Spheria Emerging Companies Limited (SEC) Earnings Call Transcript & Summary

Okay. Good morning, fellow shareholders. It's just gone 10:00 a.m. I think we should get started. Welcome to the Spheria Emerging Companies' annual results presentation. My name is Chris Meyer. I'm with Pinnacle. I'm also an Associate and Alternate Director, I should say, on the Board of SEC. I'm joined today by Matthew Booker, Portfolio Manager of the SEC Portfolio and Director of SEC. Welcome, Matt. Now he's the main event -- wants to hear what's going on in the Australian small cap equities, and it's hot off the press, given we're just talking in -- coming into the meeting this morning. Matt was saying how he's been slammed with earnings results this week. So we look forward to hearing how that went. The agenda today is quite simple. We'll -- I'll go through some of the results from the company for the 12 months ended 30 June, and then Matt will give us an update on how he sees the portfolio and the outlook for the markets. These slides, we'll go through today are on the ASX. They're also on the SEC website. So feel free to grab them from there. We will flick through them today, and we'll try and help you by giving you which page we're actually on. So let's get right to it. I think the first thing in terms of the 12 months to June 30 that are a bit of a highlight is the markets were up, although somewhat modestly, and that did result in a profit for the company of $7.6 million. It enabled us to also pay a dividend, as you can see there, which is an increasing feature of SEC, $0.12 of dividends paid or declared for the year, equating to a yield of 5.4% or 7.7%, including franking, which I think we'll all agree is a pretty healthy dividend yield for an equity product. We also, during the year, announced a conditional proposal, and we'll spend a bit of time on that a little bit later. But the whole idea of that conditional proposal is to enable investors to exchange their shares in the SEC for units in an open-ended fund if the discount to NTA that SEC trades at over the fourth quarter of this year is wider than 5%. In terms of the movement in the NTA for the year, I think really what's worth calling out here is the light blue bar as an indication that the markets were up. And so the portfolio had some positive impact on the NTA. And then the gray bar, the large grade on the right-hand side is the dividends we actually paid. So it's a little bit less than the dividends declared just because, obviously, there's a timing difference between declaration and payment. And so that's fairly typical for a listed investment company that's got equity investments as the NTA can grow if the market is up and if the portfolio performs and then you pay some of that out through a distribution. And so I think for shareholders, always remember when you compare the NTA as we're doing here in the dark bars at the period end of the financial year compared to the start of the financial year, your return is not based only on the movement in the NTA because you've obviously received that gray bar there, which is the distribution. In terms of the performance of the portfolio over the last little while, Matt will dig into this a bit more in his presentation. But we always like to remind shareholders that you should be in this investment or this listed investment company for the long term. I think you can see there, over the long term, the manager has done an excellent job of beating its benchmark. 2.3% is the outperformance since the inception of SEC. And then, more recently, as I said, the market has been a little bit lackluster over the last 3 years, but Spheria has again managed to outperform that market. Actually, for the 12 months to the 30th of June, there was a marginal underperformance of the portfolio, but you can see there, this is actually to the end of July. You can see that July was a very good month for the portfolio and most and all of that underperformance was clawed back in the month of July. I did mention that dividends are an increasing feature of SEC. The Board has taken a conscious decision to pay out a greater level of income to shareholders. I think it's been well received by shareholders. We can see that in part through a tighter discount to NTA that the SEC share trades at. At the moment, the -- at the beginning of this year, the Board actually decided to increase the dividend payout ratio and target a 1.5% of post-tax NTA per quarter dividend, which equates to 6% per annum. That's a cash dividend and excludes franking. It's in excess of 8% if you include franking. And you can see that in the light blue bar on the far right-hand side there. It's sort of a record quarterly dividend, if you like, we've been paying quarterly dividends now for over 2 years, and we're very committed to continuing to pay dividends out of SEC, the balance sheet of the company is in a very good condition, both from a retained profits and a franking balance standpoint. And then finally, for shareholders. You can see here in the orange line, which is the discount to NTA. There's been a substantial healing in the discount to NTA for SEC. We think there's 2 reasons for that or maybe 3. One is the manager's performance. I think that's a very important factor. There's -- the 2 other factors are, I guess, more structuring type things, which is the dividend, which we've already talked about. You can see that improvement, if you look over the last 2 years and the discount to NTA has tended to coincide with where we committed to pay a higher level of distributions from the company. We think it's attracted new buyers. We can see that in the share register of the company. And then the second thing is this commitment to if the discount to NTA is wider than that 5% threshold you can see, therefore, starting on the first of October and ending on the 31st of December this year, then the Board will undertake a conditional proposal to have a scheme of arrangement to convert the shares of SEC into a Spheria open-ended fund. We'll come back to you by the end of this quarter, by the 30th of September, with a little bit more information and a reminder of what that conditional proposal is all about. But at the moment, we're sort of in that -- right on that 5% discount to NTA range. So we'll wait and see how that share trades or how SEC trades over the next few months. Okay. So thank you for your support shareholders in helping us address some of these discount to NTA issues, as you can see on this chart, we're in a much healthier position. And we're very optimistic that, that will continue as the portfolio and the income from the portfolio continues. Matt, with that, I'll hand over to you to give us an update on the portfolio. Thanks.

