Unique Opportunities | Intensive Research | Constructive Engagement
Investing independently of consensus.
Equitable Investors is an independent investment manager focused on identifying investment opportunities and engaging constructively with the people behind them to maximise shareholder value. Its directors have over 50 years of combined professional experience in investment markets focused on micro, small and emerging companies and special opportunities.
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Equitable Investors Dragonfly Fund has the capability to "swap" shares in a company or companies for Dragonfly Fund units - where Equitable Investors finds the shares attractive and suitable investments.
If you qualify as a wholesale investor and have an orphan stock in your portfolio that you would swap for an interest in a professionally managed unit trust, please click the "Express Interest" button on our Stock Swap page and tell us more or get in touch with firstname.lastname@example.org.
The same goes if you own any of the companies we highlight in Dragonfly Fund updates and have an interest in swapping stock for fund units.
Why would you swap direct equity in a company or companies for an investment in Dragonfly Fund?
Equitable Investors is experienced at actively working with stakeholders to realise or create value that may not be recognised in the current stock price - and in maimising value from difficult situations
The time and effort required to manage the investment yourself may be too great
You may benefit from diversification into a broader portfolio of investments
You may benefit from improved liquidity
You may be in a position to crystallize capital losses for tax purposes
Of course, we recommend investors seek financial advice and taxation advice
Why would Equitable Investors want to issue units in Dragonfly Fund in return for receiving your shareholding in a company or companies?
We will only be interested in doing so if we see an opportunity to create value for the Fund's unitholders.
We may already own a specific stock and have a positive bias
We may see a new opportunity
Equitable Investors invests independently of consensus and that means we look beyond the prevailing market sentiment
On the other hand, we may think the market is correctly down-beat; or that the market is excessively optimistic in its pricing of a stock; or that the stock in question will not fit within our porfolio construction parameters - in which case we will respectfully decline.
(adapted from the Dragonfly Fund Quarterly Update - March 2020)
So far in April, equities have recovered some ground. Dragonfly Fund has benefited - but maintains holdings in “short” ETFs that have helped over the past two months. We see ahead a wall of difficult earnings results in the US and then later Australia and a period of global economic difficulty regardless of how well the health situation unfolds from here. We hope we are wrong but a “V” shaped recovery for the global economy and corporate earnings doesn’t seem realistic to us. It will take time. Nobody knows exactly when things will return to “normal”.
At the macroeconomic level, a Roy Morgan survey estimated Australia’s unemployment rate had risen to 16.8% by the end of March and the ABS identified an 8% decline in adults working paid hours - yet the IMF came out with a revised projection that unemployment would be 7.6% this year - we hope they are right but wouldn’t bet on it.
At the corporate earnings level, in early April analysts had not really taken a knife to their estimates. Our analysis of the aggregate numbers UBS publishes each day showed that in early April 2020 they were expecting earnings per share for the S&P/ASX All Ordinaries Index to actually be higher in 2022 than when they published an estimate three months earlier! In subsequent weeks those estimates have been revised further but it remains to be seen whether deeper downgrades will be required.
We are using the UBS numbers as a proxy for the broader market’s approach and not to single them out. All these projections are dependent on assumptions around the “known unknown” of the timing of a full recovery from the “unknown unknown”, COVID-19. Rather than back the broad performance of the market in this environment.
We see this environment as one suited to opportunistic investment in a concentrated portfolio of businesses and not to passive, diversified holdings - and we are on the hunt.
Sell-side research slow to react to circumstances - a comparison of past and present estimates (from UBS)
Five Year Returns
(adapted from the Dragonfly Fund Quarterly Update - December 2019)
Stock performance is rarely linear with ebbs and flows through time. Equitable Investors is focused on the medium-to-longer term window and while very conscious of managing volatility, fully expects there to be good and bad interim windows for investment performance.
We are fans of the question posed by quantitative investor Wesley Gray, PhD, author of Quantitative Value, several years ago: “If God is omnipotent, could he create a long-term active investment strategy fund that was so good that he could never get fired?” The answer was that God would get fired. Not because God would be a bad investor, of course, but because picking the investments that would deliver top decile (top 10%) returns over five years then sitting back and waiting would mean that God’s clients would have to hold their nerve in the interim period when the “perfect foresight” portfolio suffers drawdowns of as much as 76%.
Equitable Investors has maintained an interest in the distribution of returns across the equity market over time and take such historical evidence into account when assessing the probabilities of success or failure for investments in Dragonfly Fund. We have updated our analysis of five year total returns on the ASX through to mid-January 2020 and the figures can be summarised as follows (using data from Sentieo) and in Figure 7 (below):
Positive skew | across 476 stocks stocks with the required data (excluding resources, REITS, biotech), 63% delivered a positive return over five years v 37% declining in value
Cost of equity | the average annual return was 7.0% (the median was 6.8%); given a five year risk-free rate of 2.03% in January 2015, this implies a 5% equity risk premium, as we would expect - this is precisely in-line with the Dragonfly Fund’s performance benchmark of the five year bond rate + 5%!
