Welcome to the 2018 annual letter. Our gain in net worth during the year was 3.95% compared with a loss of 10.3% for the All Ordinaries Index, our 15th straight year of outperformance. This year our gains were driven by returns from our international equities and strong contributions from our dental and beauty operated businesses.The continued weakness in the West Australian economy continued to impact our results as we took further non cash impairments against our Perth real estate. Last year I proposed that the Trump administration’s lowering of corporate tax rates and business friendly mandate would lead to a flood of money flowing into the US. As Gordon Gekko summised, ‘Money never sleeps’ and when a better suitor is found, she will slip away in the night into his arms. This prediction has come to pass as demand for the US dollar has led to a 10% appreciation of the US dollar against most trading partners. US corporations have announced spectacular results against the backdrop of lower US corporate tax rates, with the average s+p500 firm reporting a 23% increase in year over year earnings. Obviously this growth rate is a one off, being supercharged by the tax cuts, but it has nonetheless significantly increased the intrinsic value of US firms. With the midterm elections seeing the Republicans strengthen their position in the US senate, this has ensured the Democrats do not reverse the changes.
We have been steadily increasing our interests in many wonderful US companies. In the second half of the year we have become more cautious as increasing share prices combined with the rallying US dollar has made equities look less attractive.
US Fed interest rate increases also threaten equity prices.
This caution was warranted with a correction occuring since the start of October. Ironically, even when valuations look stretched it can be difficult to pull the trigger
to sell as there are tax implications and other fees to consider. We like to act as business owners, not looking to jump ship every time we think there is a better
offer someplace else. The onus of selling is that you have to redeploy the capital. It has been my experience that often selling into an expensive market leads to purchasing something else which also will get dragged down when the market corrects, leading to a double whammy of tax consequences and share price losses.
Only the truly patient can sell and then patiently wait for the correction which may be years in the coming.
Warren Buffett has seen the value of Berkshire shares decline by over 50% three times in his investing lifetime and he still has ended up one of the richest
people in the world. So perhaps selling is not the most important decision to make, rather purchasing the right security is.
Fortunately I do not believe we are in an era where equity prices overall are outrageous which would make the aforementioned conversation more pertinent.
One needs to be flexible though because a time will come where other asset classes may be more attractive and a change of strategy may be warranted.
Our Perth real estate holdings are a stark reminder of this fact, being worth less today than 11 years ago.
Capital allocation is perhaps the most important decision an asset manager can make. All industries and asset classes have periods of outperformance
and underperformance. Yet, some managers and companies consistently beat the competition. I posit that often the reason for this is superior capital
allocation skills. As Warren points out, many executives are experts at running their businesses, but when it comes to allocating capital they are found wanting.
Kanday is focussed on the rational allocation of capital and we try to be apathetic about what industry or asset class we invest in.
| 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 | ||
| 2018 | 3.95 | -10.3 | 5533 | 14.3 | ||
| Cumulative Return | 2003-2018 | 1492% | 68% | |||
| Compound Annual Return | 2003-2018 | 20.26% | 3.51% |
Key Themes of 2018
“A bird in the hand is worth two in the bush.”
Aesop
This year the market has grappled with the looming introduction of tariffs by the Trump administration and the raising of interest rates by the
US federal reserve bank. As part of his election promise Donald is electing to use economic measures as a tool to advantage the US against its trading partners, particularly China. The refrain has been that other nations have been taking advantage of the US on trade, including the theft of intellectual property. No matter to what extent this is true, the bottom line is that Trump, unlike his predecessors, recognises that the US wields the big stick in the business world. Whatever his true motivations, MAGA or other, Trump knows that the best time to negotiate is from a position of strength. Since assuming office and with the successful introduction of major corporate tax cuts in the US, the s+p500 has rallied almost 30%, giving Trump the firepower to pressure US trading partners into signing new deals.
In contrast the Shanghai SSE Composite index has slumped by 20% over the same timeframe and the Chinese yuan has devalued.
The flood of cash into the US has seen a 10% rise in the US dollar against most major trading currencies.
I would expect to see automatic stabilisers start to take effect at current levels as US companies start to become disadvantaged from the strong dollar in term of price competitiveness.
