Saying Goodbye

This is my last post at Eighth Wonder Funds.

I created the Eighth Wonder growth fund on July 1st, 2014. My plan was to use the fund to establish an audited record of investment performance. I also hoped that sharing ideas would make me a better investor.

It has been a successful journey.

I am proud to say that the fund has achieved a return of 25.3% p.a. from inception to today. The ASX/S&P small ordinaries accumulation index increased by 7.6% p.a over this period, so this represents outperformance of 17.7% p.a.

Sharing ideas also put me in touch with some great minds. I am very thankful for the people I have met and the lessons I have learned along the way.

ewgfperformance

The ultimate goal of the fund was to improve my prospects of managing funds in a professional setting. That day has now come, and this is the main reason why I am shutting up shop.

I have been appointed co-manager of Intelligent Investor’s newly created small cap portfolio. We kicked off on Feb 1st, 2017 as a wholesale fund with seed funding from the parent company, InvestSMART. We hope to open the fund up to retail investors eventually.

I strongly believe that a fund manager’s interests should be closely aligned with the investors. So, after closing Eighth Wonder, I will be transitioning my assets to the Intelligent Investor small cap fund. My primary focus is now increasing the fund’s unit price, with luck, for many years to come.

I will be sharing my thoughts on the Intelligent Investor blog, and I’ll still post with the same twitter account (@ASX8thWonder).

But before I go, here are some of my highlights over the last 3 years.

Hidden gems do exist

With all the talk of efficient markets these days, you could be forgiven for thinking that hidden gems no longer exist. But they do, they really do. You just need to know where to look.

A profitable global leader like Cyclopharm, with strong potential to multiply in size, shouldn’t trade on 5 times earnings. But it was when I found it in July, 2014. You will struggle to find an analyst that wouldn’t have drooled over it at the time. They just weren’t looking. I made stupid returns from this position, and it took relatively little analytical effort to achieve. The returns mostly came from looking in the right place.

This cemented the lesson of carefully allocating your research time to the most productive areas. Instead of looking at Telstra for the umpteenth time, broaden your horizons and look through some unknown companies. You only need to find one.

Risking it to get the spoils

RungePincockMinarco has been a good investment for the fund. Few people know this, but to make the investment, I took a pretty decent risk. But probably not one you might think.

I had been following this obscure mining software company for a few years. My interest was initially contrarian in nature. With mining deteriorating I thought there might be an opportunity to buy it cheaply, so I kept close tabs on it.

In mid-2016, it began to sell off heavily. It looked like a big shareholder was selling and I sensed that this was my window. I needed to act quick, but I was constrained because I felt I didn’t understand the business well enough to take a meaningful position.

As luck would have it, I got a chance meeting with CEO Richard Matthews, who happened to be in Sydney at the time. Anyone who has tried to meet with management, especially a stranger like I was at short notice, will know that it doesn’t always work out.

The trouble was that I was off work studying for my level 3 CFA exam at the time. I should have been focusing on that, as it’s a difficult exam that claims many scalps, but I just couldn’t stop thinking about Runge and mining software. It was a decent personal risk, as if I failed the exam, I would have had to wait another year to re-sit it, as well as having to spend more hours reading boring finance theory.

Richard was generous with his time. He even invited me to a follow up meeting the following morning to show the software in action. It sounds corny, but I felt like a young Buffett having insurance explained to him by Lorimer Davidson of Geico.

As luck would have it, the risk was worth it. I passed my exam, and the investment has played out nicely.

Learning at the school of hard knocks

Corum Group has been the best investment for the fund.

Performance wise, it was a shocker. But because of this significant loss, I was forced to take a long, hard look at myself and my investment process. I think I have become a much better investor because of it.

My investment was based on the view that Corum’s multiple was low enough to offset its challenges. This depended on my assessment of Corum’s cash generating capacity.

Oh, how I was wrong.

Shortly after my investment, news emerged that showed many flaws in my thinking. The biggest was my misinterpretation of Corum’s cash generating capacity. To explain my mistake, we have to go back to investing 101.

For most investments, we are buying part interests in the free cash flow capacity of a business. This capacity can be displayed, and it can also be masked. Sometimes the best investments are when this capacity is being masked by temporary factors.

