Has a great run come to an end?

Hi, Mitchell Sneddon here, Head of Portfolio Services at InvestSMART. Today’s fund manager interview is with Carlos Gil, the Founder and Chief Investment Officer of Microequities, a boutique fund manager who, as the name would suggest, invests in micro caps and small caps.

Carlos has overseen the Microequities investment strategy from the start. The flagship fund, the Deep Value Fund, has been running for just over ten years now and has impressively returned over 17% pa after fees. Recently though, this portfolio has significantly underperformed the market and this is what I discuss with Carlos.

Carlos, at Microequities you take a value investing approach. Value investing is a very broad term, can you talk to us about the Microequities style of value and what value means to you guys?

Sure, I guess I’ll explain first of all what value investment entails. Our view on value investment is that it exists because the market is inefficient. That is, at any point in time the price of an asset, and in our case being equity or a stock, doesn’t actually reflect the true underlying intrinsic value. The price that that asset is traded in the market is actually not the true underlying intrinsic value of that asset and the market is thus, inefficient, i.e. it prices that asset inaccurately. That provides a value-based investor with a superior opportunity to make a superior profit. I’ll probably be referring to intrinsic valuation a lot so it’s probably a good segue to understand the difference between market values and intrinsic values.

Market values being nearly what an asset trades at, it’s the last reported transaction between a buyer and a seller. Intrinsic value is tied to a fundamental extracted base valuation. That is, you look at the asset, you make a forecast on the future expected cash flows that that asset will generate and you discount today’s present value with an allowance for risk, a factor of risk, and you get an absolute fundamental based valuation. It’s kind of thinking, for example, if you bought an investment property you would have an expectation of forecast of future rents and to work out the present value of that investment property you would discount all the future rents in perpetuity, apply a discount factor to the risk of you not obtaining that free cash flow, and you thus arrive at an intrinsic valuation.

In equity investment, what we do is we forecast the future free cash flow that a business is likely to generate and discount that against time and risk and bring it to a complete single figure.

Right now where we are in the market cycle over the last number of years, traditional value metrics have actually underperformed growth investing right now. Do you think that this will actually flip and the value will have its day again and right now it’s just where we are in the actual cycle?

It is. We, first of all, accept that value-based investing over recent periods has underperformed both at an absolute level and at a relative level. We know from our experience and our wealth of experience in investing that, whilst the market can stay highly inefficient over the short to medium time, it does not stay inefficient forever. That is, at some point in time the gap between intrinsic values and market values close. That might take a year, that might take two years or it might take three years but we know that divergence in pricing converges. So, we believe that at some point time, value investors are going to outperform materially and in our view the recent underperformance is merely laying the foundation, a very strong future outperformance. We are extremely optimistic that there is huge valuation anomalies occurring right now in the asset class that we invest in being small caps and micro caps and that are reported mark to market prices in our portfolios is really masking the underlying intrinsic valuation which is far higher than what we’re reporting to our investors on a mark to market basis.

I’d like to talk about some of those opportunities that you’re seeing in just a minute. Let’s talk about your longest-running fund which is the Deep Value Fund. For a long time it’s been incredibly successful, a very high performing fund, sitting right atop of the top-performing fund tables, and recently in the last 12-18 months you have underperformed the market, is that due to just growth outpacing value over the last couple of years? Or can you talk us through the last 12 months in this particular portfolio?

I think what we’re witnessing, and it’s quite unusual, we’re seeing a bifurcation, a dichotomy if you like, between small cap and micro-cap companies. At the one end, you have a whole set of companies that are being priced at values well in excess of their intrinsic values. In our view, some companies are at bubble-like valuations, that is, from an intrinsic valuation perspective you analyse the fundamentals and the future projective earnings. In best case scenarios if they actually meet all those projected forecasts and you discount the risk factor and you get a present value based on intrinsic values, the market values are well in excess of those intrinsic values. That is, they make no sense whatsoever.

