Prime Value Growth B (PVA0011AU) Report & Performance

The fund returned +2.4% in June, 0.7% above the ASX300 Accumulation Index return of +1.7%. June concluded the financial year and returns were strong with the fund +14.0%. Very few expected such strong market returns highlighting that short term returns are hard to predict and long-term investing is best. There are good years and bad years but over the long term, returns are very strong.

By being invested, unit holders have benefitted from a +14.0% year when many other asset values declined. Over the last 2 years the fund has marginally underperformed the ASX300 Accumulation index (+0.4% v’s +3.3% p.a.). This is because the fund is overweight small industrials which have underperformed large capitalisation stocks which dominate the ASX300 index. The small industrials accumulation index return over the last 2 years has been -8.8% p.a., creating a significant headwind to performance. When markets rebound, smaller companies typically rebound more meaning this headwind will turn into a tailwind. We saw this over the last 6 months with the fund outperforming the ASX300 by 3.3% (+7.7% v’s +4.4%).

Small industrials is an appealing market segment as it is a deep pool of opportunity. There is a large variety of companies in very different niche industries and most have limited research coverage. We meet 4 companies per day on average ensuring we find the best ideas and have them in the fund. Markets are currently trending positively and it appears we are nearing the end of the RBA’s rate hiking cycle so there are reasons to be positive on the market outlook. However, as always, it is very difficult to forecast markets in the short term. Over the long term we are confident markets will be significantly higher so the fund’s returns should be strong. Over the last 2 years of market turbulence, many quality businesses have fallen significantly, presenting the opportunity to buy at discounted prices. Earlier this year we started buying Domain Group (DHG) after its share price had halved in the previous 12 months. DHG is a high-quality business being the second largest online property portal in Australia.

The industry is concentrated with 2 main players, high barriers to entry and strong pricing power. Since our purchase the stock is up c. 20% in anticipation of an improving residential property cycle (increased listings). This highlights the market is forward looking and you can’t wait for ideal conditions to invest. In our view, investing in equities is not a speculative game. It provides the opportunity to be the part-owner of very high-quality businesses at attractive prices (when timed right). A cursory glance at the wealthiest people in Australia and globally illustrates that being a business owner is a fantastic way to generate wealth. Market falls over the last 2 years is presenting investment opportunities that should provide strong investment returns in the years to come.

The fund returned -0.2% in May, which was 2.3% ahead of the ASX 300 Accumulation Index which returned -2.5%. The month was characterised by strong returns from Technology and Lithium stocks, and weak performances from the broader Resources and Retail sectors. Local Technology stocks appeared to rally following a material profit upgrade from US-listed Artificial Intelligence beneficiary, NVIDIA. Conversely, softer Chinese economic data saw Resource stocks sold off, while Retail stocks were hit by signs that consumer demand is softening.

Key fund contributors in May were Kelsian (KLS +11.5%), Newscorp (NWS +11.3%) and Austal (ASB +19.0%). Key detractors were BHP Group (BHP -5.4%), AUB Group (AUB -8.0%) and Helloworld (HLO -10.6%). Kelsian (KLS) rose on limited new news, and has steadily become one of the fund’s largest holdings. For us, it is a reminder of the importance of investing in quality businesses at the right price. For a long time, we have been attracted to Kelsian’s resilient public bus business model, that sees it generate inflation-protected cash flows with no fare box risk from longterm contracts with government counterparties, and without material capital investment in key infrastructure in some regions. However, we were not alone in appreciating these qualities, with investors pushing the stock beyond our valuation tolerance levels to >$9ps for much of 2021 following a series of contract wins and renewals. But no-one has a perfect win rate, and shortly thereafter, the company’s extraordinary winning streak came to an end as it missed out on several tender opportunities. This saw investors lose faith and push the stock down into our hitting zone, resulting in our initial purchase in Jan 2022 at c. $6.50ps.

Further ‘disappointments’ from the failed attempt to acquire a large UK bus operator saw the stock fall lower, providing the opportunity to add 25% to the fund’s holding below $6ps in Sept 2022, and a further 25% addition below $5ps in Oct 2022. Through this time that the stock halved in price, nothing had changed with regards to its business model or operating performance; investors had simply fallen out of love. And just as a perfect hit rate is unobtainable, a perfect loss rate is sustained by few, and Kelsian has since enjoyed more than its market share worth of new wins through the NSW Government’s recent tender process, resulting in a ~50% share price rise since (to $6.80ps).

Our most recent opportunity to add to the position came in Mar 2023, participating in an equity raise (at $5.55ps) as the company acquired a large US bus business with an experienced management team and impressive organic growth profile. The key in this case study is the importance of the entry price of an investment; it is a key component of the returns ultimately generated. It will surprise many to learn that the share price of the median company in the ASX300 index is trading 17% below its 52-week high, while also trading 27% above its 52-week low – that is, the median ASX300 company has traded in a >40% share price range over the past year.

The fund returned +2.6% in April, 0.7% above the ASX 300 Accumulation Index of +1.9%.

The fund is overweight smaller companies in a focused, lower risk way i.e. growing, high quality, less cyclical businesses. Since the beginning of 2022 smaller companies have underperformed larger companies by circa 20% and this has been a major headwind to performance. In recent months this has started to reverse. When combined with the fund’s outperformance relative to the small company index (Small Ordinaries Accumulation Index), fund performance has been improving. To some extent, future performance will also be driven by the dynamic of small v’s large. However small companies are trading at an abnormally large valuation discount to large companies and that will unwind at some point. This implies there is more upside to small companies long-term. The timing is uncertain, but it can happen quickly.

April’s solid returns were driven by our exposure to smaller companies. All 3 of our best performers were small while our largest detractor was a large cap (BHP).

