Hence we have been giving a lot of thought to these risks as we assess our portfolio exposures to the UK economy and the opportunities that emerge as stock prices fall. We have direct exposure in the International Shares Fund and indirect exposure through GBST and Enero in the Australian Shares Fund. But we are also concerned about the broader implications of a general trend towards rising protectionism around the world.
A hit to global trade has been one of the key factors in our risk exposure analysis for the past few years, but we have generally focused on exposure to the overall level of trade. This is obviously a heightened risk with Britain leaving the EU, but there are potential further consequences of a rise in global nationalism that need to be contemplated.
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.
A far right candidate, Norbert Hofer, came within a whisker of winning the presidency of Austria in May this year and National Front’s Marine Le Pen is expected to be prominent in next year’s French presidential election. Both are keen on putting up physical and economic borders. From an investment perspective, their desire to unravel Europe’s integration, and the public’s desire to support them, is something we need to be contemplating.
As I have pointed out many times in the past, there is no correlation between economic growth and stock market returns. Our job is to build portfolios that are resilient to a wide range of potential outcomes. And the best opportunities always arise when fellow investors are at their most pessimistic. So do not think such turmoil would be without opportunity. But we have some very interesting years ahead of us and it would seem we are going to earn our keep.
Secondly, we believe management is of high quality. The founding Konstantakopoulos family owns 65% of the shares, aligning their interests with ours. Sensibly, they look to pay down the debt on their vessels as they age and use excess cash flow to fund a sizable dividend. They have over thirty years of experience in the sector with an admirable record of buying and selling vessels at opportune times. Within the shipping industry, the calibre of this management team is rare.
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.
While competition is quick to copy the company hit products, El.En., which was founded in 1981 by a university professor and one of his students, has a strong history of innovation as demonstrated by its ability to roll out new and successful products year after year.
Profits have been reinvested in expanding the business distribution network across the world, acquiring smaller businesses with great products that lacked the scale to compete on a global stage, and paying dividends to shareholders.
Its balance sheet looks great too. At the end of the 2015 year, the company had around €60m in cash and only €20m of debt. Despite this cash balance, the company’s return on capital has been robust.
Insiders have a lot of skin in the game, owning more than 50% of the company. And we have been impressed with their focus on capital allocation and long-term decision-making.
Since the Fund’s investment, Mr Market seems to have regained his senses and El.En.’s share price has increased nearly 40%. We are not sellers yet, because we have been more than happy with the company’s progress.
Medical lasers are continuing to sell well and the company’s industrial products are starting to contribute to profitability too. The company recently sold its investment in Cynosure and plans to reinvest part of the proceeds in expanding its distribution network.
El.En. should be able to generate in excess of €230m in revenue in 2016 and €15m in net profit, excluding a gain on the sale of Cynosure shares. Adjusting for the excess cash in the business, it still only trades on a multiple of 13 times this year’s expected earnings.
At a recent meeting with management, the CEO expressed some dismay at the valuation gap between his stock and US-listed peers. So much so that he suggested the board would consider a US listing for the company.
Were that to happen, we would expect the stock to trade meaningfully higher. If it doesn’t, we’re more than happy to own a growing, dividend paying business an attractive price.
Coal mining services company Hughes Drilling (HDX) has done an even better job of destroying a perfectly good business. This company should be generating cash and paying dividends thanks to its dominant and highly efficient drilling business on the east coast of Australia. Instead, managing director Bob Hughes’s reckless, debt-funded global expansion plans have finally caught up with him. The company’s shares are currently suspended from trading while its auditors and bankers question Hughes’s balance sheet and underlying profitability. Until it gets an injection of fresh capital, the company’s future will remain uncertain.
Thanks to hitting the jackpot with Coffey International and relatively good results from MACA and Macmahon, we are going to get reasonable results from the basket as a whole. That doesn’t make it any less frustrating seeing our returns crimped by management blunders.