17 April 2024
Elston Quarterly Portfolio Update Q2 2024
In this video, Portfolio Manager David Seager provides his perspective on the key questions discussed in the recent quarterly asset allocation meeting. Read more
By Justin Woerner
Superficially we all understand the concept of risk. We understand we face risks each day as we go about our daily activities. The Cambridge dictionary defines risk as “the possibility of something bad happening”. Merriam-Webster defines it as “possibility of loss or injury”.
Through the lens of finance, Investopedia defines risk as “the chance that an outcome or investment’s actual gains will differ from an expected outcome or return. Risk includes the possibility of losing some or all of an original investment”.
So, conceptually it seems agreed, risk is forward looking, it relates to the future possibility of an unexpected, negative outcome. However, risk remains subjective, both in its nature and magnitude, and our tolerance of it varies greatly. Risk may be absolute, or it may be relative.
As investors, how should we define it, how should we think about it, what metrics or characteristics should we be aware of, and what steps can we take to try to reduce its impact?
The industry’s view of risk
Within finance there’s a keen focus on risk. One of the key tenets is risk versus reward. The ongoing balancing act of ensuring the level of risk within an investment is offset by an appropriate level of potential return. To assist with this, the industry tries to quantify risk.
This is typically achieved by looking at historical returns, then applying mathematical models to calculate a variety of risk metrics. Different industry participants focus on different aspects of risk with the treatment of risk tending to be considered as either relative or absolute risk. Most managers of money consider risk on a relative basis; the assessment of an investment’s risk relative to a riskless asset, commonly a government bank bill or bond, or a particular benchmark, for example the Small Ordinaries index. Some managers and most owners think about risk on an absolute basis; the probability of experiencing a negative return, generally measured by the level of volatility in an investment’s monthly returns.
The industry also uses historical correlations to assess risk. Here, participants look at an investments or portfolio’s exposure to key variables, for example the level of exposure to energy prices, consumer spending, or credit. Based on historical correlations, future potential outcomes can be modelled under different scenarios, for example an oil price shock, a recession, or an environment of increasing interest rates.
Trying to quantify risk presents several issues. The first is the reliance on historic returns whereas we’re defined risk as a function of the future, and as we are constantly informed “past performance is not indicative of future returns”. The second issue is the high propensity for mathematical principles to break down during periods of extreme market stress.
How we see risk within the Emerging Leaders strategy
Rather than seeing risk as a quantitative factor we focus on the fundamental aspects of risk, we look under the hood and think about the factors which drive outcomes.
In this regard, there are many forms of risk; market risk, inflation risk, currency risk, volatility risk, liquidity risk, to name a few however within the Emerging Leader’s strategy we primarily focus on business and forecasting risk.
We view risk as the future probability of our investment thesis, our future expectations for a business, failing to eventuate, resulting in the permanent loss of capital. We therefore view risk as being forward looking, not based on historical outcomes. We view it through a long-term lens, not based on monthly returns. Ultimately, we view it as the potential to lose money on an investment over our 5-year investment horizon.
We’re not concerned with historical share price performance; we’re not concerned with historic volatility or relative returns. We understand managing a concentrated portfolio will result in periods of very high short to medium term price volatility. We don’t see risk as a movement in share prices but rather as a deterioration of the investment fundamentals or a decrease in the predictability of a business’s financials. A break down in our assumptions and forecasts, leading to a failure to generate the expected levels of earnings growth either due to disappointing revenue growth or higher than expected expenses.
Rather than looking in the rear-view mirror at historical returns we believe we’re better positioned to reduce the probability of a permanent loss of capital if we continue to look forward and understand why businesses fail.
Does history provide any insights?
Historical analysis
Why do businesses fail? Why do investment thesis’s not play out as forecast? Whilst we don’t look to history to assess risk, we thought it may be interesting to look through history to help answer these questions.
Utilising data from Factset, we compiled a list of all the businesses included within the Small Ordinaries index between January 2000 and December 2021. This provided us with a universe of 883 businesses. From this list we determined how many of these businesses were no longer listed on the ASX. We were surprised by the results.
