Welcome to the 2017 annual letter. Our gain in net worth during the year was 12.5% compared with a gain of 8% for the All Ordinaries Index, our 14th straight year of outperformance. This year our gains were driven by returns from our equity investments and the usual contribution from our dental and beauty operated businesses.
2017 was the first year of the Trump administration and despite intense media speculation and sensationalist reporting, political events have taken a back seat to economic developments. This all changed in the final two months of the calendar year when the Republican tax agenda was passed by congress and the US senate.
The historic tax deal, amongst other things, proposes a cut in the US corporate tax rate from 39.1% to 20%. This promises to act like a moth to a flame, with the spectre of a flood of capital being attracted to the US. Money is always looking for a home where it will be looked after and treated well and the prospect of low taxes and a stable regulatory requirement in the heartland of capitalism will prove to be an irresistible combination.
Money has no patriotic loyalties and short of capital controls, will osmotically flow to where it is most incentivised. I have visited the US in recent years and there is a great need for infrastructure spending to restore this nation to its best. With the usual gridlock in democratic politics, just a small pivot in the direction of capitalism promises to unleash growth and renewal across the US economy.
Our capital has followed this theme and we have been steadily increasing our interests in many wonderful US companies. Valuations appear to have become stretched as the year has progressed but may be warranted given these companies now have a the wind at their backs.
In contrast the Australian economy has muddled along, bolstered by a boom in real estate on the east coast in Melbourne and Sydney. Political indecision has been a hallmark of the Turnbull government. Up until now though Australia has been the lucky country. Recent booms in resources such as iron ore, the Chinese economic miracle and now a real estate construction boom have supported a system renowned for sky high wages, red tape and social welfare spending.
The continual upward march of home prices however has led to increasing speculation. As a result Australians have the highest debt to income ratios in the world, coming in at over 200%. The banks have been complicit in this, spruiking products such as home equity loans for spending on consumer items such as cars, boats holidays and other lifestyle toys. In recent times though, wage growth has stagnated as more and more jobs are being outsourced to other countries where the cost of human labour is significantly less. This has led to a hollowing out of several industries such as car manufacturing and industrial processes. As a result the Australian economy has morphed into one where the only things we are good at are digging things out of the ground and serving each other overpriced cappucinos.
Our increasing reliance on China to support our economic well being sets a dangerous predicament should the Chinese decide their economic interests are not aligned with ours, or more likely that they want a greater say and share in their Australian interests.
In business a key theme is that of control. It inevitably comes to pass that the party which has control in any association will eventually reach for more of the economic pie.
Building a financial fortress which is impervious to the influence of other parties is an imperative aspect of adult life, lest one is prepared to live under the auspices
and directives of another. West Australia, unlike the rest of the nation has been in recession for the past few years. We have felt the impact of hard times as those with more control than us have flexed their positions of authority and reached for a greater share at our expense. Australia is likely to face a similar consequence the next time a cold wind blows through the Australian economy.
| 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 | ||
| 2017 | 12.5 | 7.9 | 6167 | 4.6 | ||
| Cumulative Return | 2003-2017 | 1431% | 87% | |||
| Compound Annual Return | 2003-2017 | 21.53% | 4.57% |
Key Themes of 2017
“If you do good valuation work the market will eventually agree with you.”
Joel Greenblatt
This year was the year of Amazon and its perceived disruption of almost every imaginable industry, or not.
Businesses engaged in retailing or being a middleman of any sort were caught up in the speculation that Amazon was going to encroach on their turf and undermine their business and margins. Any perceived slowdown in revenue growth rates or declining gross margins was seen as evidence
that the looming threat of Amazon was taking a bite out of business and a portent of things to come.
However as the year has progressed the vast majority of these companies have continued to report solid results, with managements stating that
from their perspective everything was business as usual.
In the age of the internet and increasing access to price transparency and global trade, it is fair and relevant to ask whether the role of the middleman is being disintermediated. However this is not a new phenomenon. A decade ago the same question was being asked of traditional brick and mortar retailers in the travel space. In particular a long time holding of Kanday, Flight Centre was seen to be vulnerable to the internet and the ease with which customers could transact across the web, bypasssing the thoudands of stores Graham Turner had opened over many years. And yet, Flight Centre today is reporting profits four times higher than in 2007, clearly an ongoing success story. No doubt the company has had to evolve with the changing landscape and offers the customer the convenience of booking instore, online, over the phone, with or without assistance in order to garner the sale.