These movements have created somewhat of a conundrum as our purchasing power has become reduced when looking to purchase international
securities.
Closer to home the Australian economy continues to put up good GDP figures. In the second half of the year though a slowdown in the east coast
property market was confirmed, with prices in Sydney now sinking 7% year over year. The explanation for this may be tighter lending regulations
being enforced since the royal commission into Australian banks commenced this year. The spillover of reduced house prices into the rest
of the economy is likely to be significant as housing is the major asset of most Aussie families.
Western Australia continues to bump along the bottom, with low consumer confidence and spending. On the positive side there do appear to be some genuine signs of improvement with many reports of mining activity resuming, unemployment levels still at around 6% and no further deterioration in other macro indicators. Furthermore, some large investors have continued to pursue property deals in Perth and the government appears to be proactive in improving access to the state through direct flights to London and possibly Tokyo commencing.
Our directly operated businesses have continued to perform well against this backdrop.
Health funds made some major announcements in the latter half of the year. We will adapt to these changes as we have before. The outlook for dentistry is still bright.
Our beauty operations also are performing very well.
We increased our positions in US companies during the year but the weakening AUD tempered our enthusiasm in the second half.
Australian equities, despite being still lower than a decade ago overall, still appear expensive. This has been borne out with a fall in the All Ords index over the year. High payout ratios are the only saving grace with managements returning a large percentage of profits to
shareholders as dividends.
Who is in charge? The currency or the stock prices?
The Australian dollar began the year trading at 78c USA. It continued to climb to a peak of 81c at the beginning of February.
From there the AUD has followed a channel downward all year long to finish the year at about 72c, down 8% for the year.
The Dow Jones index began the year at 24824. During the year there were up and down periods but ultimately the index finished the year flat.
The AUD is often viewed as a commodity linked risk currency, which traders move in and out of depending on their appetite for risk. Commodities are traded in USD so it follows that the AUD has to mirror it. One would presume that movements of stock prices should mirror currencies. If it didn’t arbitrage opportunities would emerge whereby a trader could profit by taking advantage of currency/stock price mismatches. History has shown this is often not the case.
Because Kanday is domiciled in Australia and we invest abroad, awareness of currency pairs is significant in the short term.
At one of Berkshire’s annual meetings, Warren referenced a period in 2000-2001 where he felt that Berkshire’s share price dropped way below intrinsic value. I checked and found that in March 2000, BRK.B shares fell to a low of $27 a share, representing a BVM of 1. Historically Berkshire shares have traded at a multiple to book of about 1.4. So Warren was right that Berkshire was cheap. However, an Australian investor would have encountered a AUD/USD pair trading at around 50c at this time. Historically AUD/USD has trended closer to 75c. Because of this, an Australian dollar investor buying Berkshire at 1.5*BVM and AUD/USD 75c would be paying the same price for Berkshire stock as an Aussie investor paying 1*BVM for
Berkshire in the year 2000.
At Kanday we view the natural USD currency hedge from reporting in AUD and investing in US stocks as our main advantage of timing currency pairs. During the GFC when stock prices in the US fell by about 50%, the AUD/USD pairing fell by a similar amount, offsetting the fall in stock prices. This offset is for an investor reporting in AUD.
However, I do note two periods in recent history where this apparent correlation did not hold. As aforementioned, around 2000-2001 the US sharemarket marched ever higher even as the USD soared. And then in 2011-2012 at a time of US stock weakness, the AUD soared to parity and beyond against the USD. Clearly, in retrospect, this was a wonderful time to invest in US stocks.
Over the long run currencies tend to be mean reverting. This means once we have taken a position in a stock, we are generally not too bothered by the impact of currency fluctuations on business performance. Firms also have clever CFOs who are skilful at hedging currency exposures through futures contracts. However, in the short run and when making buy/sell decisions, currency is another variable we are mindful of.
Mohnish on cloning
“Paradoxically, when ‘dumb’ money acknowledges its limitations, it ceases to be dumb.”
Warren Buffett, 1993
Mohnish Pabrai is an American Indian investor who has amassed an impressive funds management track record by following an investment process which tries to mimic Warren Buffett.
