In a world of uncertainty, cash flow remains king

Angus Kennedy

Livewire Markets

Katie Hudson's career is full of bold moves. Beginning as a sell-side analyst, she moved to Goldman Sachs in June 2008 during the midst of a raging GFC. From there, she became a Managing Director and led a management buyout of the fund she was overseeing to form Yarra Capital Management. With every move, Hudson has exercised extreme due diligence - a staple of her investment philosophy and incredibly important within small caps.

"It all goes back to due diligence...We're having a really strong level of conviction about the economics of the industry, how sustainable that company's position is and then using that as the basis to really understand the cashflow. I think that's a really undervalued skill, truly understanding the cashflow generating capacity of a company."

In this episode of The Rules of Investing, my colleague Patrick Poke spoke to Katie about her focus on cash-generating businesses, how to avoid shockers in small caps and her outlook on the current COVID environment

Paving her own path

As a sell-side analyst at JB Were, Hudson had the opportunity to work alongside some of Australia's great investors, including the founders of Cooper Investors, Paradice Investment Management and GreenCape. 

"I think I learned more from them than they learned from me, but it was a great learning environment. I also had the benefit of working with a team at what was then JBWere, the number one rated analyst team in the market."

She then took the jump into the asset management arm of Goldman Sachs, despite concerns they may have been heading in the same direction as Lehman Brothers. Joining at that time presented a unique climate to adjust to equipped the team well to deal with the onset of COVID-19.  

"Certainly the first thing I'd say is as an investor, every crisis you go through, is an incredible learning experience. The benefit our team at Yarra Capital has today is, the core of that team was together around that time through the GFC. So that really helped, I think, particularly last year during COVID."

Soon after joining Warren Buffet poured $5+ billion into the company, and the quickness of the fall to this recapitalisation turned out to be the turning point. 

"So you could argue it was bad timing. You could also argue it with good timing, because really from there it was on an upward, both in terms of markets and in terms of our business."

With the team set, Yarra Capital was officially formed in 2017 as management completed a buyout and became their own entity. Today, they manage over $20 billion, having recently completed an acquisition of Nikko Asset Management. Their core mandate revolves around finding long-term quality companies underpinned by deep research, and Hudson carries this out through her small-cap portfolio. 

We do over 2000 meetings a year to undertake that due diligence. So, a really strong track record and a really heavy focus on understanding the businesses we invest in...My big focus is investing in small cap companies. I think one of the really big inefficiencies in the (small-cap) market today is actually what I'd characterise as timeframe. 

The team believes that over 30% of money currently invested in small caps is focused on short term momentum through quant or index investing. And this presents an opportunity.

"By having that longer-term timeframe (3-5 years), we think we can buy some really good companies at times when the market is very much short-term focused. COVID last year was a great example of that... Everyone was focused on the last data point and extrapolating which created a lot of opportunities for us to buy some really good companies and to set our portfolios up for the longer term."

How to value for the long term

As the time horizon stretches, your margin for error rises. But understanding the long-term trends and economics of the company can provide insight into whether it can sustainably generate cash flow in the future. There is often a headline focus on profits or further metrics such as EBITDA, which allow companies to exclude certain unflattering aspects of their operations. This is why Hudson and her team are transfixed on cash:

"There's a number of companies that we invest in that generate very little profit, but actually have very good cash flow. The reason for that is they're investing through their profit to grow. It may give the appearance that the profit is not as attractive, but actually over time, they will generate really compelling cashflow. It's really trying to unpack the elements of the profit to understand whether they can generate true free cashflow after that investment."

How to avoid bombs 

All investors hate them, but they all have them. Portfolio blow-ups are an inevitable part of any fund and the risk of encountering these certainly becomes more pronounced as you head to the smaller end of the market. Hudson flags 3 core areas to pay close attention to:

  1. Understand what you're buying: What's the franchise value? What's the strategic asset value? Make sure to understand these intrinsically, because that allows one to understand what can go wrong and what the risks are. 
  2. Look beyond the balance sheet and debt: Being aware of debt tolerance is definitely important, some companies can handle it, others can't, but this is not the only source of risk. RCR was a contractor that actually went broke despite having no debt. In their case, they had very low margins and very large contracts and commitments. They had a lot of bonds and performance guarantees that meant when things went wrong from a productivity point of view, they were exposed. What is on the balance sheet is just as important as what is off it. 
  3. Analyse the downside protection: Understand what is being bought and the downside protection. Hudson's team often invest in companies that might have some land or hard assets or that have net cash which provides some hard backing if things go wrong, or if the company has a misstep.

