Contact Australian Ex-50 (EVO4741AU) Report & Performance

The Contact Australian Ex-50 Fund gained 4.9% in July. This was a pleasing performance against both the S&P/ASX Small Ordinaries Index (+3.6%) and the S&P/ASX Mid-cap 50 Accumulation Index (+4.4%). The Fund has performed particularly well over the past six months as many quality businesses have reiterated or increased their earnings guidance. We believe that we are in a stock pickers market and that a focus on quality companies remains the most sensible strategy.Global markets moved higher across the board in July. The consensus view now seems to expect that we are very close to the peak in interest rates. Indeed, we may already be there given the moderation in the rate of growth in inflation. The Reserve Bank of Australia seems eager to take a “wait and see” approach in the near term and monitor consumer behaviour and the unemployment rate.

We added Redox Limited (RDX) to the portfolio in early July as the company listed on the ASX. Redox is a traditional Industrial company – it is a leading supplier of chemicals, ingredients and raw materials to a myriad of industries. It was established in 1965 and is still managed by the founding Coneliano family, which owns 46% of the listed company. RDX generates a high proportion of recurring revenue, strong returns on capital and has significant growth opportunities via market share gains. Over time, we expect RDX to generate steady EPS growth and offer a compelling dividend yield. The IPO was priced just under 14x P/E multiple, which we considered attractive.

We wrote about Flight Centre (FLT) last month and the stock was a standout performer in July, increasing by 23%. The company increased its profit guidance for FY23 by approximately 10% at the EBITDA level. Founder and managing Director, Graham Turner said: “Overall, we are pleased with our continued recover as demand has generally rebounded solidly across both our leisure and corporate travel businesses.”

Alliance Aviation Limited (AQZ) also generated strong returns in July following an increase in its profit outlook, which surpassed market expectations. The AQZ announcement suggests that earnings will be almost 15% better than expected. It also disclosed the acquisition of four additional E190 aircraft to satisfy increasing demand. The secondhalf profit upgrade indicates increased wet lease flight hours from additional capacity and higher utilisation. AQZ has invested heavily in expanding its fleet in recent years. As demand increases, we believe that the company is well positioned to drive solid earnings growth. There is also corporate activity bubbling away in the background, with a potential takeover by Qantas. The ACCC has expressed concern on competition grounds, however if the deal does progress, there is likely to be a material AQZ share price increase based on the current bid of $4.75.

GQG Partners (MTS) also delivered a strong update regarding both its Funds Under Management growth and investment performance. Unlike many peers, GQG continues to generate solid net inflows, yet it is being priced by the market as a business in decline. We remain positive on the outlook for GQG and are backing the founder-led management team.

The Australian market (as measured by the S&P/ASX 300 Accumulation Index) increased by 1.7% in June. As has been the case for some time, large caps outperformed small caps. The S&P/ASX 20 increased by 2.3%. The S&P/ASX Small Ordinaries Index was flat. By comparison, the Fund delivered a pleasing 3.0% return for the month.

Given the barrage of negative commentary over the past twelve months, some readers will be surprised by the returns generated by equities markets over fiscal 2023. Notwithstanding an environment of high inflation, a war in Ukraine, wage pressures, slowing earnings growth and unprecedented pace of interest rate rises, the market pushed higher. Quite a bit higher. The S&P/ASX 300 Accumulation Index generated a very robust 14.4% return for the year, yet the Small Ordinaries lagged, delivering 8.4%. The Fund return was 9.4%. The past six months was particularly solid, with a 5.5% return for the Fund against the S&P/ASX Small Ordinaries (+1.3%) and the S&P/ASX Midcap 50 Index (+4.6%). We put this down to a focus on Quality and Valuation.

Metcash Limited (MTS) delivered a solid FY23 result that was ahead of expectations. All pillars (Food, Liquor and Hardware) continued to perform well, with a notably strong performance from the Total Tools business. Revenue increased almost 6% and EBIT up 8% to record levels. The Result Presentation and subsequent Management meeting highlighted the gains that have been made by MTS over the past three years. MTS is now a larger, more diversified and stronger business, which has grown EBIT by 50% (aided by Hardware M&A). Underlying EPS has increased by >40% and Group ROFE exceeds 30%. As we’ve been saying for some time, we find it difficult to comprehend why MTS continues to trade at such a stark PE multiple discount to Coles, Woolworths and Wesfarmers. MTS remains one of our highest conviction positions in the portfolio.