This then is the crux of the argument as it pertains to all the other businesses under threat as consumer comfort and confidence in transacting across the internet has grown, led by the everything shop Amazon. Those who adapt and continue to offer the customer convenience and value will thrive and market pricing to the contrary will provide investment opportunities at attractive prices.
Incursion on the status quo of a different kind is occuring in the dental market. Private health funds have continued to strengthen their grip on the profession which has culminated in a parliamentary enquiry into their marketing practices in October. The senate hearing apparently showed the naivety of the ministers as they seemed genuinely shocked when told about how funds now offer teired rebate schemes. Patients presenting at health fund owned practices are covered virtually 100% of their bill whereas independent dentist visits are only reimbursed as low as 20% of the treatment cost. When patients query the low rebate the typical refrain from health fund staff is that ‘your dentist is charging you too much and ripping you off!’ Furthermore the patient is then recommended to go and visit a health fund owned practice where they will get 100% cover on treatment. Seems like an offer too good to refuse. Little do the patients know that the health funds have closed off agreements with dentists and often have higher fees. Our view is that this is anti-competitive behaviour and are waiting for the dental industry to galvanise against this imminent threat. United we will stand or divided we will suffer the consequences.
When the game gets tough, those in charge stop playing fairly. This has been the case in the beauty industry.
After fifty years with the same operating relationship, the franchisor abruptly announced the introduction of a franchise royalty fee. In the past few years there has been a marked decline in retail sales despite salon visitation and service treatments growing nicely. Rather than attribute this decline to lack of innovation or marketing missteps, the franchisor has sought a solution via punishing franchisees for underperformance, cloaked in the guise of a salon transformation. What is clear is that ladies are still spending a fortune on skin care and cosmetics retail, with brands such as Estee Lauder and L’Oreal reporting record results. One would think that having intimate contact with the client such as salons do, would confer an advantage over these other retail only brands. Elevating the Ella Bache brand and delivering real results to clients through research and innovation would seem to be the answer rather than pushing therapists to hard sell and risk alienating the client therapist relationship.
In effect the developments described above once more show how the economic pie gets shared depending on which party has their hands on the levers of control. There are customers, retailers, middlemen, wholesalers, insurers, bankers and other miscellaneous groups all competing for economic profits. It is important that we understand these factors in order to maximise our outcomes. Having said that we will not participate in predatory behaviour. We subscribe to a philosophy of only competing with those who strive to weaken our position, preferring to engage in mutually agreeable arrangements, fostering trust and goodwill. Those businesses which aim to undercut and abuse their position of authority ultimately will fall by the wayside as disenfranchised participants revolt against the oppression. There will always be a sense of right and wrong and ultimately it is honorable behaviour in life and business that yields lasting
prosperity.
The impact of losing money
“Rule No. 1: Never lose money. Rule No. 2: Don’t forget rule No. 1”
Warren Buffett
“Investing performance is often decided by how many unforced mistakes you make, not by the winners you choose.”
Marcel Candeias
Let’s create two hypothetical portfolios of 5 stocks. Assume they are equal weighted holdings
Portfolio A is conservatively chosen while Portfolio B is considered more speculative seeking higher returns.
| 1yr Return | 1yr Return | |
| Stock | A | B |
| 1 | 10% | 15% |
| 2 | 8% | 12% |
| 3 | 7% | 11% |
| 4 | 6% | 20% |
| 5 | 11% | -50% |
| Portfolio Return | 8.4% | 1.6% |
So even though 4 out of the 5 holdings in Portfolio B outperformed the holdings in Portfolio A, having one outsized loser in Portfolio B led to dramatic underperformance.
This may be the essence of what Warren Buffett is talking about when he states the two most important rules in investing.
Eliminating error in investment decision making cannot be highlighted enough if one is to achieve outsized returns.
