Do you know which stock this is?

Imagine you bought the stock below roughly near the bottom at 40c on the left hand side of the graph. 

That was March 2009 and the bottom of the GFC when the sky was falling on our heads. As we know, the market then rallied in a big way and this stock went nuts climbing up to $1.94; a close to 5 bagger on your investment. Can't think of anyone who wouldn't be happy with that. 

Move forward to 2011; a grinding year where the S&P ASX 200 almost hit 5,000, but didn't and then just headed south for the rest of the year to breakdown below 4,000 and wallowed there along the bottom. So too has the stock retreated all the way back down to $1.20; a spicy 38%. 

Throughout this time the stock was never 'cheap' on a traditional value basis. In fact, even though it had been around for a while, it was still not making money in 2009 and was hardly making any in 2010 and 2011 giving it a PE in the 30's. It wasn't paying a dividend during this time until September 2011 when it paid 1.5c. The fixed cost base was high for its industry. Management had an excellent reputation but this was a relatively new venture for them and had to yet prove themselves. 

Traders were probably already stopped out at this point. Fundamental investors might be wondering why they are holding this thing. If you hadn't already bought it, and as a good contrarian value investor your wonder who would buy a stock that has already moved up in orders of magnitude and wasn't cheap. You would look pretty silly if you bought it and it went down, right? 

Check out the graph below, which shows the continuation of the graph above - i.e. the subsequent performance of the stock:

You can see the subsequent performance is outstanding. And during this time the stock started paying dividends, so Total Shareholder Return (TSR) is actually much higher. Let's put some numbers around this performance. Assume you bought it at $1.50 in May 2011 - roughly halfway during it's decline after peaking at $1.94 in early 2011. The current price of this stock is $18.49 and has paid out $1.47 in dividends including franking (all of the dividends have been fully franked) so the total pre-tax return is $19.96. Not bad for a $1.50 investment. That's a 13 x return on your investment. IRR is  a blistering 142% p.a.

And remember, this is buying it after it had already increased several times over, so you have by no means picked the bottom.

This is not a nano cap that nobody had heard of.

So which stock is this? 

The stock is Magellan Financial Group (MFG). MFG is a funds manager that was launched after the founders noted that Australian investors were underexposed to international shares and Platinum had that part of the market to themselves at the time. That was correct - I was once-upon-a-time a financial planner and Platinum was seen by many as the only real serious international equity manager that wasn't a closet index hugger available on investment platforms. MFG have done a superb job at building a quality team and have built the business into a serious funds manager with $37.2bn FUM. It's an outstanding success story.

For investors, I think there are several lessons from the meteoric returns of MFG:

Scaleable businesses are amazing but patience is required

Funds management is massively scaleable. Just like software and franchise businesses. However they may not make much money to start with, so it's important to take a long term view of the company. More importantly than the short term financials is the top line growth. Can management build revenue? Is there macro head/tailwinds? What is the competitive environment to stop the top-line being grown? If the business is genuinely gearing itself up for massive growth, then quite possibly the short term financials may actually be quite poor as investment is made into product, people and marketing.

Don't be afraid of heights

It doesn't really matter if the stock has already increased several times over if the story stacks up. You would still have made a massive amount of money even if you bought at the interim top in early 2011. Personally I think looking at charts can sometimes cause false vertigo as it puts a frame around your perspective. Look again at the first chart and honestly ask yourself whether you would have thought the performance would have been what you see in the second graph.

Diamonds in your back yard

Ironically, MFG was set up as an international funds manager yet itself has proven to be an absolute diamond of an on the ASX. And just look at how many fund managers are pushing their clients to invest overseas using the sales pitch of a bigger pool and more growth offshore. This may be true, but you only need one MFG in your life...

Inverse of a cigar butt

As noted, MFG never looked particularly cheap on standard value investor metrics. You really needed to take a longer term, DCF view to see the potential. This is the same with most growth stocks to be able to get your head around paying a PE of 20+ (if it's making money at all). Sure, growth stocks have been bid-up, so perhaps you could argue MFG and other similar growth stocks may not otherwise be at their current prices. But even a decent pull back in prices has still yield MFG investors obscene returns. However the main point is the reliability of the DCF. With a 'concept' stock it's a crap shoot. With simple(r), observable businesses like MFG, DMP and REA predicting growth is easier yet not obviously not fool-proof. 

Kristian 

Disclosure: no position in MFG. 

Contango Microcap Convertible Notes (CTN, CTNG)

It's been a while since I've had a good look through the ASX listed interest rate securities. These are found at the back of the tables in the AFR. See below for this weekend's (6-7 June): 

I tend to call all of these securities 'hybrids' including the corporate bonds, floating rate notes and convertible notes, although this is not strictly correct in some cases. As noted in previous posts, hybrids have been good hunting although the by and large the market is now more comfortable with this sector than five years ago and therefore there are less opportunities. Again, as previously noted I think there is room for more of these types of securities as there are a lot of investors who really just want income to help fund their retirement. 

One security that I like (but don't own) are the AFIG convertible notes: AFIG. I've written a few posts up on AFIG before here, here and here. On a similar note are the Contango Microcap Convertible Notes CTNG. Let's look at these in a bit more detail - starting with fundamentals and then structure.  

Fundamentals  

Contango Asset Management is a fund manager of both unlisted trusts and the listed Contango Microcap (CTN). The underlying performance of CTN has been solid (note these are pre-fee figures):

Source: Contango Quarterly March Update 2015

As you can see, CTN has been around over 10 years, and the market cap is $176m with 160m shares at a share price of $1.08. Pre-Tax NTA is $1.17 and post-tax NTA is $1.132. 

