Where bargains are found - December 2023 Update
"... bargains are usually found among things that are controversial, that people are pessimistic about, and that have been performing badly of late." - Howard Marks
Image generated by DALL-E
THE MONTH | Equity markets got their “Santa Clause” rally in December. We would have been disappointed if the Fund’s listed investments did not benefit from the positive sentiment. The Fund’s NAV gained 6.86%, while the S&P/ASX Emerging Companies Index was up 6.4% and the Small Ordinaries gained 6.99%. The Fund benefitted from Intelligent Monitoring (IMB) continuing to re-rate, while Spacetalk (SPA) bounced back from price weakness in the prior month.
THE QUARTER | IMB was also the stand-out performer within the portfolio across the three months to December 31, 2023. Despite the pre-Christmas gains, overall the volume of activity in micro-caps remains at multi-year lows.
OUTLOOK | We have read commentary from a variety of sources arguing that funds will flow back into smaller stocks in CY2024. We would welcome such an event with open arms but to date we see little sign of it and would not build an investment thesis around asset class fund flows. We continue to take the view that either the achievement of value-demonstrative milestones is eventually recognised by the market; or if the marginal buyer of listed equities does not price stocks appropriately, trade buyers and private equity-style investors will ultimately capitalise on opportunities.
PORTFOLIO REVIEW
Security monitoring business Intelligent Monitoring (IMB; $103m market cap; +54% price change for the month; +115% price change for the December quarter) has been a regular feature in our updates in CY2023. The update from the company in December was that it was trading “ahead of expectations”.
IMB’s story is one that we think highlights the opportunity in unloved micro caps in the current market environment. The Fund has participated in three rounds of capital raisings, starting back in October 2021, when the current management team began recapitalising and reducing the large amount of debt IMB had held; through to a round in July 2023 to support the acquisition of ADT Australia.
We profiled IMB for Fund investors in Small Talk back in June 2023, when its market cap was just $26m - “Where previously we were talking about IMB’s share price being underpriced based on EBITDA of >$6m, this transaction is said to deliver pro-forma EBITDA of $24.8m for FY23, without factoring in any cost-out opportunity. IMB has set $31m EBITDA as the target for FY24. Free cash flow of $17.9m is projected for FY24.”
While management had a cash generating business and a strategy in place to extract value, IMB was just another micro cap that most investors had no interest in looking at. We had highlighted in March 2023 that there were literally no bids at all for the stock at times. Less than $62k worth of stock changed hands that month. But the ADT deal was a catalyst. In December 2023 there was $2.2m worth of trade, demonstrating the double-edged sword of illiquidity.
Something we like about IMB, beyond its earnings power, is the presence of supportive shareholder Black Crane, which has a 59% stake. We feel an affinity with Black Crane’s approach: “We drive corporate events and governance changes in undervalued companies. We manage a highly concentrated portfolio, taking a private equity approach to public market investments over a multi-year investment horizon.”
Of course, the reality of CY2023 was that there were more losers than winners. The worst performed Fund investment in CY2023 was our holding in New Zealand listed Software-as-a-Service (SaaS) company Geo Limited (NZ: GEO), which had been the top listed performer in the portfolio back in CY2021 but has struggled since. Post month end, GEO has proposed a delisting that it believes will save money and better position it for a sale process.
“While the Company has a wide shareholder base, the trading of shares is infrequent and occurs at very low volumes (i.e., the Company’s shares have very low liquidity). As such being listed on the NZX Main Board provides little benefit to shareholders from a liquidity perspective.”
The lack of liquidity that was evident in IMB earlier in CY2023 remains the reality for many microcaps and we have noted others also looking at delisting. Clearly the market is not functioning well. The ASX is effectively charging listing fees so that small companies can have the price of their equity held for ransom by small punters. On the day this is being written, one ASX listing the Fund holds had its stock price moved 16.7% on just $75.00 traded.
Portfolio Changes
“Internet of Things” (IoT) is no longer a hit industry but in December we took up shares in a capital raising by an IoT player focused on aged care and health, Talius Group (TAL; $23m market cap). We profiled TAL here during December, noting that TAL had delivered four consecutive quarters of positive operating cashflow, with strong revenue momentum. We also cashed out of an unlisted investment data centre cooling tech company Firmus for a return equating to just under 20% a year.
WHAT’S ON OUR MINDS
Liquidity in small stocks
The liquidity statistics are not improving for smaller ASX listings. Our proxy, the value of trade in S&P/ASX Emerging Companies Index components, as reported by Iress, was down 29% in the December quarter, compared to a year earlier. For the whole of calendar 2023, the value of trade was down 24% on 2022. 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 ~$264m) - and it was less of an issue for larger companies, with the value of trade in the S&P/ASX 100 down 14% in CY2023.
Private Market Valuations
After highlighting a median 60% year-on-year valuation decline in US tech valuations in the June quarter, CB Insight has reported a recovery in the September quarter for some VC segments (“Series C” rounds +32% but “Series a” -4%). CB Insight noted that the valuation bump “partly a reflection of some startups not being able to raise even at low valuations as investors pursue a ‘flight-to-quality’ strategy”. 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% for CY2023 - to a figure just over double the CY2021 level. Similarly, in the US, data from Epiq Bankruptcy showed a 72% increase in commercial “Chapter 11” filings for CY2023, relative to CY2022. In the month of November.
“Recap” risk and opportunity
Australasian equity capital raising activity was down 23% year-on-year in the December half-year just completed 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 as much as the market is forecasting in the near-term and if central banks do walk back rates, the implication will be that the economy has deteriorated.
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
the S&P 500 ETF, $SPY, saw its biggest single-day inflow on record | @KobeissiLetter
“Using Xero to manage your small business is easy. OK Boomer” | @parpera_money
Rate Cut Pivot Can’t Come Soon Enough for Debt-Strapped Companies | Bloomberg
The S&P 500 is up 23% this year, yet 71% of stocks are underperforming | @callieabost
The forward 12-month P/E ratio for $SPX of 19.3 is above the 5-year average (18.8) and above the 10-year average (17.6) | @FactSet
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.