By Ben Rundle | NAOS Portfolio Manager
Charlie Munger is well known as Warren Buffett’s business partner, but people who have followed him a little more closely would know that he was responsible for a change in Buffett’s investment approach. The Berkshire Hathaway portfolio shifted as it grew in size from a strict Benjamin Graham approach of buying the cheapest stocks, to instead buying higher quality businesses. In fact, the more we study the super investors, the more we realise that a key differentiating factor in their analysis is qualitative rather than quantitative.
"Once we'd gotten over the hurdle of recognizing that a thing could be a bargain based on quantitative measures that would have horrified Benjamin Graham, we started thinking about better businesses. And, by the way, the bulk of the billions in Berkshire Hathaway has come from the better businesses. Much of the first $200 or $300 million came from scrambling around with our Geiger counter. But the great bulk of the money has come from the great businesses.” Charlie Munger
With that in mind, we have come across an Australian listed company that we think meets Charlie’s filters when defining a high-quality business.
Objective Corporation Limited (ASX: OCL)
Objective Corporation Limited (ASX: OCL) is a software company that was founded in 1987 by Tony Walls who still owns approximately 67% of the company. Tony doesn’t actively promote the stock and it is not covered by any broker research.
“But Buffett and Munger hate software because it changes quickly and is hard to predict!” That’s not the software we’re talking about. The software we like is the type providing a mission critical service where there are high switching costs and the product delivers far more value than its price.
Let’s have a look at one example of what OCL does. One of the banks may use OCL software to manage the documents within the disclosure part of a PDS [product disclosure statement]. All of the statements can be vetted, the wording can be updated , the document can be approved internally and externally, it can be version controlled and then traced end to end using the software. This is a very important task for a bank to get right and OCL have in our opinion, a very long track record of getting it right.
In our view, the process a bank would be required to undertake in replacing this software is long and costly. There are numerous examples of OCL doing similar things in other industries, this is merely one.
So why is it so good?
“There is a class of business where the eventual ‘cash back’ part of the equation tends to be an illusion. There are businesses like that – where you constantly keep pouring it in, but where no cash ever comes back… struggling with a business that never produces any cash – whether its winning or losing as a matter of accounting – is no fun. You should seek businesses that just drown in money if they just pause for breath.” Charlie Munger
OCL was started with only a few thousand dollars in seed capital (yes, we confirmed the number of zeros there) over 30 years ago. At IPO in 2000, the business raised $6m and there have been no other capital raisings since that time. Despite the relatively tiny sum provided by shareholders, the company currently has $34m of cash on the balance sheet as at 30 June 2019. Since listing it has generated almost $110m in free cash flow, it has paid out $52m in dividends and has bought back $14m of its own stock. This from total equity injection of just over $6m. We have found very few businesses listed in Australia who have such impressive financial metrics.
"Pay close attention to the cannibals – the businesses that are eating themselves by buying back their stock." Charlie Munger
When OCL first listed in 2000 it had 135m shares on issue. The company now has less than 93m shares on issue after buying back over 40 million of its own shares. That’s a 30% reduction in the number of shares on issue, but you may ask why this matters. If you have 100 shares on issue and you make $10 in profit for the year, your earnings per share is 10cps. If the number of shares on issue decreases by 30% to 70 shares, then your earnings per share increases by 43% to 14.3cps without the profit having moved at all. The math works significantly in favour of the investor, it can be a fantastic way for companies to create shareholder value and it is extremely rare to find companies who reduce the number of shares on issue (tip: keep an eye on the ones who do). Even some companies who are conducting buybacks at present somehow often manage to increase their shares on issue year to year.
"If you’re right about the companies, you can hold them at pretty high values." Charlie Munger
But wait, OCL trades on a P/E Ratio of almost 40x, there is no way Charlie Munger would buy a stock at that price! A P/E Ratio can be a very misleading way to value a stock due to the composition of the ‘E’ in that equation. We are certainly not suggesting we are getting a bargain here, but let’s unwrap this a bit.
