“I think the secret is if you have a lot of stocks, some will do mediocre, some will do okay, and if one or two of ’em go up big time, you produce a fabulous result.”
– Peter Lynch (Portfolio Manager, Magellan Fund at Fidelity Investments)
“Diversification is a safety factor that is essential because we should be humble enough to admit we can be wrong.”
– John Templeton (founder Franklin Templeton)
Read the previous week’s Investment matters.
Take the time…
…to read this edition of Investment Matters. It covers a lot of interesting material, the benefit of which will be lost if you just skim-read and look at Patrick Cook’s cartoons.
A primer: Sub-portfolios?
Each client’s investment portfolio is made up of their own individually managed sub-portfolios, one for each asset class in their Investment Programme. Depending on the Investment Programme, a portfolio might consist of a sub-portfolio for each of, say, Australian Equities, Income Securities, and Property Securities.
Inevitably, in their Australian Equities sub-portfolio, most clients will hold roughly similar securities but often in different proportions. We have a bias to discussing Australian equities in Investment Matters because clients are more interested in Australian equities and also that almost all clients have an Australian Equities sub-portfolio.
A reminder: How we build Australian Equities sub-portfolios
Each week in Investment Matters, we discuss the types of themes that are crucial in building sub-portfolios. We aim to combine these themes with thorough bottom-up company research to create a well-diversified sub-portfolio that can outperform in the medium term.
Our themes that have received the most attention in recent years include:
- Companies that benefit from population growth rather than per-capita economic growth
- Energy transition opportunities, including battery materials and copper
- Companies that are likely to be subject to takeover bids
- Companies that have significant assets that are perhaps not well-run
- Globally significant businesses in niche areas
- Structural tailwinds, including aging and government spending
Over the next four weeks, leading into the end of the financial year, we will present a detailed review of individual stock positions. We will present an update on companies in all clients’ Australian Equities sub-portfolio, a year-end stocktake. 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, both thematically and in terms of the sub-portfolio’s construction?
Portfolio diversification
The portfolio construction angle will provide an opportunity to update clients on an important issue for the overall sub-portfolio. We are currently at the high end of the number of securities we typically anticipate holding.
Some clients would appreciate that diversification can have its limitations. The costs can outweigh the benefits once the number of stocks becomes too high. We contend that two countervailing factors currently require a higher number of stocks.
- The benchmark ASX300 stock index has rarely been less representative or diversified than it is now. Following several years of large company outperformance, the benchmark is now dominated by a narrow type of economic activity.
- The Australian economy is in transition, both in terms of current performance and sources of future growth and innovation. In recent weeks, we have noted concerns about productivity, the limitations of household balance sheets, and the economy’s re-orienting towards government and away from business investment.
In these conditions, simply following the market in its current form creates higher risks than necessary. Instead, risks can be mitigated by a sub-portfolio construction approach that accounts for uncertainty.
Searching for diversification
Famed investor and financial historian, Peter Bernstein, provides two critical quotes, below, that hint at the correct approach. Each supports Peter Lynch’s assertion that the search for a small number of strong performers is critical to long-term returns.
“Diversification of risk matters not just defensively, but because it maximises returns as well because we expose ourselves to all of the opportunities that may be out there.”
“What’s comfortable is not the right way to invest. You must own things that you’re uncomfortable with. Otherwise, you’re not really diversified.”
Baskets?
The implication for our clients is that today’s sub-portfolios have the following features.
- We are buying several “baskets of companies” that are exposed to a particular market, commodity or sector rather than a single holding with the same features
- Significant exposure to contrarian positions, the dramatic success of which will require conditions to change, rather than simply investing in companies that assume that tomorrow will always be the same as today
- Positively, we are investing in a broad range of companies that benefit from a range of domestic economic growth drivers
- Defensively, we have less exposure to the Big Four banks and Chinese demand for iron ore
Our contention, which we hope to explain, is that while the overall number of stocks is higher than optimal, considering the “basket of companies” as a single exposure, the overall number of positions is optimal for the current market and economic conditions.
The next four weeks of updates will assist clients in understanding where we identify the best approach is buying a basket of companies rather than simply expressing the thematic or market force in just one company.
Year-End Stocktake: Part One
Part One of the year-end stocktake will outline one of these baskets of companies we outlined above, as well as a set of six sub-portfolio stocks, including a couple that are making news. Over the following weeks, we will explore all the “baskets” and each of the stocks in clients’ sub-portfolios.
