Hiding in plain sight?

At Airlie, we look to invest in quality companies that we believe are undervalued by the market.  Often these opportunities emerge when a great business sits within an otherwise mediocre sector, or when the market assigns an arbitrary discount to a type of business.  For us, Seven Group Holdings (SVW) falls into both categories.   

Seven is a conglomerate of industrial businesses. Two of these businesses sit in sectors often unloved by investors for their volatile returns and capital intensity - mining services (WesTrac) and equipment rental (Coates). Furthermore, in listed equities 'conglomerate' is a dirty word. It can imply complexity, opacity and bloat, where the corporate structure of the company sits at odds with interest of the shareholders, and many investors choose to avoid conglomerates for these reasons.  In our mind, WesTrac and Coates are quality businesses sitting within mediocre industries, pushed further out of sight by the conglomerate structure of Seven. While investors digest the highly publicised on-market takeover of Boral or lament the decline of the namesake Free To Air TV business (Seven West Media), WesTrac and Coates quietly demonstrate their quality and form the majority of our valuation of Seven.

WesTrac - Less cyclical than it appears?

WesTrac is the authorised Caterpillar dealer in Western Australia, New South Wales and the Australian Capital Territory, providing heavy equipment sales and support to customers. Caterpillar employs an independent dealership sales model for its heavy machine sales and support services. Caterpillar thinks this model fosters a stronger relationship between dealers and local customers (acknowledging the importance of high-quality after-sales service and support) and allows Caterpillar to focus its capital allocation on product development and innovation. 

WesTrac sales are given in two segments - product sales (i.e. machine sales) and product support. Product sales have been reasonably cyclical, tied to future production volumes and the fleet replacement cycle of the tier-1 and tier-2 miners (and at a second derivative, commodity prices and miner profitability). Product support sales have been far more steady, growing at a 10-year rate of 7.0%, as new sales enter the maintenance program and old equipment sees parts intensity increase and its life extended.

Through the cycle, WesTrac has had a return on invested capital ranging from about 14% (2015, 2016) to 30% (2012, 2021) and EBIT margins between 7% to 11%.

WesTrac does not disclose earnings by segment, but our analysis suggests the earnings of the business have shifted materially towards product support over the past decade. Given product-support revenue is more predictable and still growing, this should mean that even if new sales decline the earnings of the business is more sustainable (versus a decade ago) with arguably a higher 'mid-cycle' earnings base. 

Finally, Caterpillar has an internal target of doubling its revenue from product services (via the dealership network) by 2026, as it looks to take advantage of fleet-replacement cycle extensions and expanded product lifecycle offering.

The net of this is that we believe WesTrac is far less cyclical than typical mining-services businesses, and earns stronger returns through the cycle, and should be valued as such.

Coates - Impressive transformation ahead of a revenue inflection?

Coates Hire is Australia's largest general equipment hire company and provides a range of general and specialist equipment to a variety of markets including engineering, building construction and maintenance, mining and resources, manufacturing, government and events.  The business is primarily exposed to east coast infrastructure, industrial and residential projects, as well as resources activity.

The Coates business is thriving. Following the resources boom earlier in the decade, Coates' margins slumped from about 25% to about 11% as revenue fell from about A$1.3 billion to A$870 million (-32%) from FY12 to FY16.  Management has since undertaken a material cost-out, transformation program that has been delivered incredibly successfully:

• In FY15, Coates delivered A$104 million of EBIT on A$919 million of revenue (11.4% margins). In FY21, on essentially flat revenue (A$946 million), Coates delivered A$212 million of EBIT (22.4% margins).
• Since FY15, EBIT has grown at a CAGR of 12.5%, while revenue growth has been benign at a CAGR of 0.5%.

For FY22, management has guided to high single-digit EBIT growth.  Looking further out, management is driving the business towards the internal 'Team25' project goals. Team25 is a continuation of the existing transformation strategy within Coates with the business targeting A$1.25 billion of revenue and a 25% EBIT margin. Part of the success of the Team25 targets will rely on revenue growth driven from increased market share and east coast infrastructure spend, however cost-out initiatives still form part of the strategy. Were management to successfully execute on the Team25 targets, Coates would deliver about $313 million of EBIT, versus A$212 million in FY21 (+48% overall, or a 10% CAGR to FY25).

