This week: ASX v Wall Street
FYTD: ASX v Wall Street
This week in Investment Matters, we have two news items relevant for client portfolios and a piece designed to assist with understanding how an investment in the portfolio has been restructured. The final piece in Investment Matters this week outlines how we have positioned portfolios to benefit from the view that smaller companies are likely to outperform over the next 3-5 years.
IGO Limited (IGO.ASX) – Moving downstream with Wyloo
IGO Limited is an ASX100 listed resource company which has interests in upstream and downstream processing of a range of resources such as Nickel, Lithium and Copper. These are some of the most important metals in the energy transition cycle, as they form a key component in the production of battery technologies now being used in electric vehicles.
In the past week IGO announced that, along with partner Wyloo Metals (ie Andrew ‘Twiggy’ Forrest), it had secured some land in Kwinana, WA from the State Government with a view to establishing an Integrated Battery Mineral Facility. This land is located next door to the Kwinana Lithium Hydroxide Refinery which is owned by Tianqui Lithium Energy Australia (TLEA), a joint venture between IGO and Tianqui Lithium Corporation (a Chinese-domiciled company).
Figure 1: View of proposed facility – including existing Kwinana lithium plant
From an Australian economic perspective, we like the strategy of creating a vertically integrated resources business which pursues the provision of more value-added services and moves beyond simple exploration and production of the underlying raw commodities and into services like battery chemical processing.
We think that the management at IGO have proven to be very astute operators and the company is therefore one of the largest positions that we hold across client portfolios.
Wyloo CEO, Luca Giacovazzi said: “We’re extremely excited to build upon the immense potential that exists here in WA with the development of Australia’s first commercial PCAM facility in Kwinana. Areas like Kambalda and Leinster in Western Australia hold some of the world’s highest-grade nickel, with huge potential for more discoveries to be made. WA is already a leading supplier of critical minerals, and this is the spark it needs to become a global hub for battery metals. There’s a huge opportunity to grow the industry and Western Australian jobs by supporting the world’s transition to electric vehicles.”
Note, too, that Wyloo is also a partner of Hastings Technology Metals (another portfolio position) in the development of rare earths downstream products.
IGO is increasingly becoming the pre-eminent multi-disciplinary future material company on the ASX. The company is a significant long-term position in client portfolios, and the appetite of the company to build an integrated business bodes well for Australia becoming more than a country that digs and shovels dirt onto ships headed elsewhere.
Aurelia Metals (AMI.ASX) – Strong Quarterly Update
One of the most disappointing positions in clients’ portfolios since March 2022 has been Aurelia Metals. General deterioration in base metals pricing in the middle of 2022, combined with a series of disappointing updates regarding its Dargues Gold Mine purchase (from November 2020) weighed heavily on group cash flows.
After more than 18mths of deterioration, it was finally clear that Dargues would be worth a mere fraction of what the company had paid for it ($205m).
We, and likely most owners, were impressed with the existing operating and future development assets Aurelia already owned, rather than new assets available for purchase such as Dargues.
The existing assets (Hera and Peak mines) continued to perform within expectations, and the future development asset called Federation proved up its value through additional research, mining studies and exploration through calendar 2021 and 2022.
But an unexpected cash flow squeeze, partially caused by the investment in Dargues, ultimately coincided with the need to raise additional capital to develop the Federation asset. Once all the studies and approvals had been received, the company sought additional funds – but timing is everything in financial markets and when Aurelia tapped the market the capital raise failed to proceed. The share price suffered considerably and has only begun to recover since November.
In the meantime, the CEO has been replaced and a range of plans have been revised, optimised, and refocussed to enable the company to operate within the financial capacity it has. The register (owners) of the company has also changed considerably with a private investor (of some renown) now taking a 13% position. Changes at a regional level around Cobar have also been important for the long-run value of Aurelia Metals, as its assets will ultimately form only part of a consolidated regional business in the medium to long-term.
The April update released on Thursday was the right tonic for the recent disappointments. Operationally the company is on track to more than fulfill annual production and cost estimate forecasts. The company has developed a set of plans termed “Organisational Review” (and outlined below), which appear sensible and defensible.
Figure 2: Aurelia Metals – April update
The stock price is up 60% from lows in December and is approaching the levels the stock traded prior to the failed capital raise.
We are particularly impressed by the new CEO and management teams’ approach to asset utilisation and optimization and were encouraged by new drill results which seek to capitalise on the range of options to extend mine-life around Cobar. This was a critical component of both our original investment thesis and ongoing support, so it is pleasing to see such options now attracting the appropriate resources.
Clients with a keen eye for detail may have noticed a series of transactions involving long-held investment in Enlitic in the Alternatives sub-portfolio. It is a relatively small holding in this portfolio. We first purchased a holding in Enlitic in late 2019.
The company (Enlitic) is continuing to develop machine learning or AI-based techniques for evaluating clinical medical images. In 2021 strong interest from a range of parties saw Enlitic expand its scope to also sell the system that it has built and used to warehouse, process, tag and analyse the data to use in artificial intelligence (AI) decision-making systems.
As of January 2023, the company had commercial revenues and scope to achieve strong medium-term goals. To secure its next round of funding, including from existing owners and the global Japanese conglomerate Marubeni, the ownership structure needed reshaping.
What we previously owned
First Samuel made an initial equity investment of USD$680k in October 2019 (Series B-1 round). This was held as ENLITIC in client portfolios.
