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Quarterly Report: Both Funds - March 2023


Chief Investment Officer Letter

Why monetary madness needs to be banished for good

I have to admit to a touch of schadenfreude watching the demise of Silicon Valley Bank (SVB) on Twitter. All of those Silicon Valley free-marketeers screaming at the government to rescue them was a sight to behold.

They are right, though.

Moral hazard is a serious problem in the modern economy. Bailouts and rescues are becoming ubiquitous. Not only does that create a system of heads private investors win, tails the taxpayer loses, it derails creative destruction. Dumb ideas need to fail. Poorly deployed capital needs to be redeployed to businesses and managers that have good ideas.

That’s how you get productivity growth in an economy. The fact that we don’t let anyone go bust these days has been a significant contributor to productivity growth declining relentlessly for the past 20 years.

For all that, no bank depositor should ever lose their money in a developed-world economy. It is absurd to think every single small and medium-sized business should be analysing bank balance sheets to determine the creditworthiness of their deposits. If you deposit your money in a regulated, licenced, developed-world bank, you have every right to expect that your money will be there as and when you need it.

Regulated and capitalised

Before we get onto the solutions, it is worth noting that plenty of investors are losing money despite the government bailout. SVB was listed on the stock exchange. Its $11bn of equity has been wiped out (the market capitalisation was $43bn at the peak). Unsecured lenders to the bank are in for a haircut too. There are far worse examples of moral hazard if you want to find them.

But it was an abject regulatory failure. Back in February, hedge fund manager Bill Martin (@RagingVentures on Twitter) highlighted SVB’s insolvency risk using nothing other than the company’s latest public financial statements. In 10 tweets, Martin showed how the bank had invested its rapidly growing deposits in long-term fixedincome securities that plummeted in value as interest rates rose. The bank was allowed to account for those investments at much higher values because they were supposedly “held to maturity”. When the bank’s tech clients started burning through their deposits, however, it was the market value that mattered. At market value, SVB was insolvent.

How can a regulated bank invest almost all its at-call deposits in assets with a duration greater than ten years? How can a regulator let them do that? The simplest, most basic liquidity rules should stop a regulated bank from taking such a stupid risk.

Monetary manipulation the root of many problems

My best guess is that this won’t be a widespread issue in the banking sector. Not many bank treasurers are that stupid. For most banks, including the larger regional banks in the US, valuing their assets at current interest rates will not significantly impact their capital position.

It is emblematic, though, of the stupidity that can happen when interest rates are manipulated to zero. From commercial property to unlisted infrastructure assets to Australia’s housing market, trying to rescue an economy through ultra-low rates has consequences that are now becoming obvious to everyone.

Monetary policy is a very blunt, often ineffective tool with wideranging unintended repercussions. Yet it has become the primary tool relied upon in times of crisis, despite fiscal policy (government spending) being a far more effective method of targeted stimulation.

Central Bank governors should not be on the homepage of tabloids like the Daily Mail, where Australia’s Reserve Bank Governor frequently features as a pantomime villain. The role that positive real interest rates play in efficient capital allocation should be given more weight. And encouraging people to overextend themselves at artificially low rates can cause financial crises.

The collapse of a US regional bank might be a relatively containable issue. It won’t be the last disaster caused by the monetary madness of the past few years. If inflation risks start to recede and the economy starts to weaken, I hope these lessons aren’t forgotten.

Could Australia’s banks fail?

There is no stupidity in protecting yourself against seemingly minuscule risks. Especially when protection is free. If you can spread your deposits around multiple Authorised Deposit-taking Institutions (ADIs) and avail yourself of the Australian government’s explicit $250,000 deposit guarantee, why not?

I would also be willing to bet a substantial amount of money that, were an Australian bank to fail, all depositors would be protected. For exactly the reasons outlined above, the government would quickly step in. That doesn’t mean we shouldn’t be thinking about the risk. As equity market investors, the consequences for the wider economy and our portfolios would be significant.

So, could an Australian bank fail?

They share one thing in common with SVB – an unhealthy level of exposure to one sector. For Silicon Valley Bank, that was the tech sector. In Australia, it is lending against residential property. Over 70% of CBA’s $885bn loan book is home loans.

