Finding Unloved Gems Lessons from the Value FundSpecial report | december 2013

intelligent investorPO box Q744 Queen Vic. bldg NSW 1230T 02 8305 6000 F 02 9387 8674info@intelligentinvestor.com.au shares.intelligentinvestor.com.au

Share adviSor 2

coNteNtS

In the beginning 3

enero Group 7

UXc 8

rNY Property Trust 8

Ingenia comm. Grp 9

Vision eye Institute 9

meet the team 10

WarNiNG This publication is general information only, which means it does not take into account your investment objectives, financial situation or needs. You should therefore consider whether a particular recommendation is appropriate for your needs before acting on it, seeking advice from a financial adviser or stockbroker if necessary. Not all investments are appropriate for all people.

diSclaiMer This publication has been prepared from a wide variety of sources, which The Intelligent Investor Publishing Pty Ltd, to the best of its knowledge and belief, considers accurate. You should make your own enquiries about the investments and we strongly suggest you seek advice before acting upon any recommendation.

copYriGht© The Intelligent Investor Publishing Pty Ltd 2013. Intelligent Investor and associated websites and publications are published by The Intelligent Investor Publishing Pty Ltd ABN 12 108 915 233 (AFSL No. 282288).

diScloSUre As at 11 December 2013, in–house staff of Intelligent Investor held the following listed securities or managed investment schemes: ARP, ASX, AWC, AWE, AZZ, COH, CPU, CRH, CRZ, CSL, EGG, FKP, ICQ, IFM, JIN, KRM, MAU, MIX, MQG, NST, PTM, QBE, RMD, RNY, SLR, SRV, SWK, SYD, TAP, USD, UXC, VMS, WDC, WES, WRT and ZGL. This is not a recommendation.

iMportaNt iNforMatioN

Intelligent Investor PO box Q744 Queen Vic. bldg. NSW 1230T 1800 620 414F 02 9387 8674info@intelligentinvestor.com.aushares.intelligentinvestor.com.au

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Steve Johnson loves his job. And why wouldn’t he? As the chief investment officer of Intelligent Investor Funds, he spends his days poring over annual reports and spreadsheets. Diehard value investors truly are a breed apart.He has also built a successful business in double-quick time. Under his direction, Intelligent Investor Funds has grown its funds under management from less than $8m at startup in 2009 to $120m recently.

table 1: perforMaNce

valUe fUNd

S&p all ordS. accUM. iNdeX

1 Year retUrN 44.1% 22.6%

2 Year retUrN (p.a.) 34.1% 17.8%

3 Year retUrN (p.a.) 22.5% 9.0%

SiNce iNceptioN*(p.a.) 15.1% 7.9%

Note: Performance data to 30 November 2013. * Inception date 31

October 2009.

Not all of the growth has come from investment performance. But there’s no doubt that performance has a great deal to do with it. The company’s first managed fund, the Value Fund, has produced an average annual return of 15.1% for unitholders since 31 October 2009. That’s a full 7.2% ahead of the All Ordinaries Accumulation index.

chart 1: valUe of $10,000 iNveSted

It’s certainly a great result but focusing on the outcome alone risks missing the point. Excellent investment performance is the result of a carefully developed method for analysing stocks. In short, it’s the process that matters.That’s what this report is about. It’s not about Steve, his analytical team, or even the Value Fund itself, although

they’re an important part of the story. It’s about how you can employ the methods Steve and his team use to find your own unloved gems.

iN the beGiNNiNG

But let’s jump back a step. When the Value Fund was launched four years ago, it had a clear mandate: to buy stocks that Intelligent Investor Share Advisor was unable to recommend.At the time, Intelligent Investor analysts — and Steve in particular — were finding plenty of stocks too small to be recommended in a widely-read sharemarket publication. It simply wasn’t possible for thousands of members to ‘get set’ in small stocks that traded only a few thousand shares a day.A fund would be able to take advantage of these opportunities. More importantly, anyone would be able to access them.So the Value Fund was born. While not restricted to buying small companies — indeed the Fund has owned a number of billion-dollar stocks — the junior end of the market has proven to be the most fertile ground.The stocks the Fund buys are certainly ‘unloved’, although it often goes further than that. Many are ‘ignored’ and some are even ‘reviled’. You’ll rarely read about them in the newspapers or, if you do, it’s because there’s something downright unsavoury about them. Think of ‘opportunity’ and ‘popularity’ as complete opposites and you’re on the right track.There will inevitably be a small overlap with Intelligent Investor Share Advisor. After all, they share an investment philosophy and peer into the same investment pool. Occasionally, they’ll end up buying or recommending the same companies, particularly for stocks above a $100m market capitalisation.But the main difference is this: while Share Advisor has been more about ‘large’ and ‘quality’, the Value Fund’s picks have been more about ‘small’ and ‘cheap’. If ferreting around at the small end of the market appeals, this report is for you.

hoW to GeNerate ideaS

So how does the Value Fund identify small and cheap stocks? Coming up with ideas is the crucial first step before selecting which stocks to buy.The Value Fund’s approach is different from that employed by Share Advisor, which focuses on the top 200 ASX-

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In the beginningbY JohN addiS

Coming up with ideas is the crucial first step before selecting which stocks to buy.