The takeaways for us are two-fold:

• First, Coates management has built an impressive track record of cost management and margin growth in a benign revenue environment; and
• Second, given the above, Coates should see material operating leverage in its earnings should revenue start to grow.

Coates' margins and returns sit in the top-quartile of the global equipment rental sector, and there remains the potential for considerable earnings growth over the next two to three years (on top of that delivered steadily since 2016).  Both of these factors suggest to us that the business is of higher quality than most would expect of typical rental equipment companies.

Valuation

Of course, Seven does not just consist of WesTrac and Coates. Within the conglomerate also sit stakes in listed companies Boral (70%), Beach Energy (30%) and Seven West Media (40%), as well as unlisted energy, media and property holdings. Of these investments, the recently acquired 70% stake in Boral is the most material (and where valuation is arguably most up for debate).  Including the Boral investment, we estimate Seven is trading on a P/E multiple of sub 14x FY22 earnings, which is a about a 25% discount to the S&P/ASX 200, and in our mind an undemanding valuation.

In our 'sum of the parts' analysis of the business, we see upside to the current share price when taking a more mid-cycle view of the earnings of WesTrac and Coates, and before including any material valuation upside to the Boral business, should management successfully execute the transformation program and unlock additional value in the non-core property portfolio. Finally, our confidence in the conglomerate structure comes back to ownership. Seven remains 60% owned by the Stokes family, with Kerry Stokes in the chairman role and his son Ryan as CEO. In our view this gives shareholders significant alignment with the board and management, and we have found that through time founder-led businesses tend to consistently outperform the broader index.

Sources: Company filings and website

The winter of 1978-1979 was disastrous for the UK economy. A combination of freezing weather, rising inflation, union wage demands, and public and private sector strikes caused fuel shortages, food shortages, and essential services failures. The press christened the period "the winter of discontent", borrowed from the first line of Shakespeare's Richard III. Not surprisingly, Margaret Thatcher won the May 1979 election.

The coming winter of discontent will affect much of the northern hemisphere, but particularly the UK and China. The US is all but self-sufficient in energy, although it will continue to suffer supply chain disruptions. The EU has sufficient spare generating capacity and cross-border electricity transmission to mitigate the power problems, and Russia has promised to step up gas supply. India has managed to create its own coal shortage without having a Communist Party or a Conservative Party to make mistakes, but very few global investors have any exposure to the Indian share market.

Boris Johnson doesn't have to face a general election until May 2024, but the winter of 2021-2022 is shaping up as a major public relations disaster for his government. Rising oil, gas, and commodity prices are exacerbated by higher transport costs, not to mention labour shortages in essential functions such as truck drivers, butchers, and process workers. Lack of truck drivers has forced the government to use the army to deliver petrol to service stations, and supermarkets are already suffering stock-outs of basic items such as eggs, milk, pasta, and canned fruit.

The shortages have been blamed on COVID-19, Brexit, EU bloody-mindedness, UK government incompetence, private sector inadequacies, and global supply disruptions. What is clear is that there are no quick solutions.

Xi Jinping is facing the same types of problems in China: power cuts and supply disruptions. The nationalistic (State-owned) media has blamed these on the usual suspects - corrupt officials, foreign saboteurs, counter-revolutionaries, and "bad elements" generally - but in China's case the true causes are well-documented.

Demand for Chinese goods surged in 2021 as the global economy recovered. This meant that demand for electricity surged. But more than half of China's electricity comes from coal-fired plants, and since 2016 the central government had been forcing the closure of small coal mines, not in a quest for net zero emissions, but because of the very high levels of local pollution and industrial accidents in these small mines. Alex Turnbull makes a persuasive argument that part of the shortage was caused by the disruptive effects of anti-corruption campaigns in Inner Mongolia - see https://syncretica.substack.com/p/rectification-campaign-to-energy.

