I strongly believe that 12 months ago, very few investors would have made even the slightest suggestion that the ASX-200 Index would post 11 months of gains in the financial year, with only September 2020 producing the single negative monthly return. I am a firm believer that no matter what edge any successful investor may believe they possess, at certain stages they will simply be the beneficiary of good fortune. In my opinion, FY21 was one of those years when the wind was at many investors’ backs. Even so, I firmly believe that the patience we have shown as an investment team and remaining true to our investment philosophy, has played the most critical part in delivering the strong performance over FY21.

Today, we live in a world where interest rates have never been lower. Across the globe, central banks have flooded markets with liquidity through numerous initiatives, and federal governments have resorted to fiscal stimulus initiatives to drive investment over the short- and medium-term. This has been very apparent in Australia.

This backdrop has created an excellent environment for asset prices, which includes listed companies. The nuance to the above is that the type of company that the market perceives to benefit over the long term has shifted. As such, we have seen a sharp rebound in valuations for businesses that for the prior 3–4 years have generally been overlooked by many investors. Industries in which these businesses operate include financials, building materials, consumer discretionary and construction/engineering services to name a few.

All NAOS portfolios were a beneficiary to some degree of the events mentioned above in FY21. In saying that, I am a firm believer in the NAOS investment philosophy of investing with a long-term focus in industrial-type businesses that:

• operate in growing industries;
• have a clear and increasing moat;
• are run by proven and aligned leaders;
• generate excellent free cash flow; and
• are disciplined and proven allocators of capital.

EXP finished this financial year with a total shareholder return of over +140%, in a demand environment that could be described as subdued at best. Historically, EXP is a business that has heavily relied upon international tourists to drive both its Australian and New Zealand skydiving operations and its North Queensland cruise businesses. With international borders closed for the entire year, EXP has been completely shut down from an international tourism point of view.

Despite this backdrop we saw EXP benefit from a number of factors, which we believe assisted in driving the re-rating of EXP’s valuation throughout FY21. This has occurred even though the company’s earnings profile is yet to return to anywhere near historical levels.

Firstly, to date the business has come through COVID-19 with a close to net cash balance sheet and was one of very few ASX-listed travel companies not to raise capital throughout the pandemic. Secondly, EXP’s asset base has been rationalised and arguably better suits the company’s strategy going forward.

Furthermore, the business has substantially reduced its reliance on third-party distribution deals, which we believe will lead to significant margin improvement as many third-party booking platforms can charge fees between 10–30% of the ticket price. Finally, EXP made its first bolt-on acquisition under its new board and management team. EXP acquired two luxury walking businesses in Australia that will form the foundation of a third pillar to its operations, serving domestic travellers in the Premium Adventure markets of Australia and New Zealand.

Notwithstanding the valuation re-rating in FY21, we believe the future is extremely bright for EXP. Coming out of COVID-19, the next two years should hopefully provide evidence of the high-quality nature of the underlying business. There are also numerous organic and inorganic growth opportunities in front of EXP. Organic opportunities such as the construction of the Great Barrier Reef Dreamtime Island pontoon, which is due to be operational in CY22, and inorganic opportunities such as the recent acquisitions, to further develop their Premium Adventure operations.

CGA, a business that has spent the past few years transitioning, showed some positive momentum in its third year as a distribution business, which led to its share price increasing by over +240% in FY21. CGA is the sole distributor of the WCM Investment Management (WCM) products to retail investors in Australia. As a group, WCM has >$100 billion in Funds Under Management (FUM), which is of a similar scale to the hugely successful Magellan Financial Group (ASX: MFG).

Over the past two years, CGA has been laying the foundations to ensure that the WCM investment product suite has the best chance of success and the ability to reach a point of scale within the Australian market. At the start of FY21, CGA had close to $500 million in FUM associated with WCM products. Over the past 12 months, this has grown to just under $1 billion. Driving this growth has been unique products, such as the WCMQ Exchange Traded Product (ETP) and the WCM Global Small Cap offering.

As many investors would know, the global equity product landscape within the Australian funds management industry has largely been dominated by two groups: Magellan Financial Group (ASX: MFG) and Platinum Asset Management (ASX: PTM). Over the next few years, we expect to see a continued diversification of retail portfolios away from domestic equities and property, with increased weightings towards international equities. This should be a tailwind for CGA.

The WCM investment philosophy is centred around a company’s culture and the trajectory of a company’s competitive moat. This strategy has proven successful, with WCM’s historical performance across its various strategies comparable (and in some cases superior) to its Australian-based global equity peers.

Along with its investment philosophy and the industry tailwind, in our view, another advantage CGA has is that WCM is a large, globally recognised business that offers very little in the way of business risk compared to boutique competitors. We believe that CGA has a realistic opportunity of growing the level of its WCM-managed FUM to $2–3 billion in the short term.

From time to time, emerging company investments are made with the best of intentions but due to circumstances beyond our control (or belief), the investment thesis does not play out as anticipated.

FY21 was a year to forget for WNR. WNR’s share price finished the year down by approximately –50%, which in our view was the result of various factors, including poor management, lack of quality and accuracy with information provided to the market, risk and governance issues, and finally, macro factors that exacerbated all the above.

Looking back at our investment thesis and the mistakes we made, we believe the reliance we had on the alignment of the founder/managing director, who initially owned ~20% of WNR, was too great to offset the other risks surrounding the business.

Throughout FY21, WNR conducted a highly dilutive equity raise where funds were not used on the stated strategic items. In addition, the founder/managing director left the business and sold his entire shareholding. More recently a thorough review of the business was completed, which uncovered further shortcomings and led to events such as a significant writedown of inventory.

