Wednesday, November 14, 2012

A Post Mortem of a Fairy Tale

On 5 October 2011, the Motley Fool Australia kindly published an article written by yours truly.  You can find the article here:

The Fairy Tale
A portfolio of the 5 small cap shares I mentioned has not done too badly in the intervening 13 month period. The five shares are AMA, IFM, UOS, KNH and ZGL. If an investor has allocated $10,000 equally to these five shares on the date of my article, the portfolio will be worth $14,838 today, and this does not include any franking credits attached to the hefty dividends from AMA and IFM.  A satisfactory 48% per annum return.

As a matter of comparison, the benchmark All Ordinaries Index returned about 6% during the same period.

The Reality
So much for the hypothetical portfolio.  What actually happened in reality?

AMA was bought in two tranches with average entry price of 11.8 cents. About 20% of portfolio was allocated to AMA.  It is still being held today with a gain of about 215% on initial stake.

IFM was never purchased. To put this omission into perspective, IFM could have been bought for below 20 cents, and it is now selling for 35 cents after paying 2.4 cents of fully franked dividends. That is an 87% gain thrown away.

KNH was bought for 23 cents.  About 2% of portfolio was allocated to KNH. It was sold for 20 cents after publication of its annual results in February 2012, in the wake of massive diworsefication by management into unrelated low margin businesses, and a rapidly deteriorating financial position. KNH trades at 13 cents today. The loss was about 13% of initial stake which would have ballooned to 43% if held till today.

UOS was purchased at 34 cents. About 4% of portfolio was allocated to UOS. Gains from share price appreciation, capital returns and dividends total 14 cents, resulting in a gain of about 41% of initial stake.

ZGL was purchased in two tranches with average entry price of 26 cents. About 10% of portfolio was allocated to ZGL. It was sold in February 2012 for 22 cents for a loss of about 15% of initial stake. The sell was prompted not only by deteriorating business conditions, but also due to increasing unease over management’s self-interested actions and late disclosures of bad news on projects in hand.

Overall, the total gain is about 110% of initial portfolio stake. The gain is still sitting as unrealised gains in the two remaining shares being held, namely AMA and UOS.

The Lessons Learned

I need to have the courage of my convictions. The sad omission of IFM resulted in outsized gains being missed which would have vastly improved the returns.

Buy and hold does not mean buy without regard to valuation and holding on blindly. The 5 shares were picked based on valuation, and the hypothetical portfolio shows that even if an investor held blindly until today, the gain is still a satisfactory 48% per annum. By not holding blindly and following the companies closely and continually doing due diligence, further losses in KNH and ZGL were avoided.

A concentrated portfolio is risky if I lack competence in judging the quality of a business. When these 5 shares were selected, I remember being equally optimistic about all 5 of them, with the least optimistic being IFM, resulting in its sad exclusion. Yet I choose to concentrate my holdings on AMA. In hindsight, this was a mistake despite the great outcome. I had no real rationale why AMA was preferable over the rest, I could have concentrated my holdings on KNH and suffer some significant losses.  The hypothetical portfolio assumes an equal weighting, which returned a lower result, but is still more than satisfactory with much less risks involved.

Management matters a lot more than I initially assumed. It is a very rare business that could withstand the ravages of bad management. AMA had the guidance of Ray Malone, a man of discipline and integrity, even though the business did have some industry tailwinds. UOS continues to benefit from its management of several decades of experience. IFM staged a turnaround with the return of founder Richard Graham to the helm. On the other end of the spectrum, KNH was skewered by bad diversification choices from management. ZGL’s management lost the confidence of the market when they belatedly disclosed problems that should have been apparent much earlier.

Disclaimer: the content of this post is not to be relied on as financial advice.  It contains my personal opinion only, plus facts that I cannot verify to be accurate.  Do your own research and seek financial advice where appropriate. I have made many mistakes in the past, and will continue to do so in the future.

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