Welcome to the 9th annual letter for Kanday Group, a year of two semi-annual themes.
We accumulated mostly US stocks in the first half and then purchased West Australian real estate in the second half.
At the beginning of the year I made the unusual effort to forecast the macro-economic themes for the year.
I quote verbatim what I wrote on 5th January 2014:
“Australian Central bank will lower interest rates again and print money. As a result AUD will drop against USD. Australian share market and real estate will rally, inflation will rise. US correction in the second half of the year creating buying opportunity for quality US stocks.”
Well, the central bank kept rates on hold. No money was printed. The share market was flat and real estate only boomed in Sydney and Melbourne (I live in Perth). The AUD did however drop precipitously against the USD in the last 4 months of the year as commodity prices (especially iron ore and oil) collapsed.
And there was no US stock market correction. An alarming fall of about 10% occurred in October but the indices rebounded even faster, leaving the S+P500 with a > 10% gain by year’s end.
I have a sneaky suspicion I was one year early in my forecasts, however the capital flight to the USD is showing no signs of abating.
Despite my macro postulating, Kanday group increased net book value by 15.8% versus a gain of 1.2% for the XAO index, our 11th straight year of outperformance.
I attribute this outperformance to our fastidious approach of seeking enduring value above all else.
Value can be apprarent for a long time or can be rather fleeting. The key then is being prepared both financially and emotionally and having the skillset to be flexible in strategy across asset classes. My macro call was at odds generally with my purchase of US stocks but this is where I found value so this is where I invested.
Our sources of gain were again from Crystal Brook Dental and Ella Bache Nedlands, and strong appreciation of our international equities interests, aided by the depreciating AUD.
Annual Percentage Change
| Calendar Year | Kanday | All Ords | +/- | |||
| 2003 | n/a | 11.10 | 3300 | 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 | |||
| 2011 | 19.6 | -13.9 | 33.50 | |||
| 2012 | 12.4 | 10.8 | 1.60 |
|||
| 2013 | 28.7 | 13.6 | 15.1 | |||
| 2014 | 15.8 | 1.2 | 5389 | 14.6 | ||
| Cumulative Return | 2003-2014 | 1021% | 63% | |||
| Compound Annual Return | 2003-2014 | 24.57% | 4.56% |
Key Themes of 2014
“If you are a one trick pony, eventually you will look like an ass.”
Marcel Candeias
With the ongoing march of innovation through technology and the abrupt end to the mining construction boom, many have become redundant in jobs which they thought were safe and predictable. It appears that no industry is safe, including yours truly, as I have alluded to in past letters with the shifting sands of insurance company intrusion, corporatisation and oversupply in dentistry.
We have been ‘making hay while the sun is shining’ and trying to adapt to changing circumstances and not resisting industry trends.
We continued to find attractive opportunities in US equities and took advantage of the favourable currency in the first half.
This move was vindicated in last quarter as commodity prices suddenly dived after drifting lower all year. At year end oil and iron ore were both off more than 50% and the commodity AUD followed suit, drifting over 10% lower against USD in less than 3 months.
This resurgence of the greenback has pushed US equities higher as foreign funds flow into the US looking for a safe home.
Whilst I don’t feel this trade is done, it is starting to feel crowded with the US bull market 6 yrs old now.
With the ever present reminder scratching away in my thoughts to upgrade the family home, I sensed opportunity and took the plunge in September. Wifey found her dream home and we are done in terms of lifestyle upgrades. My business rationale was that home prices in Perth have barely changed since the peak 7 years ago, it is very much a buyer’s market and interest rates are 50% lower than they were during the boom. This translates into significantly lower mortgage repayments.
Our focus in the last quarter then was to amortise the mortgage as fast as possible. We could not get satisfactory interest in our old home, so this has been leased out at a reasonable market rate. I will revisit this holding if conditions improve.
The first half of 2015 will require further mortgage reduction, but I anticipate being able to consider other opportunities in the final quarter of the year. Somewhere in 2015 I am hoping for a market correction (perhaps as US increases rates) to provide opportunity when I am again in position to invest.
Equities
“Investing is most intelligent when it is most businesslike.”
Ben Graham
Australian equities retraced a lot of the gains of 2013. The new Liberal government handed down an austerity focussed budget in May, and this has negatively impacted consumer sentiment ever since. Retailers in particular which make up a large number of our Australian holdings reported subdued conditions.