Over the survey period, of the 883 business a total of 451, or 51%, have been delisted.
We then utilised information sourced from FactSet, IRESS and deListed Australia (https://www.delisted.com.au/), including annual reports and company announcements, along with published media articles to ascertain why these businesses were delisted. We also sourced historical month end share price and last trade date information from FactSet.
Delisted companies
Once we determined the list of delisted businesses, we categorised each business within a series of higher-level buckets, as displayed in Table 1. We were interested in identifying the businesses which were removed from the ASX due to business failure.
From Table 1, it’s clear that the main reason for a smaller capitalised business to be delisted related to the business being acquired (70.1%). To some degree this makes sense, and it’s something we will review later in this article. We also categorised delistings into those which were “Insolvent”, businesses entering administration, receivership or liquidation, which accounted for 92 businesses (20.4%) or those businesses which were wound up, business which undertook a voluntary liquidation and distribution of assets, which included 12 companies (2.7%). It was these two categories which we were most interested in.
Table 1: Categorisation of reasons for delisting. Source: Elston Asset Management, IRESS, FactSet
Figure 1: number of acquired, insolvent, or wound-up businesses per calendar year
Pre-GFC
Not surprisingly, 2007 was the strongest year for business acquisitions. Robust market conditions, with euphoric levels of investor sentiment, drove increased merger and acquisition activity.
Post-GFC
The bull market ended in late 2007 as the impact of the Global Financial Crisis (GFC) impacted equity markets globally. The economic impacts were felt throughout 2008 and 2009. Domestic GDP growth during this period remained relatively robust at 2.6% and 1.9% respectively. The United States economy was harder hit with GDP growth of 0.1% in 2008 and -2.6% in 2009. Not surprising, 2009 provided the largest number of insolvent or wound-up businesses in any single year within the survey as the immediate impact of the GFC weighed on many businesses.
Receiverships and liquidations can be prolonged, resulting in a second wave of GFC invoked delistings occurring across 2011 and 2012. This was concentrated within the REIT sector. We also saw a heightened level of acquisition activity throughout 2011 as investors picked through the bones of GFC impacted businesses.
The past decade
The decade from 2011 through to 2020 saw a heightened level of both acquisitions and business failures compared to the prior decade. Even excluding 2011 and 2012 the level of business failures still surpassed what occurred from 2001 to 2010, with the last decade witness to a heightened level of balance sheet driven business failures (refer Figure 3 below).
Insolvent or wound-up businesses
Within the survey we identified 104 businesses which were delisted due to business failure or winding-up. This equates to roughly one in every 8 businesses listed within the Small Ordinaries index over the study period.
At a high level, what does our universe of insolvent or wound-up businesses look like? According to financial data sourced from FactSet, in the 2 financial years prior to last trading, the median business was relatively small, with revenue of circa $50 million, generated a low gross margin, in the mid-teens, and was unprofitable, recording a net loss of circa $5 million. The median business was also highly geared with circa $36 million of debt on the balance sheet.
For an investment manager who targets high gross margin businesses it was interesting to note that within the universe there were 16 failed businesses generating gross margins in excess of 50%.
Of these businesses, 9 were financials or real estate related businesses where the average level of debt was $2.8 billion. Unsurprisingly these businesses failed post the GFC. Another 3 businesses were heavily impacted by the loss of key customer contracts. The remaining 4 businesses failed due to: issues around accounting irregularities, unsustainable and rapid expansion, a lack of competitive advantage and an unsuccessful exploration program.
To help with classification, we applied a series of categories reflecting the reasoning behind the business failure. The categories included:
- Reg: regulation changes, businesses negatively impacted by regulatory changes.
- CA: lack of competitive advantage, businesses lacking the ability to fend off competitors or generate superior profit margins.
- VP: weak value proposition, businesses with products or services which provide a weak set of benefits or fail to address a customer’s needs.
- EM: easy money, businesses where financial discipline appears to have been loose with management consistently generating net losses, funded by the capital markets.
