Welcome to the 11th annual letter for Kanday Group, a year during which Britain voted to exit the Eurozone and the US voted Donald Trump as their new president elect.
Kanday group increased net book value by 9.7% versus a gain of 7% for the XAO index, eking out our 13th straight year of outperformance.
Our sources of gain were again from Crystal Brook Dental and Ella Bache Nedlands and an increasing contribution from our passive common equity positions.
The AUD ended the year essentially unchanged against the USD, confirming my view that it is oscillating in the vicinity of fair value against the USD.
On the other hand the GBP plummeted more than 20% against most major currencies including AUD after the aformentioned Brexit decision.
I was pleased to complete the Level 3 CFA exam in June, making it 3 for 3 in the exams, confirming I can match it with all those finance post grads.
Only about 2 in 10 starters make it through the course successfully so I feel pretty good about the achievement.
Jessica and I both diligently managed our businesses through the year, making the most of a subdued local economic environment.
With all the political goings on this year, it has been easy to become distracted by the news.
Everyone has been prophecising the consequences of the large shifts going on in the political power structure. It is at moments like these that I am reminded of Warren Buffett’s advice.
He wisely points out that, using Coca Cola as an example, the company has survived and prospered through a Great Depression, dictators, two world wars, oil price shocks and global terror strikes to name a few. Anyone who became discouraged from investing because of these macro events would have been making a mistake.
Our job is to continue to dispassionately appraise the fundamentals and prospects of individual companies, trusting that they will take appropriate steps to navigate the seas of political discourse and financial fortune. If the company’s moat is strong enough and management has competence and integrity, then the vicissitudes of business will generally be in our favour.
Our debt reduction program continued unabated and the Group is now on firm financial footing again.
We do anticipate divesting some of our real estate exposure in the new year in order to right size our sector weightings.
Real estate tends to not be my favourite asset class. The slow moving, illiquid, tangible nature of real estate is what attracts a lot of folk to it.
On the other hand, the more you understand about business, the more one seeks exposure to the complexity of it. Where things are complex there tends to be a lot less competition. And less competition means opportunity for higher returns.
As we enter 2017 sharemarkets have rallied into the year end, making selection of business to buy more challenging.
I have been working on strengthening my criteria for selling as markets begin to look frothy, with advances becoming based more on conjecture and fear of missing out than fundamentals.
Kanday Group will be patient. Our time horizon is long and we will continue to position ourselves for sustainable long term success.
I will be allocating more time to investment research in the new year, so I am excited about the prospect of deepening my understanding of our holdings and profiting from this knowledge.
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 | 14.6 | |||
| 2015 | 10.6 | -3.8 | 5344 | 14.4 | ||
| 2016 | 9.7 | 7 | 5719 | 2.7 | ||
| Cumulative Return | 2003-2016 | 1260% | 73% | |||
| Compound Annual Return | 2003-2016 | 22.24% | 4.32% |
Key Themes of 2016
“We tend to concentrate on what should happen, not when it should happen.”
Warren Buffett
The ASX dived up to 10% in the first two months of 2016 and then convulsed it’s way back, rallying into the end of the year after Trump was announced as US President elect. It certainly appeared that the financial, industrial and dirty energy sectors benefited the most from the prospective policies of a Trump administration. Or it could just be that formerly shunned sectors caught a bid as the market concluded they were cheap relative to the rest of the market.
Conversely, former high flyers in biotechnology came crashing back to earth, along with high growth sectors which had become overpriced.
I tend to not focus on individual sectors per se but rather the individual companies. Having said that, I am somewhat conscious of the portfolio weights the sum of holdings contribute to overall sector exposures.
I have aforementioned that if I am faced with equally compelling opportunities I will usually choose the stock in which portfolio weighting is proportionately less. This way the sector diversification balance of the portfolio will minimise the impact of short term market sector rotations which often dictate the winners and losers in the short term.
The other big shift after Trump’s victory was the bottoming of interest rates. Trump is expected to embark on large fiscal expansion which will accelerate inflationary pressures. The 10yr government Treasury yield rose from a low of about 1.7% to 2.7% in the final 10 weeks of the year. Banks have also begun their now customary raising of interest rates out of step with official monetary policy.
So, those invested in fixed income instruments and those exposed to variable rate debt may suddenly be feeling a little uncomfortable.
