As we wind down, we reflect on the past year which has seen a particularly turbulent one for geopolitics. Despite this, it has been an incredible year for our business and our investment portfolios. This year ECP has increased funds under management to circa $2 billion and added additional support and back-office staff to ensure that we can deliver on all our promises to our clients. As a custodian of other people’s money, we owe it to those who have invested alongside us to allocate their capital to opportunities that we believe in because we have done the work.
ECP has continued to evolve as a business, with our re-branding firming up our corporate values and our vision with a fresh new look that sets the scene for our next phase of growth. We have set ourselves the goal to ‘Redefine Active Investing’ through ensuring we continue to take a forensic approach to our analysis, valuing potential not just performance, and we will continue to have high engagement with our investment companies. I am proud of our team and thank all our clients, distribution partners, and industry colleagues for their continued faith and support.
The Global Scene
Over this past year, volatility, uncertainty, complexity, and ambiguity was at an all-time high. Geopolitical woes, market volatility, trade complexity, and ambiguity of world leadership has seen the world divided across many issues. For some time, confidence and trust in institutions have been a major concern with hostility regarding inequalities coming to the fore. However, the Edelman barometer has indicated that over the past year there has seen some improvement in societal trust with the public focusing more time on relationships they can control and finding unity in one core message: an urgent desire for change.
As the world order continues to be challenged, China comes out from behind its Social Economic Zones to establish and challenge the “five eyes” nations of the West (Australia, USA, Britain, Canada, and New Zealand) by infiltrating and asserting ownership right across the South Pacific. Chairman Xi is now entrenched as the party’s leader for life, with China reverting to the governance structure of the emperors who ruled for so many thousands of years and which, until the Industrial Revolution in Britain, gave the Chinese people at large a much higher living standard than the West.
President Trump has continued his colourful presidency, with many of his policies following economic nationalism, having an enormous impact across the world. When we consider the desire for change and an economic system that has brought vast inequity in many parts of the world, moderate political leaders we have seen through time have not brought the radical change needed. As Michael Moore correctly predicted Trump’s win in 2016, he appears to be correct in that Trump has been the “human Molotov cocktail” that has driven substantial change (for better or worse).
While I will steer clear of a critique of political policies, one cannot deny that Trump’s presidency has ignited support for both sides of the political spectrum which has forced cultural and social conversations that have been dormant for some time. We are seeing the voices of the people more openly advocated by their respective leaders who are now standing up for issues that are directly impacting the people. Time will tell whether our democratic system will allow these messages and policies to navigate through to political action and bring about the change so desperately needed.
On the domestic front, our “Morrison Miracle” saw Prime Minister Morrison smartly play a variation on the Trump election campaign, reaching out to working-class families by focusing on stability, jobs, and security. Australia has seen similar issues to those globally, with many fed up with being duped by bureaucracy, bullying by the banks and soaring energy bills, especially since we are the ‘lucky country’ blessed with an abundant supply of cheap energy. Through focusing on issues that matter to the broader public, the notable swing in Queensland (mainly mining and farming towns) turned almost entirely against Labor, consistent with trends in the rest of the world.
Declining global growth, the ongoing Brexit debacle and an escalating trade war between the US and China have been dominant in the news media. Australia, much like the rest of the world, is facing headwinds to economic growth, particularly from the flow-on effects from the US-China trade war. We have seen increased duties imposed by the US, with the trade of goods and intellectual property being central to these protectionist policies. Despite some temporary cessation of hostilities over the year, we continue to watch the global and local political milieu as we lead into 2020 and what this means for our investments.
Global Economics
After robust growth over the past few years, the International Monetary Fund (IMF) forecasts global economic growth to be 3.5% in 2020. The IMF expects that most markets will have a slight improvement in growth rates, with the US being a notable exception with growth moderating to 1.9% as fiscal stimulus unwinds. Global central banks, including our own, appear perplexed by stubbornly low inflation with many being increasingly frustrated with a lack of political action to stimulate flagging economies. In response, leaders are reaching for the only lever they have — cutting interest rates — with our own Reserve Bank of Australia (RBA) lowering the cash rate by 25 basis points in October to a new record low of 0.75%.