Mohnish created a fee structure the same as Buffett’s original partnerships, where he receives no retainer fee, only a fee for outperformance. He likes to point out that many people talk Buffett but in reality don’t act like Buffett. His portfolio is typically very concentrated ala Charlie Munger, holding up to half of the portfolio in just one or two holdings. He keeps most of his net worth in the fund soas to align his interests with limited partners.
But not everything Mohnish does is pure Buffett. He does not hold securities for the long term, preferring to sell when prices have reached his estimate of intrinsic value.
Of particular interest is the way that Pabrai selects stocks to own. He refers to himself as a shameless cloner, not ashamed that he will happily piggyback on the best ideas
of other respected investors. The decision to invest is still his to make, but idea generation can come from any reputable source.
Every quarter fund managers have to list their major portfolio holdings. Apparently if you had bought whatever Berkshire Hathaway held after it was made known to the market every quarter, you would have outperformed the s+p500 by more than 10% per annum over the past 30 years. Or you could have just bought Berkshire shares!
The important lesson is that the share market offers you the opportunity to let other smart, hardworking people make all the decisions on your behalf and as long as
you are prepared to stay the course, you can ride their coat tails to glory all the the while being a no nothing investor.
Compounding re-visited
“I’ve become more aware of time.”
Kylie Minogue on turning 50
Let’s examine the investment returns of Berkshire Hathaway to analyse the importance of the contributions from initial capital, time and rate of return.
In 1980 BRK.A shares traded at $260 per share. By the end of 2018 they were trading at $326,000 per share!
This is a time period of 38 years. Plugging those numbers into a compound interest calculator yields a return of 20.65% per annum.
Now if we play with those numbers a bit, we get some of the following results:
| IRR 20.65% | Initial Capital | End value | Time |
|---|---|---|---|
| 1,000 | 1,250,000 | 38yrs | |
| 10,000 | 1,250,000 | 25.74yrs | |
| 100,000 | 1,250,000 | 13.47yrs |
So, Warren would turn his initial $1,000 of capital into $1,250,000 at the end of 38 years.
But, not everyone has the ability to compound money at 20.65% over 38 years. That is the stuff of investment legend.
So how do we achieve the same result as Warren? Well, we need to maximise those variables which we do have some control over, namely initial capital and time.
You can maximise your initial capital by saving every dollar you can from your earned income and committing it to investment.
You can maximise your time by living a healthy life, eating well, avoiding alcohol and cigarettes and starting your investing journey as soon as possible.
Assuming we can achieve a 10% rate of return, we need to achieve the following to match Warren.
| IRR 10% | Initial capital | Time | End value |
|---|---|---|---|
| 1,000 | 74.85yrs | 1,250,000 | |
| 10,000 | 50.7yrs | 1,250,000 | |
| 33,500 | 38yrs | 1,250,000 | |
| 100,000 | 26.5yrs | 1,250,000 |
If you get some money together early, you can match Warren with a starting sum of $33,500.
Now, what if you could live for longer?
| IRR 10% | Initial capital | Time | End value |
|---|---|---|---|
| 1,250,000 | 5yrs | 2,013,137 | |
| 1,250,000 | 10yrs | 3,242,178 | |
| 1,250,000 | 15yrs | 5,221,560 | |
| 1,250,000 | 20yrs | 8,409,375 |
As you can see, the numbers start to grow pretty quickly. The first one million took around 35 years whilst the second million only took another 5 years. That is the power of compound interest! Whilst Kylie stated she became more aware of time upon turning 50, I think it is because she is focussed on the wrong thing.
In contrast, I suggest that Warren would have been excited on his 50th birthday. The reason is because Warren is focussed on building his compounding machine. Warren’s net wealth was about $200M at the time, quite a sum. But as we know, Warren compounded his wealth at 20.65% per annum for the next 38 years.
So, PV = $200M, n = 38 years, i = 20.65%, FV = ?
Solving for the above yields a future value (FV) of $250,650,394,776!!
Buffett’s wealth today is actually about $90B, so charitable giving and other factors may have skewed the results a little.
What is important to know though is that $200M represents about 0.2% of Buffett’s current wealth.
In other words, 99.8% of his wealth has been accrued after his fiftieth birthday.
Maybe if Kylie was more interested in compounding than her looks then she too would feel great excitement upon turning 50.
