Revisiting the Investment Confessional

As a lapsed Catholic the word ‘confessional’ conjures vivid memories of childhood visits to a gruff-voiced priest faintly discernible behind a metal grille who absolved my minor transgressions with a blessing and a few prayers. I suppose posts like these are the digital equivalent of ‘penance’ in the investment universe.

In my last entry I mentioned Duke Royalty. What I’ve so far neglected to account for is the sale that partly funded its entry into my portfolio.

XL Media was one of several high-yielding smaller companies I invested in with high hopes in 2015/2016. For quite some time all went well and it doubled to over £2.00. From early 2018 the share price began to fall, culminating in a profit warning in June, and a collapse from £1.70 to just over £1. This resulted in a decision to sell at in effect break-even. XL Media shares continued to fall until October, although they are just (as of November 6^th) back over £1.

I’ve taken several lessons from the case:

1. Don’t invest in what you don’t understand. 

Every investment needs to pass at least two tests:

Firstly, the ‘Just a Minute’ Test: can you explain the investment case in 60 seconds without hesitation, deviation or repetition? In XL Media’s case being brutally honest I doubt I would have got to thirty seconds. Its revenue stream was something to do with ‘push-marketing’, getting people to click onto web sites of ‘variable’ quality. I’d under-estimated its vulnerability to regulatory threats and the fickleness of online consumers navigating from site to site with little loyalty.

Secondly, the Damodaran Test: drawing on the framework in Professor Damodaran’s 2014 text, Narrative and Numbers: is the investment story of a business possible, plausible and probable?

Whilst technically possible that XL Media could go on generating profits at a higher rate through its existing activities, a rigorous assessment of the investment case would have concluded that the changing regulatory and competitive environment made that prospect less plausible and increasingly improbable.

2. Companies with a low price-earnings ratio (XL Media’s PE was about 10 at time of purchase), favourable recent growth trajectory, and a high, growing, dividend yield (XL Media was on a yield of about 5%) are rare to find. But this appealing combination alone does not make an investment case. It is the sustainability of the business’s revenue streams relative to one’s investment horizons that determines whether it should be added to your portfolio.

So, why have I re-allocated the capital freed from XL Media to another, possibly riskier, AIM stock, Duke Royalty? 

Partly because, in my view, the higher prospective yield (just under 7% at purchase) justifies the risk, but mainly because Duke Royalty is unique in the UK context in offering a proven model capable of generating high initial income with scope for growth in both in dividends and capital.

Duke applies a royalty model well-known in North America by offering capital on a multi-decade basis to businesses in return for a stream of regular royalty payments. These royalties vary with the revenue of the businesses concerned and unlike most fixed interest loans have the potential to grow over time. A recent RNS announcement from Duke demonstrates this with a 6% uplift in royalty payments from two of the portfolio companies. From these royalties Duke pays a quarterly dividend to its shareholders, recently increased to 0.7p per quarter.

If (and it’s a big if) Duke Royalty can further diversify the current roster of royalty providers, there’s potential to replicate the success of American and Canadian counterparts such as the Diversified Royalty Corporation. 

The risks are clear: 

• to secure capital to provide to new royalty partners further placings will be needed. 
• If one or more of the royalty partners runs into difficulty the income stream to Duke shareholders will slow.  

Yet compared to XL Media there is far greater transparency on the underlying sources of income. In this case the royalty partners are long-established cash generative companies:

Temarca BV a Dutch cruise ship company; Brownhills Glass, a West Midlands based glass producer; Trimite Global Coatings, supplier of specialist coatings to aircraft and military vehicles; Lynx UK, a holding company for a portfolio of royalty partners; Interhealth Canada, a healthcare management business.

Subjecting Duke to the Damodaran test: it’s possible and plausible to see this doing well; the royalty model has worked well elsewhere and the management team has a long track record of securing such deals.

Ultimately the probability of success is best left to each investor’s judgement and taste for risk.

With an eye on the prevailing investment climate, I’m cautiously hopeful.