Friday, 4 January 2013

Tracsis - Late to the party

In the past few days I've been researching a company which I've just added to my portfolio called Tracsis. This is one I've heard mentioned before on the zulu thread on ADVFN, amongst other places, but never got round to investigating it properly - sadly one of the constraints of only investing part time means I don't get a chance to do the amount of research for new investments as I'd like.

Now, I'm pretty late to the Tracsis party. The shares went from ~55p to ~160p last year - wow! Shareholders of 2012 are dancing hard but I still reckon the party has a way to run yet and I'm getting involved. Now I'm not going to do a full write up of TRCS as thankfully, as part of the NFSC on TMF, TheKingsGambit has done a brilliant, comprehensive write up here. What I will do is highlight a few aspects and themes of the investment I think are important.

High quality of earnings

I'm a strong believer in the power of the accrual anomaly. I'm going to steal Stockopedia's description of it for their screen because it's so good:

"This screen is loosely based on the influential work of Richard Sloan from the University of Michigan, published in 1996 documenting what is referred to as the “accrual anomaly”. A pound of earnings can be comprised of assumed non-cash earnings called “accruals.” His landmark 1996 paper revealed that shares of companies with small or negative accruals vastly outperform (+10%) those of companies with large ones His paper found that investors focus too heavily on earnings and not on cash generation. They value the earnings of a high accrual company just as highly as the same earnings of a low accrual company, even though the high accrual company’s earnings are more likely to reverse in future years. When future earnings reverse, investors are “surprised” and sell off the stock causing the stock price to decline. Similarly, when a low accrual company’s earnings accelerate in future years, they are surprised in a good way."

Tracsis have very high cash generation from their profits and hence very low accruals. In fact, if you ignore the one-off acquisition earn-out payment, they generated £3.57m of cash last year compared to a reported profit of £2.42m. Now part of this is due to improved working capital management which can't be a long term source of cash but even before working capital movements they generated £2.78m of free cash flow (excluding the acquisition payment, because I'm trying to work out the current 'steady state' cash flow production going forward).

This is very different to a number of software companies who love using capitalisation of software development costs to boost profits. Too many investors ignore the cash flow statement and treat all profits as being equal. I can tell you right now, I'd take hard cash over an intangible asset any day. You can't spend intangibles. This keeps me away from investing in companies like Globo (GBO), a software company that makes lots of accounting profits and so many investors go "Low P/E, good profit growth, must be cheap!" but this logic is flawed. Free cash flow has been negative for many years, so for GBO to be cheap it must demonstrate that the present value of the FCF it can generate in the future is greater than the market cap. It may well be that Globo's investment in it's software will generate these cash profits in the future and the intangibles are justified, but it hasn't proved it can go FCF positive in it's results - yet. This is the kind of situation I find hard to appraise and so I avoid.

Niche markets as a source of competitive advantage

I like companies that address small, niche markets. That sounds a bit counter intuitive, as surely investors want to find the next Facebook which have the potential to grow in to giants? Possibly, but I think it's far easier to identify companies that operate in markets in which only a very small number of companies can operate in. This specialisation allows for high returns as it generates pricing power - if you're the only guy with the best rolling stock planning software for railways then you can capture a lot of the value you create. Also, niche markets aren't necessarily low growth - they are just small in absolute terms relative to wider economy. It's also a highly defensive proposition if you're a niche, non-commodity product business. It'd be hard for someone to come along and win Tracsis's current contracts unless their software is of at least a vaguely comparable standard (which is hard to achieve given how specialised the knowledge base is) and a decent cost saving to the existing deal TRCS have.

Good capital allocation ability is under-rated

What I really, really like about Tracsis is how much they emphasise how disciplined they are in the acquisition process and make an effort to outline their approach. They also mention in their annual report about how they've looked at many potential acquisitions this year but none met their strict criteria. This makes me even happier that they a) have excess cash on the balance sheet and b) are retaining most of their earnings for growth. I strongly believe that investors under-estimate the power of good capital allocation (which is a skill surprisingly few managements tend to be good at) and the power of compounding - companies that can reinvest their earnings at high rates of return will do very well for shareholders in the long run and are worth a premium. I'm going to do a blog post about this topic at some point as I think it's a very, very important investment lesson many investors under-estimate even if they are aware of it.

I'll end this blog post with an update of my portfolio as it now stands. I trimmed some PVCS as well as adding funds to buy TRCS - still need to get around to adding more MGNS!

EDIT: Just realised I've missed off JD. from my Stockopedia portfolio, here's my updated list:

Disclosure: I own shares in TRCS


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