DNR Capital Australian Emerging Companies Fund Performance Report October 2018

Transcription

1 DNR Capital Australian Emerging Companies Fund Performance Report October 2018 Performance Global equity markets suffered a sharp correction during October, with the market reacting to concerns around rising interest rates and the global growth outlook. The Emerging Companies Fund was down 13.8 (net of fees) for the month, underperforming the S&P/ASX Small Ordinaries Accumulation Index by 4.2. The largest positive contributor to the Fund s performance was MYOB Group (ASX:MYO), with its share price benefiting from a takeover proposal from private equity firm KKR & Co. KKR & Co are offering $3.70 per share, a 24 premium to the prior close on 5 October. Our holdings in Cooper Energy (ASX:COE) and Bravura Solutions (ASX:BVS) also added to performance. A notable detractor during the month was BWX (ASX:BWX), after it delivered an earnings downgrade citing disruption from the failed management buyout. Although the impact of the unsuccessful buyout has been greater than anticipated, we view these issues as more temporary in nature. The underlying drivers of the business remain positive long term, with the current share price implying limited earnings improvement. After the business disruptions, new management are now focused on executing its growth strategy, which we expect to become more visible over the next year. Other detractors included Afterpay Touch Group (ASX:APT) and Domain Holdings Australia (ASX:DHG). Afterpay declined following news that a Senate enquiry will include a review of the buy now, pay later providers. We believe that clarity over regulation could be a positive catalyst for the company, with the underlying business and the US expansion progressing well ahead of expectations. Domain shares declined following a trading update that highlighted the impact a softening property market is having on residential listing volumes in the near-term. Monthly - top contributors and detractors Fund overview APIR Code Investment bias Designed for Investment objective Benchmark Investable universe Investment constraints Investment guidelines PIM4357AU Style neutral with a quality focus The Fund is designed for investors seeking a medium-longer term investment focused on achieving growth, with less focus on generating excess income. The investor is prepared to accept higher volatility in pursuit of higher growth. The Fund s investment objective is to invest in a portfolio of Australian emerging companies that aims to outperform the Benchmark (net of fees) over a rolling five-year period. The investment objective is not a forecast of the Fund s performance. ASX/S&P Small Ordinaries Accumulation Index Australian equities and cash The Fund will not invest in derivatives Maximum exposure to an individual security is 15 of Fund NAV Asset allocation Australian Equities Risk level Cash 0-20 High Number of securities Min 20 - max 45 Top 3 contributors Alpha* MYOB Group Overweight 0.64 Cooper Energy Overweight 0.53 Corporate Travel Management No Holding 0.36 Minimum suggested investment timeframe 5 years Buy/sell spread / Management fee 1.15 p.a. of the NAV of the Fund (inclusive GST and RITC) Top 3 detractors BWX Overweight Afterpay Touch Group Overweight Domain Holdings Australia Overweight * Alpha is the fund return less benchmark return. These tables represent the stocks contribution of alpha to overall fund alpha and is determined by the stocks active weight relative to the benchmark and share price return relative to the benchmark. Top 5 active holdings (alphabetical order) Beach Energy Bravura Solutions Cooper Energy Navigator Global Investments NextDC Performance fee Minimum initial application amount Minimum further application amount Minimum withdrawal amount Valuation and unit pricing frequency Distribution frequency Responsible entity Entry/exit fees 20 of outperformance of the Fund relative to the Fund s Benchmark (after the management fee) $20,000 $5,000 $5,000 Each business day Semi-annual The Trust Company (RE Services) Limited as part of the Perpetual Limited group of companies Nil

2 Net active return as at 31 October mth 3mth 6mth 1yr Incep.* Emerging Companies Fund S&P/ASX Small Ordinaries Accumulation Index Excess return * Inception Date August 2018 Past performance is not an indication of future performance. Total return shown for the DNR Capital Australian Emerging Companies Fund has been calculated using exit prices after taking into account all of the product s ongoing fees and assuming reinvestment of distributions. No allowance has been made for entry fees or taxation. Sector weightings Communication Services (2.6) Consumer Discretionary (9.6) Consumer Staples (8.7) Energy (16.3) Financials (15.1) Health Care (3.0) Industrials (4.6) Information Technology (27.0) Materials (9.9) Real Estate (0) Utilities (0) Cash (3.2) Market review Reviewing the market correction Global equity markets declined heavily during October, with the MSCI World Index falling 7.3, one of the worst monthly performances since the global financial crisis 10 years ago. Volatility picked up markedly as investors reacted to concerns around interest rates and the global growth outlook, with significant intraday share price moves as the sell-off accelerated throughout the month. In Australia the S&P/ASX All Ordinaries Index fell 6.9, with the small cap index underperforming given the heightened level of investor caution. The S&P/ASX Small Ordinaries Accumulation Index finished the month 9.6 lower. Several issues have been concerning investors: Higher interest rates as the US Federal Reserve (Fed) tightens monetary policy Interest rates in the US continue to rise from historically low levels, with the Fed tightening monetary policy in response to strong economic growth. The US unemployment rate fell to 3.7 in September, the lowest level since GDP growth is robust, increasing by 3.5 in the third quarter with strong consumer spending a key contributor. With signs of wage growth and inflation building, the 10-year US