In the case of WNR, we believe the commonly used saying “never waste a good crisis” applies in varying degrees. A new board of directors has joined the company, with potentially further changes to come. A new managing director has been appointed who, pleasingly, possesses sound agricultural experience both from a supplier and a buyer standpoint. In addition, the company strategy has been simplified to focus on the hay-processing business, which has also resulted in an upskill of certain key staff.

In the case of WNR, we are pleased FY21 is behind us but are of the opinion that WNR is exiting FY21 in a much-improved state. We do not know what the future holds for WNR but we firmly believe that with the sound, hard asset backing and a niche position in the supply of oaten hay products both domestically and internationally, there is a solid base that can be capitalised upon by the right board and management team.

EGG has been one of our most successful investments, not only for NCC but for the NAOS group as a whole. Since the NCC initial public offering in February 2013, EGG has been a position within the portfolio. At that time EGG was a holding company for a number of advertising and public relations businesses based in Australia, the UK, and to a lesser extent, North America. The business had approximately $100 million in revenue and was just break-even, albeit with a reasonable net cash balance sheet.

Today EGG has grown its revenue base to approximately $150 million, but most importantly, the EBITDA margins have grown to approximately 30%. From a valuation perspective you could reasonably argue that EGG shares remain undervalued based on today’s earnings. We would agree with this assertion but this, of course, is based on the assumption that the current level of earnings will be maintained.

We may well be cautious given our long-term understanding of the company but it is fair to say that historically, the level of variability of earnings in each of the business units has been significant. As with many services businesses, their biggest competitive advantage is based around company culture and people. When successful, this drives the momentum that brings new customer wins, which in turn drives growth.

Over the past 12 months at EGG we have seen the appointment of a new CEO, CFO, Head of Strategy, Head of Hotwire PR and a new chair. Change can be healthy for a business, but such a level of change can also present a significant risk that can often be difficult to mitigate. EGG itself went through this experience many years ago.

When you consider the above alongside potential headwinds, such as moving to a higher tax rate next year as tax losses are exhausted, the end of earnouts for Hotwire PR and Orchard Communications, and a hyper-competitive industry backdrop, we believe the risk could outweigh the potential returns and as such, we have exited the majority of our holding in EGG. We hope that EGG can continue to grow as it has done so successfully over the past five years, but we fear that the margin for error is small.

Technology-type companies have been some of the best-performing companies since COVID-19 as many of them have been benefactors of the expedited transition to a more digital world. With the recent rotation out of higher growth, technology-type investments into more value-type investments, NCC has invested in a new core investment in what we believe to be a value-type software company called Gentrack Group Ltd (ASX: GTK).

GTK is a technology services provider to utilities and airport operators and was established in the 1980s when New Zealand deregulated its power markets. Today, GTK has approximately 50 core customers across three main geographies: New Zealand, Australia and the UK, who are supported by over 300 internal engineering staff at GTK.

More recently GTK has undergone significant change, with a completely new executive team from the CEO down, as well as a new chair. From an earnings standpoint, the business has also experienced a significant amount of change due to internal execution issues, as well as external issues – such as regulation change in the UK for utilities providers – which has affected some of their customer base.

The reasons we are attracted to the GTK business are relatively simple. It is a business we have followed for over five years as it has a high-quality customer base. Over 75% of its revenue base is recurring in nature and, in theory, is growing. Many of the new executive team have worked together previously and have a good track record in running technology-focused businesses that solve the problems of very large organisations through innovative solutions.

Under the new team, GTK has reintroduced a move to fully expensing all research and development spend, which we view very favourably, the cash-flow generation has largely been sound, and its balance sheet stands in a healthy net cash position.

As is the case with a majority of our long-term investments, this particular investment will likely not be a smooth ride and does carry a degree of risk. Even so, we believe the risk is more than outweighed by the potential return. The returns will come if management can continue to grow the sticky revenue base, consistently grow margins, and reinvest the subsequent increased free cash flows into further improving their software, as well as inorganic opportunities that fit the strategy. If this can be achieved, the valuation multiple uplift applied to GTK could potentially be significant.

It is impossible to provide an accurate prediction as to how a portfolio of investments will perform over a 12-month period. Even so, I believe it is important to provide a general outlook to our fellow shareholders, detailing our level of comfort with the current NCC investments, their potential, and any catalysts that may occur in FY22.

We believe the current portfolio has a significant amount of unrealised value and the current trajectory for a clear majority of these businesses is where it needs to be. Some are benefiting from strong short- to medium-term industry trends, e.g. Big River Industries (ASX: BRI) and Saunders International (ASX: SND), while others, e.g. BSA Limited (ASX: BSA), need to capitalise on potential opportunities and increase their scale in a realistic timeframe, both organically and via acquisitions.

For NCC, there could be numerous catalysts that may have a material effect on the portfolio return in FY22. The key and most realistic catalysts in our view would be large contract wins for Saunders International (SND), BSA Limited (BSA) executing on plan to significantly increase its businesses’ scale, and COG Financial Services (COG) providing greater transparency around the potential of the group to grow its insurance-broking earnings and the current trajectory of this earnings stream, which in our view would command a higher valuation multiple.

FY21 was an excellent year from a pure return point of view, but we are under no illusions and believe that you are only as good as your next year’s returns. We believe the NCC Investment Portfolio has a compelling balance between risk management (protection against permanent capital loss) and long-term returns despite its highly concentrated portfolio. 

As always, the entire team at NAOS would like to thank all our fellow shareholders for continuing to be shareholders in NCC. We also welcome all new shareholders who joined the register in FY21.

If you have any queries, do not hesitate to speak directly with me or any member of the team.

We look forward to continuing to provide you with regular updates throughout FY22.

Kind Regards,

‍

Sebastian Evans
Managing Director and Chief Investment Officer
NAOS Asset Management Limited