2006 has been a positive year for the Kanday group of companies, and is a fitting start to the inaugural letter to shareholders. Our gain in net worth has been 60.2%.
This report will be presented in parts, detailing the holdings of the group and their operating performance. While some attempt will be made to forward looking performance, my comment about operations should underline that in business the future is never totally clear. However, a review of past performance and management likely holds some clues to future expectations.
Our goal is to employ increasingly large amounts of capital on the proviso the additional capital employed earns high returns.
The main focus of the Kanday group in 2006 continued to be the rational re-investment of cashflows from division earnings and the maximization of earnings from directly controlled businesses. The term ‘rationality’ is intended to represent a goal of earning the maximum return on investment, with strong consideration given to managerial commitment required from your Chairman.
The group focuses on maximizing positive cashflow whilst looking to invest through vehicles which minimize the direct and indirect tax burden the company is likely to face. We continue to try and demonstrate discipline in our purchases, by only making a decision to purchase once thorough investigation of the opportunity is assessed.
This investigation has a heavy ‘bent’ towards numerical ‘common-sense’ i.e if we cannot measure it with certainty and apply a margin of safety, then we don’t buy it. The margin of safety concept relates to asking:
1) What is the minimum this could be worth?
This typically relates to an investigation of the cashflows being generated by the investment today and as anticipated in the future, and discounting them back to arrive at some measure of tangible value. With property, this means a purchase decision is only considered when positive cashflow can be achieved without excessive equity contribution to the purchase.
2) How much return on our equity investment are we receiving today? Is this adequate? In other words, we don’t want to rely on too much ‘blue sky’ to achieve an adequate rate of return.How much further equity commitment will be required in the future?
3) And finally after 1) and 2) , How much more could this be worth than the asking price?
This approach, then, tends to search for investments which are high yield/high free cashflow, low capital requirements relative to cashflow and low levels of debt. Management believes only residential investment property is appropriate for significant amounts of long term debt. The following table shows some of the sobering realities of gearing investments. Long term returns are rather unspectacular when considering the risks and emotional anxiety involved when debt laden.
Financing Comparison
| Share Purchase | Borrowings Nil | ||
| $4,000 | |||
| y1 | $4,550.00 | Compound at 13.75% | |
| y2 | $5,175.63 | ||
| y3 | $5,887.27 | ||
| y4 | $6,696.77 | ||
| y5 | $7,617.58 | ||
| y6 | $8,665.00 | ||
| y7 | $9,856.43 | ||
| y8 | $11,211.69 | ||
| y9 | $12,753.30 | ||
| y10 | $14,506.88 | ||
| Nett | $14,506.90 | ||
| Percent gain | 362.67% | Compound return | 13.75% |
| $4000 cash | |||
| Assume : | Assume 10% capital growth | Total return 10% / annum | |
| Assume 5% dividend yield | Before tax | ||
| Dividends taxed at 25% | |||
| (Assuming some franking) | |||
| So net dividend = 3.75% , Total return = 13.75% |
| 50% finance | Borrowings $4000 | |
| $8,000 | 1% nett dividend yield after finance | |
| $8,860.00 | Compound at 10.75% | 0.75% nett dividend after tax |
| $9,812.45 | ||
| $10,867.29 | ||
| $12,035.52 | ||
| $13,329.34 | ||
| $14,762.24 | ||
| $16,349.19 | ||
| $18,106.72 | ||
| $20,053.20 | ||
| $22,208.91 | ||
| $18,208.90 | ||
| 455.22% | Compound return | 16.36% |
| Assume | $4000 cash $4000 borrowed | |
| Interest 8% interest only | ||
| $8000 shares | ||
| Dividend yield 5% = $400 | ||
| Positive cashflow = $80 |
||
| Interest expense = $320 | ||
Making some bold assumptions about a 15% compounding 10 yr rate of return and a stable interest rate environment, the 50% geared investment only manages a compounding rate of return some 2.5 % higher than the ungeared investment.
