Dear stakeholder, welcome to the fifth annual message for the Kanday Group. 2010 has been a successful year with Group nett worth increasing by 24.84 % versus a return of 1.4 % for the XAO index. Historically this represents a compound return of 27.9% per annum for past 7 years . This is after tax, whereas All Ords figures below are pre-tax.
Our results are more sobering when analysing returns without CBD input , with return on investing closer to 8% per annum. This is where we have to improve … Keep learning , refining emotions every day.
ANNUAL PERCENTAGE CHANGE
| Year | Kanday | All Ords | +/- | |||
| 2003 | n/a | 11.10 | n/a | |||
| 2004 | 62.20 | 22.60 | 39.60 | |||
| 2005 | 23.70 | 16.20 | 7.50 | |||
| 2006 | 60.20 | 20.00 | 40.20 | |||
| 2007 | 26.30 | 13.60 | 12.70 | |||
| 2008 | -16.40 | -43.00 | 26.60 | |||
| 2009 | 31.70 | 31.30 | 0.40 | |||
| 2010 | 24.84 | 1.4 | 23.44 |
There have been 3 main themes in our activities this year. Firstly, the planned development of 34 Marri Cres Lesmurdie has finally gotten under way. After much planning, works were commenced in July and will continue well into the new year.
Secondly we settled on the purchase of Ella Bache’ Nedlands business in September, after several months of protracted negotiations with the vendor, landlord and franchisor. This marks an exciting new chapter for Group CEO Jessica Candeias.
And thirdly, I began to broaden our investment base in equities after learning much from the writings of Roger Montgomery.
Return on equity is the key plank of company valuation, along with the ability to retain profits i.e grow book value, and re-invest at high rates of return.
Value.able
Roger Montgomery has written a book which has really helped me synthesise my thoughts and learnings on business valuation. The aforementioned chart reveals my condensed elements of his writings and other ‘gurus’. I here add some detail.
Focus on the asset column and the return on those assets. i.e look for a company that can grow book value whilst maintaining high rates of RoE. Dividend payout ratios are an important consideration – companies with maintainable high RoE should retain their earnings.Companies with low rates of RoE who retain their earnings are destroying shareholder value.
Equity can be looked at as a bank account – it represents how much money you have put in the business – now what rate of return do you want on your bank account?
Earnings is merely noise on an annual basis, until an identifiable trend emerges, allowing you to conclude that the underlying return on assets has indeed changed (for better or for worse) Movements in equity/book value are far less volatile and a better yardstick for performance especially during volatile times.
The exception to this are writedowns to book value, which often occur when a company admits to an ill-timed/priced acquisition. Look out for large amounts of goodwill on balance sheets.
The nature of the boat doesn’t change usually, only the people rowing. Remember Warren Buffett said, ‘when a manager with a reputation for brilliance tackles a business with poor fundamentals, it is usually the reputation of the business which remains intact’. This encapsulates why the fundmentals of a company, i.e it’s long term RoE is a predictable yardstick of measurement for predicting future performance.
Always ask “Where is the cash flowing?”. This is the fundamental question which cuts through all the accounting trickery.
I like to use the analogy of blood pumping through the body – the stronger the blood flow (free cashflow) the better the business.
NETWORKS and MOATS – and so we come full circle to what Buffett is looking for – companies with these things have consistently high RoE whilst growing book value per share, consistently increasing EPS, stable or growing margins, don’t need/use debt, only issue equity when they get more than they receive(rarely), require little capex to maintain operations and often have an owner/manager with a large vested interest in the future success of the business.
We show below Kanday’s proportional holdings in those non-controlled businesses for which only distributed earnings (dividends) are included in our own earnings.
| Name/Code/Index | Name/Code/Index | |
| Flight Centre (FLT) | Computershare (CPU) |
|
| ARB (ARP) | QBE (QBE) |
|
| Woolworths (WOW) | CSL (CSL) | |
| JB Hi Fi (JBH) |
Commercial Property Development
After significant (incomplete) planning, works on the upgrade of 34 Marri Cres Lesmurdie commenced in July 2010. The budget for the works came in at @ $500K, but this did not include upgrade of the carpark. At a late stage in planning it was discovered that there are leach drains adjacent to the existing car park. After consultation with the Shire, they indicated that the entire leach system would need to be replaced in order to expand the carpark.
The possible budget for this is an additional $150K.
This development has underlined to me the risks of a capex blowout in property development. Also timing risks are a major potential hazard. This project is likely to take 18 months longer than initially forecast. Fortunately, our operations have been unaffected, and actually the extra time has allowed me to amortise debt prior to loan drawdowns. As to the project itself, the work appears to be of a high standard and we are trying to be completed by end of financial year 2011, carpark included.
The facility will be upgraded to a modern standard, there will be an increased income stream from expansion of the laboratory, but the real return on investment will occur if we can secure a suitable tenant such as a medical group practice to complement existing operations.
