Today’s blog will most likely be our final with respect to Vita Group Limited (ASX: VTG). In a portfolio of 20-30 companies, we will make mistakes – and VTG is, in absolute terms, one of our larger ones. Importantly, despite this loss and others The Montgomery Fund has outperformed over the long term. We also maintain a continued focus on where and why we erred.
In that spirit, it seems a worthwhile exercise to document what happened with Vita Group since our last blog post ‘Why we continue to hold Vita Group’ on 15 May 2017.
One of the key parts of this blog was a scenario analysis in which we noted that the probable upside from holding our investment in VTG was greater than the downside potential as expressed below:
“The decline in the EBITDA run rate clearly has a negative impact on the valuation that can be ascribed to the shares of VTG. VTG is still in the process of negotiating a new commission structure with TLS and because of this, a great deal of uncertainty has been incorporated into the current share price (i.e. there is the potential for further declines in the EBITDA run rate to come).
On Wednesday (last), VTG’s share price fell from roughly $2.25 to around $1.50. Factoring in the possibility of very poor outcomes, our valuation in VTG is well in excess of the current share price. Given such a large differential between our estimate of intrinsic value, we are retaining our investment in VTG, however the lower market capitalisation prevents us from acquiring more.”
Of course, upside/downside analysis is not a replacement for a crystal ball. As fund managers, we don’t know the future and can only attempt to structure a portfolio which tilts upside in our favour after reading company announcements, doing deep analysis and speaking to management. Some investments however will inevitably detract from our overall performance as this one clearly did.
Little more than two days after the previous blog post (on 17 May 2017), and arguably inconsistent with both the company’s previous announcements and their communications with us, Vita Group’s problems became much worse with Telstra Corporation (ASX: TLS) changing its remuneration terms.
It was announced commissions for Telstra retail stores were to be cut by 10% from 1 July 2017, with further cuts of 10% in each of FY19 & FY20. These cuts in our view have the potential to decimate VTG’s future profitability and it’s hard to be certain that further negative changes in the firm’s commission structure would not occur.
It is now apparent that Kevin Russell’s appointment to Telstra in April 2016 would produce similar changes to the company’s relationship with its retail network as had occurred at Optus when Mr Russell was there.
Following the announcement we sold out of Vita Group, forming the view that whilst the share price may rebound, it would do so at a premium to the firm’s new estimated value.
Our mistake was “sitting on our hands” believing that Vita Group’s CEO, sales culture and unique franchise arrangement was a competitive advantage and that Telstra would be unlikely to change remuneration structures in such a severe way as to impact a vital sales channel.
A more attentive investor might have sold Vita Group shares much earlier. We made the consequent mistake of holding VTG beyond the point where it might have become evident that the prospects for the Company had either deteriorated or become too opaque to confidently assess.
Mistakes are not pleasing to admit however we believe it’s important to do so. Our blog obviously features many instances where we have been right on calls, but to do this and stay silent on our wrong calls would not meet your expectations of transparency from us.
Even though the weighting of VTG in our funds was relatively minor, we are nevertheless enormously disappointed with the result.