The topic of whether Australia’s house prices will ever fall far enough to threaten the viability of one or more of our banks is the subject of conversation at far too many Australian dinner parties. The simple fact is, it is a risk. A bank with a healthy spread of loan types is safer than one with all its eggs in one basket.

As for the specifics of the SVB demise, that is far less likely to happen here. Our capital adequacy rules do a very good job of penalising banks for taking on risk. While the technicalities are complicated, the concept is simple. The more risk a bank takes on, the more equity capital it must set aside as a buffer. That includes the credit risk of a loan (the higher the probability of default, the more capital must be set aside). But it also forces a bank to set aside more capital if it takes on market risk or interest rate risk.

That’s why our banks don’t offer competitive long-term, fixed-rate mortgages. If a bank funds a long-term loan with short-term deposits, the capital requirements make the loan uneconomical. The three- and four-year fixed-rate loans offered during Covid were matched with temporary fixed-rate funding from the RBA.

You could (and plenty of people do) argue whether home loans are as safe as our capital adequacy rules assume. But our regulatory regime is far more robust than the one that governs small banks in the United States.

Extreme value in small cap land

I recently spent some time on the phone with Macmahon CEO Mick Finnegan. It has now been more than six years since Mick and I fought off an opportunistic bid for Macmahon by Spanish-owned construction giant CIMIC.

A quick glance at the company’s financial statements and you would think we made the right decision. Mick and his team have grown Macmahon’s operating profits every single year since the offer was rejected. Macmahon made $94m of operating profit in the 2022 financial year, almost triple the $34m it made in 2018. The company has guided to more than $100m for the 2023 financial year and recently announced several important contract extensions that mean it should grow further in 2024.

Look at the share price, though, and you could argue that we should have cut and run. On the day of our phone call, Macmahon shares were trading hands for $0.13 a share, roughly 10% below the $0.145 CIMIC was offering six years ago.

There have been a few cents in unfranked dividends along the way but the total return is close to zero. Thanks to the earnings growth, the value attributed to the whole company is now less than five times this year’s profits.

Mick is scratching his head and frustrated. So am I, to a lesser extent. He has done almost everything we asked six years ago and has little to show for it (his long-term incentives are well out of the money).

It is probably not much consolation, but he’s not alone. Several companies in which the Forager Australian Shares Fund is invested reported very encouraging results in February. By the end of March, their share prices were wallowing back near the lows of 2022.

That six-year period since CIMIC’s bid for Macmahon coincided with a horrible period of underperformance for Australian small caps. After a glimmer of optimism in January, small companies have given up all of their 2023 outperformance and then some.

There is not much Mick or Forager can do about the market value attributed to Macmahon’s shares. But they can make the share price a lot less painful.

Mining services is a capital intensive industry. Macmahon’s growth has required capital and limited the amount of dividends the company has paid. Last year it paid just 25% of profits to shareholders as dividends.

The growth phase is coming to an end and it is time for shareholders to see a larger share of those profits in our bank accounts. A 75% payout ratio would equate to a 15% yield on Macmahon’s shares, something likely to get other investors’ attention. Even if the attention stays low, 15% p.a. makes for an excellent investment.

Each company has a unique set of problems to address. Some of our investee companies are still recovering from Covid-related disruptions. Others face falling demand for their products as consumers navigate higher interest rates.

Our message to all of them is the same, however. Stay focused on maximising the value of the business over the long term. Deliver on the business’s profit potential, invest incremental capital only where the prospective returns are high and, where appropriate, make those results tangible by returning cash to shareholders.

Execute on those three things and the share price becomes a sideshow.

Steve Johnson

Forager Australian Shares Fund

Forager Australian Shares Fund
Forager Australian Shares Fund

In March the Forager Australian Shares Fund fell by 3.9% while the index was unchanged. It was an eventful month offshore: the collapse, and speedy rescue, of Silicon Valley Bank left investors concerned about the safety of US regional banks and the shotgun marriage of Credit Suisse to UBS added to contagion fears.

Future interest rate expectations, including in Australia, retreated sharply during the month such that no further RBA cash rate rises are currently priced by fixed income markets.