Value Fund ASX All Ords Index

5,000

7,500

10,000

12,500

15,000

17,500

$

2013201220112010

Source: Capital IQ, Dec 2013

Share adviSor 4

‘Rolling Year Records’, which is a list of stocks hitting 52-week lows (and highs).

table 2: GeNeratiNG ideaS

1. Consider sectors where the news is bad and the outlook poor;

2. Look for stocks down more than 50% from previous highs;

3. Review ASX announcements daily for company-specific changes;

4. Filter stocks based on ratio analysis (e.g. discount to NTA) or price movements;

5. Review stocks hitting 52-week lows (and highs).

Of course, generating ideas is only the beginning. Once a promising stock has been identified, the hard work really begins.

rUNNiNG the reSearch fraMeWorkThere’s no escaping it. Potential buy candidates need to be rigorously investigated. It’s an intensive process involving analysis of the financial statements and management commentary, as well as competitor and industry information.The Value Fund has developed a research framework to guide its analytical process. All stocks progress through this research framework in which the business is valued, strengths and weaknesses are studied, and the wider context considered. The research framework, prepared by the Value Fund’s analytical team, covers the following topics:

n Business description;n The reason for analysis;n Industry analysis, including market share and regulatory

issues;n A Porter ‘Five Forces’ competitive position analysis

(see table in side column);n Competitor identification and analysis;n Management, board and internal culture;n Company strengths, weaknesses, opportunities and

threats (SWOT);n Company strategy;n Historical financial information;n Accounting principles analysis;n Cash flow analysis;n Ratio analysis;n Financial and capital structure;n Potential valuation methodologies;n Company valuation;n Ownership structure;n Substantial shareholders;n Risk analysis, including financial, operating and

analytical risks;n Psychological analysis, including potential biases.

This framework looks comprehensive, and it is. A typical report on one company, prepared by a Value Fund analyst, might run to 30 pages or more. Additional information is added to the framework as the story unfolds.

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listed stocks (as defined by the S&P/ASX 200 index). As a general rule, you’ll find the highest quality stocks in that index although, because it contains plenty of dud investments as well, the pool of potential buy ideas for Share Advisor is relatively small.The Value Fund’s investment universe is — like the real universe — far bigger. Over the past four years it has bought companies with market capitalisations as low as $20m. These stocks are too small even for inclusion in the All Ordinaries index, which covers the top 500 companies listed on the ASX.Consider the portfolio distribution of the Value Fund’s holdings in Chart 2. Many of them lurk in what you might call the ‘Wild West’ end of the market. This demands an unconventional approach.

chart 2: portfolio diStribUtioN

First, you must look for out-of-favour sectors. The news will be bad and the outlook horrid. Some might even be considered basket cases, with only time standing between them and bankruptcy. Steve uses the analogy of an ‘empty room’ — the fewer people standing in it, the better.Second, look for companies whose prices have plummeted. A 50% decline is good, but 80% is better. A decline of this magnitude almost guarantees that a stock is loathed. Hate is invariably a good starting point for value.Several early Value Fund purchases fitted this definition. Heavily indebted property trusts like rNY Property Trust and Ingenia communities Group (then called ING Real Estate Community Living) had all fallen by more than 80% before the Value Fund became interested.Today, in December 2013, the Value Fund is reviewing the mining services sector. Profit downgrades are widespread and the outlook is for trouble ahead. Some stocks are down 90% or more. Wild West, indeed.Third, review the ASX announcements, preferably daily. Look for profit downgrades, management changes, asset sales, debt re-financings, capital raisings and the like. Announcements like these can point towards changes in a business or produce share price movements of interest. Fourth, use filtering software or similar tools. The Value Fund uses Capital IQ to run filters based on financial ratios or price movements. For example, filters based on discounts to net tangible assets are currently highlighting ideas in the mining services sector.Capital IQ, useful though it is, is probably too expensive for the average private investor. So look out for internet brokers or information providers such as Morningstar that provide stock screening tools for free or a small outlay. The Share Tables sections of www.afr.com and www.afrsmartinvestor.com.au also contain tools like the

First, you must look for out-of-favour sectors.