Warren Buffett stated the first rule of making money is to not lose money. The second rule is to refer to rule number one. In other words, capital preservation is a priority. Remember, if you lose 50% of your capital, you need to gain 100% to get back to where you started. Risking significant downside to gain an extra 2.5% rate of return does not smack of good common sense.
As aforementioned, the only exception to this rule is residential investment property, where if we can find properties in good locations which cash-flow, we will use significant amounts of long term debt to fund the purchase. Your management’s performance record against these stated goals is one worthy of close inspection, as the following paragraphs may reveal several ‘questionable’ purchases when viewed in this light. Time will tell, however I am optimistic that more recent acquisitions have led to more desirable outcomes than some of our earlier decisions (which we are still paying dearly for and will continue to do so for some years to come as positions unwind).
We show below Kanday’s proportional holdings in those non-controlled businesses for which only distributed earnings (dividends) are included in our own earnings.
| Flight Centre |
| Timbercorp |
| Timbercorp converting preference |
| Telstra |
| MMC Contrarian |
| Salmat |
| Corporate Express |
| Harvey Norman |
| Westfield |
| Clime Asset Management |
| Ferngrove Vineyard |
At the beginning of this year your Chairman elected to introduce a policy of purchasing $4,000 of shares on the first day of every calendar month, in the ordinary publicly traded stock which is deemed to be most appealing. The reasoning for this was to help insulate management against the emotional rollercoaster which is Mr Market. A committed measured purchase (as a % of operating cashflows) on a pre-set schedule should help to ‘block out’ the noise of economic commentators.
Our performance in this respect is pleasing thus far, however a longer time frame is necessary to fully analyse results. Our allocations thus far are in the table below:
Share Purchase Program as per Sworn Agreement Dated 24/01/06
| Date | Security | Purchase price |
| 2/1/2006 | FLT | 9.38 |
| 1-Mar | MMA | 0.97 |
| 1-Apr | FLT | 11.22 |
| 1-May | FLT | 10.46 |
| 18-May | FLT | 9.983 |
| 1-Jun | FLT | 9.89 |
| 1-Jul | FLT | 9.9 |
| 1-Aug | FLT | 11.63 |
| SLM | 2.72 | |
| DJS | 3.04 | |
| 15-Aug | FLT | 11.2 |
| 22-Aug | FLT | 11.61 |
| 25-Aug | FLT | 11.5953 |
| 28-Aug | FLT | 11.65 |
| 29-Aug | FLT | 11.71 |
| 1-Sep | FLT | 11.69 |
| 1-Oct | MMA | 0.955 |
| CXP | 5.298 | |
| 1-Nov | CXP | 5.52 |
| HVN | 3.68 |
|
| 1-Dec | WDC | 19.31 |
As can be seen , despite best intentions, we haven’t exactly followed our own guidelines. This truly reflects the magnetic influence the market has. Your Chairman’s efforts will continue to try and grow shareholder wealth as best possible, but please be patient as I reign in my emotional urges. Some analysis of share purchase vs share price vs quantity purchased is worthy to examine ’emotional state of mind’ when purchases are made.
I include a chart demonstrating the multiple purchases of FLT made during the year, compared with the ‘line’ chart of stock price at the corresponding time. It is interesting to note that I was compelled to make the most purchases just before the annual result announcement. I think at the time I felt I had performed significant research into the stock and the size of my holdings were not reflective of my conviction of the quality of the company and the prevailing discount in the trading price.
I finally summed the courage to take a more sizable holding, just prior to the annual result, which appears to have been a good(or lucky?) decision. (ed. See miscellaneous news at end of report) The psychology of investing is a deep subject often mentioned by Charlie Munger and will require further learning as the years pass.
