Two stocks with uncorrelated returns
This time last year, I presented the case that there was hidden value in IMF which would be realised as the company generated strong returns from cases in which it had invested on its balance sheet. Case investment growth tends to be a lead indicator to profit growth. Given the spike in case investments over the last three years, I felt that earnings growth should follow. While this was not immediately obvious in the FY19 results, since the beginning of FY20 we have seen a raft of settlements and case wins for IMF’s clients. So far in FY20 we have seen IMF’s Australian balance sheet investments yield just under $70m income from $24m invested capital.
One case (which really highlights how good this industry can be when you choose the right case) is the SEAS Sapfor case where IMF’s clients were awarded over $80m in the Supreme Court of NSW from the trustee. The award is still subject to appeal, however if it comes through, this will be a great returning investment for IMF given it invested $2.4m and will likely receive $30.5m income!
My biggest concern for IMF (and the industry generally) is that it invests in the wrong cases or does not price its risk properly on a consistent basis. While this can always happen (and luck does play a part), I gain comfort from their long track record (18 years, which is 17 years longer than most of their competitors), the low turnover of staff and the fact that it only chooses 3.7% of cases which it is asked to fund. There were some positive signs over the last twelve months. First of all, as mentioned previously, the company has had a good start to FY20 with a raft of case wins and settlements. Secondly, the company has managed to raise large licks of capital from very high quality limited partners (Harvard and Partners Group among others) with very good terms for IMF relative to the early funds and other aspiring litigation funding firms.
It has been a very busy 12 months for IMF. As mentioned above, it has raised two separate new funds, which is a slight pivot in strategy. These funds have c2% management fees, however the real returns for IMF will come from their co-investment ($US100m in each fund) and the performance fees, which are up to 30% over an 8% IRR. Given IMFs historical IRRs of around 70%, I expect this performance fee to be pretty material. Fund 4’s first case yielded an IRR of 136%!
More recently the company announced that it has agreed to acquire Omni Bridgeway in Europe. Omni Bridgeway has a long history within the litigation funding industry, however, has more of a speciality in post-case enforcement of claims rather than pre-case merit based funding agreements. While this is IMF’s first major acquisition (which is always risky), the complementary nature of the geography and skill set makes some sense.
Across the sector, the demand for litigation funding/financing has continued to grow strongly. This is especially the case in the US where the industry is in its infancy but is increasing in popularity across law firms. The size of the US market will likely dwarf the rest of the world and IMF is one of the leaders in the US.
It hasn’t been all roses for the litigation funding sector globally in the last year. Burford Capital has come under some criticism for its fair value accounting through a short report (IMF uses historical cost). This combination is making it hard for newer and smaller litigation funding companies to raise funds. There will be more blow-ups in this space as newcomers compete aggressively to win the wrong cases. So many people have stars in their eyes when looking at the returns litigation funding can provide, but one needs a track record, diversification, experience and a balance sheet to be raise external capital and be able to operate successfully and sustainably in this sector. I believe IMF exhibits all these characteristics.
Does it still offer value?
I believe that IMF still offers good value and we maintain a substantial holding in IMF. This is a complicated company with opaque accounts and there is an element of the unknown when trying to predict the timing and the potential return on IMF’s cases. However, the company does have a sustainable business model, has a strong balance sheet, a proven management team and most importantly continues to represent good value.
I estimate that if IMF were to run down the sunk capital on case investments on the balance sheet and realise the investments the early funds, you could get 2/3rds of the current valuation. On top of this, over the next few years the company will continue to deploy capital from its new funds ($US1bn with an option to grow to $US2bn). We feel that as IMF starts generating management and performance fees (which should be very material) from these funds, the earnings volatility will decrease and return on equity will jump.
It is conceivable that not only will the company start generating much stronger earnings, but also will get a re-rating from the market.
Another opportunity we've identified
It is hard finding companies which have uncorrelated returns. When the economy is growing, different companies seem to be uncorrelated. However, in a cyclical downturn it’s amazing how correlated companies’ earnings are.
One area where the earnings profile dances to the beat of its own drum is agriculture. Clearly you want to look to buy agricultural companies during a drought when earnings are under the pump.
Another area we have found tends to perform well in most market conditions are companies where there is a demerger. In our own proprietary research we looked at all the demergers over the last twenty years and found that post-demerger, the smaller (less loved) company would on average return 34% over the ensuing 24 months. What is most interesting from our research is that of the 28 demergers we looked at, 18 have resulted in one of the demerged companies being acquired. A company in which we are invested which has both of these traits is Graincorp.
With Graincorp, the earnings from the oils and grains business are currently depressed. There is somewhat of a perfect storm for Graincorp currently. The east coast of Australia is entering into the second year of a very bad drought. This is really hurting earnings in the core storage and handling business. Compounding this, the company has made large losses in its grain trading book (which seems to happen every seven or so years). If over the next couple of years the weather were to normalise on the east coast of Australia and the company were to have a more normal year on the grain trading, then there would be substantial earnings growth irrespective of what happens to the economic cycle in Australia. Combine this with the demerger where history has indicated that the demerged entity tends to outperform, then there should be some decent tailwinds for Graincorp irrespective of the business cycle.
From a valuation perspective, if you value the grains/oil business on a 10% free cashflow yield on a mid-cycle basis and 12x EBITDA for the malt business you get a $10.60/share valuation which is 35% upside from the current price. In an expensive market, this is not too bad.
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Anthony is the Portfolio Manager - Industrial Shares, Pure Equity Alpha (50%), SHARE-PLUS Long-Short and an Analyst. He has 13 years experience outside of Perpetual, most recently at Ellerston Capital. Anthony is a CFA charterholder.