Climbing a Hill | July 2024 Update
Climbing a Hill | July 2024 Update
"After climbing a great hill, one only finds that there are many more hills to climb” - Nelson Mandela
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THE MONTH | Small stocks that had been impacted by pre-June 30 tax loss selling rebounded; we believe there was a general improvement in quarterly cash flow reports; and sentiment shifted a little in favour of small stocks amid heightened rate cut expectations and the valuation gaps that had opened up between the mega cap tech / “AI” stocks and the broader market. While Intelligent Monitoring (IMB) and De.mem (DEM) are singled out as the largest positive contributors to the Fund’s 10.1% return, a broader number of investments contributed with few positions detracting. The S&P/ASX Emerging Companies Index only advanced 0.2% for the month but was impeded by its exposure to a soft resources sector.
SMALL TALK | Since our last monthly update, Fund investors have received a profile of distiller Top Shelf International (TSI) in our weekly Small Talk updates.
OUTLOOK | Events since the end of July are consistent with two key views we have held on markets: (1) We could not see a strong case for reducing interest rates significantly in the near-term unless the economy deteriorated; and (2) few investors have been paying attention to smaller companies, resulting in the ASX failing as a mechanism for fair pricing of those stocks (as confirmed by the takeover premiums detailed last month); while momentum carried mega cap tech and “AI” stocks to valuations that can be very difficult to sustain. At a macro level, investors are in a room of mirrors where interest rate expectations, market movements and economic growth all reflect back on each other. Volatility has increased. We will stick to investing in individual businesses where we see opportunities for value creation and value recognition.
PORTFOLIO REVIEW
This was a rare month where very little ran against us. The share price move with the greatest negative impact was a -3% drift in Adveritas (AV1). We also marked down our holding in DIY security and sensing company Scout Security (SCT) to reflect the pricing of its entitlement offer and debt conversion.
Its “deja vu all over again” with security monitoring company Intelligent Monitoring (IMB) positioned as one of the key positive contributors to monthly performance. This was also the case in the months of May and June and more broadly over the course of FY2024. We suspect IMB’s emergence as a business with material earnings and strong market share, while trading on relatively low valuation multiples, has attracted some buying interest from larger funds. Late in the month IMB released its quarterly cashflow report, showing $5.2m of net operating cash flow before acquisition costs (for a net $3.7m). IMB reiterated its pro-forma EBITDA of $39.5m before any growth and business improvements expected in FY25. With a market cap of $175m and net debt of $57m tallying to an Enterprise Value (EV) of $232m, it remains priced on <6x EBITDA.
Late in the month water treatment company De.mem (DEM) reported essentially break-even net operating cash flow for the June quarter of -$0.003m on $7.0m of cash receipts - up 20% year-on-year. It held $4.9m cash at balance date and no debt. DEM said it is “on track for record full-year results.” With DEM having acquired mining-focused chemicals & consumables company Auswater Systems in June, adding $0.45m in annual re-tax profit, DEM is well positioned to push through into consistent positive cash flow generation and continue its consolidation strategy.
Portfolio Changes
The Fund participated in two capital raisings during July:
The placement of the ~$0.5m shortfall from the recent entitlement offer by remote monitoring technology company Spectur (SP3), which we highlighted at the NWR Security Technology Conference in mid-July (see the replays of presentations from SP3, Equitable Investors, IMB, SCT and others here).
A placement by medical device company Compumedics (CMP), which subsequently announced FY24 revenue was up 16% to $49m, bringing the company to full year profitability.
Purchases were funded by selling down some positions where our conviction was not as high or material gains had been achieved and the risk/reward scenario had become less attractive.
WHAT’S ON OUR MINDS
Liquidity in small stocks
The trend in trading activity among smaller ASX stocks has been positive for four consecutive months after a prolonged period of decline, based on year-on-year comparisons. The value of trade in the S&P/ASX Emerging Companies Index was up 46% year-on-year in the month of July but still down 6% year-on-year on a trailing 12 month basis. We use trade in the Emerging Companies Index components as a benchmark but expect smaller stocks that are not in S&P/ASX indices suffered an even greater decline in the value of trade over the past two years.
Private Market Valuations
We continue to watch private markets slowly adjust to reflect the 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 and PE investments. Despite marketeers labelling private assets as low volatility, there is underlying volatility in the pricing of private assets and there is correlation with public markets. In US secondary markets for VC investments, the median and average discounts to the price of the last funding round were 31% and 24%, in the June quarter of 2024, according to PitchBook and Zanbato (having bottomed at 50% and 42%, respectively, in March 2023). The Wall Street Journal reported in June on how stakes in private equity funds were being traded at “big discounts to the official values set by the private-equity funds’ manager” with “buyers quickly mark[ing] up the stakes they acquire to the official value, no matter how little they paid for them”.
June quarter data from PitchBook shows that median Series A valuations matched the figure from the two peak quarters in 2022 BUT the number of reported valuations was “well less than half that of each of these other high quarters.” “The fewer priced rounds are due to the inability of companies to raise a new round, as well as companies opting for convertible notes or debt, when possible, rather than raising a new priced investment at a lower valuation.”
“Recap” risk and opportunity
Australasian equity capital raising activity has been improving. The dollar value raised in CY2024-to-date is now up 39% year-on-year, following a 6% decline in CY2023 (using Dealogic data in USD). 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 and an exciting time 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 has 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 now suggest the Federal Reserve 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 from here 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. Bloomberg reported recently that “electricity demands from AI data centres are outstripping the available power supply in many parts of the world” already. 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 engineering, manufacturing and software or other industrial and technological angles.
Unlisted
A key lesson for us from FY2023 is that it is important when investing in unlisted entities to have some form of influence. During FY2024 we realised one unlisted investment, in data centre cooling tech company Firmus, for a return equating to just under 20% a year.
Applications to invest in Equitable Investors Dragonfly Fund can be made online with Olivia123.
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.