The TAMIM Small Cap Portfolio Embedded Value Opportunity

This week the TAMIM Small Cap team take a look at the embedded value within their portfolio.

Summary:

As the portfolio underlying the TAMIM Australian Equity Small Cap IMA approaches its 3 year anniversary we believe the embedded value opportunity within the portfolio is as compelling as when the portfolio was launched. The strategy is invested in high quality smaller companies which are trading well below our view of fair value. The portfolio is currently trading at a 32% FY18 P/E discount versus the All Ords despite the fact that expected FY18 earnings growth is expected to be almost four times greater. 

What is embedded value?

Embedded value is generally defined as being the underlying value of an asset based upon: 

• Earnings – The underlying value of the asset is generally calculated as the net present value of expected future cash flows.
• Assets - The underlying value of the asset is generally calculated as the realiseable value of the assets, or the price they could be sold at on the market.

In the TAMIM Small Cap strategy, we are looking for high quality smaller companies in which embedded value is far in excess of the current market cap. 

The TAMIM Small Cap portfolio embedded value opportunity in numbers:

The TAMIM Australian Equity Small Cap IMA portfolio currently owns 17 high conviction stocks which we believe are the “best of the best” high quality smaller company opportunities listed on the ASX. At present, the vast majority of these positions are earnings based positions – i.e. stocks in which we believe the discounted value of these companies’ future cash-flows is far in excess of their current market caps.

At a portfolio level the most effective way to present the earnings based embedded value opportunity is to show the underlying portfolio’s weighted average P/E valuation versus the weighted average for the All Ords, and then to compare the weighted average expected earnings growth for FY18 with the All Ords.

TAMIM Australian Equity Small Cap underlying portfolio weighted average P/E vs the All Ords (assuming portfolio is fully invested as cash has no P/E):

The TAMIM Australian Equity Small Cap portfolio is trading at a significant valuation discount versus the broader market. 

TAMIM Australian Equity Small Cap underlying portfolio weighted average expected FY18 earnings growth vs the All Ords (assuming portfolio is fully invested as cash has no EPS):

The TAMIM Australian Equity Small Cap portfolio's expected earnings growth is 3.6x that of the broader market.

​It is the combination of the above table and chart which shows the TAMIM Australian Equity Small Cap portfolio's embedded value opportunity: i.e. The portfolio is trading at a 32% valuation discount versus the broader market and yet earnings growth is expected to be almost four times the market average. In our experience, this is an usual combination within the investment company universe, and highlights the size of the strategy's opportunity looking forward.

How will the embedded value opportunity be realised for investors?

Earnings positions: Typically for earnings based positions the value opportunity will be realised through earnings reports which highlight cash flow growth rates above market expectations, and thus lead to an increase in market expectations regarding future cash flow growth rates. 

Example: Zentias (ASX:ZNT) is a typical TAMIM Small Cap portfolio earnings based position in that it ticks all our boxes for a high quality company, is trading at a significant sector discount, and its expected catalysts are earnings upgrades driven organically and through acquisitions. We believe the stock is trading significantly below its embedded value at present.

ZNT has been covered in a recent research article (again here).


Asset positions: Asset based catalysts tend to be less predictable than for earnings positions as they are often driven by one significant catalyst as opposed to regular quarterly earnings reports. The key major catalysts we generally expect for asset based positions include: asset sales, asset purchases, and growing sum of the parts visibility based on improved market communication/disclosure. 

Example: Elanor Investors (ASX:ENN) offers a compelling asset valuation opportunity at present in our opinion as the stock is currently trading roughly in line with its current net asset value which implies its highly profitable fund management business is trading at a significant discount to fair value. This is a typical example of the sum of the parts becoming increasingly visible in an asset based position over time. 

ENN was covered in a recent newsletter.


A generally long term perspective: We believe we have a significant advantage over shorter term focused investors/traders over the long term. By “not caring” about the short term market noise we find that we are well positioned for the value creation in our stocks as and when it arrives. This long term perspective will be absolutely key in realising the embedded value within the TAMIM Small Cap potfolio.

Conclusion:

​Buying stakes in ASX listed companies in which embedded value is far in excess of the current market value is what we are focused upon day in, day out. We believe this underlying value will be realised through catalysts such as earnings upgrades, as well as our old friend, time.