Trade bores

After a roaring April with double digit gains, so far May has been rather more frustrating. I have three things to thank for this: one, the rekindling of the US China trade war; two, an analyst note questioning the accounting of what was my largest holding, Burford Capital; and three, a chest infection that’s taking its sweet time to get better. None of these issues seem worth getting too bothered about in the long term, but that doesn’t stop them being a source of frustration right now. 

The recent escalation of the trade war was broadcast in characteristic fashion through a Trump tweet last weekend, announcing an increase in tariffs on $200bn of Chinese imports. This Monday, China announced its retaliation. Most investors had apparently got quite used to the idea that a trade deal was imminent and that this was a ‘good thing for equities’, so this latest spat has hit US stocks fairly hard. The current tariffs are too minor to have a very significant impact on the US and Chinese economies (and consequently the rest of the world). Obviously, the fear is that the trade war will escalate further and cause real damage. I’m optimistic that China will cave and a deal will be reached before things escalate too much. The US seems to be in a stronger position than China. It’s also worth noting that if the trade war does escalate this would probably give a green light for more doveish monetary policy. In short, I think the trade war is more likely to present a buying opportunity than something most investors should really worry about.

It’s Sod’s Law that the share I am currently most excited about, Burford Capital (as I noted in my recent portfolio review), is the one that has recently been receiving the most negative attention. The share price has fallen by 20 percent over the past couple of weeks. Often this sort of fall might prompt me to sell (better safe than sorry) but I have sufficient conviction in Burford to continue to hold. The catalyst for the share price fall seems to have been a bearish analyst note by broker Canaccord Genuity. I haven’t had access to this note myself but I have seen enough from it to be comfortable that there isn’t cause for concern. From what I’ve gathered the main points it raises relate to accounting methodology, more specifically the timing of Burford’s profit recognition of partially concluded or yet to be concluded cases. There is always scope for investors to be taken in by accounting fraud (e.g. Patisserie Valerie) so one shouldn’t be complacent, but I don’t believe any legitimate concerns have been raised in relation to Burford.

  • One potential issue is that a large proportion of Burford’s profits relate to ‘fair value’ adjustments made when the case makes progress (typically the catalyst being a court judgment) but is yet to conclude (so Burford hasn’t received any cash return yet). There seems to be speculation that Burford’s recognition of these profits could be premature/ dodgy. I don’t think this concern has merit. Most cases only last a few years (average is about 2 years) so this would come out in the wash pretty quickly when the case concluded anyway – if Burford was being overly optimistic in its profit recognition before a case concluded it would end up having to write down these profits again pretty shortly afterwards (or never conclude the case). There is sufficient transparency in Burford’s published reports to see that this is not what is happening. Its track record of profit recognition for cases that have now concluded has proven to be conservative so far.
  • The other issue raised is how Burford accounts for profits in ‘partially realised’ cases. These can be situations where Burford sells a stake in a litigation claim it owns to a third party (for example Burford sold 25% of its Petersen claim for $106m) or more complex situations involving multiple sources of potential payout which have been aggregated into a single case by Burford for reporting purposes. Burford aportions the relevant part of Burford’s total investment to use as the denominator when calculating the return from partial realisations. So for the Petersen claim, this implies the return on investment from the 25% of the claim it has sold is calculated as a proportion of 25% of Burford’s total investment in the claim. The CG analyst seems to think that the return on investment from such partial realisations should be calculated using all of the investment in the denominator. This approach is obviously a bit daft as it would effectively write-off the remainder of the ongoing investment and would mean that returns need to be restated when the rest of the case concluded. It wouldn’t give a very accurate view of the profitability of the business.

I’ve made a couple of trades since my last update. A couple of weeks ago I sold Micro Focus for a very small profit and replaced it with DotDigital. I looked into Micro Focus in more detail in advance of its return of value following the sale of its SUSE business. I still like the business but decided I didn’t have my head around the numbers well enough to justify continuing to hold.

I’ve held and written about dotDigital previously. Since then I’ve become a bit more familiar with dotDigital’s market and have a greater appreciation of what it does. As a result, I’m a bit more confident in the sustainability of its competitive advantage. DotDigital seems to be becoming more reliant on its strategic partnerships with the major CRM players (Salesforce, Magento, Shopify etc.). I largely see this as a good thing – it indicates the quality of dotDigital’s product and should hopefully provide a long growth runway. There is some risk that these partners find an alternative in the future but this seems fairly small to me. The profitability of the business, recurring revenues, long growth runway and reasonable valuation make it seem very attractive in the meantime.

This week I sold my position in Diploma for a 30% profit and bought Match. Diploma’s half-year report on Monday was pretty decent though ‘early signs of slower activity in the Industrial Seals market’ sounded a little ominous – not very serious but enough to tip the risk-reward balance and make it seem worth taking profits and switching horses.

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Match Inc

Match runs more than 40 dating platforms, including Match.com, Tinder, PlentyOfFish, Hinge and OkCupid among others. It has pursued an acquisitive strategy to get to this point, hoovering up a number of different small businesses in what has been a very fragmented and relatively nascent market. Most of Match’s brands use a ‘freemium’ subscription model where users can access the platform for free but need to pay a regular subscription to gain access to additional functionality and features.

Quality

  • Business economics: Match has a capital light business model with very high profitability. The subscription model means revenues recur to some extent (though users often switch between platforms). Returns on capital and margins are very high. The business benefits significantly from operational gearing with a high proportion of fixed costs and marketing spend that decreases proportionally as its platforms grow and can start to rely more on word of mouth.
  • Track record: Match doesn’t have a very long track record and many of its brands have started fairly recently. It has experienced steady growth in revenues and profits over the past few years.
  • Competitive advantage: Match is the biggest player by far in a still fairly fragmented market. Its scale leads to several advantages. The platforms benefit from network effects – the more users there are the easier it is to find matches. However, users frequently multi-home across platforms so there is no tendency for markets to tip to winner-takes-all. There are large economies of scale from the cost structure, particularly from marketing costs that decline as brands grow. There are advantages from scale in gathering data and sharing analytics across multiple platforms. Scale in data increases Match’s capability to innovate in improving its platforms and creating new brands. This may be particularly important in this market where competition is quite dynamic – new brands can grow very quickly and old ones can go out of fashion. While Match may have advantages, barriers to entry are not insurmountable. There is some risk that competitors with more innovative products may enter over the longer term.
  • Growth prospects: I think the growth prospects are the main draw here. There are strong secular growth drivers and ample opportunities for Match to expand internationally and introduce new products. Networks effects mean user numbers for new platforms or geographies can grow very rapidly and operational gearing means profits can grow even faster. Demand should generally be fairly defensive.

Price

Momentum is excellent with the share price breaking out to new highs following positive quarterly results last week. The valuation is not obviously cheap though seems reasonable given the growth prospects.

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