This week the Small Cap team present a brief investment thesis for Konekt (KKT.ASX), one of their favourite holdings.
Summary:
In our search for under-valued high quality ASX listed smaller companies we occasionally come across an opportunity which truly stands out from the crowd. In this article we discuss a company which is currently trading at less than 10 times FY18 earnings despite expected earnings growth of 15-20% p.a. over the next 3 years driven by solid tailwinds in a defensive industry. And to top it off, the company is led by one of the best management teams we’ve had the privilege to get to know – and we’ve met a lot of management teams over the years.
An emerging business model in a sizeable market:
Konekt is a workplace health solutions provider – the company helps companies and healthcare insurers prevent injury and help rehabilitate sick/injured employees so they can ultimately return to work. The company employs more than 800 staff operating nationally from over 125 locations helping people return to the workforce – currently injured and unemployed, but potentially also disabled people looking to enter the workforce. This pool of labour looking to return to the workforce is the supply side of the emerging Konekt model.
As at August 2017 there were over c.200,000 jobs vacant in Australia – the majority in blue collar occupations, with some national firms having in excess of 1,000 jobs vacant at any point in time. This is the demand side of the emerging Konekt business model, as it transitions from its traditional injury management business model. Konekt has strong existing relationships with many of these significant corporate and government employers through its injury management and pre-employment services. Konekt has a significant opportunity to match the labour supply it has access to with the large pool of labour demand/vacancies mentioned. The company is in the relatively unique position of having the resources and scale to place large numbers of employees into vacancies at significant national corporate and government employers. Konekt also has the added advantage of being able to offer a range of other pre-employment screening/assessments and injury and mental health management services to these employers.
The benefits to society of having unemployed, disabled and injured workers return to the workforce (and off government benefits) is likely to see Konekt’s services continue to be well supported irrespective of the government of the day.
Clear revenue and earnings growth drivers:
As a well-funded, well managed & respected ASX-listed service provider, Konekt has a 25-year track record of delivering strong outcomes for employers, employees and society more generally – Konekt’s return-to-work rates are above market at an impressive 94%. As a result, the company is well positioned to continue to take market share from sub-scale, under-resourced competitors operating in each of the three return-to-work verticals (injured, unemployed and disabled).
Konekt also has material margin expansion opportunities looking forward. The company is currently only offering one return-to-work service from each of its offices. Given rent is c.10- 12% of total costs and there is excess space in many offcies, margins and productivity could be significantly improved if Konekt can offer two return-to-work services (eg. both injury and unemployed) from the same office. And in the event that Konekt decides to enter the disability return-to-work market (and are awarded a contract) then it could offer three services from the one location, which would mean further margin upside.
Mission Providence acquisition:
On 29th September 2017, Konekt announced the completion of its acquisition of employment services company Mission Providence – a provider of employment services under the Federal Government’s $1.4bn Jobactive program. This acquisition was partly funded by a $15m capital raise, of which Konekt directors contributed c. $3m.
A key focus at the company’s recent AGM was updating the market on this acquisition. Pleasingly, Konekt management mentioned that there have been no surprises following completion and that the business is tracking to expectations. The acquisition diversifies Konekt’s existing revenue streams, and enhances its ability to provide return-to-work employment services, to complement its existing core offering of delivering return-to-work injury management programs – essentially managing the process of rehabilitating injured workers and getting them back into jobs, where it is the current national market leader.
Konekt management noted the acquisition also provides Konekt with the capacity to enter new or underserviced markets. The logical potential new market here is for the company to provide return-to-work disability employment services – an attractive opportunity with the Federal Government’s 2017 budget highlighting an additional investment of over $3 billion in disability employment services to help people with disabilities get and keep long-term jobs.
Private equity interest in the sector is building:
Interestingly, a private equity fund has recently bought a majority shareholding in one of Konekt’s key competitors – APM, the largest provider of disability employment services to the Federal Government (see here). Apart from this transaction, there has been growing private equity interest in the sector – possibly driven by the potential to capture some of the increasing amount of government funding committed to the disability sector.