Crystal Brook Dental
This year has been another great year for our core business CBDHC. Revenues increased by 17.8% and profit before tax by 30.8%. Early in the year we lost the services of John Marsell just when he was starting to perform. His replacement Helen has kept a pleasant workplace. Most of the aforementioned gains relate to the increased output from yours truly.
Our strategy focus next year will be to leverage my business cashflows to capital gain and income recognition elsewhere, as my work output is finite and increased almost to the limit. Cashflows from my business are not recognised as permanent increases of business value, so reinvestment must be where income gains are reflected in capital worth. And my goal is to not have to look in mouths for a living forever! Having said that the dental business will again raise fees by 5% on January 1st and for the forseeable years to come, a pleasant advantage over other price sensitive businesses.
Our purchase of the OPG machine has been a resounding success with revenue for the year of approx $25,000, representing a ROI of about 43%. My hope is that with the completion of the 34 Marri Cres development, CBD can grow to new heights with the addition of a complementary tenant and subsequent increased patient flows. Patient flow and overall size may be key to my diminished future role whilst maintaining profitability.
Ella Bache’ Nedlands
In early September we concluded the purchase of the franchise Ella Bache’ Nedlands. We had to reach agreement with vendor, franchisor, landlord and banker, in that order. The vendor would not budge on price, but there were several aspects which made the deal appealing. Firstly, the price was based on the depreciated value of the recent shop fitout (2007), so only a small portion of the purchase price is attributable to goodwill. This has tasty tax consequences.
Secondly, the location is in the upmarket suburb of Nedlands and the shop has 17 years trading history with only two (including this one) ownership changes, so there is embedded goodwill. Thirdly, there is ample parking and ease of access, despite the location on busy Stirling Highway. Fourthly, the franchise relationship involves a one-off $11K payment only and then the only real requirement is to exclusively retail Ella Bache’ sourced from Hallas the franchisor.
Ella Bache’ the brand has a 90 year history and is recognised by women worldwide as a quality luxury skincare product range. Sixth, the lease terms were favourable. As a condition of the sale, we had the lease extended to a minimum 5 years to ensure security of tenancy.
It has been a remarkable 18 months for Jessica, as she firstly gained employment from Lancome’ in Perth CBD against the odds (130 other applicants). She then proceeded to outsell all the other consultants, with no training, relying on her sales flair. Then only 8 months into the Lancome’ role, she has quit and taken on the ownership of the Ella Bache’ franchise.
And in her first four months there she has taken the business to new heights, so the sky is the limit for this girl, and I will give her every opportunity to fly.
$AU – USD : investing internationally
The Australian dollar has rallied sharply against all other currencies in the last 18 months. At the time of this report, the AUD was trading at parity against the USD. Long term it is the intention of Kanday group to further our interests internationally, particularly in markets such as the US, a place where capitalism appears more prized than in our current domicile, Australia.
After some research, I happened upon Valueline, which provides in depth historical financials of all major US public companies.
Furthermore, I am subscribed to Commsec international trading account, which allows me to trade all international financial markets, albeit with marginally increased brokerage fees.Also, I have made enquiries with HSBC, a truly global banking service. They have a premier account which allows you to carry any major currency, set up accounts in foreign countries, and view all international accounts on one screen.
Despite talk of recession in other countries, my examination of investment opportunities so far suggests prices are higher on lower quality issues versus Australian business. Apparently consumer items are much cheaper internationally, but this holds little interest to me. Many an author has suggested that currency speculation is just that, similar to punting on the price of gold. Therefore I will focus on our domestic operations until either I have surplus cash or obvious value starts to present. As part of my scuttlebutt I may look to travel to a destination such as the US to get a feel (dangerous) for the economic climate, and to buy some cheap toys!
Debt
The most dangerous thing about debt is the opportunities you forgo, because you have debt. Upon further reflection, I can see clearly that the number one reason why I did not load up during the GFC was because of my debt commitments.
This is where all analysis showing the virtues of using leverage fall to the wayside. Investment returns are not uniform as these pretty analyses would have you believe. Rather, investment returns are lumpy, and often there are long periods of negligible return, followed by sudden re-ratings. Well-timed investments are often the secret of a great fortune.
Being able to recognise great investment opportunities is one skill-set, being in a position to take advantage is a whole other matter.
During the GFC Warren Buffett had $45B sitting on the sidelines, I had nett debt of $XM. In his words, “when it is raining you don’t catch water with a thimble, you catch it with a great big bucket”. Emotionally, the man with idle cash is ready to act, whilst the man with nett debt is worried about the downside risk.
Expect to see the Kanday group move to a position of nett cash as time passes. We will be a lot richer for it in time – without the leverage.
