December 11, 2019
Letter to Investors – November

By Andrew Mitchell & Steven Ng
Co-founders and Senior Portfolio Managers

In our November 2019 Letter to Investors we review how many major sharemarkets are on track to post their highest calendar year returns since the GFC despite global economic growth slowing to post GCF lows. We also announce a change we are making to how we present the performance of our funds.

Dear Fellow Investors,

Welcome to the November 2019 Ophir Letter to Investors – thank you for investing alongside us for the long term.

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Dear Fellow Investors,

Welcome to the November 2019 Ophir Letter to Investors – thank you for investing alongside us for the long term.

Month in review

The 2019 calendar year to date has been one of ‘don’t fight the Fed’ as sharemarkets have been spurred on by US Federal Reserve and other central bank easing, despite global economic growth slowing to post GFC lows. The Australian and many other major sharemarkets are on track to register their largest calendar year gains since the GFC. This has occurred as lower central bank policy rates and longer-term bond yields saw investors bid up the price of shares as they looked forward to the growth benefits that lower rates might provide in 2020. And so it was for the month of November as most of the major sharemarkets rose 1.5-3.5%, with monetary policy stimulus globally now at it strongest since the GFC.

The MSCI World Developed Market Index was up 3.2% (in local currency terms), outstripping the Emerging Markets Index which saw more modest gains at +0.6% (in local currency terms). Regionally, of the majors the US led the way up +3.6%, followed up Europe (+2.8%), the UK (+1.8%) and Japan (+1.6%). In developed markets, the growth orientated IT (+5.6%) and Healthcare (+5.0%) sectors led the way whilst bond proxy Utilities (-2.1%) and REITS (-1.6%) where the only two sectors to not participate in the gains as US 10yr sovereign yields moved higher.

The local market was one of the best performing for the month with the S&P/ASX 200 up +3.3%, taking 12 month returns to a very bullish +26.0%. The Small Ordinaries Index lagged on the month but was still up a strong +1.6%, and 16.6% on the year. Sector wise for the ASX200 Utilities and REITs were trailing. The worst performing sector however was Financials as Westpac dragged down the sector as AUSTRAC applied for a civil penalty order against the bank for over 23 million breaches of the AML/CTF Act, ultimately resulting in the departure of the CEO and Chairman during the month.

Ophir Performance Expectations

As usual, in the section following we detail the performance of our Ophir Funds in order of their inception dates:

  1. Ophir Opportunities Fund (inception August 2012)
  2. Ophir High Conviction Fund (inception August 2015)
  3. Ophir Global Opportunities Fund (inception October 2018)

We place the Funds’ performance in this order as the longer the performance history, the more meaningful it should be. We care, and we urge our fellow investors to care, more about our track record of performance over longer times periods than shorter ones. That is because the longer the timeframe performance is measured over, all else equal, the more demonstrative we believe it is of investment capability. This is as true for us at Ophir as it is for other investment managers.

In line with this philosophy, from this month, we will be reversing the standard order used in the industry for the time horizons that performance is displayed. That is, we shall display performance for the longest time period first, which is since inception, on the left most column of our performance tables, and the shortest time period last, which is for the last month, on the right most column of our performance tables. We believe this directs investors to the most important information first, that is our longer-term performance.

We know from behavioural finance and from practical experience that some investors display “recency bias” where they recall and overweight more recent experiences more than distant ones. This can be a destructive behaviour in investing as shorter-term recent performance is more likely to be driven by noise and luck, than skill.  Think of the amateur darts player who beats a seasoned professional by hitting a bullseye in a competition with a single attempt each. Does that make the amateur more skillful or just lucky? With repeated attempts over a longer period of time its is much more likely that the professional outperforms the amateur. Similarly, in investing, if market inefficiencies exist, skill has a better chance of winning out over the longer term than the shorter term. Hence, allocating money to equity managers based on short term performance has generally been found in academic study after study to be a suboptimal investment strategy, because noise and luck tend to dominate shorter term returns.

Each of our three funds has generated positive performance and beaten its benchmark over the month of November. In the case of the Global Opportunities Fund, it has generated a very high 8.4% for the month after fees. Whilst better than the alternative of negative performance and underperforming their benchmarks, these one-month results provide little gratification to us as investors and we would urge other investors not to invest with managers on the basis of such short term results.

