Dear stakeholder, welcome to the 8th annual letter for Kanday Group. 2013 has been an excellent year, with strong performances from our wholly owned operating businesses and an exuberant market re-rating the prices of equities as it forgets about risk. With interest rates at all time lows, the wall of money sitting on the investing sidelines has suddenly moved towards riskier assets in search of yield, forcing up asset prices. My only comment on this in this letter is that whilst downside risk has certainly increased, the market in my estimation still seems to be pricing based on performance, with poorly performing businesses being appropriately punished, and perhaps high performers being over-rewarded in their price re-ratings.
Opportunities to add to our holdings are still available but the field of candidates is dwindling.
Net worth increased by 28.7% versus a gain of 13.6% for the XAO Index, the tenth consecutive year in which we have outperformed the benchmark index.
Our sources of gain were again from Crystal Brook Dental and Ella Bache Nedlands, and strong appreciation of our domestic and international equities interests.
Annual Percentage Change
| Calendar Year | Kanday | All Ords | +/- |
|||
| 2003 | n/a | 11.10 | 3300 | n/a |
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| 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 | |||
| 2011 | 19.6 | -13.9 | 33.50 | |||
| 2012 | 12.4 | 10.8 | 1.60 | |||
| 2013 | 28.7 | 13.6 | 5323 | 15.1 | ||
| Cumulative Return | 2003-2013 | 868% | 61% | |||
| Compound Annual Return | 2003-2013 | 25.48% | 4.90% |
Key Themes of 2013
“People say the customer comes first and all that, but actually it’s cash.”
Jorge Paulo Lemann
Reaching our goal of being debt free in the first half of the year, we now are in the enviable position of having regular excess cashflow with which to invest. I continued to add to our international equity positions, taking advantage of the favourable AUD exchange rate.
Over the past few years I have identified several attractive opportunities in US domiciled stocks.
Ben Bernanke’s (Fed Chairman til 2014) largesse has buttressed the US economic recovery.
On the other hand, the Australian Fed under Glenn Stevens has watched passively as Australia’s manufacturing sector has been hollowed out by the high AUD. Five years after the GFC and now it is Australia which appears to be on the back foot.
The only conundrum I have had to face is the risk free 5% I can earn on funds in Australia versus the 0% interest rates on international currencies. This arbritrage has come more into focus now as US and European equities have rallied to levels where downside risk is magnified.
In the latter part of the year I expanded my equity focus to the rest of the world as my comfort in my valuation process has grown.
Quality companies whose brands I recognise all provide extensive reporting in English for the benefit of foreign investors.
I am taking small steps here, focussing on the purchase of companies whose industry, market positioning and track record almost assure a satisfactory return over the long term. This is key as the majority of these positions I have no intention of ever selling.
My focus will continue to be to increase our positions in individual companies and spending time to get to know their management.
Our fully owned dental and beauty businesses continued to thrive despite the lacklustre economic environment at home. The goodwill which has been established over many years of dedicated service to the local communities largely insulated us from the downturn others have faced. These are favourable attributes of these businesses as long as we are willing and able to keep putting in the hard work.
Equities
“A rising tide lifts all boats.”
Warren Buffett
This famous quote may be appropriate to describe the performance of this year’s equity markets.
I don’t expect to repeat this year’s returns any time soon, but my focus on international markets has certainly been validated along with redemption domestically. Being faced with several capital allocation decisions I am pleased to say my methodology and reasoning has started to yield results (finally)!
Importantly I have sidestepped most all of this year’s calamities including mining services and select cases such as QBE, WTF, BBG.
My biggest blunder has been our holding of Aeropostale, a legacy of my first foray into overseas markets. Despite woeful operating performance, I have continued to hold ARO. Management has missed the fashion trends and this is the core of the teen apparel industry. Importantly though they have maintained a conservative balance sheet (zero debt), have accelerated store closures and downsizing, whilst trying to catch up with the fashion cycle and reposition the brand in the fickle minds of teens. Given my chance again I would not invest in this sector because of its volatile and undpredictable fundamentals (hot/cold), but our decimated holding in ARO has equal upside and downside risk at this point.
Our measurement of Quality is equally about operating performance and management reaction to challenges and corresponding capital allocation decisions.
As markets have risen my preference has trended to purchases of companies with limited downside to their valuations. This may be stunting upside in the short-term but will shield us somewhat(but not totally) if equity markets correct.