$0m–$100m 36.3%$100m–$200m 30.8%$200m–$1,000m 3.1%$1,000m+ 3.8%Cash 24.4%Unlisted 1.6%

What’S a porter aNalYSiS?

Harvard business School Professor michael Porter is an expert on company strategy and competition. His ‘Five Forces’ analysis is a framework for analysing a company in the context of its industry. It covers the threat of new competition, the threat of substitute products or services, bargaining power of customers, bargaining power of suppliers, and the intensity of competitive rivalry.

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While the analysis you undertake might be less comprehensive — you’re not looking after $110m of other people’s money, after all — thinking about the same issues as the Value Fund is still vital. Investing isn’t easy and, if you’re not putting in the work, somebody else is, or should be.In the interview for this report, Steve highlighted why a structured approach is necessary. There’s a psychological pressure to act quickly and a natural desire to avoid the hard yakka of careful analysis. But he explained that few opportunities are lost by spending time preparing the analysis, particularly at the small end of the market. A week or two getting to know a business is invariably a week well spent.Most importantly, he’s avoided making significant mistakes by using the Fund’s research framework. The lesson is clear: Research carefully, reduce errors, and turbo-charge your returns.

it’S all iN the head

If you want to invest as successfully as the Value Fund, you need to think like the people that run it. And that means thinking differently from the crowd. Steve Johnson is something of a freak, in the nicest possible way, of course. He’s emotionally wired in a way that few investors are. Let’s look at some of these qualities using examples from the Fund over its first four years.First of all, Steve and his team do the hard graft, as the previous section shows. Researching small stocks and offbeat opportunities takes time, dedication and brainpower. If you want to uncover unloved gems, you need to prepare yourself for the hard work involved and have a detailed research process much like the one described above.Second, because you’re searching in unloved areas of the market, you must pride yourself on your independent thinking.When most investors were convinced heavily indebted property groups like RNY Property Trust were headed for bankruptcy, Steve investigated its debt position closely and came to a very different conclusion. When others sought out highly priced IT services businesses like SmS management and Technology, Steve identified a similar but much less highly regarded competitor called UXc with unusual potential for margin improvement (see Case Study 2 on page 8).This is not about being contrarian but assessing the facts as you see them, regardless of the interpretations placed on them by anyone else. Third, you’ll need to be patient. Setbacks and false starts are common in the ‘Wild West’ end of the market. It took almost three years for UXC’s management to deliver on its promise of margin improvement. When higher margins became evident, the company’s share price soared and the Fund exited its position.Fourth, you need to carefully manage risk. Each analyst spends a lot of time thinking about unconventional risks, correlations in the portfolio, diversification and portfolio weightings. The Fund’s concentration and underlying

investments might make it higher risk than some other managed funds, but all risks are judiciously considered.Fifth, you need to be so confident in your valuation process that you become all but immune to downward price volatility. Analysts at the Value Fund are so wedded to this perspective they actively seek it out, which is why positions in QBE Insurance were topped up during heavy price falls in August 2011 and January 2012 and sold down when the price rebounded. Focus solely on the value. If it’s present, buy more.These qualities are unusual but they can be learned. Cultivate them and you’re well on the way to picking stocks like the Value Fund.

the StockS that Made the differeNceLet’s get down to brass tacks. Over the past four years, the Value Fund has owned a range of different sectors and stocks. Let’s consider a selection of them to learn what we can about the Fund’s approach. Here, we’ll look at some stocks that worked out and some that didn’t before examining five case studies.

table 3: valUe fUNd SelectioN pickS

coMpaNY Sector iNcoMe capital total (%) GaiN/loSS retUrN (%) (%)

Map GroUp Infrastructure 13.18 5.19 18.37

Spark iNfra. Infrastructure 4.10 10.47 14.57

aliNta eNerGY Infrastructure 0 81.95 81.95

1300 SMileS Healthcare 9.39 54.17 63.56

arb corp Manufacturing 2.29 55.57 57.86

rNY propert trUSt

REIT 0 107.62 107.62

iNGeNia coMM. GroUp

REIT 7.83 191.34 199.18

Mirvac iNdUS. trUSt

REIT 4.00 50.76 54.76

rhG Finance 0 90.05 90.05

ceNtrebet Gaming 5.05 15.92 20.97

rUbik fiNaNcial IT 0 141.00 141.00

GbSt IT 7.19 124.59 131.78

eNero Marketing 0 8.75 8.75

real eState capital partNerS

REIT 0 –13.28 –13.28

The first thing to notice about this list is the preponderance of infrastructure and property stocks. That’s got more to do with the nature of the opportunities around at the time of the Value Fund’s launch and the type of stocks that Steve deemed appropriate for those circumstances.In the wake of the global financial crisis, companies with complicated structures and high debt levels were out of favour. Despite having relatively stable businesses, infrastructure stocks like airports and electricity distributors were caught in the firestorm, despite their attractive high yields. Having worked on the original privatisation of Sydney Airport for Macquarie Bank in 2002, Steve

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The lesson is clear: Research carefully, reduce errors, and turbo-charge your returns.