At Ophir we seek to outperform the respective broad-based market benchmarks for each of our Funds over the long term (5+ years). Internally, over the long term we a target 15%p.a. total return (income plus capital gains) before fees for each Fund. That is, we estimate around a 10% return for the market benchmarks and target 5% outperformance through investment selection before fees. We have been fortunate to exceed this 15%p.a. result for each Fund since inception. Its achievement is never assured, and we and the team continue to work hard to achieve it over the long term. This is the standard we mark ourselves against, and we encourage our fellow investors to share the same time horizon and performance standard when marking us as your investment manager.

Ophir Fund Performance

The Ophir Opportunities Fund returned +2.4% for the month after fees, outperforming its benchmark by +0.8%. Since inception, the Fund has returned +26.3% per annum after fees, outperforming its benchmark by 18.5% per annum.

Growth of A$100,000 (after all fees) since Inception
Since Inception (p.a.) 5 Year (p.a.) 3 Year (p.a.) 1 Year 3 Month 1 Month
Ophir Opportunities Fund* 33.2% 26.8% 23.4% 39.8% 6.2% 2.7%
Benchmark* 7.8% 10.8% 11.4% 16.6% 3.7% 1.6%
Value Add (Gross) 25.4% 16.0% 12.0% 23.2% 2.5% 1.1%
Fund Return (Net) 26.3% 22.2% 20.5% 33.6% 5.4% 2.4%
* S&P/ASX Small Ordinaries Accumulation Index (XSOAI). Past performance is not a reliable indicator of future performance

The Ophir High Conviction Fund investment portfolio returned 3.8% for the month after fees, outperforming its benchmark by +1.0%. Since inception, the Fund’s investment portfolio has returned +20.2% per annum after fees, outperforming its benchmark by 8.1% per annum.  The Ophir High Conviction Fund’s ASX listing provided a total return of 0.4% for the month.

Growth of A$100,000 (after all fees) since Inception
Since Inception (p.a) 3 Year (p.a.) 1 Year 3 Month 1 Month
Ophir High Conviction Fund (Gross) 24.7% 21.5% 26.8% 3.3% 4.0%
Benchmark* 12.1% 12.4% 19.1% 4.2% 2.8%
Gross Value Add 12.6% 9.1% 7.7% -0.9% 1.2%
Ophir High Conviction Fund (Net) 20.2% 19.0% 24.0% 3.3% 3.8%
ASX:OPH Share Price Return n/a n/a n/a 2.9% 0.4%
* S&P/ASX Mid-Small Accumulation Index. Past performance is not a reliable indicator of future performance

The Ophir Global Opportunities Fund investment portfolio returned 8.4% for the month after fees, outperforming its benchmark by 3.6%. Since inception, the Fund’s investment portfolio has returned +38.2% per annum after fees, outperforming its benchmark by 31.8% per annum.

Growth of A$100,000 (after all fees) since Inception
Since Inception (p.a) 1 Year  6 Month 3 Month 1 Month
Ophir Global Opportunities Fund (Gross) 49.1% 65.1% 24.4% 5.7% 9.3%
Benchmark* 6.7% 19.8% 13.7% 7.3% 4.8%
Gross Value Add 42.4% 45.3% 10.7% -1.6% 4.5%
Ophir Global Opportunities Fund (Net) 38.2% 53.5% 21.8% 5.9% 8.4%
* MSCI World SMID Index TR (Net) (AUD). Past performance is not a reliable indicator of future performance

Macroeconomic Highlights

Economic data for the major economies was mixed over November with the Institute of Supply Management’s (ISM) manufacturing Purchasing Manager Index (PMI) for the United States coming in below expectation for both October and November, with the latter part of the reason for the pull back in share markets seen in early December. Employment data however was better in the world’s largest economy, though CPI and consumption expenditure were a little soft. China data was also mixed. Importantly though the Governor of the Chinese central bank has noted recently that it will not try to over stimulate the economy and create excess credit growth to spur short term demand at the expense of its longer-term transition to a consumption-based economy. This is meaningful as Chinese credit growth has increasingly propelled the global economy. Over in Europe more recent economic activity has improved with the manufacturing PMI and CPI both beating expectations on the month. On the weight of evidence, over the last few months, it appears that globally we are seeing tentative signs of a very modest recovery in activity as central bank interest rate cuts starts to gain some traction and US-China trade tensions and no-deal Brexit concerns ease (see chart below).