The investment industry’s solution to this is to increase the number of holdings so that the performance of any one stock cannot influence overall returns too greatly.
But ultimately when the portfolio composition represents the market, then by definition results can only be average.
The Kelly criterion
“It’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong.”
George Soros
“bet edge over odds”
John L. Kelly jnr
If we want to maximise portfolio return without dramatically increasing the risk of one poorly chosen stock hurting the overall result, then how many stocks should
be in a portfolio? And is it ideal to be equally weighted or should you have more of your money in your best ideas?
The Kelly Criterion is well-known among gamblers as a way to decide how much to bet when the odds are in your favor.
The optimal amount to bet is pb−(1−p) / b
Where
p = probability of success
b = return if you are successful
So, p is a number from 0 to 1. So 50% probability means that p is 0.5. Gamblers call pb−(1−p) their edge, and b their odds leading to the simple rule bet edge over odds.
Without getting into the statistics, this rule shows that over a large enough series of bets, you maximise the overall portfolio return. An important takeway from Kelly’s work is that it only works over a large number of trials and you need to have a sufficiently large bankroll. This introduces the idea of pooling your bankroll with others to allow for a larger bet size as the ability to withstand drawdowns is higher. This applies to industries such as insurance where the risk of a single claim is high but thousands of policies pooled together significantly reduce overall drawdown risk. In value investor language it translates into concentrating your money in your best few ideas where you have the maximum chance of being successful. Further the Kelly system advocates selling high and buying low as the probability of success increases as share prices decrease and so does the anticipated return (and vice versa).
Howard Marks perhaps put it more succinctly when he stated that the best way to outperform the market is buy things that are cheap.
It should be clear that an understanding of the intrinsic value of a security is critical in making judgement of whether it is trading at an attractive price. To save you figuring out the math, the benefits of diversification offsetting single stock risk are at about 95% when you reach 30 stocks. Any more is fairly redundant and your returns will start to mimic the market.
The other factor is position sizing. Both Kelly and Soros advocate concentrating your funds in your best ideas.
In practice, the Berkshire portfolio has about 80% of funds in the top 5-6 stocks with diversification spread across the rest of the portfolio’s 30 or so holdings. At Kanday we have a proprietary approach which on face value may appear more diversified and risk aversive but we feel we are not sacrificing extra returns to gain this benefit.
Market timing and the different types of investor
The idea of waiting for the market to crash before investing sounds good in theory. So often you will hear budding investors say they will invest when the next big market decline occurs.
This is a fallacy for numerous reasons. The first reason is that whole businesses are not for sale at these times. An example is the case of Warren Buffett’s purchase of Lubrizol in 2011.
During the GFC shares in Lubrizol fell as low as $30. When Warren paid for it two years later he ponied up $135 a share. This does not sound like the market timing of the world’s
greatest investor. The reality is that the company was not for sale at depressed prices and a quality business like Lubrizol was not a forced seller. Well you might say. I am not looking to buy the whole company. I will add to my minority positions during a large decline. Not so fast. If you are a fund manager and the market crashes you cannot buy during a decline because of all the redemptions you will be facing.
Instead you will likely be selling into the decline like everyone else. Some managers may prudently have some cash reserves on the sidelines, but that cash will be getting used to fund redemptions rather than purchase attractively priced securities. During the GFC a lot of funds even suspended redemptions as they were caught out with no cash.
During a large market drop, behavioural psychology sees everyone trying to shore up their positions in case things get worse.
The reality is the path to wealth is consistent purchases of wonderful companies at ‘reasonable’ prices during normal business conditions and avoiding participation in folly during boom times.
The tremendous structural advantages of the individual investor
“The huge structural disadvantage facing institutions and fund managers is that they are managing other people’s money. Rather than playing to win they are forced to
play not to lose.”