Much closer to home the Perth property market could only be described in one word – awful. Median rental yields have plummeted more than 30% and vacancy rates for residential investment property are at 6.9% at the time of writing. I also believe that 25% of commercial property in the Perth CBD is vacant. Depressing times indeed.
Conversely the residential property market has been flying on the east coast of Australia with Sydney and Melbourne prices increasing by more than 10% again. Perth is really in the cross-hairs with federal government policy focussing on containing the boom on the east coast to the detriment of the Perth market which clearly requires CPR stimulatory policy.
Achievements
Our result this year was achieved despite not participating in the gigantic rally in resource stocks. Further we navigated our second year burdened by the purchase of the new family home with mortgage servicing being a significant drain on cashflow.
Perth is at the epicentre of the commodity collapse and the subdued real estate market has also been a large drag on performance.
Our efforts to diversify our exposures over the past 5 years have stood the Group in good stead.
Assets in other geographies have all boomed and the domestic focus only folk have been punished.
In 2016 we once again reduced our debt from the home acquisition. This has proved to be a slow process, not helped by a slowdown in all our Perth based business interests and the onerous local tax regime.
Our equity positions continued to outperform the broader market .
Crystal Brook Dental
The dental industry accelerated it’s descent towards managed care in 2016. HBF dropped the bombshell of lowering fees by up to 10% on most commonly provided dental items. This prompted an emergency meeting by dentists as it finally began to hit home the impact of health funds steadily increasing their grip on the profession.
We were not immune. With lower fees and the state in recession, overall revenues were lower than last year. A credit to your Chairman – my fees were almost equal to last year as I took no breaks during the year. This though is obviously not the way forward. As a product becomes commoditised as dental services are trending to, economic profits evaporate.
Our dental business now represents only x% of assets under management, reflecting my efforts to reduce our reliance on dentistry.
Ella Bache Nedlands
The team at Ella Bache once again executed very well in a challenging WA economic environment.
Revenues were up against last year, a creditable achievement in a state where GDP has fallen 10% year on year.
There are ongoing headwinds from large upward revisions to leasing expenses and business strategy challenges imposed by the franchisor.
Jessica and her team have risen to the challenge and are now well known as the authority on beauty care in the Western suburbs.
Perth vs Sydney real estate prices
The Perth property market endured another subdued year in 2016. The statisticians say the market overall declined by 4%.
More alarmingly the median rental dropped by a whopping 26% and vacancy leapt to 6.9%. Truly a bloodbath.
In contrast, Sydney at the other side of the country is booming. Median home values went up more than 10% again following on from strong price increases in previous years. I wistfully look back at a trip to the harbour city 5 years ago when Jess suggested we buy something near the water. She was motivated by the beauty of the setting and the lifestyle benefits, but as it turned out it was a great time to invest too. Unfortunately that won’t be the last fish that got away.
The table below shows the history of median home prices in the two cities since the start of the millenium.
| 2000 | 2007 | 2016 | % change '00-'16 | ||
| Perth | $158,000 | $455,000 | $520,000 | 329% | |
| Sydney | $337,000 | $533,000 | $880,000 | 261% | |
| Melbourne | $264,000 | $415,000 | $798,000 | 302% |
Perhaps tellingly though, rental yields are now under 3% in Sydney and Melbourne. Perth, despite the precipitous falls in rental values still yields about 3.8%. East coast markets may have gotten ahead of themselves and I wouldn’t count on spectacular returns going forward.
Perth looks like it still may have further to fall. On a percentage basis, Perth is still higher by 330% since 2000 versus 260% for Sydney.
Kanday is still looking at divesting some of our residential investment property as the Group is still overexposed to real estate since the family home purchase.
I am confident we can achieve much better returns over the long term in alternative assets.
Equities
“I think it is entirely reasonable for them to ask “under what circumstances would you average down”. If you can’t answer that you probably should not own the stock. I should insist on it with every long investment.”
John Hempton Bronte Capital
2016 was a roller coaster ride for sharemarkets. Ultimately though most global markets finished the year strongly to record gains of about 10%.
Kanday group holdings performed very well. I tried to take advantage of opportunities when share prices fell momentarily.
Your faith and confidence in a company is tested when the share price declines. I need to improve on the triple dip. I found I would add further to a position if the share price initially declined say 10%, but I often found myself wanting if the price declined further.
Ultimately in nearly all cases the decline was temporary and an opportunity to add at a truly attractive price was missed. I will execute better here in future.
