Quarterly Report June 2016

Three times in the past 12 months financial markets have been in a tizz. We went close to a bear market in August 2015, officially entered one in February of this year and then saw frantic currency and equity selloffs after the Brits voted to leave the European Union in the final week of June.

The first two of those were buying opportunities. There didn’t seem to be a lot of rational logic behind some of the selling, and we were able to pick up businesses like Alphabet and South32 at very attractive prices.

It may yet become irrational, but so far the response to the latter, Brexit, has been orderly and appropriate. This is not jumping at shadows. Brexit has the potential to have a very serious impact on the wider UK economy and many of the companies operating within it.

Irrespective of your view on the politics (I have some sympathy for a country wanting less political interference from a supranational body), the economics of Brexit range between not great and bad.

The optimists’ argument goes that, while the EU allows free trade within its borders, it is actually quite protectionist against the rest of the world. This is true, as any Australian farmer can tell you (some 70% of European farm receipts are government subsidies, compared with just 4% in Australia). Freed from those shackles, the UK will become a rich bastion of free trade with rest of the world.

The world these people live in, where countries run around signing free-trade agreements willy-nilly, is not the one I have been living in for the past four decades. Domestic politics and self-interest make individual free-trade deals almost impossible to negotiate. The Trans-Pacific Partnership between 12 Pacific Rim counties including Australia, Japan and the US has been seven years in the making, has been dramatically watered down from original expectations and still hasn’t been ratified by respective governments. The proposed Transatlantic Trade and Investment Partnership between the US and Europe was first proposed in 1990 and is still no chance of being finalised. While Canada’s agreement with the EU, often proposed as the template for the UK, took seven years to negotiate and also still hasn’t been ratified. Even in Britain, I’m not sure unfettered free trade is what the average person is in favour of — particularly those who voted in favour of Brexit.

The argument the UK will be better off outside the EU is nonsense. The UK has been one of the largest beneficiaries since joining the European Economic Community in 1973. According to a recent article in the Financial Times, the UK has gone from being the “sick man of Europe”, where GDP per head had previously grown roughly half as quickly as it had in Germany, France and Italy to a point in 2013 where Britain became “more prosperous than the average of the three other large European economies for the first time since 1965”.

From an economic perspective at least, open access to one third of the global economy, which the UK has with its current membership of the EU, is about as good as it gets.

For all of these reasons, I still think the most likely post-Brexit outcome is something that looks largely similar to the current arrangements. Some commentators have even suggested a precedent for a second referendum if new arrangements can be negotiated that allow Britain to stay in the EU with some restrictions on immigration. Or an arrangement similar to that which Norway has where, in exchange for unfettered access to export markets, it agrees to be bound by most EU rules, contributes to the EU budget and accepts unlimited immigration from other EU countries.

All of that is still highly uncertain. Both the governing Tory party and the main opposition Labour Party are in complete disarray in the UK, so no one even knows who is going to be doing the negotiating. And European leaders have expressed contempt for any agreement which might incentivise other countries to go down a similar path.

Even if the ultimate outcome is a positive one, the route from today’s disarray to a happy place is going to be tumultuous. The prospect of exit is going to have an immediate impact on consumer spending, business investment and (probably) house prices. How much is anyone’s guess, but these risks are real and worth treading carefully around.

We own a lot of European businesses that are predominantly focused on international exports (El.En., Kapsch, Rosenbauer, B&C Speakers and Rolls Royce). These companies — particularly the first four — are massive beneficiaries of the EU project. How did a Linz-based fire truck manufacturer, or a medical device manufacturer based in Florence, become global leaders in their fields?

The answer is that, despite being from small cities, they have free and unfettered access to 500 million potential customers and the world’s largest economy in the EU. The EU also has the ability to use its leverage to negotiate access to other large markets like the US, and these companies become immediate beneficiaries. What chance is tiny Austria of negotiating an equivalent deal with dozens of other countries? The much derided rules of the EU also govern things like public tenders, ensuring the process is open, transparent and less susceptible to vested interests. What chance is Kapsch of winning a toll road contract in Bulgaria in a world without these rules?