JB Hi Fi has held its own though reporting flat same store sales and still anticipating profit growth on higher margins.
Terry Smith retired after only 4 years in the top job and was succeeded by another insider, Richard Murray.
JB’s use of modest debt is still a mild concern for me as there is plenty of operating leverage to juice results already.
Flight Centre gave a late profit warning at the end of the year. Skroo Turner is very upfront and firmly in control.
The falling currency likely will have a short term impact, but travellers will take their holiday (an Australian religion) one way or another.
WOW was maligned because of teething problems at Masters but their core supermarkets are doing just fine.
As long as WOW and WES stay domestically focussed we will be happy to hold them.
We only really added to our healthcare stakes in Australia during the year with Paul Perrault powering CSL superbly and RMD gaining investor favour in the second half. Both have bright long term prospects.
In the US again our biggest failure was ARO which is only a few quarters away from bankruptcy unless they can rapidly right the ship. Tom Johnson was finally kicked out and Julian Geiger returned to try and relive past glories. We will see, but I am not holding my hopes up. In general, discretionary retail has been our biggest challenge in the US.
This reminds me that we need to be seeking companies with sustainable moats, something discretionary retail does not have.
I will only invest in this sector in the future if I feel there is a wide margin of safety.
How do we identify a moat? Ask yourself, ‘ Can prices be raised without customers fleeing to the nearest competitor?’
AAPL reported superb results, blowing past previous highs as the market could not ignore the billions of cash pouring in.
Again this is a reminder to focus on results and not market sentiment. We did add to our holdings but should have bought more.
Visa also rocketed higher after it became apparent that this company is a toll booth cash machine. The balance sheet after it listed a few years ago masked the incredible returns on incremental equity that V is achieiving. Again I should have bought more than I did.
Many US equities have bubbled higher with the overall market. Warren once cautioned that ‘a rising tide lifts all boats’, so we will carefully screen before putting new money to work. Having said that, I don’t feel valuations in general are unreasonable.
Beauty Salons
Once upon a time we considered adding to our beauty salon portfolio. On paper it looks quite attractive. But the reality is quite different.
Up to the first 10 salons will require increasing amounts of personal management time. Profits at existing salons will likely suffer as management attention gets spread thinner and thinner. And staff management, what a headache, a sure path to early cardiac arrest.
Furthermore, a small portfolio of salons is not readily marketable, with very few potential buyers. Prices are likely to remain stagnant even if profits are able to be increased. There is still limited bargaining power with landlords and all profits are taxable at the highest marginal rate.
Only if you can truly grow into hundreds of salons and list publicly is this the way to go.
Despite some emotional conversations I convinced Jessica that this was not the wisest way.
Instead we have re-invested in building our equity holdings. Whilst we have no majority control (for now), we have an investment which is highly liquid. Further, taxes are only due upon sale or at tax advantaged rates through dividends. Also, increased profits mean improved valuations (tax deferred) and dividends. Most importantly I can manage our position from the comfort of my alfresco.
Instead of beauty salons we have minority holdings in some of the best businesses on the planet.
Crystal Brook Dental
Our dental business is now less than x% of total FUM. However it still plays a pivotal role in cashflow creation.
Obviously it is like a high paying job as associates only play a modest role in profit creation.
2015 will mark the first year that health funds have not allowed for any fee increases. I believe this will only worsen as time progresses. Further, funds have locked out any further provider agreements, effectively meaning there will be no new dental practices created. Dentists are truly in a somewhat precarious position. However, all is not lost. Dentist claims make up over 50% of ancillary claims and it is a well kept secret that customers actually are worse off under health insurance. I feel if the funds push the profession too far there may be organisation and retaliation (eventually) from the dental community. For now, though, everyone seems to be coexisting, but the listing of industry heavyweight Medibank Private may see an acceleration of structural change in dentistry.
Ella Bache Nedlands
The beauty salon industry continues to provide a steady source of profits. The economic slowdown has had some impact but all ladies like to look nice, so customer spend will continue.
The landlord of Captain Stirling centre sadly passed during the year, creating some uncertainty. The anchor tenant IGA though has many years to run on their lease and relations are good with centre management.
Jessica also begun further study in a field which holds significant promise if she can apply her excellent status in the community.
I will be excited to update her progress in next year’s report.
Links between the 3 Financial Statements
The deeper your understanding of the links between the 3 main financial statements – Balance Sheet, Profit and Loss and Cashflows, the better your ability to make informed investment decisions. In our valuation process we have found that normalised profits are best arrived at by looking at long run returns on incremental equity.