The more I know about my holdings, especially regarding valuation, the more confidence I will have to act.
JB Hi Fi
JB Hi-Fi had an outstanding year led by CEO Richard Murray. By consistently offering the lowest prices, being prepared to negotiate, locating stores in high foot traffic areas, they have decimated the competition.
This culminated in one of their key competitors Dick Smith going into bankruptcy shortly after 2015 Xmas trading (suspicious timing to say the least!).
This eliminated 360 stores. Then in August, JB’s announced the acquisition of competitor The Good Guys with their 100+ store portfolio for $890M.
I appraised the purchase as fair value with potential upside. Good Guys’ margins appear significantly lower than JB’s so profits could accelerate under new management. The outcome of these events is that now JB and Harvey Norman account for more than 50% of all electronics and whitegoods sales in Australia. A cosy oligopoly indeed. Harvey has international interests to manage and is not known in the marketplace for being the price leader, so I feel the future is very bright for JB Hi Fi.
A dark cloud on the horizon is the potential arrival of US giant Amazon which has dominated bricks and mortar retailers in the US by squeezing margins.
JB’s has a history of knowing when and against whom to pick a fight. They have had plenty of opportunity to be ready for Amazon’s arrival so I am confident they have studied the prospective new competition and have a game plan for success.
Resources rebound – can it last?
“Focus on the downside first.”
Warren Buffett
Twelve months ago I lambasted the leaders of multinational resource companies like BHP, Fortescue and Rio Tinto for their untamed animal spirits and unbridled optimism leading to the gross misallocation of capital at the peak of the commodities cycle.
Further I scolded government leaders, particularly in WA for charging headfirst into huge multi-billion dollar infrastructure projects underpinned by forecasts of never-ending royalities accruing from resource rent taxes.
A key pillar of the federal Labor government was even a super profits tax as commodity prices boomed.
I don’t think they have collected a dollar of revenue from this now scrapped policy.
Since the heady days of the boom, the government’s budget estimate for the spot price of iron ore had to be revised down from $140/tonne to $45/tonne.
Well, since my eulogy for the resources sector, the spot price of iron ore currently sits at $80/tonne, a full 78% higher than the government’s current forecast (ever get the idea they don’t have a clue?!)
The share prices of the aforementioned companies have rebounded in tune with this.
BHP has risen from a low of $15 to $25 currently. FMG has risen from $1.50 to $6 and RIO from $40 to $60.
BHP all time high is $49, FMG $12 and RIO $150, all achieved in 2008 when the iron ore price was about $150/tonne.
So, should we consider an invesment in these companies, suddenly seen as market darlings?
I always make investment decisions based on fundamental analysis, not speculation about macro-economic variables such as commodity price forecasts. After all, the Australian government with all their highly qualified advisers, was incorrect by 65% during the boom and now 75% incorrect during the recovery.
Let’s take a look at the bellwether BHP as a prospective investment.
| Year | 2008 | 2016 | current | |
| Share price June 30th | 42.89 | 18.65 | 25.5 | |
| Shares Outstanding (m) | 6169 | 5324 | ||
| Revenue($B) | 61810 | 42206 | ||
| Net profit before abnormals ($B) | 15965 | 11662 | ||
| Net profit ($B) | 15988 | -8598 | ||
| Long term debt ($B) | 15965 | 11662 | ||
| Net profit before abnormals ($B) | 15965 | 11662 | ||
| Net profit ($B) | 15988 | -8598 | ||
| Long term debt ($B) | 9593 | 42779 | ||
| Capex ($B) | 9256 | 9796 | ||
| *Book value ($B) - | 39824 | 73108 | *vast majority is PP+E | |
| Return on Capital | 34% | 11% | ||
| Share price book value multiple | 6.64 | 1.36 | @1.7 |
There are always 3 components to be considered – quality, management and finally valuation versus price.
From a quality perspective I can summarise the following:
BHP is a market leader in terms of size. This helps create economies of scale which lower production costs.
This allows BHP to remain profitable at lower commodity prices than it’s competitors.
Despite this, BHP has failed to grow revenue or net income as revenues and profitability are highly variable with the commodiites cycle.
Capital spending is regularly > 100% of net profit.
More than $30B of debt has been added to the balance sheet with no benefit to profitability. Debt is now 37% of capital.
Return on assets has cratered from 34% to 11% (even worse if write-downs included)
I don’t need to look any further to conclude that this is a business operating in an industry with less than ideal fundamentals.