Crystal Brook Dental
Crystal Brook Dental continued to take up most of your Chairman’s time, but continued to decline as a percentage of assets under management.
| Year | CBD % |
| Jan 2004 | 36.8% |
| Jan 2005 | 25.7% |
| Jan 2006 | 17.8% |
| Jan 2007 | 14.3% |
The major issue in the dental industry in WA continues to be the introduction of ‘preferred provider’ agreements by HBF. Despite losing patients to other practices clearly for ‘HBF’ reasons, your Chairman’s view is still that PPA’s are a bad idea, effectively transferring practice goodwill to a financial third party, and reducing the ‘value’ of the dental offering. Other issues include staff motivation and retention. A staff incentive program was established in April 2006 to address this. Results have been mixed, with assistant staff appearing generally more committed and motivated. However dentists have continued their trend of setting their own working hours and generally not displaying much commitment and loyalty. Con Hajigabriel is the one exception, showing signs of long term interest. Incentive schemes are unsurprisingly not as effective on dentists as their wage is high to begin with , with only a modicum of work output required. The additional wages do not have as great an impact then as they do on nurse/assistant take home pay.
On the balance, the dental game still represents your Chairman’s specialty and offers high operating margins and returns on capital, albeit at the expense of large manager commitment(sweat equity).
Commercial Property Division
The group continued to hold only one commercial property in 2006, 34 Marri Crescent in Lesmurdie, the home of Crystal Brook Dental. This property was paid for at the end of 2005, using cash and proceeds from the sale of T31 / 24 Pearson St. This was due to a combination of factors. Your Chairman tossed and turned over this idea in bed and reflected the pressure in wanting to be free of the ten year mortgage held over 34 Marri Cres, which was causing a cash outflow of $4,200 per month. In addition , I had never been involved in the sale of an investment, and curiosity got the better of the cat. A respected real estate investor, Dolf De Roos, in his book “Real Estate Riches” , suggested you should seldom, if ever , sell a real estate investment. These have proved to be sage words as the residential property boom in Western Australia has continued unabated. Shortly after I sold the property for about $190,000 , identical units in the same complex started fetching up to $295,000 for quick sale. This perhaps reinforces the mantra that trying to time the market is an exercise fraught with folly. The motif going forward for this investor must surely be to seek quality investments and to hold them for the long term.
As long as the emphasis is to increase cash earnings incrementally, then underlying capital value will march ever upwards in a lumpy but predictable fashion. Attempts at market timing are more likely to result in as many misses (as aforementioned – even though this may reverse if there is a property market correction) as hits. The psychology of when to sell is a paradigm best avoided if possible, by buying investments we have no intention in selling in the first place. As I improve my ability to value businesses/investments I may be better able to appraise when the market has overreacted euphorically, and act to take advantage. Obviously some other pressures were involved with the mentioned sale, hence your Chairman’s strong intention to increase income streams which are not derived from his own personal physical labour (a strong deterrent to rational business decision making).
Residential Property Division
We did not make any additions to our residential property portfolio during the 2006 calendar year (ed. see end of report update), though we would have liked to and with spare cash available. The problem has been the unabated boom in prices, which according to REIWA increased across the board by an unheard of 32% in WA in the 2006 financial year. Whilst this is good news for our existing three holdings, the news is not as good when you plan on being a nett buyer over time. Most people get excited when they hear that the price of their holdings have jumped. As Ben Graham said many years ago though, ‘Price is what you pay, value is what you get’.
Counter-intuitive as it may seem, the Kanday group would prefer more rational pricing of investments (i.e in relation to rentals achievable), which would allow us to add to our existing positions, as we expect over time to have increasing amounts of cash for purchases. Your Chairman feels satisfied that he has resisted the temptation thus far to jump on the residential property bandwagon. As quoted by get-rich educator Robert Kiyosaki, “If a property does not make me money today..I don’t buy it”. We will try hard to stick to this mantra, having faith that the property cycle will eventually turn, and again offer real estate opportunities at reasonable prices. Of increasing interest is the commentary that the Australian east coast markets have been sliding backwards for the past 2-3 years, with prices having peaked in 2003. I am intending to increase my travels in the next 12 months, and this may present an opportunity to become more acquainted with these property markets. The Kanday group has strong aspirations to increase their geographic footprint, and concur with the master investor John Templeton that it follows if one’s investment horizon is the world, one is more likely to find opportunities than if one’s perspective is only local.