The company holds no debt except the CTN notes which we will come back to shortly. 

Like other good LIC's, CTN pays a healthy dividend stream of a minimum of 6% of NTA each year. Forecast full year dividends are 7.7c partly franked. So at $1.08 that gives a yield of 7.1%.

Anyway, all of this is pretty straight forward as a background to CTN. Let's move on to CTNG itself. 

Structure

CTNG is very similarly structured to AFIG. To be honest, if I were running a LIC I would seriously thinking about raising some debt in a similar fashion. 

In summary, here are the key features of CTNG: 

• Face value $100
• Current Price $102.85
• Unsecured
• Fixed interest of 5.5% p.a. (on face value, unfranked)
• Interest Payment dates are March and September each year
• Convertible into CTN shares at each Interest Payment date at a rate of $100/$1.30 = 76.92 CTN shares (i.e. each CTNG allows you to buy 76.92 shares)
• Final maturity date 31 March 2020 of $100

Like AFIG, CTNG has allowed CTN to take on some leverage without the annoying standard margin loan features such as the lenders ability to just remove a stock from a margin lending list. There are some gearing covenants which should be noted - see page 17 of the prospectus. However CTNG is hardly an Alan Bond style debt-ears-pinned-back move: there are $26.5m CTNG on issue versus CTN gross assets of $206.6m (31 December). 

So, what's to like from an investors point of view? Firstly, the yield is okay which is currently 5.3% p.a. (remember this in context of an RBA rate of 2%). Secondly, the twist in the tail is the embedded optionality. You get exposure to upside in the CTN share price above $1.30. Remember, CTN is $1.08 and is trading at a discount to NTA. And you have four and a half years to achieve this - even a mediocre investment performance by CTN would get you there. The biggest point to like is a floor in the price of $100. It's unlikely CTN will blowup, so the more probably worst case scenario is a mediocre investment performance and you just get your $100 back in 2020. 

Imagine some basic scenarios of CTN being $1.50 in March 2020. Your CTNG shares are worth 76.92 *$1.50 = $115.38 each. Throw in the interest payments of $5.50 p.a. and assuming you paid the current price of $102.85, your pre-tax IRR is 7.6% p.a. If the CTN moves to $2 then your pre-tax IRR is 13.4% p.a.  

What's not to like? Well if you think interest rates will move up then fixed rate securities aren't so fun. And Cantango could hold the share price down by increasing dividends and/or issuing dilutive options. And obviously we don't know if the CTN share price will move above $1.30 in the future. 

Also, CTN is not a pure-play Listed Investment Company (LIC). Contango internalised management and the proceeds of the fund are invested in another Contango vehicle Contango Income Generator fund which itself has not yet listed. This is potentially confusing to investors and distracting for management. 

However I think the main point is that CTNG is ultimately a bearish trade. If you just buy CTN you immediately get a higher dividend yield 7.1% p.a. (plus some franking). And if the CTN share price moves up to $1.50 your pre-tax IRR is 13.4% and for $2 it is 19.5% p.a. So unless CTN moves south in a decent way, you are better off with CTN rather than CTNG. However, I've been through the GFC and the appeal of a floor in the price has decent appeal and obviously everyone has their own preferences.    

It's tough to get excited by CTNG. For me to buy CTNG I would need to see a bigger divergence between CTN and CTNG so there is more value in the security.  

Kristian 

Disclosure: no position in any of the above securities. 

Devine Ltd (DVN)

Well, I got this one completely and utterly wrong.

My reasons for buying DVN were a) big discount to NTA, b) improving/firming general property market, c) the first upgrade in years (the end of the profit downgrade cycle), c) the company putting itself up for sale (following major shareholder Leighton wanting to cash out) and d) plenty of good gossip that a firm bid would be made. 

I wrote this is in detail almost a year ago when the price was 93c. 

The company sales process has fallen over and the share price is now 75c. So that adds up to a decent loss and makes me a schmuck.

Two questions:

With hindsight, would I do the trade again? Probably. There were two decent catalysts being an earnings upgrade and the company putting itself up for sale. And plenty of value in the stock with a decent margin of safety - even taking the view the company would be sold for less than NTA.

Checkout the share price movements over the last year:

The price-action makes it pretty obvious the deal has been dead for some time and insiders have been well ahead of the market. What I would do differently is be attempting to reconcile why the share price kept sinking in the face of good news. These are tough situations to judge. As often as not, selling because of poor-price action can also be the wrong thing to do, however a stop-loss rule would have made the decision a lot easier.

The second question is what to do now. The fall-through of the sale process is the loss of a big catalyst, so to continue holding really requires some damn good reasoning.

DVN is cheap. NTA has actually pushed up a bit from $1.52 to $1.55 (31/12/14) so at 75c you get a whole bunch of property for half price. However: value alone is not a great reason to buy, and as noted in my last post (BOL) a value stock without a catalyst is a value trap. For example AV Jennings (AVJ) has been a long-term dog trading at a big discount to NTA for years. DVN's fundamentals have been improving, free cash flow has really pumped along over the last 12 months helping to get debt rapidly paid down and put a chunk of cash in the balance sheet, forecast profit looks pretty good (and is a good jump from current levels) so it's really quite eye opening to see the price where it is.

Anyway, I haven't made a decision as to what to do with DVN. The commitment I made to myself in starting this blog was not to sweep losses under the carpet - so I wanted to publicly discuss this trade. Please feel free to contact me if you have any views on DVN (or other stocks).    

Kristian 

Disclosure: own DVN