I have previously ranted on the capital allocation missteps of management, including share buybacks conducted at all time high share prices, failed acquistions and top of the cycle purchases.
Clearly acting in a counter-cyclical manner i.e restraining investment during booms and conducting buybacks at share price troughs is indeed a difficult feat for management to execute.
BHP along with virtually every other resource concern has been guilty of this. Score a C- for management.
With the wild swings in earnings it seems pointless to value BHP on an earnings basis. One might as well pull out the wooja board to predict the next commodity price move.
On an asset basis, one needs to not only consider the asset base but the expected profitability of those assets.
Clearly BHP’s assets are somewhat quantifiable but their value hinges entirely on the global spot price for the given commodities.
Despite BHP’s market leading position it appears to have no control over the price of the commodities it sells.
Warren Buffett says that if you aren’t prepared to own a stock for 10 years then you shouldn’t hold it for 10 minutes. This decision is clearly a vote on the quality of a company.
BHP appears to fail this test.
Commodities will forever be needed by the world. So BHP does have something of value to sell.
But buying a resource company entails assuming all the risk of management’s capital allocation decisions. History suggests their decisions will be suboptimal.
ETF exposure to a commodity pool may be a preferable option if one suspects that commodity prices are due for a bounce. Better get out the wouja board though.
In summary, even with BHP’s recent resurgence I will step to the side and put it in the too hard basket.
What is the moat?
Investing in businesses in commoditised industries is a recipe for mediocre results. Only those companies with identifiable durable competitive advantages are able to earn economic profits i.e returns above the cost of capital, which translate into shareholder value.
Identifying a company’s moat and it’s durability is a critical element of business analysis. It is often the difference between success or failure.
Some companies like JB Hi Fi are quite transparent about their moat. For JB’s it is having the lowest cost of doing business amongst all listed ASX retailers.
Others have tried to copy JB’s formula for success but all (so far) have fallen by the wayside.
Michael Porter is famous for describing the 5 forces or sources of competitive advantage.
I will not go into great depth here but it is worthwhile considering any potential investment in the context of competitive positioning.
The following non-exhaustive list are potential sources of competitive advantage.
Geography
Networks
Market dominance – No 1 or 2 player?
Brand power / Pricing power
High switching costs for customer and supplier
Intangible assets / Patents
Real product differentiation
Perceived product differentiation
Low cost producer / Economies of scale
Locking customers – money or time
Locking competitors – R+D, high entry, low exit costs
Non – Technology moat – narrow by nature
Low threat of substitute products or services
Low Bargaining power of customers including large number
Low Bargaining power of suppliers including large number
Low intensity of competitive rivalry
True investment wisdom comes from identifying when an advantage is durable and conversely when a long held advantage is being eroded permanently.
Management are the stewards of capital and their job is to defend and enhance the moat of their business.
Warren Buffett is famous for telling his managers – when faced with the prospect of improving profits or enhancing a company’s moat, always allocate capital in favour of protecting the moat.
So, ask yourself, are the managers of your investments allocating capital within the moat or are they self-aggrandising in some new exciting venture which will likely cost you and the company dearly down the track.
Psychology of buying and selling
“A market quotes availability should never be turned into a liability whereby its periodic aberrations in turn formulate your judgements.”
Warren Buffett
How often do you check share prices compared with how often do you think about intrinsic value of your investments?
There is huge danger in anchoring to price points rather than firming your views on a company’s worth.
In case you haven’t already guessed , psychology or behavioural finance plays a huge role in investing outcomes. This flies in the face of Efficient Market theory which is based on the premise of the rational economic man. Booms and busts would cease to occur if everyone was rational and logical in their actions.
So what steps can we take to insulate ourselves from emotional investing errors and the opportunities missed as a result?
Mohnish Pabrai talked about HALT trading.
He said you should never trade or make decisions when you are hungry, angry, lonely or tired. Most people get either grumpy or depressed when affected by HALT which leads to emotional outbursts and compromised decisions.
Another approach is to stop when faced with a choice, take a knee as Will Smith is want to say, and ask yourself, “What would Warren do in this situation?”
In Ben Graham’s The Intelligent Investor, Jason Zweig offers the concept of the Investor purchase contract.
I think this is a terrific way to help ignore the daily market commentary which can pollute your thinking.