Meanwhile smaller stocks, especially smaller non-resources companies, continued their share price underperformance in March.

Reporting season

As February’s reporting season drew to a close, the last of the smaller companies finished their roadshows in early March. In all, it was a sluggish reporting season.

For the first time since August 2020 more companies missed earnings expectations than beat them. And when companies that reported their half-year beat earnings estimates, full year estimates rose just 2%. Those reporting misses had their full year expectations cut by 7%.

Wage inflation continued to be a key issue. While in the prior year getting staff was difficult, the immediate concerns around getting staff onboarded have dissipated. Continuing, though, was economywide wage inflation pressures. Australian Bureau of Statistics data placed wage inflation in the private sector at 3.6% in the December quarter, already exceeding the 2.2% pre-Covid level. Many businesses have been experiencing wage inflation substantially above this level.

One moderation of cost inflation came from technology roles late in the 2022 calendar year. Cost cutting and higher redundancies across the technology sector saw Australian tech employees less able to negotiate double-digit wage rises they had been enjoying.

The ability to pass on wage inflation to customers was paramount. Healthcare businesses, such as Integral Diagnostics (IDX) could not hike prices to Medicare, its largest payer, as wages soared. Instead, the diagnostic imaging sector received only a 1.6% bump for the 2023 financial year. With inflation now more longstanding and widespread, indexation will rise to 3.6% for next financial year, providing margin relief for Integral and other healthcare providers.

For other businesses, like enterprise software provider Readytech (RDY), the inflationary backdrop allowed the company to pass on wage inflation more readily to customers on contract renewal. With modern, efficient and mission-critical software solutions, customers had few options but to accept the increases.

Much has been made of the weaker discretionary consumption environment, especially for large ticket purchases. In February we saw some of the first signs that increases in mortgage costs and cost of living pressures have been biting.

In January household discretionary spending was lower than June last year. Retailers reporting in late-February gave an indication of how the calendar year had begun. One of the bellwethers for large ticket purchases, sofa retailer Nick Scali (NCK), described January as “better than expectations” but still saw orders fall 12%.

Inventory balances for some businesses, across discretionary retailers and more broadly, remain elevated. Supply chain issues, most severe in the prior June reporting period, have improved but not fully normalised.

Some smaller businesses like Paragon Care (PGC), the importer and distributor of medical devices, capital items and consumables, saw inventories remain at elevated levels to “manage the ongoing impact of supply chain issues”.

Lastly, and unsurprisingly in a rising interest rate environment, businesses carrying high levels of debt started paying more interest for that debt. For now this has been largely limited to increases in base interest rates, with risk-based interest rate spreads staying consistent. Allied health provider Healthia (HLA), which last reported $81m of drawn debt, saw interest costs rise substantially. And with rates continuing to rise during the half to December and in the new year, there is no respite yet.

Travel stocks finally arriving

One of the brighter spots from the reporting season were travel companies, especially those dealing with inbound international tourists. Aviation capacity into Australia is due to reach 85% of pre-Covid levels by June 2023, helped by China opening its borders to outbound travelers.

Recreational vehicle maker, renter and seller Tourism Holdings (THL) has had a busy six months. The company finalised a merger with competitor Apollo Tourism after a drawn-out regulatory approval process, listed in Australia and saw improved international arrivals and investor attention drive the share price more than 40% higher.

Its half-year results also did not disappoint. The company upgraded its profit expectations for the 2023 financial year once again, now set to earn like-for-like net profits of $75m this financial year, much better than prior expectations for Tourism Holdings and Apollo Tourism individually.

Skydive and reef experiences business Experience Co (EXP) is also a beneficiary of the recovery in overseas tourist arrivals. It reported positive earnings before interest, tax, depreciation and amortisation (EBITDA) of $5m for the six months to December, relative to a loss of roughly the same amount the year before.

The half saw the highest level of profit since the onset of Covid forced the business to dramatically scale back operations. We expect substantially more EBITDA in the second half of the year and further growth beyond, with the earnings capacity of the business more than three times higher than the first half run-rate.

