A Quick Catch Up On Our Fund

We’re still a few weeks out from our first ‘official’ update in the form of our quarterly investor letter, but given the enthusiasm for this new venture we thought we’d say a quick g’day, wish you happy holidays, and update you on where things stand with the Lakehouse Small Companies Fund.

For starters, the Fund’s responsible entity soft closed the Fund at 2pm on Wednesday 21 December to new investors based on our recommendation (details here). Notably, existing investors may continue to top up or redeem their investments. We plan to reopen the Fund in the New Year, but with the Fund having raised more than $88 million and having commitments from some investors for more, our primary focus now is putting your capital to work.

We were about 51% invested as of this morning and are patiently navigating our way towards our typical range of being 85% to 95% invested. It’s been hard work, and with the shares of many small-caps we admire having pulled back over the past few months we think now is a good time to put cash to work in some of these great companies.

On top of its cash position, the Lakehouse Small Companies Fund currently owns stakes in 19 companies. Some of them you may recognise from my days at Motley Fool Pro but most of them are new positions that were too small for us to run with in a newsletter structure. We’re finding the managed fund structure incredibly liberating.

Collectively, our holdings have business models built on recurring revenue and, unlike the broader market, hold more cash than debt. On a collective basis, our companies are also growing quickly, with trailing sales growth of 27%, and reinvesting at attractive rates with returns on capital above 17%. We’re confident that, given the fullness of time, owning a portfolio of such businesses will deliver pleasing results for our long-term investors.

Not every holding will work out well, of course. Many will disappoint, and we’ve had our first dud in Bellamy’s Australia Ltd (ASX:BAL). You’re probably aware of Bellamy’s as a business and a brand. Also, those of you who keep up with markets will have heard by now that the company has shot itself in the foot a few times in the past three weeks.

We’ll follow up with more commentary on Bellamy’s once the company updates the market and resumes trading. For now, though, the quick background is that Bellamy’s has spent most of the past couple of years going from strength to strength. The company delivered a stunning fiscal 2016, with second-half revenue up 105% year on year and an acceleration from the first half. The company also sounded a very upbeat tone at its AGM on October 19.

Bellamy’s biggest challenge over the past couple of years has been keeping up with demand, which is a problem like being too handsome. Ironically, the agreements that Bellamy’s struck to alleviate the problem came back to bite the company when shifting regulations in China led to a disruption in the grey market channel and a liquidation of inventory from rivals who are being forced out of China.

It appears to us, having ramped up for higher volumes, the company is now stuck with more inventory than it needs, and the supply / manufacturing agreements that it struck to get more breathing room are instead choking the company’s balance sheet.

Ironically, the driver of this problem — rivals being regulated out of the market — should be a net long-term positive for Bellamy’s, as does a reduced reliance on grey market sellers. All this assumes Bellamy’s itself doesn’t get pushed out of the market, of course, but the company has given no indication that worry carries weight.

Bellamy’s shares haven’t traded since 12 December — a longer stretch of time off the market than any listed stock I’ve ever owned — and its latest self-imposed voluntary suspension gives the company up to 13 January to come back to the market with news.

Naturally, we’ve discussed all kinds of scenarios but investors (including us) are spinning their wheels without more information. For example, while our base case assumption is that Bellamy’s is able to work out new arrangements with its suppliers and manufacturers, writes down the value of a pile of inventory, suffers lower margins, and its shares get hammered when it resumes trading, another long shot scenario is that the situation and downsized share price have put Bellamy’s in play as an acquisition target. Rumours also abound that the company’s balance sheet might be worse off than it let on previously, and same for both its market share and future in China.

We’re operating in an information vacuum of sorts until the company provides a proper update, which probably won’t happen until January. In the meantime, we think it’s appropriate to mark down the carrying value of our Bellamy’s shares by 66% from its last close price to $2.29 given that we now know the company is working through problems with its working capital and key partners, an already lengthy suspension just got much longer, and the market has lost confidence in the company’s leadership.

Valuing a suspended security was not how I hoped to spend the week before Christmas but, for context, the cumulative unrealised loss on our Bellamy’s investment amounts to about 2.6% of the money invested in the Fund. It stings, we’re disappointed, and we’ll have more to say as the company updates the market.

It’s important to keep a portfolio-level perspective, though. More than 96% of the money investors have placed into the Fund is either still in cash or deployed into a mix of 18 other companies. Such is the benefit of spreading your eggs across many baskets.

Looking Ahead

Thank you for joining us at the very beginning of a long journey. It’s an exciting time and we value your trust. We look forward to catching up again a few weeks with our first quarterly letter, where we plan to shed more insights into the companies in which we’re meaningful, long-term stakes.

Happy Holidays,

Joe Signature

Joe Magyer, CFA
Chief Investment Officer

All of the commentary, statements of opinion and recommendations contain only general advice and have not taken into account your personal circumstances.