Thanks, Chris. That was a fantastic update. Just in terms of how we invest, I think we've spoken about this before, and I'll just reiterate what we're looking for. We're looking for the high cash flow businesses through the cycle. And that does mean that sometimes we're buying companies that are underearning, where we believe through the cycle they can earn more. And in some cases, we're selling companies where the valuations are stretched and all the company is overearning. But -- it's never easy, but that's our process, very free cash flow driven valuation is important to us. It's been a market for over a decade, where I think valuations have kind of gone out the window in certain circumstances. And there's a narrow set of companies which have been re-rated to nonsensical levels overseas and domestically and even in the small cap space here. But a lot of those have graduated into the large cap space. I don't know when there will be a day of reckoning, but we tend to avoid those situations where the valuations are nonsensical. But that has made our life quite difficult in hindsight. We do look for inflection points and changes in management and shifts in industry structure are important to us. We also -- we always say that you need to keep an open mind just because the company has underperformed doesn't mean it's not an opportunity. And in small caps, you need to keep with that brief and you need to be unemotional about things as well. But we're finding per small cap universe is significantly inefficient from a valuation perspective, it's really been fashions and trends and themes and narratives driving things for a while, which creates inefficiency and opportunity for us. And that's, I guess, how we've sustained good performance over the long term. Chris, can you move to the next slide, please? In terms of portfolio performance, you can see the blue line is the absolute sort of performance. The green line is the relative performance and the index is the gray line. So we have delivered outperformance as Chris stated before over the long term. We think we can continue that going forward. I think the opportunity set is quite large in our space. But it has been a pretty challenging year the past year. It was quite volatile, and I guess growth found favor after a pretty tough 2022. Growth sort of stocks just re-rated to crazy levels. So it was a difficult period. We did have some -- I guess we did make mistakes, and I guess, we learned from those mistakes. But we did make some good calls as well, but we'll move on to the next slide and discuss some of those. So the attribution for 12 months for every winner. So with [ Bravura ] we had a loser like [ Appen ]. Supply Network has been a fantastic company, we've owned for over a decade across our strategies and that continues to do well. But then on the flip side, we exited City Chic a few years ago, probably near the top and have made a lot of money, but we reentered too early and conditions for most consumer retailers has been very difficult, and for that stock it's been even more difficult given its customer base is -- I guess it's feeling the mortgage stress out there in terms of the rate increases they've seen. But yes, so we've had some takeovers in the portfolio as well, also Link and Adelaide Brighton were taken over. So we made good profits in those, but then we've lost money on paper elsewhere. So Star has been a pretty poor performer for us in the last couple of years. And then some of our media stocks have derated massively in recent years. Obviously, there's some structural headwinds in the media space, but the company is producing good cash flow and they're facing pretty challenging economic conditions, which I think will improve at some point in the next 12 to 18 months. So there's opportunity, I guess, where you've seen significant de-rates in media and retail. In terms of our top 10 holdings, we've owned IRESS for a long time. It's gone through, I guess, a difficult period, probably 12, 18 months ago. We increased our weighting to IRESS. It has performed well over that period. The new management team has exited non-core businesses, fixed the balance sheet. The outlook for the core businesses are reasonably strong, but the company needs investment. And we're conscious of that, we keep reiterating to the management team that the core products need more investment and they can't take their dominant market positions for granted. We hope the message is getting through. But IRESS has had a pretty big re-rate over the past 6 months, has been a strong performer in that back half of the year. Where to from here? It is starting to look more fully valued. So I guess the question is, do we rotate some of that position into areas where there's more -- where there's better valuation opportunities. Healius is a business we owned during the COVID period. We made decent money out of it. We did cycle out of that company, but we've cycled back in, in the last probably 6 months or so, and we got the timing fairly right and performance out of Healius in sort of the recent months has been strong. Bega has been a long-term position for us. Supply Network has been a long-term position, both stocks are doing well, produced good results and we saw significant upward re-ratings in this result season. Star Group, I mentioned before, has had its challenges, but it is trading below its property value. And once the license issues are resolved and some of the balance sheet issues are resolved, we think that the stock can close the gap in terms of valuation. Magellan is a reasonably new entry into the portfolio. We've come in there on valuation grounds. We think there's some undervalued assets in the portfolio, particularly the holding in Barrenjoey where they own 35% of Barrenjoey. And to us, that is now a top 5 investment bank in the country, and we think that's quite a valuable position. Deterra has been a long-term holding. Breville