- SBM: sustainability of business model, includes weak product offering, lack of a sustainable competitive advantage, high levels of client concentration, unsustainable cost base, or high levels of gearing.
- Loss Making: Businesses which were consistently generating net losses.
- Balance Sheet: Businesses where over geared balance sheets led to receivers or administrators being appointed.
Sector exposure
Sorting the failed businesses across sectors produced some interesting insights.
Figure 2: Number of insolvent or wound-up businesses per sector. Source: Elston Asset Management, IRESS, FactSet
The largest number of delistings occurred within the materials, industrials and financials sectors. Given the corporate structure of many listings within the financials and real estate sectors, these two sectors accounted for the largest number of wound-up businesses.
Table 3: Categorised reasons for delisting across sectors. Source: Elston Asset Management, IRESS, FactSet
The largest driver behind business failure was assessed as the sustainability of the business model with 85 businesses or 82% of the failed businesses assessed as having unsustainable business models. Over 50% of these businesses were generating net losses whilst over 40% were assessed as having a weak value proposition or competitive advantage.
The second most common factor was balance sheet weakness, which was evident in 77 businesses.
Commodity price takers
Within the materials sector, the delisted businesses were characterised by high levels of gearing, and with little control over unit prices, presented heightened risks during periods of commodity price weakness. The Energy sector also had several businesses in this bucket. Impacted by falling commodity prices, lower than expected production volumes (sometimes due to uncontrollable events such as weather or Covid shutdowns), or disappointing exploration programs these businesses struggled to remain profitable, to fund ongoing operations or to repay or refinance borrowings.
Samson Oil & Gas and Freedom Oil & Gas were two businesses forced into administration after falling oil prices, disappointing production volumes and exploration programs, or high levels of debt led to an inability to meet credit repayments.
In addition to Samson Oil & Gas and Freedom Oil & Gas other examples include CuDeco ltd, Discovery Metals, Apex Minerals, Western Desert Resources, Kagara, Platinum Australia, Mirabela Nickel within the materials sector, and Sundance energy within the energy sector.
We can also find examples outside of these two sectors. Forest Enterprises Australia (FEA) had receivers appointed in 2010 after weaker demand from Japan resulted in falling woodchip prices and the inability for FEA to refinance $216m of debt. AFT Corporation, a commercial solar panel distributor, experienced a deterioration in its business model as global solar panel prices fell more than 50%, severely decreasing the business’s revenues. Nylex, a manufacturer and distributer of branded plastic and automotive products, had receivers appointed in 2009 after automotive profits were heavily undermined by cheap Asian imports and rising raw materials costs.
The lesson here appears to suggest risk, especially credit risk, is heightened for price takers; businesses providing commodity products with no power to set pricing.
Balance sheet induced delistings
Figure 3: Number of delisted businesses involving creditors per year. Source: Elston Asset Management, IRESS, FactSet
Balance sheet strength was the second highest factor associated with businesses failing. Across the study we identified 77 businesses (74%) where the delisting was related to the balance sheet strength. However, it tended to be the secondary cause for failure. As witnessed during the GFC, business weakness tended to lead to the business being unable to service its borrowings, gain new financing or refinance existing facilities. The period following the GFC was a peak time for creditor induced delistings. This provides our second key lesson as to why businesses fail.
The backend of the last decade also recorded an increase in the number of creditor related delistings.
Whilst the largest number of balance sheet impacted businesses could be found within the materials sector, mostly for the reasons discussed above, there was also high concentrations found in the real estate (10 out of 10) and industrials (15 out of 17) sectors.
Within the industrials, where interestingly half of the delistings occurred in the years from 2015 through to 2020, 12 of the 17 were generating operating losses and highly geared. Examples include Virgin Holdings which generated combined net losses of c$1.25 billion over the 3 financial years prior to delisting and had over $2.5 billion of borrowings on the balance sheet, and RiverCity Motorway Group, operator of the clem7 tunnel in Brisbane, which experienced disappointing patronage leading to net losses and un inability to service its greater than $1.0 billion of borrowings.
