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.

Global Political Landscape

Looking back, a new world order began to emerge over the past year.
  • China’s Positioning: China has come out from behind its Social Economic Zones to challenge the “Five Eyes” nations of the West (Australia, USA, Britain, Canada, New Zealand), asserting ownership not only across the South China Seas but also in the greater Polynesian Pacific nations.
  • Leadership Dynamics: Premier Xi is entrenched as Premier for Life, with China reverting to a governance structure reminiscent of its historical emperors, which once provided a higher living standard than the West.

The “Morrison Miracle”

Scott Morrison smartly adapted elements of the Trump election campaign, reaching out to middle- and working-class families seeking jobs and security. This resonated particularly with Queensland’s blue-collar workers, many of whom turned against Labor, reflecting a broader global trend of questioning traditional belief structures and authority.

Economic Challenges

Falling global growth, the Brexit debacle, and an escalating trade war between the US and China dominated headlines in 2019.
  • Trade War Developments: After a truce agreed upon in December 2018, hostilities resumed in May, with the US increasing duties on $200bn of imports by 25% and China retaliating on $60bn worth of US goods.
  • Ongoing Tensions: A temporary truce was declared at the G-20 meeting in June, but both countries continue to negotiate amid a slowing economy and escalating tensions, including those between the US and Iran.

Central Bank Responses

Global central banks, including our own, are perplexed by stubbornly low inflation and frustrated by a lack of political action to stimulate economies.
  • Interest Rate Cuts: In response, they are cutting interest rates. The Reserve Bank of Australia cut the cash rate by 25 basis points in October to a record low of 0.75%, citing concerns about the slowing economy, stagnant wages, and low inflation.

Economic Growth Forecasts

The International Monetary Fund forecasts global economic growth to slow to 3.0% in 2019, its lowest level since 2008. While Australia has maintained its remarkable 28-year run of economic growth, it is 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 booming rather than facing challenges.
  • Market Performance: After a decline of 3.5% in the All Ordinaries Accumulation Index in 2018, the index has climbed by approximately 25% as of this writing. This marks the first time since 2009 that the index has increased by more than 20% in a single year.

Investment Performance

I am proud to share that the Morningstar survey of Australian investment managers confirms our strategies have continued to perform extremely well:
  • Ex50 Strategy: A six-year track record of delivering portfolio outperformance (alpha) of 7.7% per annum compared to the benchmark.
  • All Cap Strategy: Delivered 4.5% alpha, with 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.

Key Contributors and Detractors

While the majority of the stocks in the portfolio contributed to its outperformance, a handful performed exceptionally well, including:
  • Top Performers: Magellan, Afterpay, and Megaport.
  • Detractors: Costa, Hub24, and Corporate Travel Management.
At an aggregate level, all of our alpha was generated through stock selection, consistent with our style as a bottom-up, benchmark-unaware, high-conviction manager.

Organisational Growth

From an organisational perspective, we’ve increased our funds under management to almost $2 billion and added support and back-office staff to ensure we deliver on our promises to clients.
  • Commitment to Clients: We’ve generated over fifteen detailed written investment reports and conducted over three hundred investment meetings over the past year.
As custodians of other people’s money, we owe it to those who’ve invested alongside us to allocate their capital to opportunities we believe in.

IPO Insights

Looking externally, there have been a number of interesting IPOs this year, many of which have performed phenomenally due to high demand.
  • Recent IPOs: We participated in the IPOs of Carbon Revolution and Fineos, which we believe hold strong potential.

Carbon Revolution (CBR)

CBR is an advanced manufacturing company that develops single-piece (monoblock) carbon fibre wheels for OEMs.
  • Market Leadership: The investment hypothesis centres on CBR’s ability to maintain its market leadership within the carbon-fibre automotive wheel industry.
  • Production Goals: CBR expects to manufacture and sell 75,000 wheels by FY22, with plans for significant capacity expansion by FY24.

Fineos (FCL)

FCL, added to the portfolio in August, sells software for core systems to enterprise-grade insurers in the Life, Accident & Health sector.
  • Market Position: FCL is a clear product leader with limited competition and a significant revenue opportunity.
  • Growth Potential: With product development largely complete, FCL is entering a phase of revenue and margin expansion.

Investment Philosophy

Investment management is more than merely generating alpha; it encompasses qualitative issues central to our process.
  • Capital Allocation: We drive change through capital allocation, demanding standards of corporate governance and voting with our feet if necessary.
  • Trust in Management: The integrity and credibility of management teams are foundational to our investment process.
We engage with companies where we feel we can add value, having spent considerable time improving governance practices in one particular company in our portfolio.

Looking Ahead

As we look to the future, we believe the markets are relatively fully valued and do not anticipate a major improvement in P/E ratings. However, we expect strong financial metrics for our portfolio companies to support current valuations.
  • Return Expectations: We estimate the IRR for the portfolio to be around 12%, composed of approximately 15% earnings growth and a 3% P/E compression.

Positive Outlook

As we start the new year, there are positives to consider:
  • Political Stability: We have three years before federal elections, and low-interest rates are likely to persist.
  • Support for Local Shares: The hunt for yield in a low-interest rate environment should bolster local shares.
In closing, I’d like to thank all clients for trusting us with the management of their savings – a privilege we value greatly. 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, Manny