Group has been a long-term holding. And GWA has been probably a stock we entered about 6 to 12 months ago, and we got the timing right on that one. And Fletcher is a relatively new position. We think there's a good turnaround opportunity there. It's trading at basically all-time lows. It does have a balance sheet issue, but we believe that situation can be resolved through asset sales. Moving on to the next slide, please. Just pointing out a company that we own across the strategies. It is a holding in SEC as well is NZME, and NZME is basically the Fairfax of New Zealand. So Fairfax a decade ago had some challenges in this market that has flourished -- or did flourish out till it was taken over by Channel 9 a few years ago. And the reason Fairfax flourished was its holding in Domain. So Domain, we spun out of Fairfax probably 6 or 7 years ago, and Domain was obviously the #2 property platform in the Aussie market. NZME owns the #2 property platform in the New Zealand market. We've tried to dimension the potential of that OneRoof asset in New Zealand. And if you look at that chart on the right, top right there, you can see when you adjust Domain's revenues for the population in New Zealand, et cetera, and the currency, you can see the potential revenue upside of that OneRoof business as that market shifts to more digital away from the old property classifieds. And the New Zealand market is behind Australia in terms of that transformation from old world to new world. And so OneRoof will be the beneficiary as that market transforms to a digital market. On the left chart, we just show our cash flow conversion versus our earnings for NZME historically. Earnings did trough a few years ago and started to revise. As most of you are probably aware, New Zealand has been in a recession for at least the past 6 to 12 months. It's been very challenging over there for most companies. Obviously, media companies are exposed to advertising, advertising is down. So '23 was a very difficult year for NZME, but we're seeing revenue growth in the first half of calendar year '24 of NZME. So overall revenues are growing. OneRoof is growing at a rapid rate as that market transforms. And we think that the OneRoof opportunity is probably worth more than the entire market cap of NZME at the moment. So the other aspect of NZME is it's actual media assets are transforming as well. So about 1/3 of its revenue is now digital. That's the overall group. So you're seeing a significant transformation of the overall business. It owns the #1 masthead in that market, the New Zealand Herald. It has strong regional positions in newspapers, which are converting to digital readerships, and it is also the #1 player in the audio market, and it has the digital license over there, iHeartRadio, which is growing strongly. So that's in the podcasting space. So NZME to us, you buy it on 3 or 4x earnings overall. It's starting to move back into growth. And we think OneRoof is worth more than the entire valuation of the company at the moment. So we think it's a compelling opportunity. Moving forward. Look, we've taken this global chart that we have and the global market is obviously bigger than the Aussie market. And it's easier to compare sort of small caps globally with large cap globally. And you can see that EV to EBIT, which is a measure of valuation similar to PE, it just adjusts for leverage. You can see the EV to EBIT for small caps is at an extreme discount relative to large caps. Now we've seen this phenomenon in the past and it does go both ways. But at the moment, you can see that small caps are very inexpensive relative to large globally. We're seeing the same environment down here. We think it reflects uncertainty in the market, higher interest rates I think have driven the market to that -- there's been a flight to safety in large caps. It's a significant overvaluation in a narrow set of large-cap companies globally. And that's also happening domestically as well in some of the larger cap names, where you've got valuations which are just nonsensical. But the corollary is there's a lot of opportunity in the small cap space. And we think there's a lot of opportunity to make significant absolute returns in small cap over the next few years based on these valuation metrics that we're seeing globally and domestically. Next slide, please. Australia is in a very tough space at the moment. Most of the companies that are exposed to consumer or economic cyclicality are struggling in this market. It is recession-like. We think that will precipitate lower interest rates, and we think that lower interest rates will hopefully see some momentum shift back to the small cap market and also to cyclicals. We're seeing globally central banks are cutting rates. They raised them aggressively, obviously, from a very low base. Household debt is very large across the globe, and that's had a significant impact, although it's been a bit of a lagged impact on economies, but it is definitely hurting out there. We're at the coalface in terms of seeing companies. It's pretty tough out there. Investors have moved away from anything with earnings risk, and I think that presents opportunity. And we think there's probably some M&A activity that will appear on the scene. There are assets for sale. Healius is selling its imaging business, for example, and there's 3 private equity players looking at that asset. And it is a valuable asset. There's the chance to consolidate the market through buying that asset. So we think there will be asset sales, there will be M&A in the market. And usually, that favors small caps. So yes, I think a good opportunity in small caps. I think the market is just playing that defensive theme into large caps. And at some point, there will be a big unwind which will benefit the small cap space. And I think it will probably be precipitated by interest rates coming down. I guess we open up for questions.