Can you tell us about some of those companies, what companies are you referring to there?

For example, we owned a business called Pro Medicus in our fund, in our Deep Value Fund, it was actually one of the founding investments that we brought into our Deep Value Fund. We bought that business when it was a $40 million market cap business. By the time we sold two years ago, we’d held that investment for maybe eight years, the market value was over $2 billion. Pro Medicus, I should say, I should qualify is a phenomenally good business and they’ve done it exceptionally well. Superb management team and wonderful execution. It's a wonderful Australian technology success story, so I don’t want to belittle the achievements which are actually comprehensive and astounding.

But from a pure valuation perspective, in our view the market is pricing immaculate perfect execution and then probably applying the blue sky revenue streams that at the moment are not there, they’re not visible. They may occur but they’re certainly not in the dashboard of what professional investors can see now. There is just a tremendous optimism implied in the value of Pro Medicus today. If you actually just capture the present opportunities and you execute them perfectly and you discount the risk that you’re exposed to by owning Pro Medicus, the intrinsic value does not compute anywhere near the current market value. That’s that business that we believe know very well, that we believe that we have a firm view that the intrinsic value today is markedly lower than the market value.

Going back to the funds performance there, you were talking about there’s a number of stocks now you are seeing in bubble territory – just getting us back on track with the actual fund – and so is it simply not holding those positions or avoiding those positions? Was there a few stocks in the portfolio that didn’t go your way?

No, it’s simply avoiding. If you look at the drivers of the small-cap index over the last two years, companies like WiseTech, Afterpay, Altium, Pro Medicus, they’ve been significant drivers of the performance of that index. We know that the increased usage of passive funds of index and quant funds which now make up about a third of the small-cap index investing, have driven momentum upwards. If you think of passive funds as kind of accentuating momentum, these funds are forced to buy based on either index weightings or quant-based indexes and hence, they add momentum, they aggregate momentum. As these funds get more inflows, that momentum exacerbates further and actually drives a re-weighting of these investments within the index, and hence, you get a momentum following itself. Active fund managers like us are actually the investors that create price discovery. It’s active fund managers that bring price efficiency into the market. If you have a market where you’ve got an increasing weight of index funds, by its very nature it becomes more inefficient.

What we’ve seen over the last 18 months is that you had a greater portion of index and passive funds taking a larger and larger weighting in the composition of the benchmark index. And so, these companies that are well beyond the reach of any value investor have actually been the key engines behind the index performance. That’s created this dichotomy where you’ve got these extreme valuations at one end and you’ve got these incredibly cheap, highly undervalued businesses that might have either lower index weighting or not be actually on the official indexes themselves, that have underperformed from a market pricing perspective. We consequently don’t own any of these highly priced assets, these businesses and we own a whole stack of undervalued businesses, who’s intrinsic values are way higher than the current day to day market prices.

You were talking about a selection or an area that you’re seeing a divergence between the price and value in the micro and small-cap space, that maybe they’re not in these indices, etcetera… Can you tell us about – is there any particular themes coming out of there, any particular types of companies or sectors that you’re really finding this value in right now?

In terms of sector, interestingly enough, we own quite a lot of information technology and technology services business that are either very lowly weighted on the index or they’re not in indexes. We do own some other industrial businesses that are also highly undervalued, but from a sector perspective there’s actually quite a lot of them that are actually in the information technology and technology services space, but they just don’t have either – they’re not represented on the index or they’ve got a very small weighting on the index.

These are the stocks that you’re referring to where you’ve got these opportunities now to set up your portfolio and micro-cap and small-cap investors have got their opportunity to set up their portfolio now with these undervalued names to significantly outperform into the future.