Our decision to fix $X of debt for 2 years at 5.79% in June 2009 has proved to be a good move. Interest rates in Australia on variable rate residential mortgages have risen above 7%, so I anticipate we will book a gain of about $X on the spread. However, the fixed period will be over in 6 months. With the fixed loan maturing, we will be looking at the property assets supporting the debt.
One option is to look at selling property into the group Super fund, as this may be a strategy to reduce the debt and unlock cash. Equity investment results will impact on this.
Operating leverage vs Financial leverage. The most obvious one here is operating leases versus property purchase. I have concluded that a mix is best. Controlled leverage is desirable. AIFRS changes will mean that companies will need to treat operating leases as debt on the balance sheet in future to reflect the fixed nature of the expense, which may even up this debate. Size matters and can be gain be gained both through operating and financial leverage. Buffett used the concept of float in insurance, which can gain you the use of OPM for free.
Travel retailers and credit card companies also carry float. An idea I will likely use in the future is to leverage into someone else’s conservative company. A track record of fiscal conservatism will insulate leverage risk.People argue about real estate versus business. The way I see it, real estate offers financial leverage, which the banks love to lend against.
Business on the other hand offers operational (people) leverage. This is the biggest game of all. If you can master the art of managing people and motivating them, providing systems which a dummy can run (because one day a dummy will run the place), then business outperforms all other asset classes.
Without getting too philosophical, I can feel those who embrace business (people) truly embrace life. I need to do more of this.
Compounding
Patiently compound over time – compounding is the most important rule – analysis of 8% return vs 11% return vs salary input vs no salary input
| 8% returns | 11% returns | Stop working | ||
| Current Principal | 1,000,000 | 1,000,000 | 1,000,000 | |
| Annual addition | 300,000 | 300,000 | 0 | |
| Years to grow | 14 | 14 | 14 | |
| Annual interest rate | 8% | 11% | 11% | |
| Future value | 10,782,828 | 14,332,049 | 4,310,441 |
Obviously from the above, every % point matters and so too does my continued dedication to the task of fixing mouths.
Emotional analysis – post GFC reflection
I stopped studying stocks and business when prices fell heavily. Instead i started reading about gold and the end of the world. Most important and worryingly was the fact that I started listening to the opinions and fears of others, listening to people with NO MONEY WTF.
People have very short memories – when times are bad we think forever , when times are good we think forever.
One step I have taken is stopped managing PC money so I can’t be affected by this kind of thing in the future. I only manage my money from now on and try to not disclose my activities nor solicit the opinions of others.Look at 9 / 11 – we all stopped flying for about a week and then thought, oh , it’s safe again to fly. This may be a metaphor for the current stimulus induced recovery.
Deflation vs Inflation – should we pay any attention to the economy – Warren thinks not I will focus on my businesses instead of worrying about China’s inflation rate.
How am I different from Warren Buffett?
I will continue studying the masters – Warren , Graeme Hart , Charlie Munger, Robert Kiyosaki , Frank Lowy to name men I have learned from. Comparing my lifestage to Warren Buffett as follows.
Warren Buffett never held a job.
The game of money – have to get in front to keep up with the inflationary value of assets.
Warren exposed himself to maximum assets at the beginning using other people’s money. Then when he was in front of the game, he could start investing using cash and less asset risk.
John D Rockefeller did the same thing with bank money.
Sydney property guru Harry Triguboff said start out with debt (otherwise how else do you start), but pay it back as soon as you can and Rich list copycatting – back the Rich 200 strategically to catch up to them.
Odds are they will be richer in the future, especially the self made rich.
e.g had an opportunity to back Skroo Turner/Geoff Harris/Jim Goldberg at $4 at a temporary low ebb in their net worth.
Random thoughts
I have several generalised thoughts to impart this year, as follows:
Cashflow is King. Especially during a recession, the one element which separates quality from bankrupt is the company making a cashflow profit (not an accounting profit).
Size matters but so too does the return on that size. Size earning low returns is better off distributing those earnings to shareholders (to find better returns elsewhere).
Leverage is best in the depths of recession, not in a boom.
Consider non recourse leverage into debt free companies – the risk of default is essentially eliminated. The debt is fixed but the dividends grow – except in deflation.
But remember, when you don’t have control, then the actions of the controlling members may not align with your goals and timeframe, which can be particularly risky when you have debt. Furthermore, remember that when you have debt, you are ultimately at the mercy of your creditors, your bankers.
Margin of safety – Price is important , Don’t overpay. Patience and try to wait till there is blood in the streets (think when Lehman Bros collapsed).
Only buy quality and what you like – then you will never have to trade out on a loss – time will correct any errors you made in valuation.
Keep trading to keep the balance sheet clean – don’t leave too much debt lying around on the balance sheet.
Stick to proven records / History repeats / Know the owner manager.
Only trade on the same stock / property.
Buy things you never intend to sell.