Marcel Candeias
As an individual investor you may think you are at a disadvantage taking on the big boys, institutions and fund managers. In fact it is the opposite. Large investors like Warren Buffett are hamstringed by the fact that they can only focus on very large large opportunities in order to have any material effect on their wealth. This greatly limits the universe of investment opportunities available. If for example you see the stock of a company such as ARB trading at a 50% discount to intrinsic value, you can pounce on the opportunity. Warren on the other hand can’t. Even if he mopped up all the shares available for sale he may acquire a $200-300M position. Then if the share price doubled shortly after he would stand to gain a $200-300M profit. This is great right? Well, perhaps to you it sounds great, but to Warren and Berkshire, this would equate to a 0.06% increase in net worth. Clearly not worth the effort. Berkshire needs to shop for elephants, you don’t. This is a huge advantage for the individual investor.
A second advantage is market impact. When a fund manager or institution buys stocks, the volume may impact market prices. Supply and demand will lead to prices rising if large purchases are being made or prices to fall if large sales are being made. An individual doesn’t have this problem.
A third related advantage is liquidity. Buying and selling for the individual is usually just a matter of a mouse click whereas larger investors may find there are not enough buyers or sellers in order to clear a transaction.
A fourth advantage is during large market declines. A well structured individual investor can truly take advantage here. As aforementioned, large investors usually cannot make whole company purchases as managers of quality companies will not give their businesses away at depressed prices.
Fund managers are managing other people’s money. During normal times everyone says they will support the fund through downturns. But in reality, when the drop happens human behavioural flaws take over and people panic, trying to get out at any cost. Fund managers are always having to look over their shoulders to see if the rampaging herd of redemptions is coming and have to hold cash to cover. A well structured and rational individual has none of these concerns.
A fifth advantage is the pressure for short term performance. Due to behavioural psychology again, people will always chase the fund with the best recent performance.
Studies have shown that the best managed fund of the past decade achieved returns greater than 15% per annum. Investors in the fund however lost money. How is this possible? The reason is that there were periods when the fund underperformed in the short term. When this happened short term focussed investors sold and moved their money to the latest ‘hot’ manager. These kinds of pressures and biases lead to fund managers shooting for short term results at the expense of long term returns.
Window dressing by buying hot stocks so they can be in the portfolio at reporting dates, chasing momentum stocks and hot sectors and themed investments which sound great in presentations are all examples of the wayward behaviour which results. Fund managers make their bread and butter from funds under management, so anything and everything will be pursued in order to limit client redemptions. The individual investor on the other hand can comfortably take the long view, unperturbed by short term volatility.
A sixth advantage relates to taxes. Fund manager performance is measured on before tax returns. As a result, they will be far more likely to ‘lock in’ investment gains by selling positions. In ‘Confessions of a Street Addict’ Jim Cramer stated that if his fund was up big mid way through the year, he would sell all positions in order to lock in the result for
the year, irrespective of timing. He would go so far as to barr his traders from stuffing up their lead by limiting their activities to playing table tennis and other distractions.
The investors in the fund would have to face the tax consequences. Individual investors can be far more sensitive to tax implications. Avoiding short term capital gains taxes over a period of time gives an approximate 2% per annum structural advantage over those who are paying taxes.
In summary, when you are beholden to no-one, you can truly invest for absolute return with a long term focus. This is the same way all great businesses have been built.
Emotional psychology test
“A market quotes availability should never be turned into a liability whereby its periodic aberrations in turn formulate your judgements.”
Warren Buffett
When you take an initial position in a stock what are you hoping for? Given the following three possible outcomes, which would be your preference and why?
1) The price rises 20% in the next 3 months
2) The price stays flat
3)The price falls 20% in the next 3 months
“We ordinarily make no attempt to buy equities for anticipated favorable stock price behavior in the short term.
In fact, if their business experience continues to satisfy us, we welcome lower market prices of stocks we own as an opportunity to acquire even more of a good thing at a better price.”
Warren Buffett, 1977 Berkshire Hathaway Letter to Shareholders
Do you watch with great anticipation after you have purchased a stock? Do you feel excitement if the price rises, thinking how clever you are.?
Do you feel that gnawing feeling of pain and regret if the share price declines after your purchase, thinking to yourself ‘How could I be so stupid!’
I should have waited for the price to decline further. Or maybe there is something wrong with the company. Oh, no, I just want my money back!’