The subsequent round of funding, USD$400k, was in the form of a Convertible Promissory Note (due Mar 2023, paying 5% interest). The terms of the Convertible Note were extremely favourable and provide a significantly higher level of expected return than the original equity.
It was important that clients accessed the benefits from the Note in proportion to the investment they already had in ENLITIC. As such we “stapled” the two investments together and these were referred to as ENLITIC2. This security has resided in client portfolios since October 2021.
What do we own today?
On the expiry of the Convertible Promissory Notes the company needed to repay the notes (including interest) in the form of new shares (conversion). It sought to raise additional funds at the same time. To incentivise continued investment by existing holders, bonus shares were available for additional investment. First Samuel contributed its pro-rata share of USD$78k, and we received USD$156k of shares.
Whilst some parts of the capital structure benefitted (Convertible Notes holders and those providing new capital), other parts, mainly the original shareholders suffered as the new share price was significantly reduced.
We anticipated such an outcome was possible when we structured the investment as a stapled pair, allowing each of the outcomes (positive and negative) to be expressed fairly to all holders.
Hence the restructure you see in the portal now reflects the following.
- The original investment and the convertible notes (stapled as ENLITIC2) are unstapled into ENLITIC_B (original shares) and ENLITIC_C (new shares issued to repay the Convertible Note, bonus shares and new equity).
- This results in
- Clients’ ENLITIC_B holdings falling in value by 86%, from approximately $8USD per share to $1USD per share.
- The creation of new shares in ENLITIC_C, also worth $1USD, with an instant profit of +44%, reflecting the return of the capital for the Note, accrued interest and bonus shares where applicable.
In aggregate, the updated price for ENLITIC shares ($1 USD) is a disappointing result and represents an overall loss of ~35%, including the write down of ENLITIC_B and the profit of ENLITIC_2.
The company however remains an exciting, unique position in client portfolios. The repricing of early-stage companies by amounts such as these is consistent with global asset prices in the wake of higher interest rates. Enlitic is at the forefront of one of the most exciting applications of machine learning and artificial intelligence to radiology. Over the past 4 years it has a set of commercial tools and systems which are beginning to be deployed…
Small Cap Index Position – iShare (ISO.AKW)
Within any market there will be a mixture of trends, a variety of events which impact pricing, and a variety of factors which are driving both short-term and longer-term structural changes. In an equity market such as the ASX it will have all these factors operating at the same time.
So, while equity markets are an amalgam of real operating businesses, forces which shape the way in which participants price individual shares can often have more to do with these outside forces, than the way in which the companies themselves operate.
These factors also provide us with a way of explaining the market without having to discuss the hundreds of companies that the market contains. Amongst the simplest ways in which we derive these factors is to consider the size of the company. Other factors may include whether the company pays a dividend, whether it is growing quickly, or if its shares have been moving rapidly or sluggishly in the recent past (momentum).
In the long run some of these factors can drive permanent differences in returns, but in the short-term most factors are either fleeting in importance or tend to self-correct.
As an example, we have shown the relative performance of a range of companies organised by various factors over the past 12 months. Turning to the chart below, we see that companies with a strong dividend yield have outperformed the ASX300 (300 largest companies by market capitalisation) by a healthy 6.7 per cent over the past 12 months.
At the opposite end, we see the relative performance of Small Cap (-15.1 per cent) and Mid Cap (-5.7 per cent). Mid Cap are companies sized between the 50th and 100th largest in the market.
Source: MSCI, FactSet, Macquarie Research, April 2023
So, in the past year, and in fact for the past 4 years, smaller companies have significantly underperformed the larger companies. However, finance theory and market experience has shown that this should not be the case in the long run, and in fact may be the opposite of what is expected.
Of course, this difference in performance could simply be that the Small Caps are worse companies, and larger companies have simply been operating better.
However, when we look at the relative price of companies which are today moderately cheap (25th percentile) versus the companies that are relatively expensive (75th percentile) we see that the price of the cheaper companies (the majority of which are smaller) are cheaper in price / earnings terms (LHS) than they were 4 years ago. And on the other hand, the more expensive companies are more expensive than they were 4 years ago. This is a trend we call dispersion, and we suggest it represents an opportunity for our clients as it normalises.
The dispersion between larger more expensive companies and smaller cheaper companies is likely to narrow, providing an opportunity to profit from these smaller, cheaper companies.
We would note that a similar “dispersion” trend existed 3 years ago when we positioned the portfolio to take advantage of the value/growth dispersion.
In this case we are avoiding highly priced “growth stocks” and have concentrated on cheaper “value” stocks. This trend has assisted with the outperformance achieved by our Australian Equities portfolio over the past 3 years.
How do we take advantage of a rebound in “Small Caps”?
In general, the First Samuel portfolio has a higher proportion of its holding in smaller companies, and the simplest way to take advantage is to continue to find good value smaller companies. As an example, we could add 5-10 new smaller companies (with market capitalisation still above $200m) and ride the wave of higher returns we expect from the analysis above.
We will add some new companies – however at this point in the cycle there is merit in also adding a broad index of smaller companies to directly benefit from the anticipated returns.
The logic is simple, it is possible that there are components of the entire universe of Small Cap companies which we will not adequately have represented in the smaller companies we own in the portfolio.
As an illustration we own very limited exposure to smaller technology or smaller consumer companies. A broader index ETF would own those positions at a relevant concentration to participate in a broad rebound of Small Caps if it was concentrated in only a small range of companies.
What will you see in the portfolio?
The iShares ETF is a low cost and liquid way to gain the exposure to Small Cap index, client portfolios have begun to build a small position.