Welcome to the 10th annual letter for Kanday Group, marking a decade under current management.Kanday group increased net book value by 10.6% versus a loss of 3.8% for the XAO index,our 12th straight year of outperformance.
Our sources of gain were again from Crystal Brook Dental and Ella Bache Nedlands, and strong appreciation of our domestic and international equities interests, aided by the depreciating AUD.
2015 was always going to be a year of consolidation after the purchase of the new family home in late 2014.
I have busied myself by furthering my studies in the CFA program. If all goes to plan, I will complete the final exam in mid- 2016.
The insurance industry continues to apply the clamps to dental fees, with next year set to become the first year in my 18 year career where overall service pricing will decline. The frog in the pot with the temperature of the water being increased seems an apt analogy.
This deflationary trend is not confined to dentistry. Across the board the prices of retail, groceries, fuel, technology have all been declining. In fact the only area where prices have risen astronomically is government services, as the citizens are gouged in an effort to repair budgets.
I feel obliged to rant a little about the en-masse capital misallocation by our elected leaders and Australian corporate heads over the past decade. Budget forecasts of iron ore prices north of $100 a tonne drove a mass spending spree, funded by debt, by both government and corporations like BHP and RIO, in the expectation of resource rivers of gold. Well, this is all pumpkins and mice now and the hole in the budget and corporate balance sheets is as big as the holes they dug in the ground. Elected heads should be held accountable for this gross mismanagement but instead golden parachutes have been issued. The common shareholder is left holding the (empty) can.
The GFC reset the inflationary expectation and aided by the end of the China resource bubble and the efficiency gains from technology innovation, prices have been steadily falling.
Governments around the world have continued to run the printing press in a desperate attempt to keep people spending. My expectation is for prices to stay lower for longer, but companies with demonstrable pricing power will continue to thrive. Discerning businesses with enduring competitive advantages from commodity businesses disguised by short term bubbles as star performers is key.
Our challenge is to identify these wonderful businesses and allocate further capital to them.
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 | |||||
| 2015 | 10.6 | -3.8 | 5207 | 14.4 | |||||
| Cumulative Return | 2003-2015 | 1139% | 58% | ||||||
| Compound Annual Return | 2003-2015 | 23.34% | 3.87% |
Key Themes of 2015
“The things you own end up owning you”
Tyler Durden
I went into 2015 knowing full well it was going to be a boring year focussed on debt reduction.
After a break in January, I set about the arduous task of eliminating the non deductible debt from the house purchase. By September the debt was all converted to deductible, by funnelling business revenue through the home loan. At year end group debt is still a little higher than my ideal so debt reduction may remain the theme for a little longer.
This process has been mollified by common equities of high quality businesses generally trading at elevated prices.
Macro events still seem to be dominating the news. Commodity prices have continued to retrace back to levels considered ‘normal’ before the China construction boom distorted everyone’s opinion of metal prices. West Australia is particularly in the crosshairs of this adjustment as the state is highly dependent on resource royalties and had bet the farm on prices staying higher.
The mood is gloomy and rightfully so as job security and job losses have come into sharp focus.
Kanday group still generates the majority of our cashflow from our Perth based operations and we have a large percentage of group assets here. We have not been immune from the downturn but are adjusting better than most. Only a few years ago the shoe was on the other foot and we sought value in the depressed US markets. Our bold real estate move in Perth is countercyclical too and I expect will look as intelligent as a ‘lifestyle’ purchase can in time.
The Australian dollar has depreciated against most other currencies which is an effective pay cut on the global stage for Australian wage earners. Willy Packer from Packer and Co contends it needs to fall a further 30% before human capital in Australia becomes competitive globally. I need to balance this expectation and belief in my capital allocation skills against the risk free opportunity cost of debt reduction.
Achievements
Our key achievement this year was to convert all non-deductible debt into deductible debt. This means that our cost of capital on our debt has reduced from say 8.33% pre tax to 5% on a 5% headline rate.
That interest saving will amount to a lot of money over time.
Our dental business reduced revenues in a tough economic environment and an industry undergoing structural change.
Our beauty business bucked the trend and still managed to grow revenues by more than 10%, a stunning achievement.
Our sharemarket holdings continued to grow despite no new capital being allocated. This includes holdings in Australia, USA, England, France and Canada.
For the first time our largest source of gain was from our equity holdings, an encouraging trend we wish to see made permanent.