Micro cap malaise

Smaller industrial companies have dramatically underperformed compared to larger listed companies recently. Since the start of the 2022 calendar year, an index of the top 100 listed companies returned 4% inclusive of dividends. Small industrial company share prices have fallen 21% on average.

After some signs of recovery in January, there was no reprieve from small-cap underperformance during the February reporting season. Many smaller industrial businesses reporting good results have seen share prices slump or stay flat.

Healthia is rapidly recovering from Covid disruptions, successfully passing on wage inflation to patients and making sensible acquisitions at attractive multiples. Organic revenue grew above expectations at 5.4% in the half-year.

After reporting earnings before interest, tax, depreciation and amortisation (EBITDA) of $18.1m, Healthia reconfirmed full year guidance for more than $40m of EBITDA excluding contributions by acquired businesses. With continued acquisitions next year Healthia should be trading on a price/earnings ratio of just eight times.

Another smaller industrial business suffering despite good results is low-cost gym operator Viva Leisure (VVA).

The business reported the first half of undisturbed trading since Covid began. Revenue guidance for the 2023 financial year is 53% ahead of the prior year as gym junkies return to their workouts and new locations begin contributing. EBITDA margins improved to 20.7% for the half year and improved further to 21.6% in the second quarter of the financial year.

Viva is generating roughly $900k of free cash flow per month and ploughing that back into new gyms and acquisitions at returns on incremental equity that would make a private equiteer blush. The business also trades at eight times next year’s earnings.

Lastly, the long saga for control of PDF and e-signing business Nitro (NTO) has finally concluded. After outmaneuvering a rival private equity buyer, Potentia Capital’s somewhat convoluted bid was accepted by Nitro’s board, and subsequently its shareholders. Once Potentia’s ownership crept over 75%, Nitro’s shareholders were entitled to a further $0.03 per share, increasing the total consideration received to $2.20.

Forager International Shares Fund

Forager International Shares Fund
Forager International Shares Fund

It has been another wild start to the year for financial markets. Silicon Valley Bank, the 16th largest bank in the US, failed due to two years of mismanagement. Credit Suisse, one of Europe’s largest banks, was about to fail due to two decades of mismanagement, only to be rescued by competitor UBS in a near wipeout for shareholders.

Through all that, the unit price of the Forager International Shares Fund rose 10.7% for the quarter, versus an 8.3% return for the MSCI ACWI IMI index in Australian dollars.

Our team has attended various conferences over the past two months, across the United States and Europe. Meetings included a number of existing portfolio holdings and many other companies that are on our watchlist. Some end markets are showing signs of weakness—consumerexposed businesses being chief among them.

But we were surprised at the optimism across many other sectors. Industrials continue to do very well, driven by reduced Covid restrictions in China and onshoring efforts in North America and other Western nations. Other sectors such as semiconductors and commercial construction continue to exceed expectations of a few short months ago. The faster growing retailers on our watchlist, JD Sports (LSE:JD) among others, expressed no desire to pull back on store rollout plans. IT services businesses like Computacenter (LSE:CCC), Softcat (LSE:SCT) and Insight Enterprises (Nasdaq:NSIT), whose customers come from all corners of the economy, aren’t experiencing a slowdown in most parts of their business. Aggregates and cement companies such as Martin Marietta (NYSE:MLM) are talking about an acceleration in their business due to US infrastructure spending while solar power distributors Enphase (NASDAQ: ENPH) and Sunpower (NASDAQ: SPWR) continue to see strong demand for their products.

Even those businesses that might rightfully be a bit gloomier, including UK bank Lloyds (LSE:LLOY), advertising-dependent television production and broadcasting company ITV (LSE:ITV) and housing developers like Barratt Developments (LSE:BDEV) were less pessimistic than we expected.

Such “temperature testing” always needs calibrating. Most CEOs are perennially optimistic. And this optimism might not portend well for inflation and interest rates. But there are plenty of businesses out there doing well and trading at very sensible prices.

Dominant self-storage supplier

One of those is Janus International (NYSE:JBI). The Fund’s initial investment in this self-storage construction and renovation company was predicated on its dominant market share delivering strong revenue and earnings growth.

