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

Okay. Good morning, fellow shareholders, and welcome to the Spheria Emerging Companies Half Year Results Presentation. My name is Chris Meyer. I'm an Alternate Director on the company's Board, alongside Matt Booker, who's joining me today, Founder of Spheria Asset Management, the Portfolio Manager of the SEC Portfolio and Director of SEC. Many of you have seen Matt on these webinars over the last few years. So we're very excited to bring you an update on SEC. We will take questions at the end from shareholders. We will run through a short presentation. I'll go through some of the company matters, but the main event really is Matt and a portfolio update. So we'll make sure we leave plenty of time for that. So diving right into it on the results, I'd like to really call out 2 things on this slide. The first is the strong returns from the portfolio, 11% for the 6 months. That's a pretty good return for small caps that have not had a great time of it over the last few years. So finally found some life in the second half of last year, which is amazing. But I think what's probably worth calling out even more is that second bullet point on that slide is the alpha that Matt and his team have been able to generate over that period. So if you just bought the market, you would have had 5.5% return, your portfolio managed by Matt and team produced a return of 11.3%. So 5.8% alpha is pretty impressive for such a short period of time. So congrats to Matt and his team. And the second thing I'd call out is just the income. So we've put down there the dividend yield, including franking on that table at the top is 8.3%. That's a pretty impressive yield. I would just say that there's quite a few income LICs coming to market. Not many of them will get you into that kind of yield fully franked. So while the income objective of SEC is not at state, it's not an income LIC, it's certainly producing some income levels that are very competitive with many of those income LICs in the market. This is a pretty good visual representation of what I've just said. So the light blue bar is essentially the return of the portfolio over the period. So you can see that it's a very strong return that 11% more or less translates into that dark blue line at $2.23 plus. 11% gets you more or less to that $0.25 increase in the NAV for the quarter from the portfolio's return. And then we paid out a reasonable amount of that return in that gray bar, second from the right as a dividend. So I think it's important to remind shareholders that the return you receive from SEC is a combination of the increase in the share price, if you like, capital growth. But always remember, there's a substantial dividend that you're receiving every quarter. We're targeting that dividend to be about 1.5% of post-tax NTA every quarter. So you've always got to remember, you can't just look at the share price appreciation when thinking about the return you're generating from SEC. That's only half the picture. The other half is factoring in that income stream that it's paying off. So that's, I guess, graphically represented in this chart. In terms of the actual performance of the portfolio, I think I touched on it a little bit earlier. Small caps had a slightly better year. You can see in the 1-year column there, the index up 12.3%, SEC's portfolio up 13.7%. And that's after a couple of lean years. The 5-year return of the index only 4% in small caps. But what's super pleasing, I think, as an alternate director on the SEC Board, but also as a shareholder, it's just how well Matt and his team have done by producing almost 4% per annum outperformance against that benchmark return over the 5-year period. So instead of earning 4.3%, if you were invested in the index, the SEC Portfolio has done 8.2% per annum over that 5-year period and similar numbers since inception. So a really strong relative performance from the team. I touched on dividends. This graphically represents where we are today with dividends. So the light blue line, I think, is the most recent dividend that we announced in December. It was paid in the middle of February. And you can see those last 3 quarters now, we're targeting that 1.5% of post-tax NTA per quarter. You annualize that at 6%, you frank it up -- you gross it up for franking and you get pretty close to 8% yield. It's a very, very attractive income stream, I think, for shareholders. And then this really is the combination of all of those efforts. So if you look at the yellow line or orange line, you'll see that's the premium or discount to NTA. You can see we're trading currently at about a 5% discount to NTA and have done so for the better part of the last 12 months. And that's coming off some much wider discounts earlier on in SEC's life. You can see for much of '22, it was probably trading at that 10% to 15% discount. And during the COVID period at its lows, it got down as much as 25%. Now I would say there's 3 things that have really helped there. One is the performance. The other manager is doing what it said it's going to do and in fact, if not better, with that alpha that it's produced. If you don't have performance, you can't justify trading near your NTA. The second thing is the dividend. I think if we look at the share register of SEC, you can very clearly see that there are much few -- much lower amount of sellers, much more buyers. And many of the buyers are coming in because they are attracted by that, not just the growth you can get from small caps, but also the income that SEC is now producing. And finally, and we'll touch on this on the next slide is, we put that conditional proposal in place at the beginning of 2024, where basically we said if the discount to NTA of SEC in the fourth quarter of last year is wider than 5%, then we will convert SEC into an open-ended fund. As it turns out, that discount on average over that fourth quarter period was 4.75%, as you can see on the slide. That meant the condition was not met, which meant we keep SEC as an LIC. As we've gone to shareholders post that event and we've asked them, okay, what else do you think we should be doing? What did you think of the conditional proposal? We got some feedback from them that they basically really do respect the fact that the SEC Board has put these measures in place. They love the income, they love the outperformance, but they -- in order for SEC shareholders to buy some more shares, they would take comfort from the fact that we put the conditional proposal back in place just to ensure that, that NTA discount doesn't widen out much further beyond where it is today at that sort of 5% level. And so in February of this year, the Board announced that we are going to reinstate that conditional proposal on similar terms to the one we had in place late last year. So essentially, if between the 1st of April this year and the 31st of March next year, so over a 12-month period, the NTA -- the share price to NTA discount is wider than 5%. In other words, if that condition is met, then we will go to a shareholder vote. SEC shareholders will vote on whether we remain as an LIC or we move towards something like an open-ended fund or an exchange-traded fund. So that conditional proposal is back in place, and it should give shareholders the confidence to buy shares at this level. Hopefully, the NTA discount remains in that narrow band as it did last year as a result of it. That's all I had, Matt. Why don't we switch over to you and you can give us a bit of an update on the SEC Portfolio, and we'll take some questions from shareholders thereafter. Thanks, Matt.

