A Path | September 2024 Update
"If you find a path with no obstacles, it probably doesn’t lead anywhere.” - Frank A. Clark, US lawyer & politician.
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THE MONTH | A return of +1.43% for September with both Intelligent Monitoring (IMB) and Adveritas (AV1) rebounding from August dips.
THE QUARTER | Over the quarter the Fund returned +7.70%, while the S&P/ASX Small Industrials Index advanced +6.4% and the Emerging Companies Index was up +8.82%. You can click on these links to read the July and August updates.
OUTLOOK | While ASX indices have been quoted above for context, this Fund does not hold a portfolio that we expect will follow the path of “the market” over time, although it is helpful to now be in an environment where the decline in liquidity for small stocks appears to have been arrested and interest rates are not rising. Most of the Fund’s listed investments are not index components and do not have deep liquidity. Some of its investments are held in a convertible note form and some are unlisted. We are looking for valuation catalysts like IMB’s ADT acquisition and subsequent delivery on its financial forecasts; and MDR’s emergence into full-year cashflow and net profit positivity. Occasionally there are negative catalysts as well - the most painful for the Fund was the unexpected collapse of Ellume in FY2023. We are actively engaged in seeking to deliver positive catalysts for portfolio companies.
PORTFOLIO REVIEW
We highlighted in the latest edition of Small Talk how capital raising activity among smaller companies has kicked off, albeit it often requiring discounts of 50%. We first set out the “recapitalisation opportunity” market conditions were creating for smaller stocks in this presentation in June 2022. It has been a slow-motion thematic since but the highs, lows and activity of the last month highlight how this is continuing to play out.
Digital ad fraud identification company Adveritas (AV1; ~$62m market cap; +33% stock price change in September) released its annual report for FY24 and CEO Matthew Ratty met with investors during the period. AV1’s key message was that it has a “visible path to positive operating cashflow” as it increases prices, maintains cost discipline and takes up prepaid annual contracts from new customers as it tackles a record pipeline.
Trials of AV1’s TrafficGuard solution are underway with large advertising agencies and first revenues are expected by AV1 in the December (current) quarter.
The Fund has participated in a series of capital raisings AV1 has made over the past few years to keep it funded - these deals were priced well below 2022 market prices and also below a takeover offer made in late 2022 - and the message now is that we may have now seen the last of the funding rounds, given cash flow positivity is in sight.
We profiled AV1 in this edition of Small Talk from May 2024.
In the August 2024 report we commented that security monitoring company Intelligent Monitoring (IMB; ~$235m market cap;+23% stock price change in September) delivered FY24 numbers that bettered its guidance - but the market did not get the chance to react as the figures were announced on the last trading day of the month and IMB’s shares spent that day halted from trade. The market has had the opportunity to respond to those results in September and responded positively.
This business laboured under an unsustainably high level of debt when it was named “Threat Protect” and has had to undertake a series of capital raisings over the past three years that the Fund participated in - and bought scale through M&A.
IMB CEO Dennison Hambling’s F2024 results presentation to Coffee Microcaps can be viewed here.
MedTech MedAdvisor (MDR; ~$221m market cap; -4.5% stock price movement in September) had been falling late in August despite there being no surprises with its results and the drift lower was only arrested in the middle of September, at a time when fund manager Perennial Value moved to lift its stake in MDR to 10.4% from 8.7%.
We profiled MDR most recently in this edition of Small Talk from September 2024.
Whisky and agave producer Top Shelf (TSI; ~$13m market cap; -45% stock price movement in September) conducted a $13.9m recapitalisation several months earlier but market sentiment was damaged in September by the collapse of a peer, Billson’s (produces ready-to-drink vodka, craft beer and cordial), and an article suggesting TSI’s funding was tight and it was reviewing opportunities to sell assets, such as its whisky inventory. We are unimpressed with the lack of shareholder communication emanating from this company at this time. In the absence of information, investors are left to their imagination.
WHAT’S ON OUR MINDS
Liquidity in small stocks
The last time we saw a year-on-year gain in the trailing twelve month value of trade in the S&P/ASX Emerging Companies Index was in August 2022. The year-on-year change in September 2024 was nearly flat at -0.96%, with six consecutive single months showing growth in trading value compared to the same month a year earlier. The 12-month trailing figure for August still remains ~40% below the peak of April 2022. The Emerging Companies Index has an average market cap of $273m and we expect the deterioration in liquidity over the past few years has been even greater for sub-$100m market cap companies.
