8 Jul 2016

A Case Study in Pain

“The number of investors who deliver a plus 2% net of fees return relative to benchmark over their careers is tiny. Value investing can do this, albeit in a lumpy, at times psychologically challenging way". (Nick Kirrage, Schroders)

This quote sums up Value investing quite neatly. It delivers in the long run but can hurt in the short term. And this presents the psychological challenge that Mr Kirrage refers to. At Castle Point we have written about this dilemma before, indeed as recently as last quarter’s Market short-termism and mining services.

In that October article we wrote, how cheap Swick Mining Services was currently and how we were comfortable(!) holders, even though current news flow and sentiment created the risk of further downside. There was little doubt that this company was trading at a very large discount to its long term intrinsic value and on that basis it was, for us, a classic value investment.

In November Swick delivered an upbeat Annual General Meeting update. While it had been a tough 2014 it had finished the year with a 13% improvement in fleet utilisation. Furthermore, Swick went on to inform the market that the Managing Director, Kent Swick, had increased his already considerable stake in the business to nearly 18% of shares on issue. Given these two unambiguously positive developments, our conviction increased that this company was a fantastic value opportunity. We bought more of the stock accordingly.

December brought one of Nick Kirrage’s “psychological challenges”. The Swick share price plunged sharply, dropping nearly 25%, from 26c to 20c. As large blocks of stock were crossed at near 20c, it became apparent that a large holder was selling out and wanted it done quickly. There had been no negative news announcements from Swick, no reason that we could identify for such a sharp selloff. The only apparent issue was a general weakness in the Mining Services sector but Swick was performing far worse than those peers.

At times like this you can do one of two things – either begin doubting yourself, worrying whether you missed something in the research project, alarmed that some negative news is about to break. Alternatively, you can believe in your research and be comfortable that the sellers are acting irrationally. The key is to have done thorough research, so that you do not let these concerns overwhelm you. Because what you need to do at times like these is buy more. Which is what we did. You must take advantage of the opportunity. There is now even more upside in Swick. It may have caused the Ranger Fund to post a negative return in December but it has now the potential to add even greater returns in future months.

That’s because at these levels a quality business, that is the leader in its field of underground diamond drilling, is trading at some quite incredible valuation levels. At 20c it was trading on eight times earnings, two times its operating cash flow with a dividend yield of 3.5%. The implied enterprise value was three times operating earnings. But most importantly it is trading at less than a third of its net tangible assets. Plus its largest insider has recently increased his stake in the business and there a reasonably low level of debt.

This leads one to ask - why would a rational investor seemingly capitulate and sell a large holding at that very depressed price in December?  We have a strong suspicion that it has nothing to do with the intrinsic value of the business. Rather, it appears that a global small cap value manager with a substantial holding in Swick lost a large account in November and the account was switched in December to a new manager. This new manager does not appear to be a value investor and Swick is not wanted in their portfolio, so it was sold. Industry standard is that a transition manager is appointed to handle the switch as quickly and efficiently as possible, typically within a week. A relatively small position in the context of a large number trades can be roughly handled but go unnoticed in the overall operation. Or in this case it can really depress the share price of one of the Ranger Fund’s holdings.

This is not an unusual path for a value investor.  Taking on the risk of short term pain for greater long term gain is very much part of the course. For us, this short-term pain is undoubtedly worth it to deliver long-term outperformance. Bring on the “psychological challenges”!