Yes. Thanks, Chris. That was great. Just in terms of process, we haven't changed our process. We started this business nearly 9 years ago. The team has a view that cash flow drives business valuation. And we're very valuation focused and cash flow focused. But it's also about sustainability of those cash flows and also, I guess, what you pay for growth as well. So we're very mindful of a number of factors when we invest. We're not just value investors. We do buy some growth companies. But when we buy growth companies, they've got to have predictable growth and sustainable growth that we can pay more for. Like ideally, we don't want to pay more for it, but sometimes we do because the quality of the assets are that good. Next slide, Chris. In terms of performance, it has been a good 4 years for us coming out of COVID. There was a lot of opportunity, obviously, in that period to invest and find good businesses. The portfolio has changed over time. We do sell companies where they become overvalued, and we are always rotating, I guess, into companies where we think there's a valuation disconnect. But we are long-term investors, and we have delivered good alpha, particularly since that COVID period. We're finding good opportunities now. The market has bifurcated between, I guess, large and small, between popular and unpopular, and that provides significant opportunity down the market cap spectrum. But good performance over the last 4 years, and we think there's more ahead. In terms of stock attribution, look, there was some good over the past year. There was some bad. The good outweighed the bad. In some cases, we didn't own stocks that did particularly well. And my eyesight is pretty bad now, but I can see that Life360, as an example, hurt us because we didn't own it. Now...

Is that what the red bars mean, Matt?

Yes, those are the red bars. And you can see that Life360 was one of the major detractors from not owning it. So it's gone up a lot in the index. A lot of our peers have owned it. We look at the business and it's generating fantastic revenue growth. Obviously, it's carved out a strong niche in the market globally, but it is burning money. So it's hard for us to conjugate into a positive investment case with that story. But it's not to say it's not a good investment. Clearly, some people have done very well out of it. It just doesn't really fit with how we invest philosophically. We have had some stuff that hasn't gone well for us. Star was obviously a stock that didn't perform well for us. We've exited it during the year. We think there's good hard asset value in Star, but we underestimated the regulatory challenges with that business. And it wasn't just carded gaming that brought the company unstuck. It was the level of compliance and oversight that's required in the business. And the cost of that has made basically the gaming floors unprofitable. And if something is unprofitable, it's hard to see how that's sustainable going forward. So we did exit that position. It did hurt us during the period. I guess, the offset of that is we had a number of good performance for the year. And overall, we had a good outcome for shareholders. The top performer was Supply Network, which we've owned for probably 9 years that we've been here. And also, we owned it before when we're at Schroders, but Supply Network is an amazing business. And I guess it's performed better than what we would have expected over those 9, 10 years that we've owned it. And anyone who knows what the business does, and it's one of those businesses, it does fly under the radar, but it provides bus and truck parts to the market, and it's the #1 player in the Aussie market. So it's gone from a nanocap, microcap to a small cap company. It's grown its share from probably low single-digit market share in the truck and bus aftermarket to around 15%. And so it's really carved out a strong position in the market. There's some real tailwinds for the business with independent mechanics winning share from OEMs. Independent mechanics probably represent about 40% of the market. OEMs represent about 40%. And then there's fleet that are about 20% of the market. But SNL really dominates that independent mechanics space and is also winning share in that fleet space as well. So the upside potentially is 60% of the market. They're currently about 15%. They're the outright #1. They don't have a lot of competition. Their competition is probably from the OEMs supplying the independent mechanics directly. The supply chain, the way the business is run, it's possible that the company can increase its market share significantly. So there's good growth in SNL to come. Here's another way to look at the portfolio. So it's the top 10. Now I was talking about Supply Network. We made good money out of Insignia. We sold a big chunk of that out at $4.60-odd in the past few weeks. So that position has reduced significantly in February. There's some other positions there, which I think are good assets, which are undervalued. Deterra, for example, owns the iron ore mining royalty for BHP's biggest iron ore mines. So it takes a 4% clip of iron ore revenues from BHP. Clearly, the iron ore price has been under pressure. If that pressure abates and you start to see an increase in the price of iron ore, then the value of those royalties will increase as well. So Deterra share price has been under pressure because of that and some acquisitions they've made, but there's good value in that business. And you can see the rest of the top 10 there. Some of those stocks have performed well over the past 12 months. Others are going through, we think, temporary setbacks in their business, but there's upside in them as well.