So China needed more electricity than it had the coal to produce. The obvious next step was to import more coal. Unfortunately, the rest of the world wanted more coal too, so prices had already risen sharply. To complicate matters, in 2019 the central government had unofficially halted thermal coal imports from Australia, and the spare Australian coal had been sold to other countries.

By mid-2021 it was clear that many Chinese provinces did not have enough electricity to power their economies. Yunnan, for example, has built an aluminium industry on cheap and abundant power from its hydro stations. But in 2021 low rainfall reduced hydro power supply, so Yunnan was forced not only to shut down alumina smelters, but also to reduce electricity exports to the neighbouring province of Guangdong.

What made matters worse is that, because two-thirds of China's provinces had missed their targets for reducing energy consumption and energy intensity, the central government told cities which were home to major polluters to shut down the worst offenders for several hours a day or a few days each week. This means heavy industries such as steel, cement, glass, and paper manufacturers.

Another complication: local power prices are set by the government, usually for the benefit of industrial and residential users. When higher coal prices pushed coal-fired power stations into losses, most governments would not agree to any power price rises. In response, generating companies stopped buying expensive coal and temporarily shut down their unprofitable power stations.

Xi Jinping and his Politburo are several management levels above the grassroots, and bureaucrats are never keen to bring bad news to their bosses, so the extent of the problems did not become obvious until September. The eventual response shows that - unlike Boris Johnson - Xi Jinping took matters very seriously indeed.

• The three main coal-producing provinces have guaranteed that their mines will supply an extra 145 million tonnes.
• Because the coal price under long-term contracts is less than half the current spot price, suppliers will be allowed to double their price.
• "Flexibility" will be permitted in electricity prices, which means that end-users will bear part of the cost increases.
• Residential and agricultural users will have priority of supply over industrial users.

INVESTMENT IMPLICATIONS

Whatever happens in the UK will have very little impact on Australian investors. As a trading partner, the UK is slightly more important to us than Thailand. Ever since the Brexit vote in June 2016, the UK share market has traded at a 20% discount to other developed markets, so a lot of bad news is already priced in.

By contrast, the power cuts in China are globally important, reinforced with the property market turmoil caused by the Evergrande default. The net effect will be to reduce China's GDP growth rate below 4% annualized over the next six months. Chinese imports of Australian iron ore will fall by 10% over this period, but Chinese imports of Australian thermal coal will rise unobtrusively.

The Chinese factory shutdowns will add to the world's supply shortages and keep commodity prices weak until the Chinese economy is visibly back to normal - probably by March 2022. China's power outages will worsen global supply chain disruption, but the key factor which will end the US import shortages is consumers reducing their spending on goods and switching to spending on services.

For China's share markets, the impact of the power cuts is negative, but it is far smaller than the damage done to China's tech giants already by the central government's regulatory crackdowns.

Because Australia is already on the receiving end of China's unofficial trade war, the downside for us is minimal. Lost iron ore exports are offset by record coal exports. But Australian investors need to watch the Chinese economy, just in case it doesn't recover within six months. If so, there will be more negative consequences for the global economy.

Funds operated by this manager: 

Collins St Value Fund

Funds operated by this manager: 

Premium Asia Fund, Premium Asia Income Fund, Premium China Fund

"Anybody driving slower than you is an idiot, and anyone going faster than you is a maniac" - George Carlin. 

A few months back, my colleague Jesse wrote about the competing nature of the efficient market hypothesis and behavioural finance. Here's a brief recap: 

"The focus of behavioural finance is the idea that investors are limited in their ability to make rational economic decisions, whether that be influenced by their own biases, by a lack of self-control or resources (i.e. time), by peer pressure (i.e. herd mentality) or a number of other social, cultural and external factors. If studied and watched closely, this irrationality can begin to reveal some patterns of behaviour and can lead to opportunities. The opposing camp to behavioural finance however, is the Efficient Market Hypothesis. The Efficient Market Hypothesis asserts that investors are rational, fully informed, and that (stock) prices reflect all available information at any given time and therefore always trade at their fair value. Essentially making the ability to generate an excess return impossible. Despite one's preference for economic understanding (behavioural vs theoretical) or preference for investing (active vs passive), there seems to be a clear delineation between the two camps."