That’s right. In our flagship fund we identified over 40% of the assets are what we consider extremely undervalued. That is, we looked at the intrinsic values and the intrinsic values were either between 50-100% higher than the current market values, or well in excess of 100%. The total weighting of these investments, which were 11 companies, made up over 40% of the entire portfolio. The rest of the portfolio is undervalued, but it’s not as substantially undervalued as these 11 companies. What we’ve actually seen in the last two months is an increase of merger and acquisition activity within our portfolio. For example, we owned a company called GBST, which is a software technology business in the financial services space, which at the beginning of this year was valued by the market at $1.20. Just over 2 months ago, Bravura, which is a listed competitor, put forward a hostile takeover offer at $2.50.

Subsequently to Bravura putting forward that takeover offer, there were two other competing buyers that entered the race to acquire GBST, one being Nasdaq listed FFNC, and a UK competitor called FNZ. Between the three of them they essentially had an option battle between them and GBST late last month agreed to enter into a scheme of arrangement with FNZ at a price of $3.85. Talking back about the pricing inefficiencies we’re seeing within our portfolio, this was a company that at the beginning of the year was, according to the market value, priced at $1.20. An industrial competitor who’s an informed buyer, has just agreed to purchase the company at $3.85, which is over 220% above what the market price was just under 8 months ago. It shows you how much pricing dislocation there is at the moment within our portfolio and over the last three months we are seeing a lot more merger and acquisition activity because there is this extreme pricing dislocation.

Whilst we have underperformed over the last 12-18 months, our Deep Value Fund actually had a very good month last month and we actually delivered an 8%-plus investment return, partly due to the fact that there is heightened merger and acquisition activity within the portfolio.

I want to go back and talk about – you said about 40% of the portfolio you believe represented really deep value at this point in time. At this part of the cycle that we’re in after a long bull market, to find those deep value opportunities are you going down the scale in business quality? For example, GBST, it did have quite an ugly run there for quite a while business-wise, and hence the reason why its share price got down to where it was. That 40% deep value part of the portfolio that you’re seeing, are they necessarily maybe some businesses with maybe a few warts on them?

No, no, they might be businesses where short-term earnings might have a headwind, but that’s where value investors typically make their mark. We look at an investment on the basis of what we think the business will be worth not in the next 6 months or 12 months, but what we think the business will be in five, six or seven years from now. A lot of peers that might have a more myopic short-term horizon, are deeply interested in short-term earnings, what the business is going to report over the next 6 months, over the next 12 months.

If you actually look at GBST and you look at Bravura, which are priced very differently in the market, the underlying business models are actually almost exactly the same. They’re actually exceptionally high-quality businesses. They have very long commercial tenures with their underlying clients. The software technology solutions that they both provide are mission critical. They’re embedded in the business key operations and functions that the economic enterprise of their clients actually undertake.  The sales legwork tends to be very long and between typically 18 months and three years to actually execute on a pipeline. But once the solution is deployed in the clients operations, you have very long, sticky clients, and very costly to remove and disintegrate the software and pull apart the software once it’s actually embedded in the operation.

GBST was one of those cases where you actually had a very high-quality business, but it did, as you correctly pointed out, have short-term headwinds. Not material – they actually did deliver slight profit growth last financial year, but if you look at the year previously they had a slight decline in earnings. But when we make an investment we’re not looking at just the next 6 to 12 months, we’re looking at what the business will be valued at over a five year plus premise. The important thing though to keep in mind is that GBST was actually a very high-quality business and the reason why you’ve got three interested buyers in GBST is because they see the values or quality of the business, otherwise you wouldn’t have such a contested option for that type of business.

Carlos, whilst we’re talking about a couple of companies, do you want to give me another example of one of those deep value companies that is in that top 40% of your portfolio?

Yes, we recently also had a takeover bid over a company that we owned and we’ve owned actually for four years, a company called Pacific Energy that provides energy, both diesel and gas energy, to out of grid mining operations. It’s essentially an infrastructure provider. Pacific Energy will build and manage the energy generation at these out of grid mining operations on behalf of the mining client, enter into typically very long management contracts with the miner, typically between four to maybe seven years in duration at a quite predictable rate of investment return of around typically 16 to 20%. We owned Pacific Energy because it had a very diversified client base, it had a very predictable earnings stream and we were able to buy this business essentially at a price of about 4.5 times enterprise value to operating profit.

