Prime Value Opportunities (PVA0005AU) Report & Performance

The Fund gained 2.5% in July, building on gains posted in the previous month. For this calender year, the Fund is up by 6.8%. The best contributors to fund performance in July were banks, Commonwealth Bank (+5.4%) and National Australia Bank (+7.8%) and real estate listing portal REA Group (+10.1%). Global healthcare company CSL (-3.2%) and transport related company Austal (-7.2%) and transport and logistics group Kelsian Group (- 4.6%) were the largest detractors to performance during the month.

Moderating inflation numbers and robust economic growth in July saw markets give weight to a low inflation and soft economic landing outcome.

Consequently, Australian bank stocks benefitted from investor flows. This was quite the turnaround from expectations just two months earlier when the prevalent view was the best days of banks are in the rear view. We raise this point as investors are currently very short term focussed and are flipping between negative and positive views with extraordinary frequency.

We have invested in real estate listing portal REA Group for more than 10 years. Segments of the market view REA Group as a proxy to the Australian real estate listing environment. Listing volumes have no doubt been weak over the past 18 months as the RBA raised interest rates aggressively. With an impending surge in Australian immigration and possibly a peak in interest rates, property listings have started to improve in recent months.

REA Group should benefit from the cyclical improvements in listings – but that view detracts from the reasons why REA Group has been a successful investment for the Fund over the long term: REA Group has proven to be an innovator and essential services provider to both property buyers and sellers. That ability to translate services to consistent earnings growth has reduced the cyclical aspects of REA’s earnings profile leading the company to become a long-term winner for the Fund.

The Fund gained 1.9% in June, regaining most of the decline posted in the previous month. For the 2023 financial year, the Fund gained 10.0%. We continued to position the Fund in quality companies helmed by strong management teams for FY23. With inflation and interest rates moving higher through the year, the Fund benefitted from strong performances of essential services providers operating in good industry structures, including insurance broker AUB Group and bus operator Kelsian Group. Minimizing mistakes, a fundamental part of our approach to investing, also led us to exit most of the Fund’s exposure to discretionary spending in the retail and advertising sectors as we foresaw the impact of higher interest rates on the consumer.

The best contributors to fund performance in June were BHP (+7.1%), AUB Group (+16.3%) and Commonwealth Bank (+3.6%). Global healthcare company CSL (-9.5%), regional aviation company Alliance Aviation (-8.6%) and transport and logistics group Qube (-4.0%) were the largest detractors to performance.

CSL announced a rare profit downgrade relative to analysts’ expectations as the company prepared its financial budget for FY24. CSL’s share price did fall following the FY24 guidance which, while strong at +8-13% profit growth, was below the expectations of the more bullish analysts in the market. Notably the impact of COVID-19 has continued to make an impact CSL’s profit margins as donor fees have remained high compared to history. Overtime, we expect CSL to recoup margins through efficiency improvements. Regardless, in our view, the company is well placed to deliver strong earnings growth and is attractive over the medium-term.

Alliance Aviation’s share price has been weak due to the prolonged engagement with the ACCC with regards to Qantas’ proposed takeover of the company. In February, Alliance Aviation announced that it had entered into a sale and purchase agreement for an additional 30 E190 aircraft from AerCap Ireland Limited. Should all the aircraft be added to the Alliance Aviation’s operating fleet, its total fleet size will eventually reach 100 aircraft with 37 Fokker 100/70s and 63 E190s. In the short-term, carrying additional capital expenditure requirements will place pressure on the balance sheet at a time when interest rates are high and rising. However, successfully deploying these aircraft into a strong demand outlook market should result in profitable earnings growth over the next three years.

The Fund fell 2.0% in May, driven by stock-specific factors, compared to the SX300 Accumulation index’s 2.5% decline. The Fund continues to demonstrate strong downside protection in weaker markets, which we believe is a key pillar for fund outperformance over the medium to long term. Fund performance is driven by bottom-up stock selection that results in portfolio that is distinctly different to the share market index and has yielded strong downside protection.

The best contributors to fund performance in May were health insurer NIB Holdings (+9.5%), media conglomerate Newscorp (+11.3%) and transport company Kelsian (+11.5%). Larger cap companies such as BHP (-5.4%), National Australia Bank (-9.9%); and IDP Education (-22.5%) were the largest detractors to performance.

As we approach mid-year, we observe that share markets, including the ASX, have performed much better than anticipated. So far this year, economic indicators have been mixed. China’s reopening has been the source of much excitement at the start of the year. However, the pace of China’s economic recovery has been disappointing. Against this backdrop markets, have therefore shown reasonable strength, particularly in Australia. Whilst we expect economic activity to slow over the next 12 months as the lagged effect of higher interest rates comes through, this slowdown has been widely anticipated. We are of the view that Australia is well positioned: Demand for resources should remain robust with structural factors driving medium-term demand for some commodities, such as copper and nickel; and when combined with elevated population growth, Australia looks more resilient than many other markets.

Newscorp, which falls into the Valuation category of our investment thesis, reported a better-than-expected 3Q23 results during the month. Newscorp has sizable advertising-linked businesses, through Dow Jones and the Australia/UK/US News Media businesses. However, Dow Jones and News Media revenues are becoming more digital and subscription driven. We estimate subscription revenues has increased from 33% of revenues in FY11 to 60% in FY22, protecting the business from softer advertising revenues.

