Everything discussed in this episode is general advice only and may not be appropriate for you. Seek personal advice before acting. Adam, Adir and Luke may hold interests in the securities discussed. Thanks to Seneca for sponsoring today’s episode.
“We’re just a make money investor”: the fund that doesn’t charge a management fee
Luke Laretive started Seneca Financial Solutions nine years ago after getting sick of paying a licensee half his revenue. Today it is a four-and-a-half person business running a small cap fund, an Australian shares fund, an advice business and the Good Research subscription product he writes with Ben Richards. The small cap fund has returned roughly 23% per annum over close to three years, around eleven or twelve percentage points ahead of the index, on about $35-40M of funds under management. It charges no management fee at all: 20% of returns above an RBA cash rate hurdle, with a high water mark. Three redemptions in three years.
Luke: “You talk to a lot of managers and they say, I’m a growth investor, I’m a value investor, I’m a momentum investor, or some other fandangled strategy. We’re just a make money investor. I think why people have such poor periods of performance is they’re too dogmatic in the way they think about investing.”
Luke: “All the capital is getting allocated to index funds, which naturally allocates to larger companies, which naturally makes those larger companies overvalued and leaves smaller companies significantly undervalued. So if we can be good at creating that arbitrage, then we should be happy just to take twenty percent of returns.”
Adir: “I’ve never heard of a more aligned, more honest, more difficult way to make money in funds management. Instead of the hurdle rate being the same as everyone else’s, I’m going to make it the RBA cash rate. So every time it goes up, I’m just going to make it harder for myself. It’s the most honest fee structure I’ve ever heard of in my life.”
Luke on why active management lost the room: “I don’t think active managers have struggled because of fees. I think they’ve struggled because of returns. It’s opened up a perverse allocation of capital in the Australian economy. We’re just allocating all of our surplus capital to the biggest, slowest growing, arguably least efficient businesses going around.”
Adir: “Trust the product and love the customer. That is my view on how to run a really great business.”
AFG: seven times earnings, a 10% grossed-up yield, and a lending book nobody is pricing
Australian Finance Group (ASX: AFG) is one of the country’s largest mortgage aggregators: the platform mortgage brokers use to compare and place loans, taking a clip of the upfront and a trail for the life of the loan. That business is a cash cow but barely growing, with EBITDA up around 2% last year. The part Seneca cares about is that AFG has started lending its own money as a non-bank lender, funded through warehouse facilities, at margins Luke estimates are 20 to 40 times those of the broking business, and growing 25%+ per annum. The stock trades on roughly seven times earnings and a 7.7% fully franked dividend, close to a 10% grossed-up yield, after falling around 50%.
Luke: “AFG is Australia’s largest mortgage aggregator. They make a small amount of money on the upfront, another small amount on the trail over the life of that loan. And increasingly over the last few years, they’ve started actually lending their own money. That lending part is what I’m really interested in, because it’s 20, 30, maybe 40 times the margins of the broking business.”
Adir on how a non-bank funds itself: “You can get retail depositors to give you deposits and pay them interest, but you need a banking licence for that. Or you can go to someone that has lots of money and say, how about you give me your money to lend out, I’ll give you an interest rate, and I’ll lend that downstream and make a margin on the difference. That’s called a warehouse facility.”
Luke on the credit question: “AFG has been lending out money in one way, shape or form for 15 years. They’ve had $258,000 worth of defaults over that time. You’re never going to find a company to invest in where there’s no questions about it and it’s trading at a ten year low valuation. The knack is being able to say, is there actually data supporting that narrative?”
Adir: “The most appealing thing about this business is potentially its margin of safety. My question is not, do I think loan volumes are going to fall by 50%. My view is that if loan volumes did fall by 50%, I think they’d survive that fall and get through it.”
Luke: “It’s a really good, not sexy business. We’re not selling drones to the government. It’s not what everyone wants to be in. But it’s good risk adjusted.” Adir: “We hate the sexy stuff.”
HMC Capital: from nine dollars to two-thirty, and why Seneca is buying the whole complex
HMC Capital (ASX: HMC) grew out of HomeCo, David Di Pilla’s vehicle for repurposing the old Masters sites, into something closer to a merchant bank: an investment manager sitting above listed REITs, private credit and an energy transition platform. The stock went from around $9 on 30 times earnings to about $2.30, with earnings per share falling from 47 cents to 25 cents. Three things broke at once. HealthCo (ASX: HCW) had Healthscope as its anchor tenant and Healthscope collapsed. The energy platform, seeded with Neoen’s Victorian assets including the Victorian Big Battery, failed to raise the capital it wanted, before KKR came in with a A$600M partnership. And DigiCo (ASX: DGT) listed at $5 at peak data centre hype and fell to $2.30. Seneca owns all three: HMC, HCW and DGT.
Luke’s rule of thumb: “If you’re ever wanting to invest into something, invest in the manager. Don’t invest in the underlying. The investment management business has much more leverage.” Adam: “It’s the Macquarie model in a way.” Luke: “This really reminds us of Macquarie in the nineties, when everybody said it was going to shit and then it ended up just kicking goals.”
Adir on the failed raise: “Have you ever been on a plane that’s aborted a landing? The second time around you’re a lot less confident of the pilot being able to land the plane than the first time. That’s what a failed capital raising feels like. Once you fail one, everyone thinks, I’m not sure they’re ever going to land this thing again.”
Luke on HealthCo: “They’ve been paid their rent the whole time. By re-tenanting with a better quality tenant and looking at where cap rates are now, I actually think they can get a valuation uplift on the assets as a result of this. That HCW REIT is trading at say a 40% discount to NTA. We don’t know whether it gets back to NTA, or a small discount, or a small premium. We just think it’s not going to be forty percent.”
Adam on first principles: “Healthscope was over-leveraged because private equity bought it and over-leveraged it, and hospitals aren’t a great asset with leverage. But it’s not as if Australia doesn’t need hospital beds. There aren’t hospitals sitting in the street not being used. The underlying real estate assets really should be long-term fine.”
Adir on why it’s cheap: “The market generally does not like complexity. It likes things it can understand easily, and this is hard to understand. But there’s also a narrative around David Di Pilla, which sounds quite unfair based on this discussion, which is that this guy is just an amazing investment banker who can do great sales pitches where the underlying assets don’t live up to the promises.”
Luke on what could go wrong: “If the market crashes, investment managers will not perform well. These guys are leveraged not just to stock markets, but private credit, property. Beyond the normal operating risks of this business, I just don’t really see any particular risk that stands out at the moment, particularly at this valuation.”
Luke on private credit, and Bathla: “While Aussie private credit retail investors are shitting themselves, big instos from Asia and around the world are still coming here and still seeing really good returns on offer. I think this Bathla thing is going to come out that it’s all asset backed anyway. Take a while to get your money out, might take a bit of a haircut, but it’s not going to be catastrophic. If you’re investing in private credit in the US in software, that’s a different question.”
Find Luke: senecafs.com.au for the funds and advice business, goodresearch.com.au for the subscription research product, and senecafs.com.au/subscribe for his weekly newsletter and monthly performance reports. He’s also easy to find on LinkedIn.