Sunday, March 17, 2013

Book Review: Free Capital by Guy Thomas

A great review of this book could be found here on Amazon. I agree with the substance of this review, which I have found to be accurate insofar as it describes the book and what to expect.

Nevertheless, this is not a book for inexperienced or new investors.

This book will also disappoint readers trying to find an instant magic formula to making money in the markets.  The writer is clear in his objective of merely presenting the outcome of his interviews with 12 private investors who have been successful in the stock market. What lessons can be drawn from these interviews will clearly be a matter for each individual reader, although the writer also sets out his own thoughts at the end of the book.

To me, the interviews illustrated clearly how each of the investors applied their own strengths and expertise in their investment process, and how their background shaped a large part of their own thought processes. For me,  this is the most important message. To be successful as an investor, you have to find your own way. The general roadmap has been laid out long ago by Graham and Buffett.  There are no secrets except the secrets within each investor.

Disclosure: I received the Kindle version of this book from the publisher on a complimentary basis.

Wednesday, March 13, 2013

Everybody Loves Buffett

Everybody loves Warren Buffett.

We probably have a small contingent of young investors today who all wants to be Buffett when they grow up.  I hear of investors advocating Buffettism and also Mungerism, looking for the great company with a great moat and hoping to sit on it for decades making great compounding returns. And then plonking a huge chunk of the portfolio into a few names. Diversification is out, concentration is in, that sort of thing.

It is good to aim high, but we have to learn to crawl before we learn how to walk. Personally, I think it is much more realistic to start off with a low hurdle. The genesis of value investing started with Ben Graham and cigar butt stocks. From this genesis, there is actually a continuum towards the Munger/Buffett great business at fair value method. And the continuum is not necessarily linear, but presents various pathways.

Buffett, in his legendary article on the super-investors of Graham & Doddsville, referred to an investor who made 21% per annum (16% per annum net of fees) for a total of 46 years. 21% per annum compounding for 46 years is stupendous performance. If you do not believe me, just plug in quick numbers into a spreadsheet or an online calculator and see what $1000 is worth after 46 years of compounding at 21% per annum.

This performance was achieved with huge diversification of portfolio in many stocks, and the basic premise was just to buy cheap and sell at fair value, and protecting the portfolio with wide diversification. That was it. Remember simplicity, consistency and valuation?

The Super Investor in question was, of course, Walter Schloss (RIP).

So without further ado, I present:

Sixty Five Years on Wall Street- remarks by Walter Schloss

16 Factors to Make Money in the Stock Market

Forbes Article- Experience

Monday, March 11, 2013

CMI update

I purchased CMI base on the premises set out in this blog post.

On 19 February 2013, CMI's share price jumped as ASIC sold the overhang parcel for $2.65. The resulting market capitalisation of CMI reached $100m.  being what I estimated to be conservative fair value.

Consequently, I began to prepare to sell. The share price has reached a conservative fair value and more importantly, I was unwilling to stay the long haul with the current management. As I have explained previously, management competency and integrity at these relatively small companies can have a major effect on shareholder value.

On 20 February 2013, we found out that Acorn Capital has emerged with slightly less than 10% holding in CMI. I have great respect for the managers at Acorn Capital, and accordingly, I was prepared to wait until the half yearly result is published and hence deferred my sale decision.

On 27 February 2013, CMI published its half yearly results.  My overall impression was as if management has fallen asleep on the wheels. No doubt Mr Colin Ryan had other more pressing matters to attend to, notably his prosecution by authorities in New Zealand on charges of misleading conduct. Just to backtrack a little, CMI's announcements on 18 and 20 February 2013 did nothing to allay my deep mistrust of this board. If anything, my fears were actually accentuated by the contents of these announcements.

Looking at the results, accounts receivables and inventories continued to increase. CMI has enough inventories for 10 months worth of sales. This is an inefficient use of capital. The tax bill was higher due to an overprovision of $581k in the previous period which ate into cashflow. Only half of debt repaid. Electrical is still making good margins, but margins are decreasing. TJM still making losses of $600k despite a revenue increase, and taking up over $29m of assets. This division should be sold.  

What took the cake was that recently appointed director Stephen Lonie mysteriously resigned without any reason.  

On 27 and 28th Feb 2013, all CMI shares in the incubation fund was sold at $2.65. The gain is 59.6% in slightly under 3 months. Quite a fortuitous windfall considering the circumstances.

As a matter of disclosure, I still own a small holding of CMI in my family account. Unless circumstances change, this holding will also be sold if the share price approaches $2.65 again.

Obviously, this will continue to be on my watchlist. No doubt there are some lessons to be learned here, primarily as to whether assessment of management should be a strict filter, or whether this factor can be balanced off against a deeply undervalued share price.

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.

Sunday, March 10, 2013

Business going for a song (and a one-legged dance)

Imagine that you are the owner of a manufacturing business.

You manufacture leading edge scanning equipment which scans and analyses materials in realtime.  Your customers are operators of cement factories, coal mines, coal fired electricity stations and iron ore producers, and you are proud of your product because it saves costs for your customers. Moreover, it is good for the environment as your machines reduce wastage, reduces electricity usage and increases plant efficiency.

