My encounter with Ray Martin

My business partner and I landed in Heathrow, nice and jet lagged from Sydney. After passing through customs and getting our bags, my business partner started walking, fiddling on his phone while I followed him like a sheep in a daze. One of Australia's most famous and respected journalists, Ray Martin, sat behind on us on the flight and as happens on these 23 hour journeys you get to recognise the people around you. As we were walking, Mr Martin came up to us and asked us for the baggage carousel number. We mumbled 'number 2'.  He said thank you. We then continued walking only to realise we had somehow managed to miss the big green Exit sign and were literally walking straight towards a dead end. We felt like a couple of half-wits.  

The encounter with Ray Martin prompted some thinking. I watched A Current Affair when I was younger when Ray Martin hosted the show. However, for me the most memorable episode was before Mr Martin's time when Jana Wendt hosted the programme. It was an interview about winning control of Fairfax with three people (two journalists and a then Fairfax supporter) against Kerry Packer in his famously fierce form. I remember feeling sorry for the triplet...

Kristian 

Hastings High Yield Fund (HHY)

HHY is in wind-down mode: underlying assets are gradually being sold-down and cash is being returned to shareholders. It's a true cigar-butt.* 

A chunk of cash has already been paid to shareholders. HHY has now gone ex a further 18.1c capital return. HHY's estimated NTA as at 31 May is 69c; therefore the NTA is ~50.9c. HHY closed is 37.5c. 

This is the estimated run-off of the investment portfolio (provided by the fund):

Investors will now need to wait until September 2015 to get the bulk of their money back. In addition, income payments should still continue to be made assuming the underlying investments continue to provide a return. The table below shows the estimated remaining assets and applicable interest rates:

Corey Environmental is due to mature in 2014 while Maher Terminals is due to mature 2015.

I've assumed it costs $1.4m p.a. to run the fund (based on the current annualised rate - which is a bit rough and ready), no currency impact and the investments will be realised at the current book value at the targeted dates. Based on this, I come up with an annualised return of 18% p.a. if shares are bought at the current price of 37.5c.

These numbers are back-of-the-envelope and should not be relied upon without further examination. The main problem with this type of trade is that usually the upside is capped: it is rare that assets of this type will sell substantially above book value. Therefore, the primary source of surprise would probably be to the downside.

That leads us to risks. All sorts of things can go pear shaped here. The valuations may change substantially - they already have in some other cases such as the Hyne & Son investment. Cory Environmental is on a 'negative' credit watch. Maher Terminals is a large part of the portfolio; a small hiccup may have a big impact on the HHY valuation. And then of course is the potential for left field events.

All very interesting. I am doing some more digging on this one.

Kristian 

Disclosure: small position in HHY 

*(check out page 94 of The Essays of Warren Buffett: Lessons for Corporate America)

FSA Group Ltd (FSA)

Nigel Littlewood is a professional investor and close friend and colleague. Nigel mostly specialises in Australian small cap stocks and has been a big believer and backer of FSA. Nigel recently wrote this article on FSA, which I thought was worth sharing. 

Please note this article was prepared before the recent stock market sell-off. Figures have not been adjusted. I hope you enjoy the read. Also note that Nigel Littlewood is not licensed to provide financial advice. 

Kristian 

Disclosure: own FSA (and so too does Nigel Littlewood) 

FSA GROUP A quality micro cap and specialist finance services company

FSA was born back in 2000 when four eager debt industry individuals got together to start their own business in the debt agreement industry.  Two of the original founders, Deborah Southon and Tim Maher, remain with the company today.

WHAT ARE DEBT AGREEMENTS?

Since the end of the Second World War and the introduction of consumer finance, the level of money borrowed by consumers in the western world has steadily increased. Credit card debt in Australia now totals $36bn generating interest costs of $6.2bn p/a. There are several drivers to this but whatever the reasons, most people are now used to living with debt. However in the last 20 or so years, consumer debt started to reach epidemic proportions and individual bankruptcies started to soar which clogged courts and led to social and financial problems for individuals and government.