The opposite also exists. Unprofitable companies can also look profitable due to temporary factors, and this was Corum.

To repay its debt, Corum cut its expenses to the bone under the management of Geoffrey Broomhead. R&D was zero for many years. It allowed Corum to generate cash flow in the years leading up to my investment.

To be clear, I don’t blame management for this. It was a rational decision required to stave off bankruptcy. The blame rests squarely on my shoulders. I overlooked the unsustainably low expenses and made the mistake of expecting unsustainable cash flow into the future.

In the evolving world of software, cutting R&D is not a viable solution long term. Especially when the main competitor is backed by Telstra and its prepared to sustain low profits to dominate the industry. If a business doesn’t keep up, it will eventually result in lost market share, or higher expenses if the company eventually responds. Both factors lead to lower free cash flow.

I should have recognised this, and expected much lower free cash flow from Corum, but I didn’t. I made other mistakes too but I will spare you from them for now.

After some soul searching I made numerous changes to my process. Without going into detail, contrast Corum: which had reported profits, virtually no R&D and a lack of software expertise within the business, to Runge: which doesn’t have reported profits (yet), invests a lot in R&D and has management that “gets” software.

It’s fair to say my investing has evolved, hopefully for the better.

Avoiding losers

My main focus has always been to avoid losers. I am happy to say that, even with losses like Corum, we have been pretty successful in this endeavour. Since inception, I have made 20 investments. 13 have made money.

In addition to a reasonable strike rate, I am proud of how losses have also been contained in magnitude too.

ewgfstockpicks

Energy Action update

Energy Action reported decent half-year results which seemingly came as a surprise to the market, given the sell down to $0.74 prior to the announcement and the sharp rebound since. It certainly was a lonely period to be a fan of Energy Action, as sellers significantly outweighed buyers (on some days we were the only buyer) and plenty of critique reached my inbox. Thankfully, we averaged down, establishing a better cost base.

The procurement business continues to chug along and contributed a 2% lower result than the prior period. Energy Action has evolved to meet a wider audience by expanding into tenders and structured products, however auctions continue to be a relevant procurement tool and an important point of difference for Energy Action. Auctions numbers increased by 7%, supported by 22% higher average energy prices, albeit offset by an 8% decline in total bid value as the contract duration contracted once again. All things considered, procurement remains a good business.

Interestingly, an auction competitor is emerging in the form of Bid Energy, which is seeking to backdoor through Cove Resources (ASX:CVE). Bid Energy is very much a start-up with no profits to speak of and only a few clients to their name (CottonOn highlighted). Interestingly, if they successfully raise the $7m needed and the price holds at $0.10, Bid Energy will have a 10% higher market cap than Energy Action does today. Maybe Energy Action needs to mention “SAAS” a few more times to get a higher multiple.

On to contract management and reporting, the crown jewel of the organisation. Revenue increased by 4%, with customer numbers increasing across all segments (Activ8, Bureau services, data only). One blemish on an otherwise good result was a contraction in contracted revenue by 4%, predominantly due to cancellations which effect years post 2020. I suspect the recent stagnation of the CMER division had a lot to do with a management team distracted by the acquisition integration, and this fixable problem is at an advanced stage of being addressed.

Ever since my first post, a few investors have expressed that they think Energy Action’s software is losing relevance with the end user. After reviewing the result, and aided by some clarification from management, I think what is actually happening is quite to the contrary. In the presentation, management noted that by reviewing consumption and network tariffs charges, Activ8 identified $4m in savings for its users in 1H16. Activ8 then follows this up with the retailer, ensuring the client receives a deduction of an equal amount on their future energy consumption. To put this $4m saving into context, Energy Action’s entire software division generated $8.5m of revenue in 1H16, which suggests the bill validation feature alone pays for the entire software cost in a little over 2 years.

The software division appears to have some tailwinds for two reasons. Firstly, Activ8 Gold will be released in the second half which provides real time data to its users. Management expect that 25% of existing customers will take this up at a 30% higher price. While competitors provide real time data, Activ8 Gold has an advantage with data access in that it doesn’t need to install meters on site, so clients can be up and running at the push of a button. Given managements history, I think it makes sense to scale back the estimates, but whatever way you cut it, selling some Activ8 Gold at higher prices has the potential to restore growth for the division.