Guidance:
Konekt recently confirmed forecast revenue growth of more than 70% and underlying EBITDA growth (excluding one-off items) of greater than 70% for FY18.
On an attractive valuation:
Konekt continues to trade on a PE multiple of less than 10x, with EPS growth (excluding amortisation and abnormals and potential cost synergies) of 15% – 20% p.a. forecast over the next two years – the company offers a powerful combination of value and growth. There would also appear to be very little priced into Konekt’s current valuation to reflect the significant growth opportunities available to Konekt as the business transitions from its traditional injury management focus to a larger, diverse, more integrated employment services company, operating in multi-billion dollar markets.
This is the type of smaller company we get out of bed for, and we look forward to supporting and building upon our shareholding over the long term.
This week we bring to you a piece by friend of TAMIM Sam Ferraro of independent financial education firm Evidente.
This article was originally penned on October 13, 2017.
The RBA’s biannual Financial Stability Review (FSR) has become essential reading since the financial crisis, even for stock-pickers. The central bank has used the October issue as an opportunity to vent about its concerns surrounding investor complacency in global financial markets. It has cited some of these concerns previously, but the language it is resorting to now suggests that its patience is wearing thin. Below is the list of key risks that the central bank has identified.
In the FSR from April 2017, the RBA pointed to the risk of a sharp decline in prices of risky assets associated with a sharp reversal of the ‘search for yield’ trade. That language has now been more hard edged; low volatility and interest rates are facilitating excessive risk taking via a search for yield, increasing the risk of a ‘disruptive correction.’ In particular, high asset values and low market volatility suggest that investors might be under-estimating downside risks. Any number of uncertainties – if they were to transpire – could ‘trigger a reappraisal of asset valuations and a spike in volatility.’
Previously, financial stability risks in China were elevated; debt had grown significantly over the past decade, with strong growth in lending from less regulated and opaque parts of the financial system. The RBA has now added that these developments have ‘led to ‘considerable credit, liquidity and contagion risks in the Chinese financial system.’ Moreover, the ‘authorities face a challenging transition away from growth strategies associated with rising debt.’
Previously, conditions in commercial property markets were described as strong in Melbourne and Sydney, and weak in Brisbane and Perth. Now, the RBA has expressed ‘some concerns about non-residential commercial property markets’, with prices continuing to outstrip in Sydney and activity subdued in some other cities.
One of the key lessons taken by central banks from the financial crisis has been to become more pro-active around managing financial stability and calling out what they see as unsustainably high asset valuations. In the lean versus clean debate around the delicate task of managing asset price bubbles, the RBA has drawn its line in the sand, preferring to lean against what it considers to be speculative excesses. For asset allocators and stock pickers, the challenge remains market timing. It remains to be seen if the RBA’s warnings are as premature as were Alan Greenspan’s concerns about ‘irrational exuberance’, expressed in December 1996.
Evidente is an independent financial consulting firm managed by Sam Ferraro that delivers innovative financial advice to wholesale investors, including active long only funds, hedge funds, pension funds, and sovereign wealth funds, in Australia and globally. Drawing on academic research in asset pricing, behavioural finance and portfolio construction, Evidente provides wholesale investors with commercial solutions to stock selection and asset allocation decisions across equities and other asset classes.
Sam writes as a freelance journalist for The Age, Sydney Morning Herald and Australian Financial Review, was a member of the advisory board of API Capital, teaches business finance and international finance courses to undergraduates at RMIT, and most importantly Sam is a well respected source of information and friend of TAMIM.
This week Robert Swift digs into the recently announced Royal Commission.
Today the Australian government announced there would be a Royal Commission established to investigate the banking industry. This was done on receipt, by Treasury, of a letter from ‘the big 4’ requesting such, in order to ‘restore faith in the financial system’.