“Fat tails” | 19% of stocks returned at least 100% while 21% lost at least half their value
Drawdowns | stocks in the top decile of returns for the period had an average decline in value (using monthly price data) of 33% (see Figure 8, below)
MedAdvisor - One of Few
(adapted from the Dragonfly Fund Monthly Update - October 2019)
Few companies of this size (and valuation!) have had as much positive news flow as MedAdvisor (MDR) in the past few months. MDR is a core holding of the Equitable Investors Dragonfly Fund.
During October, MDR raised $17m in a placement of shares anchored by an $A11m investment by Nasdaq-listed healthcare analytics and technology business HMS Holdings Corp (HMSY; $US3 billion market cap). After this deal, HMS has become the largest shareholder with ~13% of issued shares, sitting alongside existing strategic investors EBOS Group and Sigma (two of the three key drug distributors in Australia).
The placement was priced at $0.05 a share, an 11% premium to the previous closing price - representing the second time in a row that MDR has executed a placement to a strategic shareholder at a premium to the market price.
Placing stock at a premium to market rarely occurs.
Since then MDR has announced:
● a $5m, three year agreement with Chemist Warehouse, the largest pharmacy retailer by revenue in Australia, under which its 450+ pharmacies will install MDR's PlusOne subscription software
● a new >$2m, two year agreement with leading Australian pharmaceutical distribution group Sigma (ASX code: SIG, already a shareholder in MDR)
● its first international revenue - from Day Lewis Pharmacy in the UK
● the signing of its first top 10 global pharma as a Health Programs customer in the US
● September quarter revenue growth of 18.8% year-on-year
● an expansion of its Australian offering to encompass delivery (when a consumer orders drugs on the app, MDR can now facilitate delivery of the drug from the pharmacy in conjunction with a transport partner)
MDR now has a market cap of ~$88m. For that valuation you have:
● a balance sheet that held $2.3m of cash at the end of the September quarter and has since added $17m of new capital
● $8.2m operating revenue in FY19 at high gross margins of 88% and sourced 60% from subscriptions (SaaS)
● core Austraslian business that delivered >$2.5m EBITDA in FY19
● a business with quality partners primed to ramp up revenue in North America, UK and Asia.
(adapted from the Dragonfly Fund Quarterly Update - September 2019)
Equitable Investors Dragonfly Fund returned 4.19% after fees in the month of September 2019 - and 1.30% for the quarter.
Education recruitment platform provider Schrole Group (SCL) was one of the key contributors to the quarterly performance.
SCL’s cloud-based subscription services allow schools to filter a database of teachers and conduct background verification. Its focus has been on international schools but it is now expanding its reach into Australian secondary schools. Importantly, founders/management are significant shareholders.
Dragonfly Fund began looking at SCL in January 2019 and started buying SCL in May 2019 via a placement that provided it with the capital to support it through to a sustainable cash-generative position (even though it did generate positive operating cash flow in the March quarter ahead of that placement, seasonality meant that the low-point in the June quarter featured a cash outflow). Since then, SCL conducted another share placement in response to demand from institutions to buy in. The stock price has roughly doubled from the initial placement price.
SCL has reported 33% year-on-year revenue growth to $2.3m for the September quarter and says its Annual Recurring Revenue (ARR) from software licences has jumped 58% to $4.5m. A fully diluted market cap of ~$20m (factoring in all performance shares) represents a multiple of 4.4x ARR and we are hopeful that ARR growth will continue to ramp as the current quarter (September to December) is the peak recruitment period.
(from our blog - blog.equitableinvestors.com.au)
Australian investors have done well out of sleep with ResMed’s market cap multiplying nearly 19x since 2002. Equitable Investors Dragonfly Fund’s best performed investment (at the time this was written), Rhinomed (RNO), has a different angle on sleep. So does a newer investment for the Fund, Oventus Medical (OVN). Both were contributors to the Fund’s positive performance in July.
RNO has a consumable nasal insert sold as a solution for mild sleep apnea but is also now emerging as a drug delivery platform. During July, RNO (a) released data showing its “Mute” nasal insert is the fastest growing product in its category in US drugstores; (b) received a CE Mark registering its “Pronto” nasal insert that releases vapour (essential oils) for Europe (having already received US FDA and Australian TGA approval); and (c) released its June quarter cashflow showing cash receipts up 150% year-on-year to $1.5m. As Figure 1 below shows, RNO has emerged as a rapidly growing product in US drug stores.
While RNO’s consumable device dilates the nose, OVN’s mouth insert acts like a “second nose”. In July, the Fund also participated in a capital raising for OVN. In its pitch, OVN set out the scope of its target market: 12% of US adults suffer from obstructive sleep apnoea (OSA, the most common type of sleep apnoea); that includes 6m adult patients in the US who are prescribed CPAP alone (CPAP devices such as those produced by ResMed pump air into a mask worn while sleeping) - of which 50-60% quit CPAP. So OVN sees 3m adults in the US requiring an alternative treatment that is more easily adhered to.
