even good businesses get hammered. That’s when we get our chance to buy into companies with very bright futures. We’ve seen it across sectors—from building products to discretionary retail. When a theme falls out of favour, share prices across the sector tend to drop in lockstep, and the selling becomes indiscriminate.

Crumbs that grow large enough for giants

The third source of opportunity lies in identifying stocks that passive buyers will inevitably need to own a few years down the track. Consider the journey of Catapult Group.

In May 2022, the stock typically traded between $100,000 and $200,000 per day. Now, with Catapult firmly included in the S&P/ASX 300, it’s rare for daily volumes to fall below one million shares. With the share price up fivefold, that equates to more than $5 million worth of shares traded daily—and $10 million days are not uncommon.

Catapult’s business has progressed meaningfully, growing revenue nearly 20% per annum and delivering improved profitability. But index inclusion has been the mayonnaise on the sandwich. The increased liquidity firstly means larger small-cap managers can get interested. Then the passive funds need their share as well. Having traded at an undemanding two times revenue in 2022, Catapult now trades at a much more optimistic eight times the significantly higher revenue.

That “mayonnaise” will matter more as passive influence keeps growing. Forager will still invest in businesses that never make it into any index or super fund portfolio. Some of them, bought at the right price, will deliver excellent returns. There’s already plenty of money trying to arbitrage which stocks will be added or dropped whenever index providers rebalance. That’s not our game.

But when we’re looking three to five years ahead, we always ask: Could this business ever attract passive buying? Index inclusion can significantly amplify profits from successful investments. And at our relatively small size, it can add a meaningful boost to total portfolio returns.

The shift toward index funds and giant super funds isn’t likely to reverse. In aggregate, money will likely keep flowing out of the small- cap end of the market. For those of us with loyal, long-term clients, that makes for particularly fruitful foraging.

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This is an excerpt from the June 2025 Annual Report and also appeared on Livewire Markets

Podcasts

Neat Reflection of 2025: Winners and Losers of the Passive Revolution

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Insights

Why July Could Be a Smart Time to Invest

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With the new financial year underway, here’s why savvy investors act now, not later.

The end of June might feel like a full stop at the end of the financial year. But for investors, July is often where the most thoughtful decisions begin. With a fresh tax year ahead, performance reset, and market jitters still looming large, it’s often the moment patient investors quietly get to work.

A Fresh Tax Year = A New Allocation Window

Many investors wait long after the End Of Financial Year (EOFY) to get their affairs in order, but July is often when the proactive ones act. New contribution limits, distributions out of the way and a clean slate mean decisions made now set the tone for the year ahead.

Early Action Means More Time in the Market

The earlier you invest, the longer your money is put to work. Starting in July doesn’t just mean getting in early, it means giving yourself the full financial year to benefit from compounding returns, reinvested distributions, and any opportunities that emerge along the way. For long-term investors, that extra time in the market can make a meaningful difference. It’s potentially a smart move that aligns your investment horizon with the financial year, setting you up for growth from day one.

Opportunity Often Looks Uncomfortable

Investors who act early in the financial year, especially when sentiment remains cautious, are often those who benefit most over time. At Forager, we’ve built our track record by focusing on parts of the market others tend to overlook. You’ll see that despite small-cap underperformance, the investment team have managed to find plenty of excellent opportunities during the FY25 financial year:

Right now, both domestic and global small and mid-cap stocks remain an especially fertile hunting ground. Our investment team is busy uncovering more new opportunities in Australia and overseas.

Of course, investing comes with risks. Markets go up and down, and there are no guarantees. But investing in July provides the greatest amount of time to weather any volatility that does happen during the financial year ahead.

Forager's Funds Are Positioned for What’s Next

We’ve made some bold investment decisions in recent months, moves that reflect where we see genuine long-term value, not where the headlines are pointing. We are also very happy about how our portfolios are positioned for the year ahead.

If you're already an investor, July is a great time to top up. If you've been watching Forager from the sidelines, maybe this is your year to jump in. Either way, now’s a smart time to act. Don't procrastinate, get your portfolio in order for the financial year ahead:

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Australian Shares

5 Small Cap Takeover Candidates

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After a period of relative quiet, public merger and acquisition (M&A) activity on the ASX roared back to life in 2024. The number of deals hit a decade high. And there are good reasons to think the momentum will continue through 2025 and into 2026 — particularly at the small-cap end of the market.

A few macro tailwinds are aligning. Interest rates are heading lower, both in Australia and globally, improving the cost of capital and restoring confidence in risk-taking. Equity markets are surging again. And changes to Australian merger laws are set to come into force in early 2026, which may see deals accelerated to avoid a more cumbersome process under the new regime.

Global private equity still has near-record levels of “dry powder” to deploy. With the Australian dollar still weak and many small caps trading at steep discounts to historical multiples, the ingredients are there for a busy year.

Already in Play

Forager’s Australian Shares Fund only owns 31 stocks. Three of them are currently under takeover offers.

One well progressed is the battle for online bookmaker PointsBet (PBH). Japanese group MIXI (TSE:2121), armed with a cash-heavy balance sheet, is in the mix alongside Australian challenger Betr (BBT). In late April, Betr had little trouble raising $130m in fresh equity to fund the cash component of its tilt. Cost reductions across technology, marketing and labour mean the company expects more than $40m of synergies should the deal consummate. Mixi fired back with an upped $1.20 cash bid and will attempt to circumvent Betr’s pre-bid blocking stake by committing to an alternate structure if the current one (which requires 75% of voting shareholders to approve it) fails. That meeting will be held next week.

Natural disaster remediation company Johns Lyng (JLG) is in the crosshairs of private equity player Pacific Equity Partners (PEP). In an uncommon and shareholder unfriendly twist, investors are still waiting to learn the price PEP proposed to secure its exclusive due diligence. Less surprisingly, the proposed deal has been structured to allow the management team, headed by major shareholder Scott Didier, to retain an interest in the business.

Capervan sale and rental business Tourism Holdings (THL) is also the subject of a private equity bid, this time by BGH Capital. The Trouchet brothers, who had merged Apollo Tourism and Leisure into Tourism Holdings three years ago and are 12% shareholders, are backing the bid. THL has been driving over plenty of potholes. Most recently, geopolitical tensions caused a reduction in US inbound travel and another downgrade in earnings expectations. The price here has thankfully been disclosed, clocking in at a chunky 58% premium to the deeply depressed last traded price.

All three are good examples of how takeover interest can emerge from offshore corporates, local competitors and cashed-up private equity firms. Some major shareholders, especially when they continue to be involved in the business and bemoan a lack of investor appreciation on the ASX, become good partners for acquirers to speak to ahead of any bid.

Businesses in Our Portfolio Worth Watching

They are unlikely to be the last three takeover offers we receive. Several companies in the Forager Australian Shares Fund portfolio are ripe for acquirers, and a few have already seen interest in the past. Here are five we think could appear on dealmakers’ radars in the year ahead.

1. Tyro Payments (TYR)

Tyro operates Australia’s largest non-bank network of payment terminals, servicing over 73,000 merchants in healthcare, hospitality, and retail. The business grew gross profit by 7% in the first half of the 2025 financial year while expenses remained well under control. Earnings were 21% higher and guidance for the year was reaffirmed. The business is on solid footing once again and valuations are attractive.

The Australian Financial Review recently reported that private payments provider Stripe was taking a look at Tyro, and it's not hard to see why. Tyro would give the international payments business instant scale in Australia and a powerful distribution network for Stripe’s online payments products. This wouldn’t be the first time Tyro has been in the crosshairs of acquirers. In late 2022 private equity player Potentia and Westpac (WBC) were working to acquire the business. At the time Potentia bid $1.60, an almost 80% premium to where Tyro stock trades now. With the departure of Tyro’s CEO over the next few months, the door is ajar for an acquirer.

2. ReadyTech (RDY)

ReadyTech is a vertical software business serving education, workforce, and government clients. It generates strong recurring revenue but has seen a moderation in growth recently. What was expected to be a revenue growth percentage in the “mid-teens” is now more like “high single digits”. The share price is off 30% from recent highs.

But the business continues to grow and should improve margins next year. Clients rarely turn the product off, with churn at only 4%. And there is scope for growth to either accelerate or for costs to be cut.

Potential acquirers would be well versed in what can be done. The business was subject to a takeover approach from Pacific Equity Partners in 2022, with the current share price at about half of the bid price. Existing 32% shareholder Pemba Capital has been invested for years longer than one would have expected. While supportive, it’s not unreasonable to think they might be open to an exit at the right price.

3. RPMGlobal (RUL)

A home-grown global software leader, RPMGlobal develops enterprise software for the mining industry. It was the Fund’s largest investment for a long time, and the business has continued to grow. The valuable and low-churn subscription software revenue stream was up 22% in the last half-yearly result.

Unlike some of the other candidates on this list, RPMGlobal is trading close to all-time highs. But it is a strategic asset that has been managed with one eye on sale for many years.

Selling its advisory division at a healthy price has left the business with a clean, sticky, recurring revenue stream which could be attractive to industry players and private equity buyers alike. Plainly disclosing remaining corporate costs mean synergies for potential acquirers are clear.

A competitor, Micromine, was acquired at ten times revenue recently by engineering behemoth Weir (LON:WEIR). This valuation would imply a very healthy premium for RPM Global. The vast majority of the company’s competitors have changed hands over the last few years. RPM could be next on the radar of acquirers.

4. Praemium (PPS)

Investment platform player Praemium has a strong position in the high net worth and separately managed accounts platform niche. It received a bid from competitor Netwealth (NWL) in 2021, which was ultimately rejected. Nearly four years later Praemium is trading at about half of the deal’s implied value at the time. Since then, the logic for platform consolidation hasn’t weakened.

Praemium hasn’t stood still since then. The last quarter showed healthy net inflows onto its platforms. The launch of the newest platform, Spectrum, garnered $440m of net inflows in the quarter, a strong result. And profitability is set to rise from organic revenue growth and operating leverage, paired with synergies from a recent acquisition of its own. Trading at one-third of the valuation of its larger peers, Praemium may be too attractive for acquirers to pass up.

5. Experience Co (EXP)

Experience Co operates adventure tourism businesses, including skydiving and reef experiences. After years in the doldrums trying to recover from COVID, the business ran a strategic review last year. The process attracted inbound interest but it was ultimately too early for the potential acquirers to price a full recovery. The business stayed the course and went about fixing its operating performance.

So far this financial year earnings have rebounded strongly — up 33% year-on-year as tourism volumes recover and pricing rises modestly. Of every revenue dollar booked so far this year, 70% has made its way to earnings. It remains a scalable business with valuable assets and would make sense in the hands of a larger tourism group or private equity buyer looking for a platform for further acquisitions.

A Window of Opportunity

Not all merger and acquisition speculation leads to action. Deals are hard to pull off — especially in the public market, where valuation gaps, regulatory hurdles and board dynamics can all scupper even well-funded bids. But with capital available and other factors encouraging action, 2025 could see many small-caps in the sights of acquirers.

The potential for a takeover at a healthy premium is a nice kicker when the fundamentals are strong, the valuation is attractive, and the assets have strategic value. With our focus on the unloved and underappreciated, we think we hold a few of those. Let’s see if would-be acquirers agree.

Australian Shares

Nanosonics: From darling to dud and back again

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By late 2024 former market darling Nanosonics (NAN) had fallen a fair way from its days of stardom. At one point, the company traded at more than ten times forward revenue and a market cap of almost $2 billion. By 2024 it had more than halved. Investors had grown increasingly frustrated by repeated delays to FDA approval for the company’s new product, Coris, which had been flagged as a future growth driver but delivered no revenue and little visibility. With few near-term catalysts and a miss to consensus expectations in 1H24, the company found itself firmly in the sin bin.

This had always been a high-quality business but too expensive for us to own. After giving the dust some time to settle, we decided to take another look. After meeting with the company in October last year it was clear many had given up on the business - exactly the sort of thing that gets us asking questions.

Since then the company has delivered a series of positive milestones in short succession, and the share price has rallied more than 50% from recent lows. In this wire, we explain what we saw in Nanosonics, how the recent result confirmed our thesis, and why we still believe there’s more to come for this Australian success story.

What Does The Company Do?

Nanosonics makes high level disinfection equipment for hospitals. Its main product, Trophon, is used to disinfect ultrasound probes. This isn’t a glamorous business, but it plays a critical role in stopping the spread of infection in clinical settings. Trophon is the standard in US hospitals and offers a fully automated, validated alternative to the old wipe-down methods that were prone to higher rates of infection.

More than 35,000 Trophon units are installed around the world, with 87% of those in the US. Market share in that region has surpassed 50%, a remarkable feat for an Australian company operating out of leafy Macquarie Park in Sydney.

What makes Nanasonics such a high quality business is the strength of its recurring revenue base. Once a machine is sold, hospitals must keep purchasing a proprietary hydrogen peroxide cartridge to perform each disinfection. As procedure volumes grow and more machines are installed, consumable sales grow. The company also attaches recurring services contracts to half of the trophon units it sells.

Underappreciated Value

When we initially entered into our position, we thought there were two key elements the market was underappreciating.

Firstly, the profitability of the core business had long been obscured by the losses coming from the company’s investment in Coris. From our perspective the core Trophon business was trading at a very reasonable valuation. Stripping out the company’s $130 million in net cash, and putting aside the value of the $100 million already invested in Coris, we were left with a profitable, growing business trading on what looked like 14 times after tax profits within a few years. Very attractive for a product with 80% gross margins, dominant market share, and strong recurring revenues.

Secondly, Nanosonics was quietly building a second high margin earnings stream with services contracts. When the business moved to direct sales in the US in 2019, it took back control of servicing newly-sold Trophon machines from GE Healthcare. Nanosonics typically attaches a multi-year services contract to around half of new unit sales. These deals are typically paid upfront but recognised over time, creating a growing recurring revenue base.

Replacing older units with the new version opens up even more opportunities to attach services contracts. About ten thousand Trophon 1 units are now more than seven years old. These older models are increasingly being replaced by the Trophon 2, which offers better workflow, traceability, and compatibility with modern probes.

While not overtaking capital or consumables, services revenue should grow faster than the other revenue streams and represents more high-quality, annuity-like revenue.

Coris: More Consumables, More Complex

Coris is a high-level disinfection system for endoscopes. Manual cleaning of endoscopes presents significant challenges due to their intricate design, featuring long, narrow channels and complex internal structures. These areas are difficult to access and clean thoroughly, often requiring meticulous brushing and flushing. Despite rigorous efforts, studies have shown that manual cleaning alone may be insufficient to remove all contaminants, leading to the potential for biofilm formation and subsequent infection risks. An automated solution like Coris is both safer and more appealing.

The product has now achieved FDA's De Novo clearance of its Coris system. Nanosonics anticipates commencing a targeted rollout in select hospitals in the first half of the 2026 financial year, followed by a broader commercial launch in the second half. What sets Coris apart is its potential to generate even more consumables revenue than the Trophon system. With an estimated 60 million endoscopic procedures performed annually worldwide, the addressable market for Coris is substantial.

Coris is more complex than Trophon and requires plumbing, which means longer sales cycles and more hospital involvement. But it should also offer more revenue per unit once installed.

The FDA approval not only validates Coris as an innovative approach to infection prevention but also positions Nanosonics to significantly expand its market presence and recurring revenue base in the coming years.

Valuation Still Stacks Up

Our initial views were confirmed in the most recent result, with the company upgrading guidance for the full year. Capital sales continue at a steady pace while consumables and services revenue surprised on the upside growing 17% and 25% respectively.

While the stock has recovered since the low point, we think our thesis continues to play out. The installed base continues to grow, albeit at a slower pace than in the past. Consumables will continue to tick up with new unit growth and procedure volumes. Services revenue will further bolster. More details will come out about the Coris commercialisation strategy in time, giving investors plenty to get excited about.

Nanosonics wouldn’t have screened cheap in the traditional sense. But we think it's a great example of the small and micro-cap opportunities we love at Forager - the unloved and underappreciated.

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Australian Shares

Catapult: Turning Momentum Into Muscle

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Consistency is more important than quantum. That’s a message we are often delivering to company management teams. Earnings matter. But the multiple investors are willing to pay for those earnings depends mostly on how consistent and predictable they are.

Sports technology company Catapult shows what can happen when management gets it right.

Catapult’s just released full-year result builds on the themes we’ve spoken about before — strong recurring revenue, improving margins, and increasing product adoption across professional sports. But the scale and consistency of execution are now making it harder for the market to ignore.

The company’s Annual Contract Value (ACV), a measure of run rate contracted revenue, passed US$100 million, growing 18% when adjusted for movements in currencies. This was driven by a 9% increase in the number of professional teams using Catapult’s products, alongside a 12% lift in average ACV per pro team. The deeper story, however, is in cross-sell success. The number of multi-vertical customers — those using both Catapult’s video and wearable technology — jumped 53% in the year to 31 March, showing that customers are increasingly buying more of the platform.

That breadth is important. Multi-product customers not only bring in more revenue, but they are also less likely to leave. ACV retention remains strong at 96%. It is over 99% in multi-vertical teams. The product is so integral to the operations of a professional team, very few teams ever turn the solutions off.

On the cost side, Catapult is showing real operating leverage. The company delivered a 65% incremental profit margin, meaning two-thirds of each new dollar of revenue flowed through to management’s preferred measure of profitability. This reflects a deliberate effort to keep fixed costs steady while growing revenue, and it’s working.

Free cash flow came in at US$8.6 million, up from US$4.6 million in FY24 and a big swing from the US$21.6 million cash burn in FY23. The business is now self-funding and generating surplus capital, something investors have long been looking for from the business.

The outlook for this year is unchanged and reassuring. Management continues to target strong growth in ACV and profitability, aiming for 30% management EBITDA margins over time. It’s a bold ambition, but with revenue climbing quickly and costs largely fixed, it’s looking achievable.

We’ve held Catapult for a long time because we believed in its potential to scale efficiently. Last year showed that the journey is well underway. There’s more work to be done, particularly in pushing deeper into cross-selling video products, but the foundations are strong.

Catapult is a globally dominant, low churn, recurring revenue business with high incremental free cash flow generation. After the result, the stock is up 23% in two days and 258% over the past 12 months. That shows the power of consistency.

Podcasts

Special Episode | Inside the World of Alternative Assets with Navigator's Stephen Darke

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Insights

Seizing the Moment in Market Chaos

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When markets move fast, staying calm and thinking clearly becomes a competitive advantage.

April’s turbulence delivered a sharp reminder of that, and at Forager, we’ve been busy turning volatility into opportunity.

On the surface, it was a month of chaos: the Nasdaq surging 12% in a single session after the White House signalled a tariff rollback and the bond market flashing warnings. On top of this an economy that, despite solid fundamentals, faces a growing crisis of confidence.

Donald Trump's tariff policies have left markets whipsawing as “Liberation Day” tariffs, slapped on nations (and penguin-inhabited islands) have damaged global sentiment. While some tariffs have been paused, China remains firmly in the firing line, and sector-specific tariffs, particularly targeting pharmaceuticals, loom on the horizon.

Markets initially shrugged. Then they tumbled. Then they rallied with breathtaking speed. But behind the headline moves, deeper concerns have taken root. Consumer confidence, already fragile, has been battered. Corporate decision-making has slowed. As Forager's International Fund Portfolio Manager, Harvey Migotti, puts it: "Animal spirits have been hit, and that damage doesn’t repair overnight."

While the media focused on equity markets, the bond market quietly screamed. A spike in long-term yields — to levels that threaten housing markets, corporate debt refinancing, and consumer spending — caught the administration’s attention. Trump himself admitted he was “watching the bond market closely,” a rare glimpse into what really matters in the White House playbook.

In short: tariffs may come and go. The hit to sentiment, investment, and earnings growth could linger.

Positioning for Uncertainty

Long before the turbulence hit, the investment team had already shifted the International Fund’s exposure away from the US, down from over 70% at February month end in 2024, to the low 40% range by February month end 2025. Capital was redeployed into more attractively priced markets like Europe and Japan, all while carrying the highest cash balance the Fund has had in years.

That defensiveness has paid off. Valuations drove the shift. We weren't finding enough value in the US compared to opportunities elsewhere.

Microcaps have been another source of strength. The investment in Nutex Health (Nasdaq:NUTX), a network of small, high-margin hospitals in the US, has been a standout. Discovered when it was down more than 99% from its highs, Nutex has rebounded sharply, backed by a turnaround in profitability and favourable regulatory developments. It’s a perfect example of how nimble investing and detailed, on-the-ground research can uncover mispriced gems, even in volatile markets.

Nutex’s recovery hasn’t just cushioned the fund during the market chaos—it’s driven significant outperformance.

Eyes Wide Open

Despite the recent rally, risks remain elevated. Tariff uncertainty, China relations, and political unpredictability in the US aren’t going away anytime soon.

The playbook here is simple:

Focus on quality. Top-tier businesses with clear growth runways and robust balance sheets.
Stay diversified. Across geographies, sectors, and economic scenarios.
Be nimble. The ability to adjust quickly to new information is critical.
Avoid the obvious landmines. Businesses heavily exposed to discretionary spending, complex supply chains, or China-dependent demand are under a cautious lens.

History tells us that the best returns are often made during periods of fear and uncertainty. We're not predicting the next move on tariffs, or Trump's next tweet, but we are confident that our focus on disciplined, research-driven investing will deliver results over the long term.

In volatile times, that’s exactly what matters.

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This article was written based on the latest Stocks Neat podcast — you can listen to the full podcast here:

International Shares

When the US Sneezes, the UK Catches a Break?

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Why a struggling America might just be good news for forgotten UK stocks

When the US sneezes, the world usually catches a cold.

But what if—this time—it’s, err hmm, different?

As cracks appear in the story of American exceptionalism, investors are starting to question the wisdom of crowding into the same seven tech stocks. A decade of rising valuations, falling interest rates, and boundless optimism may have run its course.

And while America has been soaking up the world's investment flows, one market has quietly spent years in the doghouse; the UK.

A Decade of Outflows

The country famous for its stoicism: “Keep Calm and Carry On” and Monty Python’s unflappable Black Knight, has been quietly dumping its own stock market. It’s not been a blip either.

UK-focused equity funds have seen net outflows from domestic investors every year for more than nine years.

It started around Brexit. But the pessimism stuck, and even accelerated the past three years.

British investors didn’t give up on equities altogether, mind you. They’ve been substantial net buyers of global and US-focused equity funds every single year since 2017. And 2024 was a record year for overseas allocations.

Source: Calastone

So this isn’t about fear of markets generally. It’s specifically a lack of faith in their own.

The Land of Pessimism and Pound-Stretching Bargains

The Forager International Shares Fund has owned UK stocks throughout this nine-year period—sometimes painfully, mostly profitably. And it’s added more as sentiment grew worse and prices got cheaper.

In recent years British investors said “no thanks” to Lloyds Banking Group (LON:LLOY) when yielding 14–15% to shareholders annually through dividends and buybacks. We did not. They also passed on market-leading supermarket Tesco (LON:TCSO) at just 11x earnings while returning all of its free cash flow to investors. Aggregates company CRH (NYSE:CRH) and the world’s largest legal sports betting company Flutter (NYSE:FLUT) both followed the herd to the US where investors, including many of their former UK shareholders presumably, were willing to pay a much higher price for exactly the same company. All four have been excellent investments in the Forager International Shares Fund.

These weren’t speculative punts. They’re businesses with leading market share, strong profitability and management discipline, trading at steeply discounted prices. Years of single digit PE ratios and double digit yields don’t yet seem to have piqued British investor interest. Perhaps losses elsewhere might be more impactful?

Is Sentiment Shifting?

Calling the top for US tech stocks, or the bottom for the UK, is a mug’s game. But signs are emerging that investors may be broadening their gaze.

Europe has been drawing fresh attention in recent months.

UK-based investors will soon be reading monthly statements showing bigger percentage losses in their global funds than in their domestic investments (if they still hold any). It turns out the Magnificent Seven aren’t bulletproof. Good old Lloyds, in contrast, is chugging along just fine.

If capital begins to reallocate, even slightly, the UK could find itself in the line of sight for the first time in a long while. As British investors slowly wake up to the fact that valuations matter, their own home market will be sitting there—resilient, familiar, easily available. And cheap.

Until then, the Fund is happy to keep collecting dividends and benefitting from buybacks and earnings growth from its UK investments.

Come to think of it, maybe it’s better they stay asleep.

Insights

The Allure of Small-Cap Investing

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Small-cap stocks have always occupied a strange place in the investment world. They are often overlooked during the good times and heavily punished during the bad.

For those with patience and a strong stomach, small-caps present some of the best opportunities in the market. Right now, they’re offering more opportunity than they have in years.

The sharp shifts we’re seeing in the global economy are making life difficult for many investors. Bond markets are flashing warnings. Tariffs are swinging back and forth with every political headline. Economic confidence, particularly in places like the US, is shaky at best. Against this uncertain backdrop, small-cap stocks have been hit harder than most. Indices like the Russell 2000 have underperformed their large-cap counterparts dramatically.

But there’s a catch: the indiscriminate selling is opening the door for some incredible bargains. Many small, well-run businesses have been thrown out with the bathwater. Share prices have fallen to levels that don't reflect the underlying health or future prospects of these companies. In some cases, it’s not just a slight mismatch — it’s an outright disconnect between price and value.

One of the advantages of small caps is their ability to move quickly. They’re often founder-led, niche-focused, and less burdened by layers of bureaucracy. In challenging economic conditions, these traits become critical. Management can pivot, costs can be cut, and new opportunities can be seized with speed that larger organisations can only dream of.

Yet despite these advantages, many investors shy away from small caps during turbulent times, preferring the perceived safety of mega-cap giants. It’s an understandable instinct, but historically it’s been during these periods of neglect that small-cap investing has offered the best rewards. Buying when others are fearful remains one of the most powerful edges an investor can have.

Picking Carefully in a Target-Rich Environment

Of course, this isn’t a strategy that works by throwing darts. Rigorous due diligence is essential. Not all small-caps are created equal. Some have strong balance sheets, committed management teams, and business models with genuine competitive advantages. Others are little more than speculative punts that will struggle to survive if credit conditions tighten further or if economic growth slows.

At Forager, the investment team leans heavily into that distinction. They spend time digging into companies that can weather a prolonged period of uncertainty — businesses with minimal debt, clear paths to profitability, and products or services that people continue to need regardless of where we are in the economic cycle. It’s an approach that demands patience and a long-term mindset, but in environments like this one, those are exactly the qualities that generate outperformance over time.