A medium term opportunity is also emerging as a result of smart metering technology. While Energy Action currently focuses on customers who consume over $25,000 annually on energy, increased adoption of smart meters has created the opportunity of providing procurement and contract management software to smaller commercial and industrial users. Management estimate the market potential may be to the tune of 600,000 customers. While the specifics are yet to be worked out, the model may resemble a flat $150 fee for procurement or $300 including a scaled down version of Activ8 (likely just bill validation). If accurate, this suggests the new market potential is $180m. Again, this estimate may prove to be on the high side, and it may take years to reach its full potential, but the prospect of selling existing high margin products to more people certainly is interesting.

Finally, the project and advisory division was less of a drag, as expected. While we are stuck with this division, I suspect it can and will be profitable going forward, and management are committed to capping its revenue contribution to 30%.

All things considered, we remain happy holders of Energy Action, quietly confident about a decent return over the medium term.

 

The Action is in Energy

It has dawned on me that it has been some time since my last post. The fine tooth comb certainly hasn’t been idle, as I have looked closely at a number of businesses over the last few months, I have just struggled to find anything that really tickles my fancy. That is until very recently where I have been building a stake in Energy Action Limited (ASX:EAX), what I perceive to be a good business at a good price.

Energy Action is a $26.5m software and consulting company that manages the gas and electricity procurement for  10% of Australia’s large commercial and industrial sites. Having fallen over 50% over the last year, and 75% from its 2013 all time high, it now trades on 7-8x FY16 earnings, which as I discuss below, is dramatically cheap for a business with 80% recurring revenue, high margins and returns on capital and an improving growth profile. On conservative assumptions, I think Energy Action is worth closer to $2 than it is to the current $1.01 share price, interesting for shareholders with a 1-3 year investment horizon.

Business Model

To understand Energy Action, one needs to start with reverse auctions. Energy Action pioneered reverse auctions for electricity in Australia, and they have settled over $7 billion on their platform to date. For a one off registration fee of between $0-450, large businesses (defined as those that consume more than $25,000 p.a. of electricity) can post their electricity needs (and gas) on Energy Action’s platform. Australia’s electricity retailers then have the chance to review this, before a 15 minute auction begins where the retailers compete to win the contract. The competitive tension the reverse auction creates results in a 8.1% average price reduction for the customer.

Energy Action also derives a secondary revenue stream by receiving 1.95% of the total value of the contract over its life. The average contract duration is currently 24.4 months. These two revenue streams contribute 28% of total revenue. From the customer’s perspective, a few hundred dollars is certainly a low price to pay for an 8.1% saving, particularly when we are talking about big electricity consumers, so Energy Action undoubtedly provides an important value creating service to its customers and society in general.

While reverse auctions are highly profitable for Energy Action, their more important purpose is to source and secure customers for the main profit generator, Activ8, Energy Action’s proprietary monitoring software. Activ8 allows users to monitor their energy consumption on a site by site basis, as well as a number of other functions such as bill validation, and usage forecasting. Successful software companies are fantastic businesses and Activ8 is no different, with high gross margins, recurring revenue, low capital intensity and low sensitivity to economic cycles. The average contract duration for Activ8 is 53 months, providing tremendous earnings visibility and stability for the group. The monitoring business is the key contributor, providing 51% of revenue.

In more recent years, EAX has established a projects and advisory division which makes up the remaining 21%. This division provides tailored advice and services to existing clients aiming to reduce their energy consumption.

Why is it unliked?

In 2013, Energy Action was approaching market darling status on the back of 6 consecutive years of improving financial performance, however after delivering 3 profit downgrades in FY15, culminating with a statutory loss of $2.1m, investors have largely given up on the company.

Energy Actions earnings and cashflow

Its fair to say the expansion into projects and advice has been a bit of a disaster. Consulting businesses can be very profitable, however they also have a lot of operating leverage, and hence profitability can turn south very quickly if billable hours undershoot expectations. Unfortunately it has been execution that has let investors down.

