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simon.turner@dmxcorporation.com.au

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PO Box 916,
Milsons Point, NSW 1565

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A fresh approach to value investing in
undiscovered, quality businesses.

Strategy

 

 

We are high conviction value investors who believe that some businesses are inherently better than others. In our experience human behavioural biases tend to repeat over time which creates opportunity for those who can adapt their own thinking to do the opposite to the crowd.

 

We search for companies where the conservatively estimated intrinsic value exceeds the share price by a sufficiently large margin such that it affords a margin of safety which maximises the chance of long term outperformance. To achieve this object we draw from the insights of two bodies of knowledge: value investing and behavioural finance.

We consider that both approaches are complementary aspects on the same theme – the exploitation of inefficiencies in human thinking and market efficiencies.

DMX Asset Management’s value investing approach is based on fourteen key themes. 

These are summarised below.


1. Knowledge and expertise will be more important than diversification.It is more important to know a small number of companies intimately than to know very little about a lot of companies. Risk will increase the more diversified you become.

2. Intrinsic value: cash flow, after allowance for the capital expenditure to keep the business going will be the key measure for valuation.The intrinsic value of a business – the true underlying value – will depend on its ability to produce cash in the future less the cash it consumes. The intrinsic value will vary over time as cash-flow certainty and the discount rate change.

3. Risk: standard deviation of returns or likelihood of loss?Value investors reject the idea that risk is the standard deviation of historic returns. Risk should be about the probabilistic assessment of something bad happening.

4. The share market can wildly mis-price companies relative to their intrinsic value. With time however prices will tend to correct.In the short term, the share market is effectively a popularity contest. Share price will move up and down depending on the number of buyers or sellers. In the long term, the share price will reflect the economic fundamentals of the business. Over short periods of time (even extending to several years) there can be a wide gap between the intrinsic value and that available at the stock exchange.

5. We think of investments in terms of part ownership of a business.Shares are a fractional ownership of a business – they are a lot more than a stock certificate, a CHESS statement, or a ‘blip’ on a screen.

6. “Mr Market” should be your friend.Bi-polar “Mr Market” provides you buy and sell prices every day – sometimes high and sometimes low. You should exploit his moods – buy when he is down and sell when he is high. DMX will have a long term investment horizon so this theme is used as a guide in “bear” and “bull” markets.

7. Margin of safety.The idea is you want to have a sufficiently large gap between the intrinsic value and the current share price to make the investment attractive and to allow for any inaccuracies in the assessment of the intrinsic value.

8. Governance.Alignment of rewards and treating shareholders as partners.

9. Investing or value investing.Investing should be about a considered appraisal of a business/investment case against all known facts with the expectation that on average a superior return can be achieved. This contrasts with speculation which is short term and more akin to gambling.

10. Value versus growth.Value investing can be applied to both low and high growth businesses. The key is the intrinsic value compared to the current share price – the margin of safety.

11. The distinction between price, book value and intrinsic value.Price is the current share price. The book value (sometimes called the equity value) is the value of the assets minus liabilities as reported in the accounts expressed on a per share basis. The intrinsic value is the true underlying worth of the business.

12. Macroeconomic factors.These are very hard to forecast accurately and, given the value investing approach is over the long term, frequently of only limited relevance.

13. Gold and other assets that will never produce anything.Non income producing assets have no value in the value investing framework.

14. Family companies.Very often family companies have performed well because decisions are frequently made within a longer time frame and, as the business will be the major part of the wealth of the family, they will typically have a higher level of engagement than a salaried employee.


Investment Process

At DMX Corporation we use these insights from value investing and behavioural finance to drive our investment process.

Our starting point as a value investor is that all companies have an underlying, true, value – its intrinsic value. Although this value cannot be directly observed, with skilled analysis and diligent research, an estimate may be made. This intrinsic value is then compared to the market price, and if the difference between the two is sufficiently attractive an investment will be made.

Looking at several aspects of this investment approach:

(i) We will only make investments where we believe we have a thorough understanding of the business and industry.

(ii) We will only make investments where we think there is a sufficiently large gap between the estimated intrinsic value and the share price of the investment is wide enough to compensate us for the uncertainty in our estimation of the intrinsic value. Some valuations will have greater uncertainty in them than others. Where the intrinsic value is more uncertain a greater discount to the share price is required to make the investment attractive.

(iii) The intrinsic value will not be discovered by looking at the share price or relative value measures such as PE (or EV/EBIT or EV/EBITDA). In the long run, a stock has no life of its own; it is only an exchangeable piece of an underlying business. If that business becomes more profitable over the long term, it will become more valuable, and the price of its stock will go up in turn.

The approach to asset selection has four distinct phases: initial screening, intermediate screening, modelling and management meeting, and monitoring an investment.

(i) Initial screening

There are literally thousands of potential companies to invest in. Finding the right company is the challenge. Our approach has been to draw from a wide variety of sources to identify possible investments for initial analysis. These include from the stock exchange database of which firms have achieved the lowest price in the last 12 months, newspapers magazines and investor newsletters, and stockbroker databases, as well as discussions with other investors. There are over 1,000 companies in our database.

Once a company is identified as potentially interesting the first step is to decide whether the company is within our circle of competence.