Eliminating the dividend debate – creating cashflow through stock investment
One of my favourite bugbears is when I hear people claiming they look to good dividend paying companies for investment.
In fact, unless the firm pays a ‘strong’ dividend yield, they are not prepared to invest in a company.
Berkshire Hathaway does not pay a dividend and $10,000 invested in 1964 would be worth $240M by the end of 2017.
That should be the end of the debate, but even respected commentators often reference that 75% of sharemarket gains
accrue from dividends. In reality it all comes down to the prospective returns on capital for the firm and the capital allocation skills of management. If prospective returns are high then the capital should be retained and re-invested. Conversely low return companies should pay profits out as dividends.
Putting this aside though, you don’t even need to rely on management to make this capital allocation decision. You can make it for yourself.
If a firm does not pay a dividend and you decide they should not re-invest profits, then you should sell some or all of your shares and ‘manufacture’ your
own dividend. For example, if you still like the company but seek a 4% dividend yield, and the company does not pay a dividend, then sell 4% of your shares annually to generate the equivalent cashflow to a dividend. The beauty of this is you can increase or decrease ‘your dividend’ as you see fit.
What about capital gains taxes I hear you cry. Well dividends and capital gains are both taxed and disparities in the rate of tax oscillate with time.
Tax considerations are somewhat beside the point. Just as management needs to allocate profits effectively, the investor needs to consider his capital allocation options.
The bottom line is whether you receive a dividend or not is in your control and not at the discretion of management solely.
This should eliminate the dividend debate once and for all (but I bet it won’t).
Buffett’s 20 punch rule – what he really means
“I could improve your ultimate financial welfare by giving you a ticket with only 20 slots in it so that you had 20 punches – representing all the investments that you got to
make in a lifetime.”
Warren Buffett
I have often wondered what Warren meant when he made this statement. Clearly he himself has made hundreds if not thousands of investment decisions over his career.
Upon reflection, I feel he is referring to choosing only a small subset of companies to invest in. Charlie Munger has always favoured a very concentrated approach to investing and currently holds shares in only three companies. They are Berkshire, Costco and in the managed fund of Chinese fund manager Li Lu.
Warren and Charlie both say that diversification is for people who don’t know what they are doing and holding too many names will lead to average performance and
tracking the index.
So, I suggest Warren is saying only 20 companies will be worthy of a 40yr hold time horizon. Our job is to identify them and concentrate our capital in these companies.
There are myriad benefits of taking this approach. Firstly you only have to make the buy decision once. Capital gains taxes are deferred indefinitely, conferring a 2-3% advantage which can make a huge difference over time.
Warren states that he is looking to buy companies whose operations are not likely to change significantly over time. This is likely where we will find the companies
we can hold for an investing lifetime.
Long term coupon calculation – the Microsoft lesson
I purchased Microsoft stock in 2012 for about $20 / share, anticipating that the company was trading at about 50% of intrinsic value.
From 2012 to 2014, Microsoft’s earnings per share were essentially unchanged. At the same time though, the Microsoft share price doubled to over $40 / share.
A lot of the media at the time was saying that Microsoft had missed all of the major trends in tech including the advent of mobile devices and the shift away from desk top computers. Apple devices outsold Surface by 10 to 1. Microsoft was way behind Google in search with Bing and in social Microsoft was non-existent against Facebook.
Net margins had slipped from over 30% to 23% over the time period and return on capital appeared to be declining.
It was against this backdrop that I elected to sell my Microsoft holding, feeling satisifed about doubling my money whilst holding a declining company.
Then in 2014 Steve Ballmer stepped down as CEO and was replaced by Satya Nadella.
There was one other major theme in tech and that was the advent of cloud infrastructure. Nadella aggressively pivoted Microsoft towards being a cloud centric company
with their offerings being marketed as cloud software as a service. Microsoft’s margins have begun to rapidly recover and profit growth has been re-ignited.
Microsoft was the same dominant company all along, simply needing to adapt their core businesses to the modern era of computing to restore profitability.
Since I sold, the Microsoft share price has increased 150% and I needlessly walked away from significant profits. So how could I have come to a different conclusion
about Microsoft’s prospects. Firstly, tune out the media. Secondly, Microsoft increased revenues from $73B to $87B from 2012 to 2014.
