March portfolio update

A lot has happened in the first few months of 2022. Besides the war in Ukraine, there are rising concerns about inflation, and growth stocks and other long-duration assets have been punished by the market. 

While my investments have usually performed well during volatile periods in the market, this was not the case in the March quarter. My PA dropped 20.62% while my SMSF fell 9.91%. This is my worst quarter since I started tracking the portfolio, and it has been challenging. While I am confident about the prospects of my holdings, especially at their current valuations, I've spent plenty of time thinking about how I can improve my process.

My results for the quarter were driven by my two largest positions, Naked Wines and Haier Smart Home D. 

Naked Wines

Naked Wines was caught up in the growth sell off, and fell from 6.40 GBP to 3.60 GBP over the quarter (-43.75%). The result was exacerbated by the strong Australian dollar, which rose ~6% against the GBP over the quarter. There was no significant news from Naked. The market is clearly concerned about inflation and/or the sustainability of the business model. I am sanguine on both issues. While I expect Naked's growth to be constrained in the short-term, and customer acquisition costs to rise, I see no reason why Naked should not continue to grow as it has throughout its history. 

It is also worth noting that Naked is not an expensive business. Naked now trades at 0.77x LTM sales. Management has guided to 20% growth in sales over the medium term and 10% EBIT margins at maturity. This seems achievable as Naked increases its sales in the US (which are far higher margin than UK/Aus sales) and scales up. This seems cheap for a business that has historically generated very high returns on capital, has a dominant position in a structurally growing market (Naked is the #1 DTC wine player in the world) and has a long reinvestment runway. Naked remains my second largest position.

All that said, I made a mistake by repeatedly topping up my Naked Wines position on the way down. My initial position in Naked was bought at around 2.1 GBP prior to the pandemic. When topping up Naked, I was thinking more about portfolio sizing than simply valuation. This is not the right way to think, of course. If you keep topping up a falling position, you can blow up your portfolio. (John Hempton has written an excellent post about this.) This has been an important lesson for me, and it has been costly. I hope I can avoid making the same mistake again.

Haier Smart Home D

My largest current position is Haier Smart Home D (690.D), which I have written about in previous updates. Haier fell 17.75% over the quarter. Again, the result was exacerbated by foreign currency movements, as the Australian dollar gained about 6% against the Euro over the quarter. The war in Ukraine has led many investors to worry about China. That does not explain the curious situation with Haier's D shares. Despite ranking exactly the same as Haier's H shares, which are listed in Hong Kong, Haier's D shares trade at a 57% discount. Haier is the world's largest manufacturer of home appliances, with revenue split roughly half and half between China and the rest of the world. It owns Fisher and Paykel in Australia, GE Appliances in the US and a number of other major brands. Based on the current D share price, Haier trades at less than 6 times forward earnings and roughly 3.5 forward EV/EBIT. This seems extremely cheap for a company that has grown earnings per share at more than 11% CAGR since 2016. While Haier has not made any move to convert the D share to the H share, this is an option — as outlined in the H share prospectus — and there is no practical reason for the D share listing to exist. If D shares were converted to H shares today, they would be worth 137% more, yet investors are effectively getting this option for free. Again, if investors are worried about the China situation, the exact same risks apply to the H share. Whether or not conversion happens, investors should do well in Haier D, and I see no reason to change my position.

A note on portfolio construction

Historically, my PA has outperformed in periods of market volatility. One reason has been my holdings of small, unlisted companies in Australia which trade irregularly. These stocks often trade very cheaply in relation to their assets and earnings and pay large dividends. For tax reasons, I transferred these positions to my SMSF when it was established last year. As a result, my SMSF has performed better than my PA of late. Another issue is that, in the past, I have had a higher portfolio allocation to special situations that aren't correlated to the broader market. Besides Yorkey, which worked out very well, I had no real allocation to these sorts of investments in the quarter. Effectively, I was quite concentrated and there were correlations between usually uncorrelated stocks (e.g. Haier and Naked). While I'm happy to trade increased volatility for better returns, I'm going to place more emphasis on having different types of bets in the portfolio, especially in rising markets. I'm also going to put a hard limit on new positions of 10% of the portfolio at cost. This will give positions like Naked, which have good long term prospects, room to grow, while avoiding problems of over-concentration. Effectively, if you're taking a very large bet, say 20% of the portfolio, you are implicitly saying that a particular investment is far better than everything else in your investment universe. Historically, I haven't been very good at predicting which stock will perform better than another in the portfolio. For that reason, I am more inclined to size positions similarly rather than betting 4x position X on position Y. 

Finally, the drawdown has somewhat affected my confidence — as much as I try not to be affected by short-term results, it has been hard to watch the portfolio falling month after month. I've been a bit more cautious entering into new positions for the time being, and I've been doing a lot of work re-visiting my existing positions. Overall, I think the portfolio is very attractively priced. Both my PA and SMSF trade on a dividend yield of >5%, which is the highest in memory. Most of my holdings trade on single digit multiples and less than their net current asset value. I am confident that my holdings will continue to perform well over the next few years, especially from today's levels. 

