Update No. 257 – 04/03/16

It was a significant week for EGP this week. After the 8^th strongest week in our nearly 5-year history, our total return after all costs/fees exceeds 100% for the first time.

We deployed a considerable amount of capital this week, for the first time in recent memory our cash balance is below 10%. We also eliminated a position this week, reducing our total number of holdings to 25.

The sale we made was Hughes Drilling (HDX.ASX), which was our smallest (thankfully) position and a mistake we have been stuck in for a while. We were fortunate to only commit a very small starting position into this business. I decided I had made a mistake in deploying some of our capital to HDX back in Mid-2015. I commenced selling at a price slightly above our cost basis, but the price retreated and I stubbornly held on trying to exit a mistake at a profit. In thinly traded stocks, if you decide to sell, you sometimes need to take the pain. Even if you move the market on your way out.

I should point out I think HDX is among the best run businesses of its type around. But I had anticipated much better free cash-flows than have proven to be the case. Munger has described the trouble with such capital intensive businesses, all the ‘profits’ you’re earning end up ‘sitting out in the yard – in the form of used equipment’.

I incorrectly expected that HDX would stop/slow adding to their PP&E as the mining boom slowed and the business would start to spew cash. At the FY2015 half year (around the time I decided we needed to sell), the business had generated an impressive NPAT for the 6 months of over $6.5m. Unfortunately, despite the business having operating cash-flows of about $11.5m for the half, they spent nearly $11.9m on PP&E, which was more than twice the depreciation charge. Come full year FY15, despite $8.2m of NPAT, PP&E had grown by more than $10m on the year. The business had consumed more than its entire profit in new PP&E.

Because the price had fallen substantially, I waited; we’re nothing if not patient at EGP, but the FY16 half yearly showed no change in what is happening with the business. Despite throwing off more than $19.1m in ‘OCF’ in six months, about $20.8m was spent on new PP&E.

The constant need to add to the PP&E base is destroying any hope shareholders have of ever putting any of the prodigious operating cash-flows HDX generates into their pocket.

It may be the reluctance of management to deal with the problem, or the nature of the business may be forcing their hands. Either way, I can see no way the situation ends either soon or especially well for shareholders. I can find better homes with more certain returns for our capital. The market capitalisation of less than $20m is anchored in valuation terms by net debt of nearly $55m. There is NTA of around $65m, or more than 3x the market capitalisation, but the annual depreciation charge on that is about $15m. There is also the question of how much the NTA of such a business would truly be worth in the current marketplace if partial or full liquidation were pursued.

We have managed to hit a new all-time high this week despite ‘unforced errors’ such as that described above. As with all capital allocation mistakes, the likelihood of my making a similar mistake in future is much reduced as a consequence of our experience with HDX, we try to take at least this positive out of it.

We have managed to do well by keeping our mistakes quite small and having the things we have gotten right to be much larger in scale. Hopefully that will continue to be the case.

Our invitation to invest email will go out over the weekend to existing investors and those that have lately expressed interest in EGP. If you wanted to receive the invitation, make contact with me via e-mail and I’ll add you to the list – Tony Hansen 04/03/2016

EGP Fund No. 1 Pty Ltd. Up by 7.72%, leading the benchmark by 9.58% since July 1^st 2015. Since inception, EGP Fund No. 1 Pty Ltd is Up by 100.00%, leading the benchmark by 66.13% all-time (April 1^st 2011).

^{*1 after a 31 May 2013 dividend of 2.333 cents per share (cps) plus 1.000 cps Franking Credit, a 31 May 2014 Dividend of 7.000 cps plus 3.000 cps Franking Credit and a 31 May 2015 Dividend of 8.6667 cps plus 3.7143 cps Franking Credit}

^{*2 calculated based on dividends reinvested}