Some industries are far more cyclical than others and hence relying on near term profit results is foolhardy.
Similarly, capital intensive industries often reveal their true nature by careful examination of free cashflows.
The phase of the company’s growth is also an important consideration, as start-up firms will often show poor cashflows due to re-investment requirements.
Accounting malfeasance will always be exposed by thorough examination of all 3 statements. For example, accelerated revenue recognition in the income statement will likely show up as a sudden increase in accounts receivable on the balance sheet.
At different phases of the economic cycle, some statements increase in relative importance. During boom times, revenues and profit growth assume greatest importance along with margin expansion. However, during contractions, credit quality and ability to service fixed liabilities sharpen in focus. Industry specific knowledge is key in assessing company performance and prospects.
Inception
Who gets to the customer first wins.
This is a critical concept which I think requires more attention.
Inception involves moving back in time in the customer’s mind to the point of decision making about what they want to buy.
Necessities will always be on the customer’s mind. Without them, we die. So supermarket operators advertise incessantly so that when you are hungry, their product is front and centre in your mind.
My favourite example is the discretionary travel and entertainment industry. So, in the beginning, the providers of the service such as airlines and hotels and restaurants competed for your dollar through advertising. But then with the advent of the internet, travel aggregators such as PCLN and FLT emerged, saying to the customer, hey, you can compare all of these services in one convenient location. This first derivative makes it easier (key factor) to shop and seek value. Then, the second derivative has emerged, namely through internet 2.0 – social media. Social plays such as TRIP and YELP say hey, we are going to help you talk to your friends (who you trust for advice) about it first, before you decide to spend. So customers go to TRIP/YELP first and end up booking from there because it is the easy thing to do. Over time we have all been bombarded so much by advertising that we have become suspicious. Subliminal marketing is what inception is all about.
The holy grail of marketing is to go far back enough in the customer’s consciousness so that they think the idea was their own.
Then you can make them buy anything. Especially if it is popular with their friends, as everyone wants to be accepted and fit in.
In other words, to be cool. But being cool is fleeting at best. Try to define cool today and it will be different tomorrow.
Mark Zuckerberg the incredible CEO of Facebook said it best when he stated that his goal was never to make Facebook cool.
He wants to make it as functional and useful as possible to its users. In other words, when you want to connect to your friends, you use Facebook not because it is cool, but because that is where all your friends go to connect with each other in the most convenient manner possible. With this understanding and the virtuous benefits of an ever increasing network of users, Facebook will have a lock on the customer.
Float – advanced concepts
When are accounting liabilities actually assets? And when do boring balance sheet entries such as deferred tax liabilities, actually the greatest source of hidden wealth. You have to look no further than the balance sheet of Berkshire Hathaway to uncover one of the greatest sources of Warren Buffett’s success – OPM or other people’s money.
Warren was one of the first people to truly understand the power of compounding your wealth using other people’s money.
And the liaiblity column of the balance sheet is where you find these gems hiding in plain sight. Warren often talks about using insurance float. Float is customer premiums received upfront, which are held in trust until future insurance claims are made. Any investment returns accruing on these funds go straight to Berkshire’s profit. What is most impressive is that most years, Berkshire’s underwriting ratio has been less than 100, meaning that Berkshire is actually being paid by customers to hold their money. In other words, Berkshire’s insurance operations represent an interest free (and often negative interest) loan for Warren to invest at his discretion. At last count, Berkshire’s float was in the vicinity of $80B USD. Now compare that with a bank loan!
If this were not enough, there are many other sources of OPM to turbocharge returns.
Another of Warren’s favourites are non-current tax liabilities (CGT). Many of Berkshire’s common equity holdings have been held for decades, allowing investment gains to compound higher, year after year, using Uncle Sam’s money.
As has been proven often, those accruing capital gains tax liabilities often never eventuate, with Warren legally using US tax law to make those accounting gains disappear into thin air. Two prominent examples were Procter and Gambles acquisition of Gillette and then Berkshire’s acquisition of Duracell from Procter and Gamble using PG stock. In both cases, these corporate acquisitions extinguished the tax liabilities for Berkshire.
More obvious sources of ‘float’ are accounts payable and negative working capital, whereby suppliers fund the short term operations of firms with high asset turnover. Costco is the master of this, operating on razor thin margins and selling inventory within the cash conversion cycle. And it should come as no surprise that two of Costco’s biggest fans and investor’s are Warren and Charlie Munger.