Share adviSor 6

since taken over, was an online bookmaker that the company’s major shareholder had put up for sale. While the takeover took longer than expected, selling shareholders retained the right to proceeds from a court case the company was running against the Australian Taxation Office. The Fund has since received 13.5 cents on top of the $2.00 per share takeover proceeds and expects an additional 45 cents over the next decade.In the end, though, we’d all prefer to own high quality business, which tend to produce more consistent results and deliver more positive surprises. For these reasons, they’re rarely cheap. Plus, the research process is also less intensive and the stocks that meet the criteria don’t require as much attention.No stock is suitable to ‘set and forget’ but vehicle accessories manufacturer Arb corporation and dental practice operator 1300 Smiles were far less demanding than, say, RHG or Centrebet. Nevertheless, over time these stocks rose to reflect their quality, making them vulnerable to disappointment, which is why the Value Fund has reduced or sold positions accordingly.

learNiNG froM MiStakeS

So they’re a few of the Value Fund’s successes thus far. What of the mistakes? Errors are part and parcel of investing and it turns out that ‘you win some, you lose some’ is a pretty apt expression. The key is to limit their number, as well as their magnitude.Here, the Value Fund’s record is impressive. In its review of the first three years to September 2012, Steve explained that 75% of its 24 investments made positive contributions to performance. That’s an outstanding strike rate and, in his own words, ‘if we can stay close to it, we’ll generate outstanding returns for you for a long time to come’.Limiting their magnitude has been a little less successful, as the mistake with Enero Group — refer to Case Study 1 on page 7 — shows. In its first year the Fund had 10% in this one investment and an almost complete wipeout offset the more numerous successes.Lessons have been learned. In the interview for this report, Steve explained that he now considers portfolio weightings of 5% — rather than 10% — as the Fund’s starting position. Riskier businesses such as Enero get correspondingly lower weightings.The key point is that, in the end, Enero and other mistakes haven’t mattered. That’s the nature of a well-managed portfolio — great decisions should eventually offset the not-so-great ones. And with a 15.1% average annual return over the past four years, that’s exactly what’s happened.Now, back to those out-of-favour property trusts and one that didn’t work out. Despite owning a more diversified portfolio of higher-grade properties with long leases, as well as having a more independent manager than RNY Property Trust, Real Estate Capital Partners USA Property Trust turned out to be the worse investment.Why? Its manager proved both self-interested and less capable than its peer, resulting in a bruising battle that

understood infrastructure assets extremely well.While the Value Fund favours quality businesses — those with strong market positions and high returns on capital — a ‘flight to quality’ following the global financial crisis meant few were available at reasonable prices. Infrastructure stocks were therefore the perfect ‘seed’ investments for the Value Fund in 2009 and early 2010. Large, liquid and defensive, they were perfect for parking capital until cheaper opportunities came along.The key lesson is that it’s important to buy stocks you understand. Steve’s inside knowledge of the infrastructure sector gave him an edge when businesses with high debt and complicated structures traded at attractive prices.The second lesson is one that we all know; Infrastructure businesses tend to be less vulnerable to economic downturns. In 2009 many investors had discarded that fact, scared by the collapses of hyper-complex businesses like Babcock & Brown and Allco Finance Group. More lasting franchises were unusually cheap.The global financial crisis also hit heavily indebted property trusts hard, particularly those with international operations.The Value Fund purchased three of them: RNY Property Trust, ING Real Estate Community Living (now Ingenia Communities Group) and Mirvac Industrial Trust. All were trading at discounts to net tangible assets exceeding 50% in 2009 and 2010.Careful analysis of their debt structures revealed that much of the borrowing was limited recourse in nature. This meant that while the trusts might lose certain asset pools, they were less likely to go bankrupt. Management can make a real difference in these situations (not always favourably — see Real Estate Capital Partners USA Property Trust below). But where they do, significant value can be created.