The bulk of the real estate related businesses were wound up post the GFC as they were forced to liquidate properties in the face of asset write-downs and an inability to refinance borrowings. This included CNPR group, Brookfield Australia, Tishman Speyer, Galileo Japan Trust, APN European Trust, and Challenger Infrastructure Fund.
Unsustainable business models and easy money
Over 80% of the failed businesses were determined to have failed due to the sustainability of the business model (SBM). This is a relatively broad and subjective definition. At the revenue line it includes the lack of a strong value proposition, the lack of a sustainable competitive advantage or the presence of high levels of client concentration. It also includes businesses which were generating recurring net losses or had high levels of gearing.
Figure 4: number of delisted businesses generating net losses, with unsustainable businesses models and net losses, with revenue growth and net losses and those lacking competitive advantage or value proposition per year. Source: Elston Asset Management, FactSet.
Figure 4 displays the number of loss making delistings (grey bar) per year along with the number of delistings assessed as having unsustainable business models (light blue bar), lacking a sustainable competitive advantage or a strong value proposition (dark blue bar) and those generating revenue growth but still loss making (orange bar).
There appears to have been un era of delistings involving loss-making, unsustainable business models over the past 10 years. This appears to have coincided with an increase in the number of businesses generating revenue growth but assessed as having a weak sustainable competitive advantage or value proposition.
The large presence of unsustainable business models may be explained by the increased access to easy money. A common theme across the delisted businesses of the past decade was management’s wiliness to continue to generate net losses which were funded through the capital markets – either via issuing more equity or drawing on debt facilities. It commonly occurred where a business was conducting exploration or in the early stages of product development and commercialisation. These businesses, supported by the cheap and easy access to capital, would most likely remain unlisted during more normal conditions.
Lack of competitive advantage or value proposition and revenue growth loss makers
The lack of a strong value proposition or a sustainable competitive advantage was a common theme with 46 (44%) of the failed businesses displaying this characteristic.
A business’s value proposition relates to the strength of the benefit provided to the customer or how strongly a business meets a customer’s needs and wants. It’s important in gaining and retaining customers. A business which meets the needs and wants of its customers by offering a unique product stand in better stead to build its customer base and retain those customers, especially during periods of economic hardship or intensified competition.
A competitive advantage is gained when a business conducts an activity better than its competitors. Common avenues include access to customers, supply chain advantages, distribution advantages, manufacturing or operational cost advantages, superior product offering due to intellectual property or investment in development. A strong competitive advantage can improve the value proposition and increase the difficulty for a new entrant to compete against the business.
Of the 27 businesses identified as generating revenue growth and net losses, 18 were assessed as lacking a sustainable competitive advantage or strong value proposition. These businesses lack the ability to drive customer traction and lift revenue above the cost of operating. The most represented sectors for these businesses included materials (8 businesses), information technology (6) and health care (5).
Within the Emerging Leaders strategy, we commonly look to gross margin as an indicator of pricing power, and a sign of competitive advantage or value proposition. According to FactSet, 19 of the 27 businesses had negative gross margins and an additional 5 businesses had very low gross margins (<10%).
Interesting to note that of the Information Technology businesses which were delisted only 22%, compared to 74% across the broader universe, involved balance sheet weakness. These businesses tended to have low levels of borrowings but also an inability to generate economic profits. Whilst the businesses appeared to lack the strong value proposition needed to drive customer traction and revenues they weren’t undone by credit. Rather, it appears management continued to invest in product development, generating recurring losses, until the business ultimately ran out of capital and shareholder support.
Outside of the materials and technology sectors the lack of a strong value proposition or competitive advantage was concentrated in consumer facing industries including consumer discretionary and communication services.