In Australia, the RBA has recently kept the Cash Rate at 0.75% and maintains a conditional easing bias as it waits to see how much traction its recent cuts have provided. In a key speech during November, Governor Lowe confirmed that the Cash Rate would have to go to 0.25% before the RBA would consider quantitative easing (QE) in Australia, though if its baseline forecasts turn out to be true QE won’t be needed. Market pricing currently agrees with the Governor with a 50/50 chance of either a 0.25% or 0.50% Cash Rate priced in at interest rate cycle lows in December 2020. On the growth front, September quarter GDP growth domestically had not much to crow about, rising 0.4% to be 1.7% higher over the year. Whilst the annual rate increased from the June quarter, spurred on by government spending and exports, household consumption remains near recessionary levels with its growth over the quarter the lowest since the GFC. In tough signs for retailers, retail volumes were weaker than expected and yearly growth (-0.2%) has been the worst since the 1991 recession. Recent data suggests households have used the recent $8bil in tax cuts and three interest rate cuts to increase savings and pay down credit card debt. Large listed retailers appear to be doing better than smaller retailers, and discretionary spending is being hit harder with car sales falling for a record 20th month in a row and is down almost 10% over the year. Part of the reason for this is no doubt the constraint in housing finance growth through macroprudential measures by APRA which traded off improvements in financial stability for slowing private demand (see chart below). Slower housing finance reduced housing construction, renovations, as well as house prices which had a flow on impact to household expenditure through wealth effects.

Source: MST Marquee

There is some hope that the recent lift in the savings rate by households might be reversed on the back of recent rises in house prices in Sydney and Melbourne, which combined with potentially one or two more RBA interest rate cuts this cycle could help spur the consumer into action.

 

Key Market Moves

As sharemarkets rallied in November, the value revival generally stumbled and valuation differences for value compared to growth stocks widened. Traditional growth sectors of IT and Healthcare led the way during the month both in Australia and overseas and are also the two best performing sectors locally over the last year. Valuations for these sectors have risen both in the large cap and small cap market.  It is clear investors have been willing to pay up for growth in a lower growth world with these two sectors in the small cap space in Australia trading at material P/E premiums to the index as a whole and their own 5-year average valuations (see chart below).

Table 5: Small Ordinaries Sector 1-Year Forward PEs

 

Source: J.P. Morgan Quant

For the Australian sharemarket as a whole, 25%+ total returns through the 11 months to the end of November were largely driven by the return from the price/earnings ratio expansion which disproportionately benefited high growth stocks as risk-free rates used in valuations fell domestically as well as abroad. P/E valuation expansion cannot go on forever and is an unsustainable source of total share market returns. As can be seen in the chart below, the fundamental sources of returns, being dividend income and earnings per share growth, have largely offset each other this year. Looking into 2020, we’d never be so bold as to make 1 year forecasts for the local share market, though we’d have to agree with the direction of the forecast by MST Marquee below, which is for more modest, but still reasonable returns, with valuation expansion less likely to provide the ‘free kick’ that it has so far in 2019.

 

Whilst we continue to look for growth orientated companies, and in particular those that we believe can grow and take market share even with the current modest economic growth backdrop, we keep just as keen an eye on the valuations we are paying for these companies. It always pays to remember a good quality, fast growing company doesn’t necessarily make a good investment if you are paying too higher price for it.

In key stock news for the Australian equity Ophir Funds, key holdings A2Milk (ASX:A2M) (+22.7%), Xero (ASX:XRO) (+17.8%), Cleanaway (ASX:CWY) (+14.9%) and Afterpay Touch Group (ASX:APT) (+9.5%) all rose strongly in the month, mirroring their strong returns over the year.

We have spoken at length about these stocks before and instead we’d like to focus this month on one of our poorest performing stocks for the month, Nufarm (ASX:NUF) (-16.4%), what we got wrong in its analysis and what this can reveal about our investment process.