Treasury yield has now risen to 3.15, which is nearly 70bps higher than at the start of the year. The market has been processing the transition to higher interest rates, which negatively impacts the value of financial assets. With the Fed signalling that interest rates are still below a neutral level, more interest rates hikes are likely. Trade tensions and the impact on global growth The trade war between China and the US has been escalating, with the US proposing tariffs on all remaining Chinese imports not already impacted. Although the effect on global growth appears to have been modest so far, the market is becoming concerned about the potential impact in 2019 onwards, especially in an environment where China s growth is slowing, and the US economy is potentially reaching a peak. The future of US/China trade relations will remain a key unknown for the market in the coming months, with volatility likely to persist until the outlook becomes clearer. Elevated valuations for many well-liked growth stocks The long period of low interest rates has seen valuations for many well-liked growth companies re-rated higher, especially in the Information Technology (IT) sector that has benefited from the structural drivers of rising IT spend and new disruptive technologies. The technology sector in the US has been a key contributor to the markets recent advance, with FANG stocks (Facebook, Amazon, Netflix and Google) strong outperformers. With a fair degree of optimism already baked into technology share prices, and concerns around higher interest rates impacting valuations, the sell-off in the technology heavy NASDAQ composite index set off the market correction. Australia small cap sector performance Reviewing the Australian small cap performance, there were few places to hide as the market moved firmly into risk-off mode. The defensive sectors outperformed with many of the more cyclical and quality/growth stocks underperforming, adversely impacting the Fund s performance. Companies that have been performing strongly this year were impacted particularly hard, with valuations resetting lower. We had meetings with the majority of our holdings during the month, which was timely given the significant market volatility. These meetings provided a good opportunity to review where we believe the market has overreacted to top-down macro concerns, and where the underlying fundamentals for the business remain positive. On the whole, while there are pockets of weakness in the Australian economy like housing and some segments of retail spending, generally corporates are seeing positive business conditions. The Australian economy is performing well, with GDP growing over 3 per annum and unemployment falling to a six-year low at 5. The economy is benefiting from increased business investment, higher exports and increased infrastructure spending by the government. With inflation and wage growth still low, monetary policy is likely to remain accommodative for some time. Companies with exposure to international markets appear well placed, with the depreciation of the Australian dollar providing a tailwind to earnings.

3 Reviewing the sector performance, Real Estate (10.5 of the Index) declined 1.5, with the Materials sector (17.4 of the Index) also seeing only moderate declines (-3.8). The outperformance of Materials was supported by the resilience of the small gold companies, which collectively account for close to 5 of the Index. The Fund has a large underweight in both sectors given our quality focus, contributing to a large proportion of the Fund s negative relative performance during the month. Following the negative lead from US tech stocks, Information Technology was the worst performing sector in the Index (-16). Given the strong performance of many technology businesses this year, this correction reflects more of a valuation adjustment rather than any fundamental deterioration in their businesses. Similar to the US market, Australia has seen several highly rated technology stocks attract the enthusiasm of investors. Although many are high-quality businesses with large addressable markets, the significant market optimism towards the sector had seen the valuations of certain well-liked stocks reach excessive proportions. An obvious example is the logistics software company Wisetech. The company has quickly grown to become the largest technology stock in the Index, with its market value peaking at $6.6b in September. This put the shares on a price-earnings (PE) multiple of over 100x, making it one of the most expensive technology stocks globally. The shares fell 26 during the month as the valuation deflated. We remain cautious given the downside risks to the valuation, with the shares still trading on close to 80x forward PE. Despite the Fund being overweight technology stocks (28.6 of the Fund vs for the Index), we were pleased to see this wasn t a detractor to the relative performance during the month. Our focus has been on investing in high-quality businesses where we see a valuation opportunity on offer. This has led us to out-offavour companies like the accounting software provider MYOB. The shares have been trading on a depressed valuation for some time, with the market overly concerned about the short-term earnings impact of increased investment in product development. We felt this negative view overlooked the attractive quality attributes of MYOB, like the strong market position, high margins, good levels of cash generation and high customer retention. Private equity has also identified this opportunity, with KKR & Co proposing a takeover of the company during the month. We took advantage of the weakness in technology stocks, increasing our holdings in companies where valuation multiples have fallen to more attractive levels, and where we have confidence in the long-term outlook. This included IRESS (ASX:IRE) and Altium (ASX:ALU), where share prices declined 16 and 22 respectively during the month. The Fund had small positions in both companies, as we had been waiting for a more opportunistic time