The other key advantage in the small-cap space right now is the lack of analyst coverage. Many of these companies are flying completely under the radar. That creates pricing inefficiencies that just don’t exist at the large end of the market, where every announcement is instantly digested and priced in by thousands of sets of eyes. In contrast, in the small-cap world, good news can go unnoticed for months, giving investors who do the work a serious edge.

While volatility is likely to continue, particularly with political uncertainty in the US and ongoing trade tensions, Forager views it as an opportunity rather than a threat. We expect a bumpy road ahead, but are positioning our portfolios accordingly: focused, disciplined, and ready to take advantage when opportunities arise.

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This article was written based on a podcast recorded with Rask Investment - you can watch or listen to the full podcast here

Podcasts

Trading the Tariff Tantrum

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International Shares

Nutex Health - Emergency room level of potential upside

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Despite a five-fold share price increase, this US micro cap is still a bargain. Sifting though the market's most unpopular stocks is fraught with danger. Explaining why you bought something everyone else thought was a dog isn't easy. And we have on the odd occasion purchased some dogs that we thought only had fleas but actually had terminal cancer. But among the beaten up is also where we have found some of our best Forager investments. Sometimes you get it right. Sometimes you get lucky. If you happen to get both, the upside can be enormous. We think we have that combination with Nutex Health (Nasdaq:NUTX).

This micro-cap US healthcare provider was first purchased in August 2024 and now sits among the portfolio’s largest positions. The Forager International Shares Fund acquired it during a period of turmoil, when the stock was priced for insolvency after falling some 99% from its 2022 peak. Today, it stands as one of the portfolio’s largest contributors, both for the quarter and over the past year.

Since listing via a backdoor merger in 2022, Nutex has faced significant challenges: falling insurance reimbursements, inconsistent shareholder communication, and two reverse stock splits just to maintain its NASDAQ listing. Despite that, a viable and increasingly valuable business has begun to emerge.

The model is straightforward in theory, though complex in execution. Nutex operates 24 micro-hospitals in suburban areas underserved by traditional healthcare infrastructure. It aims to offer faster service and more patient-friendly experiences, while focusing on the less complex (read more profitable) segments of emergency care. A major inflection point came with a structural shift in its reimbursement model. A Federal piece of legislation, the No Surprises Act (NSA), upended the reimbursement model, initially hitting Nutex hard.

The Act’s objective was to protect patients from large surprise medical bills where they had been treated outside their insurance company’s approved list of providers (“out-of-network”). While it achieved that objective, it also gave insurance companies cover to pay the hospitals substantially less than they were previously paid. Nutex’s revenue per patient dropped more than 30% and, in a relatively fixed-cost business, wiped out all of its profits.

By closing underperforming hospitals, renegotiating supplier contracts and performing an increasing proportion of high-value treatment in its own hospitals, Nutex had already taken steps towards a sustainable future. We had it pencilled to generate US$20 million of free cashflow in 2024, an attractive proposition relative to the US$70 million market capitalisation at the time of our first purchase. But there was an enormous amount of upside if Nutex could somehow return to prior levels of profitability. That “if” is becoming a reality.

Nutex and other healthcare providers have been in a battle with insurance companies to get what is argued to be their rightful payments ever since the legislation came into effect. Having exhausted the commercial options available to it, in July 2024 Nutex began pursuing claims through a binding federal arbitration process, a last resort included in the Act to protect providers.

Nutex has been submitting 60-70% of its patient visits to arbitration and disclosed a fourth-quarter success rate exceeding 80% on these claims. The payment awarded to it has ranged from 150% to 250% of the amount it initially received—an outcome with material financial implications. Importantly, these outcomes are consistent with the experience of other providers (the number of claims processed and awarded is in the hundred of thousands and publicly disclosed every six months).

Transformational outcomes

Following market close on 31 March, Nutex released an outstanding fourth-quarter result, far exceeding even optimistic expectations. The company booked $170 million in arbitration-related revenue—taking its total revenue to more than $3,000 per patient.

Most of the arbitration revenue remains uncollected (receivables rose to $232 million), but the cash should start flowing in the first quarter of this year. Margins remained strong despite substantial arbitration-related legal and processing costs, and full-year pre-tax profit attributable to shareholders reached $71 million.

Source: Bloomberg, Nutex Health

*EBITDA is an abbreviation for Earnings before interest, taxes, depreciation and amortisation

Even after a fivefold share price increase since the Fund’s initial purchase—including a 50% rise post-result (after month-end)—the business continues to trade at a very attractive valuation. A market capitalisation of $388 million represents roughly four times the pre-tax earnings we expect it to make in 2025. Assuming a bit of catch up from last year, we expect it to have something like $100 million of net cash by this time next year.

It remains a high-risk investment. Arbitration rules could change. A single tweet from the White House could move the share price violently. New competition will emerge if margins persist.

But each passing quarter reveals a more profitable, scalable, business trading at what remains an attractive valuation. This is a business that has gone from loss-making to generating significant cash and has a nice organic growth plan, including four new hospitals in 2025. The market has yet to fully adjust.

Insights

How to Navigate the Market Turmoil

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What a difference a month can make. On the 19th of February, the Nasdaq index of US tech stocks closed at another all time high. It had risen 28% in the previous 12 months. By last Thursday, it was 13% lower than that peak. The broader S&P 500 fell 10% over the same period and the US small cap index, the Russell 2000, fell 13% (all three rallied strongly on Friday).

I won’t rehash the reasons why here. You can read plenty of that elsewhere. Suffice to say the “US exceptionalism” train has derailed.

The point of this post is what it means for our investors.

‍Well prepared portfolios‍

First, we have been preparing for the next downturn for the past year or so. It’s no secret that Forager’s performance hurt during the 2021/22 small-cap correction. These are concentrated portfolios of mostly smaller companies - you can expect some volatility. But we have the mandate flexibility to offer better downside protection than we did in the 2022 financial year, and we have been using that flexibility to better prepare our portfolios this time around.

The Forager International Shares Fund’s exposure to the US had fallen from 64.6% a year prior to 45.8% at the end of February this year. Its exposure to Japanese stocks has increased and the cash weighting for both portfolios was above 10% at the start of March.

That is not going to erase portfolio volatility. We still have significant investments in small companies like Catapult (ASX:CAT) and Nutex (Nasdaq:NUTX) that are vulnerable to a pullback after significant recent share price appreciation (we think the long-term prospects for both make the volatility well worth stomaching).

But the International Fund in particular is showing some nice resilience. As of Friday, the unit price was down 6.5% from its peak and less than 2% since the start of the calendar year. Our European and UK stocks have performed relatively well and the portfolio of Japanese tech companies is so far trading independently of what’s happening in the US. So far, so good, and we are turning our minds to how to make the most of the volatility.

‍Implications for the Real Economy‍

It is worth noting that this correction is not just driven by a change in investor sentiment. Trump’s erratic tariff measures represent the largest upheaval to global trade since the Second World War. It is going to have implications, something that businesses and consumers have worked out quickly. The University of Michigan’s survey of US consumer sentiment registered its lowest reading since September 2022 last week. Inflation expectations have jumped significantly. We are expecting economic activity to deteriorate rapidly in the US and are baking near-term recessionary conditions into our valuations. That is leading to wariness about economically sensitive US companies and even reducing the weighting of one particularly exposed Canadian manufacturing business.

‍Firing The First Bullets‍

There are opportunities emerging already, though. As in all corrections, the market reaction is not uniform and plenty of babies get thrown out with the bathwater. We have deployed some incremental capital into shares that have been unjustly treated. Flutter (LSE:FLTR) is a good international example of an opportunity to add back some of the money that has been taken off the table recently. And AMA (ASX:AMA) here in Australia traded back near last year’s lows on Friday, despite reporting a solid half year result and showing excellent signs of progress. We have added modestly to this investment and in total have deployed roughly a quarter of the Australian Fund’s cash since the start of the month. For the International Fund, it's been around one-sixth of the cash so far.

These are fairly modest portfolio changes and that’s reflective of the fact that this has mostly been an orderly market unwind. The most expensive parts of the market have been hit hardest.

‍Deploying Cash in a Downturn‍

Bear markets come in all shapes and sizes and there is no way of knowing in advance whether this is a 10% correction or the start of a 30% meltdown. Hence we have fired a couple of bullets and kept plenty in the chamber in case things get worse.

If you are waiting to deploy cash, a similar approach could be appropriate. Many of you have heard my thoughts on the damage investors do to their long-term returns by trying to time markets. The allure of cash should largely be ignored. Focus on getting your portfolio allocation right and stick with it through thick and thin. The Dollar Cost Averaging approach also works well when investing through markets in turmoil.

Many of you also continue to ignore me. If that’s you, consider adopting a similar strategy to us. My pessimism radar is nowhere near extreme yet. But there’s no guarantee it gets there. We have two portfolios of stocks we think offer healthy long-term returns and have been able to deploy some incremental capital in recent weeks. If your aim is to deploy more cash through the cycle, there’s nothing wrong with doing the same. If this is as bad as it gets, you have put a little money to work. If it gets much worse, you have plenty of your own bullets left to fire.

Insights

Aussie Small Caps: The Hidden Gold Mine You're Missing

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The ASX is expensive, yes? Correct, but only if you're looking at the big names. The real opportunity? It’s hiding in plain sight: Australian small-cap stocks. While large caps have been marching higher and grabbing headlines, a treasure trove of undervalued gems lies buried beneath.

This disconnect between small and large-cap stocks has created an interesting dynamic. On the surface, the market looks expensive, but beneath the surface, a different story is unfolding; one that many investors are overlooking.

ASX All Ordinaries Index vs. ASX Small Ordinaries Index

Source: S&P Capital IQ

It’s natural to feel uneasy when the market is at an “all-time high,” but history tells us that this is a normal and expected part of investing. Over the past decade, the Australian market has delivered an average annual return of around 9%, meaning it has regularly pushed past previous highs to reach new ones. In such an environment though, where the index makes it look like everything is expensive, knowing where to look can make all the difference.

The Challenge of the Small-Cap Index

The small-cap index is an interesting mix - some winners, some duds (think speculative, low-quality businesses that lack profitability or a sustainable competitive advantage). That's why active management is critical for this sector. You need someone who can sift through the noise and find the companies with potential. Many of the best opportunities exist in specific sectors or individual companies that require deeper research and decision making.

Why invest in small caps now?

Undervalued: Precisely because the small-cap index has performed so poorly, many small-cap businesses are trading at bargain prices.
Growth potential: Niche tech, specialised industries, and select consumer-facing companies are starting to get investor attention, resulting in substantial share price appreciation
Active advantage: Forget passive investing. This is where active managers thrive, uncovering pockets of opportunity.

What is Forager's Edge:

At Forager, we don't just follow the crowd when it comes to small-cap investing. We dig deep to find:

Stock mispricing: We identify undervalued companies that have big growth potential before the market does (like Catapult).
Earnings turnarounds: We capitalise on companies poised for recovery before they appear on others’ radar (like Bravura).
Structural growth stories: We invest in long-term winners before the market catches on (like Praemium).

The Proof is in the Pudding:

Unlike their large-cap counterparts, Morningstar data shows that the average actively managed small and mid-cap funds outperform the index. And the Forager Australian Shares Fund? It is even further ahead since inception. The track record speaks for itself:

Source: Morningstar, as at 28 February 2025

The above figures assume that all distributions have been reinvested and are net of all fees. Past performance is not indicative of future performance and the value of your investment can rise or fall

Don't Miss Out:

The investment team at Forager believes that the small-cap market is still ripe with opportunities and continues to research relentlessly to find them.

Contact us today to learn how Forager can help you unlock the hidden potential of Aussie small caps.

Australian Shares

Bravura’s Turnaround Gains More Traction

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Psychology

The Psychology of Investing

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During the height of the dot-com boom, two friends sat at a café discussing the market. One was enthusiastic, convinced tech stocks were the future, while the other was more cautious. “The market’s moving fast,” the sceptic remarked, “but not every opportunity is worth chasing.”

This simple conversation underscores a valuable lesson: recognising market opportunities often means stepping back from the noise and taking a contrarian view. While the overall market might be overly optimistic with high valuations, there are always pockets of opportunity in sectors or individual stocks that have been overlooked. These hidden gems can offer significant returns to those willing to look beyond prevailing narratives.

The Other Side of Fear

‍Fast-forward a few years to the aftermath of the global financial crisis. Markets had plummeted, fear gripped investors, and the financial news was a sea of red. Yet, some investors saw things differently. They recognised that pessimism had pushed stock prices far below the intrinsic value of solid companies. By staying calm and patient during the chaos, they were able to make investments that would yield significant returns in the years to come.

This illustrates another timeless truth: during downturns or times of crisis, managing fear and uncertainty is critical. Where others see despair, contrarian investors see opportunity. However, this approach requires patience and discipline. Long-term value creation takes time, and it’s easy to get discouraged when investments don’t immediately deliver the expected returns.

Understanding the Market’s Mind

‍To navigate these psychological complexities, it’s essential to understand the motivations and behaviours of other investors. Sometimes, institutional investors make seemingly irrational decisions, such as selling off a stock simply because it no longer fits their portfolio criteria. These decisions can create opportunities for those paying close attention.

Take, for example, the concept of “cigar butts” — undervalued companies that have the potential for a turnaround. These opportunities aren’t always obvious and require a deeper dive into financials and market position. Successful investing is not just about numbers and ratios; it’s about understanding the psychology that drives market trends and individual behaviour.

The investment world is constantly changing. Staying ahead requires adaptability and a commitment to lifelong learning. Investors who stay informed about market trends, refine their strategies, and remain open to new ideas are better equipped to thrive, no matter the market conditions.

Whether markets are riding high or deep in despair, the key is to keep a clear head and look beyond the headlines. Hidden opportunities exist in every market, and those who remain patient, disciplined, and willing to challenge the crowd can achieve their long-term financial goals.

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This article has been written using the topics discussed in a recent chat between Forager Funds' Chief Investment Officer, Steve Johnson, and Greg Canavan (Editorial Director of Fat Tail Investment Research). You can watch the full interview here.

International Shares

A fighting start for TKO

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International Shares

Patience Pays for Wise Plc

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Wise Plc (LSE:WISE) is a stock the Forager International Shares Fund team has followed since its 2021 IPO.

The elegantly simple currency transfers app allows customers to easily move money between currencies for travel, transfers to family and friends and myriad other reasons, at a fraction of the cost relative to traditional banks. Some of your investment team are proselytizing users, so we believe Wise’s claims that 70% of the business’s rapid growth is coming from word of mouth recommendations.

The company is in the rare position of being able to drive its own positive feedback loop. By mercilessly reducing the costs of a transaction and passing those savings back to customers, it can continue growing user numbers for a long time. It’s a fact that management is intimately aware of. As CEO Kristo Kaarmann stated during the latest earnings call: “As the infrastructure gets more efficient, we invest in lower fees, wider moat, while remaining healthily profitable... We will invest in experiences that our customers want to talk about... bring more features to our customers in more places... expand geographically, and... deepen the experience. All of this is going to lead to more customers.”. It’s also one of the reasons why the market got this one wrong recently.

The company keeps cutting its already attractive exchange fees. In addition, it returns 80% of any interest earned above the first 1% to customers on the £15 billion (and growing) cash pile those customers have deposited at Wise. All this is guided by management’s principle that the company shouldn’t take a pre-tax profit margin of more than 13-17% of revenue, with any surplus returned to customers to make the product even more appealing, a so-called flywheel effect. Wise currently makes significantly higher margins than that. Rightfully, the market takes management seriously when it says it intends to lower margins. That’s a difficult thing for quarterly-obsessed market participants to swallow. It’s a little easier for those investors who, like management, have their eyes on the long-term prize.

That prize is rapid growth for a decade or more. The nascent Platform business, where the company provides its solution to customers of other financial institutions, is illustrative. While the Platform segment is currently small, management has said it can be the largest part of the business over time. In June, Wise signed up the large and rapidly growing Brazilian digital bank Nubank. No surprise there. More recently, it signed up the 150-year-old Asian-focused bank Standard Chartered. Even more surprisingly, it jagged parts of the business of global investment bank Morgan Stanley. Financial institutions that recognise the advantages of giving their customers the best deal possible are choosing to partner with rather than compete with Wise. We think that says a lot.

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Wise PLC share price performance

Source: Bloomberg

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Patience Pays

Price also matters, always. The attractions were clear but we waited patiently for the right price. We got our shot in September and October 2024. The stock is already up 60% on our average purchase price. Some has been taken off the table already, but the Fund maintains a worthwhile investment in the stock.

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This is an excerpt from the December 2024 Quarterly Report

Australian Shares

Bravura's cost-cutting delivers

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Bravura (BVS), a provider of enterprise software for wealth management and funds administration, has undergone an amazing turnaround over the last 18 months. The appointment of managing director Andrew Russell in June 2023 set the scene for cost reductions at a scale not often seen in listed businesses.

Bravura was in dire shape two years ago. For the 2023 financial year the business booked a cash earnings before interest, tax, depreciation and amortisation (cash EBITDA) loss of $28 million. After writing down the value of goodwill and other assets the business lost a staggering $281 million. And having raised $80 million in early 2023, Bravura’s entire market capitalisation was less than $150 million with the stock down more than 90% from prior highs.

At the time of the capital raising Bravura’s half-year revenue had fallen 11% whilst costs rose 17%. New executives and investments for growth were not yielding the revenue growth prior management had hoped for. Something had to be done to bring costs more in line with revenue. Enter Andrew Russell. What began as cost cutting worth $25-30 million has become $67 million, with potential for even more over the coming twelve months.

Bravura revenue and expenses

Source: Bravura

Partly implementing the cost out program resulted in a $10 million cash EBITDA result for financial year 2024. Company expectations, after yet another upgrade in early December, are for this year’s cash EBITDA to be in the range of $33 to $36 million. A common benchmark for enterprise software company profitability is 20% cash EBITDA margins, which would have Bravura earning about $50 million of cash EBITDA.

Other sensible steps include a $75 million capital return due in January 2025, the recommencement of dividends with the upcoming half year results and a $56 million one-off sale of software to large customer Fidelity.

Investor concern has turned from survival and exorbitant costs to lack of revenue growth. From $250 million of revenue growth in financial year 2023 management is guiding to $240 to $245 million for FY25, slightly higher than initially expected.

But not all revenue is created equally. Revenue from Bravura’s mission-critical software products is much more valuable than revenue derived from project-driven and people-based consulting services. Few customers stop using the software, and if they did it would take years to transition to a suitable replacement. And with the code already written, software revenue carries much higher gross margins.

Importantly, software revenue has been growing. In the 2024 financial year software revenue rose 10% whilst overall revenue was flat. With Bravura increasing pricing to customers this year, software revenue is likely to grow again, further improving the reliability of the company’s revenue. Whilst we haven’t seen large contract wins with new clients recently, the business has leading products appropriate for attracting them in the UK and Australia.

Today Bravura’s market capitalisation stands at over $1 billion. Despite being late to the party, Bravura’s price has risen more than 170% since our initial investment. The investment has been increased as we gained confidence in the investment thesis. With lower costs and higher revenue on the horizon, we believe that there is more good news to come for Bravura.

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This is an excerpt from the December 2024 Quarterly Report

Insights

How Much to Invest with Forager and When

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Forager is not a financial advisor. We don’t know enough about you to give you financial advice. But here is some information to help you and / or your financial advisor think about our role.

Forager’s investment approach works best for investors who think the same way as we do. If you are considering investing with Forager, you should understand value investing, have a long investment horizon and tolerance for volatility.

If you meet those criteria and think we can help, you still have a big decision to make: what is the right percentage of your portfolio to invest with Forager?

‍Decide on your asset allocation

Step one is to have a plan. It doesn’t need to be complicated or sophisticated but you need to sit down and come up with an asset allocation plan that suits your personal situation. If you don’t have one of these, there are some good online guides to building one, including on ASIC’s Moneysmart website, or you could seek out a financial planner.

Find Forager’s Role

Once you have your asset allocation plan, you should have some target weights for Australian and International equities. This is the part of your portfolio designed to generate higher returns over the medium to long-term (more than three years). This is also where Forager potentially comes in.

Our Target Market Determination (TMD) for both of our Funds guide that your allocation to that Fund be a minor (Up to 25%) or satellite allocation (Up to 10%) of your overall portfolio. Other factors around investing objective and timeframe are also outlined in the TMDs for both Forager Funds:

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Investors with a high risk tolerance and long investment horizon (more than 5 years) can contemplate being close to this maximum recommended portfolio allocation, whereas investors with lower tolerance for volatility and those who need to access their money sooner should select a lower allocation to Forager.

Stick to It

It has been well documented that the average investor gets worse results than the average fund. Mostly this is a result of buying in at the top and then panic selling at the bottom.

Once you have decided on the right asset allocation, don’t faff with it. While it is not hard to find evidence after the fact, there is very little evidence that anyone can consistently and repeatedly predict market crashes.

There is a strong case for being invested in equities over the long term and if you can find a fund manager who does a bit better than average, the case is even stronger.

Get your portfolio allocation right and let us worry about nabbing the bargains.

If you are interested in investing with Forager, please get in touch by calling Alex Irish on 0493 597 303 or booking a meeting with him here.

Forager Australian Shares Fund TMD

‍Forager International Shares Fund TMD

CIO Letters

The Platinum Canary in the Active Funds Management Coalmine

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The past five years should have been a wonderful period for the owners of international fund managers. The MSCI World Index has almost doubled. Institutional and retail investors have been steadily increasing their allocations to global equities. Yet the ASX’s two highest-profile global managers, Platinum Asset Management and Magellan Financial Group, have both experienced 80% share price falls since the end of 2019.

Platinum and Magellan's fall from grace

Source: Bloomberg

That share price performance has come on the back of extended periods of underperformance from both companies’ flagship funds, leading to persistent and significant investor withdrawals. From a peak of $26 billion, Platinum now manages a touch over $10 billion and suffered more than $840 million in net redemptions in November alone. Magellan’s outflows have stabilised—as has its share price throughout2024—but with $39 billion under management, the company is a shadow of its former self (at its peak in November 2021, Magellan managed $100 billion of investor money).

The founders of both companies, Kerr Neilson at Platinum and Hamish Douglass and Chris Mackay at Magellan, were all incredibly generous with their time when I was running the investment newsletter The Intelligent Investor. As investors who see stocks as shares in businesses and with contrarian bents, our investment philosophies are somewhat aligned. Over the years, I have recommended a number of friends and clients to invest in Platinum products.

Thus, their fall from grace has caused me a significant amount of angst and introspection. For shareholders, fund investors and competitors like us, there are lessons that must be heeded.

Fund Managers are risky business

I’m sure some Platinum and Magellan shareholders are scratching their heads. How does a highly profitable business with a rock solid balance sheet suffer an 80% share price fall?

Platform businesses like ASX-listed Pinnacle—where the listed company takes minority equity stakes in a stable of fund managers and provides back office and distribution services—are resilient and have an important role to play in an ecosystem where scale is becoming increasingly important. But the single-manager listed fund manager is a business to be wary of.

They can be wonderful, cash generative, capital light and high-margin businesses when funds are flowing in. At its Initial Public Offering (IPO)in 2007, Platinum’s pre-tax profit margins were more than 90%—its operating costs were less than 10% of revenues. All of those qualities work in reverse, however, when the Funds Under Management(FUM) decline. As both Platinum and Magellan show, once a funds management business starts seeing regular consistent outflows, it is almost impossible to arrest the momentum. Institutional money, where the decision maker is looking for someone else to blame, can be quick to flee. Retail investors take a lot longer to lose faith, but once you have lost it, it rarely comes back. The first thing that happens when performance recovers is a period of elevated redemptions. That might seem counterintuitive, but many investors hate selling at a loss. As soon as they get back to square, they send in the redemption notice(yes, I am talking from first-hand experience).

Platinum Asset Management Monthly Net Outflows

Source: Platinum Asset Management

*Data for 2H24 not yet available

So, if you are going to invest in one of these companies, you need to be confident that the outperformance that made them successful can be maintained. And, perhaps more than any other business model, success itself is what often brings the performance unstuck. Which brings us to the lessons for fund investors.

Size kills in active funds management

For Platinum fund investors, there are a few important lessons to consider when picking a managed fund. Beware extrapolating past performance, particularly when the track record was established with substantially less FUM than its current level. Size is the number one leveller in funds management, especially when investors can use index funds to own the world’s largest companies without paying active management fees. In June 2000, Platinum was managing just over $2billion. It tripled the amount under management over the subsequent three years, and tripled in size again by the time it floated on the ASX in early 2007. By the mid 2010s, Platinum was managing more than$20 billion. Forager had its own challenges, growing from $20 million to$200 million under management; more than $20 billion leaves you with a universe of almost exclusively well-researched, widely owned and very liquid stocks.

Next, watch out for changes in key personnel. None of these companies’ founders are working in the businesses today.

Sometimes, personnel change can result in a change in investment philosophy. Sometimes—I think this has been the case at Platinum—it can result in inertia. When an investment firm transitions from a founder to a committee or consensus-driven process, it risks becoming cumbersome in a constantly fluctuating investment environment. Platinum had 25 investment staff at the time of its IPO in2007. By 2021 it employed more than 100. Bigger is not better when it comes to managing money.

Adapt or die

None of this is good news for the wider active funds management industry. Canary in the coal mine is an understatement. Smoke is billowing out of the mine and the fire engines have arrived. In the US, more than US$3 trillion has been redeemed from actively managed funds over the past decade, and almost the same amount invested in index funds. There is now more money in aggregate invested in passive than active (in total, managed funds are roughly half the US market, with the remainder made up by direct retail, hedge funds and founders/insiders). Poor investor experiences with Platinum and Magellan will only add to the negative sentiment here in Australia.

It has been astonishing to watch an industry full of people ruthlessly dispassionate about the demise of other sectors—think traditional media and the taxi industry—struggle to accept the threats facing their own businesses.

Most arguments against low-cost index funds start with the incorrect premise that actively managed funds were actively managed. The large majority of money was with behemoths like Colonial First State and AMP, where active meant being underweight BHP by 0.5%. They were passive funds charging active fees.

Nor is there much evidence for the giant distortion theory. There are anomalies in today’s market, like the Commonwealth Bank of Australia trading at 27 times earnings, where index fund flows seem like a logical explanation. But why hasn’t CSL benefited to the same degree? By construction, the index funds aren’t playing favourites — every dollar that flows in gets allocated equally across the index.