Sorry, mute button issues. Thanks, Matt. That was great. And I saw you announced you've actually bought some SEC shares yourself, so you're certainly putting your money where your mouth is in terms of feeling like this is a good entry point into small caps. As Matt said, we're going to run a quick Q&A session. For those of you who would like to ask a question, please feel free just to drop it into that Q&A box, and we will get to it. Matt, maybe just one from me. It feels like most small cap managers would say, the market is inefficiently analyzed and small caps, it creates opportunities. It feels like we've been saying that for quite some time. But the question is more it does feel like a lot of small cap managers or money has sort of exited the market and it's created even more opportunities. I just wondered if you could give us your thoughts on that.

Yes. And I think some of that's been driven by legislation change here. So the industry funds and the big [ cert ] funds were all benchmarked to the ASX200. Obviously, small cap funds, some of them sit within that framework, but a lot of it sits outside. And with that change, I think you've seen superfunds exit the smaller end of the market, which has created the opportunity. We've seen transitions over the past 2 years, significant transitions out of smalls into other asset classes. And you've had small-cap managers disappear. I could -- there's been so many. You probably need a calculator to add it up, but a lot of our competitors have disappeared. And we don't like seeing that. I think it leads to more inefficiency because I think in effect, active managers do -- are about inefficiency in the market, but with them disappearing, it's created more inefficiency. So long term, I think that will be good for us. It kind of shakes things up a bit. But short term, it just means there's been challenges. I mean, things get a lot cheaper than you expect. If there's a negative update, things get really cheap. And when there's positive update, in some cases, things just aren't moving. And I guess there's been a growth of also quantitative and passive money as well, which I think is also generating some inefficiency in the market.

Matt, our first question is from Michael. He asks, can you comment on DRR holding, which I think for listeners' benefit is Deterra Royalties. And his question is, it's declined this year. Do you feel like it's still a sound position? And maybe just for those of us that don't know if you could just remind us what they do, that would be great.