I’m not for a moment pretending the EU is perfect, and there are fundamental flaws that need to be fixed. Hopefully Brexit is the wake-up call needed to remedy some of those. But on balance the European project has been an extraordinary economic success story over the past 50 years and some of the companies we own are specific beneficiaries.

Much has been made of the fact that the FTSE 100 rose in the aftermath of Brexit. Between the day of the vote and 30 June, the index of large capitalisation stocks listed on the London Stock Exchange increased nearly 3%.

Unfortunately, the real picture is worse than that and, as explained above, we think the damage is real.

Companies that generate most of their revenues outside the UK and don’t earn much pound-denominated revenue constitute the majority of the FTSE 100. Those that are domestically focused did it much tougher, as a quick look at our portfolio will tell you.

The share price of Lloyds Bank (LSE:LLOY) fell 25% during that week and was already down on worries prior to the vote (the return for the year was –35%). Lloyds is a very well capitalised bank with dominant market share in a highly concentrated local banking market. We expect it to navigate any choppy waters ahead and maintain its market leading position. But its loans are mostly against residential property, which could fall in value, and it is the largest business lender in the UK. It is unlikely to come through a recession unscathed.

The only other UK stock in the portfolio is Rolls Royce (LSE:RR) and it should be a beneficiary of the turmoil. Most of Rolls’ revenues are in US dollars and a good chunk of its expenses are pound denominated, so the weakening pound is good news. The company released an announcement stating that profits would be £40m higher if exchange rates stayed where they were prior to the Brexit vote. They should be hundreds of millions higher after.

Earlier this year we ventured into one of the most beaten up sectors of the market, international shipping, making a small investment in Monaco-based Costamare (NYSE:CMRE). Costamare is one of the largest independent owners of containerships in the world. It boasts a fleet of sixty vessels that can collectively haul 333,000 standard-sized freight containers (TEU), and it charters those vessels out to international shipping companies. It does not own the actual containers, nor does it provide logistical services to the broader commercial universe of companies who trade their goods globally. It simply owns and operates ships.

Investors have plenty of reasons to avoid shipping. This is an industry that has historically been characterised by high levels of debt, hyper-cyclicality and bad actors. The containership sector is somewhat unique within shipping in that it is fairly straightforward and not subject to many of the vagaries that affect other shipping markets. But it has taken it on the chin the last few years as a surge in new super-sized vessels has overwhelmed weak demand.

Despite these risks, Costamare benefits from a number of advantages that are appealing from an investment perspective. Firstly, Costamare’s charter contracts are long-term in nature. Most sectors within the shipping industry work on spot or short-term business, but Costamare’s ships are tied up under multi-year contracts with large, financially sound customers. The company has already locked in its revenue for the next two years, giving us confidence both in its expected profit and its ability to withstand volatility in the market. Looking back, the company has maintained an operating profit margin of greater than 40% in every year that we have public information, with a peak-to-trough decline in operating profit of only 13% during the financial crisis.

When we purchased the shares earlier this year, the stock had sold off almost 70% over the previous six months. It was sporting a dividend yield of 17% and a price to earnings multiple of 4, providing a suitable margin of safety for this type of business. The stock rebounded for much of the first half, getting close to a sensible exit price before the recent Brexit development changed the outlook. Global GDP growth and global trade are both likely to fall, leaving us to think it will take longer for a recovery in Costamare’s market. The stock has pulled back and we will continue to wait for a more advantageous exit opportunity.

If you have recently visited Bondi Beach, this won’t come as a surprise: tattoo removal is a growth industry. It’s an important trend for one of the International Shares Fund’s largest investments.

In early January the Fund purchased shares in El.En. (BIT: ELN), a manufacturer of medical and industrial lasers based in Florence.

The medical division accounts for 70% of El.En.’s sales and almost all of its profits. Products span machines used for the removal of hair and tattoos to more complex devices used for the treatment of conditions such as kidney stones and vaginal atrophy. The remainder of the business — its industrial division — focuses on lasers used to cut wood, metals and glass during manufacturing processes.