Clearly the company was still growing, albeit now showing improved profitability in the short term.
Dividends were increased from $0.8 per share to $1.12 per share, reflecting management’s confidence that they were on the right track.
Capital spending was increased markedly during this time period as well. And while profitability growth was slowing, it certainly was not dropping precipitously.
So, in summary, Microsoft was exhibiting some negative signs but nothing that should have prompted a sale. Patience in management’s vision was required.
My lesson from this failure on my behalf was as follows.
Assume the long term coupon is maintained if structural ROC is maintained, revenue growth rates have continued and dividend policy is unchanged.
The Microsoft lesson – never stare a gift horse in the mouth and rarely discount a company who is still growing revenue at a healthy clip.
Look at the margins and ROC. Often it is only a matter of time before management reinvestment in the business begins to pay off.
Consensus analyst estimates – are they useful?
Warren and Charlie often refer to sell side analyst reports as useful doorstops and not much use for anything else.
However consensus analyst estimates may be a bit different. Obviously analysts are closer to the news source. So, a smoothed average of their forecasts for near term earnings often are quite accurate. I think that over time being correct on near term forecasts is not that important.
Valuations also tend to look more obvious after the fact. Before the earnings are released though, there is high variability as to what ‘numbers’ to use in making a valuation estimate.
The only safe way to overcome these uncertainties is to focus more attention on the underlying quality of the business and then try and incorporate a large enough margin of safety in your forecasts.
Selling dilemma
Many market watchers talk about when is the right time to buy a stock.
A new challenge arises when you have held a stock for a while and accrued large capital gains.
If the stock contnues to rise well above what your estimate of intrinsic value, then do you sell? What about when a recession hits?
Let’s investigate with a real example.
I purchased shares of CSL (ASX) in 2016 at an average price of $100 per share.
The price rose rapidly shortly after, peaking at $230 in mid 2018.
I knew that the valuation looked stretched at over 40* earnings, but CSL is a quality business with many years of growth ahead.
Since peaking CSL shares have slid back to $175 per share, much closer to my estimate of their current intrinsic value.
| After sale value | Loss | Unrealised CGT | Re-buy risk | |
|---|---|---|---|---|
| Do nothing | 175 | 24% | 18.75 | Nil |
| Sell at $230 | 197.5 | 14% | 0 | High |
| Sell at $210 | 182.5 | 21% | 0 | High |
It appears that the do nothing scenario results in the worst outcome. The up front loss is greatest and there is still a further 8% residual CGT liability.
The most likely sell scenario is 3 where we don’t time the exact peak price before the decline. Excluding the residual CGT liability from doing nothing, we can see that the loss is almost the same. The largest factor in favour of doing nothing is the re-buy risk. Especially if we have a large accumulated position in a stock, it would be quite a challenge to repurchase an entire sold position, especially when timing the re-buy price is another timing event.
It all comes down to how certain we are about the true intrinsic value of the stock and our certainty of the quality and certainty of future cashflows.
Whilst Warren Buffett is known to trade in and out of equities, he never sells any acquired business. During recessions, many Berkshire businesses struggle but Warren supports them through. This approach has worked for Warren and is a core tenet of Kanday.
Ramifications of Apple’s $1T market cap
In September of this year, Apple’s share price peaked at around $230 per share, allowing the company’s valuation to exceed $1T USD.
This is a significant milestone. Importantly at this valuation Apple was still only trading at around 15* 2018 earnings per share.
Warren Buffett often refers to Berkshire’s size as being an impediment to high future returns. Whilst this may be true, a company like Apple has defied this logic for a long time.
What encourages me the most about this though is that Apple’s ability to defy gravity portents very well for many other firms.
Whilst Apple is somewhat unique being able to generate huge revenues along with net margins in excess of 20%, the sheer size of Apple’s business suggests that the runway of growth for other firms and indeed Kanday corp is limitless. Not every industry has the growth potential of tech but the amount of capital available for investment gives me confidence that the world economy is only just getting started and the potential for the future is amazing.
On this note, we enter 2019 excited about the myriad of prospects before us.
I look forward to updating interested parties via our quarterly results presentations.
Yours Sincerely
Marcel Candeias