Research from Goldman Sachs dispels several myths about the impact of passive investing on markets. A few fun facts for you.

There is no correlation between passive ownership and superior stock performance (the ‘Magnificent Seven’, giant US tech companies, which have driven so much of the US’s superior stock performance, have lower passive ownership than the market as a whole).

Stock price performance has become less correlated than it was, the opposite of what you would expect if passive flows were lifting all boats.

And fundamentals—predominantly long-term growth and earnings stability—still explain almost all of a company’s price-to-earnings multiple. An efficient market needs some market participants with a view on valuation, but there are clearly enough hedge funds, private investors and private equity funds to keep the market efficient enough.

There will be bubbles as investors get too optimistic about equity markets. Those bubbles will implode when those same investors get disappointed and choose (or are forced) to sell their investments at the worst possible time. But we had all of that prior to the rise of the index funds. Though they might be the medium through which the next bubble unfolds, index funds won’t be the cause of it—and at least they are a lot cheaper than the medium that came before them.

It’s my view that they are a predominant good for the world and that their share will only continue to grow.

Small and countercyclical

You know you are getting old when all of your Christmas social catchups end up discussing the worrying state of today’s youth. The worries are overblown—every generation thinks the ones that follow it are useless. And we have two wonderful, hard working, intelligent, seemingly happy twentysomethings at Forager. Either these two have slipped through the cracks, or plenty of them are alright.

It is true, however, that mental health and stress are a growing problem for young people. Talking to the older people in my life, less expectation definitely led to lower stress for previous generations. Work hard, pay off the mortgage, raise a family and call your life a success. Today’s young people want and expect a lot more, and social media pressures them to prove their success to the world.

While it is causing stress for many, the rise of index funds provides a simplicity to our purpose that is like living in the 1960s. There are not many things left that index funds don’t do well. Big blue chips at a very low cost were the first thing to go. Now you can also replicate quality, growth, value, and dozens of other factors in low-cost index funds. That leaves Forager with two clear areas where we can add value, and the past year has provided plenty of examples.

Index funds work best in markets that are already relatively efficient and where the value of stocks traded is high. The less efficient the market, the more value there is for active fund managers.

In stark contrast to large cap funds, almost none of which have been able to outperform the index over a 10-year period, small and midcap managers have a strong track record of market outperformance in Australia. According to Morningstar data, the more than 100 funds categorised as mid/small have outperformed the ASX Small Ordinaries by 3.5% over the past five years and 2.8% over 10.

Morningstar Category: Australia Mid/Small Blend

Source: Morningstar as at 30 November 2024

Identifying those smaller companies that can become future index constituents has been particularly fruitful, with Gentrack, RPM Global, Flutter and Ferguson providing wonderful returns to both Forager funds over the past year. To keep winning at the small end of the market, fund managers need to be willing to stay small themselves.

The other significant area of value is capitalising on the pro-cyclical nature of index-fund investing. Again, this is not a dramatic change from how the world worked 20 years ago. Fund managers have always been willing to launch a new fund to capitalise on the latest investor fad. But the speed of launch for index funds—no track record required—and accessibility via online brokerage accounts and 24-hour trading make for more dramatic rises and falls.

The Betashares Crypto Innovators ETF, launched at the peak of cryptomania in 2021, had lost 86% of its value by the end of 2022. Despite a 142% return over the past 12 months, it is still down more than 30% on its launch price. These factor driven flows can offer enormous opportunities for nimble investors who are willing to take the other side of the trade when panic sets in.

In the past five years, the PHLX Housing Sector Index (a US index of companies exposed to the US housing cycle) has halved, tripled, fallen 30% and doubled again. It is down more than 10% in the past month. We have our favourite structural winners in the sector, including Installed Building Products and Ferguson, but the sector’s popularity surges and slumps are wild. When the index funds are suffering outflows, the quality of the business is irrelevant. We can add a lot of value by giving our clients exposure to the right factor at the right time, often when everyone else is overly pessimistic.

I’m sure the ‘60s and ‘70s weren’t as stress-free as people think today. Likewise, running small, nimble, actively managed funds will throw up plenty of challenges. If the largest stocks keep performing better than everything else, those challenges could come soon. It has been a great year of returns, though, and our role in your portfolio is clearer than ever. With patience and willingness to stay small, there remains plenty of value to add.

‍

This is an excerpt from the December 2024 Quarterly Report and also appeared on Livewire Markets as part of their Outlook Series

Podcasts

The Rise and Fall of Active Fund Giants: Lessons for Investors

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Australian Shares

Catapult Can Deliver on More Lofty Expectations

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Catapult Group International (CAT) is the largest investment in the Forager Australian Shares Fund. Its half-year results justified our optimism.

The sports technology company grew its September half-year revenue 19% and annualised contract value, a measure of recurring revenues, 20% to US$97m after adjusting for currency movements.

Catapult’s journey to consistent profitability continues apace. Of its US$8.1m revenue increase, 75% dropped through to management’s preferred measure of profitability. That is unsustainably high, but the company has guided to 30% overall profit margins when the business hits a point of higher scale (excluding share-based compensation). At about 50% incremental margins, the target looks eminently achievable by the 2028 financial year.

It was a result difficult to fault, and there is no obvious impediment to Catapult’s momentum. Its customers, professional sports teams, are growing in number and size. Catapult continues to take share from its rivals. The best part of the recent result was the accelerating growth in its newer video segment, where Catapult faces more robust competition (the main wearables business is five times larger than its nearest competitor). It is now generating positive free cashflow and has the capacity to invest heavily in product development alongside its margin expansion. We anticipate it growing at about 20% per annum for some time to come.

Our thesis is well and truly on track (you can listen to our podcast with CEO Will Lopes from this time last year). The only question is valuation. Catapult’s share price has tripled over the past 12 months, taking its market capitalisation to a touch over $900m (US$585m). We have been buying all the way up and, after the past week’s share price appreciation, the Forager Australian Shares Fund’s weighting is above 11%. That is a large percentage of the portfolio, even by our concentrated standards.

Firstly, on valuation, we still think it stacks up. On our numbers, the business can generate nearly US$200m of revenue by financial year 2028 and over US$300m by 2031. By then it should be doing 30%+ margins after share-based compensation and, fully taxed, generating something like US$80m in net profit after tax.

It will matter a lot how much growth remains ahead of the business at that point. Even if the growth has slowed, it should still be worth 20 times earnings. If it’s still growing 20% per annum, it could easily be a 40 multiple. This is a global growth stock.

That would give Catapult a $2-4bn+ valuation and could place it inside the ASX 200.

Obviously, the high end of that range is an optimistic scenario, and there is plenty that can go wrong between now and then. But Catapult can still be a good investment on much more modest assumptions. And, in the near term, we are willing to risk a higher weighting than normal while the rest of the market gets its head around this business.

In the five trading days since Catapult’s half-year result, over $80m worth of shares have traded. That’s more than the prior 40 trading days combined. Despite its $900m market cap, this is not a widely held stock among Australia’s larger small-cap managers (most likely due to prior disappointment). They are likely to get on board now that the business is profitable, and the stock liquidity has improved. Bulge-bracket research firms are likely to commence coverage and Catapult should qualify for inclusion in the ASX 300 index next time changes are announced, bringing passive index buying to the market.

In short, the transition from illiquid small cap to widely held growth stock is well and truly underway. We won’t let it become irresponsibly large, but are willing to tolerate returns volatility while we capture as much of the near-term upside as our risk tolerance allows.

While Catapult is a fairly unique global growth story for the ASX, it had plenty of company as an unloved small cap a year ago. There remain many more that the market hasn’t yet latched onto, so register for our monthly and quarterly reports to find out where today’s best bargains lie.

‍

Australian Shares

Follow-up letter to Bigtincan shareholders

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Australian Shares

Time for change at Bigtincan

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Dear Bigtincan Shareholders,

Forager Funds has been an investor in Bigtincan since August 2021. As at the date of this letter, the Forager Australian Shares Fund owns 2.5% of the company. We are extremely frustrated with the performance of the Bigtincan business and our discussions with other institutional investors suggest this frustration is widespread.

Over the past three years we have experienced:

An 87% fall in the share price, from $1.37 to $0.18;
Cumulative cash outflows from Bigtincan of $207 million, including operating losses (including tangible and intangible capital expenditure) of $62 million and acquisitions of $144 million;
Increasingly dilutive capital raises, with shares outstanding rising from 356 million at the end of the 2021 financial year to 822 million as at the date of this letter;
A bizarre sequence of announced takeover proposals, the first of which was supposedly at $0.80 per share, more than four times the current share price;
The use of factoring to artificially inflate the company’s reported cash receipts in the 2022 and 2023 financial years;
A significant decline in organic revenue in the 2024 financial year.

Forager has attempted to engage with Bigtincan’s Chairman Tom Amos and Managing Director David Keane, as well as the wider Bigtincan board over the past 18 months. The message has been the same as for a number of our portfolio investments: the environment for tech companies has changed.

Businesses need to be run in a sustainable, cash generative manner. While many have adjusted their businesses and have seen their share prices react positively, Bigtincan’s management has not heeded this message and seen its share price plummet.

It is our view that the board did not hold management accountable, has not acted early enough to force the required changes, and approved dilutive equity issuances that should not have been necessary.

We are strongly of the view that the Bigtincan board requires turnaround and restructuring skills that it is lacking.

‍The path to a better future

Our attempts to achieve the necessary change via constructive engagement with the existing Bigtincan board have, unfortunately, failed. Shareholders do, however, have the chance to make the required changes at the upcoming Annual General Meeting (AGM). Here’s how:

Vote AGAINST the Scheme Transaction with Investcorp

We see no merit in this transaction and made that view clear to the Bigtincan board before they recommended it to shareholders. The company offering to buy our shares in Bigtincan will only have US$12.5m in cash, meaning the vast majority of shareholders will get scrip in Investcorp AI Acquisition Corp, a Nasdaq-listed SPAC, in exchange for their Bigtincan shares. This entity does not own any other businesses. It will be Bigtincan, with all of its existing problems, but listed in the US. For that privilege, the SPAC sponsors will be gifted 25% of our company. We own a lot of US-listed companies in our Forager International Shares Fund. It is our opinion that investors in the US are no more keen on small, lossmaking, shrinking companies than Australian investors.

By voting AGAINST the scheme at the upcoming AGM, shareholders will avoid the US$2.75m in break fees that will be payable if the scheme doesn’t get approved at a future scheme meeting. Approving the actual transaction will require 75% of shareholders to vote in favour, whereas this resolution only requires 50% in favour.

It is our intention to vote AGAINST the Scheme Transaction with Investcorp.

Vote AGAINST the adoption of the remuneration report (resolution 2)

At last year’s AGM, 78% of shares voted were against the remuneration report. If shareholders vote against it again, it will trigger a spill motion. It is our intention to vote AGAINST the remuneration report.

Vote FOR the conditional spill resolution (Resolution 3)

Successfully passing the conditional spill resolution will mean the company must convene a “Spill Meeting” within 90 days of the AGM. Existing directors Tom Amos, Wayne Stevenson and Timothy Ebeck would need to stand for re-election.

We are hoping the addition of Tony Toohey and Earl Eddings to the board will mark a significant improvement in Bigtincan’s strategic direction. The spill meeting, 90 days later, will give shareholders a chance to assess their progress and make further board changes at that meeting if required.

It is our intention to vote FOR the conditional spill resolution.

Vote AGAINST the election of Akash Agarwal (resolution 5)

We don’t know Mr Agarwal. He was previously a director of the company prior to its listing. His endorsement by the existing board and managing director suggests his views align with theirs. Therefore, it is our intention to vote AGAINST his appointment.

Vote FOR the election of Tony Toohey and Earl Eddings as new directors (resolutions 6 and 7)

Via my private investment vehicle, Senefelder Investments, I have nominated Tony Toohey and Earl Eddings to the Bigtincan board. Without any rationale as to why, existing directors are recommending you vote against their appointment.

It is our intention to vote FOR their appointment and hope other shareholders will do the same.

These two directors are unrelated to Forager. We were, however, substantial shareholders in ASX-listed MSL Solutions where Tony and Earl worked with the board of that company to successfully resurrect its fortunes (see their biographies below). That business shared many similarities with Bigtincan, including a number of large historical acquisitions that had not been well integrated and a valuable revenue stream that was not delivering profits due to an inflated cost base.

The business restructuring undertaken after Tony and Earl were appointed to the board resulted in a successful takeover of MSL Solutions at more than three times the share price when Tony was appointed to the board.

We believe they have the skills and experience to oversee something similar at Bigtincan.

‍Shareholder value creation

We are of the opinion that the right outcomes at the upcoming AGM can make a material difference for shareholders. Right now, we are unsure whether that should be selling the company or restructuring the business and going it alone. We do know, however, that the best outcomes come from a position of strength. And the only way we can get there is via change at the top.

If you would like to discuss the contents of this letter, please do not hesitate to get in touch with us via admin@foragerfunds.com. You can also register your email address with us here to stay up to date with our campaign between now and the AGM.

Kind regards,

‍

Steve Johnson

Managing Director and Chief Executive Officer, Forager Funds Management

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‍Nominated director biographies

‍Tony Toohey

Tony is a highly accomplished senior executive with over 37 years in the gaming, hospitality, leisure and technology industries with a proven track record of success in creating sustainable competitive advantage and a strong platform for continuing growth.

Tony was appointed as an Executive Director and Chairman of MSL Solutions on 1st September 2019 when its share price was $0.07 with a market capitalisation of $17.5m. He held this role until February 2023 when MSL was acquired by Pemba Capital Partners for $0.295 cents per share, or $124m market capitalisation.

Tony is the former Managing Director, CEO & Executive Chairman of ASX listed Intecq/eBet Limited. Intecq/eBet Limited was acquired by Tabcorp in December 2016 for $128 million. Tony served as GM Business Development Gaming Tabcorp from 2016 until July 2018.

‍Earl Eddings

Currently a Director of E4 Advisory, Earl Eddings was an Independent Non-Executive Director of ASX listed MSL Solutions from April 2019 until its acquisition by Pemba Capital Partners in April 2023.

Earl served as a Chairman and Director of Cricket Australia from 2008-2021. He was a Director of Cricket Victoria from 2006-2015 and held the position of Deputy Chairman from 2008-2015. Earl was also Director of the Kerry Packer Foundation and Director of the International Cricket Council. He is a Fellow of the Governance Institute of Australia and Graduate of the AICD. Previously he was Managing Director for WSP Asia Pacific and Managing Director of ASX-listed Greencap before selling to Wesfarmers.

International Shares

Opportunities in Japan

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Opportunities in Japan

The team undertook a research trip to Japan this month, meeting more than 50 companies. The sentiment was positive, with management teams excited about inflation returning and interesting anecdotes about how they can finally increase prices for their products and services. Moreover, salary inflation is becoming more widespread. Almost every company we met discussed hiring additional employees across sales, IT and engineering functions. How they will all achieve this, given domestic labour shortages and ageing demographics, remains to be seen.

One thing clear is that Japan’s technology sector is now undergoing a digital revolution aimed at combating decades of deflation and demographic challenges. This shift has been spurred by numerous government and private sector initiatives to modernise outdated systems. While some programs have buzzword names (“Society 5.0”), underlying it is a genuine push from the highest levels to integrate advanced technology across industries, creating significant opportunities in software, cloud computing, and IT services.

As Japanese companies ramp up IT spending to improve efficiency, and a labour shortage accelerates automation, the software market is projected to grow at 10% annually over the next five years. Cloud spending in Japan currently accounts for only 12% of total IT spending, versus 37% globally. Additionally, Japan’s e-commerce market continues to lag behind countries such as the US and UK, with e-commerce penetration at just 9%, compared to 26% in the UK and 15% in the US.

Japan’s cashless payment market has expanded from 13% of total payments in 2010 to 39% in 2023. That still substantially trails markets like South Korea (95%) and the UK (65%). Government policy is targeting 80% over the medium term.

The Fund took advantage of the Japanese market meltdown at the beginning of August to add two attractively priced investments well positioned to benefit from this growth.

As part of Japan’s digital transformation, organisations across many sectors have increased their IT budgets, fuelling a surge in software development. The Fund’s new position in Shift Inc. (TYO:3697), a leader in domestic software testing and inspection services, benefits from this trend. The growing complexity of software development and Japan’s chronic shortage of skilled IT engineers is creating demand for testing and inspection services. The company has a track record of successful acquisitions, utilising them to improve its service offerings, attract skilled talent and expand its customer base.

OBIC Business Consultants (TYO:4733) is a leading player in enterprise software, focusing on accounting and payroll solutions for small and medium-sized businesses— think of it as the Xero (ASX:XRO) of Japan. The company is well positioned to capitalise on the shift to Software as a Service and cloud solutions. The government’s push towards digital invoicing and receipts over the past few years provides an additional tailwind to OBC’s growth over the coming years. The company has significant cash reserves and has largely transitioned to a recurring revenue SaaS business model, with 76% of total revenues now recurring. OBC should have years of strong sales and earnings growth ahead of it.

‍

This is an excerpt from the September 2024 quarterly report

Australian Shares

Why Aussie Small Caps?

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Why small caps?

You won’t find too many cheerful small cap fund managers around the world.

The past three years have seen severe small cap underperformance. Larger stocks offshore have been driven by the NVIDIA (NASDAQ: NVDA) juggernaut and the rest of the Magnificent Seven tech favourites. In Australia, the Commonwealth Bank (CBA) made historical highs last quarter with the other big banks in tow.

Over the last three years, an investor in the Australian small cap index has underperformed large caps by 25%. In the US small caps have also underperformed by 25%. Globally that number is 17%.

So why bother investing in small-caps? And why now?

Valuations are More Attractive

‍Australian small companies have historically traded at a 10% price to earnings premium to the larger stocks. After a torrid three years (from elevated levels), they are now trading in-line.

Why should they trade at a premium?

The driver is mostly the faster earnings growth found amongst Australia’s small caps. In normal years earnings growth expectations hover at or below 5% for large caps. For small caps, earnings growth expectations are more variable but regularly clock speedy growth north of 10%. While not all of this will be realised, the space to look for quickly growing businesses at attractive valuations is in small caps.

Sensitive small stocks

Smaller stocks are often more susceptible to tougher economic conditions. Smaller companies are less diversified by geography and end market. They also have higher levels of floating rate debt. A larger portion of smaller companies are loss-making.

And whether in Australia or overseas, higher interest rates have tightened economic conditions.

Global central banks are now riding to the rescue of these difficult conditions. With inflation now more controlled, expectations are for rate reductions across the world.

In late September we got the first US rate cut of 0.5% to a range of 4.75% to 5%. By mid-2025, bond investors are predicting six rate cuts in both the US and the Eurozone. Australia is expected to see three rate cuts with the cash rate hitting 3.6%.

For the past 30 years the first US interest rate cut has ushered in a period of small cap outperformance of large caps. In Australia, the year after the first US cut saw small caps outperform large caps by 8%. In the US and globally the figure is 6%.

At Forager we focus on smaller companies. Over 80% of the Forager Australian Shares Fund is invested in stocks below $1 billion of market capitalisation. And over the past five years the Fund has bettered the performance of the Australian small cap index by 4.4% per year. Over the past year that number is 6.9%.

The portfolio stands to benefit greatly from any recovery in smaller stocks.

‍

This is an excerpt from the September 2024 quarterly report

CIO Letters

The Art of Portfolio Management

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Five years ago, Forager had just turned 10 and we were emerging from two very difficult years of investor returns. Changes I wanted to make within the business are outlined in the CIO letter from December 2019.

On 31 October this year, Forager will turn 15.

How is the scorecard looking mid-way through our second decade?

Five years on, Forager is in a much better place. I identified two key things we needed to do better: staff development and a better mix of businesses in both Fund portfolios. The scorecard on those two fronts is looking good.

Three of the analysts working for Forager back then are now Portfolio Managers. Alex Shevelev, now more than seven years with Forager, is co-portfolio manager of the Australian Fund alongside me. Gareth Brown and Harvey Migotti are now a combined 16 years with Forager and have been doing a stellar job managing the International Fund for the past four plus years. Attracting, retaining and getting the most out of talented investment staff was one of my biggest challenges in that first decade. It will never cease being a challenge, but we are now managing it better than ever.

Second, I wanted to get back to owning some better quality businesses. While the likes of ARB (ARB) and Sydney Airport (SYD) did very well for our Australian Fund in the early years, by the end of the first decade we had drifted into a portfolio of almost exclusively deeply distressed businesses.

“The big returns are still going to come from small, unloved and contrarian ideas. But there’s nothing wrong with higher quality, reasonably priced investments while we wait for those ideas to present themselves.”—December 2019 Quarterly Report.

There will always be a place for unloved stocks within Forager’s philosophy, and we have made investments in a few in both funds recently. But a better balance has been of enormous benefit to both portfolios.

These better quality businesses have generated the bulk of portfolio returns in recent years. Blancco (LON:BLTG), Norbit (NORBT.OL), Celsius (NASDAQ:CELH), APi (NASDAQ:API), Gentrack (GTK) and RPMGlobal (RUL) are all examples of companies that have seen healthy revenue and profit growth translate to the funds making more than three times their initial investments.

Not only have we benefited from reintroducing better quality businesses, we have done a much better job of maximising our profits from those where our thesis has played out. Gentrack and RPMGlobal, two Australian Fund holdings bought when their value was less than $200 million and traded volumes were tiny, have seen share price appreciation rewarded with inclusion in the ASX 300 index. CRH (NYSE:CRH), Ferguson (NYSE:FERG) and Flutter (NYSE:FLUT), three International Fund investments, are on the verge of potential inclusion in the S&P 500.

That we still own all four of them is a result of an intentional effort to recognise when we are on a winner and make the most of it. Two early Australian Fund investments, Dicker Data (DDR) and Jumbo Interactive (JIN), are also in the ASX 300 today. We left a lot of money on the table by exiting too early. It is never going to be perfect, but we have done a much better job in recent years.

Leaving less on the table

The one area we didn’t get right was risk management. The 2022 financial year is a blight on this part of the scorecard. We gave back far too much of 2021’s outstanding profits and ensuring that doesn’t happen again has been our primary concern and goal over the past few years.

A confidence beating

When working for Intelligent Investor in my mid 20s, we received a letter from a client. She wrote I have never met you, but I know you are young and male. Only young males could be that confident. Sexist? Yes. Accurate? Perhaps.

At 46 years old, I’ve had most of my overconfidence beaten out of me by the market. We are trying to predict the future and, as one of my good friend’s father puts it, “When it comes to the future, you just don’t know…”. He places those three dots at the end of most of his opinions and I love it as a philosophy. It’s a view as things stand, but the sentence is not finished.

The best we can do is take a sensible probabilistic view of the future and wait for the market to give us opportunities where those probabilities are heavily skewed in our favour. Things are still going to go wrong.

For that reason, we need to be careful about the proportion of your investment we have exposed to lady luck going against us. This is not an attempt to minimise share price volatility. Passive or ETF funds are now more than 50% of the market in the US and are getting close to that in Australia. The number of options for people to punt on the latest trends has proliferated. If you want to bet on artificial intelligence or cybersecurity, there’s an ETF for you. When the money floods in, share prices of everything included in the relevant index rise. When it recedes, everything falls in sync. That volatility is not a risk for us long-term investors. It is an opportunity.

Our risk is that we get the intrinsic value of a company wrong and that it ends up being worth significantly less (or more) than our investment price. That has happened often enough over the past 15 years to confirm that valuation is an inexact science and strange things happen in the world.

Portfolio management enhancements

We have tweaked our portfolio management to better reflect this inherent uncertainty. Limits on portfolio liquidity, sector, country and currency exposure are set to reflect the current environment and to make both portfolios more resilient to any single macroeconomic risk.

Whilst we are still running concentrated portfolios and you should expect up to 10% of the funds to be invested in the best opportunities, we are reserving the bazooka for situations where we believe the risk of a significant valuation error is low. We will usually have owned such an investment for at least a year, met management several times, been able to observe whether they deliver what they promise and monitored the business itself through a difficult external environment. Waiting for our investment thesis to have more certainty before upsizing the portfolio weight will likely increase the average purchase price of an investment. It will also mitigate the impact of inevitable mistakes.

The decades ahead

‍The failure rate is high in funds management. Few businesses make it to 15 years old. Fewer still make it to 15 while their founder is only 46. Early investors in both funds, many of whom we met on our recent investor roadshow, now have up to four times their initial investment assuming reinvestment. I want the results over the next 15 years to be better. We have the team, experience and process to give us every chance.

‍

This is an excerpt from the September 2024 quarterly report

Podcasts

Fifteen Years of Forager and that Fifty Basis Point US Rate Cut

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International Shares

Quality Compounders that Keep On Giving

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Quality compounders are companies that consistently achieve earnings growth and generate high returns on invested capital across different economic cycles. Approximately one-third of the Forager International Shares Fund consists of these businesses, which continue to execute, but still trade at attractive valuations.

One of the quality compounders to do well in the last financial year was building materials company CRH (NYSE:CRH). Its portfolio of “heavyside” materials, including aggregates and cement, is benefiting from increased funding in the US to restore the country’s deteriorating infrastructure. CRH also has significant pricing power from the very localised nature of heavy quarried materials, where expensive transport costs limit the shipping radius. Another part of our thesis was that following the company’s move to a US primary listing (from Ireland) last September, investors would start to close the discount that CRH has historically traded at versus North American peers. Whilst the discount has slightly narrowed, CRH still trades at around a 40% discount. There is still value to be realised. CRH added 1.4% to Fund returns last financial year.

Installed Building Products (NYSE:IBP), a market-leading insulation installation and distribution company, contributed 1.3% to the Forager International Shares Fund returns during the last financial year, despite a tough housing environment in the US. The company increased revenue by 5% in 2024, a year where broker estimates suggested the company would struggle to grow at all. Management’s strategy of buying small competitors and rolling hem into the group, improving buying power and removing overhead costs along the way, continues to add value for shareholders. While our investment thesis is playing out exactly as we’d hoped, very substantial share price appreciation means the value on offer is not what it once was. Wild fluctuations in Installed Building Products’ share price have given us plenty of opportunity to add to Fund returns over the past few years. We have reduced our weighting to this high-quality but cyclical business significantly over the past year as the share price more than doubled, and would look to add again on any weakness.