be fleXible

Along with just about everyone else, financial software providers also suffered during the GFC. The Value Fund purchased a stake in Rubik Financial below cash backing in 2010. After Rubik bought a successful financial software business with its remaining cash in 2012, the stock was re-rated. Good software businesses rarely come cheap because once software has been installed in a customer’s business it’s typically quite difficult to change, which locks that customer in. This was one rare such opportunity.GBST, a provider of software to brokers and managed funds, was another. On an EV/EBITDA multiple of 7.7 when acquired in mid-2013, it has since more than doubled in a matter of months.Another oppor tunist ic purchase was mor tgage management company RHG, a company that many members may be familiar with. Indeed, it was Steve that recommended it while an analyst with Intelligent Investor Share Advisor. While the price had already increased substantially, it was still cheap at the time of the Value Fund’s launch in 2009. Along with other activist shareholders, the Value Fund helped realise a better deal for shareholders than that proposed initially.Where RHG had a mortgage book in run off, Centrebet,

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The key point is that, in the end, Enero and other mistakes haven’t mattered.

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consumed much of the Fund’s time. In the end, the Fund found a clause in the Trust’s constitution that enabled it to exit at a small loss.As you’ve discovered with RHG and Centrebet, esoteric opportunities are part of the Value Fund’s ambit. Another was acquired in January 2012 when the Fund bought a small position in a convertible note called Gunns FORESTS.The thesis was sound enough; a proposed capital raising would make these income securities more secure. But the raising fell through and the company appointed an administrator, rendering the notes effectively worthless.Let’s sum arise the many lessons from the purchases that did and didn’t work out;

1. entire sectors move in and out of favour. Take advantage of it — Reviled companies can trade at unwarranted discounts to net tangible assets when the outlook seems very bleak.

2. Always calculate the downside — Humans tend towards optimism but for each stock, try and estimate the very worst possible outcome. Imagine, for example, what might happen if a company that needs more capital can’t raise it. Then, if the value remaining is higher than the current share price, you’ve potentially got a very cheap stock.

3. We never know when value will be realised — It can take many years, or just a few days, before the market wakes up to a cheap stock, or an activist investor shines a light on the value. We simply don’t know when it will happen, and nor do we

know which companies will become our biggest successes.

4. don’t anchor to lower prices — If a stock remains underpriced and your portfolio weightings remain reasonable, buying more at higher prices can be the best decision. Don’t let the fact that a stock has risen put you off from buying more. It may still be the best opportunity around.

5. Value changes — The source of a company’s value can change over time along with changes to the business. That’s why no company is truly ‘set and forget’. Establish what a company is worth and how much that figure changes over time.

6. Accept mistakes — Some stocks just don’t work out despite your initial assessment of value being largely correct. And mistakes are inevitable, especially in speculative situations. Learn from them and move on.

7. Activism can work — Taking an activist role can result in realising more value than you might otherwise.

8. Aim for quality but don’t be restrict yourself to it — High quality businesses tend to produce more consistent results and positive surprises but even businesses with high debt levels and complicated structures can be attractive investments at the right price. Just make sure you truly understand them and are aware of the risks.

9. Limit portfolio exposure — In lower quality stocks, mistakes are more common as self-interested or simply incompetent management is more common. Keep portfolio weightings small in such situations.

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… esoteric opportunities are part of the Value Fund’s ambit.

management had taken steps to reduce borrowings with a capital raising in 2009.

HigHEsT poRTFolio wEigHTing?

12%

How did THE sToRy unFold?

Management’s profit forecast turned out to be wildly optimistic. It had also miscalculated the deferred payments owed to the former owners of acquired businesses.With debt levels blowing out, a recapitalisation was required. In August 2010 Enero raised $103m of capital at $1.80 a share. The Value Fund participated in the raising, reducing its average purchase price to $2.70 a share at the time.Enero’s business continued deteriorating and, despite management change and asset sales, the company has consistently disappointed. Both the Value Fund’s initial purchase and participation in the capital raising in

1. eNero GroUp

wHaT’s THE sToCk?

Enero Group (previously known as Photon Group) is the umbrella company for a collection of 12 marketing and communications businesses. The stock had an 18-for-1 share consolidation in 2012.

wHy was THE ValuE Fund inTEREsTEd?

Enero was suffering from high debt levels and a business downturn following the global financial crisis. The stock had already fallen more than 80% from $110 to less than $20 (adjusted for its share consolidation). Based on management’s 2010 earnings forecast, it was trading on an enterprise value to earnings before interest, tax, depreciation and amortisation (‘EV/EBITDA’) multiple of less than six times. While debt levels remained high,

Fund case studiesbY JohN addiS

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Despite having almost twice the revenues of SMS Management and Technology, the most highly respected of the listed IT services companies, UXC’s market capitalisation was almost 60% lower. With low expectations implicit in the share price, there was significant upside if management could boost margins.This seemingly obvious value gave the Fund confidence to take a significant por t folio weighting (initially around 10%).