Aging and more health-conscious populations mean that the medical market for lasers should continue to grow — industry expectations are for the market to be worth in excess of $4bn by 2020 compared to $2.2bn today.

El.En.’s share of this is roughly 7% and company-wide sales have grown from €25m in 2000 to €220m in 2015, mainly thanks to strong demand for its medical lasers.

At the time Forager purchased its shares El.En. had a market capitalisation of €185m, traded on a price to earnings ratio of 15 times and sported a dividend yield of about 3%.

On top of a growing business and a bullet-proof balance sheet, El.En. also owned a 4.5% stake in Cynosure (NASDAQ:CYNO), a leading American company in the medical laser industry (and a former subsidiary of El.En.). While contributing little to the company’s profitability, this investment was then worth €37 million.

After adjusting for the value of this investment the company was actually trading on a price to earnings ratio of only 12. This looked extremely attractive, not only because of the quality of the business and the growth to come, but also because the company‘s main competitors, most of them still unprofitable, were trading at much higher valuations (see table 3).

At one point we were starting to lament the lack of things to write about in this quarterly report. There hadn’t been much news of note since March, either in the portfolio or in the wider market.

That changed dramatically as the results of Britain’s referendum on leaving the European Union started to filter through on Friday 24 June.

The Forager Australian Shares Fund has some direct exposure to the UK. Software company GBST Holdings (GBT), marketing group Enero (EGG) and Smart Parking (SPZ), roughly 12% of the portfolio between them, generate significant portions of their revenue in Britain.

We don’t anticipate a huge impact on GBST’s revenue — that is underpinned by contracts in place and legislative changes that are unlikely to be abandoned. But with UK revenue more than half of the total for GBST, the translation impact of a 10% fall in the pound exchange rate versus the Australian dollar is meaningful. Compounding the effect, only one third of the costs associated with GBST’s UK business are incurred in pounds, meaning costs won’t fall as much as revenue (most of the programming work is done in Australia and Vietnam).

Surprisingly, the share price of Enero hasn’t fallen at all. Public relations companies Frank and Hotwire, two of the best businesses in this marketing group’s stable, are based in London and earn most of their revenue in pounds. Some 62% of the group’s operating earnings came from the UK and Europe in the first half of this financial year. There is no cost mismatch here but a UK recession is unlikely to be good news for Enero.

Outside these two stocks and a small investment in Smart Parking, the Fund is well placed to withstand the impact if there is a global economic slowdown as a response. We have a higher than usual cash weighting at the moment and little exposure to economically sensitive businesses. Indeed, an equity market sell-off would be welcome for the opportunities it might create.

Probably more importantly, Xero’s subscription-based business model is vastly superior to the old model of selling perpetual licences on a disk. In the old days a small business would buy a disk for $500–$600 from Harvey Norman (HVN) or JB Hi-Fi (JBH) and install the software on their own computer. Many of them never bothered to update the software until they needed a new computer, if then. Not only does this leave the software provider managing dozens of historical versions of their software, it means they only get paid once every five years or so and have to pay a healthy chunk of their margin to the retailer.

Under an online model, software is updated and improved without the user even noticing. The distribution cost is close to zero. And a customer typically pays $20–$30 per month, which adds up to significantly more revenue over the average life of a customer. More revenue times more customers equals an industry much larger than the old one.

And, as good as Xero’s product is, Reckon’s existing database of clients is a very valuable asset. Many thought the end of Quickbooks was the end of Reckon but its customer retention has been unbelievably good. They have added net customers over the past few years, despite their cloud offering being well behind the competition. This shows its brand is strong and customer switching costs are high even at the small business level.

If they can migrate a decent chunk of that client base across to Reckon’s own cloud offering, it is going to be a very good business.

We are fully cognisant of the fact that this industry is changing quickly and that Reckon is starting well behind the competition. But with a market capitalisation less than one tenth of its two main competitors, many of its advantages are being forgotten.