OVN has historically struggled finding a path to market due to the dominance and profitability of CPAP. But OVN has now established a US strategy that positions its device as more profitable and it is now signing up North American sleep centres.
Figure 1: US Drug Store “Nasal Strip” market - 12 months to April 21, 2019
"The probability of a stock going up or down"
"What is the probability of a stock's price going up vs going down at any given time?"
The answer depends on how you are looking at this:
(i) if you are looking purely at the very next second with no additional information, there are three ways the stock could go: up, down or flat (no change).
(ii) if you are looking at buying a stock at any given point in time but then holding it for a period of time, historical data starts to indicate that the odds favour up over down.
A while back we ran some stats on the domestic equities market (Australia). We found that 64% of industrial stocks (a broad category that excludes resources plays but includes most other sectors including tech and financials, achieved a positive return in the five years to May 20, 2018. The first chart accompanying this text sets out the distribution of returns.
But that is just one time period in time. Using US data, alpha architect ran a more detailed study that you can read here.
If you look at market returns rather than individual stock returns, famed academics Fama and French have written a paper, “Long-Horizon Returns” and they found the distribution of continuously compounded (CC) returns for US equities “are close to, but not quite normal for return horizons of ten years or more”. The accompanying table, from that paper, shows CC returns have a positive mean over all periods from one month to 30 years.
And the next chart is also taken from that Fama and French paper, plotting out monthly US equity market returns.
"Forget EPS accretion and focus on value!"
(from blog.equitableinvestors.com.au, June 2019)
We happened upon a copy of Credit Suisse's "To Buy or Not To Buy" - 26 pages on M&A - a couple of years after it was published (Feb 2017) but found it compelling - particularly in relation to EPS accretion.
Three quarters of investor relations professionals surveyed by AT Kearney said stakeholders place a “strong emphasis” EPS accretion or dilution - and that EPS accretion or dilution was deemed to be, by far, the most important metric.
Most announced M&A deals today are accretive to the EPS of the buying company.
But EPS accretion or dilution actually provides little or no insight because value creation is based on cash flows rather than accounting measures - and the cost of capital rather than the funding source.
Credit Suisse took a sample of 95 of the M&A deals, categorised them based on whether the company said it would be immediately accretive or dilutive to EPS, then reviewed the one-day abnormal return for the buyer on the day of the announcement .
The accompanying table shows that:
Roughly three-fourths of the deals had a neutral or negative impact on shareholder value.
The bottom row reveals that 27 percent of the deals in this sample created shareholder value.
The box in the upper right corner shows that almost half of the deals add to EPS but subtract from value!
(an adaptation from our Dragonfly Fund update for the month of January 2019)
At the time of writing this, mid-February, Australia's half-year profit reporting season is upon us. The months of February and August are always a little volatile for investors of ASX-listed companies and there is the capacity for significant swings in individual stock prices - should their financial results include any surprises. We have had a number of companies in the portfolio to date report without surprise. We would like to think there is scope for some positive surprises before the month is out but we’ll have to bide our time and see.
Leading into reporting season, our data shows that sell-side (broker) forecasts for EPS (earnings per share) in FY19 declined 1.5% on average (or 1.2% using the weighted average) across the ASX in January. We’ll discuss this in detail - and its relevance to long term value.
We made comment in each of the past two reports that earnings expectations were looking like they were sliding ahead of the half-year profit reporting season that occurs in February. Our data now shows that over the course of December and January, analysts cut their FY19 EPS forecasts by 2.8% on average, including a 3.2% average trim for IT stocks, 4.2% for Financials and almost 18% for the Energy sector. The one classification to experience a slight increase in average EPS forecasts was - you guessed it - “Other”.
This matters for two reasons: (1) our read on market behaviour over the past year or so has been that any negative surprises have been treated as triggers to sell-out at almost any price, causing short-term ructions; and (2) the more rational response is for investors to update their view on the medium to long-term value of an investment when they receive new information and that information may, for example, indicate the gross margins are trending lower than expected, which means that if this trend is assumed to continue, the “present value of future cash flows” expected from the business will be reduced.
A great book focused on this subject in relation to investment management, “ Expectations Investing: Reading Stock Prices for Better Returns ”, by Rappaport and Mauboussin, explores this topic in detail. Some relevant quotes include:
➔ “Investors make short-term bets on long-term outcomes… most companies need over ten years of value-creating cash flows to justify their stock price.”
➔ “Investors must separate companies that genuinely achieve better-than-expected operating performance from those that skilfully manage expectations and earnings.”
➔ “Two or three key leading indicators typically account for a substantial percentage of the variability in the turbo trigger [the value trigger likely to have the greatest impact on shareholder value].”
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