Importantly, coming back to your question around quality, this was an exceptionally high-quality business, very diversified client base, long predictable revenue and earnings streams with very good return investment and acceptable rates of return on their capital deployed. And quite high levels of visibility in terms of their earnings. But importantly with a growing pipeline, this is a business that had a high probable growth pathway and late last month there was a friendly private equity backed takeover bid for Pacific Energy and I think they ended up paying a 60% premium to the 90-day VWAP of Pacific Energy. But again, it was one of these deep undervalued assets that we owned within our portfolio and again, it shows and demonstrates that whilst the market can be inefficient over the short to medium time, it doesn’t stay inefficient indefinitely. There are eventually the forces of competitive pressures that eventually identify undervalued assets and they eventually come to the fore.

How many positions to you typically tend to hold in the deep value fund?

Historically, we’ve typically owned between 25 investments and up to 40 investments. Currently we own 31 investments but it’s still a concentrated fund. Typically, our top five investments will account between 30-45% of the assets. Our top 20 investments typically account for 70-80% of the assets. We might own 30 companies but the top 20 investments will account for almost 80% of the assets of the fund.

Carlos, just one more question before you go, about another fund of yours that took my interest. Your company’s called Microequities, you specialise in micro caps and small caps, and I saw an income fund on your website. Traditionally, when you think of income funds people don’t tend to think about small caps or micro caps in that space. Can you tell us a little bit about that fund?

It's actually a really interesting fund because, as you rightly point out, people don’t normally think of micro caps and small caps as being these income producing assets. They erroneously have a generic view of the as being these high risk or early start-up businesses. And whilst that’s fairly true for part of the asset class, it’s not true for the entire asset class. We have a portfolio of 32 industrial-based businesses that are profitable, have significant track records of profitability and actually pay sustainable dividends. That fund’s been running for over seven years, it’s delivered a net compound return net of all fees to our investors of about 11%. Those returns don’t include the franking credits which we’ve distributed.

That fund we’ve actually moved now to monthly cash distributions and it’s got this portfolio of these 32 industrial businesses that are very diversified from a sector perspective and it allows us to feel very secure about the security of that dividend income stream. Because if at any point in time one of those companies decides to suspend or curtail their dividend payments, it does not adversely affect our ability to actually meet the dividend commitments of the fund, the distribution commitments of the fund. And so the track record of this fund in terms of its cash distribution is impeccable, we’ve never missed a cash distribution, and that’s what gave us a lot of confidence this year to say, ‘Look, there’s actually a structural change in terms of interest rates.’ Interest rates are not just going through a cyclical low, it’s actually moved to a new paradigm, they are structurally low. We’re not going to go back to interest rates and term deposit rates of 7-8% for the foreseeable future, not in the next five years and very unlikely in the next ten years. We’re going to go through very low-interest rates. Then we decided, our high-income funds have this really dependable secure income stream which originates from the dividend from these companies, from these diverse portfolios. Why don’t we just go and pay monthly fund distributions. We did that and we started paying monthly fund distributions last month and we’ve actually come out and said this is going to be the next five distribution payments.

We have such confidence in doing that because we know that the dividends that we’re going to receive from the portfolio are highly bankable. And so it is quite a unique fund and we think it has a very significant calling in the market place because I think investors, and I’m one of them – I’m looking to pull money out of fund deposits and actually find a quality investment that can provide me with a dependable income stream for many years ahead. That’s kind of the idea of providing that service through this fund.

Excellent. Carlos, thank you very much for joining us and giving us that overview of the Deep Value Fund and a brief overview there as well of the income fund. Thank you and good luck for the future.

Thanks so much and thanks for having me on InvestSMART, appreciate the opportunity.

That was Carlos Gil of Microequities.