A final and emerging source of float has been Berkshire’s recent acquisitions of large capital intensive firms such as railroad operator, Burlington Northern Santa Fe railway. Financial and tax accounting are often very different in their treatment of long lived assets through depreciation.
Tax accounting allows double declining balance accelerated depreciation versus financial reporting. The result is a lower reported income in the tax accounts and hence lower tax payable. This would be expected to correct over the life of the asset, but with the huge ongoing capital requirements of a company like BNSF, we can expect an outcome similar to insurance float, where Warren gets to perpetually have access to US government money at no net cost.
A satisfactory summary would be to conclude that float and moat go together, each furthering the competitive advantage of the other.
My accountant once said that money paid to tax is money gone forever. Berkshire has made a fine art of deferring taxes indefinitely.
Kanday group will continue to pursue an asset accumulation strategy which tries to maximise these strategies to accelerate our wealth creation.
Causes of catastrophic failure
Mohnish Pabrai provided some wonderful insights into what leads to company bankruptcy and how you can avoid them.
Foremost is the excessive or inappropriate use of leverage. Excess leverage can bring any good company unstuck,
especially when sources of liquidity suddenly dry up as they did during the GFC. There are many macro moving parts which are impossible to foresee all, even for the best operators. The only way to go is to be conservative in use of debt so that Murphy’s Law is kept at bay.
Hand-in-hand with inappropriate use of debt is poor quality management. The best business can unravel under the guidance of a no-nothing manager. The best way to assess inept management is to look at capital allocation through the company’s financials, especially the big decisions. Are they investing profits in low return businesses? Are they conducting buybacks at prices above intrinsic value? Are they stoking their own ego through serial acquisitions? What is the compensation profile for management – are they being rewarded for taking unnecessary risks with your money?
A third harder to spot source of failure is when moats fail and the competitive advantage of a firm is breached.
All businesses go through economic cycles but sometimes the downtrend is structural and not cyclical. This will often require the wisest of minds and a deeply inquisitive nature to know when a loved investment (which has probably generated very satisfactory profits) has a broken business model and needs to be discarded. If management appears to be in denial, this may be a hint that worse is to come. Similarly, if a lot of the top brass suddenly jumps ship, it may pay to jump with them and ask questions later. The onset of the internet/technology age has brought into question the business models of many a great business. This is actually great news as levelling of the playing field means more opportunity for all, but also more risks to navigate.
Valuation is another achilles heal to investment success. The most common is mistaking booms for normal business conditions.
In other words, overpaying. Overpaying for even great businesses can result in mediocre outcomes. But when overpaying for mediocre businesses such as the recent reosurces boom in Australia can be catastrophic.
Personal biases can also lead to failure. Emotional detachment in the investment process is key to making good decisions.
Too often the temptation is to be guided by past investment results and not by current and anticipated business conditions.
Experience is an antidote. The longer one follows a firm the more you get to know about management and firm performance through the business cycle. Warren said that ‘Wall Street is the place where people know the price of everything and the value of nothing’. Try not to be this kind of investor.
Finally, it all comes back to cashflows (or lack thereof). Many firms have lumpy cashflows and combined with debt this is an explosive cocktail for naïve management.
It’s all just a game
“You still don’t get it kid. It’s not about the money. It never has been. It’s about the game between people.”
Gordon Gekko
With our lifestyle goals achieved, we can now truly focus on building group wealth. Our capital will be more permanent’ than most, not seeking returns to fund some other lifestlyle ambition. It is this structural advantage that is one of the keys of Warren Buffett’s success – fascination with the process and not the proceeds.
Tyler Durden from Fight Club fame said it eloquently in another way:
“It’s only when we have nothing that we are free to do anything.”
“The things you own end up owning you.”
Tyler Durden
Restore the balance sheet first
The first half of 2015 is likely to be a bit mundane for your Chairman. I understand we need to strengthen the group balance sheet before making further invesments, after the family home acquisition.
However, we are also likely to soft launch our private equity business in the first half, which may hold significant promise in accelerating group assets under management. This is where my true passion lies.
To keep me interested I will also be preparing for level 2 of the CFA exam, a worthy qualification for investment professionals.
I look forward to updating interested parties via our quarterly results presentations.
Yours Sincerely
Marcel Candeias