The Australian market declined in May, with the All Ordinaries down 2.6%. The Fund declined by 2.0% during the month, lagging the S&P/ASX Midcap 50 Index, which was flat, yet outperforming the Small Ordinaries Index, which declined 3.3%. IT was the best sector in May, which has been rising with US technology names. Consumer Discretionary lagged the market on the back of trading updates from many retailers that signalled a weakening in consumer spending.

Consumer names were not helped by the RBA, which increased rates by 25 bps in early May, catching the market offguard. Inflation has persisted throughout the month and at the time of writing, the RBA has increased rates yet again in early June to a decade high 4.10%. Lithium stock Allkem Limited (AKE) increased by 21% in May as it agreed to an all stock merger of equals with US Livent Corporation. A large rationale for the merger is synergies. Both companies have brine operations in Argentina and spodumene projects in Quebec. Following the significant jump in the share price, we took the opportunity to take some profits in AKE.

Our investment case was tied to the growth in the Lithium market that was underpinned by AKE’s strong Balance Sheet and cash flow generation. While those characteristics persist, we thought it appropriate to reduce exposure into recent strength. We still have almost 3% of the portfolio in the stock. We also reduced our holding in IGO Limited following a similarly strong run, which sees the stock trade above our valuation.

Equity market managed to eke out gains in April. It was a month of mixed signals. The US quarterly earnings season is generating better than expected results and the Chinese reopening continues to gain momentum. On the other hand, segments of the US regional banking system are fragile and inflation remains stubbornly high across the globe. Most developed equity markets closed the month higher, led by India (+4.2%) and the FTSE (+3.4%). The S&P500 increased by 1.4%.

The Australian market performed relatively well, rising 1.8% for the month (based on the S&P/ASX 300 Accumulation Index). Small and mid-cap Australian shares outperformed their larger counterparts. The Small Ordinaries Accumulation Index increased by 2.8%. By comparison, the Fund increased by 2.2% in March.

Despite initial fears following the March disclosure of a cyber security incident. IPH Limited (IPH) was one of the best performers in April, increasing by 10%. An update from management highlighted a relative immaterial impact to date and that revenue would likely be deferred, not lost. IPH is a leading intellectual property services firm, dealing with patents and trademarks. In Australia, it has a 35% market share. IPH has global growth opportunities. It is a defensive business with a high proportion of recurring revenue and strong cash flow generation. We added to the position recently and remain optimistic on the company.

We are frustrated with the ACCC announcement that it would oppose Qantas’ acquisition of Alliance Aviation Services (AQZ) on competition grounds. Qantas announced that it intends to seek more information from the ACCC regarding the decision, requesting a meeting with the ACCC. Qantas remains adamant that the acquisition would not substantially lessen competition in any market and noted that its competitor Rex’s acquisition of National Jet Express from Cobham Aviation was unopposed, receiving ACCC clearance in 11 days. As a reminder, in May 2022, Qantas proposed a scheme of arrangement to fully acquire the remaining 80% of AQZ at $4.75/share. AQZ closed April at $3.10.

Bank of Queensland (BOQ) delivered a soft interim result that highlighted the intensifying competition in the Australian Banking Industry for both mortgages and deposits. Pressure on net interest margin has intensified. While BOQ is only a small position for the Fund, we intend to be patient for now given the discount to book value that the shares are currently trading at. The ME Bank acquisition is integrating well and should deliver on synergies. Chairman-come-CEO Patrick Allaway is eager to reduce the cost base. We expect to see any sign of good news result in a material re-rating of the stock. With mixed signals from a macroeconomic perspective, we believe that this is a stock pickers market and an environment we thrive in – one where fundamentals and quality matters.