Our assets under management increased by only 4% as we focussed on debt reduction to improve the group balance sheet.
Your Chairman completed Level 2 of the CFA curriculum and is enrolled to sit the final exam in June. Wish me luck!
Importantly though we showed durability in an environment where many others imploded and started heading in the wrong direction. As they say, sometimes your best offense is a good defense.
Crystal Brook Dental
Last year I stated that “2015 will mark the first year that health funds have not allowed for any fee increases. I believe this will only worsen…” Well, this year will mark the first year in my 18yr practising career that the overall price of dental fees will decrease.
Like many other industries, the profits available to incumbent operators are set to decline as disruptors ( health funds and corporates) attempt structural change to the profession.
We will continue to diversify our sources of earnings in anticipation of this deterioration in economics of the private dental practice.
If there comes a time to jump ship I will likely be one of the last to jump as I feel I have a fiduciary responsibility to my loyal staff.
The dental industry has a bright future. After all, everyone has teeth and even those who don’t still need to see a dentist.
There may just be a re-distribution of who receives the profits.
US corporates who serve the dental profession such as Colgate will continue to prosper from dental sales. This will likely be Kanday group’s way of profiting from the dental profession in the future.
Ella Bache Nedlands
Jessica’s foray into the real estate industry meant that she placed her beauty salon into almost full time management.
Whilst the time demands of real estate proved to be overwhelming, her salon continued to prosper due to the wonderful staff she has assembled.
In fact Ella Bache Nedlands may be one of the few businesses in WA that increased revenues this year versus last. Quite an achievement. Satisfactory terms were reached with new landlord Aldi to extend the lease at the Captain Stirling location.
This area will be assessed by the council for re-development in the near future and we are optimistic the salon and its many loyal customers will be part of the consultative process.
Perth real estate prices
The vast majority of people who buy a family home are interested in the monthly repayments on the mortgage, rather than how much the home actually costs. Why is this?
On average people change home every 7 years or so, probably bored or looking to upgrade (more kids, got a dog etc). So when they buy a new home, they sell the old one to retire the mortgage and get a new mortgage from the bank for the new home.
And so the game goes on, with no real expectation of ever paying off the debt, except perhaps when downsizing in retirement.
With this in mind, let me explain why Perth real estate prices have already collapsed, contrary to the widely held view that they are still very high.
| 2007 | 2015 | ||||
| Cost | $500,000 | $450,000 | |||
| Inflation 3.5% | |||||
| 2015 money | $636,140 | $450,000 | |||
| Interest rate | 7.50% | 4.75% | |||
| Grossed up | 12.5% | 7.92% | |||
| AUD/USD exchange rate | 0.95 | 0.7 | |||
| Monthly interest payment | $6,626.45 | $2,968.75 | |||
| USD equivalent | $6,295.13 | $2,078.13 | |||
| 33.0% | of 2007 payment | ||||
| Equivalent capitalised cashflow cost | $500,000 | $148,552 |
So, the median price of a home in Perth in 2007 was AUD$500,000. Now whether this price is high or not requires a global comparison.
I am not going to provide this, only to show the effective price change over the past 8 years, from a cashflow perspective.
The headline cost has reduced by 10% to $450,000. But this is only the start.
Inflation has reduced the value of money by 21% in the past 8 years.
Interest rates have dived to under 5% as the RBA tries to cushion the fall of the slowing economy.
The impact of this reduction is even more pronounced when grossed up (as interest on the family home is non deductible).
At the same time the Australian dollar has fallen 30% against the USD and most other developed market currencies.
Adding all these effects together yields the shocking conclusion that the cashflow cost of a Perth home is now only one third the cost of 2007 from a global investor’s perspective.
I find it ironic that everyone was falling over each other to purchase a home in 2007 whereas today the tumbleweed rolls by and dingo howls can be heard at home opens.
Equities
“We don’t read other people’s opinions. We want to get the facts, and then think.”
Warren Buffett
“Nothing breeds apathy as much as rising share prices.”
Marcel Candeias
In a year where we made very few new investments or changes to our portfolios, our result was pleasing when compared with market indices. However, just because a company share price is rising does not mean necessarily that business is going well and value is being created. Behavioural investing theory shows that often prices only go higher because they just went higher before. Conversely prices often keep falling because of yesterday’s bad news. Acknowledging this potentially creates opportunity. Being aware of macro conditions also has a lollapalooza impact.