My focus continues to be on the underlying business performance and quality metrics of our holdings.
Our best performers for the year include JBH, FLT, GOOG, GILD, MMM, MA, PCLN, BIDU and BBY, all seing their share prices more than double.
Further gains will be harder to achieve as multiples have expanded more than business performance.
Profit margins for many of these companies are at all time highs as well. History shows that margins will revert to lower levels as Adam Smith’s invisible hand dictates.
Markets have recaptured and exceeded all the losses of the GFC. Thus my urgency to allocate additional funds to equity markets has abated.
I anticipate we will use current market levels as an opportunity to spend more time in analysis of our methods and less on purchases.
34 Marri Crescent Lesmurdie Rooms
After entertaining some sketchy interest in our additional rooms, with all coming to nil, I have decided to leave the space empty for the time being.Perhaps this is for the good, as a co-tenant may eventually grow to cramp my style, like a roommate who cramps your lifestyle.I now anticipate ultimately developing the space to enlarge my investing operations, an ideal location for a thinktank amongst the trees.
Crystal Brook Dental
Encroaching health funds, corporate raiders and other intermediaries inserting themselves between the dentist and the patient, and I was concerned the best days for dentists may be behind us. But when the rules of the game change, the game players adapt and adjust. Aligning ourselves with the major funds, suddenly we found ways to increase patient case acceptance. Competition amongst funds has seen them offering 100% rebates on checkups and other incentives. This has all translated into more patients, moderately lower fees but greater treatment acceptance. The net result has seen revenues climb more than 6% higher than last year’s record, despite your Chairman taking a one month break to the USA in September.
This pleasant outcome has me optimistic about the next five years in the profession.
We have a wonderful. close knit group, great momentum and I anticipate a strong 2014.
Ella Bache Nedlands
Ella Bache Nedlands has had another wonderful year with revenues climbing 10% over 2012. This has not come easily though as several unforeseen and unfathomable events threatened the business. Unfortunately it emerged that a key staff member had long been plotting to establish her own salon and tried unethically and unscrupulously and ultimately unsuccessfully to steal the salon database. The quality of the location and service offering at Ella Bache Nedlands and the support and loyalty of the other staff, demonstrated the economic goodwill which has been built over three decades.
The second half of the year was much more pleasant with the salon going from strength to strength and Christmas trading an all-time record. Jessica introduced a new make-up range Jane Iredale in November which has proved to be an extremely popular addition to the salon.
What to Buy – the focus on Sustainable Quality
“Don’t ask how much an industry or innovation is going to change the world, instead ask who is going to make the most money from it.”
Warren Buffett
An examination of our equity holdings reveals some important insights, a product of the filters we utilise in selecting stocks to own. The best businesses are those with an emotive or addictive quality attached to their product or service, and a necessity factor.
There are three types of business which I would like to touch upon, all of which exhibit wonderful economic characteristics.
They are Brands, Derivatives and Lifesavers.
Brands
Recognition of a product or service is one of the key ways in which we all decide whether to buy. A brand represents a certain image which the customer can rely upon in the purchase process. It may stand for lowest prices (e.g FLT and JBH) or it may stand for high quality (e.g AAPL or LULU). Importantly it also stands for consistency so the customer knows with confidence what they are going to receive when they make a purchase.
A brand alone though is often not enough to ensure customer loyalty. For brand loyalty often the company needs to make a simple and clear guarantee to the customer which the competition cannot match, and then to take this one variable to its limit.
GOOG stands for search and does it better than anyone, matching the customer with the search result they want with alarming precision and ease. Suppliers know this and so shower GOOG with advertising profits in order to get to the top of search results lists.
Another of our holdings is Coach, a maker of luxury leather products particularly women’s handbags. COH has a well recognised brand built through a quality product over many years. However its’ grip on the consumer is not nearly as strong as GOOG. Companies such as KORS can steal the customer by offering similar high quality fashion accessories.
Look at an industry and ask yourself, are there any up and comers challenging the incumbents? If there are then likely the protective moat we want is not there and we should allocate new funds elsewhere. It is perhaps not surprising that our holding in COH has not performed as well as GOOG. B – Brands work best when the company with the recognised brand has a monopoly over its’ industry. eg entrenched duopoly of big 4 Australian banks.
