Running the Risk | March 2024 Update
”It is better by noble boldness to run the risk of being subject to half the evils we anticipate than to remain in cowardly listlessness for fear of what might happen." – Herodotus
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THE MONTH | NAV continues to oscillate month-to-month as a positive February was followed by a -2.2% pull-back in March. This compared to a +5.8% gain for the S&P/ASX Emerging Companies Index (EC Index). Water treatment company De.Mem (DEM; +12%) continued to advance and Locality Planning (LPE; + 45%) bounced back on a material surge in volume that preceded a takeover offer lobbed in April by investor River Capital. Liquidity remains low at the micro-cap end and that was clear in some of the weaker stocks in the portfolio, with no material news flow as a driver.
THE QUARTER | The March quarter was the first negative quarter of FY2024 for the Fund, with NAV down 3.5%. This compared to +5.3% for the EC Index and an average 0.64% for Equitable’s micro-to-mid cap “FIT” Universe median stock performance. Over the financial year to date, the Fund has gained +6.5%, compared to +4.0% for the EC Index.
SMALL TALK | Since our last monthly update, Fund investors have received a profile of LPE.
OUTLOOK | A key opportunity (for new investments) and risk (for some existing investments) remains the tightness of capital markets. Those who get to the ‘What’s On Our Minds” section of these reports would know that we have not agreed with prevailing market sentiment that interest rates would decline materially this year - and that this would be a good thing. Market sentiment has been turning towards our view and this may cause short-term volatility in equities. But at the same time we see value in small companies beginning to be recognised through M&A and expect that to continue.
PORTFOLIO REVIEW
We are frustrated that the Fund’s investments have not performed more than is the case so far in FY2024. While we always maintain a medium-to-long term perspective, we felt the valuation and catalysts for investments made by the Fund would lead to a double-digit percentage recovery. At +6.5% so far, the Fund has stabilised after two very negative financial years but we remain a long way off from meeting our ambitions.
Just how quickly can things turn when there is minimal interest in the micro caps in which we focus? One of the top performers for the month, Locality Planning Energy (LPE), provides a classic example. There has been virtually no interest in it since 2022. Only $1.6m worth of stock was traded over the 2023 calendar year. But already in CY2024 there has been $3.6m traded, of which $2.7m changed hands in the month of March. The key buyer that suddenly started paying attention was an investor, River Capital. The activity drove the stock price from $0.04 at the end of February 2024 to a high of $0.076 in April. River has put an unsolicited takeover offer on the table priced at $0.08 a share, conditional on reaching 90% acceptances.
On fundamentals we do not think the stock should have been trading at $0.04 a share. While the company has fallen short in the past of achieving its growth ambitions, some quick action in CY2022 when energy prices surged saw the company improve its financial position materially by closing out its hedge book. At March 31, 2024, it has a niche business it expected to generate $1.6m to $1.8m in net profit in FY2024 from its 32,867 customers; plus a $5m loan asset that has accrued another $1.16m in interest and fees; with underlying net debt of $2.8m (including as debt $1.3m LPE has received from the Queensland government and must pass on to customers). That’s on a <$13m market cap. If the LPE business can be sold for the $800-$1,000 a customer range that it has highlighted in the past, then the stock on our numbers would be worth more than double what it trades at today ($0.071 at the time of writing). We can only assume it is a thesis similar to this that would drive an investor to launch a takeover proposal.
Portfolio Changes
We accumulated MadPaws (MPA) opportunistically in late March. The major source of funding for that was the sale of “free attaching” options that the Fund received when participating in a capital raising. The realised value of those “free” options ended up being equivalent to 29% of the initial investment, highlighting the potential upside from such deals in a market where options are regularly being attached to sweeten deals.
WHAT’S ON OUR MINDS
Liquidity in small stocks
Liquidity remains a key issue for the ASX’s smaller listings. The value of trade in our proxy, the S&P/ASX Emerging Companies Index, was down 22% year-on-year in the month of March - it was the lowest dollar value of trade for March since 2019 (as was the case in January & Februrary). On a twelve month rolling basis, the value of trade in the Emerging Companies Index over the 12 months to March 2024 was the lowest since the 12 months ended May 2020. We do not have statistics at hand but we expect liquidity declined to a greater degree for microcaps outside the S&P/ASX Emerging Companies Index (which has an average market cap of ~$282m).
Private Market Valuations
The March quarter of 2024 was the second lowest recorded for global startup funding since the beginning of 2018, according to Crunchbase. Late-stage funding deals declined 36% year-on-year. One opportunity for listed companies is to acquire or merge 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 was up 41% in the March quarter of 2024, having surged 43% in CY2023 - to a figure more than twice the CY2021 level. In the first two months of CY2024 the figure is up 45% year-on-year. The US data is the same - Epiq Bankruptcy counted a 43% year-on-year increase in commercial Chapter 11 filings in the first three months of 2024.
“Recap” risk and opportunity
Australasian equity capital raising activity was down 34% year-on-year in CY2024-to-date, following a 6% decline the prior year (using Dealogic data in USD). We analysed the latest round of quarterly cash flow reports (for the December quarter of 2023) and found over 230 companies with no more than four quarters of cash funding at hand based on their most recent burn rates (and backing out the R&D tax rebates many received in the quarter). Thus it continues to be the case that businesses are 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 as much as the market has been forecasting in the near-term (noting the market has been becoming less bullish on rate cuts over the past month or two) and if central banks do walk back rates, the implication will be that the economy has deteriorated (not necessarily a great thing for businesses).Shifting market sentiment regarding the extent to which interest rates could decline from here will have influence over 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. 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.
Applications to invest in Equitable Investors Dragonfly Fund can now be made online with Olivia123.
Twitter
Open AI’s model all but matches doctors in assessing eye problems | AFR.com
Equity Risk Premium has fallen to its lowest level in 22 years | @Barchart
Small caps now reflect the same percentage of the market as 1930 before the Great Depression | @KobeissiLetter
Japan’s stock market is booming | FT.com
Think stocks are cheap? In the early 1980s, cosnumer staples sold for mid-to-high single-digit multiples | @turtlebay_io
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.