Earlier this year we had a Twitter follower question our value credentials when we disclosed a position in loss-making Tinybeans (TNY). Had we become speculative momentum investors? Even in our own investment team, there has been some discussion on whether some of our pre-profit positions are appropriate for a value fund. In this article, DMX Asset Management Research Analyst, Chris Steptoe, ponders: are we still value investors?
Classic Value Investing from yesteryear was often founded on texts like Benjamin Graham’s “Intelligent Investor”. The concepts in this book are a foundation of securities analysis, but I would argue that beating the market using these techniques has well and truly disappeared with the masses of analysts covering stocks. E.g. Graham would look at historic earnings per share growth for the last three years, together with a low PE ratio as two of his filters for defensive investors. Even among the more inefficiently priced small cap stocks, this kind of setup is nowadays very rare.
Modern day Value Investing has evolved since “Intelligent Investor” was written in 1949. Warren Buffett’s method of calculating “intrinsic value” employs discounted cashflow analysis (DCF). Simply put, DCF attempts to calculate value based on the future cashflow of a business. In fact, most analysts now employ this technique for valuation of a company.
Buffett’s partner, Charlie Munger, recently commented in an interview… “All good investing involves getting a better investment than you're paying for. And you're just looking for it in different places, just as a fisherman can fish in one place or another. But he's always looking for more value than [he's] paying for. That will never go out of style. I mean, that is just basic and fundamental. Some people look at it in stocks where the earnings are going up all the time, some look at consumer goods, some look at bankruptcies, some look at distressed debt. There are different ways to hunt, just like different places to fish. And that's investing. “1
We would like to extend Charlie’s fishing analogy. We think we can fish in multiple fishing spots. We don’t know where the next unloved fishing spot will appear, but we need to have the flexibility and willingness to invest if we see value.
Our nano and micro-cap focussed fund, DMX Capital Partners has now been around for nearly 5 years. Among our early successful investments were asset play opportunities we identified such as Oncard (ONC), Oakajee (OKJ), and EZA Corporation (EZA) which were trading below the value of their tangible assets. However, in recent times we have come across fewer compelling asset play opportunities. Today, these represent only a small portion of the portfolio.
Back in 2016, we wrote a blog on value investing highlighting our “Focus on low PE stocks” in the micro-cap space. A number of these ideas have subsequently played out, with the likes of Zenitas (ZNT), Konekt (KKT), and Legend (LGD) all being taken over in the last year by private equity. When we do our scans of this space today, it is now littered with “value traps” with few quality companies trading below a PE multiple of 20x. So, it could be argued that this space is now over-fished compared to three years ago. We still employ this style of investing when opportunities do present, and during 2019, we have bought names such as Shaver Shop (SSG), Academies Australia (AKG), and Dreamscape (DN8). However, these profitable, low PE, dividend paying micro-cap names have become less of a focus than in previous years due to more limited opportunities.
Ultimately, we want to own a portfolio that is different and provides our investors with some unique exposures. We therefore want to fish where there are few other investors. We are also conscious of the market being dynamic and that yesterday’s opportunities may not be available today. Right now, we see unloved nano-caps to be an under-fished area. There are plenty of companies in this space that are unloved due to concerns around lack of liquidity and/or previous disappointments. We focus on the companies in this space that are cashflow positive or will be within a year and have strong business models with recurring revenues.
In the last year we have invested in nano-cap names (with market capitalisations of under $20m) such as CV Check (CV1), Vault intelligence (VLT), Aeris (AER), Knosys (KNO), Tinybeans (TNY), Tambla (TBL), and Chant West (CWL). Some of these companies are loss-making. You may ask how can a loss-making company also be a value play? We use the same cashflow model (DCF) as we do for profitable stocks and require increasing future cashflows to justify the current valuation with the main difference being that more of the value is attributed in later years. The “margin of safety” is generated from the discounted cash flows associated with the long term recurring revenue (less costs) exceeding our very low entry price (usually under $20m as mentioned above, and often under $10m). However, we do require a higher than usual margin of safety given the future cashflows are less certain, and typically allocate these stocks a smaller position within the portfolio.
A good example is a recent position in Urbanise (UBN). Urbanise is a Software as a service (SAAS) company that provides facilities and strata software to Australian and International clients. We bought in at 3c valuing the company at just $20m. This year, we expect UBN to generate 40% revenue growth (to around $11m) and to reach break-even on a run-rate basis. With high gross margins, recurring revenues with high customer retention, costs now under control under sensible new management, and further revenue growth in FY21, we believe the cashflow valuation provided a large margin of safety, relative to our $20m entry price.
As the likes of Xero (XRO), another SAAS company, have moved from loss making to generating strong profits, the recurring revenue model focussed on customer acquisition has been proven to have very profitable outcomes. This supports the thesis that these loss-making businesses with the right models and right products can turn profitable, and that a DCF model with properly thought out and critiqued assumptions is appropriate for valuations.
The whole Value vs Growth debate does not make sense to us. Growth companies can most definitely represent value if they are priced at a discount to future cashflows. Our investing DNA is very much value focussed. Some of our companies may appear speculative due to their current loss-making status, but we see significant value and asymmetrical payoff potential from many of these positions. So, to answer the question, yes we still consider ourselves value investors.