There will be many comments available on this imminently so ours will be short. We will also mostly ignore the apparent ‘wordsmithing’ whereby the request from the big 4 was to “restore faith in the financial system” rather than investigate the big 4 specifically. That is, “the system is good, we just need folks to be educated” rather than “maybe the system isn’t so healthy; please help us fix it”
Banks have been unpopular in Australia (and elsewhere) for justifiable and unjustifiable reasons. It is not clear that Australian banks have been less well behaved than banks in other countries. It seems that banks are unpopular when they transgress with retail clients or the smaller end of town? Wells Fargo in the USA for example has had problems with mis-selling and over zealous account openings, and it has become the banking pariah, rather than the large investment banks which facilitated a number of ‘grand schemes’ which dwarf the WFC account opening scandal. Greece’s entry into the Euro for example, was facilitated by a sleight of hand on a gargantuan scale by a global investment bank. This has cost far more than any account opening or financial planning ineptitude for retail customers done by CBA or WFC!
Since they have only been as badly behaved with equivalent cultural ‘problems’ as banks elsewhere why then is there a Royal Commission and what damage will be done?
It is a political gesture for a marginal government to appear to listen to the people. It is another ‘populist’ gesture much as the UK referendum was or even the Trump victory. Folks are pretty unhappy and rightfully so.
To get the banks to request the inquiry reduces the impact of the accusation of a ’U turn’ by the government and is a clever manoeuvre.
However a Royal Commission is NOT the best avenue to deal with the banking system and the problems of culture and poor behaviour at the big 4. Ironically a Royal Commission remit SHOULD be established and focus instead on the idea of breaking the oligopoly of the big 4. Somewhere along the line the Australian mantra of “4 pillars” became only 4 rather than at least 4. The problem of concentrated power lies in the decisions of the Rudd government to let Westpac take over St George, and for CBA to then buy Bank West. Four with a few small competitors became four with two of the more viable competitors subsumed. To have an industry which is price competitive needs competition and of that there is now too little. It is also clear that bank owned platforms with bank owned asset managers and tied planner networks is hardly the stuff of competition and low fees for the retail consumer. It is not all the fault of the Rudd government but they sure were nudged into acquiescing to what the big banks wanted.
A Royal Commission is designed to work when there is one major systemic issue and for which bilateral policy change can be agreed.
Inadequate banking competition and the overly powerful banks control of super fund administration in Australia, would be a valid target for a Royal Commission but it appears that this is not the requested objective.
Consequently we guess that this Commission will just be a sniping exercise where tabloid headlines of ‘scandalous policy and unsavoury behaviour’ will be the norm.
Here are our considerations if the toxic cultural norms, inadequate skills and bad incentives are to be improved:-
The best way to deal with poor behaviour is for the owners of the business, the shareholders, to get engaged before the event. ESG or Environmental, Social, and Governance, issues are all investment considerations, and yet we find that rarely are boards engaged by activist investors to effect change before something happens – at least not yet. Were the warning signs not there at CBA for some time as the Storm Financial scandal broke? Hindsight is a great thing but if ESG is an approach you highlight as part of your process then maybe there should have been more change required after Storm? I think the regulator might have been a little slow here too? People respond to incentives and staff are the same. Consequently shareholders should investigate management incentives and understand better the behaviours they produce. We understand it is difficult. We know some powerful UK based shareholder friends, who owned a decent slug of the Royal Bank of Scotland, and they were constantly telling the Chairman that Fred Goodwin was not a CEO who was building a sustainable and solid business. They got nowhere even though they were right. Engagement can be a thankless task but at least they tried before he blew up the bank and cost shareholders and tax payers a lot of money.
It is all about culture. Make the staff targets revenue based and you will get very different behaviour from imposing a target that is client retention based – for example. This Australian banking ‘problem’ is about behaviour, business culture and the true qualifications of executives to run retail and wealth management businesses. Business culture and the true level of management experience and skill should not be a Royal Commission remit.
Shareholders find it hard to vote with their feet if the company is too powerful and too large in their benchmark. Not owning CBA when it comprises over 10% of your benchmark assigned by the pension consultant is a tough and risky call to make for any fund manager. “Small is beautiful” in that the shareholders can afford to disinvest from a company they believe has a toxic culture and / or is a bad business. We think that government should use the Royal Commission to investigate breaking up the banks; and that more funds here should invest internationally using a global equity index which acknowledges the plentiful supply of well run banks offshore. This would make Australian banks less influential.