Overall, appreciate the prospective returns and opportunity, but never overlook the other side of the ledger - risk. 

One such risk that Hudson's team has been paying close attention to is that posed by over-earners. These are companies that may be earning at rates that are higher than their long-term trends. COVID-19 has been a big contributor to this phenomenon, so it is important to exercise caution

Examples of industries experiencing this include:

  • In the automotive sector, new car sales are probably 9% above the pre-COVID levels;
  • Hardware sales are 15% above pre-COVID levels; and 
  • Homewares sales are more than 25% above pre-COVID levels. 
"We're not travelling, we're not spending on entertainment, we're staying home and spending on the house. And that's certainly been a massive boom for companies that operate in those sectors. And we're just treading very carefully because it may prove to be unsustainable."

Tech small caps at an appropriate price

Tech companies make up a large portion of the small-cap index, yet many of these growth names appear to trade on exuberant valuations. So with quality and hyped companies both trading up together, how should valuation conscious investors approach the sector?

"There's been an investor focus on sales growth and on sales multiples, which we think is actually a flawed way of looking at these companies.  When we look at the technology sector, what we're trying to understand is the sales growth, but also the durability of that sales or revenue - how sticky it is, how long those companies can have confidence that they'll get that revenue."

Appen (ASX:APX) is an example of a company with a really interesting product but has what Hudson characterises as relatively short duration revenue. There is not a lot of visibility on what their revenue will look like over the next 12-18 months, yet going back 12 months investors were having to pay 10+ times sales revenue for that company.

"That's like paying forward 10 years of sales for a company that doesn't have a lot of visibility out beyond 12 - 18 months for its revenue. That relationship just didn't make sense to us. For that reason, we didn't own that company. 

A company she sees in a different light is Megaport (ASX:MP1).

"They've got mission-critical software. Every month of every year, they know what their revenue is going to be because their customer base is very sticky. They pay month in, month out, and their churn is extremely low as a consequence. We know with a very high degree of confidence on a multi year basis, what their revenue will look like. That's what we would characterise as being very durable revenue. It's also very high margin revenue. So the economics of the business are really compelling as they grow."

Nanosonics: Cleaning up the competition 

Nanosonics (ASX:NAN) had a difficult period through COVID-19 given a constrained sales stream. They create disinfection technology and have been unable to both sell the product and install it into the hospital as a result of restrictions. But the winds of change are swelling:

"The Northern hemisphere economies are getting back to business and they're now getting access to hospitals and growing their revenue again. That's a really good example of timeframe inefficiency ....you have some short term impact on the business that's not changing the longer-term opportunity. From our perspective, that revenue is deferred not lost. We think they will absolutely regain that over time and where the share price is weak, that feels like a great opportunity for us to buy a really strong long-term growth franchise."

Staying along the medical theme, Katie tips Fisher and Paykel Healthcare (ASX:FPH) as the one stock she'd invest in if the markets were to close for 5 years. 

"They have a global leadership in respiratory technology, which has actually been a big beneficiary of COVID...If you said to me over the next one to two years, how would that company go? I think there's probably a bit of a headwind for them as they cycle that strong COVID growth, but on a five-year view, I'm very confident...The market opportunity for that technology is probably 20 times their current revenue. So they've got a long, long runway for growth and fantastic management, really exceptional manufacturing capability."

In typical fashion, the theme of long-term compounders with visible cash flows shines through; even though there may be hiccups along the way. Exploiting the time frame inefficiencies from an impatient market opens up a suite of opportunities - if you have the nerve to leave it be. 

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Australian investors can access the Yarra Australian Smaller Companies Strategy via the UBS Australian Small Companies Fund, a fund which has been managed by Yarra Capital Management since December 2018. For more of Katie Hudson's insights, click the 'FOLLOW' button on her profile.

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Angus is a Content Editor at Livewire Markets. He has previously interned in the Global Investment Research division at Goldman Sachs, covering resources and small caps.

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