The financial year has drawn to a close, and it is remarkable to consider the current position against the outlook from 12 months ago. Thinking back to July 2020 we had witnessed an unprecedented market decline and hopeful recovery against the backdrop of a worldwide pandemic. The future prospects of the economy, at home and abroad, relied heavily on the development and rollout of vaccines and the ongoing coordinated stimulus from government and federal banks. Health officials were nervous, businesses were defensive, consumers were cautious, we braced ourselves for an unknown future.

Keep Calm and Continue On

And what happened? The world kept turning, particularly in Australia, which lived up to its title of “The lucky country”. With comparably minor interruptions from intermittent lockdowns (my sympathies to the Victorians), the Australian business environment has been positive. Job keeper and job seeker packages have helped maintain employment and targeted stimulus in housing and infrastructure have assisted key areas of the economy. The delivery of the budget in October 2020 highlighted the government’s commitment to stimulate the economy and monetary policy remains favourable for spending and growth.

In the US we witnessed the end of the Trump administration. It was always going to be a dramatic affair, but I don’t think anyone expected the civil unrest that occurred. In spite of this the Dow Jones Industrial Index was up by 39% over the past twelve months Of particular interest was the activist nature of retail investors in the US against companies that had been targeted by short-sellers. In addition, during the last 18 months, the number of individuals getting involved in the financial markets has increased dramatically however the mob-like behaviours of the WallStreetBets crowd have been a truly unique phenomenon.

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ASX All Ordinaries Movement FY 2021. Click to expand.

Throughout Europe, the control of COVID has been problematic with continued outbreaks occurring. Particularly in the first half of the financial year, the pandemic wreaked havoc on local economies while leaders of the EU and UK progressed with the Brexit deal. In the third quarter, like in much of the world, there was optimism surrounding vaccine progress and economic recovery with forecasts suggesting that the UK and Eurozone economies are on track to reach pre-pandemic levels by mid-2022.

In the Australian securities market, the ASX All Ordinaries increased by 26% over the financial year as vaccine-related news generated optimism, the Reserve Bank of Australia lowered the official interest rate to 0.1% and Biden won the US presidential election.

Twelve months ago, we forecast a substantial increase in the earnings for our portfolio companies which did occur and is in part the cause of our out-performance as compared to the market and of which we are incredibly pleased. This year’s annual performance of 40.7% adds to the since inception performance of 13.5% which is 9.0 percentage points higher than the ASX All Ordinaries over the same period of time.

Even though we are now coming off a much higher base, we expect the earnings of our portfolio companies to increase by approximately 12.5% per annum over the next five years. This provides some reassurance as we begin the new financial year where valuations (PE multiples) are stretched and which we expect are likely to contract by around 5.5% over the next five years from current levels. While it is almost certain that there will be further COVID outbreaks in the months ahead despite the vaccine program, the past year has shown how resourceful and resilient quality growth companies can be and this provides us with the confidence to face the new year and to make the most of the opportunities ahead of us and the ongoing volatility in the financial markets will provide us with welcome opportunities to deploy our capital.

Almost every sharemarket investor loves LICs. What’s not to like about a low-cost way to get allocation to the market through a quality manager….and be able to do some income planning along the way!

LICs are world-renowned for their ability to be able to pay a dividend each year. As long as they are solvent they can declare a Dividend and pass through franking the portfolio has earned plus any franking generated by it paying tax. Australians love LICs for good reasons.

Chart 1: Source IIR. April 2021 LMI Monthly Update

Australian Equity LICs after Covid-19

Now that we have gone a full year since the onset of Covid-19 we are able to review the way that many LICs have managed their dividends through a falling market followed by a sharply rising market. While most have maintained their dividends it is worth looking a little closer to ask how sustainable some of those dividends may be. While we won’t speculate how other LICs will fare going forward it is clear that FSI has a responsible Dividends policy and its payments are supported by long-term strong performance.

In the recently released March quarter LIC/LIT review by Independent Investment Research (IIR) they observed that investors should look closer to ensure that the LIC they have invested in is maintaining a stable dividends policy.

As IIR noted with an estimated (overall) 25% decrease in dividends paid by ASX companies over 2020 it was no surprise that in 1H’FY21 most equity reliant LICs paid out more in dividends than they reported as Net Profit- creating payout ratios greater than 100%, as seen in Chart 1 above. While eyebrows may raise here it should be noted that this was only a 6 month period and many LICs that have low portfolio turnover, may not have generated “book profits” to Dec 31 and some have International Exposure that generates minimal dividends.