Despite a challenging inflationary environment, where steel prices moved up significantly throughout 2021, it has delivered more than hoped for. Full year 2022 results came in approximately 20% higher than the company had forecasted at the start of 2022. It was 40% higher than our expectations from two years ago.

As the largest player in the self-storage supplier industry, the company remains in a strong competitive position. They have almost two years visibility from a large order book and occupation levels for its clients (self-storage facility owners) remain healthy. Janus has reduced its leverage significantly since going public a few years ago and further reduced leverage targets just last year. It finished 2022 under those targets already. This puts the company in a strong position to further consolidate market share by acquiring smaller competitors over the
coming years.

The business is cash generative and should continue growing organically through geographic and product range expansion. Management also kicked-off 2023 by providing investors with a longer term guidance framework which includes 4-6% annual revenue growth and healthy operating profit margins in the high 20% range. Their conference call also indicated that it is their intention to continue providing guidance that is “realistic” (read conservative) and that they are confident they can beat.

For all this, the share price is down over 30% since Forager’s first purchase.

Are we missing something?

The biggest risk is that customer demand collapses. Although the industry trends remain strong, a higher-for-longer interest rate environment could result in their customers pulling back on capital expenditure over coming years. In addition to this, undertaking largescale acquisitions always comes with risk (although the company has a 20-year track record of growing this way).

Mostly, though, we think the company is misunderstood. It came to market via a SPAC and still has a private equity company as 35% shareholder. It could be perceived as a low-quality manufacturer of doors.

Our discussions with clients suggest the opposite. With most of the competition being tiny operators, Janus is almost the only choice for larger professional storage companies. It is involved in the design of storage centres years in advance and offers logistics, security and technology as part of its solution (replacing doors on existing, occupied storage facilities is a logistical nightmare). Janus’s services are typically less than 10% of the cost of a storage facility—it is not in clients interests to skimp on the most important component of their business.

These qualities are already showing up in the numbers and, if it keeps growing and generating cash flow, that will show up in the share price eventually. Trading on just 11 times expected (likely conservative) 2023 earnings, something needs to give.

Taking off

Shaking off the shackles of an underpriced bid, one we fought against, Flughafen Wien (WBAG:FLU) shareholders have refocused on what matters. That is, rising usage of Vienna Airport as the world recovers from the pandemic, increased profitability and dividends. In the second half of 2022, the group’s revenue was down just 13% vs the same half in 2019 (the last results before the world shut down). Net profit is not down much more. The proposed dividend creates a 2% yield and we expect dividends to grow from here. The stock has risen 22% since the
start of 2023 and now significantly exceeds what IFM was willing to pay. It’s a good outcome for minorities.

The fourth quarter result from global gambling company Flutter Entertainment (LSE:FLTR) was another tick confirming our thesis. Revenue from the US business FanDuel more than doubled versus the same quarter in 2021. And that operation would have been profitable if not for a large marketing investment in two brand new sports-betting states. That investment will prove well-spent. Ohio and Maryland have a combined population of nearly 18 million people and, unsurprisingly, FanDuel is showing early signs of a dominant market share in both
states. Massachusetts also opened for online sports betting this past month and there are more states to follow. FanDuel is expected to be profitable over 2023 and beyond.

The share price of auto parts, agricultural and industrial equipment manufacturer Linamar (TSX:LNR) fell nearly 15% the day it released fourth-quarter earnings. The results looked fine to us. The outlook has come under some pressure and capital expenditure over 2023 is expected to be towards the high end of historical norms. This is a natural outcome of retooling after three highly interrupted years. Free cash flow for 2023 is still expected to be “strongly positive”. Linamar is undoubtedly cyclical, but it’s also a structural grower and trades at roughly eight times expected earnings.

New Zealand listed fashion retailer Hallenstein Glasson Holdings (NZSE:HLG) released its first half results in March. Sales were up 31% against a heavily Omicron-impacted comparable period last year. That represents almost 40% growth from the last normal period ending in February 2020. Margins were pressured by the USD exchange rate, increased freight costs and general cost inflation. Sales for the first seven weeks of the current period are coming along nicely, up 13.9% on last year, but management are understandably cautious given the macroeconomic environment.