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

All right. Good morning, everyone. It's just gone 11:00 Sydney time. We should get started. Welcome to the Spheria Emerging Companies Half Year 2026 Results. My name is Chris Meyer. I am with Pinnacle. I'm also an Alternate Director on SEC's Board. I promise you I do not normally have this orange tan, which is really quite disconcerting, but we'll crack on. I'm joined today by Marcus Burns, who is much more important than me on this call. He's a director of the company and Portfolio Manager of the portfolio. And so we're going to hear from Marcus what's going on inside the SEC portfolio. So welcome, Marcus. And thanks to all of you for your support. We're fellow shareholders in SEC. And so we, like you, are very interested in this kind of an update. I think what you'll hear from us today is 2 things. One is very pleasingly, what has been a persistent discount on SEC over many years has now actually turned into a premium. So as shareholders in the LIC, you've enjoyed a narrowing of that discount and a move to a premium. It's helped your total shareholder return from holding shares in SEC. So that's very important, and we'll spend a bit of time on that. And the second thing I think you'll hear is that it's been a good period for the portfolio in terms of -- it's up a lot and it's had a good absolute return over the period under review, but it has underperformed the market, and we'll hear from Marcus some of the reasons for that. So Marcus, if you can just flick forward to the agenda. Well, I'll do a very quick overview of the company. And then as I said, Marcus will provide a portfolio overview, and we'll go into Q&A. [Operator Instructions] So if we just go to the financial highlights slide, Marcus, please. Yes, that slide there. I think what you'll see, as I mentioned, is that the portfolio was up 12%. Obviously, that the profits of a LIC are driven in part by how well the portfolio does. And so an increase in the portfolio has led to a reasonable amount of profits for the company, which is good. I think an important feature of SEC these days is the dividends. And you'll see we have paid 4 quarterly dividends during the period under review to the end of 2025, 2 quarterly dividends for the 6-month period to the end of December last year. And importantly, we did move to monthly distributions from February of this year, 2026. So I think every time we've come back to you, we've been able to strengthen the income message on SEC, and we think that, that's a significant part of what's made SEC more attractive to shareholders and therefore, a significant part of the shrinking of the NTA discount over the last couple of years. You'll also see we have the conditional proposal, that very last data point. We're almost through it. So it runs from the 1st of April '25 to the 30th of March 2026. And so we're in March. We're about a month away. And pleasingly, we are well within the 5% threshold that would trigger that conditional proposal. So, so far, so good. But I think that's also a factor in what's helped the discount to NTA reduce over the year under review. If we go to the next slide there, Marcus, we'll quickly look at the NTA movement over the period. And so on the dark blue bar on the left-hand side, it's the start of period NTA. The light blue bar, you can see that's more or less the movement in the portfolio. That's -- if you look at that figure, it's sort of $0.295 on a base of $2.40 NTA, so roughly that 12% increase. We took a little bit out of the NTA with operating costs, although it's really not that much. And then the big gray bar on the right-hand side is the dividend. And so essentially, what you can see is that the movement of SEC's NTA between periods is really a function of the return of the portfolio in light blue and the payment of distributions in gray. And so you can see the NTA at the end of December was $2.61, and it's maybe a little bit below that where we are today, but it's in the same sort of ballpark. Next slide, please, Marcus. This is really a Marcus slide, and he'll talk a bit more about this in his remarks. But I think what's important to stress is that since inception, the portfolio has beaten the market by in excess of 1%, so 1% of alpha after fees since inception. But you can see over the 1-year period, 10% behind benchmark. But I think that's much more about what drove the 22% return of the benchmark rather than anything sinister in the SEC portfolio. So we'll maybe hold fire on those comments until Marcus' prepared remarks. On Slide 8, the next slide is the dividend slide. And as I said, you can see it's a nice -- it's kind of a nice steady growing dividend profile that we've been able to produce over the last 2 to 3 years since we moved to quarterly distributions. And as I mentioned in my opening remarks, from February this year, we've moved to monthly. And so again, we're just trying to keep enhancing the income message of the SEC LIC. And so hopefully, as shareholders, you're all feeling good about the fact that the Board is taking income as a key feature of SEC very seriously. And the most recent indication of that is the payment of monthly dividends. And that is all summarized then really on Slide 9. The LIC -- the discount to NTA of an LIC or the premium, if you flick over to the next slide there, Marcus, is always probably the best barometer of -- or an indicator of the happiness of your shareholder register. I think a tight NTA discount or even a premium is an indication that investors want more exposure to SEC. And so if you look at the dotted gray line, which is the discount to NTA over time, you can see that since maybe the middle of 2023 in the middle of that chart when we were trading at 15% to 20% NTA discounts. Since then, we put in the conditional proposal, we've put in much more attractive income, quarterly income and monthly income. And through that period, we've been able to tighten the NTA discount to a period now where, as we've indicated in that circle, we've actually been trading this year, in fact, for the last 6 months, mostly at a premium to the net tangible assets of the company. And so we take that as a sign that shareholders are encouraged by that progress and some of those initiatives. And so as a Board, we will continue to take those initiatives very seriously. And Marcus, with that, I think I will hand over to you for the portfolio update.

