Quick Portfolio Update

It's been a little while since I've updated my portfolio here, primarily because there has been nothing noteworthy happening. That is, until today, when I allocated 10% of my portfolio to Antares Energy (AZZ) at $0.515.  It is a rather unconventional purchase for me in that I do not intend to hold it for the long term, and I am valuing this business on its prospective net cash position instead of its prospective earnings. This situation involves a little more speculation than I am accustomed to, however it seems that there is an adequate margin of safety at the current price to cover any downside, with the prospect of a decent return in a relatively short period of time (less than 6 months). Unfortunately, I'm quite busy these next couple of days so hopefully I will be able to properly outline my rationale for buying AZZ soon. Yes, I can almost hear your squeals of excitement, quieten down please.

Smiles All Around

Today I noticed the 1300SMILES annual report (ASX code: ONT) came out, which unsurprisingly was a pleasure to read. Just to give you a brief overview, 1300SMILES relieves self-employed dentists of administrative hassles and provides them with dental surgeries in return for a fee, allowing them to concentrate on actually being a dentist (ONT also has some employed dentists too). I remember stumbling across this business a couple of years ago and after reading the managing director's letter, came away impressed with the level of transparency and the efforts taken to emphasise that this truly was a long-term shareholder oriented business. Regrettably, I thought it wasn't quite cheap enough to buy at the time, and have since missed out on a nice doubling in share price.

It seems the situation today is not dissimilar with Dr. Daryl Holmes still at the wheel, and ONT trading at a fairly rich 24x FY2013 earnings. As the founder of this $152 million company, Holmes owns 62%, and it is these owner run businesses that tend to produce exceptional results over the long term. You may be wondering why this is so. Well, as the largest shareholder, Holmes has a huge incentive to act in the best interests of shareholders, in contrast to many businesses with high-flying CEOs with little equity ownership that happily take their multi-million dollar pay packages, and simply jump ship when things flounder. This year, Holmes took in just $111,663, less than another executive who received $173,916! However, as he has pointed out, most of Holmes' financial reward comes from dividends and share price appreciation - I calculate he would have received over $4 million in grossed up dividends over the past year. But often more important than money in these businesses is the desire to see them succeed - it is the blood, sweat and tears that founders pour into their company that explains their zealous determination to protect and enhance the company.

Indeed, Warren Buffett recognises this formula for success and generally prefers to buy businesses in which management who are not in it for the money but are have plenty of passion. I think Holmes' shareholder letters exemplify his passion for dentistry and Buffett fans will likely find more than a few commonalities in their business philosophy, perhaps more than any other ASX listed company, which is the highest compliment I can pay a manager. I suspect Holmes may have been taking notes. ONT would probably make a great fit for Berkshire if only it were larger.

To fully understand why I like the management so much, I would recommend you read their most recent annual report here. But I'll try to pick out some key points that literally left me smiling. If you pay attention to the wording, many insights can be garnered as to how management really views their role. In the case of ONT, Holmes begins with "Dear Shareholders," before emphasising the need to read the entire report to "help you understand how your company has managed..." (emphasis mine). Not "the" company, not "our" company, as he could rightly call it, but "your" company.

He then clearly explains important business matters such as what the Chronic Disease Dental Scheme (CDDS) was and how its end affected 1300SMILES this year, the introduction of their Dental Care Plan, brand awareness, and new acquisitions amongst other issues. But this bit stuck out to me: "I have always stressed the fact that 1300SMILES is managed to deliver the best possible results over the medium and long term. Good results in the short term are always agreeable, but I believe that most 1300SMILES shareholders take a long term view and expect management to focus always on stable and growing Earnings Per Share and dividends." And these aren't just empty words, with earnings per share increasing at 15% pa since its IPO in 2005 (also keep in mind ONT pays out the majority of its earnings as a dividend), while dividends have risen by 22% pa.

Holmes believes the future looks quite good too, anticipating it seems likely that the years ahead will offer "more favourable acquisition opportunities than the years just finished. We remain totally focused on making acquisitions which make an immediate positive contribution to our results. We won't be rushed, but we will be ready to act decisively as and when suitable opportunities present themselves." This is music to my ears as all too often managers are too eager to pay for an overpriced acquisition, and it seems so far acquisitions have been very sensible. Since 1300SMILES only has 24 dental practices primarily in Queensland, there is tons of room to expand geographically to one day operate throughout Australia. In addition to the patience highlighted above, this acquisition strategy is further de-risked as the business model has been proven to work quite well - ONT could be in the 'rollout' phase, similar to retail stocks like JB Hi-Fi and The Reject Shop that have lifted earnings dramatically by simply expanding their business geographically. 

Unlike many other boards, ONT "do not seek to influence the price of shares in the company. We strive always to deliver the best possible results and leave the share market to its own activities." This is precisely the role of management: to manage the business, not the share market. 1300SMILES' management seems to be hard at work doing this: "This situation proves once again that the harder you work, the luckier you get. 1300SMILES had been working on arrangements with Queensland Health and the HHS boards for a long time, since long before there was any hint of the end of the CDDS. We didn't go looking for a replacement deal with a government when we heard about CDDS; rather we had been pursuing this obvious need and opportunity for a very long time." Through this deal, "waiting times have been reduced from ten years to a still-shocking two years, but we're working to reduce this just as fast as the various boards authorise us to go."

And they're not getting complacent about costs either: "Long term shareholders will be aware that 1300SMILES has always maintained an intense focus on cost control. Despite that, the unusual circumstances following the demise of the CDDS created opportunities for further improvement in this area." This relentless focus on costs reminds me of what Buffett said: "The really good manager does not wake up in the morning and say, 'This is the day I'm going to cut costs,' any more than he wakes up and decides to practise breathing." 

So what does excellent stewardship result in? A return on equity of 23.6%, zero debt (cash of $8 million), a net profit margin of 17.6% and a very healthy cash flow. These great numbers have been maintained over a significant period of time, resulting in a total shareholder return of 26.5% pa over the last 5 years.  As previously touched on, the future also looks bright for 1300SMILES, which wouldn't immediately require a huge capital expenditure program either - Holmes reckons the company could increase its revenue by 50% with no significant capital expenditure since they always build in extra surgery capacity in anticipation of expansion. Without going into details, ONT has a number of other tailwinds going for it.

After reading the managing director's letter, one is able to gain a thorough understanding of how the business works, how it performed, and where it is likely headed - something I cannot say about most businesses. I must admit it is very tempting to go in and purchase shares and hold forever, but once again, I just cannot stomach the price tag. 1300SMILES will likely stay on my watchlist for a long time, as I pray to the stock market gods for its share price to fall. And to Daryl Holmes and his team, keep up the great work. Not only is this how annual reports should be written, this is how businesses should be managed. Bravo.