For those unfamiliar with the company, Nufarm is a global crop protection business with its main exposure through herbicides, but also with exposure to high margin insecticides and pesticides formulations. The business has historically been ‘cheap’ for a reason. Despite being geographically diverse, it has been very much subject to the vagaries of the agriculture cycle making earnings visibility poor and volatility high. Compounded by high financial leverage Net Debt/Operating Profit > three times, it had not offered us much appeal. However, by agreeing to sell its South American business in September this year to Sumitomo for a very attractive price (>$1bn) the company would be able to finally pay down its excessive debt levels. We took the view that the company would transform into something more investment grade leading to a sustainable rerate in its price/earnings (P/E) multiple, and a reduction in its then high level of short selling. We then believed we had a free option on an improvement in weather conditions, coupled with the development of its Omega 3 seeds business which the market was yet to ascribe significant value to. However, we decided to exit our position after our thesis was derailed with the company cutting its earnings guidance less than 2 months after initially providing it. We began to question the quality of the financial year 2019 result, which was likely flattered by inventory build in the market, though hard to ascertain due to the opaqueness of the business. With the company still on the lower end of the quality curve, and more question marks over its earnings power, we determined it was better to cut our losses. Ultimately, the probability of the company re-rating through P/E valuation expansion as it shored up its balance sheet and had growth options through its Omega 3 business and a potential upturn in the agriculture cycle was outweighed by the surprising worsening in seasonal conditions, mainly in the US. What this said to us is we didn’t understand how seasonality was affecting the business better than the market. Seasonality was a key factor driving share price performance currently, and without superior insight into its earnings path we chose to exit the position.

Every fund manager knows they are not going to have every stock outperform the market. In competitive financial markets, where trading by professionals dominates turnover, over the long term the best might have 55-65% of their portfolio outperform. Firstly, from a process perspective it’s important to be honest with yourself that if it turns out you don’t have unique insight on a variable that is central to the underlying performance of the company, that you recognise this, and redeploy the capital into other areas where you believe you do. Secondly, it is important that your lowest conviction holdings, of which Nufarm was, are reflected in lower holding weights. As we didn’t believe our particular insight on the company was large and that there were significant risks to the outcome, we did not hold a large position in the company. As a result, this limited its negative contribution to performance for the month.

At Ophir, we know we are not going to get 100% of stocks right. If our original investment thesis turns out to be incorrect, then one of the worst things we can do is invent a new thesis as to why we should continue holding this now cheaper company. As we do for ourselves, we encourage all our investment team to be honest with themselves and transparent with the team on why a particular investment thesis may not have worked out. The market is full of new investment ideas, if only we look hard enough. We want to continue to make sure we are re-deploying capital into our best ideas to keep the quality of the Ophir Funds high, and this sometime involves cutting our losses when things don’t go to plan.

We thought we would also take the opportunity in this month’s Letter to Investors to introduce you to one our favourite smaller cap companies in the Ophir Global Opportunities Fund. The company is Celsius Holdings (NASDAQ:CELH), the brand behind a ‘better-for-you’ energy drink that is carving out a increasingly large piece of the US$53bn global energy drink market (for context that is three times the size of Telstra’s total revenue).

While the total energy drink market is growing mid-single digits, after multiple years of double-digit expansion, CELH is growing +30-40% as it helps create the ‘better-for-you’, all-natural category. Made with Green Tea, Ginger, Vitamins and no added sugar, CELH was born in the fitness and health channels, proving its benefits to the most health-conscious consumer before expanding to the mass market.

Source: Celsius Investor Presentation – April 2019

Now CELH is trying to carve a niche in a much bigger pie: the global energy drink market. This $53bn market was created by the duopoly of Monster Beverage and Red Bull which collectively hold ~70% market share. They have been rewarded for their success: Monster Beverage is the best performing stock of the century returning +67,000% since its debut in 2003.

For a long time, this duopoly enjoyed uninterrupted success but a recent entry into the market, Bang Energy, has shown there are cracks in these behemoths’ armour.  Bang Energy sales increased from a run-rate of $300m in September 2018 to a run-rate of $1,000m of sales today. That is over a three-fold increase in sales in the course of a year, and we think CELH is charting the same course. Bang has successfully taken 8.0% of the market in domestic US energy drink sales. CELH current market share is 0.5%. Bang Energy is essentially riding the narrative of ‘performance’ energy drinks which offer both energy and sports/exercise benefits, a narrative CELH has preached since inception. Indeed, Monster’s Chairman and CEO called out Celsius on their June quarter conference call as potentially expanding the total market for performance energy drinks.