APi Group (NYSE:APG) continued its strong contribution for the second year running, adding 1.4% to Fund returns. The business was founded in 1926 as a small insulation distribution company and has grown organically and through acquisitions to become a market leader in safety and specialty services. APi Group continues to acquire smaller competitors and benefit from various secular tailwinds. Management has also proven its ability to integrate and turn around larger acquisitions such as Chubb, which has increased its scale and boosted returns since the company acquired it in 2022.

The Biggest Contributor - An Emerging Quality Compounder

Zeta Global (NASDAQ:ZETA) was the top contributor to the Forager International Share Fund during the last financial year, adding 2.1% to portfolio returns. With a limited public company track record, it took some time for the market to appreciate the growth potential and execution of this data-driven marketing technology company. The company’s ‘one-stop-shop’ marketing platform combines client data with proprietary data to generate customer insights used in multi-media marketing campaigns across SMS, email, display ads and social media.

Despite the challenging macroeconomic environment, Zeta has grown about 25% annually due to the usefulness of its proprietary data. Perhaps counterintuitively, its larger customers often view depressed business conditions as an opportunity to increase spending on the platform while their competitors are in a weakened state. Whilst the share price has appreciated more than 100% over the past year and we have reduced the Fund’s holding, it is still valued at a discount to peers and offers plenty of upside should management continue to execute.
‍

This is an excerpt from the Forager International Shares Fund section of the June Annual Report

Australian Shares

Macmahon's Bold Takeover: An Investment Insight Amidst Mixed Opinions

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Podcasts

Riding the Small-Cap Wave: Opportunities Amidst Market Volatility

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Podcasts

Breakfast Burritos and Boom Time Stocks

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Podcasts

Let Your Winners Run: AI, Commodities, and Emerging Markets

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International Shares

The Fiserv Story: A Clover Thesis

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During the March quarter, the Forager International Shares Fund invested in Fiserv (NYSE:FI). Fiserv is a global payments company offering an array of transaction processing solutions to various clients, from big global banks to your local coffee shop. It owns the third-largest debit network in the world, trailing only Visa (NYSE:V) and Mastercard (NYSE:MA). It also owns and operates Clover, a digital Point of Sale (POS) and payments system for small and medium businesses.

Clover is a key part of the thesis, having grown from nothing to more than US$270 billion of annualised Gross Payment Volume in a few years. Clover has been taking share from other merchant processors over recent quarters, including Square (ASX:SQ2) and Global Payments (NYSE:GPN), with Clover customers benefiting from a wide selection of value added services. Clover products don’t just facilitate payments but also allow merchants to track inventory, manage employees, process online sales and manage customer loyalty programs.

In 2023, Clover accounted for 10% of group revenues and the division is expected to grow 30% annually over the coming years. E-commerce growth has been an important source of growth in digital payments, with global transaction volumes rising significantly over recent years and likely to continue growing more than 10% annually over the remainder of this decade.

In addition, outsourcing amongst banks and credit unions has also contributed to the payments processing sector’s growth. The majority of Fiserv’s revenue comes from long-term, recurring contracts that generate predictable and strong free cash flow.

Fiserv Inc Share Price Premium (Discount) to S&P 500

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Despite impressive earnings growth over the past few years, the company is trading near a 10-year low price-to-earnings ratio. For most of the past decade, Fiserv has traded at a 20-40% premium to the broader S&P 500 index. However, along with industry giants like Visa and Mastercard, Fiserv faced challenges during Covid, which persisted into 2022 and 2023 due to concerns regarding consumer spending, the US banking crisis and, more recently, competitive threats.

Even though the company has consistently surpassed market expectations, its valuation has struggled to catch up relative to its peers. Investors currently seem overly focused on threats, overlooking strong execution and valuation fundamentals. For a business with a footprint of over six million merchant locations, serving ten thousand financial institutional clients and overseeing 1.4 billion accounts, there seems to be a current disconnect between price and value. The company’s earnings per share should grow faster than 10% annually, and perhaps faster than 15% over the coming years.

This is an excerpt from the Forager International Shares Fund March Quarterly Report

Australian Shares

Revitalizing Paragon: A Strategic Merger with CH2

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We have meaningfully increased the Forager Australian Shares Fund’s investment in Paragon Care (PGC) during March. Cobbled together through acquisitions over the past decade, Paragon is one of Australia’s largest health care suppliers. Most acquisitions didn’t live up to expectations and the share price was languishing at a level that suggested the whole was worth substantially less than the shareholder capital spent putting it together.

The inevitable fix-it job was already underway. In early 2022, John Walstab merged his business, Quantum Health, with Paragon and ended up owning 19% of the combined company. Since the merger Paragon has been a small investment in the Fund. By the end of 2023, frustrated with its performance, Walstab had taken over management of the whole business. His efforts over the past six months were showing signs of progress in Paragon’s half-year result.

That was completely overshadowed by an announcement that Paragon would be merging with another distribution company, CH2. This is a deal that we like. A lot. CH2 is a privately owned company that has become one of Australia’s largest distributors of medicine and medical consumables. You might be familiar with the big players in this market: Sigma Healthcare (SIG), Wesfarmers’s (WES) API and Symbion, owned by New Zealand’s EBOS (EBO). They deliver everything from drugs to bandages and vitamin pills to the country’s pharmacies and hospitals every day.

These companies, including CH2, have been around a long time — replicating their distribution networks is almost impossible. CH2 was owned by Spotless in the early 2000s and part of a private equity/API joint venture until 2015, when it was sold to prior management.

That’s when everything changed for the company. API’s ownership of CH2 meant CH2 was unable to compete with API in retail pharmacy distribution — a market several times larger than the hospital market. Freed from those shackles, CH2 was granted a license to distribute drugs to pharmacies from 2017. From a standing start, it has picked up 7% of Australia’s $18 billion pharmacy wholesaling market and, in total, is expected to generate almost $3 billion in revenue this financial year.

CH2 Revenue and Earnings Before Tax

This is a low-margin business with relatively fixed overhead costs. As it has grown, CH2 has become increasingly profitable. It made $12.8 million of net profit in the 2023 financial year and is on track to make $16.8 million this year. We are confident that trajectory can continue.

Its three giant competitors all own or are aligned with retail brands. Sigma owns Amcal and intends to merge with Chemist Warehouse. API owns Priceline and Symbion owns TerryWhite Chemmart. CH2 is the only independent distributor and wants to stay that way, leaving it ideally placed to service a significant number of “non-aligned” pharmacies. Management estimates those non-aligned pharmacies represent some 44% of Australia’s total retail pharmacy sales.

That share probably falls over time — Chemist Warehouse looks like a genuine category killer. But we think CH2 can keep growing its share of a growing market for many years to come.

Profitability in its hospital distribution business should be helped by its acquisition of Sigma’s hospital business in mid 2023, leaving CH2 as one of only two players in that market. And, perhaps most importantly, the opportunities within Paragon’s existing business look significant. If the deal is approved by Paragon shareholders, CH2’s two shareholders will end up owning 57% of the combined entity. David Collins, CH2’s managing director, will take over management of the company and he and his co-owner will both take seats on the board. Walstab will keep his board seat and two independent directors will be appointed.

The ParagonCare Board, including Walstab, is supportive of the deal. Unless something significant changes, we are too, making it highly likely to proceed. At the stroke of a pen, Paragon will be transformed from a sub-scale distribution business with a patchy record of capital allocation to a profitable owner-manager company taking market share in a growing industry. And there should be significant synergies between the two companies.

Healthcare distribution is not an easy sector in which to operate. Sigma’s return on capital has been sub-par for a long time and API hasn’t been much better, even under the stewardship of Wesfarmers. There are risks associated with being a minority shareholder in a company controlled by management, including the inability to replace them if necessary. It might take several years for the benefits to become obvious and, given the insider ownership, the stock will remain illiquid for a long time to come.

On balance, though, this is a significant change for the better for Paragon shareholders. Collins is not taking a cent in cash as part of the transaction and will have his life’s work tied up in Paragon, making him heavily incentivised to make a lot of wealth for all shareholders.

We think we have finally found the right jockey for a horse that has been particularly difficult to ride, and have added meaningfully to the investment over the past month.

This is an excerpt from the Forager Australian Shares Fund March Quarterly Report

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CIO Letters

A Simple Forager

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Assuming the Australian Fund does get delisted, it will be the last element of a two-year project to simplify the Forager business.

By July 2024, we could be back to two simple open-ended funds with the same Responsible Entity and registry, both accepting daily applications and redemptions.

We are often critical of listed company managers for not focusing on their core strategy. I run a business with just 10 employees and I can inform you that it is easier said than done. It is very easy to add new ideas, products and technologies to your business. They all come with logic and rationale that makes sense. It is much harder to take them away. Consultants and strategy experts love to talk about “mission, vision and values”. I’ve found it mostly a waste of time. Boxer Mike Tyson once said “everyone has a plan until they get punched in the face”. In a business as dependent on financial markets as ours, you get punched in the face often enough to know there’s no point planning too far ahead.

That only makes it all the more important to understand the principles on which we operate, though. I have a similar conversation with a lot of young people about their careers. Many seem stressed about not knowing exactly what they want to do and ask me how I knew I wanted to be a fund manager. The answer is, I didn’t.

I knew I wanted to be challenged intellectually. I knew I wanted to do something I was interested in. I knew I wanted to work hard with people I liked and I knew I wanted to be financially independent. Within those parameters, I was open to wherever life took me. Each decision I had to make, I asked those four questions and made my choice. It could have led to an equally happy alternate life, but those principles led me here to founding Forager.

Rather than a destination, our business needs its own decision making principles. At Forager, we want to create wealth for our clients. We want to give Forager staff fulfilling careers. In recent years, we’ve learned that we want to keep it simple. By the end of this financial year, we hope to have taken some big steps forward on all three fronts.

This is an excerpt from the Forager Chief Investment Office Letter March Quarterly Report

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CIO Letters

Time for small cap investors to stop whinging

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The 2024 year began the way 2023 ended. Globally, the MSCI World IMI Index (in AUD) rose 12.7% in the first quarter of the year while the ASX All Ordinaries Accumulation Index (including dividends) rose 5.5% over the same period. The composition of the rally changed meaningfully, though, with the Magnificent Seven becoming a magnificent five (Apple and Tesla both experienced share price declines over the quarter) and a significantly higher percentage of the market participating in the rally. More than half of the S&P 500 constituents traded at 52-week highs during the quarter.

Plenty of smaller companies have seen significant share price rises. There are reflections of the 2021 meme bubble in some Artificial Intelligence related stocks (I use the word “related” loosely). But, for the most part, I would argue there are often logical reasons for those that have risen to rise and those stocks that haven’t participated in the rally to be left behind. Companies that are delivering good results are seeing it reflected in share prices. Those that aren’t, aren’t.

Take a couple of examples from our own portfolios.

Utilities software company Gentrack (listed on the ASX and NZX) has experienced a fivefold share-price increase in the past 18 months. Its market capitalisation — less than NZ$150 million not long ago — is approaching NZ$1 billion. That’s all thanks to a dramatic turnaround in profitability and growth prospects. Gentrack went from losing NZ$3 million before tax in 2022 to making NZ$15 million in 2023. We expect that to at least double again over the next three years.

Over in the US, insulation company Installed Building Products has seen its share price more than double since October 2023. Our original thesis was that, despite facing a difficult housing construction backdrop in the short-term, this company had great long-term prospects. The weak housing backdrop hasn’t proven an impediment at all. Rather than a 2024 year of no revenue growth, as implied in prior broker estimates, the company’s recent guidance suggests 8% growth in 2024.

They have historically given conservative guidance. In the chart below, you can see the impact that has had on expectations for 2024 profitability.

Installed Building Products Share Price vs Earnings Per Share Expectations

On the flip side, two years ago antipodean tourism operator Experience Co was expected (by the broker community) to make more than $0.02 in earnings per share this financial year. It will be lucky to break even. And US outdoor brand Yeti has seen expectations for its 2024 profits slashed by 40% and its share price hammered as a result.

Yeti Share Price vs Earnings Per Share Expectations

The message for investors and companies is clear. There are plenty of smaller companies trading at appropriate or even optimistic share prices. If your company isn’t one of them, it’s time to stop whinging about small cap malaise and start focusing on what the business needs to do to be recognised. Deliver profits, cashflow and growth, and there are plenty of investors who want to own your shares.

Deliver broken promises and your share price will remain in the dumps.

You can quibble about the magnitude in both directions. We sold a meaningful percentage of our investment in both IBP and Gentrack due to valuation. We think the long-term story for both Experience Co and Yeti is delayed rather than destroyed (the investment in the latter was made after most of the downgrades). And there are exceptions where good progress is not reflected in share prices.

But, overall, the market mood for small caps has changed from outright pessimism to selective optimism. The opportunity for share price appreciation is significant for those companies that can give investors a good reason to invest. It is up to us to find the right stocks and companies to deliver results.

This is an excerpt from the Forager Chief Investment Office Letter March Quarterly Report

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Insights

The Deceptive Allure of Cash

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This article was originally produced for Livewire Markets

In Homer’s epic poem The Odyssey, beautiful Sirens attempt to lure sailors off course by hypnotising them with their song and causing them to crash into rocks and land.

Is the allure of cash currently having a similar effect on investors?

With some banks now offering north of 5% on savings, cash and cash products have re-entered the thoughts of investors, after being absent for so many years of ultra-low interest rates. That’s good news for investors. It’s also good news for markets. The “hunt for yield” when interest rates were zero caused harmful distortions in the market for capital.

Yet higher rates on cash brings risks of its own. Five percent might be better than zero percent, but cash is still a horrible long-term investment. And that’s a lesson many investors are learning the hard way.

The Illusion of Current Cash Returns

In a financial world where there has been over a decade of low interest rates, it’s easy to get excited about the opportunity to earn what appears to be a decent return on cash. High-yield savings accounts, certificates of deposit (CDs), and money market accounts are currently offering annual percentage returns in the range of 5-6%, and in some cases even higher. These returns appear competitive when compared with the last decade of low-rates, leading some investors to favour cash as a safe and accessible means to grow their wealth or as a less risky alternative to equities.

Comparing Cash Returns Over Time

While the immediate returns on cash seem appealing, a closer examination reveals a different story. Cash rates are higher at the moment because inflation has been higher – this means the real rate of return on a cash investment, after accounting for inflation, is close to zero. As you can see in the table below, that’s always been the case with cash. At best you will retain your purchasing power. If inflation falls, interest rates will fall too, and your 5% return will become 3% or 4% before you know it.

Stocks offer much better real rates of return than cash and cash products over long periods. Stocks have generated an average real rate of return ranging from 6% to 7% annually over the past 100 years. You have been able to earn those returns plus inflation by owning these real assets.

Big differences over the long term

Four to six percent might not sound like a massive difference. But when the power of compounding works its magic, the differences become stark over time.

Let’s imagine two hypothetical investors: one who places $10,000 in a high-yield savings account at 5% annual return, and another who invests the same amount in stocks in an Exchange Traded Fund (ETF) with a 10% annual return (assume inflation of 5% plus 5% real return). After one year, the cash investor earns $500 in interest, while the ETF investor’s investment grows to $11,000. Not a huge difference over a year, so you might as well favour the safe haven of cash?

Fast forward ten years though, and the cash investor’s $10,000 has grown to $16,386. That’s not buying any more than it was. The ETF investor’s investment has ballooned to $25,937 – a much greater difference to the cash return – showcasing the true advantage of higher returns over time, and in turn providing a real rate of return after accounting for inflation.

The Compounding Conundrum

Now, let’s take this comparison to a more extended time frame, say 25 years. The cash investor’s $10,000 has grown to $33,864, a seemingly impressive feat. However, the ETF investor’s initial $10,000 has now grown into a huge $108,347. The gap between the two investors’ returns is now strikingly wide. At 30 years, the cash investor would have $43,219 versus the ETF investors $174,494.

This phenomenon is the essence of compounding. While cash investments may provide an appealing yield in the short term, their low real rates of return limit the potential for long-term growth.

The Cost of Safety

Many investors understand the maths above. Their strategy is not to be invested in cash for the long term, but to park their money in cash until the outlook for equities improves. That’s perfectly understandable. When bank interest rates first hit 5% in mid 2023, equity markets were in a tizz. With recession looming and inflation running riot, who wouldn’t be attracted to the safety of a government guaranteed bank account?

Well, me for one. The “wait till the coast is clear” approach is the most pervasive, wealth destroying, unshakeable investor mindset I see. And there is no better example than the past 12 months.

Feeling a bit better about the world? Inflation seems to be subsiding. The economy seems to be holding up ok. The RBA is talking about the potential for rate cuts.

Well, I’ve got bad news for you. Stock prices have since surged, making it 20% more expensive to buy back into the market than when you were feeling worried. In the US and Australia, equity markets are at all-time highs.

Combine this with the prospect of lower rates on cash and the investor is hit with a double whammy that could potentially cost years worth of returns.

The Allure of Cash may be Enticing Today, but..

Cash, of course, plays an increasingly important role in most investors’ portfolios. Their priority should be an asset allocation plan (this may change as an investor reaches different stages in their life, and should include a growing allocation to liquid assets like cash over time).

Once you have a plan, though, it needs to be stuck with, through thick and thin. Odysseus (from our famous poem) went to the lengths of strapping himself to the mast of his ship and getting the sailors to plug their ears with beeswax so they wouldn’t be distracted by the song of the sirens. By doing this, Odysseus managed to sail unscathed through the notorious straits between Sicily and Italy. Whilst we don’t suggest strapping yourself to a mast any time soon, it’s worth remembering this story if you ever consider wavering from your investment strategy during future times of market panic. The allure of cash in times of distress is nothing more than that, an allure that should be avoided.

References: Sirens in the Odyssey

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International Shares

A Rollercoaster Year: The Flutter Case Study

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In Forager’s December 2023 CIO letter, Steve Johnson talked about increasing volatility and reduced focus on intrinsic value:

“I don’t think any rational person is changing their valuation of the market by 20% based on one month of inflation data. Rather, financial markets are being dominated (more than ever, in my opinion) by money that doesn’t care what stocks are worth, only where they are going to trade in the short term. The computer says rates up equals sell. The computer says rates down equals buy.”

It’s a tale evident in both markets and individual stocks. Global online gambling giant Flutter Entertainment (LES:FLTR), held in the Forager International Shares Fund (the Fund), is a topical case study.

While Flutter owns market-leading positions in the UK and Australia via the Sportsbet brand, its most valuable segment is its number one position in the growing US market. The Fund first invested in late 2021 on the thesis that it was establishing a leadership position in the US market and would grow immensely over the coming years.

That thesis quickly became mainstream and the stock price rose significantly over the second half of 2022 and the first half of 2023. The Fund sold many of its shares by the first half of 2023, although it remained an important investment. Then, in the second half, Flutter shares commenced a gradual but persistent decline, down almost 30% by November.

There were genuine concerns to ponder. After a period where Flutter’s FanDuel brand had it perhaps too easy, competitor DraftKings (NASDAQ:DKNG) has proven a resilient number two player. FanDuel’s brand grew revenues significantly quicker than DraftKings over 2022 and the first quarter of 2023. But DraftKings grew faster during the 2023 northern hemisphere summer, coinciding with the legalisation of online gambling in Massachusetts, DraftKings’ home state.

Draftkings’ improved performance might have nudged our valuation of Flutter down a couple of percent. It’s mostly been a case of both companies winning market share at the expense of smaller players. Consolidation is going to prove good for the bottom line.

Flutter’s mid-January trading update put many concerns to bed. The company claimed a fourth quarter sports-betting market share of 51% (based on net revenue). Perhaps more impressive has been its growth in iGaming. As a sports-led brand, FanDuel has been a laggard in iGaming behind casino-focused BetMGM and DraftKings. But over the past 18 months, it’s grown iGaming market share from 19% to 26% and has now claimed the number two mantle for the first time.

FanDuel achieved scale and profitability before anyone else in the American market, and we expect Flutter overall to continue growing rapidly.

The stock, formerly listed in both London and Ireland, abandoned its Irish listing and listed on the New York Stock Exchange in late January. New York will likely become its primary listing in short order. The stock is grabbing a lot more US attention than it used to.

We added to the investment in late 2023, although less aggressively than we ought to have. Flutter’s share price is up 35% since the recent lows in November, bringing to mind another quote from Forager’s CIO’s December missive:

“All of this focus on the next data point, however, makes the job somewhat easier for the investor with a longer investment horizon. The more the weight of money is focussed on the short-term, the more opportunity there is for those with a longer-term view.”

This is an excerpt from the Forager International Shares Fund January Monthly Report

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International Shares

Six years, six baggers and four important investment lessons: The Blancco investing story

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In late 2017, there weren’t many buyers of Blancco Technology Group. The CEO had just been fired, the company had overstated its revenue figures, its financial reports were delayed, and the share price had fallen over 80% in a matter of months. It’s understandable why most investors were running for the exits. The International Share Fund team at Forager, however, were willing to take a look.

Forager’s investment in Blancco was ultimately one of the Fund’s most successful in its 11-year history, ending with a tense fight for the company’s future where it was eventually taken private.

So what attracted the investment team to Blancco? And what lessons are there to help identify the quality turnaround stories from the duds?

History of Blancco

The company’s roots are in Finland, where in the 1990s two business partners developed software to permanently delete the contents of a hard drive at the end of a computer’s life. Over time, the process was tweaked to deal with different types of hardware – computers, laptops, tablets and mobile phones – and different types of drives.

Specialised IT Asset Disposal firms (ITADs) and large corporate clients deal with mountains of used hardware each week. If data security means anything to them, they’ll want to clear all those hard drives before recycling or re-selling their old hardware.

That can be done in one of three ways: by physically destroying the hard drive; by ‘scrubbing’ or overwriting the device (often multiple times); or by using software to methodically clear the drive in a process that is irreversible by hackers. Some such software is available online for free. But if you want a reliable audit trail and a guarantee it’s been properly cleared, you’ll use a piece of paid erasure software. Overwhelmingly, Blancco is the global leader in paid erasure. Its customers buy licences typically linked to usage, and repeat business is extremely high.

Only scrubbing and erasure software leave a hard drive intact for reuse or recycling, a growing tailwind for the business.

The Opportunity

Up until March 2017, the business had been trading well. It had exited some of its other business operations to become a pure-play software company and its share price rose to 300p. In the following months, however, Blancco’s board began dropping clues that their reported revenue figures may not be entirely accurate.

April 2017 trading update

In April, commentary from management was that everything was going swimmingly. Sales were up 48% year on year and 34% for the 9 months to 31 March. Then they slipped in this paragraph:

“Since the interim results on 14 March 2017, the Company has undertaken a review of its cash flow forecasts. The Company has identified that costs associated with past acquisition activity, including earn‐outs and advisors’ fees, the later arrival of a large government contract and the slipping of larger contract deals to later in this current quarter will all build pressure on the forecasted cash available to the Company during Q4.”

Odd. Not great, but not the end of the world.

July 2017 trading update

Revenues were up 40% for the year, and 30% on constant currency. A slowdown on the previous quarter but still robust. Then the big gremlins started to come out:

“However, cash flow and net cash are below market expectations due to the non‐payment of £3.5m of receivables, the majority undertaken in the prior year. Taking a prudent approach to these receivables we have decided to provide against them by taking a charge of £2.2m, resulting in Adjusted Operating Profits of not less than £5.5m and Adjusted EBITDA of not less than £7.0m (subject to fully closing the accounts and audit). This reflects the Group’s intention to apply a more prudent approach to revenue and income recognition on this type of contract in the future.”

They seemed to be suggesting the previous year’s revenue was overstated. Yet the worst was still to come.

September 2017 trading update

“Blancco Technology Group Plc announces that, following matters that have recently come to the Board’s attention, the Board has decided to reverse £2.9m of revenues represented in two contracts that had previously been booked during the financial year ended 30 June 2017. As a consequence we now expect revenues for the financial year ended 30 June 2017 to have increased by approximately 29% over the prior year, approximately 15% in constant currency. This correction means that Adjusted Operating Profits will be not less than £2.6m and Adjusted EBITDA not less than £4.1m for the financial year ended 30 June 2017 (subject to fully closing the accounts and audit). Cash flow for the financial year is not impacted.

Pat Clawson, Chief Executive Officer, has decided that it is in the best interests of the Company that he should step down from the Board with immediate effect. Accordingly, he will be leaving the Company and Simon Herrick, our interim Chief Financial Officer, has agreed to become our Chief Executive Officer on an interim basis.“

Subsequently, the company’s full-year results were deferred to an unspecified date while they tried to work out exactly what the revenue was. By October that same year, the company was trading at 48p a share, down 84% and trading at one times revenue.

Inflated revenue figures, a delayed full-year report, no CEO and a share price down 84%. It was understandable why there were few buyers of the company at the time. Many were selling due to fear, others were no longer permitted to own it due to the accounting issues. The stock price fall might have been entirely justified, but it was also fertile ground for overreaction. Our analytical focus sharpened. We talked with one of the founders, with sales executives and with customers.

Sure, the problems were real but obvious. But we developed confidence that Blancco remained a growing business with significant tailwinds, happy customers and strong profitability. We laid out the following reasons in our internal 2017 research note:

Despite overly aggressive revenue recognition, the business is clearly growing.
Most of the revenue is recurring. In the 2016 financial year Blancco retained 91% of its clients and increases in revenue from the remaining clients more than offset the 9% lost. Once this software is embedded in a company or government department it is likely to be very sticky
With a significant R&D budget and existing patents, it could outspend and stay ahead of the competition.
The business was and should be high margin. Most of the cost increases in recent years have been people and that should be relatively easy to reverse.
One times revenue is a very low multiple for a business that has been growing quickly and should be high margin (20-30%+). It could easily be worth four to six times revenue.
Blancco and its customer base make for a very logical acquisition target

At this point, we made an initial investment in the company right into the teeth of the market panic. On several days, we were the only buyer, buying 100% of the shares traded on the exchange. It’s quite likely the share price nadir would have been lower without our buying, but when it’s bargain basement time, you take the liquidity you can get.

Increase weightings with increased confidence

A new CEO, Matt Jones, joined the business in March 2018 and released his first set of results a few months later. This also included an updated strategy for the company. These results confirmed that Blancco’s problems were temporary. And the updated strategy was simple: focus on what the company already did well. These developments helped confirm the team’s initial thesis.

At this stage, six months after the share price nadir, the stock was already up 50% or so. We not only held on tight but bought more shares. The risk had fallen a lot, and the risk-adjusted potential returns had improved.