Chart 2: Source IIR. April 2021 LMI Monthly Update: # of Years LIC can maintain current dividend levels given the latest reported retained earnings/profit reserve

Look beyond the headline yield

While the pay-out ratios are interesting, IIR noted that investors should be more interested in the sustainability of Dividends that LICs pay.

As can be seen in Chart 2, were LICs to maintain the same dividend amount, Australian Equity-focussed LICs have on average a little over 3 years of dividend coverage.

Investors in Flagship Investments can take comfort that the dividends the Board makes are responsible, sustainable, and backed by investment performance and it has more than six years of Dividend coverage.

LICs for all stages of the cycle

With the ability to always pay dividends LIC investment managers can focus on investing through the cycle and look for portfolio growth, rather than feeling pressure to generate income from their portfolio to bolster the LICs dividend reserve.

Investors who favour LICs should look beyond the headline historic yield and ensure that its performance has justified and supported the Dividend payments. They should also research how sustainable future dividends may be. While markets go up over the long run there is volatility along the way and any extended declining or even flat market may see some LICs exposed for returning capital and not providing real dividends. What could compound the futility of paying unsustainable dividends is that Boards may have depleted the investment fund size just prior to the market recovery.

LICs that are holding years of reserves will be able to ensure their shareholders continue to enjoy more steady income streams through the investment cycle and the investment manager has artillery (capital) to invest into a rising market.

Chart 4: Source Bell Potter. LIC Yield Comparisons

Setting a responsible Dividend policy

The Board of a LIC adds value by declaring the right amount of dividends. Their objective is 3-fold. First to provide shareholders with growing and reliable income streams while Secondly ensuring the strong-performing investment manager is provided with capital to deploy into the market and finally that they are not shrinking the portfolio by simply giving shareholders a dressed-up return of capital.

With this in mind, we can look at the research produced by Bell Potter LIC/ LIT analyst Hayden Nicholson to look at Yields paid by Australian Equities LICs. Readers can look across various data metrics such as Yields paid, dividend reserves, and underlying performance of a LIC to form their own opinion of whether that LICs yield (dividend) has been responsible and is sustainable through a cycle.


Chart 5: Source IIR. April 2021 LMI Monthly Update: NTA and Share Price performance

Flagship speaks from a position of Authority

Flagship Investments’ objective includes providing shareholders with continued growth in fully franked dividend income. It does this through professional, disciplined management of the investment portfolio and not charging shareholders a management fee – with the manager being remunerated only on a performance basis.

In this performance table produced by IIR, we can see that FSI is a stand-out performer in both NTA growth and Share Price return.

Chart 4: Source Bell Potter. LIC Yield Comparisons

Extending this performance to the most current Bell Potter report dated 11 June 2021, which also looks at the 10-Year performance we see extended FSI performance and outperformance.

Flagship Investments Limited (ASX: FSI) has been a strong performer since it first listed in December 2000.

The Market recognises Flagship performance

Chart 7: Source Bell Potter. LIC Yield Comparisons

In the Bell Potter LIC March quarter report respective Pre-Tax Premiums and Discounts are plotted within each LICs area of investment focus. FSI can be seen as near parity to its share price.

Chart 8: Source Bell Potter. FSI Share Price and NTA growth

Considering its long-term profit that was generated by strong portfolio performance, its outperformance to the market and peers, a constant and responsible dividend, and its record high NTA and Share Price this would be of no surprise to FSI shareholders.

Positive forward sentiment

In recent investment commentaries the investment manager of the FSI portfolio Dr Manny Pohl, AM, has continued to indicate a positive sentiment towards the markets. Articles and Interviews with Dr Pohl and the investment team can be read and watched through the Flagship website and also the Investment Manager’s website.

Shareholders can have confidence in the ability of the manager to continue its strong performance and the board to deliver rewarding and responsible dividend outcomes.

Important Note and Disclaimer
This article is provided for educational purposes only and should not be considered as financial advice. Please consult professional advice before making any investment decisions.

In the last six months, the phrase “new normal” has been used to describe the overhaul of every element of daily life. Since the world’s introduction to COVID-19 every activity that was part of our day to day life has been disrupted, cancelled or reimagined in the name of public health and safety. And as the financial year comes to a close we are left to think, is this our new way of life? Or, is there more to come?

In terms of the financial markets, the impact of COVID-19 couldn’t be more dramatic. Every major index has shown some depression point as a result of the pandemic and the ASX All Ordinaries is no exception. As shown in the graph attached, the index in the first half of the year actually reflected the expected forecasts of moderate growth without upward pressure on inflation. In December 2019 there was excitement and relief about a potential result in the US-China Trade war and a Brexit date of 31 January 2020. In the first two months of 2020, the index climbed slowly higher until the Wall St drop on 21 February precipitated the crash in the ASX All Ords. It was the ongoing spread and impact of COVID-19 that had nations and markets worried, businesses were starting to flag the impact on earnings growth, it was clear that this was going to be a major event.

