Read the previous week’s Investment matters.
Background
This is the fourth in a series of stocktakes provided to clients as we approach the end of the financial year. Let’s remind readers of the background for the series.
In the weekly Investment Matters, we often discuss the themes crucial to building Australian Equity sub-portfolios. Themes that have received the most attention in recent years include population-led growth, energy transition, companies ripe for takeover, and structural tailwinds.
In this four-week series of Investment Matters, we will look a layer down: the individual security positions. These updates on portfolio companies we might call a year-end stocktake. So to speak. In each company update, we will note:
- What are the opportunities?
- What is the investment proposition, and how has it changed?
- What has been the progress in the past twelve months?
- How does the company fit in the sub-portfolio both thematically and in terms of the sub-portfolio’s construction?
The portfolio construction angle helps explain why we are at the high end of the number of securities positions we typically anticipate having in our standard Australian Equities sub-portfolio.
The market
Following the marketing creates risks
Our contention is that the combination of a non-representative benchmark ASX300 index and an Australian economy in transition means that simply following the market in its current form creates higher portfolio risks than necessary.
Year-End Stocktake: Part four
Part four of the year-end stocktake will outline our exposure to a final basket of stocks, the gold basket, our mining services exposure, three large industrial companies and two long-held smaller companies.
Gold Basket: Finding pay-dirt in a range of companies
Four companies are in the Materials and Copper basket: Newmont Mining, Catalyst Metals, Aurelia Metals, and De Grey Mining. In the case of Aurelia Metals, it occupies a position in both the Copper Basket and the Gold Basket.
| Portfolio Positions | FY-24 YTD Average return | FSL Portfolio Share |
| Gold Basket | ||
| Newmont Mining | +12.0% | 3.25% |
| Aurelia Metals | +106.0% | 2.00% |
| De Grey Mining | -12.0% | 3.00% |
| Catalyst Metals | +63.5% | 0.75% |
Why are they in a basket?
We are predominantly interested in owning exposure to movements in the price of gold, both as an insurance policy against global uncertainty or conflict and as a hedge against inflation.
However, buying physical gold has high ownership costs and generates negative cash flows, reducing its appeal as an investment for self-managed superannuation.
So, we need to own gold miners instead of gold itself. We wish to avoid a scenario in which the gold price rises, but exposure to the vagaries of single mines, which see their weak performance, cancels out the benefit of higher prices.
As such, we are looking for gold mines with a range of the following.
- Mines of differing lifespans. Short-term mines (less than seven years) tend to see more price volatility in periods of higher prices, whereas great global mines, which last more than 20 years, are rewarded when markets appreciate the truly long-run value of gold has risen. One of the key reasons we own Newmont Mining is the extended life of its mines.
- Mines with differing grades. The best gold mines have the highest grades (the most gold per sqm or tonne) of mining operations. Such mines tend to have lower costs and more consistent earnings. When the gold price rises, their earnings improve but not by as much as mines, which have lower grades and higher costs. Considering the long-run value of gold investment is predominately based on the rising value of gold, a mix of grades and costs can create the best basket, that is, mines that survive regardless and mines that thrive when prices are higher. Mines such as Catalyst and De Grey benefit from developing high-grade mines, whereas Newmont is continually developing a range of grades across its portfolio of assets. Aurelia has the lowest grades and the higher variation in costs.
- Mines with different by-products. Often, gold mines can be marginal propositions by themselves without the by-products of silver, zinc or copper, helping support the cost of extracting the gold itself. Our basket has a range of by-products.
- Mines with exploration potential. Gold mines are expensive to develop and costly to maintain. Often, the strength of an investment in a mining enterprise is reliant on being able to extend the original life of a mine through additional exploration once the mine is up and running. Indeed, many gold mines that have started as a 10-year venture will still be operating in one form or another 30 to 50 years later. In a basket, you need this exploration potential. There is potential for exploration in the case of Aurelia, Catalyst, and De Grey Mining. As a matter of course, Newmont is continually exploring, although such investment is less likely to make a step change in value.
- Developing mines. One of the features of gold stocks is the significant discount that is often given to known but currently undeveloped mines. This occurs almost regardless of the future quality of the mine under development. Markets appreciate miners who are mining, not just planning to mine. As patient investors with a longer time frame, and as part of a business, we find value in mines that are in development, especially if the planned mine is of sufficient quality and size. This is the case with De Grey Mining.