In an age of Fintech it is not clear that reducing the size and scope of the banks would raise the cost of borrowing in the economy – a claim you can be sure the banks will make if it ever is threatened! In short it may be a good thing to reduce the grip of the banks, but their written request was to “restore faith in the financial system”, not investigate and change the system!
This will be embarrassing for and potentially emasculate, the financial regulators. Or they could come back “badder and bolder” and heap a whole load more regulation and pointless oversight onto listed companies. We don’t know but as ever more regulations don’t appear to change behaviours. Someone somewhere is always breaking the law. If you make more laws, more laws will be broken. It’s not about the number of laws but the principles and ethics in which the business is immersed; and then how you respond IF you do break a law. Again we don’t see how a Royal Commission can help with ameliorating poor behaviour.
Our response in conclusion? Prepare for a year of revelations and rumours and heightened volatility in Australian banks. Look elsewhere, especially internationally, for diversification.
There has been much commentary surrounding the ASX breaking through the 6,000 barrier. This week Guy Carson weighs in and looks at whether the run can continue or not.
A lot has been made over the last month about the ASX 200 breaking through the 6,000 barrier. In doing this it reached the highest level since the Global Financial Crisis. A number of commentators have pointed to the psychological impact of breaking this round number and have suggested it could herald a sustained rally. We, however, are not so sure and in order to understand why we think it’s important to look at the structure of the Australian equity market and what its potential drivers are.
Over the last 10 years the S&P 500 has given investors a return of 106.3% or 7.51% annualised whilst over the same period the ASX 200 has delivered just 37% or 3.2% annualised. One of the key reasons for the Australian market lagging is the evolution of the US market over time. To illustrate this point the chart below looks at how the top five companies in the world and how they have changed over the last decade.
The most notable aspect is how the composition of the top five has evolved over time away from Energy (Exxon, Total, PetroChina) and Banking (Citi, ICBC) to Technology. The technology sector globally has been the key driver of the recent rally and the major source of earnings growth. One can point to current valuations and suggest that the Technology sector has run too hard and too fast. We would certainly agree that the likes of Facebook, Amazon and Netflix do trade at very high multiples, but with a lack of growth in other sectors, investors remain attracted to them.
Australia has missed out on this latest boom as the Technology sector currently represents just 1.8% of the ASX 200 and has a limited impact on the direction of the market. In fact, amazingly when you do a similar comparison of the Australian market you see that the companies at the top have barely changed over time. Amongst the top five companies in Australia, only one has changed since twenty years ago with ANZ replacing News Corp. This leaves us with four banks and a miner in the top five and highlights the concentration risk in the Australian economy to just two sectors (housing and mining). It is therefore these two sectors that will dictate to a large extent the direction of the ASX.
In order to understand where we are going it is often quite helpful to look where we have been. As the mining construction boom came to an end back in 2012, the RBA started to cut interest rates and this in turn led to a residential construction boom (something we wrote about here). The key driver was low interest rates encouraging consumers to take on debt; as a result Australian consumers took on more leverage at a time when consumers in most of the developed world were going the other way.
This was a significant tailwind for the banks. Higher demand for credit allowed them to continue to grow their asset books (as discussed in this article here) and this has led to profit growth. The question now is whether this growth continues and to that end we have started to see consumers begin to get squeezed by a combination of factors. These factors are the previously mentioned high debt levels combined with continuing low wage growth, a raise in interest rates through APRA intervention (on interest only and investor mortgages) and a 17% jump in electricity costs. As a result retail sales have fallen over the last three months and the property market has started to slow. The easiest way to measure demand in the property market is the auction clearance rates. These have started to fall with Sydney having recorded rates of below 60% for the last four weeks suggesting consumers are less willing (or less able) to take on more debt.
The impact for the banks will be constrained asset growth and if the situation worsens, rising impairments. The major banks have responded to this outlook by a further round of cost cutting with NAB in particular announcing that nearly 1 in 5 people will be made redundant. The outlook for the banks in our opinion remains one of low growth at best and therefore we don’t expect a meaningful rerate of the share prices to drive the market.