Great. Thanks, Chris. Appreciate the intro there and the run-through on dividends, et cetera. Just going through the portfolio and the update we're seeing as managers of the company. A quick reminder of our process for all investors who bought shares in us or the SEC. We are a -- I think the key differentiator of how Spheria invests is we are very focused on things like free cash flow. So we're very fundamental bottom-up investors. The team that myself and the rest of the team spend a lot of time looking through accounts, doing models, all the basic things on investing, and we are looking for businesses in small-cap land that can generate sustainable free cash flow through a cycle. They might seem extremely obvious, but I do like to highlight to investors that in the top 100 companies, almost all of them generate substantial cash flows and have the right to be a top 100 company. But in the small cap space, the next 200 companies in the ASX, many don't generate cash flow and many don't generate sustainable free cash flow. And it is one of our key criteria why a business must be proven and generate good free cash flow for us to be interested in buying the business. Secondly, we like businesses that are modestly geared. Obviously, gearing is conduced returns. But during tough times, gearing can be your enemy. And so we prefer businesses with net cash balance sheets or businesses that are lowly geared or in many cases under-geared and then obviously, we are trying to buy businesses on your behalf at a trade discount to what we think is fair value. If we buy them cheaper, then we're going to get more of a return for investors. And obviously, there's somewhat of a buffer. If things go some other ways as well, we have a buffer to hit their value. So that gives us a cushioning. We like in small caps to keep an eye open for changes. So changes in management teams, circumstances can have bigger impacts on share prices down in the small cap space. So we look for those dynamics and hope to profit from them from time to time, especially if there's a new management team coming in or an exit of a poorly performing division. There are typically times when we like to be revisiting a stock we might have ignored previously and come back in and hopefully make some good returns if there's a substantial positive change going on. And then we do like to remind people that there is, we think, having active management down here because there's the whole index is less researched in the small cap space, and there's a lot more dynamism with share prices and management teams going on. To that end, this is the performance of the SEC since inception. And you can see we have had periods of underperformance and outperformance. And over time, we've managed to eke out reasonable returns. As Chris touched on, the relative performance over the last 12 months has been -- 6 and 12 months have been challenged for us. So absolute returns have been reasonably strong. But I'll show you in a minute, the real strong performance within the small cap space has been resources. And for many reasons, we have been underweight resources, but that is the relative performance of the company. So this slide here just details what's going on in resources versus industrials. There's a few things going on here, but the red line is the performance of the small resources sector, sorry, over the last 12 months. So that includes any energy names, oil and gas and gold and any base metals that comprise that resources index. You can see the small ordinaries is the line in blue there. And then industrials is the -- which normally have done very well in smalls, has really, really lagged. So industrials are only up 4% over the last 12 months versus 80% for resources. So that dispersion of returns has been truly extraordinary and something I think you probably see in smalls once every 15 years or so, where resources truly have an amazing run from probably a weak position 12 months ago to a truly well-invested position as we currently stand. What's driven that has been a couple of factors. Obviously, resource prices, particularly gold, to some extent, energy, but more gold and precious metals, so silver and platinum, et cetera, have had an incredible run over the last 12 to 18 months, driven by any kind of -- a lot of macro forces. So I think people looking to defend their asset values by buying gold as a