Over time geographic diversification is also more likely to protect from local market volatility. The group’s existing holdings consist of 2 properties in Como tenanted as student rentals for nearby Curtin University and one unit in Churchlands, adjacent to beautiful Herdsman Lake. The properties all continued to perform very well with close to 100% occupancy at all times. The yield on the student rentals is an attractive 5% versus the purchase price, being higher because the houses are rented by the room. This is an attractive niche your Chairman has identified, whereby otherwise normal residential housing can be converted to a higher yielding alternative. This dual option of student housing or family residential will give flexibility to adapt the property to future market trends. Yields however have not moved up as much as aforementioned capital values, a sign of uncoupling of value and price. As with most of our holdings we are content to hold for the long term. The management of the properties is generally minimal, including late rent reminders, minor repairs, re-letting etc.
Of great assistance have been the services of Kanday group matriarch Patricia Candeias who has relished the role of general property maintenance.
Flight Centre Ltd.
The most significant investment undertaken by the group during 2006 was the establishment of a sizable position in the ordinary common stock of Flight Centre Ltd. Whilst still a very minority holding, the position represents up to 10% of the group’s nett assets, and places us in the top 200 of share ownership. Flight Centre has been much maligned in recent times due mainly to the threat of disintermediation in the travel industry and the emergence of online travel bookings.
The Kanday group investment in Flight Centre represents our first major step into minority control investments since the meltdown in the bear market of 2000-2002. During this period our wings were severely clipped by being in investments which we neither understood well nor had any control over. We believe Flight Centre is different. Graham Turner has been at the helm of Flight Centre since it’s inception in 1981. He still holds 19% of the company along with other co-founders and majority shareholders Geoff Harris and Bill James.
Graham Turner unlike other CEOs derives his wealth from his shareholdings and not his remuneration package. In other words he runs the company for shareholders. And apparently he is a big fan of Warren Buffett. The company has a culture which empowers staff to act like business owners and rewards performance on an individual and team level. The travel agency business creates lots of free cashflow without requiring much capital investment. Prior to a profit downgrade in 2005, Flight Centre had enjoyed 20 years straight profit growth. Internal profit margins appear to be the problem , as travel revenues as a percentage of sales appear to be holding up well, despite moves to zero commissions by airlines. The company is also growing it’s reach internationally (to 50 countries through ownership or licenses), creating a platform for further growth (profitable growth ??).
The company has flourished despite significant upheaval in the travel industry (9/11, SARs). Graham Turner is back in charge as MD since the resignation of CEO Shane Flynn in late 2005. We feel there is now margin of safety in the share price as negative industry sentiment and Flight Centre’s short term problems depressed the share price. The long term competitive advantages of the company are still intact, namely an honest , able manager, entrenched empowering company culture and dominant brand recognition especially in Australia, still the company’s major market. Furthermore, the main competitors to Flight Centre appear to have somewhat lost their way with Harvey World, Gullivers being swallowed by acquisitive Queensland property owner S8 , which is now in merger talks with fund manager MFS. We will continue to look to add to our position if the aforementioned conditions persist.
Primary Production
We will continue to devote time to our primary production investments until their positions unwind in the next 4 years or so. These positions were established between 1997 and 1999 thanks to our former advisors the Smith Coffey group. The holdings include Timbercorp, Integrated Tree Cropping and Ferngrove Vineyards. Unfortunately at the time, your Chairman did not have the knowledge or conviction he has today of only investing in immediate positive cashflow investments. These investments are the antithesis of this ideal, being negative cashflow from inception, all the way through til divestiture (and a promised, maybe profit). A further lesson from these holdings is to avoid taking advice from incentivised/commissioned advisors. The Timbercorp project should mature in 2008 wth ITC in 2009-2010. In the meantime , these investments are costing us a cash outflow of approximately $4,000 per annum , along with an already committed $70,000 of capital.