That brings us to resources which has been one of the key drivers of the recent rally. Commodity prices have rallied from December 2015 lows as China fell back on the infrastructure and property lever to boost their economy. Whilst prices have rallied they remain below their 2011 highs. Global growth has picked in recent times but China remains the overwhelming centre of demand, consuming between 50-60% of most raw major raw materials. As a result the ever expanding debt levels of the Chinese corporate sector remains the key risk.
One area within commodities that has seen significant speculation in recent times has been electric vehicles and battery use in general. With a shift globally occurring, the expectation is the demand for commodities associated with battery production will boost prices. Whilst we can see the increase in demand that is occurring we would point any investors interested in the sector towards a recent Massachusetts Institute of Technology study. This study looked at the five commodities most likely impacted by increased battery production, which are lithium, cobalt, manganese, nickel, and carbon in the form of graphite. The study found that the increase in demand from planned battery manufacturing will not lead to significant supply problems. There are however political risks, in particular for cobalt where a substantial part of the supply comes from the Democratic Republic of the Congo. Whilst speculation can always push prices higher, this study suggests the fundamentals may not necessarily line up. Of course the other major threat is the evolution of the battery technology that may remove some demand.
Ultimately, commodity prices are nearly impossible to predict and whilst there could continue in the short term, the rally over the last 18 months potentially limits how much further they can go.
So with both of the major sectors unlikely to provide significant earnings growth, our expectation is that the ASX 200 has limited upside. That is not to say that the recent rally is over, share prices can fluctuate and it would not be surprising to see the market 10% higher (or lower) in six months’ time. However without sustained earnings growth, any upside will be capped. This is the key difference between the Australian and the US market, the US market has evolved and earnings have been driven by innovation whilst the Australian market continues to be dominated by old industries.
That is not to say we don’t have innovation within Australia. There are a number of smaller companies that have done and are doing exciting things. Our portfolio has benefitted from owning companies such as Altium, Hansen Technologies and Gentrack. These are global technologies operating in niche sectors with structural tailwinds providing earnings support.
This week we bring to you a piece by friend of TAMIM Sam Ferraro of independent financial education firm Evidente.
This article was originally penned on October 16, 2017.
In a recent research paper, former Chair of the Federal Reserve, Mr Ben Bernanke, proposes price level targeting as an alternative framework for monetary policy. Since 2012, the Federal Reserve has had an explicit inflation target of 2% pa, with inflation commonly measured in terms of the chain price index of personal consumption expenditures (PCE), excluding food and energy. The chart below, re-created from Mr Bernanke’s paper, shows that this measure has consistently undershot 2% since the financial crisis.
Source: Evidente
At present, the Federal Reserve’s inflation target has no memory. Despite the negative deviations from the target over the past decade, the Federal Reserve’s mandate does not allow it to consider past shortfalls into account when formulating its outlook for monetary policy. As long as it believes that core inflation will return to the 2% target over the medium term, the central can justify the the current stance of monetary policy. In fact, this represents the rationale for the lift in the federal funds rate over the past year, with the US Federal Reserve expecting factors holding down inflation to be temporary, notably lower import and energy prices.
Under Mr Bernanke’s proposal of price level targeting, when the federal funds rate is at the zero lower bound, the central bank would be accountable for past inflation misses relative to the 2% target. It would no longer have the discretion to neglect past deviations and would need to make up for past misses. To illustrate, Mr Bernanke depicts the path of core PCE price level since the December quarter 2008 – when the federal funds rate hit the zero lower bound – against a counterfactual price level that grows at the 2% target (see chart). At present, the actual price level stands at 13.8% higher than 4Q2008, below the the 2% target trend which has grown by 19%. The cumulative miss amounts to over 400 basis points. Under the proposed new framework, the Federal Reserve would vow to maintain the federal funds rate at zero until the price level makes up for the past cumulative shortfall.
For argument’s sake, suppose that the federal funds rate was still anchored to zero. The central bank would then promise to hold its policy rate at this level until the core PCE price level rises by no less than 400 basis points relative to the target price level (bearing in mind that the target continues to grow around 0.5% per quarter).
