Return on capital, drives return on share price

Now the partner and portfolio manager of Hebrew Investment Partners, Mr. Ben Rundle, just joined the call.

Some background of the Hebrew Opportunities Fund.

It is a long-only, small-cap Australian equities fund investing in a portfolio of 20 to 40 high-quality, small to mid-sized ASX listed equities.

They believe companies exhibit a greater degree of pricing inefficiency over their larger counterparts, which can cause a large variation between the company's trading price and their assessment of a company's market value.

Bain has 17 years of experience in financial markets, previously experienced working in Nausea Asset Management, Morris Company, Ominet, Macquarie Bank, and Taylor Collison.

Ben's topic today is return on capital drives return on share price.

Welcome, Ben, to the webinar.

Thank you.

Thank you for having me.

Thank you for investment markets.

Hello, everyone.

My name's Ben Rundle.

I'm the founder of Haber Investment Partners and the Haber Opportunities Fund.

So I'll spend just a couple of minutes just quickly introducing myself and the fund in our process and then I want to talk to you about two real-life examples of listed companies on the ASX operating in very similar sectors and look at quickly why one has done so much better than the other and

So just starting with the team.

So myself, obviously I've been in the markets now for about 17 years.

I started on the stock broking side and moved on funds management about eight and a half, nine years ago.

My business partner, George Capozzi has been in the markets for 20 years.

He's been doing small caps for a significant period of that time.

And our chairman, Jeff Ellison is the founder of a company called C-Link.

Well, it's actually called Kelsia now, which is an ASX listed company.

He'd been out of administration in 1994, I think it was, and now it's a one and a half billion dollar business.

And he exhibits a lot of the traits that we look for in our management teams of the companies we invest in.

Just a bit on our business.

So we launched our fund in March 2021.

So we're a little over two years old.

Our performance in that time has been 27% versus the small cap index, which is down four and a half percent.

We launched with $10 million in FUM in funds under management, and we're sitting at about $50 million now.

George and I are the largest unit holders in the fund.

At our two-year anniversary, we were crowned the highest performing small mid-career in Australia, according to Morningstar, out of about 200 funds.

So that was a pleasing result.

And we're available on some of the more popular investment platforms for financial advisors to be able to allocate to our fund.

There's essentially five pillars to our investment philosophy in the way that we invest.

The first is our circle of competence.

We don't know everything.

There's two and a half thousand listed companies.

We try to stick to a very small subset of those of about 150 businesses that we know we've been following for a long time.

We have financial models on.

and we build a portfolio of 40 stocks out of that universe.

We really like businesses where the management team own a significant stake in their business.

We like founder-led.

Most of our portfolio is run by founders of their business.

And we really like companies with very strong cultures.

We've found that over time, businesses that do have a strong culture have a very high and consistent track record of taking market share from incumbents, particularly the larger, more bureaucratic competitors that they operate against.

And then on the numbers, we really like businesses which have a high return on capital and I'll show you the example of why we like that as a core part of our investment process.

And then finally, no business is so good that we'll own it at any valuation.

Valuation is a really important factor of our process and how we try to limit mistakes in the portfolio.

So the examples of the companies that I want to briefly take you through are two ASX listed companies.

They're both of a similar size, roughly around $1.5 billion market cap, each of these businesses.

The first is lifestyle communities.

LIC is the code and Engenia communities is one of their competitors and the code there is INA.

Now the businesses aren't exactly alike.

There are some subtle differences between the two, but really they both operate in the retirement living community sector.

And it's worth noting that both have actually been fairly strong performers in that space, but we'll look at why one's been such a strong performer

over the other and the way that we've done that is by looking at a five-year return analysis from 2017 to 2022.

Now the reasons to 22 and not 23 is because the numbers haven't been announced yet for 23 we hope to get those next month.

So it's a backwards looking view but it gives us the benefit of hindsight to know what the numbers look like, what the starting valuations look like and why one company's done better than the other.