Yes. So Deterra take a royalty of BHP's main iron ore mine, which is mining area C. The royalty off the top of my head is around 3% to 4%. So basically, as -- so volumes for that asset have matured. So there's no growth to come in terms of volume but the price of iron ore can fluctuate. So with the price of iron ore falling, the royalty is less because it's a percentage of overall revenue. So at the moment, they're suffering from the iron ore price falling. Obviously, if the iron ore price goes up, there's leverage to that as well. The other thing that's hurt Deterra is they bought -- they've taken over a company in the U.K., which was a roll-up of royalty streams in the mining space, and some of that exposure is to lithium. Well, the main exposure is to lithium. And I guess lithium is kind of on the nose at the moment, and there's a view that they paid too much for that asset. So it's kind of being discounted for the iron ore price, for the lithium price and for paying too much for an acquisition. But we think the long-term outlook is good. We're a bit disappointed that management did buy that asset. We had been on the record with them that we believed that their best options were capital management rather than making acquisitions at valuations which weren't going to create value.

Okay. Thanks. We have no more questions, Matt. I'm not sure if anyone wants to drop the last question in there. But I think if not, we'll just give you a few seconds there. But if not -- Matt, I think one thing that's always helpful, I guess, other than just talking about the portfolio that you're managing, do you want to just give us a quick update on Spheria Asset Management as a business? I think it's always helpful for shareholders just to hear a bit about how things are going.

Yes. That's good. Yes, look, our business is traveling well. We have 9 people in our business, when we started, we had 3. We were doing 3 strategies when we started the business with 3 people, so micro-cap, small-cap and our mid-cap products. All strategies have delivered strong alpha generation over the long term. I guess the last year or so has been difficult for the micro-cap and small-cap strategies. The mid-cap fund has actually done really well in the last couple of years. I think with that flight to safety thematic, it's been driving better returns in that space. Yes, so 9 people will -- 5 years ago, we started a global small cap product. It's getting traction. It's up to about $30 million of retail. It's invested in the same way that we invest the domestic product. We're finding that there's significant synergy in running that product. We're getting better perspective on offshore and that's helping with the domestic products and also some of the domestic experiences we've had like REA, et cetera, are helping with that global product. So the global product, I think, has good legs. The beauty of the global market, it's -- there's so many companies to look at. We use screens to drill down that universe to a manageable -- a very manageable level. So we're not trying to do too many things. We're looking for cash flow valuations, high returning sort of companies. And valuations offshore are much cheaper than Australia in terms of growth stocks. So you find a growth stock here like Altium, it's sold -- the Japanese took that over pretty much 100x PE. You can buy the third biggest player in the PCB software market in Japan for about 15x PE. So a fraction of what our team has taken over for and a very similar business with very similar growth profiles. So we're finding a good opportunity in that space. The team is functioning really well. I think covering global and domestic has been very positive for the team and provides a lot of diversity for everyone. So with 9 people, the business is traveling extremely well. We've got $1.7 billion, $1.8 billion under management and we're finding good opportunities. We're taking large positions in some small- and micro-cap names taking long-term views. and we think we're going to make significant money out of those positions. And we've seen the micro-cap fund this month, for example, has had a massive bounce back as interest has come back into the micro-cap space. And maybe that's some indicator that some interest will come back into the whole small-cap market. But yes, our business is going very well.

Okay. Thanks, Matt, and thank you, everyone, for dialing in today. We'll make sure we get you a copy of this or a replay of this presentation by the end of today. And as I said in my comments, the next significant piece of information, I think, that shareholders should expect from the company is just a bit of an update on that conditional proposal that we should have in your inboxes by the end of September. So thanks again for your participation this morning. We appreciate your shareholding.

Yes. Thanks, everyone, for the support. I just like to say in terms of the [ lid ], I personally like the structure. It's more efficient from a tax perspective in terms of streaming franking credits and avoiding capital gains being paid out like in the trust. And hopefully, we get through this period, and our shareholders continue to support product. But thanks for the support, everyone.

Good morning.

Thank you.