And we can come back to some of those during the quick Q&A, Matt.

Yes, yes, I don't want to stretch this out. And Domain Holdings, which we invested in last year, so derated massively, particularly relative to REA Group. But also on an absolute basis, the stock derated heavily. And that presented an opportunity to invest in it last year. It is a duopoly structure. Most of you would know REA and Domain. You would use one or the other or both potentially. Domain hasn't been that well run, but that's the upside is execution in the business. You can see the cash flows on the top left there for the business have always been strong. It's just a matter of getting -- winning market share outside of the key markets of New South Wales and Victoria, pushing prices up, maintaining low-cost growth. All those things they haven't really executed well on, but that, I guess, presented an upside case. And as most of you are aware, CoStar Group has taken a significant stake in that. CoStar is an American business that's rolled out property portals around the world. And it is looking to acquire the rest of Domain from NEC and minority shareholders, but it's built a significant stake up in Domain. We've kept most of the stocks. We sold some of the stock above the actual bid price, above $4.20 in the aftermarket. But we've retained most of our holding there because we think CoStar will probably come back at a higher price. NEC owns 60% of the business, and we suspect they'll extract a higher price from CoStar. But there's never any guarantees with this. But yes, we think there's a good asset there that was undervalued by the market. And I guess it shows how we invest. We are not always buying the #1 player in the market. So we do own REA in our mid-cap funds, for example, but we're not always buying the #1 player. Sometimes we're buying the #2 player or we're buying a player that has substantial share in the market and the market structure is good, but the company is going through temporary setbacks, and it might be execution issues. But Domain is a very good example of that of how we invest. We think small caps globally look like a good investment. And this chart just depicts the relative valuations of small caps versus large caps, and you can see that historically. And you can see that we're at pretty much a record divergence between small cap and large cap valuations globally. If we could do the same chart domestically, it would -- we believe it would show a very similar picture. We think there's a high correlation between smalls and large globally. But it just show how the dislocation that we've had between large and small. I think some of that has been driven by rising interest rates and a flight to safety thematic. Small companies are seen as more risky, I guess, in a high interest rate environment, and there's a flight to safety thematic that has definitely played out through the global markets and the domestic markets. And that means there's huge opportunity down the market cap spectrum, and that's why we think small caps have definitely a place in everyone's portfolio. In terms of key themes, obviously, inflation is moderating, obviously, from very high levels. Lower interest rates will be supportive, particularly for cyclical companies where the economic weakness has seen earnings down, and therefore, you've seen capital move out of companies that are quite cyclically exposed. So we think inflation coming off, interest rates coming off will be positive for more cyclical exposed companies, and we've definitely biased the portfolio over the last 18 months towards more cyclical companies. There are short-term earnings risk in the market. I mean, the economy is quite volatile at the moment. The government is spending a lot of money, and it's causing some dysfunction within the economy. So for example, health care companies are really struggling to find employees. And we think a big part of that is the NDIS spend is really consuming a lot of the employees. So very hard for health care companies to find employees, and that's seen significant inflation. But that appears to be abating as well. So yes, it is risky out there. There is dysfunction in the economy, but there has been some M&A activity, obviously, CoStar coming into Domain, and we saw some other activity late last year as well. So hopefully, there's some -- a bit of an M&A pickup. And perhaps that arbitrage is away at the discount between small and large cap that we've seen that's been very prevalent for the last couple of years. So overall, we think it's a good time to invest in small caps versus large caps. I think large cap valuations are very stretched when we look at them, and there will be a shift back to smaller companies. So in the meantime, we're getting quick payback on owning small companies, where there's takeovers, obviously, we close out that arbitrage, that discount pretty quickly as well. We think SEC is highly attractive because there's a very strong dividend, as Chris discussed before. You've also got that valuation thematic in the small cap space. And obviously, we've reinstated that conditional proposal. And that should keep theoretically the discount between the NTA and the share price hopefully pretty tight. So I think there's a good play on a fundamental basis and a good play thematically with SEC given the conditional proposal that we've got in place and the strong dividend that we've got in place as well.