While Australia continued its world-beating 28 year run of economic growth, strains are beginning to appear with our economy currently growing at an annual rate of 1.7%, the slowest in a decade. Despite the IMF cutting our expected growth rates, we highlight Australia’s economy remains resilient through robust policy frameworks, strong institutions, a healthy fiscal position, and a sophisticated financial system. For us, uncertainty regarding the new year hinges upon consumption and how our unemployment rate will evolve. Tightening labour market conditions have already seen wage pressures, and we expect this to continue into 2020.
Interestingly, as the global scene continues to evolve, we are seeing early signs of a shift toward policymakers being more acutely aware of environmental, social, and economic factors. The ‘Wellbeing Economy Alliance’ is seeing some early-adopting countries shifting toward frameworks that move beyond GDP as a sole marker for economic success, which can only be a positive political development. In much the same way ESG (Environmental, Social and Governance) factors have become integral in investment markets, wellbeing indexes are a shift in the right direction for policymakers to recognise what is important to the broader public.
The Markets, Our Portfolio and ECP
Turning to the stock market, one could be forgiven for thinking that the world was not burning but rather booming. After financial markets slammed on the brakes in 2018, resulting in a decline of 3.5% in the All Ordinaries Accumulation Index, the index has climbed by c25% at the time of writing this note. Not since 2009, when the index increased by 39.6%, has the index increased by more than 20% in any one year. Within this positive environment, I am proud to share that the Morningstar survey of Australian investment managers confirms that our strategies have continued to perform exceptionally well.
Our Ex50 strategy now has a six-year track record of delivering portfolio out-performance (alpha) of 7.7% per annum as compared to the benchmark. Our All Cap strategy has delivered 4.5% alpha, which is a compound return of 12.8% per annum since its inception in 1998 versus the All Ordinaries Accumulation Index return of 8.8% per annum. Our track record places us in the top quartile of Australian Small Cap managers over 1, 3 and 5 years and our All Cap strategy has also been ranked it in the top quartile of Australian managers over 1, 3, 5 and 10 years, respectively.
While the majority of the stocks in the portfolio contributed to the outperformance of the portfolio over the market, a handful of names performed exceptionally well, which included Magellan Financial Group, Afterpay and Megaport. The biggest detractors from returns over the year included Costa Group, Hub24 Limited and Corporate Travel Management. At an aggregate level, all of our alpha was generated through stock selection, as opposed to sector selection and this is consistent with our style as a bottom-up, benchmark unaware, high conviction manager.
New Ideas
As our process aims to find high-quality businesses that we own for the very long-term, our portfolio turnover remains low. Through time we continue to have investments that we have held for over ten years, however, this doesn’t mean we aren’t always looking for new investments. This year’s IPOs have seen a relatively poor uptake, with many companies being pulled before listing. For us, we have passed on all IPOs except for two notable businesses: Carbon Revolution and Fineos Corporation.
Carbon Revolution (ASX: CBR)
Carbon Revolution is an advanced manufacturing company that develops single-piece carbon fibre wheels for OEMs. The company has developed the world’s only approved mass-manufacturing solution and has already secured leading high-performance vehicle brands such as Ferrari, Renault, and Ford. Our investment hypothesis centres around the company’s ability to continue to maintain its market leadership as an OEM supplier within the carbon-fibre automotive wheel industry.
We expect the company to manufacture and sell 75,000 wheels by FY22, with their first mega line production facility to be in place by then, adding additional 80,000-wheel production capacity to current production. We expect that by FY24 the company should be selling over 100,000 wheels p.a. with the expectation that the companies’ facilities will have the capacity for up to another 400,000 wheels within the next five years.
The company’s organisational positioning, innovative practices (including their patents, high-quality and engaged workforce) and market leadership are key drivers of their competitive advantage. The company has the potential to become the world’s leading carbon-fibre OEM supplier, with the company demonstrating clear momentum in growth in wheels, an increasing number of OEM relationships, and significant investment in automated manufacturing. For us, the management team presents us with considerable comfort given the experience, capability, and tenure of their executives.