So if we start with probably the most common financial numbers you'll see in an analyst report, the growth in their profit, the growth in their net assets, and the starting valuation of what we've bought each company at in 2017.

So that's the valuation of the business in 2017.

So you can see over that time, Ingenie has grown their profits over 100%, Lifestyle Communities has been lower than that.

Ingenia is growing their net assets at almost 200% which outpaces lifestyle communities again.

And there's a starting valuation of Ingenia of 0.9 times its book value versus lifestyle communities, which is almost three times its book value.

So you're paying a lot less for lifestyle.

So for Ingenia than you are for lifestyle, and you're getting a lot more profit and asset growth.

But if we look at the share price performance over that period, investors have made almost three times more money invested in lifestyle communities versus in Genia.

And we believe the reason is, so if we go back to that chart that I just showed you a minute ago of the growth in profit and the growth in assets.

The bottom chart here is numbers that we prefer to look at in analysing a company.

So the first is the growth in contributed capital, so how much capital it's taken for a company to actually grow, how much capital has gone into the business.

The second is return on equity and then the final piece is look at the incremental returns on capital.

And you can see there that to get their results, Ingenia has grown their contributed capital by over 100%.

So it's the equivalent of having a bank account with $100 in it and putting another $100 in it and having $200.

You haven't really actually created value.

Whereas Lifestyle Communities hasn't grown their contributed capital barely at all during that period.

They've had a much higher return on equity and you can see that the incremental returns on capital are so much higher.

That's driven a vastly different outcome, sorry go back to the previous slide, of making literally three times more money invested in lifestyle communities despite being valued at three times higher at the starting process.

That's the framework that we like to use, if you like, from looking at a company and from our historical track record and our experience in markets, it's the track record of companies being able to allocate their capital successfully that can drive share prices going forward.

And we have actually found that historical views on capital allocation have been a pretty good indicator for future returns on their capital and therefore future returns on their share price.

So just to summarize, the ideal company for us that we look at is founder-led.

We really like companies that have high insider ownership.

The management team treat their capital as if it's their own because it is.

We really dislike share issuance, so we dislike capital raisings on the market, so we like low issuance of shares, high returns on capital, companies going through an earnings growth phase.

In small caps, we tend to find that a lot of businesses can be undiscovered by the wider market, and we have a very favourable bias towards a high cultural within the business as well.

So that's a quick sort of 10 minute overview of Haber and what we do and how we do it.

So I invite any questions that you might have.

Thanks, Ben.

I recall you mentioned in your presentation that you like to analyze a company's culture.

I get that.

But how do you do that?

Yeah, that's where the hard work kicks in.

So it's not as easy as just pulling up a spreadsheet and looking at the financial numbers, you actually have to go out and talk to people.

So we spend a lot of our time speaking to not only the businesses themselves, but also their suppliers, their competitors.

People who have operated in the industry can give us a fairly good flavor of how that company operates as well as lower level management So we obviously as fund managers get to speak to the management teams pretty regularly But we it's a lot harder to get access to lower level employees There are easy ways to do it of looking at things websites like Glassdoor and that sort of thing But we prefer to actually speak to people in the business and the industry to get a better view of what we're investing in

And why do you have a bias towards founder-led management teams?

Well, founder-led management teams, given that they have so much money on the line invested in these companies, we're a big believer in incentives drive outcomes.

So if you have a management team who owns 10 to 20% of the business, they're going to make decisions very differently from a company that

Has a management team that doesn't necessarily have a stake in their business.

They might have options that they get granted through Not having to put their hands in their own pockets, but that can drive very different outcomes and incentives to us in particularly small growing businesses really drive strong outcomes in share price returns and

That makes sense.

Thank you, Ben.

Lifestyle communities and Ingenia, lifestyle communities have found a lead business, whereas Ingenia is not.

You can see the differences in the returns between those two businesses.

Yeah, makes sense.

Thank you, Ben.

It's great to see you.

Excellent.

Thanks for having me on.