During the next couple of years, by June 2019, Blancco moved firmly out of recovery mode and into growth mode. Sales and profit expectations for the financial year 2019 were upgraded and, more importantly, the company began investing sensibly in both new product capabilities and improved sales channels. By June 2019, Blancco was a 10.3% weighting in the Fund, having risen 73% during that financial year.

“Let your winners run” is one of those trite sayings that is wrong as often as it is right. But business valuation is an inexact science and risk is a variable. Forager’s “upside” valuation didn’t change dramatically through this period, but the probability of that case unfolding increased dramatically alongside Blancco’s growth, profitability and cash flow. Conversely, the likelihood of our downside case arising kept getting smaller. This reduced the risk of the investment and increased our team’s confidence, justifying a much higher weighting despite the higher share price.

In the latter stages of 2019 and into 2020, we sold a lot of shares, pushing down the weighting despite continued strong share price growth.

Portfolio management matters

By June 2021, Blancco had increased meaningfully for the fourth year in a row, with its share price rising in line with Forager’s investment team’s estimate of its value. Things were looking good for the business.

In the middle of a tech bubble, though, enthusiasm was running high. While still liking Blancco’s prospects, it no longer justified a maximum weighting. By number of shares held, we’d already sold more than 70% of our peak holding from 2 years earlier.

That proved fortuitous. In both financial years ended June 2022 and 2023, Blancco’s share price fell. Prior selling meant that, in the latter months of 2022, we were able to start adding to the investment again. We should have bought more aggressively.

A Frustrating Ending

Unfortunately, it wasn’t just the investment team at Forager who were optimistic about the future of Blancco. These “good years ahead” came to a rapid conclusion.

In mid 2023, Francisco Partners put in a bid for the shares of 223p in order to take the company private. Although this was an uplift on the share price at the time, the team at Forager believed it massively undervalued the company.

The team worked hard to convince other shareholders and the Board at Blancco not to accept the bid, as there was still a huge opportunity for years to come. The fact that shareholders collectively couldn’t see that opportunity as a listed entity cost us all dearly.

There were a few factors going against us. Firstly, UK stock markets are depressed. The bulk of Blancco’s revenue came from elsewhere, but UK institutions were an important part of the shareholder base, and they’ve had a rough few years. They also have lots of cheap investment opportunities to redeploy capital into.

And while we didn’t know it at the time, Blancco’s second largest shareholder was contemplating winding up its operation and returning proceeds to investors. Immediate liquidity was more important to it than absolute price.

Ultimately, the bid went through in October and the battle was lost. Although, arguably, we won the war.

Lessons from Blancco

They say you learn the most from mistakes but successes can be instructive too. This investment contained both. We give ourselves an 8 out of 10 in this stock. We should have sold the lot in mid 2021 and we should have bought a lot more in late 2022 and early 2023. We were also never entirely happy with the makeup of the board, and should have worked on that more aggressively over our years of ownership. But we got a lot right too. Blancco has been a great success for Forager investors and a treasure trove of lessons for all of us.

General lessons? Developing a thesis that is both contrary and, ultimately, correct is everything when it comes to stock market outperformance. It’s periods and locations of immense pessimism where such opportunities are most likely to be found. Just because a stock is down 80% doesn’t mean the market has it wrong. But it’s a very good place to concentrate one’s analytical efforts.

Due diligence is crucial here, it can enable you to confidently turn a loose theory into a firm thesis. And you’re going to want a firm thesis if you’re buying what everyone else is selling.

Don’t forget risk management, but also rework your odds as new information arrives. Just because a stock has doubled since you bought it, doesn’t mean that the risk/reward equation has deteriorated. Sometimes, often even, that’s exactly the time to be max sizing your position. The real money is made by having the biggest weighting at the right time.

Managing position size as your perceived edge grows or shrinks, that’s a key lesson for both profit maximisation and risk management.

*For more information on the takeover offer see: Open Letter to all shareholders in Blancco Technology Group

**The takeover was also discussed in this podcast episode and in our Fund Update Webinar.

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Podcasts

Wild 2023 market swings: Uranium prices surge to nuclear highs and small caps start to recover

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Podcasts

From the Australian Institute of Sport to the NBA: How this Aussie small cap is making a name for itself

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Podcasts

What our trip to the US and Japan is telling us about the economy: Insights from the road

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Podcasts

Why higher rates are good for the world (and which stocks can do well)

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Podcasts

Running with the Uranium Bulls

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International Shares

Open Letter to all shareholders in Blancco Technology Group

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Dear Shareholder,

Francisco Partners board approved offer for Blancco is undervaluing your shares

Private equity firm Francisco Partners has made a cash offer to take Blancco private for 223p per share. The bid has been endorsed by Blancco’s board of directors. Two large shareholders have offered irrevocable undertakings to accept the deal unless another bidder offers at least a 10% higher price. A third has given a non-binding letter suggesting it intends to accept the offer¹.

A fund managed by our firm, Forager Funds Management, owns 2,365,271 shares in Blancco, representing more than 3% of the company’s equity. Forager is a top 10 shareholder and has owned stock in the company since 2017.

It’s our opinion that the 223p offer price significantly undervalues the potential in Blancco’s business.

Our base case valuation is more than 30% higher than the bid price. Our top end valuation is significantly higher again, and doesn’t lean on any heroic assumptions.

Blancco is a quality tech company

You can make your own discounted cash flow model. But we wanted to share some thoughts relevant to valuing this company, in case you find it useful in forming your own opinion about the proposed takeover. Consider this:

1. Revenue growth is inflecting higher. Blancco has grown revenue at a compound annual growth rate of 12%² over the past five years. But that’s while carrying a Mobile segment that has disappointed – barely growing revenue over that period. With each passing year, the Mobile segment is becoming a smaller part of the pie, from 36% of company revenue in 2018 to an estimated 23%³ in 2023. The much faster growth coming from the Enterprise and ITAD segments will accelerate overall company growth.

2. Profit margins should rise from here. Blancco’s adjusted EBITDA margins have increased from 20.4% in 2018 to an estimated 29.5%⁴ in 2023. Those margins should and will continue to rise. The gross margin on Blancco’s products is more than 95%. Much of its remaining cost base is relatively fixed in nature. The incremental margin on sales over that same five-year period was above 40%. It’s not unreasonable to expect this margin to trend towards that level over time, relying on no change in current trajectory. And there’s an immense amount management could do proactively to further improve margin from there. You can bet Francisco Partners have a list of such actions ready to go after settlement.

3. Untapped pricing power. Related to points 1 and 2 above, Blancco has significant pricing power that has historically been untapped. Software-as-a-Service (SaaS) customers are becoming increasingly accustomed to annual price rises. Blancco has rarely pulled that trigger in the past, with revenue growth closely linked to volume growth. That might be changing. Enterprise and ITAD customers have both experienced price rises over the past year. Blancco’s dominant global share in paid erasure software and extreme customer loyalty provide the foundation for modest annual price increases going forward. Even a 5% annual price adjustment will meaningfully add value for shareholders – the drop through to profit should be almost 100%.

4. Strengthening ESG tailwind. Blancco helps customers secure their data, and the increasing importance of data security barely needs mentioning. The environmental pitch to customers is also growing more relevant with each passing year. Blancco already counts some of the largest technology firms globally as customers. Among those tech giants, an unsustainable proportion of their used hardware is still shredded rather than cleared then recycled or resold. See the Financial Times article Why Big Tech shreds millions of storage devices it could reuse from 6 October 2022 for more insights. Blancco’s revenue from its existing customer base alone will likely grow at an impressive rate, based entirely on volume increases.

Undervalued on historical multiples

In addition to the fine business attributes outlined above, which you may want to incorporate into your own thoughts on value, here are some other metrics that make the case that the current bid is substantially too low.

Francisco Partner’s bid is pitched at an Enterprise Value to current year (2023/24) estimated EBITDA multiple of just 11 times⁵. Despite the board’s rightful concerns about the lack of investor appetite on the AIM market, Blancco shares have traded well above that multiple for most of the past five years.

Also note that versus the broader software index⁶, Blancco has traded at a premium for much of the past five years. But it’s not currently, despite the 25% deal premium. It is hard to imagine that disconnect wasn’t a factor in the timing of Francisco’s bid.

Transaction data

Other takeovers are even more telling. There have been plenty of transactions done for relatively similar businesses in the software and cybersecurity markets globally over the past few years.

The cybersecurity market in particular has been hot. Where deals are being struck, it’s typically at mid-to-high single digit multiples of the last 12 months’ revenue⁷. Broader software multiples are a little lower but still well above the 3.4 times revenue implied in Fransico’s offer price⁸.

Businesses of Blancco’s strong and improving revenue growth, mature margin potential and customer loyalty (recurring revenue) don’t tend to get sold for 3.4 times expected revenue or 11 times expected EBITDA⁹, as the Board is proposing to do here.

We’ve collected details of a few transactions that offer some degree of relevance. To avoid any accusations of cherry-picking, we’ve ignored any deals greater than US$1.5bn, focused mainly on targets outside the US where the spotlight shines less brightly and have only considered deals inked in the past 9 months.

In comparison with Blancco, the following list includes a fair helping of businesses that are lower quality, with a lesser growth outlook and lower to non-existing profitability. And yet they point to solidly higher valuations. Four times revenue would still be cheap. Five times would be closer to fair.

Frustration is not a reason to sell too cheap

Over the past two years to 30 June 2023, Blancco has grown revenue by 30%, while its share price fell more than 40%.

Forager acknowledges the board’s concerns about liquidity and the wider pool of investors and potential investors not properly recognising Blancco’s value. We share their frustration and other large shareholders clearly feel likewise. But accepting a miserly 25% premium over the pre-bid share price is not the way to correct it. The bid price doesn’t properly bridge that undervaluation, and indeed solidifies it.

If the right time to sell the business is now, shareholders must get an appropriate valuation for their shares.

Best and highest offers

It is in our individual and collective interest for a sale process to be allowed to play out in a way that ensures maximum value for all shareholders. That doesn’t mean blindly accepting this first bid.

There are surely other private equity and trade buyers who would have interest in a business of this quality. If the board is convinced a sale is the best way for shareholders to maximise value, we have concerns that this asset hasn’t been thoroughly shopped to a sufficiently long list of potential buyers. We want a fuller, more detailed process to explore that on behalf of all existing shareholders, incorporating the use of additional third-party advisors to guide it through this process. That’s an issue Forager will take up with the Board directly, and you may consider doing likewise.

If, after a full and complete sale process, Francisco is the only bidder currently interested and 223p is all they are willing to offer, then the board should focus on growing the business and selling it for significantly more in a few years’ time.

The board of directors will need to buckle down and ensure Blancco has the right management team and indeed board composition to take it forward. The business needs to grow revenue above that seemingly magical US$100m mark where markets and bidders start to pay real attention. At that point, if the stock is still being ignored on the AIM market, the board can move the listing to a more discerning market like the NASDAQ or seek a bid then. Blancco could top US$100m annual sales within 4-5 years via organic growth alone. This is an area where patience should pay. It would not be unreasonable to expect to crystallise multiples of this bid price should that growth occur.

If large shareholders have had enough

Forager is also perfectly happy continuing on as a minority shareholder with a large talented private equity firm as the major shareholder, be that Francisco Partners or someone similar. In the offer documentation, Ravi Bhatt of Francisco Partners said:

“Sustainability and e-waste reduction are increasing strategic priorities for customers of all sizes globally, and we see tremendous organic and inorganic growth opportunities for Blancco worldwide.”

We couldn’t agree more.

We’ve long thought that more can be done at Blancco to drive the business faster. If today’s large shareholders disagree, let them move on and bring in someone with vision and a plan. Forager would certainly appreciate a like-minded larger shareholder on board, and are more than happy to swap notes if anyone cares for our thoughts.

But our initial thoughts on this bid price is that it’s inadequate. There’s no obvious premium for control. And our opinion is that shareholders will do better continuing to own their shares than to sell out for 223p today.

If any shareholders, media or potential bidders want to get in contact with us to discuss further, please do. You can reach Gareth at gareth.brown@foragerfunds.com and we’re happy to set up a call.

Footnotes

¹See Blancco release Francisco Partners II – Recommended Cash Offer of 2/8/23

²Uses market estimate revenue for the year to 30 June 2023 of £47.5m

³Forager internal estimate

⁴Uses market estimate EBITDA for the year to 30 June 2023 of £14.0m

⁵Uses market estimate EBITDA for the year to 30 June 2023 of £14.0m

⁶S&P500 Software Industry Index

⁷https://www.spglobal.com/marketintelligence/en/news-insights/latest-news-headlines/mandiant-multiple-sets-pace-for-cybersecurity-m-a-in-2022-69478262

https://momentumcyber.com/docs/Quarterly/Cybersecurity_Market_Review_Q1_2023.pdf

http://cdn.hl.com/pdf/2023/cybersecurity-market-update-first-quarter-2023.pdf

⁸Uses market estimate revenue for the year to 30 June 2023 of £47.5m

⁹Uses market estimate EBITDA for the year to 30 June 2023 of £14.0m

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Insights

The Revolving Door of the Aussie Share Market

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It’s been a busy, record-breaking year for the Australian share market. Not only did the S&P/ASX 200 close out its best financial year in two decades, but initial public offerings (IPOs) and mergers and acquisition (M&A) activity also reached new highs.

So, where might opportunities lie in this avalanche of prospectuses and scheme deeds?

On the way out

M&A activity in 2021 has eclipsed the 2007 record, with corporate acquirers driven by cheap interest rates, low leverage at many listed companies, and an imperative to grow earnings. Meanwhile, private equity firms are sitting on a mountain of cash and super funds have entered the fray in a bigger way, seeking a home for accumulating retirement savings.

A $23.6 billion bid for Sydney Airport (SYD) was announced recently and, if complete, will represent one of Australia’s biggest ever buyouts. A $2.8 billion takeover bid was also proposed for fund administrator Link (LNK) – a rehash of last year’s offer for the business. In another replay, Blackstone is back bidding for Crown (CWN).

Premiums have also been higher than usual this year, averaging roughly 30%. Class Super (CL1) was bid for by HUB24 (HUB), with a staggering 72% premium. The Mainstream Group (MAI) takeover saga, which we chronicled in our June Monthly Report, finished with Apex Group paying $2.80 per share – 153% higher than where the business was trading before the initial bid. The $14 million for our remaining Mainstream shares landed in the Forager Australian Shares Fund’s bank account at the end of October.

A more recent example is Seven West Media (SWM), which made a bid for Prime (PRT) in October and handed Prime shareholders a 74% payday. By spending $72 million to fully own Prime, Seven West has paid just under three times earnings before interest, tax, depreciation and amortisation. Coupled with news that the company gained access to flexible new lending arrangements, its share price was more than 67% higher at the November peak.

Breaking in

While there were several businesses leaving the market this year, there were also plenty of new listings. Australia’s IPO market has been back in full swing – rebounding from last year’s COVID slump and overtaking the 2017 record to raise about $3 billion in the first six months alone. And so it should; macroeconomic conditions are favourable, equity valuations are healthy, and investors are opening their wallets in search of the next success story.

Small-cap IPOs have been landing on fund managers’ desks quicker than they can be chucked in the bin. Many of these small, and largely unproven, businesses have been dressed up for sale and offered at hefty prices. There have been plenty of well-timed exits from private equity sellers.

We haven’t found a lot to participate in so far, but we are sifting through the rubble. The post-IPO blues can send good businesses far below their listing prices as the market’s attention wanes and the reality of listed life sets in.

For example, the Forager Australian Shares Fund invested in online beauty retailer Adore Beauty (ABY) after its well-timed October 2020 IPO, but at a discount of about one-third to its IPO price. The Fund also invested in fintech lender Plenti (PLT), purchased a quarter below its IPO price. These are unlikely to be the last blown-up IPOs offering opportunities to patient investors.

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Insights

Insights Behind the Wheel of Carsales

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Insights

ThinkSmart Torpedoes Efficient Markets

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Efficient Market Theory is the idea that asset prices accurately reflect all available information and thus it’s impossible to beat the market on a risk-adjusted basis without luck, and lots of it.

This is not another pointless rant against a theory nobody believes in literally, at least in its hard form.

But anyone who has ever invested in the sharemarket recognises the usefulness of the idea. Markets are mostly efficient, most of the time. When it’s time to make any investment, we better have a good theory as to why we’re right and “the market” is wrong.

Seamless information flow, more analysts, more computer power. These are but a few reasons why markets are also getting more efficient over time. Although their periodical insanities may also be getting more extreme too.

Still, markets can be surprisingly ignorant from time to time. Especially at the smaller end of the market.

Afterpay’s little cousin

Afterpay (ASX:APT) and ThinkSmart (AIM:TSL) are joined at the hip. Afterpay needs no introduction for Australian investors. The Buy Now, Pay Later (BNPL) giant took the Antipodes by storm. It is now doing the same in the US and UK. Early investors have made 20 times their money and it is now one of Australia’s largest companies by market capitalisation.

Thinksmart won’t be so familiar, unless you are an investor in our Forager International Shares Fund (which has made a lot of money out of the stock over the past few years).

A few years ago when Afterpay was focused on Australia, tiddler ThinkSmart started a copycat business in the UK called Clearpay. When Afterpay decided to take on the UK, they deemed it wiser to acquire the fledgling Clearpay than start from scratch.

That’s how ThinkSmart ended up with a 6.5% stake in Afterpay’s UK operation, which is overwhelmingly ThinkSmart’s main asset. Afterpay has the option to buy this 6.5% stake in Clearpay from mid-2023, and ThinkSmart has the right to force Afterpay to buy it from mid-2024. The sale price will be based on “agreed valuation principles” which link to Afterpay’s market capitalisation at the time of purchase and the size of the UK business relative to Afterpay’s other markets come that date.

For a few years now, it’s been pretty easy to calculate fair value for Thinksmart shares. The two stocks should walk largely in lockstep (adjusted for any moves in the UK pound against the Australian dollar). Even if you think ThinkSmart should trade at a large discount to fair value, which it has, the shares should still dance in tandem.

And yet, here’s what happened over the first 6 months of 2020.

Afterpay shares rose 99%. And ThinkSmart shares fell 11%.

It was enough to perplex some folk:

Pretty stark contrast in recent share price performance between Afterpay ($APT) and ThinkSmart ($TSL), which owns 6.5% of Clearpay in the UK.

+100% vs nada. pic.twitter.com/WRY8mIs2KX
— Gareth Brown (@forager_gareth) July 2, 2020

Buy Now, Rally Later

And what about the almost 9 months since 1 July 2020?

Afterpay rose a further 73%, ThinkSmart 271%.

Efficient markets?

As you might have guessed, we’ve been selling ThinkSmart shares aggressively over the past few months and have been putting the proceeds into more certain bargains. We sold the last of our shares a few weeks ago. The stock is still cheap enough to make sense to a long/short fund. But for us, the Afterpay exposure is unhedgeable, and we don’t want to own it at anything other than a gaping discount.

What about that all-seeing, all-knowing market? Well there’s still plenty a diligent investor can do to gain an edge over it. Look hard and think smart.

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Insights

Big Short Interest: Should You Be Worried?

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Chief Investment Officer, Steve Johnson, discusses what can take place when short interest arises in a stock and raises the question of whether this should be a cause for concern.

Watch this video to gain an insight into the upside of knowing both the bear and bull case for a stock.

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Transcript:

Hi everyone, and welcome. It’s Steve Johnson here, Chief Investment Officer at Forager Funds Management. Today we’re going to talk about shorting stocks. Not us shorting stocks, but when others are shorting a stock that you’re invested in.

Chloe walked in this morning, swearing her head off. That’s not true, she wasn’t actually swearing, but she was very unimpressed that the share price of Stitch Fix was up 30% in the aftermarket. This is an online retail stock that she’s been researching. They put out some pretty good results yesterday, and the share price jumped 30%. The thing that was really surprising was she said there is a 37% short interest in the stock. Now this means that of the company’s total register, 37% of its shares have been sold short by hedge funds, who are betting that the share price is going to go down. Those people are probably going to be losing a lot of money when the stock starts trading tomorrow, and they’re probably going to have to buy it to cover their positions.

This brought up a really interesting issue. We’ve actually had a stock in our international fund, Celsius, which has had a big short interest in it for most of the past year and the share price has gone up sevenfold. The question is, when you see a big short interest in your stock should you be worried that a lot of people want to sell it? Or should you see it as a reason why the share price might react very strongly if they can produce good results? The answer is obviously a bit of both. We’re always concerned when a short interest arises in our stock, particularly when one of those big shorting reports comes out.

The good news about that is we always want to know what the bear case is on a stock if we’ve got a strong bull case, and understand why people on the other side are selling it. Usually with the shorters, they’re pretty public about their concerns. You can go and get the report, you can read it, do your own research and work out whether you think they are right or not. We’ve been willing to overlook their concerns in a few situations. I think the big upside in these stocks is that when they are wrong, it can cause a surge in the share price in a very short period of time as they’re all rushing to get out of their positions. You can see the short interest in all of the ASX listed stocks on the ASX website. It’s a really good idea if you are researching something on the long side, go and have a quick look at how big the short interest is. Then you can usually Google a short interest report about the company that you’re looking at. It’s an interesting way of seeing the bear case.

That’s it for today. We’re coming up to Christmas over the next few weeks, but we’ll keep producing a few videos to keep you up to date with what we’re doing. Thanks for tuning in.

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Insights

Volatility: Only a Risk for the Unprepared

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“Risk adjusted returns”. That’s one of the more common phrases you will see on fund manager websites. It is, after all, what we are all trying to do: maximise returns and minimise risk.

The return part of that equation is a straight forward number. But how do we measure risk? And who am I minimising risk for? They are not easy questions to answer. Certainly not as easy as the industry would have you believe.

As the sole measure of risk, share price volatility has been a bugbear of mine since I studied economics at university. It simply made no sense to me that a company whose share price was volatile was necessarily riskier than one with a stable share price.

Volatility is not risk for everyone

One, your time horizon is crucial. If you need to sell your shares next week, then stock price variability is a significant risk for you. If you have the capacity to hold an investment for 5 or 10 years, what happens next week doesn’t matter.

Second, volatility is itself a variable. A stock that has historically shown very little volatility can become highly volatile, and vice versa. Look no further than March’s meltdown, where shares in airports went from trading like infrastructure safe havens to highly volatile tourism stocks.

Most importantly, though, for an investor with a long time horizon, volatility can be more friend than foe.

Volatility is risk for someone who needs to sell. For someone who wants to buy, it can be an appealing feature of an investment.

Low prices equal lower risk

We want to buy shares at highly attractive prices. Almost by definition, the more a share price bounces around, the more chance that, at some point in time, it trades well below its fair value.

Further, the smaller the gap between your purchase price and fair value, the higher the risk that fair value is less than your purchase price over the long term.

When used to invest at low purchase prices, higher volatility can actually reduce investment risk.

Market volatility can be stomach churning. It’s hard to enjoy your breakfast when reading about the billions of dollars “lost” on global sharemarkets. But, if you’re a Forager client, you should welcome it. With volatility come the genuine opportunities for risk-adjusted returns.

Insights

The Value Case for Uber Technologies

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“I have no way to value it and neither does Steve because they need to increase prices to have a sustainable (presumably smaller) business … I just see that y’all are long garbage like that and [Forager is] plainly uninvestable for me unless you get your act together.”

That’s one investor’s feedback on our recent investment in Uber. He isn’t alone. We’ve never had a more visceral response to a new portfolio addition.

Uber is not the first unprofitable company we’ve invested in. In fact, some of our International Fund’s most successful stocks, Lotto24, Bonheur, Blancco Technologies and Betfair were loss-making at the time of investment. But Uber seems to be the most controversial.

Perhaps that is part of the opportunity. But I’ll come to that at the end.

The aim of this blog is to raise and address some of the key questions. And get some considered feedback (I’m guessing there will be plenty of feedback, considered or not).

Here are my answers to the main issues people have with the investment.

Issue 1: This business shouldn’t even exist. People only use it because it is cheap. The service is only cheap because Uber subsidises it.

Forget about all the economic rationale Uber puts forward for its existence. There might be some benefits to utilising a car fleet that is mostly idle. There are definitely benefits to a workforce that can flex depending on demand, as anyone who has tried to get a cab home on New Year’s Eve can attest. But these are not the main reasons ridesharing has a place in the world.

The ridesharing segment exists for two reasons.

One is regulatory arbitrage. Prior to the arrival of Uber in Sydney, a set of taxi plates cost as much as $400,000 to buy. That’s a lot of money for two small pieces of aluminium. They were worth so much because their supply was constrained by the NSW government and the pricing of taxi rides artificially inflated.

For a driver who wanted to lease some taxi plates, the going rate was $300 a week (roughly a 4% annual return for the plate owner). So before worrying about fuel, depreciation, Cabcharge’s take, insurance and the like, a driver had to earn $300 in fares just to cover the economic rent.

Along comes ridesharing and says “how about we split this $300 between customers (lower prices), drivers and the booking platform?” Wherever supply of taxi plates is constrained (everywhere, basically), you can offer lower fares and still make a profit.

The second is because it is a better service. I’m guessing you’ve had the same taxi experiences as me. Bookings that don’t turn up. Drivers that don’t know the way. Drivers that do know the way but intentionally take you the long way around. Drivers that won’t take you at all because it’s a busy night and the fare isn’t long enough. Cars that stink and rattle.

I’ve had the odd bad experience with Uber, too. But they are few and far between. For the most part, from booking to leaving the car, the experience is seamless.

According to a recent UBS survey, only half of users cite cost as the main reason for using a ridesharing service:

Convenience matters, a lot. With the recent addition of government charges, it is hardly cheaper for me to use Uber relative to a cab. I do it because I prefer it.

More than 100 million different people used an Uber service in the last quarter of 2019, suggesting I’m not the only one who values it.

Issue 2: There are no barriers to entry. A constant stream of new competitors means Uber is always losing money.

It’s true. Pay a driver enough and they will put your app on their phone and a sign in the back window. Offer free rides and you will undoubtedly get a few users to try your new ridesharing service. That bit is not difficult. But this is a scale game.

"Very small differences in UI and UX (user interface and user experience) matter immensely … if you are 0.5% better, that can be the foundation of hundreds of billions of dollars in market value." – Gavin Baker on the Invest Like the Best Podcast

To offer a competing service, you need the same infrastructure as the large, established player. You need an app that is at least as good. Useability is hugely underrated, difficult and only noticed when it is bad. You need the same number of drivers, so that there is always availability. You need marketing, distribution and customer services teams.