We started to see a mean reversion in small stocks versus large stocks in April and believe this could continue given the extent of dispersion over the past two years. The Fund remains invested in high quality companies that are profitable, generate solid returns and offer an income stream. At a P/E multiple of just 12.6x, we believe that there is inherent value available.

The Fund retracted slightly in March in a more volatile Equities market. At a macro level, the failure of several US regional banks weighed on sentiment early in the month before the US Fed provided liquidity support. As fears of contagion of a run on the banks subsided, investors focused on the likely change in policy action by Central Banks. We witnessed the start of a change in behaviour in early April as the RBA paused on its rate hiking.

The Fund declined by 2.6% in March, which was broadly in line with the S&P/ASX Mid-cap 50 Accumulation Index.

After a busy February reporting season, there was less stock specific news in March. Of note for the Fund, Kelsian Limited (KLS) announced the acquisition of All Aboard America! Holdings, a US based bus business providing contract and charter coach passenger services. The purchase price of almost A$500 million will be funded through a combination of debt and equity. We took up our rights under the nonRenounceable rights issue at $5.55.

The transaction opens the door for significant growth in the US for Kelsian. AAAH is the 4th largest motorcoach operator in the US with 1,069 vehicles. For reference, KLS Australian bus segments has ~3,000 buses. The US market is large (over $30 billion) but very fragmented. The business has a high degree of recurring revenue and solid EBITDA margins of 25%. The majority of the management team (including the founders) will remain with the business.

The Fund performed well versus the Australian market as investors focused on fundamentals during the February Reporting Season. Quality prevailed. While the Ex-50 Fund declined by 0.7% in a very volatile month, it was pleasing to see significant outperformance of both the S&P/ASX Small Ordinaries Accumulation Index (down 3.7%) and the S&P/ASX Midcap 50 Accumulation Index (down 3.2%). Reporting Season is always an interesting time for bottom-up stock pickers such as Contact Asset Management. Our investment approach involves a robust process whereby we analyse the individual qualitative and quantitative characteristics of companies. At a high level, we noted consistent themes from company results: tight labour supply, rising interest expense, a cautious consumer and ongoing inflation. Top line momentum was strong; however, this was primarily driven by pricing increases rather than volume growth.

Companies with limited pricing power were treated harshly by the market.Despite the cautious tone that has set into market sentiment, there were several pleasing results that give us cause for optimism. After enduring challenging operating conditions over the past two years, Smartgroup Corporation’s (SIQ) operating momentum is improving. Novated leasing leads have been buoyantwhile supply chain pressures on vehicle availability are only just beginning to abate. As the environment normalises, we expect sales to improve (as orders are converted) and costs to drop (as redundant service expenses are removed ) at a better-than-expected trajectory. Growth in EVs is an unappreciated additional boost to activity as are benefits from the recent investment in digital platforms. SIQ has a strong Balance Sheet with near zero debt forecast.

The better-than-expected dividend highlights management’s confidence in the outlook. A forward-looking P/E of 11-12 times suggests excellent value in Contact’s opinion. As noted last month, both Hub24 (HUB) and Netwealth (NWL) are beneficiaries of rising interest rates, which lifted margins on cash balances. Market share gains from the incumbents continues. We added Flight Centre (FLT) to the portfolio recently. Strong momentum is emerging in the corporate business, which now accounts for over 50% of earnings. Leisure is also recovering, yet still has upside with Australian arrivals at c70% pre-Covid levels. The resumption of Chinese tourismwill help drive growth. FLT’s Balance Sheet is in a sound position following the recent raising.

We expect this founder-led business to return to dividend payments next financial year. Kelsian Group (KLS) was another investment that delivered a pleasing result. The earnings stream from the buses business is particularly resilient and has inflation protection mechanisms in place, which are valuable in the current climate. Similar to FLT, KLS noted strong forward bookings in Marine & Tourism, with scope for further price increases. We continue to believe that the Portfolio is well positioned, with attractive Fund metrics offering an enviable combination of Quality, Value and Growth. We seek to deliver a long-term return of 10% p.a. through a disciplined investment process that avoids unprofitable and high-risk companies.