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[SMALL CAPS] A win on the trifecta

By Victor Gomes

Small cap investing should not be like gambling. Our aim is to invest our clients' money in good businesses run by competent and honest management that we expect will be much more valuable in the years ahead. We look to take advantage of compound returns that can really add up over the medium to long term as reflected in our fund's performance since inception. To sensibly invest in small companies requires a lot of initial homework... and then you need to keep doing it. It should not a part time job, otherwise it is more akin to gambling.

This week, despite our failure to have a win on the Melbourne Cup we did have a few winners in our UBS Small Companies Fund.

1. Blackmores (BKL)

We first wrote about this investment in late May this year. Readers may recall where we again become interested in Blackmores whilst wearing out the show leather on a Brisbane company visit (we saw a competitor who said they couldn't keep up with demand from China via the tourist 'suitcase ' trade). Having admired and followed Blackmores for many years we were cautious due to the short-term turbulence that started a couple of years ago when major grocery retailers started exercising more market power and a key competitor was irrationally discounting.

After the insight from that Brisbane company visit, our existing good understanding of the business allowed us to quickly update our detailed financial model for Blackmores. It was soon evident that the rising sales trend over the prior three quarters was not a flash-in-the-pan but possibly the start of a long structural growth trend as the China market for their highly sought after Australian-sourced products blossomed.

The share price at the time was about $75. We quickly bought our fund a mid sized position. It looked a full price at the time but only because of the market's myopic 12–18 month view of a business' prospects. Our six year cash flow valuation analysis told us there was significant value in the company. We wrote this at the time:

"Although its valuation appears full on a simplistic 12-18 months investment horizon our...initial investment in this company is predicated on the belief that it can double its current revenues and profits without needing much additional capital. ...On this basis we are confident that Blackmores will be a significantly more valuable business in five year's time" 
UBS Small cap weekly, 29 May 2015.

We got it wrong...It didn't take five years but six months. Mistakes such as these we like.

Late last week the company released their latest quarterly results (1Q FY16). Sales grew by almost +65% and profit after tax by +161% over prior year's Q1. The share price momentarily hit $200 after the release but has since drifter back into the $170's. The valuation may still look full but Q1 revenue was much stronger than we had expected and margins also much higher. How high can it go? We think higher than $170 if current trends continue, even if only for 2–3 more years.

2. APN Outdoor (APO)

APO is another of our more recent positions. We like it for a number of reasons but mostly for the strong growth driven by technological change (digitalization of big billboards – 5x revenue increase per billboard) which is increasing the addressable market

There are also increasing barriers to entry and a rapid structural decline of other advertising especially TV which we think will leak revenue to the outdoor media sector. TV in Australia still represents more than 30% of the advertising pie with outdoor media only about 5% (in the UK outdoor media is already at 10% and still growing). We think this can also grow to 10% or more over time in Australia. It's a well-managed company with high growth opportunities, low capital needs and high returns on capital. Not much to dislike here.

3. Flexigroup (FXL)

One of our longer term holdings, it has had a tougher time of late. Management change and questions about organic growth had dogged the company in recent times. Last week they announced a very attractive acquisition of the Fisher & Paykel point-of-sale finance business in NZ. This is essentially a NZ credit card business previously owned by the appliance manufacturer. F&P appliances is now owned by Haier of China and the interest free credit cards business is non-core to them (but very core to Flexigroup).

Paying about 9x PE for a well run finance business looks like a fair but not overly cheap price. However what can be easily missed is the revenue synergies (and more modest cost synergies) available to FXL. The business will dovetail nicely with its existing smaller Australian interest-free credit cards business, providing FXL with greater scale and expertise in this important growth sector.

The statistic we like about F&P finance is that 21% of NZ residents have one of their cards in their wallet but it only represents 2% of credit card spending. Introducing the Mastercard function onto F&P cards (currently these cards are more like a private department store cards) should boost consumer usage. F&P were very good at origination of customers (capturing 21% of all New Zealanders) but not good at driving volume from these customers (only 2% of credit card spend). Driving volume per customer is FXL's forte and taking share of spend from 2% to say 4% could see a large profit boost.

The original founder is now back in charge and the company is getting its mojo back. We like recent developments, still like the 22% returns on capital and especially like the valuation with a PE of less than 10x and a fully franked dividend yield close to 6%.

A happy trifecta of winners for us over the past week.


Victor Gomes is a Portfolio Manager for UBS.

DISCLAIMER: Whilst the information and statistics contained in this article are believed to be correct at the time of publishing, they are indicative only and do not constitute legal or financial advice. Investors should seek independent financial and legal advice before deciding whether any investment is right for them.

Published on: Tuesday, November 10, 2015

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