HigHEsT poRTFolio wEigHTing?

7%

How did THE sToRy unFold?

In 2011 UXC sold its last remaining non-core business, eliminating all debt. While it took time for management’s cost-saving initiatives to bear fruit, by 2012 it was clear that margins were increasing – and quickly. As the market became aware of the margin improvement, UXC’s share price rose 79% in the September 2012 quarter.The Value Fund has now sold its entire holding in UXC at a significant profit. Steve has referred to UXC as a ‘signature stock’ for the Fund – an unloved company trading at a cheap price where patient capital can await improved results.

wHaT sHould you REmEmbER?

n A cheap price forgives a multitude of sins, especially those committed by management;

n Look for sensible plans to improve results where the market is sceptical;

n Low expectations mean downside is limited and upside can be substantial;

n Share price performance can come in a rush;n Confidence in the underlying value allows for a higher

portfolio weighting.

3. rNY propertY trUSt

wHaT’s THE sToCk?

RNY Property Trust is an ASX-listed real estate investment trust (REIT) with a portfolio of 25 mid-tier office properties in north-eastern USA.

wHy was THE ValuE Fund inTEREsTEd?

At the time of purchase in 2010, RNY Property Trust traded at a discount of more than 50% to its net tangible assets (NTA). This contrasted with most US-listed office property trusts, which were trading at a premium to NTA. Prices for the best office properties had already recovered from their lows as the worst of the global financial crisis passed. While RNY Property Trust had high debt levels, its four debt facilities were limited recourse to four separate pools of property. RNY could default on two of the aggressively financed pools and still have sufficient equity on the other two pools to more than justify the unit price.The Fund also took the view that China was bound to stumble at some point, and the Aussie dollar would fall from elevated levels. US-based assets would be worth more to Australian investors should that occur.

2010 turned out to be mistakes.The Fund bought additional stock in Enero in 2012 after re-evaluating the investment case at approximately $0.30. Now debt-free and with some promising businesses, this later decision has proven correct. With Enero’s share price having more than doubled to around $0.70, the Value Fund has been reducing its holding.

chart 1: eGG Share price SiNce liStiNG (MaY 2004)

wHaT sHould you REmEmbER?

n Just because a stock has fallen sharply doesn’t mean it is cheap;

n Don’t place undue trust in management profit forecasts, or even numbers in the company accounts;

n Portfolio weightings around 10% are too high for variable businesses like this;

n Beware of psychological commitment (‘commitment bias’) to an existing holding;

n A poor purchase at one price can be attractive at another.

2. UXc

wHaT’s THE sToCk?

UXC is a large IT services company with revenues of approximately $600m. At the time of acquisition in 2010, UXC also had environmental and utility services businesses (now sold).

wHy was THE ValuE Fund inTEREsTEd?

While UXC was the largest ASX-listed IT services company by revenue, it had a chequered history, a reputation for mis-steps and margins less than half those of its competitors. Management had announced plans to cut costs and improve profitability.

chart 2: UXc Share price SiNce liStiNG (Sep 2002 )

Fund initial purchase

0

3

6

9

12

$

2013201120092007 Dec 2005

Source: Capital IQ, Dec 2013

0

0.50

1.00

1.50

2.00

2.50

$

20132011200920072005Dec 2003

Source: Capital IQ, Dec 2013

Fund initial purchase

Fund sells

a cheap price forgives a multitude of sins, especially those committed by management.

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HigHEsT poRTFolio wEigHTing?

7%

How did THE sToRy unFold?

Over the course of 2011 and 2012, Ingenia sold its US assets and other non-core assets for book value or above, reducing borrowings and creating equity. The trust also internalised its management, eliminating the significant amount of operating income flowing to external manager ING. The last of the Value Fund’s Ingenia holdings were sold in October 2013 at $0.48 a unit, more than five times the initial purchase price of $0.09.

chart 4: iNa Share price SiNce liStiNG (JUl 2004)

wHaT sHould you REmEmbER?

n Management change can be a catalyst for value realisation in a difficult situation;

n It’s impossible to determine which investments will be very successful at the beginning, so adopt a portfolio approach;

n The time spent identifying investments does not necessarily correspond to the ultimate result (Ingenia took the Value Fund only three days’ work before the decision to buy) but proved to be one of its best investments;

5. viSioN eYe iNStitUte

wHaT’s THE sToCk?