As a proposed solution, a debt agreement, was introduced into the Bankruptcy Act (1966) in 1996. A debt agreement is a simple way for an indebted borrower to come to a payment arrangement with their creditors. A debt agreement provides creditors with a superior return compared to bankruptcy and provides the borrower or debtor with a payment arrangement they can afford and ultimately avoid the stigma of bankruptcy.

The industry is overseen by the Insolvency and Trustee Service Australia. More information is available at www.itsa.gov.au.

HOW DO THEY WORK?

Basically when a borrower gets to a point where they cannot repay their debt i.e. they are insolvent, they can approach their lender(s) and try to negotiate a debt agreement. However, most people don’t possess the skills or confidence to do this so they call FSA (or a competitor) who assesses their financial position, negotiates on their behalf with the creditor(s) and then administer the agreement over its life to (ideally) a successful completion. FSA gets paid a percentage (15-20%) of money collected over the life of the agreement.

That is where FSA started and within a couple of years, they had backed the company into a public shell and FSA was born. The future of FSA was in the hands of the executive directors Tim Maher and Deborah Southon. They would both prove to be very competent asset allocators and sensible managers and with the vast majority of their own wealth in FSA shares, appropriate shareholder-friendly incentivisation is in place.

As the company grew it became the largest broker of non-conforming home loans in Australia. Some people who call FSA end up refinancing their home mortgage to repay their unsecured debt rather than entering a debt agreement. The pre-GFC debt boom and associated securitisation market resulted in FSA exploiting the opportunity and providing its own non-conforming home loans rather than just broking other companies’ products. This created another arm to FSA along with debt agreements and the smaller factoring business.

The GFC has slowed the growth of this division but the home loan book has performed exceptionally well with nominal capital losses and an average LVR of about 67%. During the GFC the capital provider (Westpac) stood by FSA and the business continued to perform.

The macro environment has finally started to turn in FSA’s favour as banks start to clamber for market share. While this is a real positive and in coming months could lead to an increase in both the size of the home loan warehouse facility and an improvement in its terms, it is incredibly important to appreciate that through the worst debt crisis since 1929, FSA didn’t lose capital for its lender or shareholders and maintained a strong relationship with its bank when many other businesses simply failed.

WHO ARE THE EXECUTIVE DIRECTORS

When investing in the small cap space there is perhaps no more important single element than the quality and integrity of the senior management team.

Over the last 8 years I have got to know Tim Maher well and seen him manage his business through various challenges including the GFC. During this time, I believe Tim has performed brilliantly, nobody is perfect but Tim is smart, motivated, energetic, and appropriately conservative with an entrepreneurial flair and what I affectionately term, a bit of mongrel. Tim is not afraid to get in the ring if he needs to. 

I have used Tim as a benchmark for small cap managers in my investing and find few his equal. In recent years he has become a passionate student of Warren Buffett and capital allocation and investment theory. This ultimately contributed (along with some friendly shareholder prodding) to his decision in mid 2011 that the best allocation for excess capital in the business was to buy back stock at what we all agreed was ridiculously cheap. When Tim announced the buyback (and first dividend) the stock was 27c, trading on a P/E of about 4 times and below its NTA. The company has since bought back around 13m shares (10%) and paid 4.95c in divs.

Tim owns about 36% of FSA and his first priority is to conserve that wealth, consolidate and grow when low risk opportunities present themselves.

Joint founder Deborah Southon who owns 10% of FSA complements Tim. Deborah runs the debt agreement side of the business and sits on the board. She probably knows this industry better than any other executive in Australia and has done an outstanding job consolidating FSA’s position as the dominating market leader in the industry with market share over 50%.

BUSINESS SUMMARY

FSA has three distinct divisions:

1    Services

This division consists of debt agreements, personal insolvency agreements and bankruptcy. It contributed circa 78% of last year’s pre tax profit of $14.9m.This industry was explained above but FSA is the industry leader both by market share circa 51% and by technology and marketing spend. It is the dominant player in the industry.

