Livewire Article | NAOS: Why we don't invest in Afterpay

This article was produced by Livewire Markets, 31 July 2019

NAOS Asset Management established its first listed investment company (LIC) in 2013 with 400 shareholders. Today, NAOS manages $260 million across three LIC vehicles for close to 8,000 shareholders.

Its directors and employees have a significant interest in all three of the LICs that it operates, meaning the manager is invested alongside its shareholders and thereby creating strong alignment of interests.

The stated mission of NAOS is to provide investors with genuine long-term, concentrated exposure to undervalued, Australian-listed micro, small and mid-cap companies with an industrial focus.

According to Sebastian Evans, Managing Director and Chief Investment Officer of NAOS Asset Management, each of NAOS' three LICs – NAOS Emerging Opportunities (ASX:NCC), NAOS Small Cap Opportunities (ASX:NSC) and NAOS Ex-50 Opportunities (ASX:NAC) – target a concentrated portfolio of 10-20 companies.

In NAOS' recent update for the fourth quarter of fiscal 2019, Evans points out that the previous year had not been kind to the manager for a number of reasons, but mainly due to the fact that their investment philosophy has simply not been in vogue.

"Clearly, we've made some mistakes – we don't shy away from that – but very much our strategy and philosophy has not been the right strategy and philosophy to be investing in during this type of market, as many of you would be aware of," Evans says.

This is a market in which high-growth and technology stocks continue to outperform, which leads to a question that Evans says he is confronted with nearly every month: Why doesn't NAOS invest in stocks such as Afterpay Touch (ASX:APT)?

"I think from a valuation perspective, Afterpay is expected to earn $17 million (in FY19) at the EBITDA line … if you look at the market cap and what the market is valuing the business at, you're applying a 380x multiple to that EBITDA level," he says.

As Evans points out, people are willing to pay big multiples for businesses that are willing to grow. That doesn't make them bad businesses, just because they have an expensive FY19 multiple. But what it comes down to is the growth rate of these businesses.

To highlight this and to get his point across, Evans made up a table that looks at an imaginary business. He assumes this business earned $100 this year, and also assuming that business today is valued at around 110x EBITDA, this gives a share price of $11.

Source: NAOS Asset Management

If Evans believes that business can grow over the next five years, then obviously there's a growth rate that needs to be assumed for him just to maintain that share price. He also believes that multiple will reduce from 110 to 15x over the next five years.

"It's a fact that businesses that as they grow and as they mature – think BHP (ASX:BHP), think CBA (ASX:CBA), some of these bigger, industrial-type businesses – multiples reduce because mature businesses find it harder to grow as they get bigger and more cumbersome," he explains.

"So, we believe a 15x multiple is fair. It's above the market, but it's still fair. So, to maintain an $11 share price over the next five years, that business would need to grow its earnings each year at 50% per annum … that may well be possible."

However, Evans believes that when looking at some of these high-growth and tech businesses, there will be some of that will be able to grow at that rate, but there will be others that will not.

And when applying a sensitivity analysis, say, that EBITDA grows at only 20%, investors in such a scenario would stand to lose an awful lot of their capital.

"It won't be 10% to 20%, it could be 70% to 80% - and we're simply not willing to take that risk for our investors and that's not how we invest," Evans says.

"Considering a lot of these businesses and the markets they operate in, they move at a very rapid pace, and at a pace that I would argue very few investors could understand in the depth that they really need to, to make these sorts of investments at these levels."

So, if it's not the Afterpays and "WAAAX" stocks of the world, what sort of businesses are NAOS looking for?

"I always try to get the team to focus on looking at a business that we can understand and focusing on what we can control," he says.

"So, we invest in businesses that have revenue and can drive margin growth; they've got balance sheet flexibility; they're valued on today's earnings and don't necessarily factor in any growth into the future; they've got proven management teams; they focus on a core competency that they do well and they understand well; and then obviously, we're ESG-aware as well."

Discussing one such stock that meets the manager's criteria, as part of the NAOS Ex-50 Opportunities (NAC) strategy, Evans says the manager recently entered a new position in AP Eagers (ASX:APE), the largest owner of car and truck dealerships in Australia.

Longer term, NAOS expects this investment in AP Eagers to yield fruit as a result of its merger with Automotive Holdings Group (ASX:AHG), while new car sales rebound from cyclical lows.

Evans also said that within the NAC portfolio, workforce solutions provider People Infrastructure (ASX:PPE) had been a "stellar performer," with the company having completed a $20 million equity raising and having finalised two acquisitions, both of which operate in the healthcare staffing industry.

PPE also said that the second half of fiscal 2019 has been stronger than the first half, which Evans said is pleasing given the strength of the first-half result.

"We continue to like this business. Obviously it's run by an excellent management team, but most importantly, the dynamics and the thematic around healthcare, the NDIS scheme, and an ageing population, there are going to be more requirements to find qualified staff who can fill the voids in the opportunities that come up from these large service providers," Evans says.

"You need to be nimble, you need to have quality staff, and obviously if you don't you won't get the repeat business, but if you do you will get a lot of repeat business from very large operators in a market that is growing at a significant and very steady clip."

"So, that's why we think that's an excellent business, and an industry and I suppose a thematic that's actually very hard to get a pure exposure to – it's not easy to get an exposure to healthcare and the ageing demographic."