Thanks, Matt. That's great. Maybe if I can start and shareholders, please, those of you online, feel free to type your questions into the Q&A box. But one thing that sort of struck me as you were speaking about small caps being cheaper than large caps and this being a good time to buy small caps is, if you remember right at the start of this conversation, we showed a table that -- in fact, maybe I'll just quickly flip back to that, a table that showed the -- since inception performance of the small cap index is about 5.4% per annum. I mean that -- like what would you -- in very round numbers without obviously promising returns. But what do you think small caps should be doing sort of through the cycle per annum type returns?

Given higher risk premium, you would think that it would be high single-digit, potentially low double-digit. So the index has underperformed, I guess, for the past 8 years or so that SEC has been listed. And I guess that is a period of time. I guess over the long term, you would expect that there would be mean reversion. So if you do go to high single-digit or low double-digit type returns, that means there's probably a good window of generating significant small cap returns in the next 5 to 10 years, let's say. So it would indicate that there's a good opportunity in small caps, I think, just looking at that since inception return for the index. And obviously, if we can outperform the index and the index is doing something around high single-digit or low double-digit then there's extraordinarily good absolute return that we could generate, assuming we can outperform. And I think the way our process is constructed, I think that we can outperform the index over time, and we have obviously done that in the past.

Thank you. Okay. Matt, Bill asks a question about IFL, which is Insignia. I think you answered some of it, which is, do you still hold IFL? He's making the point, it looks a bit full the valuation given the PE bids. And what do you think from here given their results look like they may have been a bit weak?

Yes. Look, good question. Yes, we've reduced our holding by about 2/3. So that table before said we had about 5% of the portfolio in it. I think we're down to just over 1%. So we've sold a big chunk of that position out in February at around $4.60. We think just looking at it, it's gone from a fundamental position to a takeover play. Obviously, you've got 3 bidders for it. The natural assumption is that, one of those bidders will get something across the line. We look at it, and we think if a bidder got, say, $5 across the line and it was trading at $4.60, there was only an 8% return basically from $4.60 to $5 over a 12-month period. And we think it would take 12 months to complete the acquisition through due diligence, financing and regulatory approvals. So at $4.60, we didn't think there was a decent risk/reward play in there. At $4.20, we think there's probably a decent opportunity and a decent risk/reward at these levels. We think that a couple of the bidders are genuine bidders, at least 2 of those 3 parties are legit. And the other issue, and we've got more transparency on it now is around the consolidation of the Master Trust at Insignia. There's a contract that SS&C won on that front. And we think that, that contract is very -- on very favorable terms for Insignia. SS&C needed a big foundation customer in this market. And I think they've entered that contract, and it's highly favorable in terms of profitability and risk for Insignia. So I think once DD is further and they go from a very sort of brief DD, but into a more complex DD, I think that, that transparency around that contract will probably remove some of the risk around the acquisition. So I think down at these levels, there's an opportunity, whether you get $4.60, $4.60 would be a decent outcome on a 12-month basis and potentially more if 2 of the parties get a bit more aggressive on it.

Great. Then Jane has our final question unless some more come through while I'm asking this question about she obviously noticed on this chart that I'm showing here that you're underweight Sigma Healthcare. It's been a fairly topical stock in the press over the last few weeks. Just wanted to get your thoughts on why you don't want to own Sigma Healthcare.

