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,