2    Home Loans

This division contributed $4.1m (NPBT) last year representing 27%. These loans are classified as non-conforming. Therefore, the margin is high along with the risks however, FSA’s experience and track record show that if it’s managed carefully and growth is not chased exuberantly, an attractive return on capital is generated in this business. Ongoing negotiations may lead to a change in the size and terms of funding but I have not factored in significant growth at this stage although the division has big potential.

3    Small Business
This division consists of factoring finance which, is still small. It reported a loss last year due to restructuring costs. Its loan pool grew last year from $12m to $25m at the end of the 2012 fiscal year. While this business is still small, it has the potential for plenty of future growth albeit at a measured pace.  I expect it will contribute around $1m NPBT in 2014.

FINANCIALS

The current share price of 75c with shares on issue of 125m provides a market cap of $94m, there is however around $10m of excess cash on the balance sheet that can be backed out for valuation purposes although the conservative nature of management is such that I don’t expect that capital to be returned to shareholders outside of the (potential) ongoing buyback and regular dividends.

The company has provided NPAT guidance this year and I’m expecting a result around $10.5m providing a P/E of 9x or 8x if we back out the excess cash. Free cash flow is close to NPAT due to the nature of the business so another dividend at the end of the financial year is likely. I’m expecting 2.25c ff making 4c for the full year, equating to a payout of circa 48%. The board has no stated payout ratio but I know Tim and Deborah would ideally like to pay a higher dividend each year, business permitting.

The company has no corporate debt on its balance sheet. The debt from Westpac that sits within the non-conforming home loan warehouse and the factoring finance warehouse is secured by the underlying assets and is non-recourse and limited recourse respectively to FSA.

For 2014 I expect some growth in the home loan division, a flat result in debt agreements and growth in factoring providing npat around $12m (9.6c p/s).

This provides a forward P/E of around 6.5 times based on further accumulation of excess cash (circa $6m after total div payout of $6.25m) on the balance sheet (EV of circa $80m). If FSA pays out 5c (52%) it will yield 6.7% fully franked based on the current price of 75c.

Given FSA is hardly using any additional capital to grow, its profit is effectively free cash flow. If we invert the multiple of 6.5x (as Warren Buffett might) we get a free cash flow yield of about 15% (after tax). That means if you could buy the whole business and consolidate it, that is the yield you would be looking at….Not bad in this environment I’m sure you will agree.

RISKS

As with all investing there are risks. Businesses have problems that’s a fact of life and things happen but when you have a market dominating position, strong IP, debt free balance sheet and good management, risk is somewhat mitigated.

Australians since the GFC have gone from being net savers of zero to savings around 10% of their earnings. If this trend accelerates it is possible the debt agreement business in time starts to reduce in size. Currently, FSA administers around 5000 new agreements per year. If this falls, earnings will fall in that division.

The funding of both warehouses may not be renewed and this shuts down both divisions (assuming no replacement funding can be found). Given Westpac stuck with FSA thru the GFC, I see this as a remote risk.

Key man, Tim is 41 years old (Deborah is around the same age but I’m too afraid to ask), fit, just married and about to have his first child. He is highly motivated to be with us for a long time although I think every shareholder should send him a letter warning him off his occasional cigarette. No doubt in any small business key man risk must be considered but both Deborah and Tim can fill in for each other.

The board has been with Deborah and Tim for a long time and accumulated a great deal of IP however I expect much of the board to undergo a generational change in the next few years.

The home loan business is leveraged to employment and property prices. A significant deterioration in either or both of these variables pose potential risks for this division.

Factoring is a fairly high risk business subject to fraud and small business failure. As this business grows its risk reduces via customer diversification.

The market as always posses its own risk or at least volatility. During the  the GFC in a fit of fury and fear, FSA shares dropped from highs of $1 to lows under 20c for no great (company specific) reason. Volatility is part of investing and its important (as long term value style investors) to keep your eyes on the company rather than the market.  We should be endeavouring to exploit market volatility not be victims of it.