Derivatives
Derivative businesses are typically paper shufflers or aggregators of the products of others, making their money by clipping the ticket as the customer makes the purchase. They are capital light leaving all the heavy loading (i.e owning all the physical property and inventory) to the actual provider of the service. D – Derivatives wedge themselves into the supply chain until the primary producers can’t do business without them or they will be omitted from the game by the influence of the derivative. Eventually the customer’s first point of contact is no longer the actual supplier. Instead, the customer will contact the derivative in the hopes of getting a better deal. The derivative convinces the customers that they are imperative to the provision of the service, and once they have captive control of the suppliers, they do indeed become the only way to access the service. This is despite the fact that often all the derivative does is hand an invoice from the supplier to the customer, taking a commission in the process and likely actually adding to the overall cost of the service.
Whilst my tone may sound negative, the economic characteristics of derivative businesses are often mouthwatering and their dominance increases with time. Therefore I look to own them wherever they exist in an industry.
The best businesses are the derivatives, or better still the derivative of the derivative. Visa is a derivative (I.e a way to pay) which is a beneficiary of almost every business in the world. Without Visa you may not get paid! PayPal is a derivative of a derivative, taking a commission when people pay for a good or service with say visa or mastercard but access the payment through their Paypal account.
Derivative type businesses in our portfolio include aforementioned Visa(payments), Mastercard(payments), Priceline(travel), Ebay(payments/retail), CHRW(transport) and GS(finance).
Lifesavers
As the name suggests these businesses provide a service vital for the survival of their customers. Because of this, they are economically insensitive, as clients are not going to defer treatment if it means they will die without it. Lifesaver companies provide a form of portfolio insurance during economic downturns.
Furthermore, with healthcare an ever increasing need, the discovery of blockbuster new drugs can provide potential significant upside to these companies. Gilead Sciences has been one of our most successful holdings and provides an excellent example. When I purchased GILD it was already a market leader in medications for treatment of HIV. But with some drugs coming off patent protection, the share price was withering. Then GILD announced the big deal it was purchasing Pharmasset, a company with experimental drugs for the treatment of Hepatitis C, a major community problem. Just the possibility of finding a drug to cure Hep C sent GILD’s stock price soaring. Recently the company received FDA approval for sofosbuvir, it’s revolutionary Hep C once a day treatment with high cure rates.
LS – Lifesavers – are likely to be good businesses – look for companies which get your money no matter what.
Finally, it is worthwhile doing a shopping budget analysis.
Ask yourself – where do I spend my money- things you buy all the time without even contemplating the purchase are likely to be quality businesses.
A good example of this is Colgate – brushing your teeth is not going to go out of fashion any time soon.
Remember though, I am not advising you to rush out and buy these companies just because I own or mention them. There is far more to the investment process than that and I am not a registered financial adviser so seek your own advice in light of your personal financial circumstances.
The Long term – thoughts on Selling
“Let’s say you identify 10 companies as being of high quality, run by able management and trading at an attractive price. I wager you that in 10 years time 9 out of the 10 will have one thing in common – they will be trading at a higher price. Armed with this knowledge, why would you ever sell? Your task is merely to increase your holdings in those securities still trading at an attractive price. Even the GFC proved to be a temporary event for long term prices of quality companies.”
Marcel Candeias
How would you act if you knew you couldn’t fail? You would look for companies who were going to dominate over time and buy as much as possible and then go to the beach or park to celebrate your impending success. You certainly wouldn’t stay glued to a computer screen everyday, worried that your holdings were going to drop a couple of percent.
So, ask yourself – who will be the winners in 20 years from now – what will the industry look like and who will be making all the profits – that is the most important question. The more long term you can look the greater the opportunity.
Everyone is always looking for the next shiny thing, rather than staying the course.
With this mindset, only look to sell if the business is broken or management actions are leading the company down the path to bankruptcy.
The following is food for thought to sway you on the subject.
In the past 100 years the US share market has only twice fallen by greater than 50%. That was during the Great Depression when the market fell 90% from peak to trough and the recent GFC in 2008-09.
If you owned anything during this time, stocks or other, you got wiped out anyway. Apart from this time then, the most the market has fallen is about 50%. Sure there have also been long periods where the level of the overall market has gone nowhere. However, during the past 100 years, the market has ultimately risen by thousands of percent, buoyed by the inexorable buoyancy of inflation and the performance of businesses and their retention of profits reinvested for further growth.