ASX All Ordinaries Movement FY 2020. Click to expand.

The Advantages of Unfranked Dividends

Governments around the world stepped up to determine the best course of action, medical and safety considerations were given utmost priority and a string of social distancing restrictions were put in place. Following these restrictions were financial stimulus packages, announced by the government to soften the impact on business viability and household incomes. So while schools, shopping centres and hospitality outlets shut down, the population trialled working from home and sanitising their hands every 15 minutes.

The market reaction to the distancing measures was dramatic, with the All Ords gaining 12.5% three days after the low point on 23 March 2020. And, slowly over the quarter as COVID-19 cases reduced the All Ords has increased to close at 6001.3, 31.5% above the March low and 10.4% decrease for the 2019/2020 year. The quarterly gains provided some reassurance to investors, however if investors were simply tracking the index then they will have suffered in the short term. At the end of this volatile period the Flagship Investments’ portfolio was up 31.8% and over the financial year has increased 8.4%. This is only a short term view though, so we consider the 5 year, 10 year and since inception performance as our preferred yard-stick.

Underlying Portfolio Performance. Click to expand.

There remains plenty of uncertainty around what’s to come and therefore we expect volatility will continue. On the positive side, the stimulus measures may have been enough to keep businesses afloat such that as restrictions are released consumption and earnings can rebuild and grow back to previous levels. On the negative side, the stimulus has been likened to a Kugel Fountain, a steady flow of money that is holding up businesses and markets, but, shut off the money and watch the ball plunge back to earth with significant consequences…

Time will tell which view is right, however like most periods in history, with time, things will improve. The priority of Flagship Investments remains focusing on the long term earnings potential of our investee businesses and remembering that even during times of turmoil a high quality, sustainable business with a competitive advantage will produce superior investment returns over the long term and in that sense, the “new normal” is the same as the “old normal”.

As stage one restrictions are lifted in Australia and we feel there is light at the end of the tunnel it is interesting to observe the reactions and actions taken by the investment community over the last 3 months. Trend data suggested that retail investors had become substantially more active across the securities market. This included increased trading frequency and the number of different securities traded per day, while the duration for holding securities decreased. This activity prompted ASIC to release a public warning about the risks involved.

But, investing in the stock market doesn’t have to be risky. Knowledge and experience are strong factors to mitigate the risk. We take a moment with our Manager, Manny (EC Pohl & Co), and ask – what does a long term investment manager do when there is so much volatility in the markets and uncertainty across the globe?

Has COVID-19 impacted the investment philosophy? Did the process change at all over the last 2-3 months?
As companies and countries responded to meet the health concerns of the community we conducted a thorough assessment of our investee company’s prospects in the current climate. Our investment portfolio comprises high-quality, low capital-intensive growth companies that have a sustainable competitive advantage. During the current challenge, we made sure that the competitive advantage was still relevant, that the company had sufficient capital to survive the downturn and maintained our discipline to the process.

Essentially saying that we made sure our investments still met our investment criteria, but our criteria did not change. We don’t know how long the current situation will last, but our investee companies are still in a position to provide excellent investment returns over our 3-5 year investment horizon. We are a long term manager so the fact that there is some short-term volatility does not impact the way we assess our investments.

We’ve heard that Warren Buffett is currently sitting on a large portion of cash – have you made a similar move?
Generally, our cash levels are maintained in accordance with our investment mandate, for example, with Flagship Investments Ltd the guideline target is 5% with a maximum cash holding of 20%. Some clients are very strict in holding to the limit, which means that as investment values change, we respond appropriately adjusting the portfolio in-line with the mandate. Other clients are more flexible with the limits, which means we can manage the portfolio in accordance with the internal rates of return (IRR). This means that when the IRR decreases we start to hold more cash, which did occur from December 2019 to Feb 2020.

Given that the market has broadly decreased from the highs in February, our IRR has increased significantly and many of our high-conviction investments are cheaper than at any time in recent history. This has presented a unique buying opportunity which is implemented in accordance with our model portfolio construction.

Understanding that we are not out of the woods yet are there any learnings/observations to date from the COVID-19 experience?
We have witnessed an incredibly unique global event which has had wide-ranging impacts on all elements of society. People are thinking about health and wellbeing as a priority, our communities, our businesses, the way we work, the way we interact, the things we value have all been disrupted in some way. And, we’re seeing individuals, communities, companies and all levels of government doing the best they can to work through this period balancing short term and long term priorities. We are incredibly grateful for the hard work of all members of society in doing their part. For our part, as the Manager of Flagship Investments Ltd and as custodians of shareholder wealth we have focused on doing our best during this challenging time and producing the best portfolio returns possible.