Despite having less sexy economics than software, I still think operating an in-house consulting business is a logical extension of Energy Action’s business, assuming it is run well, as existing customers could be up sold, adding an earnings stream and potentially boosting customer retention. Management have responded by right sizing the labour force, incurring a $1.5m charge in FY15. My view is that the challenges in this business are not insurmountable, and with more focused management the consulting division will be profitable from 2016 and beyond, and therefore 2015 will be remembered as a blemish on an otherwise good growth story.

Another important point to consider is the shortening in Energy Action average contract duration. In response to the uncertainty of the carbon tax and generally falling prices around 2013, electricity consumers intentionally avoided locking in their electricity costs beyond December 2015. This resulted in the average contract duration falling to 24.4 months, the lowest on record. When electricity prices are falling, and are expected to continue falling, it makes more sense for businesses to source a greater portion of their electricity from the spot market. Just like having a mortgage on a variable rate when interest rates are falling.

Hence, electricity prices are a key factor into how much energy is transacted through Energy Action’s platform. With energy prices now on the rise, particularly so in South Australia. Energy Action operating outlook has arguably improved. As outlined recently in the AFR’s Electricity is the one hot commodity this summer, prices have started rising as an additional 1000mw of electricity is required for Curtis Island’s 6 LNG trains, while thermal supply has simultaneously been cut by 5-10% following the closure of Energy Australia’s Wallerawang c NSW plant and Alinta’s South Australian Northern and Playford plants. Input prices are also rising for generators as legacy energy hedging contracts expire.

When prices are expected to continue rising, customers are incentivised to lock in greater proportions of their energy needs for longer periods, resulting in more reverse auctions, at higher contract values with lower customer acquisitions costs for Energy Action, three powerful drivers of earnings. Based on the recent energy price activity, I suspect energy Action is likely to have improving earnings momentum as a result.

Energy Action energy price index

Another concern was the departure of the founders at the beginning of the 2015 year. Perhaps they were aware of troubles ahead, or maybe it was merely coincidental. My view on this is relatively simple. With the current board and management collectively owning 26% I believe there is a sufficient level of aligned interest. Further, Microequities Asset Management, perhaps the best small cap manager in the country owns 16%, and has installed ex-Vocus executive director Mark de Kock as its representative on the board, which provides an additional layer of incentivised oversight.

Valuation

I am not one to get too scientific with valuation (cue Buffett’s “approximately right” quote), instead preferring to estimate a fair value “ballpark” and only buying when the price significantly differs.

EAX is currently trading on 7-8x FY16 underlying earnings guidance . Unfortunately we do not have any ASX listed peers to compare multiples; for what it’s worth competitor Schneider Electric trades at 17x on the Euronext exchange. While saying little about valuation, the earnings multiple of 7-8x seems intuitively low for a well financed business with such high quality earnings (where profits are exceeded by cashflow, with net profit margins and returns on capital averaging 16% and 28% since listing). It certainly is rare to find recurring revenue businesses on single digit multiples. I certainly think the guidance is achievable, as the business has generated higher earnings before ($4.4m in 2013) and the revenue base is now 45% higher since then. The key swing factor will be an improvement in consulting earnings. As a crude approximation, I do not think a market type multiple of 15x would be unjustified, giving a valuation of $1.96-2.25.

As an additional cross check, I have built a simple DCF, which produces a $1.45 valuation assuming free cash flow rebounds to $4.3m in 2018 and then grows at a terminal rate of 2%. It seems that at the current price, the market is assuming 0% terminal growth, and a 15% discount rate.

Energy Action DCF valuation

Risks

Solar power – The shift to solar power is likely to reduce the amount of electricity supplied from the grid. This poses risks to Energy Action’s procurement business which contributes 28% of revenue. Importantly, there are two offsets to this. As more people use solar, the costs of the grid are incurred by fewer users, suggesting energy prices are likely to rise. Further, Energy Action’s consulting division generates revenue by helping businesses establish solar generation. It is my view that adoption of solar for businesses is likely to be an incremental process with many maintaining grid supplied power for redundancy purposes, suggesting the risk to Energy Action’s procurement division largely lies beyond my investment horizon. I believe the market for Activ8, the monitoring software, is likely to remain strong irrespective of the source of the energy supply.