Private Market Valuations
Private markets continue to slowly adjust to reflect change in the cost of capital that has occurred over the past two years. Clearly not all is rosy in the world of unlisted VC, PE and “real assets” - and despite marketeers labelling private assets as low volatility, there is underlying volatility in the pricing of private assets AND correlation with public markets.
Private equity’s annualised IRR fell below 10% in the year to March 2024, according to PitchBook data cited by the Financial Times, compared to a target of 25%. Meanwhile, the Wall Street Journal reported in June on how stakes in private equity funds were being traded at “big discounts to the official values”.
In US secondary markets for VC investments, on average, the ZX Index Values for September 2024 showed a 12% discount compared to the last fund raising round’s price per share.
Wilshire used an 11.9% decline in its Real Assets Benchmark for pension fund giant CalPERS in the year to June 2024 (covering real estate, infrastructure and forestland)
“Recap” risk and opportunity
Australasian equity capital raising activity has continued to gain momentum and - as of October 15 - is up 27% year-to-date, compared to the same period a year earlier (as measured in USD by Dealogic). IPOs remain scarce. The ASX calendar currently features eight companies only - five in the minerals space and only one raising more than $20m (a listed investment trust).
We analysed quarterly cash flow reports for the June quarter of 2024 and found over 262 companies with no more than four quarters of cash funding at hand based on their most recent burn rates - and also 95 companies in net debt positions that reported negative operating cash flow. With these companies competing for new capital, there is a funding risk for existing investments that are not self-funding at this stage. The situation is also an opportunity for investors to apply bottom-up, fundamental research and engage constructively with companies to provide them with capital on attractive terms.
Interest rates & inflation
Interest rates remain low by historical standards (see 700 years of declining rates charted here). Our view through the first half of CY2024 had been that there was not a strong case for reducing interest rates in the near-term and that if central banks do walk back rates materially, the implication will be that the economy has deteriorated. Increasing signs of softness in the economy has led the Federal Reserve to begin cutting rates in the US this month and other central banks may make some rate reductions. In Australia there remains more uncertainty regarding central bank policy. Shifting market sentiment regarding the extent to which interest rates could decline will influence the market in the short term.
Energy
We see energy as a quasi-currency - if you have energy you hold something valuable and exchangeable. The world is going to need all forms of energy to sustain or further advance standards of living. “Electricity demands from AI data centres are outstripping the available power supply in many parts of the world” already, reported Bloomberg. In Ireland there has been a ban imposed on new data centres connecting to the grid until 2028. Dragonfly Fund does not invest in the resources sector directly but we do own and seek out opportunities to participate in the energy economy - through industrial and technological angles.
Unlisted
A key lesson for us from FY2023 is the importance when investing in unlisted entities to have some form of influence.
Applications to invest in Equitable Investors Dragonfly Fund can be made online with Olivia123.
10k Words | September 2024
Liquidity in small stocks
Tech IPOs - there have been very few of them lately - but the unlisted world is bursting with “unicorns”. Now that the Fed has cut rates in September, what’s next? The market is not only oscillating around interest rate expectations but is also exhibiting volatility in the short time between the rate cut announcement and the press conference. We check in on PE multiples relative to historical levels by geography and sector, consider market moves in relation to risk premiums, then the performance of “AI” stocks. Finally we turn to the ASX’s recent reporting season and look at the average sector-based consenus revisions to nano-to-mid caps plus the stream of dividends flowing into investors’ accounts this month and next.
Dragonfly Fund has the capability to "swap" shares in a company or companies for Dragonfly Fund units where Equitable Investors finds them attractive and suitable investments. If you have a stock in your bottom drawer that we might be able to do something with, please reach out. NOTE to date we have used this capability sparingly, rejecting all but a very small number of proposals, but we continue to seek favourable opportunities.
Want to catch up?
If you are interested in learning more, please get in touch via mpretty@equitableinvestors.com.au and we will be pleased to arrange a meeting.