Stocktake: Materials and Copper Basket
Four companies are in the Materials and Copper basket: Sandfire Resources, Aurelia Metals, Metals Acquisition Corporation, and Lynas Corporation.
Why are they in a basket?
- First and foremost, we are looking for exposure to a range of materials, especially copper, that benefit from higher demand due to the long-term electrification trend.
- We are also trying to benefit from a copper-specific trend rewarding existing mines and productive regions around the globe. Weak exploration results for decades have seen copper grades (concentration of metal in ore) decline, few new resources identified, and production costs rise. Assets or regions with a history of expanding production and those rare assets with exploration success will likely continue to increase in value.
- We are looking to avoid a scenario in which successfully anticipating a trend of rising copper prices was thwarted by owning just one company that came with unrelated other risks. These risks include:
- Country-specific risks, include sovereign and military risks
- Mine-specific risks, including mine failure
- Production variation, especially variation that lasts several years
- Australian dollar movements, both for revenue and costs
The combination of Aurelia, Sandfire and Metals Acquisition achieves this by combining.
- Australian assets and costs in Aurelia and Metals Acquisition and USD and Euro currency exposure in Sandfire
- both lower-cost and higher-cost mining. Lower-cost mining benefits from the scale of future demand growth, regardless of ultimate copper prices, and higher-cost production benefits from being in place and exponentially in periods of higher prices
- four global regions: Botswana, Spain, USA and Cobar (NSW), with strong historical records of exploration success
- a wide range of customers and comingled by-products. By-products are critical in copper mining because rarely is copper the only mineral mined in a particular mine. Other minerals, including gold, lead, and zinc, can both assist and detract from the economics of mining in a specific location. The basket of companies we own reduces the impact of a decline in any specific non-copper mineral on the overall success of the position.
With global demand for copper assets rising, it is also important to have a wide range of assets that could be bought for high prices or subject to merger activity. This basket has companies with such assets.
Lynas Corporation is the remaining part of the basket, and it owns one of the world’s pre-eminent rare earth assets and a unique non-Chinese supply chain.
Although related to the electrification trend, the scale of the opportunity of rare earths is a fraction of the copper opportunity in terms of industry size. In a basket approach, we solve this by including Lynas in a smaller size. Despite its smaller industry scope, the volatility of future rare earths’ prices and Lynas profit outcomes are considerable. Having a small position could provide outsized returns, as suggested by the Lynch analysis. In this case, Lynas stock has already provided clients with large returns (greater than 300%).
The Materials and Copper Basket represent a significant 7% of clients’ Australian Equities sub-portfolio. If combined in one position, it would be our largest exposure.
The basket has been a very successful part of clients’ sub-portfolio, with both Aurelia and Sandfire returning more than 45% in FY-24. Lynas is slightly down for the year, while Metal Acquisition Corporation is trading 23% higher than its listing price in February 2024.
During the past 12 months, Sandfire has made significant progress on starting its new Motheo mine in Botswana, Aurelia is progressing with the final stages of developing its Federation Mine, and Metals Acquisition Corporation is providing ongoing updates to its future resource base and mine plans.
Some clients will also own a more minor position in New World Resources. It owns mineral properties in the USA. The company is exploring for gold, silver, lead, copper, and zinc deposits, and holds a 100% interest in the Antler copper near Yucca in northwestern Arizona. The company continued to make good progress in 2024. For clients with the appropriate risk tolerance and time horizon, adding exploration upside to a preferred metals basket rounds out the basket approach.
Figure #1: Aurelia Metals, Investor Day March attended by First Samuel: Driving the Federation mine down towards target depth.
Stocktake: Four companies with dramatic changes in 2024, – 360 Capital, Paragon Care, Bapcorp and MMA Offshore
One key theme we pursue in client portfolios is a conviction that quality assets eventually shine through. All four companies in this group have been at the centre of significant change. In each case, the core value of the assets was significantly discounted by the market, or the market’s perception of the capacity of the existing management to release this value was discounted.