Earnings downgrades – As management have issued guidance, a short term risk exists that this could be lowered or withdrawn. Given the predictability of earnings, I suspect the probability is low, however if the consulting division turnaround is not achieved, it certainly is possible.

Rear View Vision

With the takeover by Chinese acquirer Jangho nearing completion, it has come time to say goodbye to Vision Eye Institute (ASX:VEI), an early investment in the Eighth Wonder growth fund. Since our initial investment, which we outlined here in May 2014, Vision has delivered  a return of 78% for the fund in 14 months.

eye

Vision is a leading provider of eye care (ophthalmology) with a strong presence on Australia’s eastern seaboard. We were initially attracted to Vision because of its ability to generate a lot of free cash flow in both good economic times and bad. For many years, shareholders didn’t see any of this free cash flow as it was used to repay debt to strengthen Vision’s weak balance sheet, which had got out of hand due to the flawed acquisition strategy of previous management. Our investment was based on the view that Vision was in the final stages of repairing its balance sheet, suggesting that the free cash flow would finally become free.

During our acquisition period in mid 2014, Vision remained heavily out of favour as most investors worried that it was incapable of growing. It was feared that the employee ophthalmologists would continually demand a greater share of revenue, or leave to compete. Somewhat ironically, the markets fear of a lack of growth drove the price down to a level where growth became irrelevant. We agreed that the ophthalmologist’s bargaining power was a risk, however with Vision trading on 6x earnings compared to many health peers trading 3 to 4 times higher, we concluded that this risk was already well and truly factored into the price. At the time of our investment, we thought the earnings outlook was favourable, the stock was trading on a free cash flow yield of 16-20% and management was on the verge of initiating dividends and investing for growth. Primary Healthcare (ASX:PRY) also owned 20% of Vision at the time, so we thought an acquisition was certainly possible.

It’s fair to say that the key pillars of our thesis panned out as expected. Vision generated free cash flow in line with our estimates. Dividends were reinstated, culminating with a 1.25 cent final dividend just a few months after our purchase. Vision will ultimately be acquired, but not by Primary as we initially expected.

vei price

While we are encouraged by the successful investment outcome, it always makes sense to ignore the outcome to determine whether the initial decision was sound. Good decisions can have bad outcomes, just as bad decisions can have good outcomes.

It’s fair to say that had Pulse Health and Jangho not emerged as acquirers, Vision’s share price was likely to have continued to languish. In my opinion, this was partly due to the lack of leadership and credibility of Visions management and board. Case in point being the statements made by Vision when the hostile bid from Pulse Health (ASX:PHG) emerged. Management were quick to suggest that the offer materially undervalued their stock; the cynical side of me can’t help but thinking it was because their jobs were at risk.

It’s all fine and dandy to say your stock is cheap, but talk is cheap, it is action that ultimately counts. If management thought their stock was cheap, why did they raise $10m at 60 cents through a placement in October 2014, a 32% discount to the implied value of Pulse Health’s offer which they later said ‘materially understated’ their value. Instead of raising capital, why didn’t they buy back their own stock if it was such an obvious opportunity? It’s capital allocation 101 to only issue stock if it is expensive, and to only buy it back if it is cheap; Vision management clearly failed this test.

We didn’t have strong feelings either way about Vision’s management when we purchased our position. We see this as a friendly reminder to always take a close look at the captain, before you board the ship.

The Structural Advantage of Small Caps

“It’s not supposed to be easy. Anyone who finds it easy is stupid” Charlie Munger.

As Charlie said, investing is not easy. I am a firm believer that if an investor wants to have any hope of being successful over time, they need to have as many ‘edges’ working in their favour as possible. An important aspect of this is identifying inefficient areas of the market where a business is currently selling for significantly less than its true value, the proverbial dollar bill trading for fifty cents. So where are these great investments most likely to be found?

A.) The $100 billion company, which has 19 professional analysts scrutinising every nook and cranny?

