Never Invest in the Present - October 2023 Update
“Never, ever invest in the present. It doesn't matter what a company's earnings, what they have earned… you have to visualise the situation 18 months from now..." - Stanley Druckenmiller
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THE MONTH | A tough month for equities generally as the five year government bond yield rose 39 basis points to 4.54%. While the Fund slipped 1.62%, it was in an environment in which the S&P/ASX Emerging Companies Index fell 4.7% and the S&P/ASX Small Industrials Accumulation Index slumped just over 7%. The value of trade in the Emerging Companies Index slumped to a level last seen in April 2019. Adveritas (AV1) and Intelligent Monitoring (IMB) were strong positive contributors to portfolio performance for the month. Tech companies MedAdvisor (MDR) and 8Common (8CO) had the most negative impact, despite no negative news forthcoming.
STOCK PROFILES | Since our last monthly update we have profiled cybersecurity company Archtis (AR9) and remote security monitoring company Spectur (SP3) in our weekly SmallTalk updates for investors.
OUTLOOK | Liquidity - and by implication investor interest - remains poor for microcaps. While even fewer investors are paying attention, the long-term opportunity for smaller stocks is even greater. Share prices may be wallowing in many cases but we see the underlying businesses improving. We cannot predict a short-term turning point in sentiment but see recent corporate activity as a reminder that if the marginal buyer is not interested, companies that are achieving objectives and demonstrating value will ultimately attract industry or financial acquirers. We can, in the mean-time, report that at the time of writing November is looking positive.
An anniversary is soon to pass for digital ad fraud prevention company Adveritas (AV1; +8.5% share price change for the month) - it was on November 30 of 2022 that the company said it would not be granting Nasdaq-listed Integral Ad Science due diligence to firm up a non-binding indicative offer, reported to be set at $0.11 a share. Our reading of the situation was that AV1’s highly concentrated share registry, which is led by Citadel Group founder Mark McConnell with 14.8%, had their eyes on a larger prize.
Instead, in January 2023 AV1 raised $4m from investors at $0.085 a share. Then in May 2023 it raised $6.5m at $0.048 a share. The Fund participated in this latter raising, which came on top of $3m cash still retained in the company. AV1’s stock price in CY2023 has mirrored the performance of many micro cap tech companies that have not yet achieved positive cash flow. It traded between a low of 3.9c in September and a high of 5.3c in October.
AV1’s September quarter cash flow update reported a 50% increase in Annualised Recurring Revenue (ARR) to $4.3m in October, up 50% so far in CY2023. It predicted “record cash receipts” in the current December quarter and spoke of an “accelerated path to positive cash flow” as its entry into the US gathered momentum. It burned $3.48m in the quarter and held $3.45m cash in hand.
Security monitoring leader Intelligent Monitoring (IMB; +4.9% share price change for the month) has been a regular feature in monthly reports over CY2023 and was among the leaders again in October. On an unadjusted basis, IMB was up 54.6% for CY2023-to-date (and at the time of writing has risen further in November).
IMB released its September quarter cash flow on October 31, reflecting only in part its transformational deal to buy ADT Australia, completed on August 1, and emerge as the leading security monitoring company in Australia. IMB said ADT contributed $0.95m positive operating cash flow over two months, while group operating cash flow digested $2.7m in transaction costs and $4.7m in refinancing costs for a -$5.5m total for the quarter. IMB said “early operating results indicate the business is on track to meet or exceed the guidance of $31 million (annualised) EBITDA it set at the time of the ADT acquisition” and highlighted that it was trading at only 3.8x that EBITDA figure.
On the down-side, MedAdvisor (MDR; -17.4% share price change for the month) struggled to attract investor interest despite announcing a 27% jump in revenue for the September quarter, with both its US and Australian businesses growing by at least that amount, while gross profit was up 31% to $15.7m. It burned $4.16m in operating cash flow, compared to -$4.89m a year earlier, with the company exposed to both seasonality and material working capital movements. Payments management software company 8Common (8CO; -14.7% share price change for the month) delivered a 52% revenue increase in its quarterly update, with recurring and transactional revenue up 20%. It burned $1m in operating cash flow as it also experienced working capital swings.
There has been one change in our “Top Nine” since our September 2023 update, with MDR falling 17% in the month its position was taken by family safety and communication tech company Spacetalk (SPA), which was unchanged for the month (Disclosure: Equitable Investors’ Martin Pretty is a non-executive director of SPA). While the Fund did not participate in any capital raising activity in the month, we continue to look to participate in select opportunities - having last month noted an investment in the entitlement shortfall placement for battery technology company Redflow (RFX), the Fund has also in November completed its participation in the SPA entitlement offer, post shareholder approval.
WHAT’S ON OUR MINDS
Liquidity in small stocks
Year-on-year declines in the value of trade among stocks in the S&P/ASX Emerging Companies Index have continued to soften - trade in October 2023 was down 29% on October 2022, marking the lowest monthly figure since April 2019. This follows a 39% dive in the value traded in FY2023. Anecdotally, we think the decline in trading activity has been more severe for smaller companies not included in the Emerging Companies Index. For patient investors, such pull-backs in “the market” risk appetite for smaller stocks tend to create opportunities.
Private Market Valuations
News of “down-rounds” and corporate failures continues to flow. In the June quarter, US tech valuations were hit by a median 60% year-on-year decline for companies doing “Series D” or later funding rounds, CB Insights found. Series C companies faced a median 48% valuation drop and Series A & B companies faced into a 30% de-rating. One opportunity for listed companies is to acquire or emerge with unlisted businesses that can no longer hold out for high valuations. Data from ASIC, meanwhile, shows the number of Australian companies entering into external administration surged 62% in FY23 - and have risen 35% year-on-year in the first four months of FY24.. Similarly, in the US, data from Epiq Bankruptcy showed a 61% increase in “Chapter 11” filings for the first nine months of CY2023, relative to CY2022.
“Recap” risk and opportunity
Australasian equity capital raising activity was down 40% year-on-year in the September quarter and was less than half off the figure from two years earlier, using Dealogic data (in USD). We updated our analysis of ASX-listed cash burners following June 2023 quarterly cash flow reports. Nothing much has changed since we honed in on this theme a year ago: hundreds of ASX listings either have less than a year of cash on hand or do not generate enough earnings to cover their interest expense. Businesses are increasingly desperate for funding. This is a risk for existing investments that may require capital. It 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 and central banks should be keen to get back to something like the Taylor Rule estimate that an equilibrium policy rate is 2% above inflation. We do not see a strong case for reducing interest rates in the near-term and if central banks do walk back rates, the implication will be that the economy has deteriorated.
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. 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.
A key lesson for us from FY2023 is that it is important when investing in unlisted entities to have some form of influence.
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Investing is about return & risk | @jsblokland
The rapid expansion of renewable energy means global emissions could top out as early as this year | @climate
It’s a pool party as private equity splashes cash on small cap financial advisors | @stockheadAU
I know the conventional wisdom is that rates are going back to zero…it just seems kind of early to get on that train when median inflation is still 5.3% | @jessefelder
Small-caps are the cheapest size segment by market capitalization | @Greenbackd
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