30th April 2019
In this article I have set out a risk-controlled strategy for generating much higher income and total returns on investment than one would ordinarily expect over the medium to long term from a well-diversified portfolio of investments in ASX listed companies.
The strategy contemplates establishing a well-diversified portfolio of investments in good quality, well-established, unlisted companies with capable management, suitable organizational structures, maintainable annual EBIT profits of $2-10 million and valued on achieved EBIT multiples of up to about 6 times.
Although generally industry agnostic the strategy excludes highly speculative and highly leveraged businesses, those in cyclical industries and requires one to be particularly cautious about investing in retail businesses exposed to fashion, fads and online competitors. ‘By definition’, it excludes start-ups, early stage businesses and those commanding high multiples due for example to targeting a global market.
It is generally much more difficult for these unlisted companies to secure additional capital than it is for listed companies and those that succeed generally pay a handsome premium for it. Whereas the S&P/ASX 300 is trading on a PE multiple (at 30th April 2019) of about 16.7 times, these unlisted companies are generally valued on a 4 to 6 times EBIT multiple, which (assuming a debt to EBIT multiple of about half the value multiple and an interest rate of about 8% pa) equates to PE multiples of 3.4 to 5.6 times. The PE multiples imply returns on investment, including franking credits, of about 8.6% pa from the S&P/ASX 300 and 25.5% to 42% pa from these unlisted companies. A world of difference!
There is a high prospect of the diversified portfolio of investments in these unlisted companies well exceeding the medium to long term returns from a diversified portfolio of investments in ASX listed shares, bonds and REITs. That is due to amongst others:
- Provided one has been cautious and diligent in one’s implementation of the strategy it would be reasonable to expect some investments to outperform, some to underperform and some to perform generally to expectations, with the resulting portfolio return to be over 25% pa.
- The expected return does not rely on the realization of ‘blue sky’ nor does it require the implementation of a higher risk business model.
- Since these unlisted companies have generally been deprived of capital, having access to it would give many ‘a new lease of life’ to pursue value-adding projects.
Some say unlisted companies are of a higher risk than listed companies and that top listed companies are of low risk. I disagree. The risk of a company imploding or its shares suffering a material drop in value does not depend on the size of the business or whether it is listed or not. It depends largely on the business model of the business concerned. I can however concede that a top listed company has a greater prospect of raising capital to weather a storm than would an unlisted company and so justifies the investor requiring a higher return from an investment in an unlisted company. Nevertheless, investments in good quality, low risk unlisted companies would struggle to argue for much of a premium.
The main justification for a higher return from unlisted companies relates to the relative lack of ‘liquidity’. In the case of top listed companies one can sell in a relatively competitive market and receive the net sale proceeds within a couple of days. In the case of investing in unlisted companies one should require an agreed exit strategy after a pre-determined period of up to about 5 years post investment and thereafter every three years. The extent of the premium an investor would reasonably expect from investments in these unlisted companies depends on that party’s objective and personal circumstances. If, like me, you are looking to establish and then maintain a well-diversified investment portfolio then you would not need much of a premium as compensation for the relative lack of liquidity. That’s because one needs to replace the investment and it is a lot more difficult, costly and time consuming to replace an investment than it is to maintain it.
In conclusion, I’m arguing that the return one can reasonably expect over a medium to long term from a well-diversified portfolio of investments in good quality, profitable, unlisted companies is not only materially higher than the return one can generally expect over a similar period from a well-diversified portfolio of investments in top ASX listed companies, the return-for-risk is also materially higher.
Many family owned investment companies have been capitalizing on this market inefficiency for many years and intend to continue doing so. Why so, because the returns they’re earning and expecting are multiples higher than the returns generally expected from a well-diversified portfolio of investments in ASX listed companies.
Written by: Mark M.J. Morris of Rogers Morris Pty Limited, an investment business focused on unlisted securities