If one participant can reach a dominant market share, they are almost impossible to dislodge. With roughly similar overheads, the largest player makes more money (or loses less) at every single pricing level.

'if you build it, they will come' pretty much only works in the movies. Demand aggregation is really, really hard @bgurley https://t.co/9TAneHm5j5
— christian dahlen (@mercurygod) April 21, 2020

That’s why every city ended up with one highly profitable newspaper in the twentieth century. It’s why Virgin Australia could never make a profit. And it’s why Uber’s competitor Lyft, with roughly one third of the ridesharing market, is struggling in the US.

It’s also why the competition is so ferocious in the early years. Everyone knows that only the largest player is going to make money at maturity, so they are willing to spend a fortune trying to get there.

It’s a fight that Uber has won in most of the western world.

Having withdrawn from expensive forays into Asia, Uber is now number one in every market that it operates in, with market shares higher than 65%. Trying to dislodge them now is pointless, and that’s why you are seeing a lot fewer companies try.

Issue 3: They are just going to waste money on hare-brained schemes like driverless cars.

This is going to surprise quite a few people. Uber’s ridesharing business (Rides) is already profitable. And not just a little bit. It contributed $742m of EBITDA (earnings before interest, tax, depreciation and amortisation) in the December 2019 quarter, almost four times the $195m it made in the same period the previous year.

Yes, there is $644m in corporate expense. And there’s another $350m of operating expenses that come underneath the EBITDA line. But the profitability of Rides was growing fast prior to COVID-19. It will resume growing fast once the world economy starts to recover. The business as a whole was expected to break even at the EBITDA level in 2020, thanks to significantly reduced losses in its Eats business (see below).

This is not the Uber of old. It is not the Uber most people think it is.

Uber was founded by, Travis Kalanick. Uber would not be what it is without him. First mover advantage was crucial and his single-minded vision of global domination meant that it was Uber, not one of its many copycats, that ended up dominating most Western markets.

Backed by seemingly unlimited funds from Softbank’s Masayoshi Son, Kalanick’s ego became a significant liability from 2016 on. His attempts to dominate eastern markets and build driverless cars were costing a fortune. His disrespect for drivers, customers and anyone else who crossed him was a giant public relations disaster.

"It was the middle of winter of 2017, and Jeff Jones, the man responsible for Uber’s public perception, was trying to shake everyone in the top ranks of the company awake. Uber didn’t have an image problem. Uber had a Travis problem." – Super Pumped: The Battle for Uber by Mike Isaac

You might not have read much about Uber lately. I doubt many would be able to cite its CEO’s first name, let alone his surname. That’s a good thing.

Kalanick has been out the door since August 2017. Masayoshi has his tail between his legs after the meltdown of his futuristic Vision Fund.

Uber’s other shareholders were fed up with the damage Kalanick was doing to their investment and appointed Dara Khosrowshahi to point the company on a path to profitability and respectability.

Dara has been delivering. Uber has exited markets where it doesn’t see a clear path to being the number one player. In most cases, that has been in exchange for a significant percentage of the remaining dominant player. Today the company owns stakes in market leading regional players such as Didi (China), Grab (South East Asia), Zomato (India) and Yandex (Russia). Uber recently announced a COVID-19 related writedown of these investments, but still pegs their collective value at more than $10bn.

He has worked tirelessly to improve the company’s public reputation and relationship with drivers, introducing tips for drivers (something Kalanick refused to budge on) and working on new legislation to provide drivers and passengers more protection. The more this industry is regulated, the higher the barriers to entry.

The path to profitability and beyond has been clearly, transparently and consistently presented to investors.

The last remaining significant impediment to profitability is its food delivery business, UberEats. Progress has been highly encouraging.

The South Korean and Indian food delivery landscapes have already rationalised over recent months, thanks to Uber’s sale to Zomato. The Indian business alone was costing Uber $350m of annual losses. Its sale was the reason for EBITDA breakeven being brought forward by one year to the end of 2020 (prior to the impact of COVID-19).

UberEats’ key market is the US where there are four large players and consolidation is likely, perhaps even accelerated by the current environment. Two of the four (Postmates and DoorDash) are private. Postmates has attempted to IPO twice, unsuccessfully, and there is a clear urgency to sell or merge given it is a sub-scale player in a highly competitive, cash-burning market.

DoorDash has been aggressively using discounting to drive growth, all funded by cheap venture capital money. The company had raised a total of $2bn through December 2019 and lost $450m of EBITDA in 2019. Estimates suggest that Doordash is likely to have at most $550-650m of cash as of the start of 2020 and, given the COVID-19 situation, they are likely to be forced to merge or raise further capital at a discount and attempt to become more price rational.

Provocative question Roman! Which company (@Grubhub , @UberEats , @Doordash, @Postmates) will need to bend first/fastest to profitability? We know that 3/4 of the players in US food wars are heavy cash burners. That makes the analysis calculable... https://t.co/zvXS8VUqxT
— Bill Gurley (@bgurley) January 17, 2020

In January 2020 GrubHub said they are considering alternative strategies including a possible sale of the business amid increasing competition and continued share loss to the likes of Uber.

This theme is unfolding the same way in other key markets around the world. And when the war ends, industry profitability changes dramatically. China’s Meituan went from losing $200m per quarter to making $300m per quarter following industry consolidation (it took just 12 months). Uber’s CFO recently said that Eats is already profitable in more than 100 cities, and that just 15% of bookings contribute half of its EBITDA losses in that segment.

Rationalisation is well under way and, in a few years’ time, this market will be no different to ridesharing. There will be one or two profitable players in each geographic market, and Uber will own more than a few of them.

I’d argue the permanently loss-making question was still open for debate at the time of Uber’s IPO in May 2019. But the steps taken in the 12 months since leave no room for doubt. Shareholders and management are committed to making money. They are on a very clear path to doing so.

Issue 4: How can you possibly buy Uber and call yourselves value investors?

This question perplexes me somewhat. It’s ok to buy Facebook at $190 a share now that it is profitable, but it wasn’t ok to buy it at $25 when it was losing money?

Uber is no different to any other investment we have made. We estimate how much it is worth, based on future cashflows the business is expected to generate, and compare that to the current share price.

The IPO price was $45 a share. At that price (and at that time), you needed a lot of growth and/or optimistic profit margins in the near future. You also had a lot of unanswered questions, particularly whether management’s focus on profitability was genuine.

We missed the bottom by a couple of days, but our entry price into Uber is approximately $23 a share. We have had a year of disposals, exits and improving margins. Governance and capital allocation gets a tick. And at half the price, the assumptions are a lot less heroic.

Here’s our base case. That $23 share price equates to a market capitalisation of about $40bn. Those minority shareholdings in Didi, Grab, Yandex and Zomato are worth $10bn, leaving us with a $30bn purchase price for the core Uber business.

Our expectation is that revenue will double over the next five years to more than $30bn. EBITDA margins will continue rising to 15% or more. That’s $4.8bn of EBITDA, from which we subtract $1.8bn of share based compensation and depreciation. We’re expecting at least $3bn of EBIT by 2025, flowing into the coffers as cash.

There is clearly a wide range of potential future outcomes. That’s why Uber is 3% of our portfolio, a relatively small weighting. But those are numbers you can hold us to. I expect the business to do better. And, if it is making $3bn of EBIT and still growing, it is going to be worth a lot more than $30bn in 2025.

A stock that people love to hate

None of this is wildly different to analyst expectations on the stock. Almost all investment banks have valuations of $40 or more. Which makes you wonder why it was selling for $23.

We’re about to experience a gigantic global recession and Uber’s Rides business will suffer accordingly. There’s one good reason. But I think it’s more than that.

The views of our critics are widely held. The perception is that Uber is an uneconomic business run by a nutter who is happy to lose money forever. I’ve engaged with a few of our clients who feel this way, and haven’t yet come across one who has read last year’s annual report.

It’s a view that was accurate three years ago. The fact that Uber has changed so much is where the opportunity lies.

If we’re wrong, we’re going to get crucified. That’s a risk I’m happy to take.

*All currency is USD unless otherwise stated

Insights

Fortnite is Changing the Game

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My little brother is one of millions of crazed Fortnite fans. His current routine involves playing the online game in his toy room with headphones in, while simultaneously watching someone else play on his iPad.

For context, he’s in primary school (it’s complicated) and he’s clearly not alone. It’s allegedly injuring elite sportspeople, being cited as a cause of divorce and doctors are saying it’s as addictive as heroin. I hear middle-aged men in suits discussing Fortnite strategy on my commute to work.

For those of you who aren’t familiar with the game, it starts with one hundred competitors dropping from a virtual flying bus onto a colourful cartoon island. The aim is to be the last one standing at the end of the “Battle Royale”. There is killing involved, but it’s not visual. There is no gory detail, which has almost certainly contributed to the game’s mass adoption.

I’m not a gamer. But as an analyst, if people are obsessing over something, then I want to know more about it.

Scale is important, but it isn’t everything

Gaming is already a big business. Generating more than $120bn in annual revenue, the global games market dwarfs the takings of Hollywood. The industry has grown more than 10% annually for the last five years and doesn’t look like it will slow down any time soon.

Shareholders of the three industry giants, Take-Two Interactive Software (Nasdaq:TTWO), Electronic Arts (Nasdaq:EA) and Activision Blizzard (Nasdaq:ATVI) have done exceptionally well. Even with the recent price falls, a five-year investment in these stocks would have returned more than 300%, 200% and 100% respectively.

And for good reason. Video games can cost upwards of $200 million to develop. They require large teams and lots of experience. This creates significant barriers to entering the industry.

Fortnite’s new business model

Fortnite is both a threat and an opportunity to the existing cabal. Epic Games created it. They’ve been around for some time, but aren’t one of the big three. That, presumably, means the barriers to entry aren’t insurmountable.

But I still think big budgets and experienced teams are likely to win the day. And the economics of these new free-to-play games are mouthwatering. Distribution is online, cutting out the margin to distributors like Gamestop (NYSE:GME), which is currently trading almost 80% lower than its 2013 highs.

And, despite being “free”, they generate bucketloads of revenue. Fortnite generated US$2.4 billion in revenue in 2018—the highest yearly takings of any video game ever. Last reported player numbers stood at 200 million, and there is speculation that there were 10 million concurrent players during a recent online concert. Revenue is generated through in-game purchases—largely costumes, which are referred to as ‘skins’.

The ability to continue updating the game with new seasons (approximately every 10 weeks) means that revenue should keep flowing for years.

Big boys enter the fray

Electronic Arts recently released their own free-to-play, ‘Battle Royale’ title, Apex Legends.

The marketing strategy for Apex Legends was very different to EA’s historical releases. For one, it was only announced within a few days of the official release date. There were no teasers or heavy public relations campaigns—the company relied on “influencers” to market the game. EA reported ten million registered users and one million concurrent players within the first 72 hours.

At the one week mark, 25 million players and two million concurrent players were announced. These numbers are significantly higher than the Fortnite launch. It’s too early to tell whether Apex Legends will be more popular than Fortnite. Or whether EA will be successful in monetising the game. What is clear, though, is that these new releases are gaining traction much faster than their predecessors.

Creating games with addictive gameplay and high skill curves, like shoot-em-up hit Halo, should continue to be a profitable business. The new free-to-play model has the potential to be even bigger. Entrenched industry players with large budgets are in a good position if they can work out how to best capitalise on current trends.

We don’t own any of the stocks mentioned, yet.

Insights

Now is NOT the time to panic

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Occasional contributor to The Intelligent Investor Tony Scenna once remarked ‘if you’re going to panic, panic early’. With the market down 21% from its peak in November last year, now isn’t the time to be switching to cash. In fact, the All Industrials Index (which excludes resources companies) yesterday hit a two-and-a-half-year low.

Screaming bargains are still hard to find. The most significant pain has been in the sectors that were most overpriced – namely insurance and banking. Even in these sectors, though, we have high-quality businesses like QBE Insurance coming back to much more reasonable prices. Overall, industrial companies are 29% cheaper than they were in November.

Sure, there’s plenty to worry about. Credit crises, liquidity crises, a US recession, a global slowdown, Australia’s dependence on the commodity boom – the list goes on. But there’s always plenty to worry about. The time to do something about it is when conditions seem best. Consider the big banks. For the past two years conditions have been perfect and the banks have been lending money willy-nilly and at prices that in no way compensated them for the risks. That was the time to worry.

Now the big four banks’ competitors are dropping like flies. Macquarie Group has quit the market for mortgages and most of the non-bank lenders are on their last legs if not already dead. Risk is once again being priced appropriately at worst and attractively at best. That’s a recipe for future profitability. And in anticipation of that profitability, you should be considering buying, not selling.

For mine, at two times book, the banks still aren’t screaming value, especially given that some of the stupid loans made over the past few years are yet to manifest themselves as bad. But they’re a lot cheaper than they were.The same holds true elsewhere. In some areas of the market – particularly among heavily indebted companies – the falls look justified. But many high-quality and well-financed businesses have been dragged down alongside them. Cochlear (-30%), Macquarie Group (-48%), ASX (-38%), Westfield Group (-21%), Aristrocrat Leisure (-39%), Billabong (-34%), Cabcharge (-34%), Computershare (-28%) and Harvey Norman (-51%) are just the ones off the top of my head. Some of these make better buying opportunities than others, but in all cases we’re certainly past the time for panicking.

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Pay Now, Save Later

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Afterpay, and now Flexigroup, are changing the face of consumer credit. In the old world, someone who didn’t have funds available for a medium sized purchase either went without or went into debt. Any costs associated with that debt was borne by the consumer. It was a customer-pays funding model.

Buy now, pay later has changed all that. The new world is a retailer-pays model. When a customer buys a new suit using Afterpay, the retailer pays a 30 cent transaction fee, plus a commission ranging from 4-6% of the sale price. That’s how Afterpay makes money - err, intends to make money - providing ‘free’ funding to consumers.This is a hefty burden for the retailer versus the transaction costs associated with a more conventional sale, typically in the range of 1-1.5% whether by credit/debit card or cash.

Of course, retailers aren’t charities. They’ll try to push up the sticker price to compensate for the increased cost burden. Whether they’re successful or not, one thing is evident. Those of us with the ability and desire to pay upfront are subsidising the funding of those using the more expensive buy now, pay later approach.

Afterpay and now Flexigroup are changing consumer credit from customer-pays to retailer-pays. It's time those of us with the ability/desire to pay upfront start asking for discounts. Otherwise we're subsidising buy now pay later. 5% is about right. Don't ask, don't get.
— Gareth Brown (@forager_gareth) February 26, 2019

Retailers are clearly happy to make the sale via Afterpay even if their net proceeds are 3-5% lower. As a matter of principle, I’m going to start asking for 5% discounts for upfront payment wherever buy now, pay later is offered. I don’t care about the few bucks. But I do care about subsidising some snivelling hipster into trousers that are three inches too short. Enough!

Problem is, I’m not much of a discretionary consumer. A pair of jeans and a few plain t-shirts from Kmart annually, and a suit every few years. The rest goes on kids, rent and Sydney tolls.

So can we make this a collective effort? Let’s make the comments section of this post a depository of our successes and failures in getting discounts for paying upfront. Let us all know how you go.

As Mr Micawber once said:

Annual income twenty pounds, annual expenditure nineteen nineteen and six, result - subsidising Millennials....

It's time to end this rort.

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How to Retire Happy, Comfortable and Property Free

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My parents, some investors, politicians and a large number of journalists seem very concerned about me. I’m one of the renter generation, and everyone seems worried about us because they think we are going to retire without a roof over our heads.

Please don’t concern yourself. Yes, it’s true. My wife and I don’t own a house. But we do have a very clear plan for living a happy and secure retirement. For any of my fellow renters out there, here is a simple three step plan for you to do the same.

Let’s begin with a few assumptions.

Rent versus own

I am going to use an example of a 30-year-old renter in Sydney or Melbourne considering buying a home to live in. The assumption is you are 30 years old and are currently renting a home for $700 per week, or $36,400 per year. You and your partner have saved $200,000 thanks to financial discipline and some good investing and now have enough for a deposit to buy the home you live in, or something equivalent.

The market price is $1.3m, equating to a 2.8% rental yield, roughly in line with average rental yields in Australia’s two largest cities at the moment. Adding stamp duty you will need a $1.16m mortgage. To pay it off by the time you are 60, assuming a 4.5% interest rate, you will need annual repayments of $71,291 to the bank, or slightly less than $1,400 per week. You’ll also have council rates and maintenance on the house, which I have pencilled in at $8,000 per annum, so a total cost of home ownership of $79,291 per year.

Your alternative is to rent for the rest of your life. Assuming 3% annual rental escalation, by the time you are 60 your rent will have more than doubled to $88k per annum. Follow my simple three steps, though, and you will have enough investment income to cover the rent for the rest of your life, and more than $73k^[1] per annum of additional spending money. Here’s what you need to do:

1. Save what the homeowners save

The one irrefutable benefit of taking out a mortgage is that you are forced to save. If you want to do better than your homeowning friends, you have to be at least as disciplined. The most important element of our savings plan to is put away the difference between your rent and the cost of owning the same home. In year one that’s going to be almost $43,000 and the early years are particularly important. The rent is going to increase while the mortgage repayments stay the same (see the chart below). In fact, by the end of the 30-year period, our rent is going to be more than a homeowner’s cost of owning a home^[2], but by then we are going to have a big pot of money stashed away.

While you are looking at the chart above, let’s end some arguments before they start. This blog post is not about whether you will be better off renting than owning a house. That will depend on dozens of different variables that I don’t have the answers to.

The point I’m making is that, if you have the discipline to save those black bars and invest them sensibly, you are going to retire with a big pot of money. Whether it’s bigger than the value of the same house in 30 years’ time, I don’t know. But it will be more than enough to cover the rent.

2. Minimise tax on your investment returns

Homeowners get a few free kicks from the tax office but there are plenty of things you can do to keep your own tax low. Most beneficially, get your savings into a super fund where the tax rate on long term investment gains is only 10%. I have assumed you can contribute the initial $200,000 deposit you have saved as a non-concessional contribution and keep doing the same with your post-tax savings. You will do a bit better than this if you have room to make more concessional contributions up to your $25k annual limit, but we will keep it simple for the purposes of this exercise.

As you can see in the chart below, keeping your tax rate low makes a massive difference to your investment balance at 60. Even if your starting point is a 40% marginal tax rate, if you do your saving outside super, your growing investment returns are going to push you up into the top tax bracket fairly quickly. I have assumed a 10% tax rate but your average tax rate will be even lower if you build wealth in a super fund, avoid realising gains for longer periods of time and generate a good portion of your returns as fully-franked dividends^[3].

3. Maximise your investment returns

Cash in the bank isn’t going to cut it. You need your money working for you. Minimise costs, and make sure the portfolio is invested in a portfolio of real assets like shares, property and bonds.

You should target total portfolio administration and management costs of less than 0.5% per annum, either through a low cost industry fund or running your own self-managed super fund. And I have assumed a 6.5% gross annual investment return, leaving you with a net return of 6% per annum. This is below the historical returns from most aggressive or even balanced low-cost super funds, but we are starting with high asset prices across the board and I think this is a sensible long-term expectation^[4].

The difference between a 7% return and a 3% return is staggering, as you can see in the chart below. At 3% per annum our savings will be $1.7m in 30 years’ time and the annual investment returns won’t go anywhere near covering your rent. At 7%, you will have $4.0m of savings and $160k per annum of spending money over and above your rent. If you can get to an average return of 10% per annum, you’ll have a balance of more than $7m^[5]. That’s the power of compounding.

Our base case, however, is that you can earn 6% net on your money. This, combined with your annual saving, is going to build you an investment pool of roughly $3m over 30 years. By the time you retire, these savings will be earning you $180,000 per annum before tax, more than double your rent.

No need to live in fear

There are plenty of non-financial reasons to want to own a house: security and flexibility to renovate just a couple of them. And for all I know property prices might keep rising and rental yields falling, meaning the mortgage-free home owner could end up with something “worth” more than the renter’s pot of savings. More importantly, most people I know aren’t capable of saving $3,000 a year let alone $30,000. A mortgage is the financial discipline they need.

This post is not to criticize anyone who does buy a house. I simply want to point out that there are alternatives. A life of renting is perfectly feasible.

Be as financially disciplined as someone with a big mortgage, invest the money sensibly and you won’t have to worry about retirement^[6].

Footnotes
[1] $3m savings at a 6% return = $180k per annum of investment income. Less 10% tax, less $88k rent equals $73k. Worth noting that your rent is likely to keep increasing during retirement, so you should be stashing some of the extra away to cover future increases in rent.

[2] Conservatively assuming interest rates, rates and maintenance costs stay the same.

[3] There is a big downside to building your wealth inside super: there’s no changing course half way. If you get 15 years into this 30 year plan and decide you would actually prefer to own a house, you won’t be able to access the super until you retire.

[4] Obviously there are lots of moving parts here. Returns could clearly be lower. Interest rates could also be much higher than 4.5%.

[5] Note that this is all separate from whatever saving you need to do to fund your ordinary retirement expenses. A homeowner is going to need something other than the house they live in to retire on, so this pot of money is just the “roof over my head pot”.

[6] I’m not a very disciplined saver. Thanks to a few successful investments, we are well ahead of schedule.

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What is Value Investing?

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Will Ingham’s be the Next Dick Smith?

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Just how similar are the Ingham’s and Dick Smith IPOs? Both are (or in Dick Smith’s case, were) iconic Australian businesses. Private equity firms bought both businesses from trade owners. They then floated them for healthy gains (Ingham’s lists this coming Monday). And in both cases, private equity sold a truckload of assets prior to listing, leaving incoming shareholders with hollow balance sheets.

But as far as one can tell based on the Ingham’s prospectus, that’s where the similarities end. Dick Smith’s main undoing was booking stock purchase rebates as revenue at time of purchase instead of at time of sale. No signs of that from Ingham’s.

So does that make Ingham’s a solid addition to your portfolio?

The first thing I did when I downloaded the prospectus was search for the word ‘Woolworths’. This took me straight to page 35. And there it was, powerful supermarket customers such as Woolworths, Coles, IGA and their Kiwi counterparts Countdown and PAK’nSAVE comprise over half of Ingham’s revenue. Throw in fast food giants like KFC and that total moves to 70%.

And therein lies a problem. The big risk for Ingham’s is not that it turns out to be another Dick Smith but rather another Goodman Fielder, Asaleo Care or Patties Foods. Or any other supplier to the supermarket channel, even Pacific Brands. When you have a commoditised product, dealing with powerful customers is not a recipe for earnings growth. It’s a recipe for wealth destruction.

Perhaps some investors will disagree with me because Ingham’s is an Australian icon. Tell that to the Woolworths and Coles buying departments. Make no mistake, iconic or well-known brands do not equal brand equity. Helgas, MeadowLea, Sorbent, Libra, Four’N Twenty and Bonds weren’t able to steer the fortunes of the above-mentioned companies towards growth. Pricing power is everything in domestic wholesaling and unless a product has true brand equity such as Coca-Cola, the supermarkets will dominate price negotiations.

Sure, maybe things will go ok for a year or two, while prices are locked in for the short-term and the vendor’s remaining shares are in escrow. But let’s look at what happened to the above-mentioned supermarket suppliers in the years following their IPOs.

After two or three years, their share prices started falling off a cliff. Why? They were dressed up for IPO as dependable staple goods manufacturers, paying a steady dividend stream from their stable profits. After a few years the reality set in. These companies would struggle to maintain profitability in the face of gruelling price negotiations with their powerful customers. Earnings were far more volatile than the inelastic demand for their products.

It’s hard not to see the same thing happening to Ingham’s. The business is expected to generate a return on equity of 76% in the 2017 financial year. How long will Woolies let that go on for?

And don’t get me started on valuation. The private equity vendors bought the business in 2013 for $869 million, sold $540 million of property in 2015 and are now floating it for an enterprise value of $1.6 billion. This implies a price to earnings multiple of 12 times based on forecast 2017 earnings, which are a whopping 91% higher than what the business earned two years earlier. For mine, this looks fairly valued at best, with little margin of safety given the risks.

‍

Insights

Will You Fitbit in the Future?

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From a standing start less than ten years ago, Fitbit (NYSE:FIT) has grown into a company with sales of almost US$2bn. It has been a remarkable growth story.

Fitbit essentially created a new product category, wearable technology. Its products record a multitude of things we previously didn’t know we needed to measure every second of the day, including heart rate, sleep quality and how many steps we took to grab that afternoon double vanilla latte. It has launched new products and entered new markets. Almost as impressively, it has generated solid and growing profits when many of its Silicon Valley brethren are struggling to prove their business models.

So then why is its stock price down 73% in the last 11 months? Something seems to be amiss. In the most recent quarter, Fitbit reported a 92% increase in sales, a 15% operating profit margin, and 37% growth in earnings per share. It has a ton of cash and no debt. These are drool-worthy results. Yet it is trading at only 12 times 2016 expected earnings. Any other tech company with similar results would be trading at astronomical multiples. <strong>Facebook</strong>? Try 37 times next year’s earnings. Twitter A cool 29 times. Square isn’t even expected to be profitable next year but while Fitbit is selling for less than one year’s revenue, Square trades at more than six times.

Truth be told, those aren’t fair comparisons. For all of Fitbit’s success, it is mainly a consumer gadget company. Perhaps a more worthwhile comparison is Apple, which also trades at 12 times earnings. Both companies need to keep selling vast amounts of physical product each year just to maintain their current profitability. The others mentioned are software driven platforms selling services that are much harder to replicate.

And that’s the rub. It is hard to imagine a world where everyone suddenly stops using Facebook. But your Fitbit? Now that your smartphone is able to provide you all the same data, you might just chuck it in the trash. Maybe you already have.

This is why the stock has collapsed and why it trades at such a low P/E ratio. These other companies trade at higher ratios because investors believe they will continue to grow at elevated rates, and at some point in the future, those ratios won’t look so high. Investors in Fitbit obviously do not believe it will continue its dizzying level of growth. Is this the next Kodak?

So here is my question to you? Will you Fitbit in the future? Are you familiar with its devices, and do you believe it provides a compelling service? The company is attempting to do more with its data and connection to the consumer by offering specialised health tracking services. Is this of interest, and does it differentiate Fitbit in any way? Is your historical data important to you? If you are considering a new device, would the fact that your historical data is with Fitbit likely sway your decision?

