26 Apr 2018

Fund activity!

Those who regularly read our commentaries and review our monthly fact sheets will be aware that our long-term investing style results in few changes month by month, or even quarter by quarter. Sometimes we look about as active as limpets, as we invest in companies and proceed to hold the shares for several years.

But we are as disciplined with our selling as with our buying. You generally cannot buy and hold forever, unless of course you bought Microsoft in 1988. Most of the time you reach a point when you need to sell a company and move on. Occasionally we do sell something.

We have two main reasons for selling. First, the investment thesis is not playing out as expected and we must sell, even though this may mean crystallising losses. Second, the 100% gain (or more) we were looking for has happened.

We have had two occasions when we have sold at a material loss, those being Emeco Holdings and Slater & Gordon. Emeco Holdings is a mining services business that was trading at a massive discount to its net assets, mostly big yellow trucks. We sold when management had a complete change of tack and decided to grow out of its problems and piled on more debt. We disagreed with this change in strategy and exited 46% below our purchase price.

The other occasion was Slater & Gordon, the Australian legal firm which we bought well after its UK acquisition began falling apart and the share price had already dropped significantly. By the time we exited though it had fallen another 94% from our entry price. In retrospect we paid a full and heavy price for our view that Slater & Gordon’s bank debt could be quickly paid off by reducing working capital and receivables. It wasn’t even slowly paid off and by the time this was a cold reality the share price had plummeted. Our dislike of companies with large debt balances has reached new levels of intensity in the aftermath of Slater & Gordon and Emeco.

The second reason for selling or reducing our position size is when a share price rises towards our assessment of its fair value. We do not have exact target prices for all our companies. The question we ask is, do they have 50% to 100% upside from here? Where that has become questionable, selling must be considered. In March we reached this point with two of our companies and sold. The two companies, A2 Milk Company and Millennium & Copthorne Hotels, have both been good investments but they had both reached the point where the remaining upside, in our view, no longer justified continuing to own them. A2 Milk has become a neutral position in the Trans-Tasman portfolio.

Millennium & Copthorne Hotels was a straight forward Value opportunity, in our opinion. Early in 2016 when we purchased shares at around $1.40 we effectively bought two hotels for the price of one. We felt that with a supportive operating background there was significant upside from those levels. Hotel companies have amazing operating leverage which is a real positive kicker to earnings when room rates rise, as they did in 2016 and 2017. This underpinned a 100% increase of the Millennium & Copthorne Hotels share price from our purchase price. And, while the near-term outlook continues to remain positive, there are signs of an industry supply response as several operators are in the process of completing new hotels across New Zealand. From here the upside is less compelling.

A2 Milk Company was held because it was a Mid-Cap Grower that we felt had sufficient runway for growth that over the course of the next 5+ years could see its market capitalisation double and then double again. As it happens, we had sold out of A2 Milk in 2015 because we had some concerns over patents rolling off and the potential impact on its intellectual property, but in 2016 we bought back in when it became clear that the company was successfully leveraging its brand, particularly with its latest product, infant milk formula, which was selling well into China. The subsequent success A2 Milk experienced exporting that product into China was frankly astounding and surprised even the company, as evidenced by continual sequence of earnings upgrades took place over the next two years.

You can only be impressed with how well management have executed on the opportunity into China, especially the way they have handled the intricacies of the “Daigou” channel that exports the infant milk formula into China from Australia. However, one product into one market carries a high level business risk. There are opportunities to add other products and sell into other markets and A2 Milk will be seeking to execute on those other opportunities. We believe they have a good chance of success.

However, its share price indicates that the market expects success.  So, while we still believe that A2 Milk is a quality growth company, we are less convinced that it remains a Mid-Cap Grower, which we believe can at least double over the next five years. The problem is that at $14 a share a huge amount of growth is required to justify the resulting $10 billion market capitalisation of the company. Our analysis is that to support that valuation A2 Milk has to at least double its market share of the Chinese infant milk formula to 10% and then proceed to take 10% of the rest of remaining global markets, within three years. And on top of that retain its current profit margins. This is not impossible, but it is clearly a big ask and if they do achieve it, then $14 a share is a fair value.

We need to be able to see more like $28 a share in 5 years to justify owning it as a Mid-Cap Grower. This is getting too hard for us to have the required conviction, especially as A2 Milk’s competitors are responding to the threat it poses to their market shares. With a Return on Equity of 50%, new entrants will be attracted to the sector. Other corporates will look at that number and be extremely motivated to see if they can get even a 25% return on equity. Without barriers to entry, excess returns such as these are competed away over time.

The recent launch by Nestle of an “ATwo” infant milk formula in China is a clear example of such a response. It also indicates that Nestle doesn’t see A2 Milk possessing any patents which prevents it from entering the A2 protein milk space (as an aside, we agree with that analysis, it was why we sold it in 2015). Additionally, it seems likely that other competitors are also in the process of responding to the success of A2 Milk Company with their own A2 protein offering. None of this is shocking or surprising. It is just a regular product life cycle in action for a popular new product that makes supernormal profits in the beginning before they are gradually normalised over time.

It is not necessarily time to panic about A2 Milk. Management may well continue to execute well. But at a market capitalisation of $10 billion, A2 Milk ceases to fit into our definition of Mid-Cap-Grower and must be sold.