We have remained focused on the business fundamentals, diligently implementing our proven investment process and supporting our business partners as best we can.

News about the coronavirus (COVID-19) has been as prevalent as the virus itself, the overwhelm of information (and in some cases misinformation) has had an impact throughout the country and particularly in financial markets across the globe.

At Flagship Investments Limited (FSI) we are not qualified to assess the humanitarian impact of the virus, nor can we say how long the whole situation will last. We thank the medical and scientific community for their efforts in trying to solve the problem and caring for those impacted. We also acknowledge those leaders in the world who are providing rational, clear guidance to maintain the safety of the population.

FSI through the dedication of our Manager maintains diligent observation of events and the impacts on underlying revenue, cashflows, net assets, supply chains, etc of our investee companies. Some of this analysis comes from the public updates released to the market as well as comparison data points from private businesses who operate globally and can provide comments on a number of aspects of their ongoing operations. They continue to monitor the situation as it progresses and do not believe that drastic measures are required.

FSI maintains our philosophy to be a long-term investor and that our investments over a three to five-year period will provide superior performance. With a long-term view on the current situation, one can gain valuable context of the daily movements in the market. For example, during the SARS outbreak between February 2003 and July 2003 the ASX All Ordinaries only dropped 5.35% to 2778.4 during February and by December 2003 was at 3306.0 (+19.0%). During the GFC, September 2008 to June 2009 the All Ords moved from 5209.2 to 3937.8 (-24.4%) and by December 2009 it was 4882.7 (+24.0%). We don’t know how long the current situation will last but we can be confident that with a three to five-year horizon our performance will continue to provide Shareholder value.

On this note, we highlight that our Chairman, Dominic McGann, and Managing Director, Manny Pohl, have increased their holdings in the Company and we congratulate our Shareholders who are also taking a similar long-term view and maintaining their ownership in the Company. By avoiding the noise of the crowd and staying calm and rational the value of our Company is preserved.

Perspective comes from distance and we are looking towards the future when this period will be a blip on the charts of history.

Scott Barrett
Company Secretary

Before we begin to wind down for the year, I thought I would take the opportunity to provide some thoughts on the politics at play in the world, the continued development of our business, the performance of our portfolio, its attribution and insights into two of our recent investments.

Looking back, a new world order began to emerge over the past year. China came out from behind its Social Economic Zones to establish and challenge the “five eyes” nations of the West (Australia, USA, Britain, Canada, New Zealand) infiltrating and asserting some ownership not only across the South China seas but also in the greater Polynesian Pacific nations. Its Premier, Mr Xi, is entrenched as Premier for Life, 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. As to the “Morrison Miracle”, he very smartly played a variation on the Trump election campaign, reaching out to good middle to working-class families who wanted jobs and security, who were fed up with being duded by the bureaucracy, bullied by the banks and facing soaring energy bills in a lucky country blessed with an abundant supply of cheap energy. The result was that Queensland’s blue-collar workers, many of them miners, turned almost completely against Labor, consistent with the rest of the western world where traditional belief structures and lines of authority are being questioned.

Falling global growth, the Brexit debacle and an escalating trade war between the US and China has been the dominant story on the front-pages in 2019. After President Trump and Premier Xi agreed in December 2018 to a ninety-day truce, the gloves were off in May when the US increased the duty on $200bn of imports by 25% and China retaliated by increasing the duty on $60bn worth of US goods. A truce of sorts was declared at the G-20 meeting in June, but it was merely a temporary cessation of hostilities. The good news is that the two sides have agreed to keep talking. Nevertheless, Australia, like the rest of the world, is expected to face headwinds from a slowing economy, fallout from the ongoing trade war between the US and China and escalating tensions between the US and Iran.

Global central banks, including our own, are perplexed by stubbornly low inflation and are increasingly frustrated with a lack of political action to stimulate flagging economies. In response, they are reaching for the only lever they have and cutting interest rates, with the Reserve Bank of Australia cutting the cash rate by 25 basis points in October to a new record low of 0.75%. The RBA cited concerns about the slowing economy, stagnant wages and low inflation.

After solid growth in 2017 and early 2018, the International Monetary Fund forecasts global economic growth to slow to 3.0% in 2019, its lowest level since 2008. 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 almost a decade.