UPSIDE

As I like to say: consider the downside first and only then consider the upside. For taking the risks above we obviously want a much better return than the risk free rate.

Upside will come from dividends and that I’m confident about. Upside should come from modest earnings per share growth over time and the incremental increase in share price. Even if the P/E stays the same, the share price should increase by the eps growth. Next if the company continues to buyback shares, this should lead to increase in eps. Given where the share price is, cash in the bank is earning around 2.5% (before tax) and buying shares back (as illustrated above) is yielding 15% after tax so buying shares makes sense. 

Its worth pointing out that this stock is not leveraged to GDP, global interest rates or central bank activities while so many businesses are leveraged to the economy doing well. FSA is largely insulated and in some ways is counter cyclical.

Finally, there is a fair chance that after many years of institutional neglect, FSA will receive some institutional shareholders and thereby see a P/E re-rating. This is a maybe and not something that I would bank on but it is a possibility. With a rerating from 9x to 12x, the share price would move up 30%.

VALUATION

This of course, is always difficult because ultimately it’s a function of future earnings being discounted back to today at an appropriate discount rate to reflect the risks taken in the business.

Given the nature of the business, the free cash flow yield, strong balance sheet, sound management, I am a happy holder of this quality micro cap and expect it to move into the small cap range over time. I would be most surprised if this company did not provide satisfying investment returns for long-term patient investors who like a regular dividend.

I am a shareholder of FSA. 

Dividend Yields and Bond Yields

Two questions I ask myself is whether dividend yields versus bond yields are a good timing indicator for the stock market, and if so, is now a great time to be buying equities?

The chart below shows a comparison between bond and dividend yields in Australia since 2002: 

Australia

Source: unisuper.com.au

I don't currently have access to primary data via Bloomberg or similar, so this chart (and the ones below) are sourced from elsewhere on the internet, hence why they look a bit grubby, inconsistent and not completely up-to-date. No matter: the point is the average dividend yield is currently substantially greater than bond yields, and that is a somewhat rare phenomenon in recent history.

In 2002-2003 when Australian bond and dividend yields were kind-of similar, it was right before the massive equity bull market ending in 2007. Again, in 2008-2009 when dividend yields spiked well above bond yields was a fairly well-timed signal ahead of the equity market rally. Ditto for 2011-2012 ahead of the recent rally.

Here in Australia, a very common yard-stick to measure how much income the stock market can provide is to look at the big four banks. Listed below is the historical, grossed-up dividend yields:

NAB: 8.9% p.a.
ANZ: 7.8% p.a.
WBC: 8.9% p.a.
CBA: 7.7% p.a.
Average: 8.3% p.a.

The RBA Cash Rate is 2.75% p.a.

So the big banks pay over three times the cash rate.

Also note from the graph that bond yields were actually gradually increasing from 2005 - 2008 despite a big stock and property bull market. At one point late in the equity bull market, dividend yields were almost half of the bond yield.

Yeah, but...

The next chart shows bond yields and dividend yields since the 1950's in the US:

U.S.A.

Source: www.clime.com.au

Hmmm, this tells a slightly different story. It's actually been very common for bond yields to be higher than dividend yields. Part of this is probably due to the taxation of dividends in the US.  The last major time dividend yields were higher than bond yields was the 1950's. Bond yields started pushing higher in the 1950's leading to a monster spike in interest rates in the 1970's. The two and a half decade period from the mid 1950's to early 1980's was basically waste of time for stock market investors in inflation adjusted terms, unless you could trade through volatility or had the vision to invest in a struggling textile manufacturer called Berkshire Hathaway.

Note the great equity bull market starting in the early 1980's occurred when bond yields were massively higher than dividend yields.

