Update No. 194 – 19/12/14

We eliminated another two holdings this week as I seek to get our number of holdings down to a more appropriate level. We hold shares in 26 businesses after these eliminations; I still view that as too many for a properly focused fund running a small pool of capital. I will continue to focus on ensuring the largest proportion of our capital is focused primarily on the greatest risk/reward opportunities.

I first mentioned our holding in Iron Ore (IO) producer Mount Gibson (MGX) in the report for the December quarter of 2013. We had made out fairly well out of MGX, and had done some selling at prices north of $1 per share after buying in the 40c range. Unfortunately we hung onto a small parcel of shares – fortunately before the horrible recent announcement, it was our second smallest holding, for immediately afterward it became our smallest.

I articulated the investment thesis a few months ago to a couple of investor friends. Explaining they held cash levels close to their share price, and at their best mine, Koolan Island were capable of producing some of the best quality IO at FOB prices in the $10 – 20 per tonne range (depending on the level of strip required) close to the cheapest FOB prices in Australia. Even if IO prices continued to crater, this mine could still be operated profitably.

Obviously, with the other two mines producing at cash costs nearer to (or slightly above) the current spot IO price, the profits were going to be greatly diminished as the IO price fell, but if management had the discipline to minimise output from the high-cost mines and maximise the output from Koolan, they would remain profitable and very cash-flow positive. Given their cash pool was around the same size as their market capitalisation, something would have to go very badly wrong for a share price in the 40c range to work out badly.

The three key risks I had identified were firstly, the potential for a board ostensibly controlled by the MGX’s largest customer acting contrary to the best interests of shareholders (for example, running the two less cost effective mines at high-volumes at a loss to ensure their  supply). This first risk would prevent the proper maximisation of shareholder returns, but was not catastrophic as the sales would still be made at or near market prices, with output from Koolan ensuring average costs were lower. The second big risk was that the cash-pile was used to overpay for an asset. This is an ever present risk for miners as they diminish their resource, and the only way for management to ensure their long-term jobs is to replace the mined resource. As an owner, you need simply keep your eye out for such an acquisition that appears to be a mistake and act accordingly.

The third risk and the one that recently was a fairly costly one for us was a failure of the sea-wall that enabled mining to take place below sea-level at Koolan. This sea-wall had been in place for nearly a decade, enabling mining and whilst it was to be considered a fairly low-probability risk, it was the one most likely to be catastrophic to the valuation of MGX. Whilst it is pleasing to have correctly identified the major risk in advance, it was extremely disappointing to have the risk realised. MGX have stated they carry insurance for the risk, but the recent failure of the sea-wall led to us to try and sell on open after the trading halt was lifted. We did not end up selling on open, but with the price rising somewhat this week, I decided to dispose of our smallest holding and take the loss that came with it. There is a possibility that the company will get a decent payout from their insurance (though you can be sure the insurer will do everything in their power to avoid/minimise the payout) and if the board act in the most share-holder friendly way in what they do with the assets, the company is certainly worth more than the current trading price. But between the small size of the position and the extraordinary uncertainty now embedded in the company’s future, the most prudent action seemed to be to move on and redeploy the capital into opportunities where the risk/reward scenario is more certain.

I must offer a mea culpa for the mistake, only hoping the foregoing paragraphs explain why the position existed and reminding holders that the holding performed very well for us last year, and most of it was sold at much higher prices (this is cold comfort for those who have joined us this year and got the downside with none of last years upside). Despite the small position sizing some of our underperformance of the indices since July 1 2014 would be eliminated had we not held MGX. I will be doing everything I can to ensure we are positioned to recover all of this shortfall and more in the second half of FY2015. It is much more important that I set out the mistakes I make than reporting the victories. I set out this principle in the most popular blog I have written on this site, though I suspect the popularity and subsequent nearly 400,000 hits have more to do with the fact it mentions the NFL than some particularly cogent insight. MGX was our only mining company and it will take a truly compelling opportunity for us to again deploy capital into any sort of commodity business.

The other sale was a fairly brief holding in BSA Limited. We bought some BSA when they recently announced a rights issue. The issue pricing looked fairly compelling and there was a ‘shortfall offer’ to subscribe for greater than your entitlement, which we did. BSA is fairly mediocre business that looks to be emerging from an extremely difficult period after some restructuring and a new management team being in place. We had about 2% of the fund invested in BSA after our rights were issued, after a very short holding period and a decent spike in price; we eliminated the position and booked an IRR comfortably exceeding 200% (the mathematical upside of a short term holding and a reasonable price spike).

As with the other recent sales, this is primarily about reallocation capital with better medium-term prospects, as I try to migrate our capital to areas of greatest conviction to ensure returns in 2015 are better in both an absolute and relative sense than we have experienced in 2014.

As to the underperformance of 2.04% against our benchmark set out below, we led Tuesday evening after the poor start to the week, but the very fast finish to the week left us in the dust. I have commented before that our holdings have no conception of time, but as much as I would like to lead the benchmark come December 31, it will mean more if we can blow past it by June 30 and mark our 4^th consecutive financial year of outperformance, we rely now on a good reporting season in February to deliver this and I have rarely been more confident of getting one than I am this year, hence the reason I will be scratching around for every spare dollar I can locate to buy new shares in the fund come the 31^st – Tony Hansen 19/12/2014

P.S. It has been our custom to use the average of the EGP share price over the final 5 trading days before the issue date (to avoid spikes in illiquid holdings creating pricing issues) – this intake will be done on the 3-day average of the closing price on 29, 30 and 31 December. We hold a more liquid portfolio now and I think this is perfectly adequate to ensure fairness.

EGP Fund No. 1 Pty Ltd. Down by 1.10%, trailing the benchmark by 2.04% since July 1^st. Since inception, EGP Fund No. 1 Pty Ltd is Up by 68.41%, leading the benchmark by 38.12% 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}