When a software company spends money on research and development, subject to accounting rules it can either be treated in one of two ways:
- As an ordinary expense which is accounted for in the profit and loss statement and thereby reduces reported earnings, OR;
- An item that is capitalised on the balance sheet and amortised over a certain time period.
In the case of OCL, they expense 100% of their R&D spend each year, which goes against the trend of what ASX listed software peers generally do. Looking at the FY19 accounts, OCL spent $13.2m on R&D and reported a pre-tax profit of $10.8m. If OCL chose to capitalise the R&D spend, their pre-tax profit would increase by 122%. In that scenario, their P/E ratio falls closer to ~20x which is just above the average of all ASX300 listed stocks of 17x and far below the average for the IT sector of 28x. And as we have highlighted, OCL enjoys economics that are far above average. Conversely, if the R&D of listed peers was 100% expensed in the manner OCL do, many of those companies would look extremely expensive.
However, what we really want to focus on is the cashflow statement. By our estimates, OCL should report operating cashflow somewhere in the vicinity of $20m in FY20. As they don’t capitalise any R&D spend, it will mean that free cash flow to shareholders (i.e. the owner’s earnings and not the accounting earnings) should closely match that figure, which means OCL trades on a free cash flow to market cap yield of around 4.5%. Further to this however, OCL has $34m of cash on the balance sheet and no debt. If the market cap is reduced by this amount, the cash flow yield is even higher. This compares to the Australian 10 year government bond yield of 1.7% and cash in the bank that earns virtually zero. And we are talking about a company with a 30-year track record of compounding capital for shareholders, with 20 of those years having been in the public eye.
“Over the long term, it’s hard for a stock to earn a much better return that the business which underlies it earns. If the business earns 6% on capital over forty years and you hold it for that forty years, you’re not going to make much different than a 6% return – even if you originally buy it at a huge discount. Conversely, if a business that earns 18% on capital over twenty or thirty years, even if you pay an expensive looking price, you’ll end up with one hell of a result.” Charlie Munger
In the twenty years since listing, OCL has averaged a 28% return on invested capital. Over the past 5 years the average is above 30%. OCL has recently transitioned its selling model from a perpetual licence arrangement where the customer pays for the service up front, to a subscription model which generates more of a recurring style of revenue. We have seen numerous software companies go through this transition which has often resulted in multiple downgrades to earnings. To date, OCL has been able to maintain returns through this transitional period.
“Look for great managers, because management matters.” Charlie Munger
Given the tremendous value that Tony Walls, the founder and current CEO of OCL, has created for shareholders, it would not be unreasonable to assume he has paid himself a handsome salary along the way. According to the Australian Council of Superannuation Investors (ACSI), the average pay for an ASX200 company CEO was $1.03m. The CEO of OCL however pays himself much less than this, receiving $300,000 in 2018. On top of that he owns approximately 67% of the company, so he is heavily aligned with shareholders. In our experience, a management team that is so closely aligned with shareholders, will often do the right thing by those shareholders.
We did mention earlier that the stock has had a fantastic run of late, with the share price almost doubling in the last 12 months. Does it double again from here in the next 12 months? We doubt it. But given the long track record of this business, we expect them to continue to operate in a way that will best serve customers and significantly enhance shareholder value over the long term. In a world where market participants are happy to pay revenue multiples for software companies that have been in existence for only a couple of years, it is refreshing to see a company with a long track record of cash generation and an ability to operate through various economic cycles.
At the time of writing this article NAOS Ex-50 Opportunities Company Limited (ASX:NAC) holds a position in Objective Corporation Limited (ASX: OCL).
Important Information: This material has been prepared by NAOS Asset Management Limited (ABN 23 107 624 126, AFSL 273529) and is provided for general information purposes only and must not be construed as investment advice. It does not take into account the investment objectives, financial situation or needs of any particular investor. Before making an investment decision, investors should consider obtaining professional investment advice that is tailored to their specific circumstances.
Livewire article published 25 November 2019