hedge against inflation, monetary basement. You've had obviously a lot of geopolitical uncertainty around the world, and that's seen people flock to gold, which has flowed on eventually into gold. Gold equities have now rallied to levels we've not seen for many, many years in that space. So the gold subindex within smalls is now something like 17%, 18% of the index. So it's become -- gone from a relatively small component to a very large component and driven a lot of that performance of resources versus industrials. The second big macro factor that's gone on has been obviously the advents and the popularity of LLMs and AI. And as that technology is spreading out from purely chatbots to Anthropic and agent -- agentic AI, et cetera, it's caused somewhat of a rethink with investors around technology names and what that means for the longevity of some of these names and whether they can be disrupted, and that's also seen somewhat of a sell-off in some of the names in the industrial side. Just to summarize how the performance has gone over the last 12 months. Again, I think we should probably issue this with a 6-month chart as well. So clients can see, investors can see how 6 months has gone versus 12 months where we've got 12 months here. You can see the kind of names that performed well for us. So to summarize, the blue bars are stocks -- on the left-hand side, the stocks we own in the portfolio within the company. The red lines there or the red hollow lines are stocks we don't own. And you can see positive contributions above the line and negative contributions below the line. So just to summarize names that have helped our returns over the last 12 months have been things like Domain Holdings. So that was -- as you know, it's a property portal in Australia. It was taken over by CoStar out of the U.S. and provided a spectacular return for investors. That was predominantly in the first half of last calendar year, not the second half. And then A.P. Eagers was a strong performer last year as well. We bought that from an oversold position. It did a deal last year and had incredibly strong returns, driven by good organic performance and acquisitions they've done and then bought into a strong position in Canada, all of which saw the shares rerate last year and give us very strong performance. And then you can see that running our top group there, the Sims Metal, L1 and HMC Group, which we didn't own for a period, which made the relative returns stronger. On the negative side, we've held stocks like IRESS, which are a really strong cash-generating business with a new management team that we have reasonably high conviction in, but it has performed -- struggled on a relative basis versus the index. So the index ran aggressively and IRESS traded sideways. So that hurt us on a relative basis. And then you can see many of the other names there that did relatively damage the funds were things like Westgold, Regis Resources, Greatland Resources. So most of the gold names we touched on earlier, which because they rallied so hard meant the fund underperformed on a relative basis. And then on the right-hand side of that chart, you can see a good summary of that. Again, so by sector, you can see we've got reasonably good attribution or positive returns from things like financials, so they bet on L1, health care and real estate to some extent. And on the negative side, materials, but in particular, gold, which more than doubled last year, saw a material impact on the relative performance. So being very underweight gold has hurt us. Just as a smaller slide there, we have typically issued gold stocks because they have been very short mine life and have been prone to multiple issues at mine site. There's a lot of things that go wrong on mining, especially with single mine site stocks. And we sought to get exposure through mining service names. So names like IMDEX, which is a mines drilling technology. Mader, which is a business that services on-site kit for miners. And also stock called C79, which is a disruptive mining service name. I'll touch on that in a second. So we've got 7%, 8% of the fund in those 2 names, and they all performed very well over the last 12 months. So it didn't materially help our returns. But because gold price rallied so aggressively, which meant the gold names even better, the relative performance was damaged or hurt on that basis.