to add to our holdings. our shares in MYOB after the recent takeover approach by private equity. The Energy sector (-9.8) was a notable detractor to the Fund performance during the month, negatively impacted by the oil price falling nearly 10. We have positive views on Cooper Energy (ASX:COE) and Beach Energy (ASX:BPT), with both trading well below our fair-value estimate. These companies are more exposed to East Coast gas and are set to benefit from the favourable price outlook given the tight gas market. We had meetings with the management teams of both companies during the month and both highlighted that their strategies are firmly on track. Cooper Energy expects to experience a substantial uplift in its cash generation over the next year, with production expanding 5x as it commissions the Sole gas project off the coast of Victoria in July Beach Energy is generating significant cash flow as it extracts value from its transformed portfolio, with the integration of the Lattice Energy acquisition from Origin Energy progressing ahead of expectations. The Financials sector also fell heavily (-9.7). Despite many value stocks in the Index outperforming during the month, our value holdings in the Financial sector underperformed and are now trading on very low valuations. Credit Corp Group (ASX:CCP) is Australia s largest debt collections company, with an impressive long-term track record of earnings growth and capital allocation. Following the recent correction, the shares trade on a forward PE of just 13x, with a strong balance sheet, earnings growing at double digit and a return on equity of 24. Navigator Global Investments (ASX:NGI), an asset manager we have profiled later in this report, also fell sharply, offering an attractive opportunity to add to our holding. Our recent contact with both companies suggests that the underlying businesses continue to perform well. Valuations The retracement in markets the past month has seen valuations pull back in line with historical averages towards. The below chart highlights the PE multiple of the Index over the last seven years with the average PE of 17.5x. It is worth highlighting the composition of earnings for the index have increased during this period towards businesses that are generating earnings in larger markets and technology companies with high recurring revenues. As outlined in this report we have an overweight exposure to these high-quality companies and the portfolio s PE has de-rated in the past month from 18.8x to 16.1x, despite earnings expectations increasing from 30 growth to 37. This type of market dislocation where sentiment is overriding fundamentals is creating attractive investment opportunities. ASX Small Ordinaries Index FY1 PE Multiple IRESS is a global business providing technology solutions to the financial services industry. We are becoming more confident in its UK strategy, where management has been investing to expand the wealth management division. Altium is a leading provider of software used to design printed circuit boards for the global electronics industry. It continues to take significant market share given the strength of its software and price positioning compared to its competitors. We funded these additions by divesting Source: IRESS

4 Fund positioning Our current positioning is as follows. Overweight Information Technology (+17), where we see a number of high-quality businesses benefiting from the structural tailwinds of rising IT investment and the emergence of new disruptive technologies. We remain disciplined on valuations given the high levels of market optimism towards some technology stocks in the benchmark. Overweight Energy (+7), given attractive valuations for companies with good-quality assets, improving cash generation and strong balance sheets. We are underweight the Materials sector (-8) given our quality focus, avoiding the more speculative exploration-focused mining companies. We prefer companies exposed to mining and energy investment that continue to improve from depressed levels. A large exposure to foreign earners, as we like investing in strong domestic businesses that are expanding organically into significantly larger global markets. Overweight Financials (+7), where we see disruptive business models taking market share from established market players. Stock moves One of the stocks we added to during the month was Navigator Global Investments (ASX:NGI), an asset manager that delivers hedge-fund solutions to a range of clients around the world. Navigator is the holding company for US-based Lighthouse Investment Partners and it has been managing portfolios of hedge fund assets since 1999 with US$16.1b assets under management as at 30 September In March 2018 Navigator announced it acquired the client assets of Mesirow Advanced Strategies, the multimanager hedge fund division of Mesirow Financial. Management structured the deal in a way that deferred an upfront purchase price with the consideration determined under an earn-out payment over seven years based on an earnings before interest, tax, depreciation and amortisation (EBITDA) on the assets transitioned over the period. This arrangement lowers the risk of Navigator overpaying for the assets and better aligns both parties by maintaining client relationships and key staff. This was a transformational and high value-creating transaction for Navigator shareholders, with earnings accretion over 40. It has created scale, expanded the skill set and enhances the distribution offering. Navigator meets DNR Capital s five-point quality web: 1. Industry position Navigator focuses on multimanager hedge fund solutions and offers clients its proprietary managed accounts program. The managed account program delivers investment solutions capable of adapting to regulatory requirements, managing risks and provides transparency over individual portfolio holdings. This provides a competitive advantage over peers. 2. Earnings strength Navigator earns solid EBITDA margins, high recurring revenue, high and improving ROE and strong cash flow conversion. 