Source: Evidente
Evidente has extended the methodology and created core price level gap measures for other countries and regions to offer guidance on what a flexible price targeting regime would mean for their respective central banks. The key assumption used for consistency is a common 2% inflation target even though some of these central banks have slightly different targets. Of the small sample, only Australia and the United Kingdom have positive deviations; their core price levels have grown faster than their target since 4Q2008. (see chart). But Europe and Japan have shortfalls that are significantly larger than the United States, suggesting that any moves to tighten policy in those countries would be premature based on a price level targeting framework.
Source: Evidente
Mr Bernanke acknowledges one of the pitfalls associated with this flexible price level targeting regime; how does the central bank treat deviations from the target price level associated with supply side shocks? For example, a coordinated cutback in global oil production by OPEC and other oil produces could lead to a lift in the general price level above the target level. Strict adherence to price level targeting would see the central bank tighten policy to compensate for past positive deviations, which would further depress activity. A flexible framework of the type that Mr Bernanke advocates, would given the central bank discretion to look through such supply side shocks, but its credibility would hinge on its ability to communicate this effectively to market participants.
A debate on a price level targeting regime represents a welcome development in the direction of what market monetarists advocate; a framework that targets the level and/or growth of an aggregate income measure, notably nominal GDP. Nominal GDP has a number of desirable properties relative to overall prices. First, nominal GDP is a better measure of economic well-being because households earn nominal wages and business earn nominal profits. Second, it is not subject to the same mis-measurement issues as overall prices or inflation. Third, demand shocks – which central banks ought to focus on – are better reflected in changes to nominal GDP than prices. Fourth, households mistakenly believe that low inflation is desirable because they focus on what they buy and not what they sell, notably their labour (a point highlighted by market monetarist, Scott Sumner).
Against this backdrop, Evidente has developed an alternative policy measure that focuses on deviations from a target level of nominal GDP. To that end, I have estimated a target trend for the United States based on the period 1993 to 2008, and extrapolated this trend out to 2017. At present, the shortfall amounts to 20%; the economy’s counterfactual nominal GDP would be 20% higher if it had grown since 2008 at the same trend rate posted from 1993 to 2008 (see chart). The shortfall has continued to grow and at present, is at its highest level. This framework would suggest that the Federal Reserve should have waited longer before embarking on its tightening process.
Source: Evidente
Evidente has extended the methodology to other countries and regions, which shows that the nominal GDP shortfall amounts to 15% or larger for Australia, United States, United Kingdom, Europe and China. Interestingly, there is no shortfall for Japan (see chart).
Source: Evidente
Many would view the conduct of monetary policy globally to be in a state of flux. Many central banks have implemented macro-prudential policies to promote financial stability at a time when policy rates remain close to record lows. On this front, the RBA has been a pioneer, formally adopting financial stability as one of the key objectives of monetary policy.
Mr Bernanke’s paper represents the start of what is a likely to be a drawn out debate about monetary policy and what it ought to target. Whatever the new central bank standard looks like in the future, one that incorporates level targeting and makes up for past deviations from target would amount to a significant enhancement on the current inflation targeting standard, particularly if policy rates remain close to the zero lower bound for an extended period.
Finally, the price level gap outlined by Mr Bernanke and the nominal GDP level gap reported here contain potentially valuable incremental information about the stance of monetary policy above and beyond real or inflation adjusted policy rates. Evidente is currently working on developing a framework that utilises this information to improve measures of expected returns at the market level. In due course, these measures are likely to become an indispensable part of the toolkit just not for central bankers, but also for asset allocators.
Evidente is an independent financial consulting firm managed by Sam Ferraro that delivers innovative financial advice to wholesale investors, including active long only funds, hedge funds, pension funds, and sovereign wealth funds, in Australia and globally. Drawing on academic research in asset pricing, behavioural finance and portfolio construction, Evidente provides wholesale investors with commercial solutions to stock selection and asset allocation decisions across equities and other asset classes.
Sam writes as a freelance journalist for The Age, Sydney Morning Herald and Australian Financial Review, was a member of the advisory board of API Capital, teaches business finance and international finance courses to undergraduates at RMIT, and most importantly Sam is a well respected source of information and friend of TAMIM.