The Investor purchase contract is a variant of dollar cost averaging. It is a document written for you and signed by you, representing a commitment to allocate a set percentage of your monthly income to the purchase of investments.
The idea is that no matter what the prevailing market emotion is, on a monthly basis you scan your investment universe and purchase what you deem to be the most attractive prospect. Maybe the macro environment seems bleak or bullish, but importantly you invest regardless focussing on the prospects of individual companies and not whether Trump is going to impose trade tariffs on China or whatever.
Erroneously staying out of a rising market can be just as damaging to a portfolio’s long term returns as avoiding the next recession. The Investor purchase contract helps you to keep investing even when your emotional fears are telling you to sell.
Fashion vs Lifestyle
“Our business is that of ascertaining facts and then applying experience and reason to such facts to reach expectations.”
Warren Buffett
I talked last year about the lessons learned from my debacle investment in ARO.
One of the upsides has been my avoiding investments in other retailers now fallen from grace such as Michael Kors and Ralph Lauren, both once market darlings.
I want to make a distinction though in this space, brought to my attention by Group COO Jessica.
She highlighted the difference between fashion and lifestyle retailers.
This jolted my memory about the transformation Coach is trying to undertake, that of from a fashion brand to a lifestyle brand.
Fashion retailers as the name suggests, come in and out of style according to the whimsical tastes of consumers (often fickle teens and millenials).
What is hot today can be gone just as quickly tomorrow. Not a recipe for an enduring competitive advantage.
Trying to guess the tastes of the customer seems to be as elusive as trying to find the fountain of youth.
But there is another subset of retailer that does appear to have enduring value in the minds of shoppers. And that is the lifestyle brand.
Nobody has executed this better than Nike, with their feel good ‘tick’ logo and ‘Just do it’ adage inspiring feelings of optimism, energy and inclusiveness in a fitness movement.
New kids on the block like Lululemon and Under Armour are trying to repeat Nike’s incredible success.
If I am going to allocate capital to the discretionary retailer space I will be looking at lifestyle brands rather than fashion’s current flavour of the month.
The latter is just too risky.
Structuring the workplace environment for maximum productivity
“If you want to win the lottery you have to make the money to buy a ticket”
Louis Bloom from Nightcrawler
In the era of the internet and mobile devices and unlimited content for a few dollars a month, distractions are everywhere.
I am sure a lot of you would agree that it is easy to sit down to do some research and half an hour later find yourself still checking Facebook updates.
Once you have accessed the reading materials you need, I suggest operating in an internet free zone. That way you can’t check on share prices every 5 minutes or check to see if someone liked your latest Facebook post. That craving for stimulation and the dopamine hit of constantly updated information is wasting a lot of your precious time and making you unproductive.
It has become so bad in modern society that people struggle to drive their cars without looking away from the road ahead in order to check their phones.
Sheer madness!
Workplaces need to monitor staff because the staff are more likely to be updating social media accounts than working.
Structure your research environment to be somewhere quiet, cool and isolated. Perhaps somewhere with a view to a garden outside.
You need to make blocks of time available where you can simply sit with your thoughts. This gives you time to access the creative, thinking part of your brain.
In doing your research, try to always read source data rather than secondary data. i.e get a hold of company reports – Qs and Ks.
Make sure you appraise the competition to your invested companies – read their reports to compare strengths and weaknesses.
As Charlie Munger says, you have to become an expert in your chosen craft.
It is not good enough to just be able to repeat the daily financial commentary.
You have to be able to form your own opinion based on common sense reasoning based on the facts at hand.
Howard Marks refers to second order thinking – drawing conclusions from your own worldly experience.
The only way to achieve this is through constant reading, professional skills and constant curiosity.
Macro forecasting and doomsday commentary
“Once you change your relationship to money you will stop seeing the sharemarket as a risky place.”
Marcel Candeias
If you follow economic commentary you would know that the outlook for the market changes on a near daily basis. For example, before Trump got elected the pundits were saying the market would crash if he won. Then after he won, markets around the world rallied 10% in 3 months and everyone was calling it the Trump effect. It’s enough to make your head spin. And if you followed the advice, you probably lost money.
The same goes for when companies report their quarterly profit results. After the fact, economic commentators are always quick to explain subsequent share price movements as if they knew all along what was going to happen.
If the company reported poor results and the share price fell, then clearly it was because of the poor results. But if the share price rallied, it was because the result was not as bad as expected, or the outlook was for improvement. Basically any narrative can be applied to suit the storyteller’s need.