Your business has a history going back to 1981, with a founder hailing from the esteemed CSIRO.  You employ a group of dedicated engineers who has created ingenious products which have been successfully installed in over 1000 locations around the world. Your patents and intellectual property portfolio is valued at over $1m. Your business has weathered the turbulent economic climate for over 3 decades, and most recently has emerged from the GFC unscathed.  Your bank is flushed with cash of over $5.2m, and you  own your own factory valued at $4.43m, with a $2m mortgage on it. Other than that, you owe the banks nothing.

Your business has had its up and downs, but nevertheless the business has generated profits for the last 7 years, even through the trough of the GFC. You have build up net value from under $5m all the way to over $10m in 6 years, despite generously returning over $1.7m in capital to all shareholders last year. Business is good, with a backlog of orders. on the books. You will probably make about $1.5m to $2m this coming year.

One day, some hotshot investment banker walks into your factory. He takes a look around, and says that he will offer to buy your business, your factory, your IP, your management team, on a walk-in walk out basis for $8m. He figured that you have $5.2m in the bank, $4.4m worth of real estate property and a mortgage debt of $2m, which comes to roughly $7.6m, and he says you can keep the change.

Would you agree to sell? Chances are you would tell the banker to go to hell. The offer is insulting. Even if you make only $1.5 m per year after tax, you would probably be asking for $7m at least for the business on top of the cash and property values. A realistic offer to start talking would have to be in the vicinity of $15m.

For some curious reasons, even with exactly the same situation, things work slightly differently in the sharemarket.

On 11 March 2013, Mr Market is kindly offering me a slice of Scantech Limited (SCD) for 45 cents. With 17.6m shares on issue, plus about 1.7m worth of options exercisable at prices of 70 cents and above, the undiluted market capitalisation of SCD at 45 cents is $7.9m.

This is the 90 seconds pitch to buy SCD:

“As at Dec 2012, SCD has $5.2m of cash in the bank. It owns a factory valued at $4.4m, and this factory has a mortgage securing $2m. Cash and property less debt totals $7.6m. At 45 cents, SCD has a current market cap of $8m. At this price, the business is valued by the market at just $400k. The business has been profitable for the last 8 years, and generated cash of $50k and NPAT of $260k last half year. The company manufactures and supplies equipment which analyses compositions of materials in realtime on conveyor belts. The equipment is used by companies in bulk commodities such as cement, coal and minerals. The order book is increasing and stood at $9m as at Dec 2012, and importantly service revenues are starting to catch up with equipment sales. Management owns a substantial amount, and navigated the GFC without making at losses or raising any capital. In fact, they did so well that they returned $1.7m to shareholders as a capital return in 2012. Management has given guidance for a similar result in 2013 as 2012, which is about $1.7m of NPAT.”

This is the 90 second pitch against buying SCD:

“The company owns the factory and therefore does not pay rent. Let’s assume the company sold the land and leased it back at market rates. As industrial property is valued at yield, taking a conservative 8% yield on $4.4m yields a yearly rental expense of $352,000. We credit the finance costs of $130,000 per annum (since the $2m mortgage is no longer required) to yield a net expense of $222,000 impacting the bottom line. This virtually wipes out half of the half yearly profit to $150,000, and puts the company into cashflow negative for the half.  In this scenario, the company will have $7.5m of cash, and a business barely breaking even.  We should assume mining capex is decreasing going forward, and thus 2012 and 2013 will probably be peak revenue for SCD. $8m is probably a correct fair value, being $7.5m of cash with a nominal amount of $500k for the business which has historically erratic margins, net profits and cashflow.”

The critical investment issue with SCD is just simply, is the business worth more than $400,000 and if so, how much is the business worth? The problem with the negative case is that the first half is traditionally the weak half. SCD sold 11 machines, but is contracted to deliver 17 machines the next half. So we can be reasonably confident that figures for the full year will be respectable, probably above $1m in NPAT.  If we average out NPAT over the last 7 years, we get average NPAT per year of $850k per annum. A conservative 6x multiple for this equates to $5m. These are conservative, and we can easily mount an argument for the business to be valued at $8m. If this is so, addition of cash and property yields intrinsic values of $15m to $16m, double the current market cap, thus achieving a 50% margin of safety.

The downside to SCD is adequately covered by real cash and hard assets. The cashflow of SCD is also covered by an increasing stream of service fees. Service fees have increased steadily from $1.9m in 2006 to $4.5m in 2012, and the only year it has dropped is 2011 by a mere 10%. As the installed base of equipment gets larger, service fees will form an important buffer to earnings going forward. Another investor has pointed out that any decline in mining capex will not have a major impact on operating mines which will concentrate on production efficiencies, thus increasing opportunities for SCD.

Enjoy and prosper.

Disclosure: The author owns shares in SCD.

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.

Tuesday, March 5, 2013

Simplicity, Consistency and Valuation

Knowledge is timeless.

This piece of lucid and erudite wisdom from 1981 by Dean Williams.

I read it when people say "this time it is different" or when I reach for spreadsheets.

Enjoy and prosper.