IDP Education fell sharply following Canadian regulators expanded the set of approved English proficiency test providers for students applying for a study permit through the Student Direct Stream (SDS). The Canadian market is a key market for IDP and one where the company had a monopoly over English language testing. We expect IDP to lose Canadian market share to new competitors, but IDP should sustain its market leading position. We believe IDP’s brand and reputation are key differentiators that sits well with the student referral infrastructure that has been built over time. IDP’s valuations have declined to a material discount to its long-term averages but the company’s prospects driven by structurally growing demand for higher education is undiminished.

The Fund rose 1.3% in April, driven by stock-specific factors, compared to the SX300 Accumulation index’s 1.9% gain. The Fund is higher by 10.2% for the financial year to date. The best contributors to fund performance in April were CSL (+4.3%), insurance broker AUB Group (+7.7%) and National Australia Bank (+4.0%). Larger cap resources companies such as BHP (- 6.0%); and Omni Bridgeway (-13.9%) were the largest detractors to performance no doubt affected by weaker sentiment towards financial institutions.

United Malt, one of the largest maltsters in North America (- 7.4%) was affected by a weak trading update, which followed a very strong share price performance in the prior month. Given the strategic value of United Malt’s assets we remain confident the takeover offer by peer Malteries Soufflet, that was announced last month, has a reasonably high probability of proceeding.

Outlook: Looking back over the past year, the portfolio has largely protected investors capital through challenging market environments in the first half of 2022 and has recovered positively since the middle of 2022. While market conditions have been volatile, dictated by top-down events including one of the most aggressive phases of interest rate increases in history, this phase is close to drawing an end as global inflationary pressures are easing.

The economic implications of higher interest rates are still unclear as it takes time for higher interest rates to work through the economy. Hence, we conclude that the market environment may still be choppy in the short term. We also believe that as economies slow, corporate earnings would be harder to come by, creating opportunities for active, fundamental investors. This favours our long term, bottom-up approach.

The Fund fell by 1.9% in March, compared to the SX300 Accumulation index’s 0.2% decline.

The Fund ended the March quarter up 2.0% and is higher by 8.9% for the financial year. The best contributors to fund performance in March were BHP (+7.5%), reversing from an exceptionally weak performance in the prior month, REA Group (+12.3%) and global malt company United Malt (+33.0%). Larger cap companies such as National Australia Bank (-7.6%) and Macquarie Group (-7.1%) were the largest detractors to performance no doubt affected by weaker sentiment towards financial institutions.

Similarly, insurance broking group AUB Group (-7.8%) was affected by the weak sentiment, which follows a very strong share price performance in the prior month. We have owned REA Group for more than 10 years in the Fund and have been investors in REA through other Prime Value funds for approximately 20 years. The on-line property advertising portal is almost like a core holding for the Fund. Over our 10 years of ownership, we have increased our ownership gradually although we reduced our weighting in REA last year as interest rates rose aggressively. Our thinking then was it would be only a matter of time before the property market started to soften. We have maintained our ownership of the company.

REA continues to account for a meaningful part of the portfolio. We believed the reasons for investing in REA remains unchanged: it’s a business with high incremental margins, low capital requirements with great flexibility to scale business. Finally, the threat of substitution is low and allows REA to price well. As for the property market, a recovery will see listing volumes improve and will be a bonus to a quality business franchise.

The Fund fell by 1.3% in February compared to the SX300 Accumulation index’s 2.6% decline—with the Fund’s consistently lower than index exposure to resources and bank stocks, the Fund’s relative to index performance in February was positive. The best contributors to fund performance in February were insurance broker AUB Group (+17.4%), QBE Limited (+9.8%) and auto parts supplier GUD Holdings (+23.3%). Larger cap companies such as BHP (-8.5%), Commonwealth Bank (-8.5%, ex dividend $2.10) and National Australia Bank (-5.6%) were the largest detractors to performance.

We have followed, but not owned, QBE for a long period of time. Past earnings have been volatile and inconsistent, and the business was difficult to understand. Following several changes in leadership and strategy over the past ten years QBE is finally demonstrating potential of a company in turnaround. QBE’s shares performed well in February following a robust FY22 results, with cash NPAT 15% ahead of consensus estimates. More importantly, the result demonstrated QBE is making considerable progress in delivering stronger and more consistent earnings. In the North American market, which presents large growth opportunities for the group, QBE had failed to execute to its potential. We believe QBE’s management has more recently be able to improve the performances of the North American business.

Auto part supplier GUD rerated strongly following its 1H23 result as the recently acquired tow bar manufacturer APG delivered a result that exceeded the market’s low expectations. APG and similar auto OEMs had been curbed by supply chain delays due to semi-conductor shortages and widespread lock downs curtailing new car production capacity across the industry. Consequently, the reduced demand for APG products and uncertainty in demand for APG products has been a headwind for GUD. We expect these headwinds to ease as new car production recovers with GUD’s core aftermarket auto parts division likely to be resilient in a slowing consumer spending environment.

Outlook: We were pleased with the performances of our portfolio companies through the February reporting period. 27.2% of companies in the portfolio had reported profits ahead of expectations, 30.9% in line with expectations and 27.1% below expectations (the balance being cash and companies that did not report this period). A key takeaway from the February reporting period is the expectation of a more challenging backdrop over 2H23. The Fund remains focussed on companies with resilient earnings, with a relatively high cash position providing good optionality.