Marcus, before you move on, maybe just to take a pause here and also give you a break is it's a little bit hard to see, but I think that gold bar on that chart is minus 10%. That's 12 months to January.

That's right.

And if you remember that table that I started with, which showed your relative return for the 12 months to January for the overall portfolio on Slide 7, showed that you were about 10% behind the benchmark for that period of time. And so would it be fair to say that -- I know it's a bit simplistic, but almost all that negative relative performance was driven by that underweight gold sector position.

I think it's fair to say that. I mean there's always been -- even within the portfolio section, there's some good stocks and some mistakes we made. But overall, the overarching impact was gold and the fact that we were very underweight in the space. In fact, we had no gold stocks at all until the final quarter of last year, and we bought 1 or 2 names that were designed to give us some protection against the gold price running further. So yes, Chris, that's a fairly simple, but I think accurate summary. And just to leave you with the stock story slide, we -- our current holdings, current exposure, we like to give investors some transparency on what we hold and happy to discuss the rationale with investors on these. But the top 10 names you can see are listed there. So Supply Network, which has been in the fund for some time, remains a high conviction core holding for us. Supply Network, just to remind you, is a bus and truck parts supply around the country. They're the leading aftermarket supplier of those bus and truck parts to independent mechanics. And the tailwinds there are that they are an incredibly good operator of their business and aftermarket mechanics are taking share from the OE mechanics in the truck space. And so their share grows continually year-over-year. Their first half results this year, that supported organic revenue growth of 17%. That was based on no acquisitions, no M&A, just the rollout of their locations and improved customer wins. So that business continues to trade very well, almost no gearing and the valuation we think is supportive given the growth rate that they sustain. Sims Metal, which is a metal recycling business in Australia and the U.S., has performed really strongly based on the cycle plus also the recycle -- a good business that recycles compute memory. So when machines or computers are end of life in data centers, these guys securely break them down and sell the parts off. And obviously, with data centers booming right now and the memory chips rising aggressively, Sims has been a beneficiary of those memory chip prices rising. And then IRESS, which I touched on. Perpetual, which is a chief fund manager, we think it's a bit of a breakup takeover play plus good cash flow business and very undervalued. Fletcher Building. IMDEX, which is a mining service name I touched on. And then we've got some exposure to minerals through Deterra, which is a royalty on Mining Area C for BHP. Universal Store, which is an excellent run retailer. Healius, which is a sort of health care play, very cheap net cash balance sheet from on property. So a bit of a mixture of things there. But again, all generally got good balance sheet, strong management teams and very supportive valuations. And then on the right, you can see the sector allocations probably worth highlighting there that materials is still fairly -- we're still underweight materials, although we've got reasonable exposure. And then our overweight in consumer discretionary isn't purely retail, names like Supply Network, which are 5% of the fund fit into that space. So that probably drives most of the overweight there. So we're not as overweight retail. I think some investors might think we have good retailers like Universal. But yes, it's not a bet on resale being a super strong space to be. And then you can see the rest. IT, we're slightly overweight and real estate, we're slightly underweight. Just to leave you with the stock story. We've invested in Chrysos Corporation, which is a very interesting technology that was actually created by the CSIRO and spun out maybe 5 years ago into a company called Chrysos. And what attracted us to Chrysos, it IPO-ed 4 or 5 years ago. We looked at the business at the time because it was a potential competitor disruptor to ALS, which is another business we own a mid-cap fund. And at the time, the stock was fairly nascent in terms of rolling out the technology. But as that progressed, they've penetrated the market well. And now something like 7 out of the top 10 gold stocks in the world are using or testing PhotonAssay as a way of measuring gold in samples. And the reason it's superior is it doesn't destroy the actual sample. So the way fire assay works on mineral samples is that it dissolves and destroys the samples part of the process, so you can't possibly retest it later on. Chrysos x-ray -- did some x-rays and it looks at the excitation of those atoms to get a reading on where the gold is in the sample. So the sample can be preserved for many years, it can be retested later on. It's much quicker, much less energy intensive and labor, produces much less pollution than the traditional method of doing it. And so they produce a machine, they put on site and they effectively lease that to both mines and to mineral testing businesses. The key thing here on the right-hand side is that you can see they've got something like 40-odd machines currently rolled out globally all over the world in many jurisdictions. And as I said, all of the major testing businesses, SGS, ALS, et cetera, have them in their laboratories and 7 of the top 10 gold miners worldwide now using them. And the great thing about the technology is not only useful for discovering gold, it can also be potentially applied to copper, which is the other major mineral that most exploration goes on to. They believe the mine, the total potential market might be something like 600 machines. It may be materially higher or lower than that. I think possibly in the upside long term, it could exceed that, and their penetration is less than 5% currently. The return on assets in the business is very strong, and they're protected by many patents and 20 years of research history to protect the technology. So that's been a strong performer for us, obviously, partly related to gold price, but also the revenue and the growth of the business is incredibly strong, and we think there's potentially good runway for that business to continue to grow. We hold about 1.5% in weighting in the SEC portfolios. We've touched on this before, but we've seen a fairly strong performance in smalls versus large caps in Australia over the last 12 months. And we still think -- I mean this is a relative valuation of small caps versus large worldwide. And we think the same logic applies domestically in Australia, there's a good valuation between large and small. And we think that the small caps are going to be an exciting place to be for the next 1 or 2 years, depending on macro cycles settling down, obviously. And I'll leave it with a quick summary. We've seen an aggressive rotation as we discussed, into mining service well into resource names generally, particularly gold, where SEC has been underweight. We have sort of partial exposure to resources through mining service names. And we do have some 1 or 2 gold names now in the portfolio, but they're probably -- and we're still materially underweight. So we've got 2 producers with good balance sheets. And if the gold price holds up, they should produce good returns and earnings, but we're still underweight in the space because we think we're at a fairly cyclical high in gold. We've got high-quality mining service names. We think give us good exposure. And we still -- the team does continue to look at gold names and other resource names for interesting avenues and angles. So we're not completely assuring resources as a space to invest, by the way. It's just an area we've been typically underweight. We do think small caps still retain a good valuation support versus large caps, both domestically and globally. And we think the SEC is a good way to play that space with the dividend yield supporting our stock ability, hopefully on the capital return side. So with that, I'd like to hand back to you, Chris, for any questions.