We first met the CELH management team in December of 2018 and distinctly remember two things from that meeting: firstly, Celsius CEO John Fieldy’s passion for his product as he seemingly drank more of the tester product than the investors and secondly, his detailed knowledge of the energy drink landscape and the critical importance of nationwide distribution. We followed the business closely and subsequently invested during September 2019 on the back of an accretive deal where the company bought out their European distribution partner. In completing this acquisition and subsequent capital raise, CELH added a significant amount of earnings and free cash flow to the business, solidified their balance sheet (now $13m net cash) and effectively took in $13m of new equity capital from their two biggest shareholders. Those two shareholders are billionaire vitamin entrepreneur, Carl DeSantis, and the richest man in Hong Kong, Li Ka-shing.

Rarely do we find companies that can accelerate growth rates as they get larger, but when we do, we dig in deep. We believe CELH is entering a hyper-growth phase as they scale nationwide distribution deals in existing, blue-chip channels. With major name brand retailers and convenience partners like Walmart, Costco, CVS and 7-Eleven already carrying the product, the key to CELH’s future success is to optimize shelf space and placement. This task is carried out by nationwide beverage distributors that dictate product placement and stocking levels. Why is this important? When you have warm, stocked out product at aisle 27 in Target, any significant sell-through is a testament to a strong brand. When your product is then moved to the cooler at aisle 1, your sell-through goes up exponentially. This distribution change drove Monster Beverage revenue growth from +30% to +80-90% in their hyper-growth phase and helped triple Bang Energy sales in the last year. CELH is just launching these relationships, and early indications is when you go from aisle 27 to aisle 1: you see a 3x uplift is same-store sales.

It is companies like Celsius Holdings that get us excited to get on the road to discover other companies that are creating or expanding product or service categories and that are currently underappreciated by the market. Despite a slower macroeconomic cycle, we see plenty of ideas for allocating capital to smaller companies that we believe have good prospects of delivering on their growth ambitions.

As always, thank you for entrusting your capital with us.

Kindest regards,

Andrew Mitchell & Steven Ng

Co-Founders & Portfolio Managers

Ophir Asset Management

 

This document is issued by Ophir Asset Management Pty Ltd (ABN 88 156 146 717, AFSL 420 082) (Ophir) in relation to the Ophir Opportunities Fund, the Ophir High Conviction Fund and the Ophir Global Opportunities Fund (the Funds). Ophir is the trustee and investment manager for the Ophir Opportunities Fund and the Ophir Global Opportunities Fund. The Trust Company (RE Services) Limited ABN 45 003 278 831 AFSL 235150 (Perpetual) is the responsible entity of, and Ophir is the investment manager for, the Ophir High Conviction Fund. Ophir is authorised to provide financial services to wholesale clients only (as defined under s761G or s761GA of the Corporations Act 2001 (Cth)). This information is intended only for wholesale clients and must not be forwarded or otherwise made available to anyone who is not a wholesale client. Only investors who are wholesale clients may invest in the Ophir Opportunities Fund and the Ophir Global Opportunities Fund. The information provided in this document is general information only and does not constitute investment or other advice. The information is not intended to provide financial product advice to any person. No aspect of this information takes into account the objectives, financial situation or needs of any person. Before making an investment decision, you should read the offer document and (if appropriate) seek professional advice to determine whether the investment is suitable for you. The content of this document does not constitute an offer or solicitation to subscribe for units in the Funds. Ophir makes no representations or warranties, express or implied, as to the accuracy or completeness of the information it provides, or that it should be relied upon and to the maximum extent permitted by law, neither Ophir nor its directors, employees or agents accept any liability for any inaccurate, incomplete or omitted information of any kind or any losses caused by using this information. This information is current as at the date specified and is subject to change. An investment may achieve a lower than expected return and investors risk losing some or all of their principal investment.  Ophir does not guarantee repayment of capital or any particular rate of return from the Funds. Past performance is no indication of future performance. Any investment decision in connection with the Funds should only be made based on the information contained in the relevant Information Memorandum or Product Disclosure Statement.

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