Prime Value Emerging Opportunities Fund (PVA0013AU) Report & Performance

The fund returned +2.9% in July, -0.6% below the Small Ordinaries Accumulation Index return of +3.5%. Key fund contributors over the month were Lindsay Australia (LAU +18.4%), SG Fleet (SGF +13.9%) and Credit Corp (CCP +19.2%). Key detractors were Kelsian (KLS -4.5%), Austal (ASB -7.2%), and AUB Group (AUB -2.4%).

July continued the strong recovery in the Small Ordinaries Accumulation Index which has risen 12.8% from September 2022 lows, reflecting a recovery of 40% of the fall from peak levels in December 2021.

As we mentioned last month, very few investors expected such strong market returns highlighting that short term returns are hard to predict and long-term investing is best.

We highlight this via a couple of twenty-year charts, the first of which shows the monthly returns of the Small Ordinaries Accumulation Index since July 2003, which appears relatively volatile and lacking direction.

The fund returned +2.9% in June, 2.9% above the Small Ordinaries Accumulation Index return of 0.0%. June concluded the financial year and returns were strong for both the market (Small Ords Accum +8.5%) and the fund (+13.7%).

Very few expected such strong market returns highlighting that short term returns are hard to predict and long-term investing is best. There are good years and bad years but over the long term, returns are very strong. By being invested, unit holders have benefitted from a +13.7% year when many other asset values declined.

The fund has performed well in recent years consistently generating returns above the market (table below) through highly variable conditions that have tested investor styles and biases. Markets have experienced bull/bear markets, rising/falling interest rates, strong/weak economic growth, tech boom/bust and covid. The fund’s risk is also well below market as measured by volatility of returns (table below). Higher returns and lower risk is our ongoing aim.

The fund returned +0.4% in May, which was 3.6% ahead of the Small Ordinaries Accumulation Index return of ‐3.3%, and 2.1% ahead of the Small Industrials Accumulation Index which fell ‐1.7%.

The month was characterised by strong returns from Technology and Lithium stocks, and weak performances from the broader Resources and Retail sectors, with the Small Resources Accumulation index ‐7.1%.

Local Technology stocks appeared to rally following a material profit upgrade from US‐listed Artificial Intelligence beneficiary, NVIDIA. Conversely, softer Chinese economic data saw Resource stocks sold off, while Retail stocks were hit by signs that consumer demand is softening. Key fund contributors in May were Kelsian (KLS +11.5%), Newscorp (NWS +11.3%) and Austal (ASB +19.0%). Key detractors were AUB Group (AUB ‐8.0%), Helloworld (HLO ‐10.6%) and EQT Holdings (EQT ‐3.7%).

Kelsian (KLS) rose on limited new news, and has steadily become one of the fund’s largest holdings. For us, it is a reminder of the importance of investing in quality businesses at the right price. For a long time, we have been attracted to Kelsian’s resilient public bus business model, that sees it generate inflation‐protected cash flows with no fare box risk from long‐ term contracts with government counterparties, and without material capital investment in key infrastructure in some regions. However, we were not alone in appreciating these qualities, with investors pushing the stock beyond our valuation tolerance levels to >$9ps for much of 2021 following a series of contract wins and renewals. But no‐one has a perfect win rate, and shortly thereafter, the company’s extraordinary winning streak came to an end as it missed out on several tender opportunities.

This saw investors lose faith and push the stock down into our hitting zone, resulting in our initial purchase in Jan 2022 at c. $6.50ps. Further ‘disappointments’ from the failed attempt to acquire a large UK bus operator saw the stock fall lower, providing the opportunity to add 25% to the fund’s holding below $6ps in Sept 2022, and a further 25% addition below $5ps in Oct 2022. Through this time that the stock halved in price, nothing had changed with regards to its business model or operating performance; investors had simply fallen out of love. And just as a perfect hitrate is unobtainable, a perfect lossrate issustained by few, and Kelsian has since enjoyed more than its market share worth of new wins through the NSW Government’s recent tender process, resulting in a ~50% share price rise since (to $6.80ps). Our most recent opportunity to add to the position came in Mar 2023, participating in an equity raise (at $5.55ps) as the company acquired a large US bus business with an experienced management team and an impressive organic growth profile.

The key in this case study is the importance of the entry price of an investment; it is a key component of the returns ultimately generated. It will surprise many to learn that the share price of the median company in the Small Ordinaries index is trading 22% below its 52‐week high, while also trading 29% above its 52‐week low – that is, the median company has traded in a >50% share price range over the past year.