Thanks, Marcus. And certainly, we, as Pinnacle, talk to a number of different types of investors, advisers, individual investors. And the one thing for sure with Spheria that we get consistent feedback on is that they're true to label. This cash flow as their North Star is not something they deviate from. And even in markets that might not reward cash flow as much as Spheria would like over the long term. So in the short term, when they don't do that, they like the fact that Spheria sticks to its knitting. And I guess this is another half year where that's been the case. Marcus, yes, so Q&A, we've got a few minutes left. And as is fitting with the Spheria updates, we always get stuck. Everyone loves good small cap stock questions. So the first one from Andrew is just about Healius. What gives you the confidence to continue to hold Healius and the EBIT margin target of high single digits?

Look, it's a fair question and one that quite gets challenged. I guess the fact that Healius has got significant market share in the country, and we don't think it's been run as well or as efficiently as it could be. So it's got a very stable revenue line, supported by government. Obviously, government funding for blood test predominantly is most of the business in Australia. They're a strong #2 without earning #2 like margins. So we just think there remains a very strong case for margin improvement with the business. It's a necessary service, and we don't think they're running anywhere near as efficiently as they can be. So balance sheet is no longer geared. And they should be earning margins that are much more like the #3 player ACL than they currently are. And there's also a possibility that eventually ACL and Healius merge, which if they did, it would see substantial cost savings. So I think that's really the rationale for holding it. We've got a balance sheet that's supportive. Management team is trying to improve efficiencies and a very strong possibility that at some stage, ACL and Healius get together, which would be, I think, a pretty rational way of reducing costs, but maintaining service for doctors and patients.

Okay. We've got another question on Fletcher Building, which is, do you have a view on what sort of normalized cycle earnings could be for Fletcher Building?

Look, we do, obviously, and that feeds into our valuation. I don't think I should forecast that necessarily on a call. I mean happy to chat about investors one-on-one. It has been -- it's not -- we've bought Fletcher and sold it a couple of times in the past, we've only gone back to it fairly recently. I think there's been some pretty serious changes in both management and Board there, which -- all of which we think is positive. They're divesting assets at the moment to shrink back debt and to focus on core businesses, all of which I think is positive. They are in strong market shares and a strong -- in a recovering market in New Zealand. Hopefully, they can continue to squeeze value out of reducing the number of industries they're in, selling off assets. And also, it's a hard asset business, too, which right now should prove to be fairly disruption proof. So there's a few reasons for owning Fletchers, I think, in the market, including new management and improved margins.

And Marcus, our final question, unless anyone jumps in quickly is on Tyro. So any views on Tyro and the recent weakness?

Look, we think Tyro is performing pretty well and has a valuable sort of valuable business in Australia that's finally turned the corner. So for many years, we didn't own Tyro. It was a loss-making technology company that sort of turned the corner and making earnings. I guess we see it as a fairly critical component of the payment network in Australia. And with that, it remains a solid asset that's making income for change, balance sheet is okay. And also, there's a reasonable case for consolidation in that industry as well, and they would be a natural player in that consolidation. So I think that's really the rationale for that name. It's cash flow positive. It's growing moderately and there's a decent market share in business or industry that's consolidating.

Okay. And Marcus, Mark, it's like a last-minute question in just on Fiducian Group. He's picked up that you were recently a substantial holder. So I'm not sure if it's in SEC and if you have any comments on that?

Yes. It's not really in SEC, no, it's more held in our microcap fund, to be honest. But yes, look, we've been shareholder in Fiducian for quite a few years, our microcap fund. It's not -- I don't think it's an SEC or it's a very small holding. I don't think it's actually held by -- it's all a microcap position. But look, it's a case of a moderately valued financial services business with a platform bolt together, has strong cash flows, good dividends. It's growing. There's 1 or 2 small issues with funds that had historically that had run failed. I'll stick on 1 or 2 areas, but I don't think it's anything particularly serious, it's more related to the disclosure on ESG. There's nothing -- there's no mouthpiece as far as we can tell and they've been criticized by anyone. So it's modestly valued cash flow generating growth machine, conservatively run. The founder still retains a big holding in it, but it's only owned by microcap fund. So that's where the potential holding comes in.

Got it. Okay. Well, we're just on 11:30. That's nice and slick. Well done, Marcus. Thanks, everyone, for your time and your questions. And more importantly, for your shareholding in SEC, we do appreciate it, and we look forward to updating you in the future about the portfolio and about the company.

Thank you. Thanks for your time and questions.