Or if nothing happens, you quickly lose interest. As you hear on the daily news about other hot stocks that have just jumped 20% or more overnight, again you feel regret. ‘Why am I holding this stupid stock when I could be making so much money by holding xyz hot stock?’
The temptation is strong to sell your boring stock and buy the hot stock which has just rallied.
These are the typical reactions of the speculator after purchasing a stock.
Can you guess what Warren hopes will happen after his initial purchase. Yes, he hopes the price falls 20% in the next 3 months. This may seem counterintuitive. But, if he has done his homework correctly and valued the business and prospects of the company well, then a declining share price represents a great opportunity to add to his position at ever more attractive prices.
Changing your psychological approach to stock prices is one of the keys to long term investment success.
Equities
“If you don’t find a way to make money while you sleep, you will work until you die.”
Warren Buffett
There was a period this year when it felt like the only stocks in existence were the FANG stocks. Facebook, Amazon, Netflix, Google and a few other tech behemoths saw tremendous increases in their share prices this year. It seems to be the nature of the internet to trend towards concentration and winner takes all. Other industries have acted like this in the past but never on such a global scale. The open internet creates a network effect. As the eyeballs accumulate at a particular site it tends to quickly move towards dominance of its market. For example, up to 80% of new advertising spend online is directed to Facebook and Google. On a global scale, this is unprecedented. Indeed, some are predicting that Amazon will consume all of retail in due course!
At the market caps of the tech giants, growth rates greater than 20% show how much new business and market share these companies are taking.
At Google’s over $700B market cap, 20% growth would mean a further $140B increase in market value. This would swallow several companies making up the S+P 500.
Whether these trends continue is hard to foresee as the heavy hand of government intervention is already surfacing in order to control these giant monopolies.
The demise of the middleman or 2018 the year of the retailer?
“The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor,
you’ve got a very good business. And if you have to have a prayer session before raising the price by 10 per cent, then you’ve got a terrible business.”
Warren Buffett
Pricing power is an incredibly important variable in business. This has truly come to the fore in 2017 with the rise and rise of Amazon.
Amazon represents the new world of pricing transparency ushered in by the advent of the internet and mobile smartphones.
Companies which used to rely on the ignorance of customers with regards to pricing comparison have struggled greatly as informed consumers now price compare everything before committing to a purchase. It is not uncommon now to see a customer in a shop taking a photo of an item with their smartphone and then uploading the information to Amazon to see what is the best price available.
Amazon places customer focus at the centre of their strategy and customers now see Amazon as a trusted guide to what is the best price for any retail item. And Amazon is famous (or infamous) for not making any profits on their gargantuam $170B USD of retail sales, also providing convenience of same day home delivery with free shipping. So where does this leave incumbent retailers and middlemen and how can they compete against the Amazon death star?
Should we sell all of our retail and middleman exposures? Or should we hedge our positions by buying more Amazon stock?
The key I believe is to identify which companies are structurally positioned to compete with Amazon, either by having a low cost of doing business and/or through offering a service component which cannot be matched by pure online retail.
Each industry has its own unique characteristics and it is paramount that we understand the key drivers which differentiate company performance.
For example, in the auto parts business, customers do not want to wait any amount of time when their car needs urgent repairs. Immediate availability of the correct part is even more important than having the lowest price. Knowledge of the parts needed is also highly valued by customers. Customer service then can truly differentiate the offering versus a simple internet listing.
Many retailers and middlemen have seen their share prices wobble during 2017. Whilst I believe in many instances the falls have been warranted, there are also likely to be opportunities created as the market throws the baby out with the bath water.
Growth drivers
“We’re into profitable growth. One without the other isn’t much good.”
Graham Turner
One of the hallmarks of a great invesment is growth. All of the multibagger winners of the past shared one thing in common – growth. But not all growth is created equal. Some growth is illusory. As per Graham Turner’s quote, growth for growth’s sake is not a winning
proposition. It is profitable growth that really matters. So, our challenge is to distingusih between what is creating the growth and the likelihood of it being sustained. Companies can grow revenues in two ways. Firstly they can reinvest profits in existing operations by buying new equipment, engaging in research and development, opening more stores amongst other things. Secondly they can grow by merger and acquisition, acquiring the revenues of other companies. A third method is growth in per share metrics via buybacks.