This capital commitment is being carried on the balance sheet at only about $20,000, reflecting our uncertainty as to the eventual (if any) payout from these investments. The Ferngrove business has struggled with the glut of wine production in Australia pressuring prices. Jack Bendat, millionaire investor, provided a lifeline to the group by underwriting a recent capital raising ,which without, I feel the company’s balance sheet may have become severely strained. The wine industry is very capital intensive with long lead times before production, uncertain brand recognition and environmental uncertainty.
Hopefully I can steer clear of investments such as these in the future. The only consolation is the shareholder discounted wines taste nice!
Fixed Interest
When I cannot find anywhere interesting to invest free cash flow from operations, I look to invest in at call interest bearing accounts. At the end of 2006, the Company held x% of total assets in cash or equivalent at call deposits, versus x% in 2005. The most rewarding and logical of these is the variable rate investment mortgages I have for the group’s residential investment properties. The prevailing interest rate for 2006 has hovered around 7%, which compares with about 5% in cash management accounts. This 2 percentage points may seem insignificant with smaller sums of money , but given time and the laws of compounding, it can amount to a serious amount of money(acquired with no additional risk).
Your Chairman has been a little laggard in this respect, sometimes not shifting excess funds with enough fervour, perhaps in anticipation of more exciting opportunities for the funds (the itchy trigger finger so to speak). One should always elect for the easy 2% certainty than the uncertain rewards posed by more speculative opportunities. As aforementioned earlier in this report, the effects of 50% leveraging of a portfolio compounding at 10% per annum, are likely to be a mere 2% increased rate of return, along with all the accompanying risk that debt brings. Why not take the risk-free 2% instead. Your Chairman will endeavour to continue to identify such ‘obvious’ strategies to grow the portfolio with minimum downside risk.
As a final point, a cash-rich portfolio, ‘keeping the powder dry’ , seems like a good choice when nearly all asset classes worldwide are at all time highs. Opportunities will surely present themselves again in the future and the cash-rich investor will be able (and ready hopefully) to take advantage of depressed prices, as the masses race for the exits.
Miscellaneous
In life and in business a lot can happen in a short period of time, even after long periods of seeming inactivity (the analogy of the duck on the calm lake). Since the bulk of this report was written (in late October), several interesting developments have occurred, which fall in this calendar year, and hence belong in this report. On the day before the FLT AGM, which your Chairman flew to Brisbane to attend, the company’s founders announced the intention to privatize the company, with the help of private equity group Pacific Equity Partners. The buyout price offered $17.20 per share including a 20c per share dividend. This deal on face value provides a handy capital gain for the Kanday group.
However, I feel the offer may yet undervalue the current and potential future value of FLT. Based on the integrity of historical management behaviour, I am inclined to defer to the decision having been made with minority shareholder interests in mind, rather than being an opportunistic move by management to acquire ‘on the cheap’. The AGM was an uneventful affair, however I was afforded the opportunity of meeting MD Graham Turner, formerly Queensland’s richest man. I was more fan than businessman, however we had a short but meaningful conversation, and I feel richer for the experience.
My trip to Brisbane had another silver lining. I took the opportunity to check out some real estate opportunities, and was pleasantly surprised . Whilst prices are similar to the inflated prices in Perth, the rental prices are significantly higher, which brings the value and price equation more into alignment. The prices are not cheap, especially after due consideration of body corporate fees, but I feel there is worthwhile value on offer. With my brother Miguel currently residing in the near city suburb of Spring Hill, this presents as a good time to try and establish a position in the east coast property market, from which to grow from. A small deal will reveal the process of purchasing real estate from afar, and hopefully establish some long term contacts from which future deals can be brokered.
Until next Xmas, I look forward to providing up to date reports of the group’s financial position through the quarterly reports and welcome any queries from interested parties.
Dr Marcel Candeias
Kanday Corp MD and Chairman