The next chart is from an even older time period in the US:

Look at the whip-sawing in dividend yields: and we complain about current volatility! You can see the big spikes in dividend yields relative to bond yields ahead of two very big equity rallies: the Roaring 20's and the huge expansion in wealth following the Great Crash to the end of the 1950's. No wonder life looked so much fun in the early 1960's in the Mad Men series. What I now observe from the first chart of US bond v dividend yields is this was the end of an era where dividend yields outstripped bond yields and bond yields were on the march upwards.

Note that during much of this time in history dividend yields were greater than bond yields. People didn't trust equities as much back then.

Also note that from the late 1930's to the late 1950's, bond yields were in-fact increasing from historical lows, yet the stock markets continued a bull run.  

Fast forward to today.

Facts:

• Interest Rates are very low from an historical perspective.
• Dividend yields are higher than bond yields.
• Lots of money is being printed in the US.

A number of things could happen: inflation kicks in and we get higher interest rates, and/or the mother-of-all bear market in bonds) leading to an average or perhaps poor time for equities.  Lots of volatility for sure. Alternatively, stock prices could increase massively if interest rates stay the same or even meander upwards.

And that is a big generalisation. With inflation, businesses that can increase prices could do really well. Income securities with floating interest rates could do really well. Businesses that can't increase prices will do very badly.

Hence part of the reason why equity markets have rallied so hard in the last nine months and  have also come-off pretty hard as well in the last two months: people feel they have been forced into riskier assets due to low rates and have now been scared senseless out of risk when they get a sniff from the Fed that money printing may stop and interest rates might go up.

Plenty of academic studies show a negative relationship with changes in interest rates and changes in stock prices. Even then, it doesn't appear this may hold true in the short term as the charts above show. The story is more far complicated with absolute interest rates and dividend yields. Sometimes periods of high interest rates have been a great time to get into equities. Sometimes low interest rates have meant a great time to be in equities.

I was hoping to be definitive with this post.

Unfortunately I am not.

I hope this is interesting anyway.

Kristian

Kick the habit with Keverette

In today's Sun-Herald. Apologies about the blurry smaller text. 

Funny.

MacarthurCook Property Securities Fund (ASX: MPS, SGX: AOP)

The last post can be found here.

So, the capital raising at 6c has now been completed and the price has held steady while the market has sold-off (after a big rally). The capital raising was not fully subscribed, which I actually think is okay given it reduces the NTA dilution. The NTA as at 31 May has been stated as 11.6c. Debt at the corporate level has now been fully re-paid, which as previously noted introduces the potential for the recommencement of distributions. Clearly a unit price at 7c and NTA at 11.6c is either a massive bargain or something else is going on. I think the proposal to use the bulk of the funds to recapitalise one of its underlying investments smells, and is potentially a catalyst to wipe out some of the current NTA. However, with such a big discount I am happy to continue holding and take the risk.     

Kristian 

Disclosure: own MPS

Two cracking quotes

It's a rainy, Winter's Sunday afternoon here. Perfect for lounging around - I love the occasional day like this. There are many far smarter people than me out there, so I take the time to read what they say. Often, they articulate things with extraordinary accuracy and insight. Two of my favourites are Seth Klarman and John Hempton, and here some recent quotes from them: 

Seth Klarman (recent investor letter)

'Investing, when it looks the easiest, is at its hardest'

So true! Admittedly I have been getting complacent in the last few months and quite probably took my off the ball a bit. It's fun making money without having to work too hard. I'm being a little self critical here, but some complacency has definitely been lurking in the background. But the opposite also applies: investing is easiest when it is hardest. An excellent, practical quote for investors. 

John Hempton (from the blog post Practical lessons in assessing exotic risks)

'...most financial experts are really just salesmen selling you the risks that their employers do not want to take'

This might be a bit harsh in some circumstances, but is so spot-on in many situations. It always bugs me why clients are pushed into trades when the research house doesn't take the trade itself. Why? Some investment houses invest a relatively very small portion of the house money to a trade in order to claim they have skin in the game. But that is misleading: we make $10 by selling research, brokerage, management and performance fees, and in return we risk 20c of our own money on the trade. Really generous. Not. Well put John.

Kristian