Organic growth is usually preferable because it focusses on the core competency of the firm.
How that growth is funded may be more important than the growth itself.
My favourite funding source is growth by reinvestment of profits, because it is not accompanied by share dilution through issuance
of more shares or debt funding which increases the vulnerability of the balance sheet.
Another source of growth used by a lot of US corporations is growth in per share metrics through buybacks. Buybacks can be funded
via available cash, retained profits or debt funding. This is often referred to as financially engineered growth, but in reality it is the company growing by repurchasing itself from shareholders in preference to seeking growth externally.
When a company is demonstrating revenue growth, don’t just assume that is a good thing.
Look at the trend in operating margins. Are margins declining? Is it because of the mix of business or is it because management is having to sacrifice margins to maintain growth. If margins are improving and growth rates are accelerating, this may be a great indicator of a company with a growing competitive advantage.
Look at the trend in return on invested capital as it compares with growth.
McKinsey partners has released some great research on the subject. They state that high ROIC is easier to maintain than high growth.
This is because it reflects the presence of an economic moat.
Also, increasing ROIC from a low starting point has a greater effect on value than increasing growth, but not so much when ROIC is already high.
One of my current areas of interest is trying to model fade rates in growth rates and implied time vectors to reach a steady state equilibrium.
Currency speculation
“I am not a currency trader but I do try and take advantage of currency movements.”
Marcel Candeias
The Australian dollar managed to rebound 7% against the US dollar in 2017. Because Kanday group reports results in Australian dollar terms, the movement of currencies can have a significant effect on short term results. This year we made significant purchases of US currency and managed to average an exchange of about $0.75 USD/AUD.
We do not attempt to hedge these fluctuations for the following reasons.
Firstly, our principal cash generating businesses are domiciled in Australia. Therefore we are always creating more income in Australian dollars.
Any debt exposures that we have are denominated in Australian dollars, so there is no currency translation risk against our principal cashflows.
We are happy to diversify our currency exposures through investing in international markets unhedged. This protects our downside should the
commodity focussed Australian currency depreciate as it did sharply during the GFC and early 2000s. Many folks in Australia are blissfully
unaware of how volatile the Australian dollar can be. Perhaps they get a taste though when taking an overseas holiday and converting to Euros or Pounds.
When we do invest overseas we try to be opportunistic in our purchases of foreign currencies, even though we are not trading the currency per se. Our dominant international holdings are in US dollars, principally because this is where we have found the most compelling investment opportunities.
Over time our approach to currency management may evolve as the group becomes more complex and if any overseas subsidiaries are purchased.
Generally speaking though we are happy to incorporate currency diversification into our structure, cushioning the impacts of Australian dollar volatility and providing capital availability to invest should the Aussie depreciate materially.
During the GFC one may point to the attractive prices available on international equities. It is easy to overlook that at the height of uncertainty the Australian currency fell to a low of $0.62 USD/AUD which made the ‘effective’ purchase price far more expensive if one had to convert Australian currency into US dollars in order to have capital to trade. Building a capital base in foreign currencies will allow us to take advantage of investment opportunities as they arise without having to be as conscious of currency exchange rates in our decision making.
In summary, prevailing currency exchange rates are an important consideration in our investment decision making and we look to take advantage of currency movements, without losing sight of our core objective of purchasing high quality businesses. We understand that the currency exchange rate is a one-off transaction and thereafter our investment outcome will be determined by the performance of the business we buy. Share prices tend to automatically adjust to currency fluctuations as foreign earnings become more valuable if the local currency depreciates and vice versa.
Finally, for those of you who are interested in asking, the answer is NO, we will not be diversifying our currency exposures into Bitcoin!
Interconnected corporate boards
“Berkshire still owns every subsidiary acquired since 1970; among the hundreds of securities reported in its portfolio over the years”
Excerpt from Lawrence A. Cunningham. “The Enduring Value of Values”
When I spent some time this year perusing the make-up of the boards of some of our holdings, it dawned upon me how many firms share executives. And it should come as no surprise as companies are groupings of individuals who interact and form relationships.