With the “gold basket” features laid out above, the year-end stocktake will also note that it remains a great time to hold a significant proportion of the portfolio in gold. Other than the portfolio benefits that have persisted throughout financial history, current circumstances that are benefiting include
- Return of persistently higher inflation
- Reservations about central banks’ fortitude
- Increasing geopolitical tensions & bi-polar world risks
- Central banks’ buying
- Chinese devaluation risks
- Post-GFC ‘money printing’
- Years of increased production costs
For several years on the ASX, the gold stock sector hadn’t delivered the returns an investor would have generated from simply buying gold alone. This result has been counterintuitive (gold stocks are more leveraged to the gold price than the gold price itself) and surprising, given the general quality of Australian gold miners and their assets.
In early February 2024, mining analysts from UBS produced the following chart, highlighting the underperformance since 2016. The price of gold had risen by more than 45%, while the price of gold stocks (GDX) had only increased by around 30%.
We believe such a spread is unjustified, so we have added to our positions in 2024 in Newmont Mining, Aurelia Metals, Catalyst Metals, and De Grey Mining. Despite the strong share price performance in the past 4 months the gap between physical gold and gold stocks has barely moved.
Figure 3: Gold price vs gold stocks price (GDX Index)
The differences in the performance of the stocks we hold, from stellar changes in Catalyst and Aurelia (more than 50%) to the muted growth in De Grey and Newmont, may relate to our markets’ views on the long-run value of gold.
Whilst there are many reasons the current price may be elevated, and we believe many reasons that these themes can remain important for the medium term, the market is still discounting that gold will once again fall in value considerably.
This is why we maintain a portfolio of gold stocks, some of which benefit in the short term, some of which benefit in the long run, and all of which provide insurance for the unexpected.
Other larger companies exposures: Mining Services and Industrials
We finish the series with brief notes on our mining services exposures, which have worked well this year. We suspect that the sector is likely to continue to outperform despite tough conditions. The stocks in the sector are particularly cheap from a cash flow, earnings and strategic value perspective.
We see the companies themselves engaging in a great deal of sensible self-help, including cross- company partnerships, new investments in technology, and fine tuning of balance sheets. With the sector trading on constrained valuations this is a great time to continue to strengthen the core of operations. Both Emeco and Imdex in clients’ portfolios have been undertaking such strengthening.
| Portfolio Positions | FY-24 YTD Average return | FSL Portfolio Share |
| Mining Services | ||
| Emeco Holdings | +11.4% | 2.00% |
| Imdex | +28.0% | 2.00% |
| Large Industrials | ||
| Nufarm | -10.4% | 2.75% |
| Bluescope (part year) | -7.0% | 2.50% |
| Smaller positions | ||
| Traffic Technologies | -73.0% | 0.05% |
| TZ Limited | -4.0% | 0.50% |
Mining Services: Emeco Holdings (EHL)
Emeco Holdings (EHL) is a long-held portfolio position. We’ve elected to persist with holding the stock, despite some challenges in recent times with execution, given it appears to remain undervalued at the current share price.
We were pleased with the decision of management to dispose of the company’s underperforming ‘Pit and Portal’ business to Macmahon’s, a competitor mining services business. Recent discussions with senior executives leave us convinced that the company is prepared to take further action to realise value for shareholders, including further divestments or exploring mergers or takeovers.
Emeco’s largest shareholder with 39%, Black Diamond, is an alternative investment manager based in Toronto. But it does not seem likely to make a takeover bid for the entire business. Instead, we’d expect a combination with ,another potentially undervalued mining services company as likely to deliver most value. In the meantime, we see scope for a capital return to deliver franking credits to shareholders.
Mining Services: Imdex (IMD)
Imdex develops cloud-connected devices and drilling optimisation products for the global mining market. The company’s share price has fared a little better in the past 12 months, as its transformational Devico purchase (combining the No. 1 and No. 2 players in some market segments) delivers value and growth against a difficult backdrop.
Global mining exploration spend levels are currently around 60% of the level of the 2012 peak. The majority of this spend is dedicated to drilling, where Imdex’s technology is useful for producing better geological surveys, more efficient drilling and fluids for enhancing the drilling process.
Despite a strong gold price, junior mining explorer financing and activity levels remain subdued. This is particularly the case in Canada and Australia. Declining interest rates would likely be a fillip for improvements in mining exploration with gold miners, being the largest users of Imdex and the services provided by specialist drilling companies.