Having done that, the next step is to do some basic screening on the main financial metrics of the business. This considers aspects such as return on equity, normalized earnings, PE ratio, and margins. The initial screen is based on the most recent reported results (multiplied by two if it is a half year). The results used are adjusted for asset purchases or sales, exceptional items, unusual tax charges, etc.

This initial screening enables a quick analysis which will eliminate companies which are loss making, have strange return characteristics, low ROE’s or PE’s which are astronomical. The purpose of the screen is to screen out not screen in. As such some good companies might be rejected but lots of bad companies are likely to be eliminated. From this screening we use the team’s judgement and experience to decide which companies get through to the intermediate valuation.

(ii) Intermediate Screening

The intermediate stage uses a more considered estimate of earnings and valuation of aspects of the business which have no earnings (such as surplus land) or minimal earnings (such as share portfolios). The approach is to adjust the historic earnings for seasonality, and the effects of asset purchases or sales, exceptional items, unusual tax charges, etc. This will provide an estimate of what the underlying profitability of the business is.

Other factors also considered at this stage include the structure of the balance sheet, management compensation, dilutionary impact of share issues, and items from the balance sheet which should be separately valued.

This analysis produces an estimate of the intrinsic value of the business under a range of growth assumptions as well as tests for the quality of the businesses, governance structures, balance sheet and indebtedness ratios, bankruptcy risk, and return characteristics.

A further judgement is then made on these outcomes. The most attractive businesses will generally have high returns, little or no debt, trustworthy and competent management and have a relatively simple business with predictable cash flows.

(iii) Modelling and Management meeting

The small number of companies that get through this screen (about 10%) are then thoroughly analysed. This includes a detailed review of historic earnings and company announcements, a full model of the business (including of each of the group’s divisions, balance sheet, income statement, cash flow statement, share numbers and dividends) for at least four years out, a desk review of the industry (competitors, markets, regulators, suppliers, customers, litigation), and a review of any corporate gossip such as on Hot Copper or in the financial press.

We try to keep our models as simple as possible. We want them to capture the essence of what the business drivers are but to retain an ability to rapidly update them and to enable sufficient simplicity to rapidly understand and maintain them. Earnings forecasts are important but other softer factors can be just as important.

Once all of this knowledge is incorporated into the model, a further estimate of the intrinsic value is undertaken. If the business is still attractive we arrange a meeting with the company.

When we meet with the company we are interested in the company’s openness and frankness, the strategic direction of the business, and any opportunity to visit the operations to gain a better understanding of the business. We also ask management to explain the business, both to check our own understanding but also to hear the way they think about the business. We are also interested in management’s thoughts on our model structure and approach. Although most companies will not say if your forecast is too high/low (and under the continuous disclosure rules nor should they) we seek their help in identifying logic errors in our models.

After our desk research and management meeting we assess the firm’s competitive advantage. This will probably involve further research and meetings considering competitors, suppliers, customers, regulators, meetings with former employees, academics and industry experts, and regulators. The purpose of these meetings is to assess the firm’s competitive advantages and the risks to the business model.

We believe competitive advantage stems from five sources:

Network effects
This occurs where the value of the product increases as more people have or use the product. A good example of this would be the internet. If you and another person were the only people on the internet it would be far less value to you than if many people use the internet. The more people that use the internet the more valuable it is for other people to join and the more people that join the more valuable it is to join. It becomes a virtuous circle. Examples of this would include telecommunications, credit cards, and credit rating services.

Cost advantages 
This includes scale in distribution (such as railways or grocery retailing) and manufacturing (for instance there is only one incandescent light globe manufacturer left in the world). It will also include companies whose costs are structurally lower than competitors (for instance the Escondida mine jointly owned by BHP and Rio Tinto has the highest concentration of copper and lowest strip ratio of any copper mine in the world).

Intangible assets 
This will include factors such as brands, patents, licences and government concessions, and even corporate culture.

Switching costs 
For instance it is difficult and time consuming to change the bank or telephone company you use. In the corporate environment it can be expensive and risky to relocate plant and equipment or transition from one IT system to another.

Scale efficiencies
This would include natural monopolies (airports, or water or electrical utilities, for instance), niche markets, and rational oligopolies (such as the Australian banking market).

An important factor that tends to indicate that competitive advantage is the return on equity being greater than the cost of equity.

Generally, the expected duration of the competitive advantage will be more important than the size of the competitive advantage.

Having identified the source of competitive advantage we then look to understand how sustainable it is and whether it is becoming greater or being eroded. Generally we assume that economic theory works and competitive advantage will erode with time – our key assessment will be how rapidly this is likely to occur.

(iv) Investment and monitoring

It is only after all of these steps have been undertaken, that an investment decision is made. For an investment to be made there needs to be a sufficiently large gap between the assessed intrinsic value and the share price to justify the investment. This margin of safety will vary depending on the reliability of the forecasts (some things are just easier to forecast accurately than others) and the expected time frame before the gap is expected to close.

In most cases no investment will be made and instead the share will be monitored for share price fluctuations, with the investment being made only when the margin of safety is sufficiently wide.

Shares will be sold from the portfolio when the margin of safety between the assessed value and the share price becomes too narrow or a new investment is identified which is so attractive that it justifies exit.