During booms invest in low volatility sure bets. Their prices are less likely to have shot to the sky. During recessions, invest in volatile stocks which have had their share price hammered – the upside may be large.
Dramatic changes in foreign exchange currency values also likely had a large effect on stock prices this year.
The AUD has depreciated 30% against the USD in the past 2 years, dramatically impacting ‘effective’ pricing of stocks and on the operations of companies who deal with foreign customers and suppliers. I will devote more to this important topic in a future letter, but for now understand that rising Australian stock prices may be more to do with the depreciating Australian dollar than to improved operating performance.
ARO what did I learn?
“When one stock in a sector warns you can dismiss it. When two warn, get out ASAP.”
Jim Cramer
“If you don’t like it, you sell the lot.”
Marcel Candeias
Five years ago I bravely made my first foray into international equities. Armed with newfound investing skills, convinced the Aussie dollar strength against the USD was a great opportunity, I scanned the US market for undervalued securities.
My first investment was in Aeropostale, a discount teenn clothing mall retailer.
ARO was well managed, had no debt except operating leases, was buying back stock and had increased profits at greater than 20% per annum for the previous decade.
Well, that investment is now worth next to zero.
So where did I go wrong? I don’t think it was arrogance or even poor management.
I think ARO is simply a company in a very difficult industry where what is cool today is trash tomorrow.
ARO management have tried everything to get the teen customer interested in the brand once more, but it seems the clothes and accessories have been consigned to the yesterday’s fashion bin to die a slow and painful death.
The misstep of Investing in ARO has not been wasted on me. I have learned that the market appropriately discounts businesses which operate in fickle industries where profits can evaporate at a moment’s notice.
I was drawn to ARO because it looked cheap – but wiser heads had marked it as cheap for a reason. The company like many others, has no durable competitive advantage so is susceptible to competitors usurping their customers.
It may be fitting that I can look back at my first international investment and say it was a wipeout, and yet our international results have been outstanding. You don’t have to be right every time, you just need to become a little wiser than you were yesterday.
Risk
“Too often investors associate risk with share price volatility, when it is the permanent loss of capital which is more concerning.”
Ben Macnevin
“Volatility does not determine risk.”
Michael Burry
Modern portfolio theory centres around the premise that volatility = risk. A lot of mathematical analysis can follow after accepting this premise. My concern is that following this mantra leads the investor away from understanding individual businesses and their management and more into looking at equities as statistical challenges.
I propose it is more important to ask – “Will the company still be around 20 years from now and will it be earning more money than it is today?” You should only look to buy if you can confidently answer yes and yes to these two questions.
Proper structuring of an investment operation helps to ameliorate any concerns about excess volatility and allow the investor to more appropriately focus on the operational performance of the company and the rational or otherwise capital allocation demonstrated by management.
Resources fiasco
I have been railing for quite some time about the debacle of the mining industry in Australia. I feel I am in a unique position to comment because my brother and several of his friends are trained as engineers in the industry.
Through conversations with them I have gained insight into the boom and bust nature of mining and mining services in particular. However, one did not need to be an industry expert to have predicted the collapse in commodity prices from the giddy highs of 2010.
Readily available charts of commodity prices show for example that the quoted price of iron ore averaged about US$10 per dry metric tonne from the period 1985 to 2003. In that 18 year period, the price never exceed about $12. In 2010 prices peaked at $190.
Commodities prices are based principally on supply and demand. I am pretty sure we are not going to run out of iron ore any time soon.
So the obvious explanation of why prices skyrocketed is that demand from China exploded, and the wheels were set in motion for supply to rise to match this demand. I understand that China has over 1 billion people so the opportunity seems huge.
Trying not to single out any one individual, the management at BHP made multiple huge blunders with shareholder money which destroyed considerable value. They spent $20B buying into US oil and gas shale just before prices plummeted. Buoyed by record operating profits they ploughed billions into a share buyback rather than paying a dividend, right at the all time high share price. They even launched the attempted biggest takeover in Australia’s corporate history bidding for Rio Tinto. Fortunately for them they were arrogantly rebuffed by another over confident management team.
The list is endless with everyone in the industry, both corporate and government clambouring over each other to fulfill the Chinese demand.
The Gillard federal government even proposed a resource rent super profits tax in anticipation of endless profits.
Unfortunately developing mines takes time and costs a lot of money. So, just as the construction of these mines was being completed, the demand from the Chinese was beginning to taper. This has left a lot of ore being put on ships with not enough buyers.