Yes. We don't own Sigma. So Sigma, there was a backdoor listing of Chemist Warehouse in Sigma. We did own Sigma, and we made good money out of it. Probably 7 or 8 years ago, we bought it, and we did well out of it. But the backing of Chemist Warehouse has really changed the complexion of the business. And if you look at the market cap now, I think it's over $30 billion you're paying for Chemist Warehouse. Now that market cap is very similar to Woolworths, for example. And I think it's might be in excess of Coles. And so you're paying a lot for Chemist Warehouse. Look, Chemist Warehouse is a great business, but it is fully penetrated, we believe, in most of the locations it's operating in. And there are some restrictions around penetration of geographies and pharmacy licenses. So it's not without risk. You need to bake in a lot of growth to justify the current valuation. But yes, it's a good business. I think the market is overpaying for it now based on the penetration -- like I said, the penetration story. And we think it's probably run a bit too hard. But it's one that it's on the radar, but it's probably going to move into the -- I'm not sure if it's in the top 100. We haven't looked lately, but it's probably moved straight into the 100 and probably into the 50 at some point given that market cap.

Yes. Got it. Okay. Well, as I call final question, we've got a few more. Paul asks, how many companies do you currently own? And how do you sort of gauge how many companies you would ideally own in the portfolio?

Yes. Look, we've always said that we'd be around, I think, the 40 to 60 mark. We're currently around 50 stocks in the portfolio. So around the average. We think if it goes -- if that number goes too high, then we're obviously probably a bit overly diversified and there's a lack of conviction in what we're doing. So we think around that 50 level is probably a normal level. And I think if it gets too low, then it's pretty concentrated and that brings a bit more risk into play. But it does really depend on the environment. I mean if there's good opportunities around, we're probably going to have more stocks in the portfolios. And if there's probably less opportunities, then we'll probably have less stocks in the portfolio. But at the moment, as I said, there's this almost barbell effect in the market where there's stocks that are very popular and very extensive and then there's a lot of small cap stocks, which are on the nose and there's a lot of opportunity in that lower set of companies.

What's the maximum position size, Matt?

Yes. We usually operate at right around 5% maximum active weight, so 5% versus the index weight. So Insignia, for example, has a 1% index weight, and we had a 5% absolute position in that stock at the end of January. So it was a 4% active weight. But we generally -- the biggest weight will be 5% active. And that would have to be a highly liquid company, good cash flow, good balance sheet, good sustainable industry structure and earnings.

Got it. Okay. Last one from Bernard is, can you comment on the prospects for City Chic?

Yes. Look, City Chic has been through the ringer over the past few years. Some of that has been self-inflicted through bad acquisitions, but they brought the business back to the core now. They've sold off the assets they've acquired. The share price is massively derated. The company has fallen off the radar. The recent update from the company was quite strong. I think they had 30% like-for-like growth in January in their core business, and they're back to what they're doing best. They're back to selling to the demographic in the Aussie market that they're good at selling into. And they've still got a penetration story in the U.S. with their City Chic brand. So it's kind of back to basics for the business. And it feels like the environment -- the macro environment is improving for them. Obviously, their customers were under a lot of pressure in the last couple of years with mortgage rates going through the roof here. Any relief on that front is going to play into more disposable income for their customers. And their customers, they tend to have a mortgage. They're having to be more thrifty with their spending because they've got kids. They're probably going out less at night as well. So that customer has been under a lot of pressure. But it looks like the macro is improving. If they can maintain their share or grow it, then there's a really good story here, but it's really dropped off the radar. I mean it's a company that's really shrunk over the last few years, but we think there's a good opportunity there.

Okay. And the position size of that one, Matt?

Look, it's pretty small in the scheme of our portfolio.

It's not in the top 10 as well.

No, it's 1% of the portfolio. So it is less liquid. It's effectively a narrow cap now. Its market cap is -- has come off that significantly. It's only $50 million market cap. So liquidity is pretty tight. But yes, the management team has definitely got the business going in the right direction. I mean 30% growth in January. I think that's the sign that the health of the business is improving dramatically.

Great. Okay. Well, congrats, Matt, again, on not just a very good 6 months but last 5 years and what frankly hasn't always been a typical Spheria market has it. So congratulations to you and team. Hopefully, some of those comments you were making about the prospects for small caps in the future come true because it will benefit all of us as SEC shareholders. And in the meantime, you should take comfort, I think, all of you, that our shareholders from the fact that the Board takes the discount to NTA and the reputation of the company very seriously. And obviously, that was a major factor in us reinstating that conditional proposal. So we're always open for feedback. We wanted to give you this update. You'll get a recording of it, and you'll get the slides in your inbox probably by the end of the day. So thank you very much for your time and attention. And Matt, thanks again for all your comments.

Chris, thank you, and thank you, everyone, for supporting us. Have a great day.