Market Retrospective

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 approximately 25% 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 our strategies have continued to perform extremely well. The Ex50 strategy now has a six-year track record of delivering portfolio outperformance (alpha) of 7.7% per annum as compared to the benchmark. Our All Cap strategy has delivered 4.5% alpha, that is a compound return of 12.8% per annum since its inception in 1998 versus the All Ordinaries Accumulation Index performance 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 us ranked in the top quartile of Australian managers over 1, 3, 5 and 10 years.

While the majority of the stocks in the portfolio contributed to the outperformance of the portfolio over the market, a handful of names performed extremely well which included Magellan, Afterpay and Megaport. The biggest detractors from returns over the year included Costa, Hub24 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.

From an organisational perspective, we’ve increased our funds under management to almost $2billion and added additional support and back-office staff to ensure that we are able to deliver on all of our promises to our clients. When we founded the business, we carefully articulated our brand promise and created the necessary performance measures needed to track that promise to customers. I’m happy to say that we’ve delivered on these promises to our investors generating typically over fifteen detailed written investment reports and conducting over three hundred investment meetings over a twelve-month period.

As a custodian of other people’s money, we owe it to those who’ve invested alongside us to allocate their capital to opportunities that we believe in because we’ve done the work.

Looking externally from the portfolio there have been a number of IPOs this year. Most of the IPOs we found interesting, have been well bid and have had phenomenal share price performance as the demand for stock has far exceeded supply. It is great to see the capital markets opening up and there does seem to be a pipeline well into the new year. However, as a long-term investor with a strict investment process, we preclude ourselves from getting too caught up in the hype around most of these primary issues, even if it means leaving some short-term upside on the table in the meantime and focusing on the relative strengths of the business. The last two IPOs which we participated in were Carbon Revolution and Fineos.

Carbon Revolution (CBR)

CBR is an advanced manufacturing company that develops single-piece (Monoblock) carbon fibre wheels for OEMs. The investment hypothesis for CBR 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 will continue to build OEM relationships, develop more programs and increase its annual production of wheels. CBR is expected to manufacture and sell 75,000 wheels by FY22, with their first mega line production facility to be in place by then, adding an additional 80,000-wheel production capacity. 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 capacity for up to another 400,000 wheels within the next five years.

CBR’s Sustainable Competitive Advantage (SCA) is driven by innovation, technological, organisational, and reputational resources. The company’s organisational positioning, innovative practices, including their patents, high-quality and engaged workforce, and market leader status, all are valuable, rare, hard to copy and are non-substitutable. We expect these resources combined will deliver sustained growth for many years and the firm should be able to extract large sustained profits through time.

Fineos (FCL)

FCL was an IPO that was added to the portfolio during August. FCL sells software for core systems (policy administration, billing, absence and claims management) to enterprise-grade insurers in the Life, Accident & Health (LAH) vertical in a market with an increasing need for its product and limited competitive alternatives.

Our due diligence concluded that FCL is a clear product leader with no close competitor, 1% penetrated in a $10bn+ 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 the FCL headcount. It has a technology, innovation and organisational SCA which allows it to exploit its core competency of product differentiation, depth and R&D leadership.

With product development largely completed, Fineos is entering the sales harvesting phase of its lifecycle with a large runway for revenue & 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. Finally, the business is founder-led, supported by a senior executive team that has been together for twenty years in pursuit of its long-term 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, there are other very important qualitative issues that 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 have the best interests for all stakeholders and we have faith that they will make sound strategic decisions and have strong experience and capabilities in their chosen field. As custodians of our client’s capital, we have an obligation to 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 18 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, we have managed to improve the disclosure around remuneration and the corporate governance practices of the company which should hold it in good stead in the next growth phase of its lifecycle.

Coming back to the portfolio, we do feel that the markets are relatively fully valued and do not see a major improvement in the P/E ratings of the companies from current levels. However, the short-term financial metrics for the companies in the portfolio, including organic sales growth, earnings and dividend growth, should provide the impetus for an improvement in valuations or at least be supportive of the current valuations in the future. Looking forward to next year we estimate the IRR for the portfolio to be around 12%, which is composed of roughly 15% growth in earnings and income and a 3% P/E compression. As such we have set our sights on finding a few more companies to replace those whose expected returns are declining.

As we start the new year there are some positives to consider. We have three years before the disruption of a federal election, low-interest rates will be the norm for a while and the hunt for yield in a low-interest rate world should support local shares.

In signing off, I’d like to firstly thank all clients for trusting us with the management of their savings, a task which we believe to be a privilege, and on behalf of all the staff at ECP, I wish you a very happy Christmas and may 2020 bring good health and happiness to you and your families.


Kind regards,

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