3. Strong balance sheet Cash of US$38.2m with no bank debt. Navigator has a $15m line of credit to Underweight Consumer Discretionary (-4), given the structural pressures facing many of the domestic-exposed consumer businesses in Australia. Competitive pressures are increasing from online businesses, with weakening house prices and tighter bank lending likely to weaken demand. Underweight many of the bond proxies like Real Estate (-11), leveraged to low bond yields. A strong preference for companies with strong balance sheets. This provides management with strategic flexibility to reinvest back into the business or return cash to shareholders. It also provides investors with downside protection from a more challenged macro environment in the future. The average debt levels for holdings within the Fund are significantly below the benchmark, with approximately 60 of our holdings having no debt. The average forward PE for the Fund is 16.1x, slightly ahead of the benchmark on 13.8x. This reflects our focus on companies with higher quality characteristics than the benchmark. On average, earnings for the Fund s holdings are growing more than 2x the benchmark, with a higher return on equity and significantly less debt levels. provide the group with access to funding if necessary. 4. Management CEO Sean McGould co-founded Lighthouse and still owns 12 of the company. Sean is a high-calibre individual and has developed strong relationships in the industry as evidenced by the recent Mesirow transaction, which is highly value accretive to Navigator shareholders. 5. Environmental, social and governance (ESG) We assess the ESG risk as low. Three of the five board members are independent and have extensive experience in the financial services industry, particularly in investment management. A key aspect of the Navigator business that the market is overlooking is its platform solution for clients. The platform allows clients to hold the underlying funds in Navigator funds directly as opposed to other structures that provide better transparency and lower transaction costs. Navigator has been developing this technology since 2005 and is now heavily marketing to endowment funds and pension schemes, having added an experienced executive to capitalise on the substantial market opportunity. We are yet to ascribe value to this opportunity but it could be a sizeable part of the business in the future given the scale benefits of the platform could see Navigator manage multiples of the current funds under management. We are attracted to the quality characteristics of Navigator overlaid with a compelling valuation at a cash PE of 11x and offering a 7 dividend yield. We met with management during the month and gained conviction that the business is still performing and we have used the share price weakness during October to increase our position. The Lighthouse portfolios are absolute return products with lower correlation to traditional equity products, which should benefit them from the recent volatility. The pipeline for fund flows is attractive as it has been investing heavily in Asia, Middle East and Europe with new mandates being won in these regions.

5 Investment philosophy DNR Capital believes a focus on quality will enhance returns when combined with a thorough valuation overlay. DNR Capital seeks to identify good quality emerging businesses that are mispriced by overlaying DNR Capital s quality filter, referred to as the quality web, with a strong valuation discipline. Investment strategy DNR Capital s security selection process has a strong bottom-up discipline and focuses on buying quality emerging businesses at reasonable prices. The process involves comprehensive company and industry research, company visits and meetings, and detailed valuation analysis and modelling. This information is used to assess the quality of a business, and the expected return. The portfolio construction process considers stock weightings based on the risk versus the expected return. It is also influenced by a top-down economic appraisal, sector exposures and liquidity considerations. The investment strategy of the Fund is intended to result in a concentrated portfolio that is high conviction and invests for the medium to long-term. Platform access HUB24 Disclaimer This document has been prepared by DNR Capital Pty Ltd, AFS Representative of DNR AFSL Pty Ltd ABN , AFSL It is general information only and is not intended to be a recommendation to invest in any product or financial service mentioned above. Whilst DNR Capital has used its best endeavours to ensure the information within this document is accurate it cannot be relied upon in any way and you must make your own enquiries concerning the accuracy of the information within. The information in this document has been prepared for general purposes and does not take into account the investment objectives, financial situation or needs of any particular person nor does the information constitute investment advice. Before making any financial investment decisions you should obtain legal and taxation advice appropriate to your particular needs. Investment in the DNR Capital Australian Emerging Companies Fund can only be made on completion of all the required documentation. The Trust Company (RE Services) Limited ABN AFSL No (as part of the Perpetual Limited group of companies) is the issuer of the PDS for the Fund. An investor should obtain and read the PDS and consider their circumstances before making any investment decision. The PDS is available at the Fund website at or a paper copy can be obtained, free of charge, upon request by calling DNR Capital Pty Ltd ( Manager ), the investment manager of the Fund. This material is general information only and not an investment recommendation. The Manager or The Trust Company (RE Services) Limited does not guarantee the repayment of capital from the Fund or the investment performance of the Fund. Office address Postal address Telephone Website Level 22 GPO Box info@dnrcapital.com.au Queen Street Brisbane QLD 4001 Brisbane QLD 4000 DNREC