You will be far better off if you manage to tune out macro-economic commentary and sell side analyst forecasts and company reporting analysis. Bullish forecasts will tend to imbue you with fear of missing out and overpay for over-optimistic forecasts.
Bearish commentary will leave you less invested than you should be, shying away from all the perceived risks and doomsday predictions. I was not immune this year. When Brexit occurred the negative commentary of the day led me to lighten some of my holdings not because of valuation but purely to reduce my exposure to the market. Well, after an initial slip, the market rallied and I learnt about opportunity cost.
In summary, do not gather your information by following the nightly news or watching CNBC.
Media channels need to write stories which gain attention and the best way to do this is to generate an emotional reaction.
As I already mentioned, emotions and investing never mix well.
Levers
In his earlier letters, Warren Buffett talked about the levers a business manager can utilise to improve results.
It is worthwhile to remind ourselves of them.
Levers can be subclassified into operations and financing.
Operations
i) Increase sales
ii) Reduce costs as a percentage of sales
iii) Reduce assets as a percentage of sales
Financial
i) Increase debt/leverage
ii) Lower the tax rate
The key metric of business performance is return on equity (ROE) defined as net income divided by shareholder’s equity. i.e ROE = Net income/Shareholder’s Equity. It was famously deconstructed by the DuPont company in the 1920s into its component drivers which help us to understand Buffett’s levers.
According to Dupont:
ROE = Profit margin * Asset turnover * Equity multiplier = Net income/Sales * Sales/Total Assets * Total Assets/Shareholder’s Equity
Looking at the formula above we can see elements of Buffett’s levers which clarify their contribution to overall return on equity. Increased sales will improve asset turnover.
Reducing costs as a percentage of sales will improve profit margins, along with a lowering of the tax rate.
Reducing assets as a percentage of sales will increase asset turnover.
Finally, increased use of debt will expand the equity multiplier, a lower quality tactic used by businesses to boost ROE.
Clearly operating improvements are more desirable and sustainable than their financial engineering counterparts.
In summary, I like to think of return on equity in the same way as you would look at a bank account. Roger Montgomery helped me with this simplified approach.
If you had a checking account with a bank i.e shareholder’s equity, what rate of return i.e interest rate, would you like to receive? As high as possible of course.
In business, the best companies are those which can earn the highest returns on shareholder’s equity through operational excellence with little or no debt and employ incremental profits at those same high rates of return.
Balance sheet deconstruction – asset liquidation values
“Investing is most intelligent when it is most businesslike.”
Ben Graham
When you look at a company’s balance sheet there are a listing of assets and liabilities. One of the lists is very real, whereas the other may be completely false.
Can you guess which is which?
Well, liabilties for anyone who has a debt commitment, are 100% real.
Assets on the other hand may be worth more (less common) or less than their stated value, despite accounting conventions attempt at accuracy.
To be fair, book values are based on the business as a going concern, but what if things don’t go as well as planned?
Our job as investors is to make a conservative appraisal of a business’ worth.
Warren Buffett wrote that he used to assess the value of a business’ assets in a forced liquidation i.e hypothetical bankruptcy to assess its’ accounting/book value versus its’ market value.
He offered the following as guidelines for asset liquidation values:
Cash = 100%
Accounts receivable = 85%
Inventory = 65%
Prepaid expenses and other = 25%
Liabilities = 100%
If you are looking at a ‘cigar-butt’ opportunity, utilising this framework may be helpful in determining if there is hidden value and a margin of safety.
An objective view of the consequences of selling
“Stop behaving like a tourist and start acting like an owner.”
“I own the company as much as Skroo Turner does. I am not looking to sell out. My advantage is I can add to my position if the market presents the opportunity.”
Marcel Candeias
When should you sell an investment? There are many qualified responses to this question such as:
Sell if the business has lost its’ competitive advantage.
Sell if you can find a better alternative.
Sell if the share price becomes too high.
Assuming the first two criteria do not apply, I am going to try and quantify the consequences of ‘market timing’ a position.
The biggest consideration here is your skill at market timing and tax consequences of selling.