Other Industrials: Nufarm (NUF)
Nufarm is best known as a crop protection and fertiliser company (think Roundup) but it also has a developing presence as a grower of Seeds including Canola, Sorghum, Sunflower seeds, nutrient-rich Omega-3 and Carinata,
Omega 3, often associated with fish, can also be found in flaxseed and is used to curb inflammation and is particularly good for the heart and reducing blood fats.
Carinata is a low-carbon fuel feedstock which adds vital organic matter back into soil and is an important opportunity in regenerative agriculture processes by improving soil health.
These emerging business lines are currently around 15% of revenue, but represent much of the growth opportunity of the Nufarm business and, accordingly are a disproportionate driver of the value of the business. While the traditional NUF business might typically be valued at a 5.5x Enterprise Value/EBITDA multiple, similar businesses to its Seeds business might command a 12x Enterprise Value/EBITDA multiple. Up to one-half of the value of the NUF business is contained within its prospective Seeds business.
Other Industrials: Bluescope Steel (BSL)
Bluescope Steel operates in the Asia Pacific and North America, which is its largest market. It is a resilient and diversified business with strong cash flows and has an under-geared balance sheet, leaving potential scope for higher returns. While, for the most part, it has commoditised earning streams, these are somewhat insulated by a downstream branded business (eg Colorbond).
We consider U.S. steel markets as structurally attractive, with higher steel pricing than other markets and more internal demand than supply. If global trade flows become narrower, Australian production can replace Chinese steel as a source of supply to the US market.
Bluescope is trading on an undemanding valuation at ~4.5x EBITDA, which is a significant discount to North American steel peers which are trading on 6-8x EBITDA. Given the weak AUD$, Bluescope seems likely to be an attractive acquisition opportunity for a North American steel company – either in part (US operations) or in full.
Smaller companies: Traffic Technologies (TTI)
Traffic Technologies Limited (TTI) provides traffic solutions in Australia and internationally. The company designs, manufactures, and installs traffic signals, controllers, road lighting products, and control systems.
The company’s Traffic Smart City Technology platform enables the integration of streetlights and other traffic management equipment into a central control/management system through remote Internet of Things sensors, primarily for the road industry, councils, and power authorities. The company was “founded in 2004 and is headquartered in Fairfield, Australia.
TTI is a small position in client portfolios and has had a volatile share price over the past couple of years. In FY2024, the company successfully repaid $1.5m of its outstanding loan (originally $3.5m) to First Samuel.
Operationally, the business has been constrained by working capital movements and softer revenue. The CEO, Con Liosatos, and Chairman, Carey Stynes, are capable operators, and we anticipate that the current forward order book and the strong underlying operating capacity will combine to find solutions for working capital and supply chain issues.
The medium-term outlook for businesses of this type is highly dependent on infrastructure projects and maintaining a good-quality parts supply and cash flow. The structural tailwind behind infrastructure, especially in the eastern states, remains strong; the technology-facilitated Smart City platform is the type of solution that communities are increasingly looking towards. When operating well, we have seen this business generate strong cash flow.
Smaller companies: TZ Limited (TZL)
Clients will note that the position in TZL has been a long-held one. The combination of debt funding and having a significant stake in the company (>20 per cent of issued capital), means that TZ Limited is a business that is closely watched. Following a number of years of weaker operating performance but solid debt repayment and debt servicing, FY24 has been a pleasing year.
Noting from the company’s market announcement from late April 2024
- The Company continues to show positive business performance with a Q3 EBITDA of $73K, bringing the year-to-date (YTD) performance to an unaudited positive EBITDA of $719K and a YTD net profit of $359K.
- This represents the third consecutive net positive quarter for the Company.
- The company is generating positive operating cash flow in FY24.
We have been pleased with the increase in recurring revenue the business has generated from its very competitive network locker software solutions. Gross margins have improved, and the cost-cutting undertaken in calendar 2023 has seen good results.
With a great lineup of clients that includes Microsoft, Apple, major US universities, and a scalable technology stack, we are confident that the business’s underlying value is significantly in excess of current values.
Summary
This concludes our four week, comprehensive portfolio ‘stocktake’.
We have explored the reasons for sometimes holding more stocks with smaller positions in some segments of the market, especially in our mining company holdings. We have highlighted some of the other tilts within our portfolio and the reasons for those – eg avoiding concentration in a manner where the traditional ASX index increasingly is inadequate (ie ~60% of the Index is weighted to the largest 20 stocks).
The information in this article is of a general nature and does not take into consideration your personal objectives, financial situation or needs. Before acting on any of this information, you should consider whether it is appropriate for your personal circumstances and seek personal financial advice.