Harris Scarf, competing within the crowded department store market, unable to leverage a competitive advantage or provide a differentiated offering, was forced into price discounting post the introduction of the GST to maintain market share. This ultimately led to net losses, increasing borrowings and receivership in 2001. Oroton Group was another business competing in a crowded market where it was difficult to establish a competitive advantage or differentiate the business’s product offering. Kresta Holdings, a retailer of blinds, curtails, awnings and shutters, was delisted in 2020 after suspending its shares in 2018. The business had been suffering from falling sales and deteriorating profit margins since 2010 with a series of net losses being recorded since 2015.
Client concentration
Within the survey client concentration was a recurring weakness. The reliance on a limited number of customers increases revenue risk and resulted in the downfall of several businesses within the study. A telling example of this was Videlli (previously ERG Limited), a provider of automated transport ticketing systems. The business had a global customer base but was highly reliant on the establishment of the Sydney Tcard ticketing system. After delays and product issues the NSW Government terminated the program in 2007. Videlli was delisted in 2009. Other examples of client concentration include Unilife Corp which relied on just 3 customers for 90% of the company’s revenue, Open Telecommunications, which was delisted post the loss of a key Telstra contract, Quintis was delisted after Nestle cancelled its contract, Catuity which run into difficulties after Visa ceased using the company’s technology, and Carbon Energy which generated the bulk of its revenue from Government grants. There were also several cases of contractor related businesses, including Henry Walker Eltin and RCR Tomlinson, which were placed in administration or liquidation after suffering large losses on key client projects.
Regulatory or structural change
The number of businesses failing due to adverse regulatory changes was lower than expected. Over the course of the study, we only identified 7 businesses which delisted post some form of regulatory change. Three of those businesses, Forrest Enterprises Australia, Timbercorp and Great Southern, were all impacted when the ATO amended the tax treatment of forestry based Managed Investment Schemes. AFT Corporation was impacted after the NSW Government lowered the electricity feed in tariffs.
Whilst regulatory changes impacted less businesses than expected, structural changes in the operating environment did impact a larger group of businesses. Overall, we assessed 29 businesses (28%) which were impacted by a structural change in the business’s operating environment or customer base. Examples include Ten Network which entered voluntary administration after falling revenues, impacted by viewers moving away from free to air television, resulted in the business being unable to service its debt. The business model for Reverse Corp, the owner of 1800-RESERVE which allowed teenagers to phone home from any payphone in Australia, was undone with the increasing adoption of mobile phones. Salmat, a provider of letterbox marketing, struggled to deal with the shift of advertising spend to online, digital platforms. It may also be argued there has been many highly leveraged business models, especially within the REIT sector, which were no longer viable after a structural change in the pricing of debt ended environments of cheap money.
Acquired businesses
A quick note on the acquired businesses.
We have discussed the key reasons behind why businesses failed. However, most businesses within our study, 316 of 451, were delisted post acquisition. After initially seeing this result, our first question was what percentage of these acquisitions were optimistic? Were the bulk of these businesses acquired because they were performing well with robust outlooks or were the acquisitions conducted during periods of stress, disappointing results and depressed share prices? In other words, how many acquisitions crystalised a loss of capital?
Before we answer that question, let’s have a quick look at the universe of acquired businesses.
Figure 5: Number of acquired businesses per calendar year
Throughout the surveyed period there was an average of 15 acquisitions per year. Outside of large spikes in activity during 2007 and 2011, the level of activity was relatively consistent between decades. There were 149 businesses acquired in the ten years from 2001 through to 2010 and 154 businesses acquired in the ten years from 2011 through to 2020.
Across the universe, the median business generated c$175 million of revenue and c$11 million of net profit in the 2 financial years prior to acquisition. Approximately 37% of the businesses were experiencing contracting revenues over the 5 years prior to acquisition, approximately 60% recorded weaker net profit and approximately one third of the businesses were generating net losses in the 2 financial years prior to acquisition.
The bulk of the acquired businesses come from within the materials, industrials and real estate sectors.
Figure 6: Number of acquired businesses per sector. Source: Elston Asset Management, IRESS, FactSet
Performance of acquired businesses
To answer our question regarding the capital return generated on acquired businesses we looked at the share price performance over the 12 months and 3 years prior to the last trade date.