Hypothetical example:
Own 5 stocks in equal proportions
| Stock | Buy price | Current price Year 0 | CG | 1 yr later | 10 yrs later |
| 1 | 10 | 25 | 15 | 45 | 100 |
| 2 | 10 | 20 | 10 | 25 | 80 |
| 3 | 10 | 15 | 5 | 15 | 30 |
| 4 | 10 | 10 | 0 | 5 | 10 |
| 5 | 10 | 5 | -5 | 0 | 0 |
Decision 1 Do nothing
End value 220
Decision 2 Sell all because the market is hot
After 1yr buy back into each
| Sale of 75 | |||||||
| CGT | 6.25 | Assumed CGT rate = 25% | |||||
| Residual | 68.75 | ||||||
| 1yr later | |||||||
| Buy price | 90 | ||||||
| Receive | 0.76 shares only | ||||||
| End value | |||||||
| 167 |
Real life example: The GFC
| Year | 2000 | 2007 | 2008 | 2009 | 2010 | 2011 | 2012 | 2013 | 2014 | 2015 |
| ASX Value | 3311 | 6275 | 5237 | 3903 | 4800 | 4800 | 4250 | 4500 | 5300 | 5546 |
Assume we bought the index:
2000-2007
Bought 3311
Sold 6275
CG 2964
CGT 741
Value 5534
12% market fall required to breakeven
Scenario 1
Bought back in 2009
Bought 3903 receiving 1.418 shares
Current 5546
Value 7863
Scenario 2
Bought back in 2008
Bought 5237 receiving 1.057 shares
Current 5546
Value 5860
Scenario 3
Sold 20% below top receving 4593 after CGT
Bought back 20% above bottom at 4684 receiving 0.98 shares
Current 5546
Value 5438
Sold 5020 (20% below top)
CG 1709
CGT 427
Value 4593 27% market fall required to breakeven
Buy at 1
| Sell | 1.25 | 1.5 | 2 | 3 | 4 | 5 | 10 | 20 | 100 |
| Breakeven price | 1.1875 | 1.375 | 1.75 | 2.5 | 3.25 | 4 | 7.75 | 15.25 | 75.25 |
| % fall required | 5.0% | 8.3% | 12.5% | 16.7% | 18.8% | 20.0% | 22.5% | 23.8% | 24.8% |
In summary, the greater your gain the greater the % fall in price required to validate selling.
However after a capital gain greater than 500%, the implicit tax cost of selling becomes a less important criteria in the hold/sell decision.
The dollar value at stake may complicate the issue though when sitting on large capital gains.
I think in summary you would only look to sell then for reasons of price if the price became clearly WAY too high versus valuation.
Even then, predicting a market high and subsequent low re-entry point is almost impossible. As scenario 3 above demonstrates, missing the market tops and bottoms by 20% during the GFC was enough to make market timing a loss making exercise. Historically this was one of the most volatile periods in stock market history and emotions were red-lining. And yet, the buy and hold investor would have found themselves in no worse position just one year later compared with the investor who tried to time the market.
Time is Money – the tradeoff of consumption
It’s a given that most of us wish we didn’t have to wake up everyday and go to work. We all dream of the day that we don’t have to go to work anymore.
So, let’s do a comparison of time and money. The dollars vs hours trade-off. Every time you buy/consume some lifestyle good/service I contend that you have just given away part of your life.
For example, if you earn $40/hr and just bought something for $80, you have just given away 2 hours of your life. i.e you have to go to work to make it back.
The corollary of this is if you can resist spending/wasting and save $10,000 a year (about $200 per week), then you have just added 250hrs (time that you didn’t have to work) to your life.
This is more than 10 full days or 31 work days (assuming 8hr working days) a year. Are you feeling younger yet? And it gets better.
Assume you were able to get a blended rate of return of 10% per annum on the money you saved and didn’t spend. Well at year end it would actually be worth $11,000 instead of $10,000.
So now, you have added 275hrs to your life continuing on with our analogy, representing more than 34 days you don’t have to go to work next year to be in the same position financially.
If you continued to resist spending that extra $200 per week for the next 20 years and earned 10% interest on the funds, it would grow to a grand total of $697,000 by then.
So if you started this program at age 30, by age 50 you would have an extra 17425 hours up your sleeve based on your original $40/hr salary. This represents 2178 working days or 8.71 years you didn’t have to work. What’s that noise I hear knocking – oh yes, it’s your comfortable, early retirement.
Before I hear all the moans and groans about ‘I can’t save that much money!’, for most it would just be the case of skipping that international holiday every third year or quitting smoking/drinking less booze.
You get the picture.