In 2024, we appreciated the speed at which management, external influence, and/or outside intervention extracted this value. It reminded us that identifying good assets and remaining patient is vital in the portfolio approach we are pursuing.
| Company | What has changed? | Future prospects? |
| 360 Capital | The company has reorganised its balance sheet and sold various assets, including an HPI in March. It currently has no debt. Management implemented a share buyback program (5% of stock in FY24) at a discount to the predominantly cash-based asset value. | The company is now looking for opportunities that are beginning to emerge in real estate and property development. Stress is rising in pockets of commercial real estate with high financial leverage. When mixed with slowly falling asset prices, caused by higher interest rates, distressed opportunities are emerging. 360 Capital’s expertise and exceptional track record is in capitalising from these points in the cycle. The balance sheet provides huge capacity to generate value from this starting point. |
| Bapcor | Bapcor has a portfolio of great assets in the automotive sector. Since board level troubles, it has been poorly managed. Weak operating conditions have combined with poor execution, resulting in reductions in profitability and uncertainty regarding future direction. Bapcor has just become subject to a takeover bid. | This week’s bid should only be the first for the company. Based on the industry’s global structure and the history of the company’s ownership, there should be a minimum of four industry players interested in purchasing the company. An auction process would be our preferred approach for the board. Operating a standalone listed operating business is the least likely outcome. |
| MMA Offshore | The company provides marine vessels and associated services. In 2023 and 2024, the industry saw a rebound in activity from depressed levels for the past 5-7 years. The sales momentum rapidly turned into significant profits as the underlying improvements made in the business became apparent to the market. MMA Offshore received a takeover bid of $2.60 per share in March. | The final outcome of the shareholder vote to endorse the takeover is due following the Scheme meeting on 1 July 2024. Recent trading updates have reinforced the strong momentum the business has. Should the vote to sell fail, additional value may be available, but we prefer the Scheme be implemented. |
| Paragon Care | Paragon Care is a wholesaler and manufacturer of medical equipment devices and consumables and has been a long-held First Samuel position. In recent years, it has struggled to grow at a low scale, despite a value accretive merger in 2022 and extensive investment in 2023. Few in the market agreed there was value in the underlying assets, until Clifford Hallam Healthcare (CH2), a large private operator agreed to a merger that created significant value to Paragon Care shareholders. | After appreciating by 70% in 2024, next year will be vital as the company completes its integration with (CH2). A more effective approach to market execution, mixed with a new balance sheet diligence is expected to improve margins and present a more clarified approach to growth. Structural change in the pharmacy sector, including the merger of Sigma and Chemist Warehouse is expected to provide new opportunities which the combined company can exploit. |
Stocktake: Worley – business momentum and ownership changes
Worley is a significant global player in energy, resources, and sustainability projects. The $7bn market capitalisation company fits nicely into the First Samuel theme of ‘global significance’ in a niche capacity. It also benefits from ‘structural tailwinds’ as the developed world retools its energy infrastructure.
According to the IEA’s annual World Energy Investment report, total energy investment worldwide is expected to exceed $3tn in 2024 for the first time, with some $2tn set to go toward clean technologies. The remainder, slightly over $1tn, is going to coal, gas, and oil. Worley’s 2023 revenue was almost $11bn.
Figure #2: Worley aggregate revenue by project type
Worley, the world’s largest supplier of engineering, consulting, construction, and project management services to the oil, gas, chemical, and energy sectors, operates in more than 60 countries and 250 locations, with a worldwide workforce of tens of thousands.
The ‘Sustainability-related work’ includes solar power, wind power, lithium, carbon capture and low-carbon hydrogen projects.
After selling a significant proportion of our holding in 2022, the company underperformed in the market. In late April, Worley Limited’s largest shareholder, Dubai-based infrastructure group Sidara (previously Dar Group), was selling 19% of the ASX-listed engineering group, which was a monster block trade worth $1.4bn. The history of the Dar ownership was both contentious and value destroying. Losing its presence is a distinct positive long-term outcome.
The sale price of $14.50 was more than a 10% discount to the range the company was trading in the previous 6-12 months. The stock has continued to trade at a lower level, likely due to the sheer volume of the stock sold, and Dar still holds a further 4.5% of the company. This stake is also assumed to be sold in the coming twelve months.
We are using the Dar sell-down and ongoing weakness to rebuild the Worley position to one of the most prominent positions in client’s sub-portfolios. We appreciate the company’s capacity to successfully bid for projects and sense a large future committed pipeline. Its capability to grow margins and improve cash flow at the same time as increasing offers further upside to the current share price.
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.