Lindsay Australia (LAU.ASX, +38%) is a relatively small position in the fund but materially benefitted performance after upgrading guidance for earnings in the current financial year. EBITDA is now expected to be 50% above last year and it appears this may be conservative. The recent liquidation of Lindsay’s largest competitor (Scott’s) has removed capacity from the industry coming into the seasonally strongest period which provides strong pricing power to incumbent operators. In many cases, contracts are being locked-in for 3-5 years at significantly higher prices thereby ensuring long term benefits for the company. Despite the stock price tripling from our original purchase last year, it remains attractively priced on an FY24 PE of c. 10x, yielding 5% fully franked.

Helloworld (HLO.ASX, +36%) is a tourism operator exposed to international travel. In April HLO also upgraded earnings guidance for the current financial year. Guidance still appears conservative given the implied earnings for the fourth quarter is similar to the seasonally weaker third quarter. It is reasonable to expect the fourth quarter to be materially higher. Momentum remains strong for tourism operators globally due to pent-up demand after 3 long years of covid restrictions and health concerns.

AUB Group (AUB.ASX, +8%) is an insurance broker that made a UK acquisition in 2022. Initial concerns with the risk of a large offshore acquisition are dissipating and the insurance premium cycle is still positive, further supporting earnings growth.

February was a weak month for equities, as company results illustrated declining earnings momentum. The MSCI Developed Markets Index fell (-1.5%), and the S&P500 Index also lost momentum (-2.4%) in local currency terms. Emerging markets underperformed Developed Markets, falling (-4.3%) across the month.

The RBA began the month with a more hawkish tone outlining their intention to take interest rates further. Australian 10-year bonds fell in reaction to tightening monetary policy, with yields rising 30bps to 3.86%. US 10-year bonds also fell with yields rising 39bps to 3.92%, in reaction to stronger than expected economic data.

The fund’s return was -1.3% in February, 1.3% better than the ASX 300 Accumulation Index of -2.6%.

We continue to hold a portfolio of stocks which individually are high quality, all are profitable and most we consider structurally growing with less dependence on the economic cycle. The equity we own in this group of companies should grow in value over coming years and provide a reasonable dividend stream along the way. Less certain is market sentiment and how this value is reflected in stock prices in the short term. We hold stocks for an average of 4 years which reflects our belief in the power of compounding wealth through the patient ownership of quality assets that grow in value over time.

The fund’s return was +4.7% in January, 1.6% below than the Small Ordinaries Accumulation Index of +6.3%.

The strong market performance was led by stocks in the Retail and Mining sectors. Retailers benefited from still strong consumer spending (refer to strong updates from the likes of Super Retail and Accent Group), while Miners benefited from strong commodity prices (and is a sector in which the fund tends to be underweight due to a low predictability of earnings).

The fund currently has a limited exposure to Retailers given the exhaustion of ‘excess’ savings that resulted from COVID stimulus payments and the pending fixed rate mortgage cliff. This sector of the economy has experienced conditions that are about as good as it gets, both in terms of sales and margins, which we expect to revert over the medium-term. In particular, the household savings rate has returned to a more normal level of ~7%, having increased to as high as 24% in June 2020 as land-locked households were restricted from spending on services that were in lockdown, instead deflecting this spend into buying more goods than ever. Additionally, a temporary low cost funding facility provided to the banks through COVID saw them offer very low fixed rate mortgages that will largely expire over 2023. This will result in ~10% of Australians move from fixed rates of ~2%pa into higher variable interest rates of ~6%, which will likely further impact consumer spending levels.

Key fund contributors in January were BHP Group (BHP +8.2%), CBA (CBA +7.3%) and Macquarie (MQG +12.2%). Key detractors were Austal (ASB – 20.2%), Regis Healthcare (REG -7.2%) and Lindsay (LAU -7.2%). BHP was strong on higher commodity prices which were buoyed by China’s re-opening, with Iron Ore and Copper both +10% in January.

CBA rose on no news flow, as the major banks continuing to gain market share against non-bank lenders due to a cost of funding advantage.

Macquarie (MQG) also rose on limited news flow, with some expectations that its 3Q trading update could highlight benefits from the dislocation in natural gas markets.

Austal (ASB) downgraded its FY23 earnings guidance by ~40% as it raised a provision for an onerous contract with the US Navy. The company has submitted a claim for reimbursement of higher quantities of steel and cost inflation in relation to the T-ATS contract, which may or not succeed. Either way, the outcome should not, in theory, impact future earnings.

Regis Healthcare (REG) was weak following the release of the Department of Health’s Aged Care Star Ratings which ranked REG in the bottom quartile of the larger peer group.

The fund’s return was -2.3% in November, 1.0% better than the ASX300 Accumulation Index of -3.3%.

Key positive contributors in December were Lindsay (LAU +19.5%), NIB Health (NHF +6.2%) and Hotel Property Investments (HPI +6.3%). Key detractors were Commonwealth Bank (CBA -4.9%), Omni Bridgeway (OBL -15.8%) and Austal (ASB -14.8%).

It was good to see the end of a tough year for equities in 2022. Rising inflation resulted in higher interest rates that impacted valuations, particularly for small cap companies (-18% in 2022) in which the fund has exposure. Equities generate strong long term returns however volatility is part of the trade-off. There are good years and bad years. Thankfully the good years far outnumber the bad years.

Historically small cap stocks rebound strongly after years like 2022 which was the 3rd worst in the last 20 years (chart below). But forecasting the timing is very uncertain. Global macro factors are a key driver which are notoriously difficult to forecast. Our best estimate is “sometime in 2023”.

Historically when equities rebound, smaller companies rebound the most. We expect it will be similar this time with the steeper falls experienced by smaller companies in 2022 during the downturn reversed in the upturn.