So, armed with this knowledge and a permanent time frame (you can live off the dividends in time), why would you look to sell your securities in anticipation of a market collapse when probability is so heavily skewed to the upside. You may get lucky with your sell timing every now and then but this will be more than offset by the missed gains from selling too early.
Furthermore, when you sell you introduce multiple mental biases to your thought process in trying to re-establish a position in the stock. You will likely anchor to the price at which you sold and have to factor in tax liabilities if you sold at a gain. Especially painful is selling and then watching the stock price keep rising to the moon like a rocket blasting off.
To illustrate my point, FLT was trading at $25 a share in 2001. By my estimates FLT’s intrinsic value was about $5 only at the time. So at 5* value there was high risk of a downside correction in FLT stock, no matter how bright the prospects. And so it came to pass. When the GFC hit in 2008 FLT shares were marked all the way down to $3.50 when the market got highly pessimistic about just about everything. In reality though, FLT continued to grow at about 13% per annum from 2001 with its intrinsic value reaching about $30 by 2013. So where do we stand now. Well, FLT shares are trading at about $50, equating to about an 8% per annum return including dividends since 2001. Even paying 5* value is offset by the long march of compound growth and so too is the case for the broader market.
So your job is not to jump in and out of the market but to look to add to your holdings of quality companies when the opportunity arises.
Right or Wrong
“It is not as important whether you are right or wrong but how much you win when right and how much you lose when you are wrong.”
George Soros
It surprises me somewhat to find that our equity holdings have grown to some 30 names. I think it is a combination of finding many attractively priced, high quality companies and my reluctance to over-commit funds to any one company. This ‘diversification’ will protect me from downside from excess exposure to any one company but similarly will limit the upside if I am proven to be right about the future fortunes of the business. I expect with time my confidence in the valuation process will grow and I will be happy to have more concentrated holdings. Like Warren Buffet in his early days, I have lots of good ideas but not enough money so I may appear a little thinly spread at this stage.
The 10 bagger in 10 years
What a 26% compound annual return looks like year by year and how so much of the growth comes at the end of the tail.
| Year | Value |
| 0 | 1000 |
| 1 | 1260 |
| 2 | 1588 |
| 3 | 2000 |
| 4 | 2520 |
| 5 | 3176 |
| 6 | 4002 |
| 7 | 5042 |
| 8 | 6353 |
| 9 | 8005 |
| 10 | 10086 |
Note that in the spreadsheet provided the first 5 years only provides about 30% of the gain. The remaining 70% or so comes in the final 5 years, demonstrating the power of undisturbed compound interest over time.
Quality score checklist
Note that the Quality of the business still matters the most to me. Quality will forgive you for overpaying over time. I I feel one of the best comparators is the stock performance during the GFC years of 2008 and 2009 when stocks plummeted.
Financial strength doesn’t imply immunity from recessionary conditions but rather the ability to absorb the unsatisfactory earnings until more favorable circumstances prevail.
During recessions it is often the balance sheet and linked cashflow statement which is more important than the profit and loss statement for the company, especially when solvency is at stake. I will expand upon this subject in future correspondence.
Risk and a reasonable rate of return
“I believe in a reasonable rate of return.”
Le Chiffre
“The riskiness of an investment is the reasoned probability of that investment causing its owner a loss of purchasing power over his contemplated holding period.”
Assets can fluctuate greatly in price and not be risky as long as they are reasonably certain to deliver increased purchasing power over their holding period. And as we will see, a nonfluctuating asset can be laden with risk.”
Warren Buffett
Only invest when the odds are great that the company will not disappoint.
One bad year unwinds many good years and seriously crimps returns so focus on not losing money first.
A reasonable rate of return in the context of the risk free rate and prevailing inflation is the essence of what we are looking for.
The year ahead – taking on the World
This year we have cemented our ambition to becoming a global company. As the accompanying map shows, we now have positions (admittedly small) in multiple countries including Australia, USA, Canada, UK, Europe and Japan. By widening our perspective across the globe we will have the opportunity to selectively take advantage of differing market conditions and circumstances. Our process is methodical and deliberate and my plan is for the next 100 years and beyond, well after the baton has been passed. For now though, the baton remains firmly in my grasp.
I look forward to updating interested parties via our quarterly results presentations.
Yours Sincerely
Marcel Candeias