B.) Or the $100 million company, which is lucky to have a single analyst covering its stock.

From the table below I think it is clear where the best opportunities are likely to lie. Small caps! At the time of writing, there was more analysts covering the largest 7 ASX companies than the smallest 1141 companies combined! The small cap advantage can be condensed down to the following formula:

more companies + less competition = greater investment returns

ASX small caps structural advantage

The Hidden Gem that is Cyclopharm

I was fortunate to sit down with James McBrayer last week, the CEO of Cyclopharm Limited (ASX:CYC). Cyclopharm was one of the first investments in the Eighth Wonder Growth Fund after it was formed in July 2014, and it remains a core holding in the fund. While we have had a pleasant experience with Cyclopharm thus far, I would like to discuss why we think the best days lie ahead.

On a Sunday afternoon in July 2014, I was sifting through a group of unknown companies, looking for something interesting. My interest was piqued by Cyclopharm, which stood out because it had a profitable division that was being completely masked by a loss making division, a classic Peter Lynch style situation from his book One Up On Wall Street. Management had recently exited the loss making division however the market hadn’t taken notice. We were fortunate to acquire our holding with the market cap at $11m, which represented just 5x historical earning of the profitable division (which is known as Technegas). I thought fair value was closer to 15x.

Technegas sells devices and consumables used to detect pulmonary embolism, a blood clot of the lung which affects 1 out of every 1000 people in Australia with varying degrees globally. The technology was founded in Australia in 1984 and it has been used globally ever since, one of just a handful of technologies used to detect the disease.

Similar to Gilette with their razor/razor blade strategy, Cyclopharm also seeks to expand the installed base of their devices, a reasonably significant capital outlay for a hospital or lung specialist, which then locks them into consuming Cyclopharm’s high margin consumables from that point forward. It is estimated that 1350 devices, or generators as Cyclopharm calls them, remain in operation today. Cyclopharm sells roughly 50 generators annually, at an average price of $38,000. However, the key driver of earnings is from the sale of the consumables, known as PAS, which are used each time a patient is tested for pulmonary embolism. PAS unit sales have been very consistent and growing at low single digits rates over the long term, contributing 80% of revenue at impressive gross margins north of 75%.

Technegas generator unit sales

Technegas PAS unit sales

The recurring use of PAS has allowed Technegas to consistently generate earnings around $2m. Cyclopharm sells its products all throughout the world, with key markets in Europe, Canada and Asia. This global earnings profile was a headwind when the Australian dollar was high, further masking the earning potential of the business, however now that it is receding Cyclopharm’s true earnings power is being exposed. Based on the currency translation gains, organic growth and expansion into Russia and tax benefits from accumulated losses, I think Cyclopharm can generate net profit of $3m in the coming years.

Cyclopharm is currently trading with a market cap of $36m, which is equal to 15x Technegas’s $2.4m trailing earnings . I continue to hold because I think the price does not factor in any of the upside from Cyclopharm’s numerous growth drivers.

Technegas sales

Technegas operating earnings

The most important growth driver is COPD. It was recently discovered that Technegas may be able to detect and treat chronic obstructive pulmonary disease, a disease which affects 30x as many people as pulmonary embolism. If it turns out that this is possible, Cyclopharm could become multiples of its current size simply by selling its existing technology to more people.

The second driver is FDA approval. Cyclopharm has been trying to enter the US market with Technegas for more than 10 years, however due to some mistakes on the part of Cyclopharm and its advisers, this has continued to elude the company. Cyclopharm has persisted and it has built some momentum with a clinical trial beginning in the final quarter of 2015. Management estimate that sales could more than double if they gain access to the US, a market which holds more than half of the world’s nuclear medicine departments.

The third driver is a new technology the company has recently developed called Ultralute. Ultralute is a patented technology that reduces a hospital’s costs for molybdenum 99 by 30-40% and reduces operational complexity. Ultralute could add an additional recurring revenue stream at respectable 50% gross margins targeting existing customers.

I think Cyclopharm is a high quality business with a bright future even without the aforementioned drivers. However if just one comes good, Cyclopharm could be multiples of its current size, and a game changing investment for the Eighth Wonder Growth Fund.