This is why I believe China is a one off not part of the normal commodity cycle. It appears not one resource major or government showed restraint in managing through the China bubble. This has left a lot of balance sheets and budgets loaded with debt and dwindling cashflows. The Chinese buyer is now firmly in charge.
To worsen matters, producers will naturally up production to try and trade out of debt. The supply glut will only end when there are bankruptcies.
The new normal is adjusting operating costs to the permanently lower commodity prices and future expectations of much lower profits and largesse.
Sources of Capital
Should I start my own private equity fund? The following analysis shows why raising capital through debt is the cheapest option (sweat is NEVER cheap) especially with the Australian Taxation system.
However, debt and managing the equity of others carry emotional burdens. Be clear, capital allocation will be influenced by this, probably negatively.
Risk management and not straying too far from the herd so as not to become an outlier become more important when managing the money of others.
This may lead to playing to not lose rather than playing to win.
The market has not seen a significant downturn since 2009. Downturns are where borrowers and fund managers truly get put to the test.
I think everything in moderation is probably the right way to go.
1.Assume market increases 10% but my picks increase 15%
| $1.67M sweat ($2.8m pre tax) | Borrow $2.8m 6.07% I only | Managed fund $10M | ||
| increase 15% | increase 15% | increases 15% , fee of 20% of outperformance plus 1.5% AUM | ||
| income | income | income | ||
| 250000 | 420000 | 250000 | ||
| expense | expense | expense | ||
| 0 | 170000 | 0 | ||
| net | net | net | ||
| 250000 | 250000 | 250000 |
2.Assume market increases 10% and my picks increase 10%
| $1.67M sweat | Borrow $2.8m 6.07% I only | Managed fund $10M | ||
| increase 10% | increase 10% | increase 10% | ||
| income | income | income | ||
| 167000 | 280000 | 150000 | ||
| expense | expense | expense | ||
| 0 | 170000 | 0 | ||
| net | net | net | ||
| 167000 | 110000 | 150000 |
Rational capital allocation
“Skate to where the puck is going to be.”
Wayne Gretzsky
“Ask not whether the company can grow, but rather enquire as to the capital allocation skills of management.”
Marcel Candeias
If you have 12 sheep and 1 jumps over the fence, how many sheep do you have left?
“None.”
“Well you sure don’t know your subtraction.”
“Maybe not but I darn sure know my sheep”
Professor Henry TC Hu
University of Texas School of Law
Over time I have concluded that the best way to assess a management is to assess the result of their capital allocation decisions. Talk is cheap and it is only through analysing trends in key profitability metrics that one can form an opinion whether management talk is bankable or just PR spin.
How much capital is being used to run the business?
What is the return on that capital?
Is debt increasing or decreasing?
Are profit margins increasing or decreasing?
Too often manager behaviour follows what Warren Buffett referred to as the institutional imperative. i.e if the other guy is doing it, it must be a good thing. Quality managers stop and ask whether the opportunity in front of them is going to add business value or is just another commoditised prospect. Often not participating is the right choice of action.Too often manager behaviour follows what Warren Buffett referred to as the institutional imperative. i.e if the other guy is doing it, it must be a good thing. Quality managers stop and ask whether the opportunity in front of them is going to add business value or is just another commoditised prospect. Often not participating is the right choice of action.
Few managers can resist the temptation, and doing deals is infinitely more fun than the mundane day to day of running the place.
Manager incentives are often improperly structured to reward growing the size of the enterprise rather than focussing on profitability.
CEO egos are well known too. Who wants to be seen running the small profitable enterprise instead of the large sprawling empire?
When you can identify a manager who allocates capital rationally you are well on the way to finding a great investment.
2015 was always set to be a rather mundane year for the Kanday group as we digested our largest lifestyle acquisition ever. With a slowing local economy, increased interest expense and incessant government taxes, our progress was a little slower than I anticipated. Despite this, we enter 2016 in a stronger financial position and dispassionate in our processes. 2015 was always set to be a rather mundane year for the Kanday group as we digested our largest lifestyle acquisition ever. With a slowing local economy, increased interest expense and incessant government taxes, our progress was a little slower than I anticipated. Despite this, we enter 2016 in a stronger financial position and dispassionate in our processes.
With a global view of the investment playing field and a committed management team, I am confident in the prospects for the Kanday group.
I look forward to updating interested parties via our quarterly results presentations.
Yours Sincerely
Marcel Candeias