Vision Eye Institute provides ophthalmic services, including treatments for eye diseases such as cataracts and glaucoma. The company employs 34 doctors at a number of clinics in New South Wales, Victoria and Queensland.

chart 5: vei Share price SiNce liStiNG (dec 2004)

HigHEsT poRTFolio wEigHTing?

16%

How did THE sToRy unFold?

Quite beautifully. Management was able to negotiate a re-financing on one of the aggressively financed pools, with lenders taking a haircut. The deal created significant equity from nothing and gave RNY breathing space to allow a recovery in property prices to take hold.Borrowings have fallen, while NTA has increased from $0.30 a unit in June 2011 to $0.51 a unit now. While the Value Fund has been selling some stock to manage portfolio risk, it remains the Fund’s largest holding and strongest idea.

chart 3: rNY Share price SiNce liStiNG (Sep 2006)

wHaT sHould you REmEmbER?

n Yesterday’s complicated structures can be today’s bargains;

n Look for multiple sources of potential value realisation;n Improvements in the investment case can be slow

to be reflected in the stock price, particularly at the small end of the market;

n Don’t ‘anchor’ to your purchase price at much lower levels. If portfolio weightings allow, buy more if the investment case improves significantly;

n Sensible management can make a big difference.

4. iNGeNia coMMUNitieS GroUp

wHaT’s THE sToCk?

Ingenia Communities Group (formerly ING Real Estate Community Living Group) owns a portfolio of retirement villages in Australia (and student accomodation in New Zealand).

wHy was THE ValuE Fund inTEREsTEd?

There were significant similarities with RNY Property Trust (see previous case study). Ingenia was trading at a discount of more than 60% to its NTA of $0.25 a unit in late 2010. While the Australian assets were conservatively geared, the US assets weren’t. But as the debt on its US assets was limited recourse, the Australian assets, representing 14 cents a share, were much lower risk. A new managing director from a respected competitor had also been appointed in 2009, so there was upside from improved management.

Source: Capital IQ, Dec 2013

Fund initial purchase

0

0.30

0.60

0.90

1.20

$

20132011I2009Dec 2007 Source: Capital IQ, Dec 2013

Fund initial purchase

Fund sells

0

0.30

0.60

0.90

1.20

$

2013201120092007Dec 2005

Source: Capital IQ, Dec 2013

Fund initial purchase

Fund sells

0

1

2

3

4

5

$

2013201120092007Dec 2005

improvements in the investment case can be slow to be reflected in the stock price, particularly at the small end of the market.

Share adviSor 10

How did THE sToRy unFold?

The Value Fund helped facilitate Vision’s late 2012 capital raising, including underwriting the shortfall. This shored up the company’s balance sheet and moved it a step closer towards dividend payments. The 2013 final result was at the lower end of expectations, but Vision remains somewhat underpriced and one of the Fund’s more significant holdings.

wHaT sHould you REmEmbER?

n Consider how changes to the business model, including staff incentives, might improve profitability;

n High debt can cripple businesses, although good cash flows make them more likely to survive setbacks;

n Look for other sources of value, such as franking credits;

wHy was THE ValuE Fund inTEREsTEd?

Whilst still heavily indebted during 2012, Vision’s previously unsustainable business model had been restructured to link doctor remuneration to company margins. Revenue and profitability were showing early signs of recovery, while strong cash flow was facilitating debt repayment.The Value Fund determined that the banks were unlikely to pull the plug, because the business would have no value if put into administration. Doctor-shareholders would simply leave.At less than seven times earnings, the stock looked cheap. And, with $27m in imputation credits, the company should be able to resume paying fully franked dividends at some point.

HigHEsT poRTFolio wEigHTing?

9%

maTT Ryan

Matt is an investment analyst with Intelligent Investor Funds, providing stock research and analysis on Australian companies. He joined the team in 2011 after gaining experience as a commercial analyst at WorleyParsons in Western Australia.Matt has a Bachelor of Engineering (Mechanical) and a Bachelor of Laws (both with Honours) from the University of Adelaide. He has passed all three levels of the CFA program, making him eligible to be a CFA charterholder upon completion of the requisite work experience. Matt also lives in Sydney, but not with Steve.

kEVin RosE

Kevin is a senior analyst with Intelligent Investor Funds, joining the International Funds arm in 2013. His work experience includes roles at Salomon Smith Barney, Atari Inc. and Freshford Capital Management.Kevin has a Bachelor of Arts in Economics cum laude from Vanderbilt University and an MBA from the Columbia Business School. Kevin is mainly responsible for American stocks and lives in New York.