Rereading this got me thinking about the active vs passive investing debate. In particular, how we might divide them into the two above camps and the similarity to George Carlin's infamous stand-up routine. On the matter of dividing them into camps, it seems that passive investing is more akin to the Efficient Market Hypothesis, given its implied nature of not seeking an excess (or outperforming) return. Whereas with active investing, this would better align with behavioural finance, as often the mandate is to seek outperforming investments. Unpacking this further, we know that in theory all publicly listed companies must distribute pertinent information to the market equally. Although in practice, we know that despite this dissemination, rarely is every page or slide considered prior to making an investment. Put another way, assuming all investors have the time to read and digest all available information, and process this information at the same rate, we would essentially all drive at the same speed and arrive at the same time. Behaviourally however, we know that human decision-making does not always follow the same logic, which may help fuel mispricing's such as market bubbles and exponential growth in speculative assets (such as cryptocurrency). Similar to when some drivers may be driving faster and more erratically than you.

The relevance of George Carlin's routine to this debate is not necessarily its humorous nature (an added benefit), rather the confirmation bias many of us (sub)consciously ascribe to. Essentially Carlin's routine is famous for the very flaw it highlights in our tendency to confirm our own biases; if someone drives slower than us, they're a fool, and if they drive faster, they're a maniac. So, through the lens of the active vs passive debate; should we rush towards passive investments and drive at the same speed (risk) as everyone else, or are we better off driving at our own speed (risk tolerance) and actively seek out investments that suit that profile?

It's little surprise that as investment managers of the Spatium Small Companies Fund, an actively managed fund that has outperformed the index by 10.8% per annum since inception (to 31 August 2021), our bias is naturally weighted towards active investing. However, parking that aside for the moment, there may be some merit to low-cost passive investing for retail investors, especially those who entered the market in 2020. A report out of the University of NSW highlighted direct stock ownership by retail investors (defined as having 1,000 or less shares in the ASX300) increased by 7% in 2020, whilst CNBC reported that an estimated total of 15% of all retail investors began investing in 2020. No doubt retail investors were, in part, motivated by the unprecedented rise in markets post the COVID-invoked bottom of 23 March 2020. To put this rise into 'unprecedented' context, the S&P500 has doubled in value from the 23 March 2020 bottom to 16 August 2021. Considering that it normally takes an average of 1,000 trading days (of which this time only took 354 trading days) for the market to double from a bottom (such as the GFC or World War II), labelling this rise unprecedented may be not giving it enough justice.

Furthermore, as many global markets drove at similar speeds post the initial COVID shocks, it is easy to get carried away with the (false) assumption that past performance is an indicator of future performance. Especially for the retail investors that sought to directly invest in stocks throughout 2020, there may be those who are beginning to drive at different speeds relative to the broader market. This begs the question, if retail investors are finding their once 'speeding' portfolios slowing to a school zone pace, might they be better off driving at the same speed as everyone else in a passive product? It is hard to argue with the ease of access and diversification options that passive products can offer one's portfolio. Additionally, a retail investor can access these options easily and at a relatively low cost.

That said, a word of caution on passive products; there is a growing criticism that passive investing is eliminating the need for price discovery or individual research at the stock level. The lack of price discovery in passive products may be driving markets to be more inefficient as opposed to serving the very camp that they belong to. Given the relatively recent trend in passive products over the past decade, the full ramifications of their impact on markets is still unknown - some industry heavyweights such as Michael Burry have even gone as far to say that when passive product inflows become outflows, "it will be ugly".

Fundamentally, an investor's willingness to agree with one investment style or the other resides with internal biases and past experiences, notwithstanding that the available data on the ever-evolving allocation to passive investing is still quite premature. As such, an assessment on exactly how this will affect markets remains an argument for another article. Either way, as the debate rolls on, we encourage all readers to abide by respective speed limits (levels of risk), rather than focusing solely on an estimated time of arrival (target return).