Reporting Season

Dear Readers

Reporting season is nearly over.

I have now read over 100 reports in less than 4 weeks.

My main focus this reporting season is to ensure I don't get lost in short term details.

By and large, there are few surprises. Even Forge was not a surprise. I counted at least three other investors who saw the warning signs and exited at much better prices than me.  One of these investors is an eighteen year old student, who published on his blog way back in June 2013 the exact reasons why FGE is likely to have a nasty ending. To have a better view, it is not always necessary to step on the back of giants.  Mere mortals will do.

The FGE fiasco, judging by the postings on the Hotcopper website, contains many important lessons. The first of which is to be wary of the lure of quick money. Even so-called professionals were not immune from the deathly siren call. Ill-gotten quick gains from lack of toil and effort have a corrosive effect. 

The second lesson is to be wary of the power of incentives. He whose bread I eat, his song I sing. There are many worshippers of Mammon.

The third lesson is to be aware of our psychological tendencies to do stupid things. This is ungodly important. To name just a few- anchoring, confirmation bias, "house money" effect, ownership bias, super-deprival syndrome, consistency bias, etc.  All of these are evident with just a quick perusal of  the FGE thread on Hotcopper.

Back to reporting season. Darling status prices appear to rule the day. Quite a few names are valued as if their earnings will increase 20% per annum on a compound basis for 10 years. For example, FLN with annualised net profits of $1m (and negative free cashflow) is now worth $600m on the ASX. IIN with an enterprise value of $1.5b compared to free cashflow of $40m is valued at similar lofty levels. There are many other shares priced at growth rates exceeding 15% per annum for the next 10 years.  There are even some shares yet to make any money priced at giggle levels- witness IPP and XRO.

Investors are no doubt making comparisons with market darlings such as SEK, REA, and CRZ. The buzzword of the season appears to be "network effect". A prospect may be the next SEK or next REA, and if so, then the share price will grow to the sky. There are many problems with this sort of rear-window reasoning and comparison.  For starters, I have yet to see the next CSL.  Or the next FLT.  The other major problem is that investors are not asking whether current valuations of the market darlings are realistic when they automatically stick the same multiple on the johnny-come-latelies.

But hey, don't listen to me.  I am only the One-Legged Investor.  How about learning from Uncle Warren himself?

"But for a major corporation to predict that its per-share earnings will grow over the long term at, say, 15% annually is to court trouble.


That’s true because a growth rate of that magnitude can only be maintained by a very small percentage of large businesses. Here’s a test: Examine the record of, say, the 200 highest earning companies from 1970 or 1980 and tabulate how many have increased per-share earnings by 15% annually since those dates. You will find that only a handful have. I would wager you a very significant sum that fewer than 10 of the 200 most profitable companies in 2000 will attain 15% annual growth in earnings-per-share over the next 20 years."

(Source: BRK Letter to Shareholders 2000)

An expected rebuttal to the above is that Buffet was only referring to large businesses.  It does not apply to small companies. There is probably some truth in this.  Both Buffet and Munger have repeatedly said that concentrating on the small cap arena is likely to yield outsized returns for small portfolios.  Buffet even guaranteed 50% returns for any portfolio below $1m.

A small business growing too quickly faces numerous problems. There are operational problems. Staffing problems. Lack of skills. Competitors. But it is certainly possible to "get them while they are small" (see Munger "The Art of Stock Picking"). The issue is how much to pay. For me, it is precisely bonkers to pay a price reflecting near perfection of a 20% pa CAGR growth trajectory.  In this case, I may get to win big if growth actually exceeds 20% pa.  But what if things go wrong, or even things going well but just not 20% pa?  Would it not be much better to pay a price reflecting modest growth, or even no growth at all, and then let the upside take care of itself?

Most investors will see this argument as the divide between so-called "growth investors" and "value investors". In reality, it is just a simple issue of valuation and protection of capital.

Yours Truly,
One Legged