The fund returned +3.4% in April, 0.6% above the Small Ordinaries Accumulation Index of +2.8%. April was the 5-year anniversary of the fund being managed by at least one of the current team. Over that time investment returns have been strong (+11.6% p.a. v’s Small Ords Accum +3.9%/Small Industrials Accum +3.0%) and consistent (outperformed both indices every year). In our view, more important is the way in which those returns have been achieved.

The fund consistently ranks as one of the lowest risk in its smallcap peer group (measured by volatility of returns). We value more certain returns over potentially high returns with high risk. Investment returns are prominently disclosed and highly visible for most funds but risk is often overlooked, particularly in the small cap space. It is a key part of our investment process.

Over the last 3 years the fund’s risk measured by volatility of returns (standard deviation) is 16.4% which is circa 20% below the Small Ords Index and its peer group. Capital preservation is reflected in the fund’s performance in down-markets with it outperforming the Small Ords 81% of months when the index return was negative.

The fund returned -0.8% in March, broadly in line with the Small Ordinaries Accumulation Index of -0.7%, but was +2.2% ahead of the Small Industrials Accumulation Index which fell -3.0%.

The month was characterised by a strong Resources sector (+5.6%), with Resource companies representing 15 of the top 20 performing stocks for the month, driven by a +7.8% rise in the Gold price as a flight to safety response to the global banking crisis.

It was also interesting to see a resumption of corporate activity in the form of M&A and capital raisings, with bids made for Invocare (private equity bidder), Estia Health (private equity bidder), Healius (trade buyer) and United Malt (trade buyer).

The fund was a beneficiary of the latter transaction, as French competitor Malteries Soufflet lodged a nonbinding and indicative proposal for UMG for $5.00ps in cash. The United Malt Board has indicated that it is supportive of a binding offer of at least this amount, should one eventuate.

Key fund contributors in March were United Malt (UMG +33.1%), Regis Healthcare (REG +23.9%) and Lindsay Australia (LAU +17.5%). Key detractors were Bravura (BVS -41.6%), AUB Group (AUB -7.8%) and Kelsian (KLS -9.6%).

The fund’s return was +0.2% in February, 3.9% above the Small Ordinaries Accumulation Index of -3.7%.

The fund’s strong relative performance in February (+3.9%) followed relative underperformance (-3.0%) in January. Returns were positive in both months and it feels like the fund is steadily moving upward while the market is bouncing around it as risk appetite ebbs and flows. The fund has delivered a positive return in 6 of the 8 months this financial year (index 4 of 8) despite fears of inflation and rising interest rates.

We continue to hold a portfolio of stocks which individually are high quality, all are profitable and most we consider structurally growing with less dependence on the economic cycle. The equity we own in this group of companies should grow in value over coming years and provide a reasonable dividend stream along the way. Less certain is market sentiment and how this value is reflected in stock prices in the short term. We hold stocks for an average of 4 years which reflects our belief in the power of compounding wealth through the patient ownership of quality assets that grow in value over time.

With February marking the 3 year anniversary of markets first being impacted by covid, it is interesting to look back at asset returns over this time. Most asset prices are higher, benefitting from significant monetary and fiscal stimulus e.g. large cap equities, commodities, residential property and even bitcoin, used cars, wine & watches. With this stimulus being withdrawn over the last 12 months, many assets have been falling in value. One asset class that is already below its pre-covid high is small industrial equities, in which the Emerging Opportunities Fund specialises. It appears reasonable to draw the conclusion that this asset has already deflated and there are attractive opportunities available. This is reflected in valuations with small industrial valuations at 20 year lows relative to large industrials.

In small cap equities there are 2 main sectors; Small Resources (mining companies) and Small Industrials (non-mining companies). Relative to pre-covid (Feb ’20), the Small Resources Accumulation index is +40%, while the Small Industrials Accumulation is -8%. As the Emerging Opportunities Fund does not invest in mining, this has been a significant headwind to relative performance over the last 3 years. Despite this the fund has outperformed the index which combines both sectors (Small Ordinaries Accumulation) by 6% p.a. (after fees) over 3 years. When markets turn and small industrials come back into favour, we believe the fund is well positioned to deliver strong returns.

At the stock level there are many opportunities that highlight the value on offer. One of the largest holdings in the fund is EQT Holdings, a trustee business founded in 1888. It is a high quality, resilient business with a diverse, growing customer base that we expect to grow for decades to come. EQT’s earnings per share is expected to be 50% higher in FY25 than in FY19 yet the stock price is currently 20% lower than 2019. At some point this value creation will be reflected in a significantly higher stock price and the fund will benefit. Good things come to those who wait…