gaRETH bRown

Gareth has been a senior member of the Intelligent Investor analytical team for more than 10 years. Before that he worked for Commonwealth Bank for more than seven years. He transferred to the International Fund’s analytical team in 2013.

tWo of a kiNd

The odd mistake notwithstanding, it’s hard to argue that the first four years of the Value Fund were anything other than a success. The performance numbers prove it.The Fund’s carefully selected portfolio of unusual opportunities has produced excellent returns for unitholders.So if the team can do well with Australian stocks, why not international ones? There’s a good chance it can, which is why Intelligent Investor Funds launched the International Fund in early 2013.It’s a bigger task of course, and it called for an increase in resources. To help him seek out opportunities globally, Steve Johnson has hired a team of analysts from around the world (see below). The team’s already working hard, having acquired stakes in a small speaker manufacturer in Italy, an airport operator in Switzerland and even big American stocks like Google and American Express.It’s early days of course but the International Fund is already up 32% (slightly ahead of the index), despite an average cash weighting of 40%. While it’s been fast out of the blocks, there’s a long way to go before this marathon is over. Stay tuned.

sTEVE JoHnson

Steve is the chief investment officer of Intelligent Investor Funds. A former employee of Macquarie Bank, Steve joined Intelligent Investor in 2003, becoming a major shareholder in the business in 2004.He has a Bachelor of Economics (Econometrics and Finance) from the University of New South Wales, is a CFA charterholder and lives in Sydney.

Meet the teambY JohN addiS

while it’s been fast out of the blocks, there’s a long way to go before this marathon is over.

Special report11

WaNt to kNoW More?

We’re not saying it’s easy. Identifying and buying stocks like those in the Value Fund these takes time, effort and more than a little courage.Of course, there is a way to take advantage of these opportunities without the headaches. You can invest in the Value Fund or the International Funds (or both), delegating your small company and international stock exposure to highly skilled investors who devote their days to ferreting out bargains. For some, that may make a lot of sense.

table 1: WaNt More iNforMatioN?

Download a PDS from www.iifunds.com.au

Call the team on 1800 804 964

Read the monthly and quarterly reports of the Value Fund and International Fund

Read the Bristlemouth blog

If you think so too, why not download a Product Disclosure Statement from www.iifunds.com.au? Or telephone 1800 804 964 if you’d like a PDS sent out in the post or some more information. A real person will answer the phone because that’s how we do things around here.If you’re not ready to invest yet, why not follow along with the Fund’s quarterly and monthly reports? Successful investors read as much as possible, and Steve Johnson and his analysts write (and speak) more sensibly than most.So read the Value Fund’s quarterly reports regularly (as well as the International Fund’s). You can also follow the Bristlemouth blog, where Steve and his analysts discuss their latest thoughts and investment ideas. Why not bookmark them now?Whether you’re embarking on your own small company portfolio, or about to delegate the management to Intelligent Investor Funds, it really is just the beginning. Brace yourself, it’s going to an incredible journey.

Note: This report has been prepared using the Value Fund’s published reports, the Bristlemouth blog and an interview with chief investment officer Steve Johnson. It discusses a selection of the stocks the Value Fund has bought but is not fully comprehensive.

Gareth has a Bachelor of Business from the University of Technology in Sydney. He is mainly responsible for European stocks in the International Fund and lives in Vienna, Austria.

alVisE pEggion

Alvise Peggion is a junior analyst with Intelligent Investor Funds, and is an aspiring value investor. Alvise is fluent in Italian, Mandarin and English. Alvise has a Bachelor of Finance from the University of Adelaide and has commenced studying for the CFA program. He lives in Sydney.

YoU caN do it

Steve and his team are highly experienced and years of poring over balance sheets and industry journals gives them a sixth sense for the potentially profitable opportunities that others investors tend to avoid.Tools like Capital IQ help narrow down the investment universe and filter the most promising ideas but nothing builds expertise like analysing businesses day in, day out. But the great thing about investing is that anyone can do it. With a bit of effort, you can find exactly the same opportunities. It’s not even that difficult to buy international stocks these days.As a small investor you have an advantage. Size makes it difficult to acquire large positions, a limitation the Value Fund will need to deal with as it gets bigger.Perhaps your biggest advantage comes at the small end of the market. Small stocks have low liquidity and can suffer from distressed selling. In fact, in our interview Steve explained that fund managers exiting positions indiscriminately can push prices down to very attractive levels. Only small investors who want small holdings are able to take advantage.So give it a go. Just remember what you also need: the right mindset, an ability to deal with volatility, and sufficient capital to diversify widely.

we’re not saying it’s easy. identifying and buying stocks like those in the Value Fund these takes time, effort and more than a little courage.

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