I have added a small position in Countryside Partnerships (LON:CSP). Countryside is a capital light homebuilder in the UK that has historically earned > 40% ROCE. The company is currently undergoing a turnaround after poor operating results in the March quarter. Activist investor Browning West now has a board seat, and the company is buying back a significant amount of shares. While execution is a major risk, Countryside has a good business and a clear policy for capital allocation (any excess cash that isn't needed for growth will be used to buyback stock). I think the risk-reward here is attractive, but I need more evidence of execution before adding to my position.

The results of my private investment account and SMSF are summarised in the table below. The portfolios are constructed differently and performance will vary. 

My PA was down 1.69% in January, down 12.05% in February and down 8.19% in March. The cumulative return for the period was -20.62%. The S&P/ASX 200 Franking Credit Adjusted Annual Total Return Index (Tax-Exempt) gained 2.24% over the same period.

	August 3, 2017	March 31, 2022	Since July 1, 2021	Since Inception	Annualised
G&W Portfolio	1.0000	1.6790	-25.03%	67.90%	11.76%
Benchmark (SPAX2F0)	61,250.80	101,525.11	7.16%	65.75%	11.45%

My SMSF was down 0.75% in January, down 6.81% in February and down 2.60% in March. The cumulative return for the period was -9.91%. The S&P/ASX 200 Franking Credit Adjusted Annual Total Return Index (Tax-Exempt) gained 2.24% over the same period.

	August 4, 2021	March 31, 2022	Since July 1, 2021	Since Inception	Annualised
G&W SMSF	1.0000	0.9158	-8.42%	-8.42%	-12.57%
Benchmark (SPAX2F0)	98,123.18	101,525.11	3.47%	3.47%	5.34%

G & M Holdings — a HK-listed net-net with 10% dividend yield trading at 4.4x PE

As I've mentioned in previous posts, I've been finding a lot of cheap stocks in Hong Kong lately. One I've recently purchased is G & M Holdings (HK:6038).

G & M designs, builds and repairs podium facades, curtain walls, glass walls and other products in Hong Kong. At 16.2 cents per share, the market cap is 162m HKD.

G & M is an attractive opportunity because:

• It trades at a low multiple of earnings. G & M earned $36.8m net income in FY21, putting the company on a trailing P/E of 4.4. From FY16-FY21, G & M earned cumulative net income of 225.75m, equivalent to 22.58 cents per share (roughly 140% of the current market cap).

• It trades at a discount to its net current asset value. As of December 31, G & M trades at a roughly 33% discount to its net current asset value of $240m (calculated as current assets less total liabilities).

• It has a history of paying dividends. Since listing in June 2017, G & M has paid dividends of 7.25 cents per share. G & M recently announced a final dividend for FY21 of 1.1 cents per share, payable on July 8, 2022, bringing the total to 8.35 cents per share since listing. In other words, G & M has paid more than 50% of its current market cap in dividends since FY17. The trailing dividend yield is 10.2%.

• G & M has historically earned a reasonable return on capital. In FY21, G & M earned roughly 45m pretax on invested capital of 266m, ~16.9% ROCE. (Note I have not deducted any cash from working capital in calculating invested capital, for reasons I will discuss later.) ROCE averaged 15.72% over FY18-FY21.

• G & M has $574m in outstanding contracts, equivalent to 1.4 years of revenue at current rates. G & M is currently bidding or waiting on the results of four podium facade project tenders with an estimated contract value of $357.8m.

Financial data

	FY17	FY18	FY19	FY20	FY21
Revenue	315.71	365.44	299.76	243.40	403.21
EBIT	64.54	45.53	31.62	28.07	45.01
EBIT margin	20.44%	12.46%	10.55%	11.53%	11.16%
Net income	52.27	36.94	26.37	23.3	36.80
Net profit margin	16.55%	10.11%	8.80%	9.57%	9.13%

	FY17	FY18	FY19	FY20	FY21
Invested capital*	208.09	219.02	228.76	248.00	265.64
EBIT	64.54	45.53	31.62	28.07	45.01
ROCE	31.01%	20.79%	13.82%	11.32%	16.94%

* N.B. I’ve assumed zero excess cash, but G & M has historically held very large cash balances

Dividend history from David Webb’s site

Announced	Year-end	Type	Amount	ex-Date	Distribution
2021-08-25	2021-12-31	Interim dividend	HKD 0.0055	2021-09-08	2021-09-29
2021-03-31	2020-12-31	Final dividend	HKD 0.0110	2021-06-24	2021-07-21
2020-03-30	2019-12-31	Final dividend	HKD 0.0140	2020-06-23	2020-07-17
2019-03-18	2018-12-31	Final dividend	HKD 0.0180	2019-06-18	2019-07-12
2018-03-19	2017-12-31	Final dividend	HKD 0.0240	2018-06-11	2018-07-06

N.B. Final dividend for FY21 not included in table: https://www1.hkexnews.hk/listedco/listconews/sehk/2022/0328/2022032800190.pdf 

Why is this opportunity available?