Interesting, the data suggests acquired businesses tended to record share price gains over both time periods. Over the 12-month period preceding acquisition, 252 business recorded share price gains (average gain was +55%), with 55 businesses generating negative share price performance (average loss of -25%). Average performance over the 3-year period preceding acquisition was still positive but less so with 195 businesses recording higher share prices (average gain of +125%) and 108 businesses generating share price losses (average loss of -44%).
The probability of an acquisition providing an investor with a capital gain did shift depending on the quality of the business and the timing of the acquisition.
According to FactSet data, the businesses experiencing deteriorating net profits recorded a higher occurrence of share price losses over the 3 years leading to acquisition. Of these businesses the median 3-year return was 9%, with 45% generating capital losses on acquisition.
It’s not surprising to see, on the back of the strong bull market, acquisitions conducted between 2005 and 2008 resulted in a stronger 3-year capital gain. Of the 71 acquisitions, 58 resulted in the investor generating a profit on their investment whilst only 13 resulted in a capital loss.
The period post the GFC, 2009 through to 2012, was a more sombre period for capital gains. Of the 72 acquisitions, 40 resulted in a capital gain over the previous 3 years with 32 generating a capital loss. For acquisitions occurring in 2011, the average businesses suffered a loss of 48% from their previous high to the last traded price.
How we protect against risks
The key lessons from the study suggest increased levels of risk are associated with price takers and low gross margin businesses, unsustainable business models, and high levels of gearing.
Within the Emerging Leaders strategy, we have guardrails built into the process to ensure we avoid these risks.
Materials, industrials, and energy account for the largest number of failed businesses. The largest number of wound-up businesses were found in the financials and real estate sectors. The strategy’s sector exposure is very concentrated and naturally steers the portfolio away from these sectors. The portfolio has no exposure to the industrials, energy or real-estate sectors. The only exposure to the materials sector is via Imdex (IMD), a mining technology business. As at the end of June 2022, excluding the holding in IMD, the portfolio’s exposure to these 5 sectors was just 9% compared to the benchmark exposure of 60%.
The portfolio does have material exposures to the information technology and consumer discretionary sectors which were the 4th and 5th highest sectors for failed businesses. The information technology sector was signified by the large number of failed revenue growth loss making businesses. This provided a key reminder for the team – beware loss-making businesses. Whilst the portfolio holds businesses which generate net losses, we apply additional scrutiny to these businesses to ensure the underlying business is profitable, the net loss a result of ongoing growth investment rather than unsustainable financials. Each loss-making business held in the portfolio operates close to break even, is growing revenue strongly, has conservative or no gearing and is not expected to require additional external capital.
We are attracted to industries where structural change is occurring, but rather than working against our businesses, it acts as a tailwind supporting revenue growth.
We seek pricing power and revenue predictability, which tends to be very low within price taking businesses. We also seek businesses with high gross margins. The weighted average gross margin across the portfolio, at the end of June 2022, was 69% compared to the index at 34%. A preference for businesses with pricing power and high gross margins act as a deterrent to owning price takers.
We take the time to understand the business model. The investment process requires the team to assess all aspects of the business model, our investment checklist comprises over 150 questions and requires completing for all businesses prior to investment. The process is designed to identify businesses with the opportunity to drive revenue growth via a strong value proposition and large addressable market, and with lower competitive risk due to having a strong protective moat and sustainable competitive advantages.
Regulatory risk was less of a factor than expected however we still limit our exposure to businesses operating in highly regulated industries or where there is the potential for regulation to impact the business model.
Finally, and possibly most importantly, we do not like debt. We avoid high levels of gearing. We’ve seen several examples of credit’s ability to leverage business risk, and ultimately lead to administration. Across the portfolio we hold a net cash position, the level of cash held on our businesses balance sheets exceeds the level of debt. As at the end of June 2022, the portfolio had a net debt to EBITDA ratio of -0.5 and an interest cover ratio of 15 times.
If you would like more information please call 1300 ELSTON or contact us.
