Update No. 85 – 9/11/12

I have said previously many times I will talk minimally about our holdings. I do this for two primary reasons. Firstly, I think if I give away too much information about what we hold and in roughly what proportions, it would be relatively easy for readers to just mimic our holdings and achieve approximately similar results and no one likes a free-rider, I spend a lot of my time and effort in beating the market and love the fact that if someone joins me, they can enjoy the same results for only a small clip of the outperformance and no fee.  We are not a widely marketed opportunity, YET; however my expectation is that with a few more years of similar results to what we have achieved since inception – I will significantly broaden our investor base through a marketing program.  Secondly, we are an investor in primarily small (often VERY small) companies.  These companies are often quite illiquid and buying them can require considerable patience if you wish to do it without needlessly driving up the prices.  Even though we are presently only managing a small 7 figure sum, given we have quite concentrated holdings, small increases in the entry prices paid for our holdings could meaningfully punish results.  Worse yet, competition could drive a stock we wish to acquire out of our price range.  The risk at our current level of capital is minimal, but will increase as new capital continuously flows in.

In any case, upon full elimination of a position, I have previously stated my intention to disclose the holding and why we held it.  Our first full elimination occurred this week.  On 5 November, the funds from the purchase of our holding in Mesbon China Nylon (MES) were deposited into our accounts.  MES was our second largest holding – N.B. If you look back at historic prices, MES closed 31 December 2011 at 16 cents as expectations the deal would fall over abounded.  This was well down on our average purchase price of about 20.6 cents, and a big part of the reason we did poorly in the period ending December 31 2011, and also a big part of why we have performed VERY well in the subsequent period.  It gives weight to my explanation that you must measure our results over longer periods (I prefer 3 – 5 years), as short term swings could be large due to our concentration. – representing almost 20% of our portfolio until a few days ago.  It was also different to most of our holdings in that it was not profitable in the last Financial Year and carried a lot of debt.  Nonetheless, we were fortunate to produce a gain of about 75% on our holding in MES, which annualises to about 45% per annum over our holding period (we started acquiring just after the fund’s inception – so about 18 months).  In fact I originally began purchasing MES on personal accounts in late 2010 at levels that have represented an even larger return.

It should be noted that MES operate in a commodity industry; they are a manufacturer of nylon.  Normally I would avoid such an industry because above average returns on capital are difficult to achieve (when management is a ‘price-taker’ rather than a ‘price-maker’, it is probably not a sustainable business).  We own only one other stock (out of 12 holdings at time of writing) that could be defined as operating in a ‘commodity’ industry.

In looking back over my research, I was primarily drawn to MES due to their attempts to capture the ‘fine denier’ nylon market it China this is a much higher margin business with (slightly) less of a commoditised nature.  With a burgeoning Chinese middle class, and Chinese manufacturers generally producing poorer quality nylons, the Phase 4 expansion of MES’s facilities made them the largest local supplier of the product – as people get wealthier, they desire better products.  The market for nylon, like many commodity products is extremely volatile, but my view was that the underlying ‘normal’ earning capacity of MES with Phase 4 fully operational would be $17.4m (at my estimates mid-point).  Now I expected this to range widely over time (I was not disappointed!), but a conservative valuation of about 5x EBIT would draw a valuation figure of around $87m.  At the time of purchase, MES was not carrying net debt and was selling for a market capitalisation of about $28m, which I thought to be very good value.

When the offer from the MD & majority shareholder Zhehao Shen appeared, I was extremely reluctant and voted our holding against the offer (In September 2011).  I attended the AGM in May 2012, in order to get a feel for the true drivers of the buyout.  I felt the directors’ explanations that the ability to raise capital on the ASX for MES had not been what was expected upon listing and that the expansion plans Mr Shen had for the business would require substantial further capital had merit. It was apparent that there was no appetite from the other major shareholders to resist the offer also.

In my view (if you deducted the cash, notes receivable and inventories from debts, MES was still effectively debt free), the $47.32m takeover price was around half of my view of the fair value of the company.  Despite this, I decided the pragmatic course was to accept the offer and when it again came to the second vote (early October 2012) I voted our holdings for the offer.

I am very sure that when global markets fully stabilise, Mr Shen will find he has struck an extraordinary bargain.  In the meantime, we are once again about 25% in cash and looking to find some bargains to add to our holdings – Tony Hansen 9/11/12

P.S. EGP holdings declined 0.4% this week, against the small gain registered by the benchmark.  We did manage to buy some stocks we’ve been waiting patiently to fall into our target price ranges though…

EGP Fund No. 1 Pty Ltd. Up by 15.95%, leading the benchmark by 4.51% since July 1^st. Since inception, EGP Fund No. 1 Pty Ltd is Up by 19.42%, leading the benchmark by 19.64% all-time (April 1^st 2011).