I’m curious to know what people think and appreciate any feedback.

Australian Shares

Dick Smith is the Greatest Private Equity Heist of All Time

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Want to know how to turn $10m in to $520m in less than two years? Just ask Anchorage Capital. The private equity group has pulled off one of the great heists of all time, using all the tricks in the book, to turn Dick Smith from a $10m piece of mutton into a $520m lamb.

Having spent the morning poking through the accounts, we're going to show you how it all happened.

Firstly, Anchorage set up a holding company called Dick Smith Sub-holdings that they used to acquire the Dick Smith business from Woolworths. They say they paid $115m, but the notes to the 2014 accounts show that only $20m in cash was initially paid by the holding company.

It doesn't look like they even paid that much, because they acquired the Dick Smith business with $12.6m in cash already in it. Dick Smith Sub-holdings was formed with only $10m of issued capital and no debt, and that is most likely Anchorage's actual cash commitment.

So if Woolworths got paid $115m and Anchorage only forked out $10m, where did the rest of the cash come from?

The answer is the Dick Smith balance sheet, and this is always the first chapter in the private equity playbook: pull out the maximum amount of cash as quickly as you can.

In this case, first they had to mark-down the assets of the business as much as possible as part of the acquisition. This was easy enough to do with a low purchase price. You can see in the table below, that $58m was written-off from inventory, $55m from plant and equipment, and $8m in provisions were taken.

The inventory writedown is the most important step in the short term. They are about to sell a huge chunk of inventory but they don't want to do it at a loss, because these losses would show up in the financial statements and make it hard to float the business. The adjustments never touch the new Dick Smith's profit and loss statement and, at the stroke of the pen, they have created (or avoided) $120m in future pre-tax profit (or avoided losses).

Now they can liquidate inventory without racking up losses. And boy did they liquidate.

At 26 November 2012, Dick Smith had inventory that cost $371m but which had been written down to $312m. Yet by 30 June 2013, inventory has dropped to just $171m.

That points to a very big clearance sale, and the prospectus confirms that sales in financial year 2013 were exaggerated by this. The reduction in inventory has produced a monstrous $140m benefit to operating cash flow, basically from selling lots of inventory and then not restocking.

The cash flow statement shows that Anchorage then used the $117m operating cash flow of the business to fund the outstanding payments to Woolworths, rather than funding it from their own pockets (note that the pro-forma profit was only $7m during this period).

And that, my friends, is a perfectly executed chapter 1: How to buy a business for $115m using only $10m of your own money.

Chapter 2 involves selling a $115m business for $520m, and it's a little more nuanced. The good news is that, while private equity are focused on cashflow, equity market investors aren't really focusing on how much cash has been ripped out of the business. All they seem to care about is profit.

So the focus now turns from the balance sheet to the profit and loss statement, and it's time to make this business look as profitable as possible in the year following the float (allowing them to sell it on a seemingly attractive ""forecast price earnings ratio"").

The big clearance sale in financial year 2013 leaves them with almost no old stock to start the 2014 year. That's a huge (unsustainable) benefit in a business like consumer electronics which has rapid product obsolescence.

Remember that marked down inventory? Most of it was probably sold by 30 June 13 but there would still be some benefit flowing through to the 2014 financial year.

Remember the plant and equipment writedowns? That reduces the annual depreciation charge by $15m. Throw in a few onerous lease provisions and the like, totaling roughly $10m, and you can fairly easily turn a $7m 2013 profit into a $40m forecast 2014 profit. That allows Anchorage to confidently forecast a huge profit number and, on the back of this rosy forecast, the business is floated for a $520m market capitalisation, some 52 times the $10m they put in.

Anchorage were able to sell the last of their shares in September 2014 at prices slightly higher than the $2.20 float price and walk away with a quiet half a billion. Private equity are renowned for pulling off deals, but if there's a better one than this I haven't heard about it.

‍Chickens home to roost

Of course, all of the steps taken above have consequences. By the end of 2014, inventory had increased to $254m, with new shareholders footing the bill for repurchasing inventory. This should have resulted in poor operating cash flow, but most of this was funded by suppliers at year-end, with payables increasing by $95m.

Come the end of 2015 financial year, however, it really comes home to roost. Operating cash flow was negative $4m, as inventory increases further and suppliers demand payment, decreasing accounts payable. The business is required to take on $71m in debt to fund a more sustainable amount of working capital. As the benefit of prior accounting provisions taper-off, profit margins fall, and the company reports a toxic combination of falling same-store sales and shrinking gross margins in the recent trading update.

Following a profit downgrade yesterday, the shares are now valued by the market at $0.77, and investors in the float are sitting on a 65% loss of capital from the $2.20 float price.

This float, as we pointed out in Dick Smith Takes A Bath, Comes Out Nice and Clean, smelled funny from the very beginning. Sorry Dick Smith investors, you've been had.

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I'm $100 Trillion Poorer

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How Much Do You Need to Save to Retire?

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Time For a Square Up on Taxes

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A little over a decade ago, I set up a discretionary trust to hold most of my investment assets. The structure means that income can be taxed at the corporate tax rate (currently 30%), which is lower than my personal marginal tax rate. Because most of my capital gains are discounted, they can be effectively taxed the same as if I held the assets in my own name.

I hate the paperwork, organising the additional tax returns, and the unnecessary accounting and ASIC fees. I’d much rather not have to do it. But, to quote or paraphrase Kerry Packer:

‘Anybody in this country who does not minimise his tax wants his head read. I can tell you as a government that you are not spending it so well that we should be donating extra.’

The problem with our tax system is that the investment income of the wealthy and super wealthy is being taxed at 30% or less, whereas someone saving a more modest nest egg (and likely unable to justify the expenses of a trust structure) might be taxed at higher rates. Aren’t we supposed to have a progressive tax system?

Unsurprisingly, perhaps, the Germans have it all worked out. They have punishingly high taxes on wages (which I cannot condone). But earnings from savings—whether income or capital gain—are taxed at 26.5%, which is actually quite a bit lower than the German corporate tax rate of about 30%. There's no financial incentive to set up an unnecessary structure to legally minimise tax. The family with a nest egg of €100,000 is not paying a higher tax rate on savings than the fifth-generation multi-millionaire.

Australia should consider doing something similar. I’d settle for parity between corporate tax rates and taxes on personally-held savings. And it's only fair that those on lower marginal tax rates would pay tax on savings at their lower marginal rate rather than 30%.

There would be a huge push back from vested interests, accountants and tax advisors for starters. And one could certainly make the argument that it’s unfair to tax savings at 30% when taxes on wages are up to 47%. But that argument would be almost irrelevant, because Gina Rinehart and Malcolm Turnbull are likely paying only 30% tax on their term deposit interest today.

Meanwhile, some young kid who’s working hard, earning good money and putting it away for a house deposit might pay 40% or more (including Medicare levy) on his term deposit. Surely nobody can argue that this is right and proper.

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Forager International Partners with Russia

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We first looked at dominant Russian bank Sberbank (MICEX:SBER) after a presentation at the Italy Value Investing Seminar in July 2013, filing it under ‘interesting’.

It barely collected any dust. The panic surrounding the Ukrainian crisis sliced more than one-third off the stock (in US dollar terms) in the first three months of 2014, and the Fund acquired a position in mid-April. The London-listed Sberbank American Depository Receipts (LSE:SBER) currently make up 2.5% of the Fund’s assets. Roughly half of the underlying Russian rouble exposure has been hedged back into US dollars, as partial insurance against greater turmoil in the region.

Sberbank dominates the Russian banking sector in a way that would make an Australian Big Four bank blush. It commands a 44% share of Russia’s retail banking deposits—partly a quirk of the 1998 crisis when a government guarantee applied to deposits with this bank alone. Every sane Russian transferred their bank account to Sberbank. It has about a third of the market for retail and corporate loans and far and away the biggest branch presence in the country. The Russian government owns a little more than half of the shares outstanding.

The bank has a significant funding cost advantage versus competitors, and this translates into a very high net interest margin (NIM)—the difference between what the bank pays on deposits and what it collects on loans—of around 6%. We are anticipating significant contraction in this figure over the coming years. But the high NIM versus competitors and the quite conservative balance sheet (for a bank) gives Sberbank ‘last man standing’ status among Russian banks in any deeper crisis. We also think any erosion of the NIM is likely to be compensated by a concurrent expansion in the loan book; Russia’s personal debt levels are extremely low by global standards.

Although the stock has risen 13% on the Fund’s average purchase price, it still trades on a price earnings ratio of about 5 and a price to book value of less than 1.0 times. This is extremely undemanding for a bank generating 20%+ return on equity, with a hardy balance sheet and an extremely impressive history of earnings per share growth.

The stock pays a 3.0% yield despite currently paying out only 15% of its earnings (versus, say, the Commonwealth Bank which pays out about 75% of its earnings). There is significant scope, and also fresh political pressure, to expand the dividend. But there are also opportunities to reinvest retained earnings at high rates of return. Either suits us fine.

We’ve gone in eyes wide open to the likely shrinking of the NIM and increase in bad debts over the coming months and years. Even allowing for that, the stock looks dirt cheap.

Of course, every investor in Russian stocks takes on some risk that their investment goes to zero. All Russian stocks, even those not controlled by the government as majority shareholders, should be viewed as a non-voting minority stake in partnership with Putin. While in the good books now, Sberbank might not always hold favour in political circles and no Russian company is completely immune from being Yukos-ed (wiped out). But we think it is considerably more likely that the Fund’s modest speculation will double or triple in value in a few short years, and feel the upside outweighs the risk.

This excerpt is from the Forager International Share Fund’s June 2014 quarterly report. Please download the report for more detail on the Fund’s recent activities.

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How You Can Help Forager Funds

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Mohnish Pabrai is a successful US investor and author. In the early days of his fund, he sat down with investors and told them that he’s going to focus on the investing and that they’re going to be his marketing team. A cocky declaration, sure, but also a task every fund manager would dearly like to outsource so that they can focus on investing.

As you’d know, we’d like for both the Forager Australian Shares Fund and Forager International Shares Fund to get a bit bigger—to where there’s a sensible trade-off between economies of scale on costs for the business and prospective returns for our clients.

But, as Steve Johnson has highlighted on numerous occasions, most recently in the video An introduction to Forager, we’re not going to change our spots to appeal to the investing masses. Our funds are only suitable for investors prepared to take the long term view (5 years), that have the stomach for periods of underperformance which will stem from being both contrarian and human (in return, we promise to learn from and forthrightly report investing errors to you), and that share a passion for the sort of unloved bargains both funds target.

In other words, we’d like to meet more people just like you.

Your past word of mouth efforts have helped us tremendously. Without wanting to stretch the friendship for which we’re immensely thankful, we could use an extra boost over the next few months. With the shift to the name Forager Funds, we’ve given up the name-association with Intelligent Investor. Potential customers think we’re newborns, and that modern arbiter of importance—search engines like Google—aren’t sure we even existed before 1 July 2014.

Here are a few ways you can help Forager get established:

- If you use LinkedIn, please follow Forager Funds Management

- If you use Twitter, please follow @ForagerFunds

- Facebook users, please ‘like’ us at Forager Funds Management

- If there are any Bristlemouth blog posts, tweets or media interviews that you enjoyed or think others might find useful, please share them with likeminded investors. Email your friend or, better yet, share via Facebook or Twitter. This alerts potentially suitable investors to our existence and also builds the company's Google search history. The recent AFR article 5 of the best young stock pickers profiles Steve and four other very capable fund managers. Look past the photography and pliable definition of ‘young’. We’ll keep writing posts and doing interviews that current and potential investors might find useful, please pass them on if you find them so.

- Share any monthly or quarterly letters you found useful (here’s the latest Forager Funds June quarterly). Written chiefly for existing investors, these letter are also a way for potential investor to gauge whether either fund might be a good fit for their portfolios.

We’re in your debt for the kind word of mouth offered over the past years, this business wouldn’t be successful without it. Please keep it up. We’re now going back to looking for cheap stocks and will leave the marketing mainly in your capable hands. Thank you!

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Low Interest Rates Don't Build Wealth

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The Issue of Over-Insurance

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Under-insurance is a regularly quoted by accountants, financial planners, and insurance companies (surprise) as an endemic issue in Australia.

To be fair most of the discussion centres around home and contents, life insurance, and business insurance, areas more worthy of attention than others. But it strikes me that we concurrently have an issue of over-insurance, people buying insurance they really don’t need.

The issue of both over and under-insurance centres on people not having a great understanding of their insurance needs. Whilst some people fail to consider their insurance requirements at all, others have been convinced by unscrupulous insurance operators that they should have insurance to fully cover the potential loss of just about any risk or expense they might encounter.

This might sound appealing but insurance is an expensive form of risk management. Claim ratios at major insurance companies are typically around 60%, which means you are paying a 2/3 premium to the probable value of your protection. I'm not suggesting that insurance companies are gauging, just that underwriting is administratively expensive and private companies require profits.

A better view of the purpose of insurance is that it should be used to protect you from risks that you can’t manage yourself. This would include risks that are either hugely expensive or that could erode your future ability to earn, risks that these sorts of insurance cover:

- Health insurance

- Income protection insurance

- Home insurance

- Life insurance (if you have dependants)

- 3rd party property insurance for your car

But not necessarily things like:

- Tenants insurance

- Credit card insurance

- Funeral insurance

- Travel insurance for domestic flights

- Comprehensive car cover

The last one might be a little controversial, but in my view if you can’t easily afford to replace your car in the event of an accident, the car is probably too expensive for you. If you have a car loan requires comprehensive cover you should look to secure that debt against investments where the interest will be tax deductible if you can.

Insurance is a personal matter; people have different levels of risk tolerance and different coverage requirements. But for the risks you are capable of managing without insurance, you’ll generally be better if you save on premiums and invest that money instead.

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Dick Smith Takes A Bath, Comes Out Nice and Clean

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Retail Investors Squander Billabong Capital Raising

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Free Option Anyone?

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We find a few amusing announcements when we trawl through the ASX looking for opportunities, and we thought we'd share this announcement by plastics company Millepede International (MPD) which has staked an early claim for the prize of most needlessly convoluted corporate transaction of 2012.

Millipede is to acquire Agline Pastoral, a Protein based intensive farming operation, by issuing 1.585 billion new fully paid shares (Millepede currently has only 273.8 million on issue). Prior to acquisition however, both Agline and Millepede intend to raise funds by issuing convertible notes.

Millipede will issue a note that converts into Millepede shares at 0.4c per share, but upon conversion each noteholder also receives a free attaching option with a strike price 0.5c expiring 15 February 2013.

The Agline notes will convert into Millepede shares at 0.2c per share, and once the transaction is complete a further 300 million shares will be issued to Silver Jubilee Overseas Inc. and Renalin Ltd as a kickback for services and advice relating to the acquisition. Finally to clean things up a twenty for one consolidation will occur if the share price trades at less than 20c after the transaction.

Confused? You're probably not the only one. Existing Millipede shareholders are likely to own only 10% of the new capital structure. We've seen a few capital raisings with free attaching options of late and they are of course not really free, being paid for through the dilution of the upside potential in the ordinary shares. The sum of all interests in the company's capital must, after all, add to 100%.

Usually investors will value options based on the potential of the underlying stock, but it is important to understand when a large number of options are on issue there is a feedback effect in play - the existence of the options actually affects the stock. A good example of this is construction company VDM Group (VMG) which last November issued 1 free option for every 2 shares on issue at a strike price of 5c.

If you were considering investing in the ordinary stock you need to consider that if the stock trades above 5c when the options expire in November 2013, the option owners are going to obtain one third of your equity at a bargain price. You need to adjust what you are willing to pay for the stock accordingly.

These free options are really an excuse for investment bankers to justify their fees and an attempt by unscrupulous management to boost the morale of shareholders who are naive enough to fall for it. ASIC should take a close look at this sort of nonsense as it is designed to mislead the investing public.

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Retirement Villages Going Cheap

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I’ve been spending some time on the small end of the listed property trust market. They weren’t always so small, but now there are quite a number with market capitalisations of less than $50m.

I already touched on Galileo Japan in The Value Fund already has a large stake in RNY (the old Reckson New York Property Trust). Real Estate Capital Partners USA(RCU) looks to have some interesting optionality. It agreed to buy the US portfolio of Record Realty back in February but has had trouble arranging finance. The deal has been extended umpteen times but this Friday looks like the drop dead date.

I still have no idea where it is going to get the cash from, but the current price looks interesting (the market cap is $20m, they have paid a $12m non-refundable deposit on the Record Realty portfolio and have a bunch of US property themselves).

Most of my time, though, has been spent on ING Real Estate Community Living Group (ASX Code ILF). ILF owns retirement villages here and in the US. Remember the 'ageing population' investment craze? This property trust is a remnant of that mini-bubble and its performance, just as Gareth Brown suggested in Cashing in on the retirement boom, has been appalling; down more than 90% from its $1 listing price.

The interesting thing about it now, a bit like RNY, is the limited recourse nature of the debt. The overall loan to value ratio (LVR) is 73% but most of the debt is tied to the US business and is limited recourse to those assets.The LVR on the Australian assets is only 41% and, out of a total of 24.9 cents of net tangible assets (NTA), 13.6 cents is attributed to the Australian portfolio. The current share price is 8.6 cents, so you’re getting the Aussie assets at a 37% discount to NTA, already written down substantially over the past few years, and the rest of the assets thrown in for free. So what’s the catch?

Well, I always like to compare these NTA figures to the income the assets are spinning off. If you’re buying at a big discount to NTA, you should be getting massive yield on your investment. The US assets still in ILF’s portfolio generated $6.1m of operating income last year and the Australian and New Zealand assets $11.1m. Subtract $8.3m of finance costs and you are left with a total of $8.9m of net operating income.

That is a substantial amount of income for a trust with a market capitalisation of $38m and corroborates the underlying NTA. The problem, before we all run out and load up, is that the owners don’t get to see most of that income.Underneath the operating income line come the trust’s operating expenses ($2.5m) and ING’s management fee ($3.3m). In total, fees and admin charges chew up an extortionate 62% of operating income. (Last year’s numbers were boosted by $7.4m of derivatives income which won’t be recurring, making the overall numbers look more respectable.)Apparently one of the main challenges for 2011 is ‘replacement of earnings from derivatives and divested assets’. Any ideas, anyone?

I'm having trouble tracking down the management agreement for this trust but, in the right hands, its assets are clearly worth more than the current unit price suggests. As things stand, though, it's ING that is getting all the value.

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Rain Stinks for Bumper Wheat Crop

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It’s been some 15 years since I lived on a farm. I have become citified, my mother would tell you. A ‘yuppie’, in my father’s language.

It’s true. I feel at home in big cities, not in the bush. But whenever I return to the family farm, the memories come flooding back. For many people sights and sounds invoke memories. For me, it is the smell of the bush.

The smell of a diesel engine finally silent after 12 hours on the go. Freshly baled lucerne hay. Morning dew and the dry air of a summer sunrise. All these things bring back memories of my specialty, night shifts on the round baler, and the satisfaction of a finished paddock, job well done.

More than anything else, though, I remember the different smells of rain. The smell of an approaching storm rolling down the valley. The smell of rain on 40 degree schoolyard asphalt. Or the smell – it only lasted 30 seconds – of the first drops of rain bounding off a dry dirt paddock.

The reason the smell of rain stayed with me is because our livelihood depended on it. It could bring joy – the smell of a drought breaking before your nose – or heartache, as tens of thousands of dollars worth of hay rotted in the paddock.

For most of 2010, farmers in Australia’s eastern states have been rejoicing at the smell of drought breaking rains. For 10 years they have suffered the worst drought conditions in living memory. This year, it has rained, and rained, and rained, to the point where dams that many thought would never be full again are at capacity.

At the moment Australian Crop Forecasters are holding firm with their forecast of a 23.9m tonne wheat harvest this year, up about 10% on last year’s crop. With Western Australia only producing half last year’s 8m tonnes, the eastern states are expecting a bonanza and, even better, prices are also the best they have been in years. With many family operations taking on substantial amounts of debt to survive the past decade, 2010 was shaping up as the bumper season everyone so desperately needs.

If that is to happen, they need the rain to stop. Now.

Too much rain at this time of year makes it impossible to operate harvesting machinery without getting bogged. Contract harvesters begin the season in Queensland and Northern NSW and work their way south. They are already more than two weeks behind where they are supposed to be.Worse, ready-to-harvest wheat that gets too much rain can become ‘shot and sprung’. This is when the grains germinate while still on the stalk, reducing its value from something like $280 a tonne to $100 per tonne, if you’re lucky.

Combined with a forecast wet November, all of the anecdotal evidence is pointing to a serious downgrade of the national harvest. That will be bad news for Graincorp and AWB. For our farmers, the smell of another failure is the last thing they need.

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Why Does Anyone Use Webjet?

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I like Australia’s listed internet businesses. Jobs (Seek), car sales (carsales.com), property (REA Group) and hotels (Wotif) are all markets that demonstrate extremely powerful network effects. The more people that visit the sites looking for jobs, cars, properties or hotels, the more sellers want to use the sites to sell jobs, cars, properties or hotels. The more sellers, the more use it is to the customers and hence more traffic. On and on we go until your website is worth more than a $1bn.

The economics of these businesses are mouth-watering. Minimal capital requirements; which means all the profits can be paid out as dividends. But high barriers to entry thanks to the network effects outlined above. What’s more, in many cases (jobs being a notable exception), the progression from offline purchasing to online purchasing is far from complete.

The problem is that these attributes are plainly obvious to everyone and the shares come with an appropriate price tag. The big four are all sporting price to earnings multiples of 30 or more.

There is, however, one exception. Back in November and December I spent a few days working on Webjet, a listed online travel agent. I’ve followed the business for a number of years and it displays all the economics of its listed online counterparts: prodigious cashflow; minimal capital requirements and rapid growth.

But Webjet wasn’t trading on thirty-something times earnings. The asking price was 16 times and the company had already announced that turnover in October was up 50% on the prior year. It wasn’t too difficult to look 12 months down the track and see a rapidly growing business that you’d bought for 11 or 12 times 2010 earnings.

But I didn’t buy the stock. And it wasn’t because of stock exchange announcements headed ‘Webjet growth rockets!’ (no, the exclamation mark isn’t mine). It’s because I don’t understand why anyone uses the website.

Webjet is an aggregator of flights. You can go to the site, search for a flight from Brisbane to Melbourne next week, for example, and Webjet will show you all the fares from Australia’s four domestic airlines. Then you can choose which flights you want and book them through Webjet for a $30 fee (including the $10 ‘price guarantee’ fee). Or, you can choose your flights and book them through the airlines’ own sites for free.

It takes me less than a minute to search for the same fare I’ve found on Webjet on an airline site, so an economically rational person would need to value their time at $1,800 per hour to justify the convenience of booking through Webjet (if your time is worth that much, you should be paying someone to book your flights). Or perhaps people don’t realise they are being charged the extra $30. The fees aren't immediately obvious, I must admit, but when I select two $100 flights and get charged $230, I’m soon asking questions.

I was that exasperated about my lack of understanding that I rang Webjet and asked them directly about the customer proposition. ‘People use us’, they told me, ‘because we offer a valuable service’. Really? They pay you $30 out of the goodness of their hearts? ‘Oh’, he went on, ‘and we offer a 24/7 help desk’.

Can someone please put me out of my misery? The stock price is up 30% since I was looking at it but you only need two more years of growth like this for it to still be exceptionally cheap. Please, please, please, why do people use Webjet?

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ACCC Toasts Breville; Wont Touch Big Boys

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Fairfax's Strategy in a Nutshell

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Interest Rates: How High Will They Go?

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An estimated $150 million was bet on the 2009 Melbourne Cup. The well-backed Shocking winning the race wasn’t the best result for bookies but, roughly, punters probably lost something in the order of $15 million. That’s big money for a horse race, but small change when compared with the damage RBA Governor Glenn Stevens did on the same day.

The latest RBA statistics show $865 billion of homes loans outstanding in Australia. An estimated 85% of those are variable rate. So, when the Governor puts interest rates up 0.25%, the cost to Australia’s homeowners is $1.8 billion a year.

Now that’s big bikkies. Still, the cup day rate rise shouldn’t have come as a surprise. It had been well flagged by the RBA and expected by financial markets. The big question now is: how high will they go?

All the official talk is about keeping inflation under wraps. But, for a guy who has sensed the need to start applying the monetary brakes before any other central bank around the world, Stevens seems remarkably sanguine about the risk of inflation: ‘Both CPI and underlying inflation are expected to be consistent with the target in 2010.’

Of course, he may be worried about beyond 2010. The economy is, Stevens pointed out in a recent speech to The Melbourne Institute, coming out of this recession with less ‘spare capacity’ than previous recessions. That’s good news if you’re looking for a job, but also means inflation could rare its ugly head much sooner than we all would like.

But I think the RBA is also pursuing a different agenda. Stevens has been at pains to point out that the 3% benchmark rate we’ve seen over the past 6 months was an ‘emergency’ rate. Now that we’ve seen off the emergency, the RBA wants to get back to a level that it considers ‘normal’ sooner rather than later.

Official interest rates are a tool that the RBA uses to regulate the economy. When things get a bit heated, they put rates up, which reduces the demand for loans and takes a bit of cash out of people’s pockets. When the economy hits the skids, like it has during the past year or so, the RBA can slash rates, making it easier for people to borrow and giving them more cash so that demand can be maintained.

The problem is that you can’t have rates less than zero (Well, that’s not quite true. Sweden’s Riksbank did make its deposit rates negative at one point. Generally, though, this rule holds. Why would you put your money in the bank if you get less back once you take it out?). Japan has been hard up against this limit for more than a decade. Interest rates are zero, the economy remains moribund and there’s nothing the central bank can do about it. The US is also at zero, has been there for almost a year and shows no signs of raising rates soon. So what happens the next time a recession rolls around? Ben Bernanke, Chairman of the US’s Federal Reserve, will have nothing to play with.

That and not inflation is, I believe, why Glenn Stevens is so keen to get interest rates back up before Australia gets used to 3%. He’s trying to rebuild his ammunition pile so that, next time trouble rolls around, he has plenty to play with again. I’d guess his target is somewhere between 5% and 6%. Whether our highly leveraged economy can handle it or not is another question, but that’s where Stevens would like to be.