Many people equate croporations as faceless machines hell bent on the profit motive. This may be partially true at times, but the driving forces behind these corporations are real people with real lives. Hence it comes as no surprise that the boards of great companies often share close relationships, intermingle their ideas looking for synergies and mutually beneficial outcomes. Business dealings are often portrayed as cutthroat and ruthless. However I found that often the companies with enduring moats and legacies do not conduct business quite in this manner. Sure they are competitive and looking to gain market share, but they go about it in a manner which
respects others and are humble in their success. They often collaborate with peers to achieve win-win outcomes.
As a starting point look at the board of Starbucks corporation and the history of their board and their close connection with executives
of Pepsico. Is it any surprise then that several Starbucks executives are former Pepsico executives and Starbucks has struck lucrative distribution deals with Pepsico in order to leverage their distribution network and broaden their geographic availability.
Looking at the composition of company boards I have found is another great way to identify wonderful companies.
Behind the corporate logo are groups of people making decisions which determine the fate of the company. Finding wonderful managers and which companies they choose to work for, is akin to Charlie Munger’s method of inversion. Rather than trying to identify the wonderful company yourself, look to the insiders who by their career choices will uncover the great companies for you.
“What, then, is Berkshire’s moat? The answer: Berkshire’s distinctive corporate culture. Berkshire spent the last five decades
acquiring a group of wholly owned subsidiaries of bewildering variety but united by a set of distinctive core values”
Lawrence A. Cunningham
High performing company attributes
“Low margin businesses typically have little or no pricing power and therefore rely on industry growth and cost control
to drive growth and profitability.”
Marcel Candeias
High performer companies have many attributes in common.
These include a high return on invested capital. This makes intuitive sense. Just as you would ask the bank for the highest interest rate possible on your term deposit, you should seek to own companies that can invest capital at high rates of return.
High gross margins are an important signal of long run performance.
If gross margins are sticky and persistent, then a good turnaround candidate is a company with a high gross profit margin relative to industry peers and a low operating margin. Low operating margins reflect internal issues which are easier to remedy than external structural industry issues.
Big companies tend to cement their advantage by finding efficiencies in selling/general/administrative expenses that smaller firms don’t. In investing, scale and track record matter. Unlike in sports where this years champion may be next year’s cellar dweller, in business the winners tend to remain winners. Competitive advantages tend to strengthen as a firm grows as long as management is prudently
attending to its affairs.
Taxes and Donald Trump
Lollapalooza effect is when multiple biases, tendencies or mental models act at the same time in the same direction.
Motley Fool paraphrasing Charlie Munger
On December 20th Donald Trump signed into law the largest change to the US tax code in 35 years, reducing the corporate tax rate from 35% to 21%. Simple modelling of the new rate suggests a one off bump to earnings of US companies paying the current max rate of about 20%. This may go a fair way in explaining the meteoric rise of the US sharemarket this year. But what are the long term consequences of this new business friendly environment that the Donald has ushered into being? I think one has to look no farther than our neighbour Singapore to see what is likely to happen. Singapore has been governed by a single family and their patriarch and founding father Lee Kuan Yew since 1965. They have adopted an open, transparent system which welcomes foreign investment and importantly has a headline corporate tax rate of 17%. This business friendly system has seen Singapore transform in the past 40-50 years from, in Charlie Munger’s words, a mosquito infected swamp into the economic powerhouse that it is today.
This confluence of policy decisions created a lollapalooza effect which turbo-charged Singapore for third world nation to first world powerhouse in a single generation. I believe the tax cuts, proposed infrastructure spending and America first jobs policy Trump is enacting is set to have a similar effect on the US economy. Although the market there has rallied tremendously , we may all be underestimating the lollapalooza impact the business friendly president will have.
Loyalty and Trust – the Berkshire and Kanday way of doing business
“To get what you want be deserving of it by your actions first”
Charlie Munger
“My life story is the combination of their life stories.”
Marcel Candeias
Berkshire Hathaway is a conglomerate like no other. The head office employs about 30 people despite the group having about 50 major subsidiaries and an equity portfolio worth well over $100B USD. The equity portfolio is managed by one man – Warren Buffett.