Causes of average performance
Active managers all like to think that they can beat the market. But the vast majority don’t. I have borrowed the following from Warren’s earlier writings as some of the reasons why most market participants underperform. Most of these reasons are related to psychological bias i.e where emotions override logic.
Firstly is ‘group think’. Investing is not a team sport. In basketball, when the clock is winding down and the game is on the line, you give the ball to Michael Jordan.
The same should apply in investing. Once you know what you are doing, you need to make decisions based on your own insight. Seeking consensus from others introduces all manner of bias. Sitting in a quiet room by yourself, as lonely as it sounds, is the right way to go.
An extension of group think is the desire to conform to the accepted views of others. Go to a meeting of investment professionals and you will be surprised at how uniform opinions are in the room about financial issues. Just like zebras run together in herds to minimise the chances of being eaten by a lion, investment professionals cluster together in a similar act of survival to avoid being exposed as the analyst who got it wrong.
The personal rewards for independent action are in no way commensurate with the general risk attached to such action. Getting a bonus is far outweighed by the risk of getting the sack.
A third cause of average performance is the perception that ‘average’ is safe. Just because the crowd agrees with you does not mean you are right.
Investors tend to weigh the negative emotions of losses far higher than the positives of gains which leads to seeking average outcomes.
A flow on from this is adherence to certain diversification practices which are irrational. If your best opportunity is already 20% of your holdings does it make sense to diversify into your 20th best opportunity to ensure you are well diversified?
A final cause of average results is inertia. This is a form of regret aversion, where investors tend to do nothing for fear of missing out on further gains or being wrong.
In summary, the best advice is to act out of common sense, which in practice can be a difficult thing to do.
CFA Level 3 completed
“I take comfort in the fact that anyone who is good at investing in usually a billionaire.”
Marcel Candeias
I was very satisfied to complete Level 3 of the CFA exam in June. The course was very comprehensive in covering modern economic and portfolio theory.
Study requirements for each level of the course were about 500hrs each. I scored mostly >70% for each component of the course. This achievement has given your Chairman greater credibility in the finance sphere. I feel more like I can have peer to peer conversation with others when I go to CFA presentations.
Importantly, the course has added to my financial armamentarium. I attribute my improved understanding of currency exchange rates, earnings based valuation approaches, derivative instruments and portfolio construction among some of the areas the course was valuable. Of course I did not agree with all the course content.
In particular the core assumption that volatility represents risk is at odds with my beliefs. I belive risk equals prospect of permanent capital loss.
That is a topic of conversation for later.
I am still wedded to the dental industry for its earnings capacity but I will be allocating a day a week next year to purely investment undertakings. If this yields improved returns then my CFA achievements may come in handy as I expand my involvement in the finance industry.
Risk management
“The rational way to observe the conservativeness of past policies is to study performance in declining markets.”
Warren Buffett
Our equity returns have been very satisfactory over the past 5 years. This leads me to start asking the question, ‘when the next big decline comes, where will we stand?’ How are we structured and positioned to take advantage of a decline rather than scrambling to cover over exposure.
will we stand?’ How are we structured and positioned to take advantage of a decline rather than scrambling to cover over exposure.
I anticipate a 30% decline in the overall market would lead to a 10% decline in our overall group position.
The best test of conservatism is to evaluate your performance in declining markets.
We currently have securitised credit lines of over $1M at call, so in some ways I would welcome a market decline.
It would provide an opportunity to add to existing positions at far more attractive prices, assuming my emotions held out and I act rationally.
Having said that I would still like to be closer to debt free when a big decline occurs.
Permanent capital dominates leveraged capital during market declines.
“When you react to what actually happens rather than guess about what might happen, I think you make less mistakes.”
Howard Marks from Oaktree Capital
I would add to Howard’s statement that when you are ‘acting logically and emotionally neutral and positioned to react logically’ to what actually happens, you naturally make less mistakes.
2016 was a further year of consolidation for Kanday Group.
I am proud of our achievements, where we executed on all of our objectives for the year.
Politics appeared to play a greater role than usual with all the excitement of the US election. With Trump at the helm, 2017 promises it’s own share of surprises.
We will continue to take our investment cues from company performance, management execution and an evaluation of future business prospects, within the confines of what we consider a quality business.
And no, I won’t be transforming into a commodity trader even if Mr Market thinks the resources boom is back!
I look forward to updating interested parties via our quarterly results presentations.
Yours Sincerely
Marcel Candeias