• G & M is an extremely small company with a market cap of ~162m HKD (~25.5m AUD)

• The public float is only 250m shares (40.5m HKD/~$7m AUD at current prices). The two controlling shareholders — Mr Lee Chi Hung (chairman, CEO and co-founder, age 56) and Mr Leung Ping Kwan (non-executive director) — own 75% of G & M’s shares through their holding company, Luxury Booming Ltd. Mr Lee controls 75% of the issued share capital of Luxury, and therefore has ultimate control of G & M; Mr Leung owns the remaining 25% of Luxury Booming.

• Despite solid operating results, G & M shares have performed poorly since IPO. G & M currently trades 60% below its listing price of 41 cents. Even when dividends are included IPO buyers are still down ~43%.

• The Hong Kong market has performed poorly in recent years. The Hang Seng is down about 23.5% over the last year and down about 10% over the last five years. Besides the political unrest in Hong Kong, there has been a widespread sell-off in HK and Chinese stocks following the Ukraine crisis. HK is also experiencing a deadly COVID wave, however it seems the peak has passed.

G & M’s business

A podium facade is the external surface of the podium or atrium part of a building, typically made up of glass, cladding, granite and other materials.

Podium facade by G & M, Taikoo Place Development

A Curtain wall is the external surface of the building above the atrium portion, typically made of glass, aluminum or other materials. 

Curtain wall by G & M, KCTL 522, Kwai On Road, Kwai Chung

G & M is a subcontractor, and typically works with property developers, main contractors or public bodies. It specialises in podium facade projects; according to the prospectus, G & M was the second largest player in the HK podium facade industry as of 2015. 

The biggest risk with G & M is customer concentration. Typically, G & M has had a high portion of its revenue come from one or two main customers, including Sun Hung Kai Properties, one of Hong Kong’s largest property developers. In 2021, 93% of revenue came from two customers.

This is obviously not good news. However, Hong Kong’s property development sector is highly concentrated. Million Hope, a larger curtain wall business listed in HK, also has a high level of customer concentration, with 94% of revenue in FY21 coming from its top five customers. 

Historically, G & M’s most important customer has been Sun Hung Kai properties. G & M and SHK have a relationship spanning nearly 20 years, which brings some comfort. SHK has a strong balance sheet, with a 17.5% gearing ratio and interest coverage of 13 times as of December 31, 2021.

I am concerned about the customer concentration, but with G & M selling below liquidation value, we have significant downside protection. Additionally, we can manage the risk further with position size.

A note on G & M's cash

G & M has roughly $77m of net cash on its balance sheet, more than 50% of its current market cap. However, much of this cash is needed for operations. One of the reasons G & M listed was to raise cash to increase its ability to take on contacts. The prospectus notes:

“Based on the experience of the directors, according to the nature and specification of each project, the Group may generally incur maximum net cash outflows of approximately 23-28% of the contract sum at the early stage of its projects, particularly where the Group acts as a nominated subcontractor for the projects, and the customers generally make the first progress payment to the Group not until approximately five to seven months after the commencement of the relevant projects. Furthermore, the Group’s customers generally withhold usually 10% of each interim payment up to an aggregate of usually 5% of the total contact sum as retention money, which will only be fully released to the Group subsequent to the expiry of the defect liability period.”

While the cash offers some downside protection, I think it’s prudent to assume $0 excess cash (for enterprise value calculations, etc). On this basis, G & M still seems extremely cheap on both an earnings and asset basis.

• Trailing EV/EBIT: 3.6

• Trailing P/E: 4.4

• Price to NTA: 0.62

• Price to NCAV: 0.67

Outlook

G & M has contracts worth 1.4 years of revenue at FY21 rates. It is also bidding on additional contacts worth ~$350m. There is a significant pipeline of construction work in Hong Kong, with government spending on infrastructure projects expected to reach $100b annually in the next few years. 

However, there are number of headwinds in the near-term, including COVID, labour issues and rising costs of materials. 

The Group also experienced increasing staff drain owing to various social and labour market factors, reduction in work scope of already awarded projects attributable to economic uncertainties, and rising material prices as a result of disruption in supply chain, all of which will have lasting impact on the Group’s operations …

Faced with the uncertainties brought on by the prolonged COVID-19 outbreak, the Group will continue to adopt a more prudent approach in its bid for projects, focusing on those involving higher level of design element, technical capability and customized features with an aim to conserve its resources on quality projects by reputable customers with healthy profit margins.

While these issues are concerning, and will likely impact margins, G & M remained profitable through the initial COVID outbreak and has some protection from its forward order book. If we assume earnings fall back to 30m, G & M would still trade on ~5.3 PE, and could maintain the current dividend.

Catalysts

I don’t have a particular catalyst in mind. G & M seems extremely cheap whichever way you look at it. It would benefit from a recovery of the broader HK market (which has been depressed). If the stock continues to languish, the majority shareholder could also take it private, which could likely be funded through the dividends paid to date. 

If you buy today, you're entitled to a 1.1 cent dividend on July 8, worth roughly ~6.8% of your purchase price. (The ex-dividend date is June 13.)

If you have any thoughts on G & M, or if you spot a problem with my thesis, I'd be very interested to hear from you.