What is the glue that keeps this large group of disparate businesses together. Charlie Munger calls it a ‘seemless web of desevered trust.’
Over the course of 50 years Warren and Charlie have managed to cobble together a group of entrepreneurs and managers who share similar traits in how they conduct themselves and their businesses. To generalise broadly, they operate on the principles of integrity and fair play but with a capitalist’s heart.
Kanday group is being built upon similar principles. We have a long runway ahead and plan to establish lasting relations with our business partners through showing the same commitment and passion to their enterprises as they do. This is our mission and will ensure our prosperity and longevity.
“The ultimate measure of a man is not where he stands in moments of comfort and convenience, but where he stands at times of challenge and controversy.”
Martin Luther King, Jr
Mistakes and lessons learnt
“High risk comes primarily with high prices.”
Howard Marks
My biggest errors this year and in previous years has been overpaying for growth. As a result I have been caught when expected
earnings did not materialise. Whilst I am confident that these are short term issues, the share market reaction can be brutal and unforgiving when the former growth high flyer falls off its perch. The market fills in the narrative when this occurs, attributing the slow down to structural disruption, accelerating the fall from grace.
A case in point is O’Reilly Automotive. I began accumulating a position in the stock in the early part of the year. Before the next earnings report O’Reilly shocked investors by announcing a downgrade in earnings expectations. Management attributed the short fall to consecutive mild winters which had deferred the need for essential vehicle maintenance. Instead of believing them, the market concluded that Amazon was intent on entering the auto parts market. Gross margins were going to be squeezed and O’Reilly’s best days were behind them. The share price plummeted, plunging 40% in a matter of days as analysts reset all of their growth expectations. The fact that I already had taken a position in the stock reinforced to me that I hadn’t allowed for an adequate margin of safety. Two quarters later and the O’Reilly share price has recouped a large chunk of its lost value, as results have started to stabilise, and perhaps helped by Trump’s tax cut. This underlines how imperative it is to buy quality. You can overpay for quality and be forgiven in time. In contrast, if O’Reilly was truly being disrupted then the decline may be permanent.
I have mainly addressed this downside risk through demanding a greater margin of safety by trying to identify a ‘low margin’ intrinsic value for a stock before considering purchasing it.
I also spent too much time watching share prices leading to emphasis on price movements in decision making, rather than focussing on valuations.
It really is sobering when you recognise how you can become fixated on price reference points for a stock. For example, ‘wow it is up 40% this year, so surely I can’t buy in.’ or ‘I bought it at 68 so I won’t buy anymore unless it goes below 68.’ or ‘the price is falling…I’ll let it fall further before I buy any more.’ or ‘All the stocks in that sector are getting punished so I can’t buy because I can’t stand buying into a falling sector’ or ‘I think I will buy this high flying stock even though the price is implying a 40% growth rate for the next 5 years, because I have a fear of missing out.’
Charlie Munger says you should spend your life collecting and avoiding folly, preferably through observation of the missteps of others. I did a bit of both this year.
CFA and Fortune’s Formula – William Poundstone
“When faced with a choice of wagers or investments, choose the one with the highest geometric mean of outcomes.
This rule, of broader application than the edge/odds Kelly formula for bet size, is the Kelly criterion.”
Excerpt from Fortune’s Formula by William Poundstone
I read the abovementioned text during the year and found it an intriguing read on the history of modern finance and the rise to prominence of quantitative investing. The influence of mathematicians and computers on financial markets has been profound with up to 40% of all trading on markets now conducted by computer algorithms.
I was also surprised to find how much of the financial market innovation discussed in the book mirrored the CFA course.
Claude Shannon and Ed Thorp literally could have written a large proportion of the accepted wisdom espoused in the course notes. A number of modern day hedge funds including Renaissance, Bridgewater and Citadel have recorded spectacular track records using quant investing methods. Their arbitraged investing approach smooths results and adds significant liquidity to markets. We look to incorporate some of these learnings into our methodologies, complementing our core philosophy of being long term business owners and partners.
I look forward to updating interested parties via our quarterly results presentations.
Yours Sincerely
Marcel Candeias