With global markets pulling back sharply over recent days, it was pleasing to see the positive trading update by Codan Limited (ASX:CDA).  The company – which makes communications, metal detection and mining technology – has been a significant contributor to The Montgomery Fund’s performance for a long time.  And the update led to a significant boost to the share price.

Source: Bloomberg

The Montgomery Fund initially invested in Codan in the middle of 2017 at a price of around $2.40/share. The share price increased in a steady way on the back of continued earning upgrades to top out at ~$8.50/share or about 3.5x just before the pandemic hit in early 2020. We were actively managing the position during this period and took profits along the way.

The sell off in March 2020 saw the shares more than halve in value to bottom out at ~$4/share as the market worried that economic weakness would impact sales in both the Metal Detection and the Communications divisions.

It turned out there was an impact in the Communications division as governments around the world diverted resources towards COVID related stimulus and other spending and travel restrictions resulted in Codan’s sales team not being able to travel and win new customers. This was however dwarfed by the positive impacts that the pandemic actually had on the Metal Detection business. To quickly describe these impacts:

• Artisanal gold miners in Africa were not discouraged from investing in metal detectors as it is by its very nature a socially distanced activity and some additional demand was created from people having lost their normal jobs turning to gold prospecting to feed their families.
• In the Western World, the combination of stimulus payments to populations combined with additional spare time from being furloughed during lockdowns and the need to social distance led quite a few people to take up recreational metal detection for relics and coins etc. as a new hobby, creating additional overall demand.
• At the same time as this additional demand came, Codan’s main competitors were having manufacturing issues due to their manufacturing being based in the US where the high number of infections impacted production facilities. The main competitors also seem to be less sophisticated in their component sourcing than Codan and the global electronic chip shortage seems to have impacted them much harder than Codan resulting in Codan being able to take quite significant market share during this period.
• In early 2021, Codan announced two acquisitions that increased its product offering in the Communications division. Both acquisitions seemed at the time to make sense and the market liked them.
• Lastly, Codan also announced that it had agreed with Caterpillar to sell the underperforming Underground Tracking division through an earnout structure which the market took positively as it removed a distraction for management.

As these trends became obvious once the market bottomed out after March 2020, Codan’s share price again steadily increased to around $19/share or up 5x from the bottom in the middle of 2021. Again, we managed the position size during this period and took profits along the way but Codan was one of the real standout contributors to fund performance during this period.

I detailed what happened to drive the share price down after August last year in this blog post from November so I will not recap it here and only add that there has not been any incremental news since then.

Codan is scheduled to report first half results on 17 February but 25 January, it released a trading update saying that sales in the first half grew by 32 per cent and profit after tax grew by 21 per cent to around $50m from $41m in the first half of financial year 2021.

Figuring out the market’s real expectations is not always easy for quite a few reasons:

• Firstly, the consensus of sell side analysts’ forecasts can be skewed by outliers who deviate from the rest. The reason for this can be both from genuine insight or the opposite and different investors gives different weight to different analysts forecasts meaning that even if just sell side consensus was the only influencing factor, different investors would have different perceptions of what that consensus is due to them assigning different weight to the components that makes up the consensus.
• Secondly, sell side analysts numbers often go stale as analysts don’t always publish updates to their forecasts and you therefore over time get a natural drift between what is included in expectations as more information becomes available over time. This has been the case for Codan where the attempted coup in Sudan, which is their biggest gold detector market, will have impacted during the first half but we have not seen any analysts explicitly take this into account in their forecasting.
• Thirdly and most importantly, what sell side analysts predict does not matter if the buy side analysts think something different.

All these factors make it very hard to establish the true market expectations but our perception from the weak share price during the last months is that the real market expectation was significantly lower than what the sell side consensus was looking for. Just figuring out what the sell side consensus is can sometimes also be hard as Bloomberg and other data providers are not always picking up all analysts and it can be particularly tricky for interim numbers as not all analysts explicitly publish this. There is a new tool available called Visual Alpha where sell side analysts submit their actual models that are then deconstructed by humans to ensure that they are comparing like for like numbers. We have just started using this tool and it is turning out to be very useful.

For Codan, Visual Alpha reported that the consensus profit after tax for the first half of 2022 is $48m and the guidance for $50m would therefore imply a beat of ~4 per cent which is good but nothing earthmoving. Looking at the initial share price reaction, which at time of writing shows the share price up by 17 per cent, it is clear that our assessment that the real market expectation was significantly lower than the published consensus was correct and the profit guidance was a clear positive surprise and provided strong reassurance to investors. We continue to be believers in the company and see good potential for the valuation to recover now that the market’s worries have been at least partially addressed.

The Montgomery Funds owns shares in Codan. This article was prepared 25 January 2022 with the information we have today, and our view may change. It does not constitute formal advice or professional investment advice. If you wish to trade Codan you should seek financial advice.