Fineos Corporation (ASX: FCL)
Fineos was an IPO that was added to the portfolio during August. The company sells software for core systems (policy administration, billing, absence and claims management) to enterprise-grade insurers in the Life, Accident and Health insurance market. The company’s product is well-positioned as there is an increasing need for their service, with limited competitive alternatives.
Fineos is a clear product leader with no close competitor. The industry is 1% penetrated, with a +$10 billion revenue opportunity, a point of which has been reached with a limited salesforce given most of the available capital has been spent on R&D, which currently comprises 50% of their headcount. The company demonstrates a technology, innovation and organisational competitive advantage, which allows it to exploit its core competency of product differentiation, depth, and R&D leadership.
With product development mostly completed, we expect Fineos to enter the sales harvesting phase of its life cycle with a significant runway for revenue and margin expansion. We expect the current pipeline will continue to grow substantially and their $100 million revenue to double within our five-year time horizon. The company is founder-led, supported by a senior executive team that has been together for over twenty years, and we have high conviction in their ability to execute its long-term strategic vision.
Sleep Well rather than Eat Well
Investment management is more than merely generating alpha in excess of a benchmark. While that is a core part of our mandate, other very important qualitative issues are central to what we do. For example, we recognise that capital allocation is a vehicle through which to drive change. We have the opportunity to demand specific standards of corporate governance, decide whether specific social and ethical issues are acceptable and, if they are not, we vote with our feet.
For us, the integrity and credibility of any management team is a founding principle to our investment process. We need to trust that management has the best interests for all stakeholders, and we have faith that they will make sound strategic decisions and have substantial experience and capabilities in their chosen field. As custodians of our clients’ capital, we must ensure that we are doing whatever we can to preserve capital and grow it over time. We allocate capital to investments which we believe are sustainable in the long-term, and finding trustworthy, values-based management that aligns with our core values and beliefs will ensure above-average economic portfolio returns.
In cases where we feel we can add something to the conversation, we engage with the company. We have spent the better part of eighteen months engaging with one particular company in our portfolio which has been transitioning from private to public life. We are pleased to announce that due to our efforts of engaging with the company, we have managed to improve the disclosure around remuneration and corporate governance practices of the company which should hold it in good stead in the next growth phase of its life cycle.
Looking Forward
As trust remains a central theme across the world, I for one hope this shift towards trustworthiness continues. Through time, we have emphasised the importance of management in our investment process, and we applaud further developments in the trustworthiness of our leaders and the management of companies. Sustainability of investment performance or the improvement of the well-being of broader society hinges upon ethical, transparent, and honest leadership.
Our investment philosophy is based on the belief the economics of business drives long-term investment returns. The short-term financial metrics of portfolio companies, including organic sales growth, earnings and dividend growth, should provide the impetus for improvement in valuations or at least be supportive of the current valuations in the future. Our companies have strong business models with capable and experienced management teams which we expect will continue to deliver above-average returns.
While we do feel that the markets are relatively fully valued and do not see a significant improvement in the P/E ratings of the companies from current levels, our estimates and forecasts remain promising. At present, our estimates suggest the IRR for the portfolio be around 12%, which is composed of roughly 15% earnings and income growth, and 3% PE compression. As such, we have set our sights on finding a few more companies to replace those companies whose expected returns are declining.
In signing off, I’d like to firstly thank all our clients for trusting us with their savings, a task which we believe to be a privilege and, on behalf of all the staff of ECP, I wish you a very Happy Christmas and may 2020 bring good health and happiness to you and your families.
Kind regards,
Manny
The article has been prepared by ECP Asset Management Pty Ltd (ECP). ECP is a funds management firm based in Sydney, Australia. For further information, visit www.ecpam.com. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for financial advice. ECP and the analyst own shares in Commonwealth Bank of Australia. ABN 26 158 827 582, AFSL 421704, CAR 44198.