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Buffet's Burlington Deal

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On Melbourne Cup day, Berkshire Hathaway produced a shock of its own. Warren Buffett's company announced it had made an 'all-in wager on the economic future of the US'. Berkshire has agreed to buy the 77.4% of Burlington Santa Fe railway group that it didn't already own for US$100 per share in cash and stock - a 31% premium to the 2 November closing price.

The price - equating to an equity valuation of $US34bn and a price-to-earnings multiple of about 18 times - could hardly be considered cheap. Particularly when judged against Buffett's historical standards. But you can draw one of three conclusions from the deal.

Firstly, in a world of rising inflation and rising energy prices, Buffett believes rail is going to be the big winner: 'Burlington Northern Santa Fe last year moved, on average, a ton of goods 470 miles on a single gallon (3.8 litres) of diesel, and society has an enormous interest in using less oil to transport goods'. He went on to say that 'Each train displaces 280 trucks on the road. When it comes to spewing pollutants there is nothing more efficient than trains.'

The second conclusion you could draw is that he thinks Berkshire's own stock is overvalued. A significant portion, 40%, of the purchase price will be paid for with Berkshire shares. The last time Buffett made such a large scrip acquisition was the US$16bn, 1998 purchase of General Reinsurance. At the time, much of Berkshire's $US60,000 share price comprised of overpriced (by Buffett's own admission) equity investments. Many of his long-term holdings, such as Coca Cola and American Express, are still trading below their 1998 levels more than 10 years later. Berkshire itself looks more reasonably priced today, but perhaps Buffett knows something we don't.

Finally, while I don't want to upset the Buffett world again by suggesting the Oracle may have lost his marbles, he may simply be preparing Berkshire for a post-Buffett world. Burlington mightn't be the cheapest investment he's ever made but there's every chance it will still be around and profitable in 50 years' time. Perhaps that gives him a lot more confidence in the future of his estate than leaving behind a large pile of cash for someone else to manage.

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Tips for International Investing

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A strong Aussie dollar and a wealth of online information mean it’s never been easier to invest overseas. However, those who dined on similar logic ten years ago may wish they’d skipped a meal.

The MSCI world stock market index has withered by 0.73% per year over the past decade. Though it’s a damning statistic, stock prices in 1999 were intoxicated by the excitement of the new millenium and in many cases it’s taken a decade for earnings to catch up. With valuations now looking more reasonable, this augurs favourably for future returns.

Successful international investing isn’t guaranteed by our strong currency, though. Practicalities, such as having time to commit to learning about new businesses and negotiating various taxation and legal regimes, for example, put many investors off the idea of diversifying their portfolios overseas. But for those interested, this blog aims to help get you started.

Choosing a broker

I use Commonwealth Bank’s Pershing service, a decision born mainly of convenience. You can download the application forms online and the service is relatively efficient, though the website is slow. Here’s how it works.

Once your application has been approved, you’ll be issued logon details as though it were an ordinary Australian brokerage account, but you can’t place an order without first making a foreign currency deposit.

I’ve only traded in the US, but if I call Pershing before 10:30am, or thereabouts, cash will be withdrawn from my local bank account and converted into US dollars at the morning’s prevailing exchange rate. If you miss the cut off, you’ll be waiting another 24 hours before your funds are exchanged and a further 24 hours after that before your funds are available to trade. Your cash won’t earn interest, either, so the opportunity cost of holding US dollars, for example, is high.

Service and cost

Pershing provides access to the world’s major markets but the costs vary. For example, Pershing’s minimum US brokerage charge is currently US$65; potentially four times what you might pay in Australia. This is particularly onerous if you’re investing small amounts. Be sure to ask what protection you have, if any, against your broker getting into financial trouble.

The other foreign online broker we’re aware of but haven’t investigated is US-listed Interactive Brokers, which seemingly offers lower transaction costs and is relatively easy to open an account with.

Taxation

Taxation is considerably more complicated with overseas investments and your author is not an expert. However, you can make life much easier by keeping your transaction records, including dividends (showing withholding tax that you might be able to claim a refund for) and the exchange rate on the day the transaction took place. Pershing only holds these details for two years, for example, so remember to keep a well secured personal copy as well.

The Australian Tax Office provides a schedule of average exchange rates each year to assist investors. However, I find it far easier to open Yahoo! Finance, which provides current and historical exchange rates for major currencies at the touch of a button.

Not many investors have the time or inclination to invest overseas. But if you have experience or tips that could benefit others, such as a good online broker, helpful websites or a tax tips and traps, for example, then please leave your comments below.

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Australia's Retail Battle Royale

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As a shareholder, I couldn’t wait to get my first taste of the Costco experience at the debut Australian warehouse, which opened recently at Docklands in Melbourne. But as The Intelligent Investor’s Woolworths analyst, I was also eager to know the extent of the threat Costco poses to Australia’s major grocery players.

Costco is one of three major club warehouse operators in the US, along with BJ’s Wholesale Club and Sam’s Club (owned by Wal-Mart). Costco boasts Warren Buffett and Bill Gates as shareholders, and Buffett’s business partner, Charlie Munger, sits on Costco’s board.

Such clubs charge an annual membership fee, typically around $50, which entitles you to take advantage of bulk prices in their cavernous warehouses. My family and I made our first pilgrimage in late August.

Packed to the rafters

On a wet and blustery Saturday Melbourne morning, the car park was busier than a Pro Hart canvas. Until Costco gets closer to achieving it’s reputed goal of opening 20 to 30 warehouses, it can’t go close to the convenience factor of having a Woolies or Coles around the corner. Fortunately we paid our $60 membership online and skipped the enormous queue to gain entry. It felt like gaining entry into an exclusive nightclub, except that I was actually allowed in.

Upon entering you realise just how apt it is to refer to these stores as warehouses. There are items stacked floor to ceiling, as you’ll see in the background of the photo below. Like Woolies, Costco’s rapid stock turnover means that it sells its merchandise before it needs to pay suppliers. With suppliers effectively financing the company, Costco generates copious free cash flow. No wonder suppliers give it such keen deals, though – Costco’s biggest warehouses generate over US$300m a year in sales.

While Costco offers wholesale prices, it only comes with wholesale product sizes. Want a Snickers bar? I hope you’re hungry, because they only come in boxes of two dozen. And saying ‘Can you please pass the Vegemite jar?’ might no longer be appropriate, given the bright yellow buckets in the photo below. This photo perhaps best illustrates the Costco experience for those who haven’t visited a store.

Overall Costco’s prices seemed a bit cheaper than elsewhere, but that’s what you’d expect for buying in such vast quantities. Costco doesn’t mark up any branded products by more than 14% or private-labels by 15%, which is why membership fees represent the bulk of Costco’s profits. The trick is to keep shoppers coming back by offering low, low prices.

During the downturn, Woolworths boasted that shoppers have been making more regular visits as they trade down from eating out. Costco’s entry is unlikely to change this in the short term, especially for perishable items. These items come in such large sizes that, unless you’re catering for a party, storage might prove an issue. Longer term, Costco has the task of convincing Australians to install a second freezer in the garage, as is so common in America.

Despite such potential impediments, shoppers have shown an early willingness to buy in bulk. There were some hilarious conversations to be heard, and the general consensus was that as long as shoppers were getting value for money, they don’t mind holding significant inventory on their shelves at home.

It’s worth noting that Costco’s offering is broader than grocery items, though. It resembles a small shopping centre under one roof. You could, if you so wished, get your photos developed while buying a giant watermelon, a diamond ring and a new set of radials for the car.

A small fast food outlet also provides relief for hungry shoppers. But with staff offering food samples at the end of each aisle, I was full before passing the checkout.

Costco stocks only what it knows it can clear and can buy cheap – there’s no guarantee an item there today will be there next time you visit. This provides a treasure hunt feel, which we found enjoyable but could prove annoying for some.

Passing judgement

Costco was an entirely new experience and my wife couldn’t wait to get back – we didn’t buy anything as we were in a hurry to get to the footy. But I can certainly envisage a fortnightly or monthly visit becoming part of our routine. Our weekly needs will still largely be met from a combination of the brand new Coles that’s opened nearby (my wife and friend think it’s a revolution, showing Wesfarmers means business), the two Woolies on either side of us, the Aldi supermarket around the corner and the Footscray and South Melbourne markets.

Costco isn’t about to bring Woolies or Coles to its knees anytime soon, but the Australian retail sector is becoming increasingly competitive. Margins could come under pressure as they strive to outdo each other – Woolies is spending nearly $2bn on refurbishments – and that means shareholders might need to adjust their profit growth expectations accordingly. Whether you’re an investor in these companies or not, their stoush means lower prices, more choice and more pleasant shopping experiences.

If you’ve visited Costco, or want to share any thoughts about the Australian retail industry and its major players (perhaps Woolies’ latest move into hardware is a sign that it’s best days are behind it, for example).

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Wesfarmers' Board Gets it All Wrong

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Economics used to be known as the dismal science. But that description could hardly be applied to the authors of scintillating books such as Freakonomics (Steven D Levitt) and The Logic of Life (Tim Harford). This new breed of economist focuses its attention on practical questions viewed through the prism that, as Levitt puts it, ‘incentives are the cornerstone of modern life’. And they both make a compelling case, explaining fascinating conundrums by examining the underlying incentives.

Charlie Munger, Warren Buffett’s business partner, puts it this way: ‘I think I’ve been in the top 5% of my age cohort all my life in understanding the power of incentives, and all my life I’ve underestimated it.’

At The Intelligent Investor, we’re convinced: incentives matter. A lot. That’s why I’m always interested in the compensation schemes managing directors are able to negotiate for themselves. And I took a particular interest in the incentive scheme recently announced by Wesfarmers for its MD, Richard Goyder.

All too often, executives get large ‘golden handshakes' for arriving, and even larger 'golden parachutes' for leaving, well it appears that Goyder is being offered a generous 'golden armchair’ just to stick around. The new remuneration arrangements apparently reflect ‘the increased responsibilities the Coles Group acquisition has brought to the role’ (hmmm … did somebody force him to make that deal?) and follows ‘an independent review of his remuneration’ (which I’d have thought was one of the key things shareholders pay the board to do). But it’s the details shareholders need to worry about.

The sheer quantum of the numbers is striking: a base salary of $3.15m; the same amount again if he meets his short-term (less than a year) performance targets; 100,000 shares if ‘long-term’ return on equity (ROE) targets are met; and another 100,000 shares for each percentage point that the ROE exceeds the undisclosed target. The performance shares won’t be allocated for at least three years, and only then if ROE is ‘sustained’ above the relevant level (‘sustained’ meaning for a period of two years, at least for the additional percentage point bonuses; it’s not clearly spelt out for the first 100,000 shares).

At the current share price of $29, each percentage point he adds to the ROE would mean an extra $2.9m to Goyder’s hip pocket. By way of comparison, former managing director and careful steward or shareholders’ capital Michael Chaney’s salary was $2m a year. Chaney’s short-term performance bonus was a maximum of $500,000 and, when the business’s outstanding performance meant the payments due to him under the long-term incentive plan had ‘risen to levels beyond those originally envisaged for excellent performance’, he voluntarily capped his bonus at $2m a year.

Chaney’s behaviour is to be commended. But, in the scheme of things, a few tens of millions of dollars paid to the managing director won’t make a huge difference to Wesfarmers’ $19bn market capitalisation. My concern lies with the more insidious incentives this scheme puts in place for Goyder.

Boosting return on equity, in the short to medium term, is not difficult. Especially if you have a bunch of high quality assets like those on Wesfarmers’ books. Ask any investment banker and they’ll tell you the secret: borrow. Borrow all you can. If the returns provided by the assets are above the cost of debt, your return on equity will skyrocket. The highly leveraged acquisition of Coles shows Goyder knows this trick all too well.

Of course there’s a degree of risk involved. But, from Goyder’s point of view, it’s a good bet that it will take a few years before any risks rear their ugly head. Even if he struck out with an early disaster, his base salary is hardly chicken feed (and he’d have a lovely golden parachute to escape with).

Why boards don’t lock the remuneration up for longer is beyond me. If they do need to offer such potentially lucrative rewards (I’m sure Goyder would do it for half as much), at least tie him in. Make him hang on to his shares for 10 years – the company confirmed today that he can sell them the day he gets them – and he might think differently about the risks he’s taking on.

I have no reason to believe Richard Goyder is a bad person or that he’d intentionally destroy shareholder value. But most of the world’s current financial problems can be traced back to intelligent, confident, driven people, incentivised to maximise their own wealth without regard to risk. This Wesfarmers plan sounds far too similar."

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Buffet's Goldman Deal; When Size Matters

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Wall Street's Mad Monday as Lehman Collapses

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Dutch Disease Infects Aussie Explorers

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If you'd asked me 10 years ago what effect a mining boom would have on the Australian economy, I would have responded with an 'all good': more profit, government surpluses, low unemployment and plenty of people with lots of cash to burn. That in turn should, I would have guessed, be good news for Australia’s stock market. Unfortunately, it hasn’t quite worked out that way.

The past seven years have indeed been a bonanza for mining stocks – reinvesting dividends you’d have ended up with a 27% annual return, or more than five times your money in total.

But for the rest of the stock market, life’s been surprisingly tough. The 8% annualised return provided by non-mining stocks (again, assuming reinvested dividends) wouldn’t even have doubled your cash over the same period. Obviously you’d expect mining stocks to perform well in a mining boom, but the fact that industrials have delivered returns lower than the long-term average is surprising. Surely some of the benefits get shared around?

The reason they haven’t been might come down to an obscure economic theory known as the Dutch disease. The phrase was coined in the 1960s to describe the Dutch economy’s unexpected troubles in the decade following a huge natural gas find in the North Sea. The guilder’s subsequent rapid appreciation sent the rest of the Dutch export industry – a large part of its economy – into a tailspin.

Might the rapid ascent of the Aussie dollar be having a similar effect on our non-mining economy? It’s certainly not helping a few of my favourite businesses. Cochlear, Infomedia and ARB Corp. are all making strides on the world stage, but profits are being crunched as they convert their revenues back to the home currency.

It’s not just the exporters that are struggling, though. Record agricultural commodity prices don’t look quite so good in Aussie dollars and, at 7% of GDP, we’re running the biggest current account deficit since statistics began in 1959. Hard to believe given the prices for our commodity exports but, as the Aussie rises, imported competition is having a field day with our locally produced product.

There’s no doubt that, for now, we’re net better off – just take a look at the bulging government coffers. But it won’t be pretty if the mining boom comes to an end and the rest of the economy is in a state of disarray. Dutch disease or not, our world class exporters are worth looking after.

Disclosure: Steve owns shares in Infomedia

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Your Weekend Reading List

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Gambling Goes Online

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One of my earliest recollections of the race track is walking out of Sydney’s Rosehill Racecourse crying because I had lost $12. I was 13 and, ever since then, I've been trying, unsuccessfully, to get my revenge on the bookies that stole my money.

The battle between bookie and punter is something that’s always fascinated me, and it has provided the foundation for my obsession with value investing. Successful punters (not me, but there are a few) exploit the difference between price and value just like value investors. The price being the ‘odds’ the bookies offer you and the value being the true chance of a horse winning the race (the big difference is that the stockmarket goes up on average whereas punters have to be net losers). Like the stockmarket, the bookies are mostly pretty efficient. But with enough research and patience, professional punters will occasionally come across a situation where the bookies get it wrong.

Attractive model

The TAB, or totalisator, doesn’t face that problem. Here, you don’t know what price your horse is until after the race has been run and won. You can, of course, get an estimate of what it would be at any point in time but that price can change after you’ve placed your bet. The way a totalisator (the pari-mutuel system a TAB uses) works is simply to aggregate everyone’s money after the race has been won, take out the profit due to shareholders and divvy the remainder up amongst those that backed the winner.

Well before I started thinking about competitive moats, this struck me as an attractive business model: Australians love to gamble; the only place you can gamble, apart from a racecourse, is at the TAB; and the TAB can’t lose. Not only that, but the correlation between disposable income and gambling is strong – the more people have to spend, the more they gamble (the percentage has actually been increasing over the past 20 years, although racing’s share has been declining). In short, TABs were businesses you’d love to own. That, at least, is what I thought.

Whenever there’s a large moat around a business, it’s worth asking why that moat exists. In this case, the answer is simple: tax-inspired government regulation. The only reason there is only one TAB in each state is because the respective governments have legislated to have it that way. If there was an alternative that took less than the 15% the TABs take out of the pools, punters would use it. In a fully deregulated market, gambling would be a highly competitive industry like it is in the UK.

Despite the governments’ best efforts, we’re headed that way. The internet is slowly deregulating the gambling business, and there’s little governments can do about it without fostering a thriving black market.

Punting elsewhere

I’m a fair-weather punter these days, but still like to get involved at carnival time. I’ve had a bet on each of the eight weekends of Sydney’s autumn carnival – two days at the races and six from home or a friend’s house – and, for once, I’ve kept my nose in front. Apart from this unusual eventuality, though, what has struck me most is that I’ve hardly used the TAB at all. Of my total turnover, 80% would have been through online bookmaker IAS Bet and betting exchange Betfair. The remainder was bet on course; a small percentage with the TAB thanks to better prices on offer, but the vast majority with bookmakers.

Not only do I get better prices but, when I’m not at the racecourse, I get to sit in the comfort of a lounge room, bet at my own leisure and watch the races on television. For me, there’s no going back to the TAB. And if the statistics are anything to go by, I’m not on my own. Annual NSW wagering growth averaged more than 5% in the 20 years to 2003*. From 2003 until 2007, that growth rate dropped to 2% (pre-equine influenza)*. People aren’t punting less, they’re just punting elsewhere.

For Australia’s protected gambling businesses, this is bad news.

They’re not about to disappear overnight – massive distribution networks and familiarity will ensure that – but margins and market share are under threat and there’s no way the trend will reverse. Equine influenza and smoking bans have caused plenty of immediate problems but, underlying it all, the old grey mare ain’t what she used to be.

*Source: 2004 TAB takeover defence and Department of Gaming and Racing industry statistics

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Rising Aussie Dollar Defies Inflation Logic

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The Aussie dollar and inflation are rising in tandem. How long can the relationship last?It’s got me stumped why exchange rates go up when inflation goes up. I’ve heard the spiel a thousand times: higher inflation means higher interest rates and higher interest rates mean everyone wants to own the currency. I still don’t get it. Over a decent period of time, high inflation has to equate to a depreciating currency.

That’s what inflation is – the depreciation of money. If the currency doesn’t depreciate, you end up with absurd situations where everything in the country with inflation costs ten times more, in real terms, than in the country without it. And you could in theory print as much money as you wanted and buy the rest of the world’s assets, goods and services. That’s the path we’re headed down, but I doubt the rest of the world will let us get away with it. Yesterday’s CPI data sent a strong message to the few remaining economists contending that inflation is not an issue: you’re wrong.

Most of us have known prices are going through the roof for quite a while, but it seems even the official bean counters have run out of items to exclude from the ‘core’ number. The real number is undoubtedly higher than the 4.2% reported, but even that’s enough to have everyone concerned. In stark contrast to the US, growth in money supply (M3) here is rampant – it’s currently growing at a year-over-year rate in excess of 20% – and until the Reserve Bank slows it down, the problem is not going to go away. The dollar bounced this week, but the rest of the world won’t let us get away with printing money and running a huge current account deficit forever. There are a couple of arguments in favour of the Aussie.

One is that we have a lot of stuff in the ground that the rest of the world needs to buy, and for that they need our money. Another is that inflation is a global problem, not a domestic one. Currencies are, after all, relative and if inflation is on the rise everywhere, we’re relatively fine. That doesn’t explain why the Aussie dollar rises when we report a high inflation number, but it does at least have some logic to it. I certainly agree that we’re in for a serious bout of global inflation, but I don’t know that it’s going to help our situation, even in a relative sense. It’s more likely that this only adds to our existing problems. There aren’t many attractive alternatives and it’s partly a case of picking your poison. But I’m bearish on the Aussie dollar.

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Worry Not About the US Economy

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The US economy is looking rather sick. The IMF expects a recession, the Federal Reserve believes the economy is currently contracting, house prices are plummeting, unemployment is rising (although still at a historically low rate of 5.1%), the US dollar is buying 25% less euros than it was two years ago, the US current account deficit – despite the falling dollar – remains at a stubbornly high 5% of GDP, the recently tabled 2009 budget forecasts a deficit in excess of $400bn and Fed Governor Bernanke is doing everything he can to make the already worrying inflation problem worse.

If that’s got you sweating, you can relax. The US will survive and, given enough time, prosper. For all the excess, disasters and unfair distribution of the gains, the system works.

Real economic growth arises through improvements in productivity. You can fiddle with interest rates, money supply and government expenditure all you like, what really matters is increasing the amount of ‘stuff’ produced per person. And, thanks to its devotion to capitalism, increasing the amount of stuff it produces is something the US is better at than any other country in the world.

That’s because the capitalism encourages competition, and competition encourages innovation. The barriers to building something better are small and the potential rewards huge. It's no surprise that the companies leading the technology revolution (think Google, ebay, Facebook and MySpace) are products of the US – it’s hard to imagine building the world’s most popular search engine while attending an Australian university. In fact, think back over the 20th century and it’s hard to think of too many revolutionary technologies that were developed outside the US (fire away in the comments section below). Plenty of the ideas came from elsewhere, they just don't tend to get developed.

In a few (mostly Asian) countries, times are changing – there’s an excellent article in yesterday’s Fin Review about technology and innovation in Korea (page 62 of the hard copy, unfortunately not free online) and, with more than four times the population, China’s economy will overtake that of the US one day. But as long as the US remains the capitalism capital of the world, there’s no need to worry about its obsolescence. It’s been spending much more than is prudent and an adjustment is necessary, but in 10 or 20 years’ time, it will be bigger and stronger than ever.

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Don't Always Bet on Black

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Nassim Taleb, author of The Black Swan and Fooled by Randomness, is interviewed in this month’s Fortune magazine. The interview is excellent, and so are his books. But when Taleb’s theories go mainstream, it’s time to start thinking about what is likely as well as what is possible.

The crux of his argument is based on Karl Popper’s falsifiability theory. It was once assumed by Europeans that all swans were white but, no matter how many white swans were seen, the theory could never be proved, only disproved (which, in fact, it was with the discovery of black swans in Australia). Just because something has never been seen before doesn’t mean it doesn’t exist.

The risk models used by the world’s largest financial institutions, which rely solely on what has happened in the past to predict what will happen in future are, therefore, useless (and, in Taleb’s opinion, extremely dangerous).

The meltdown of the US mortgage market and the hundreds of billions lost by said financial institutions has thrown Taleb’s theories into the limelight. Although he’s described this financial disaster as a ‘grey swan’ at best (being somewhat predictable), people have thrown the past out the window and are looking for black swans all over the place.

It’s now time to remember that black swans are rare. Flip a coin 10 times and the probability that you flip 10 heads or 10 tails in a row is 1/512. But flip a coin a thousand times and the probability that you’ll get a run of at least 10 heads or 10 tails, at some point, is more than 85% (it’s been a while since I’ve done probability theory, so correct me if I’m wrong – I get 85.6%). Play for long enough, and it's highly likely that you’ll get a freakish run or two.

But they’ll be few and far between. And at the moment many securities, especially in debt markets, are being priced as if there’s a black swan swimming in every pond. Set yourself up so that the rare events won’t send you broke – little or no debt, thoughtful diversification and a thorough understanding of what you own – and small risks can be rewarded with extremely attractive returns.

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Fruit, Chocolate and the Sydney Morning Herald

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Economists at the London School of Economics got some students into the lab. They got them to fill in a survey (the survey was basically a decoy). Then they said to the students ‘Thank you for filling in the survey, as a token of our appreciation, would you like a snack? What would you like: fruit, or chocolate?’ The students, being members of the human race, mostly chose chocolate.

In another variant of the experiment, the economists got the students to fill in the survey and said ‘thank you very much, next week, we’ll bring you a snack. What would you like next week, fruit or chocolate?’ And the students said ‘fruit sounds nice, thank you very much’. The next week they would turn up with the fruit and say ‘here’s the fruit you asked for ... are you sure you wouldn't like chocolate?’ At which point many students would switch: ‘Last week, when I said I would want an apple, I must have been insane!’

That’s a slightly edited excerpt from a recent speech by Tim Harford, author of The Undercover Economist and, most recently, The Logic of Life. He followed that example up with another experiment by the same economists. This time they offered the students a choice of films. When deciding what they wanted to watch that night the students chose American Pie, Mrs Doubtfire, Sleepless in Seattle and the like. When asked what films they would like to watch in two weeks’ time, the students chose Kurosawa’s Rashomon, Three Colours: Blue, Raise the Red Lantern and Schindler’s List.

My knowledge of movies is atrocious and I have to confess I had never heard of Rashomon, but you get the idea: the choices we make in the here and now aren’t necessarily the same as the choices we make over a longer time frame. Whether it's an exercise regime, a diet program or trying to quit smoking, we’ve all been torn between satisfying our immediate desires and doing what is best for us. But what’s that got to do with the Sydney Morning Herald?

Well, many people out there fight the desire for immediate satisfaction and find a balance between the present and future. People do exercise, they do eat fruit and, in an effort to better themselves intellectually, they choose to read Fairfax’s Sydney Morning Herald over Murdoch's Daily Telegraph. SMH’s high-brow reputation, 177 years in the making, is a valuable one; the fan base is loyal and there are plenty of advertising dollars looking for high-brow consumers. Unfortunately, it is a reputation being rapidly destroyed.

The internet gives the paper’s editors the ability to see, instantaneously, what we read. It will come as no surprise to Tim Harford that the most popular stories are about sex, nudity and, in today’s perfect example, incest – even amongst SMH’s supposedly sophisticated readers. Put chocolate in front of us, we eat it.

The powers that be see what’s popular and, presumably abiding by the motto ‘the customer is always right’, feed us more. The net result is that Bob Irwin (Steve’s father), Nicole Kidman and a hedgehog all make it onto today’s SMH homepage. Robert Mugabe does not.

That is sad. It is also faulty logic. Sure, we’re all guilty of clicking on the populist articles but our actions belie the reason we’re there. If I want to read trash, there are better places to get it. I type smh.com.au into my browser because I’m looking for serious commentary and, if I don’t get it, I’ll go elsewhere. With many of the world’s great papers now free online, there is no shortage of competition for my time.

Fairfax’s business is under assault from all sides. Its most profitable source of revenue – classified ads – has been diverted to the likes of Seek and realestate.com.au. Succumbing to populism and destroying its wonderful brand names will only accelerate the decline.

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