Update No. 216 – 22/05/15

We removed another holding from the portfolio this week, bringing our total holdings down to 26.

The stock we disposed of was ICS Global, a relatively short term holding, not much more than 12 months on average was our ownership. Our return from this holding was very sound, exceeding a 55% IRR. The reason for the sale was valuation; we sold this week at $1.25 per share.

ICS was not extremely cheap when we purchased it (relative to the median valuation multiples of our other holdings), but has a likely earnings growth profile that is a good deal better than the median of our holdings in my estimation (the market of course isn’t perfectly efficient, but usually basically works this way!).

I had figured that what looks like a very good business had the potential to grow its earnings by a fairly high double digit multiple for a few years hence. Perhaps averaging more than 20% compounded if things go right.

The way that ownership of such a stock plays out in my mind when I purchase is something like this:

1. Stock grows earnings by 20% (or a little more) annually
2. Stock price grows by perhaps 25% (or a little more) annually
3. 5 or 10 years go by and EGP makes a killing and sells out when full value is materially exceeded

7 years at 25% IRR gets a near 5-fold growth in your original investment, so even if it is a fairly small holding (ICS was never among our larger holdings) it can have a fairly meaningful impact on your results.

It rarely plays out like this in my experience. When a good growth story starts to become known and appears to be correct, what usually happens is the stock re-rates to a multiple that more fully reflects the good growth prospects now being attributed to the business.

This has happened in a fairly meaningful way for ICS of late. When one-off earnings are stripped out, it is now trading at a multiple exceeding 20x TTM earnings for the continuing businesses. This is a fairly full multiple for a $14m market capitalisation company with a patchy record of success (though much improved of late).

Obviously, with a few years of 20% growth (should they achieve it) would make 20x TTM earnings seem perfectly reasonable.

Despite the attractive prospects of a business that appears to have excellent operational leverage and good tailwinds, I am not really in the business of owning fully priced businesses and hoping for operational excellence. I tend to prefer obviously cheap businesses and hope not to have operational disappointment. The upside can be a little smaller this way, but the downside in the event of an error in strategy execution is much smaller.

There is a very strong chance I will rue this sale. This would not be the first time and it definitely won’t be the last. But when I can take capital from a business that has a 20x multiple and likely high double digit growth and deploy it into a business with a 4x multiple (before excluding cash-hoard), a 17% grossed up dividend and modest growth prospects (probably low single digit), I feel like I am removing downside risk from our portfolio. Certainly removing more downside than upside, and that’s what risk management is all about – Tony Hansen 22/05/2015

EGP Fund No. 1 Pty Ltd. Up by 10.05%, leading the benchmark by 0.64% since July 1^st 2014. Since inception, EGP Fund No. 1 Pty Ltd is Up by 87.50%, leading the benchmark by 46.28% all-time (April 1^st 2011).

^{*1 after 31May 2013 dividend of 2.333 cents per share plus 1.000 cent per share Franking Credit & 31 May 2014 Dividend of 7.000 cents per share plus 3.000 cent per share Franking Credit}

^{*2 calculated based on dividends reinvested}