Thursday, March 6, 2014

Recent Thoughts in Brief

The more things change the more things remain the same.

I remember back in the late 90s where companies with no earnings burning through cash were trading at market valuations above companies which actually made profits and paid dividends. At one stage, was trading at twice the market value of Vision Systems. I shook my head in wonder, shrugged and moved on.

Nearly fifteen years later to the present, it appears that things have not really changed much. For example, XRO is now valued at $5 billion dollars, and yet the company is burning through cash like there is no tomorrow. The software contains nifty features, being operated in the cloud with crowd-sourcing features in its error systems. Read more about it here from Bronte Capital.  There are many rave reviews, and it has some serious investor backing. NZ and Australian fund managers are scrambling to get a slice of the action as they are now underweigh XRO which has become a significant part of the indices. Even the good old Motley Fool has chimed in to say that this stock has huge potential, making it the number one technology stock pick.

Then we have IPP, valued at $500m as the market superimposes and projects the trajectory of REA onto this relative minnow. The excitement is understandable if one sees REA currently valued at $6.8 billion, about close to a 50 fold increase over 10 years.  My problem is that REA needs to grow its free cashflow at annual compounding rates approaching 25% for ten years to justify its current price. The market cap of REA is about 34x operating cashflow. Mr Market appears not to be too concerned about this small little detail. Drink and be merry, for who cares what tomorrow brings?

I can cite many other examples, but I am too lazy to do so in this blog post.

On the other end of the scale, we see many companies sold down severely upon news or perception that earnings will not be flying to the sky, at least not within the next 12 months. The mining services sector is now the whipping boy of the ASX, much like what happened with financials, retail and media in the past few years. The malady is not restricted to the mining services sector. The fact that some of these businesses (especially mining services company) will likely survive and thrive in the future is not considered at all, let alone factored into any sort of valuations. Share prices are sent to the sin bin if there is no promise of earnings growth within the next 12 months, or if there is no compelling story.

Several examples suffice, with names withheld to protect the innocent. There is a company, whose business has significant tailwinds, who irritated Mr Market when it said there is too much business and the company needs to spend some money to ensure it has better processes and staff in place to handle the volumes. As they will be expensing all of these spending, short term profits will be affected, even though revenues will keep increasing. This name is now trading at less than 10x cashflow, with 30% of its market cap comprising of cash in hand. Even with the spending and payment of dividend, there is still free cashflow retained. There are two possible outcomes- the spending initiative pays off and free cashflow increases, all of which will continue to swell the bank account which is already swollen with cash. Or the spending initiative is not fruitful and management stops spending. As management already holds a big shareholding, the likely outcome is apparent.  Whilst I wait, I am receiving 3.4% of my entry price in dividends every year. Even if there is no growth, I will not be losing any money. If there is growth, I get it all for free.

Another company also suffered the same fate as the company described above. Mr Market assumed this company will die an inglorious death. Bear in mind that even though this company has cash comprising about 1/3 of its market cap, Mr Market will still sell this to you at less than 5x normalised cashflow.

There is another company with monopolistic assets. Mr Market is unhappy because He cannot see any growth and concerned because the company was impacted by adverse environmental and weather conditions which affected its earnings. This company is trading at 10x cashflow. It pays a 5% dividend even from its currently depressed state.

Another company which I am looking at incurred the displeasure of Mr Market last year when earnings stalled whilst it was integrating some acquisitions. Even though the last half yearly produced a sterling result, the company is still trading at less than 10x cashflow. It has no debt and has recurring revenues streams unlikely to be disrupted in the future.

From a broad perspective, it is not the case that investors are not focusing on risks.  They are. What is apparent is that investors are not factoring both risk and return together. Investors in the current climate either discount for risks severely without factoring in upside of possible returns, or they will pay a premium for potential returns without discounting for possible downside risks. Just have a look at any broker research reports.  You will likely find a nice table with earnings progressing up every year. This is a vivid illustration of linear thinking aka one track mind. Real life in business is much more messier than this. A Bayesian approach is the most appropriate, but I have seldom seen this applied in any brokerage reports, let alone snippets and articles in investment newsletter.

The Chinese are pretty big on the concept of yin and yang.  The basic lesson is one of maintaining a correct balance, which is where good judgment is called for.  Balancing risk and return is a basic requirement for any successful person in business. The same applies to investing.

Lastly, here is one simple tip: if you do not see a valuation anywhere in any report, tipsheet or article recommending a particular stock, keep your cursor away from the BUY button.

Yours truly,
One Legged


Stefanie said...

Hi Peter,

Thanks for the great article. As a beginner, I find your article clear and simple to understand. Do you mind giving me the names of the companies mentioned above so that I can do some research please?

Many thank,


Peter Phan said...

Dear Stefanie,

Thank you for your comments and inquiry. I have deliberately chosen not to disclose the names of these companies. There are not that many companies on the ASX which are cashflow positive. Going through the 2000 plus names on the ASX one by one is a very good way to find some treasures on your own.

One Legged

Stefanie said...

Hi Peter,

Thanks for your encouragement. I have spent quite a long time finding out about the companies you mentioned. Just want to see if I get them right:

NWH,COF,CDA???,AMA respectively.

Can you give me extra clues on the third company and is it a mining service company?

Kind regards,


Anonymous said...

Hi Peter
Just to let you know I value your blog, but am not showing as a follower because I can't be bothered with Facebook.
PAul in NZ

Peter Phan said...

Hi Paul, thanks for the support. I think you just need to join Google plus to follow. I dont use Facebook either.

Anonymous said...

i,or, we too follow the blog and a number of others but because of wanting to be private we do not subscribe to any universal cloudy database thingys that need a log in name.. we are shareholders in the private investment company though:) i expect there are many others who read in as well... keep blogging Peter it is always interesting..

Peter Phan said...

Dear Stefanie

Those are incorrect. Only one company has half of its business exposed to mining services. The company with monopolistic assets has debt, and the other three companies have no debt. I encourage you to keep searching (and sharing if possible), because you will eventually end up with a list of companies that are cash rich, no debt, positive cashflow generation and trading at below multiples of 10x cashflow. Ideal place to start for a beginner.

To 2nd anonymous, yes, Google is really not handling privacy issues well. John Hempton has talked about this issue several months ago, concerning public access to children's locations. Thank you for your support and readership, I dont usually have much to say, and I dont write very well, so I end up having many many thoughts in draft form which will probably never get published.

Anonymous said...

I can think of one such company that fits the description but while cash rich at the moment, you need to stress test the business (the figuring out how a fish would swim in different currents rather than predicting what the current will be) scenario similar to FGE could see all that cash walk out the door.

While it hasn't happened - yet - the odds of such an event rise and leads to higher increased probability of permanent loss of capital. It's a somewhat left field event but I can see why someone would swing if they are aware of that risk.

Peter Phan said...

Thanks for the comment anonymous. The basic filter is the same that Buffet uses via Rule Number 1- anything with a likely possibility of going to zero is rejected.

Understanding the business model is vital.

The general details of the 4 mystery companies are as follows in no particular order:

1. Company one has assets which cannot be replicated at all. Customers are diverse, numbered in hundreds of thousands, with a significant chunk of the total market. Even though it has debt, the debt will always be on best terms and very unlikely to be called upon.

2. Company two has long term revenue streams from a diverse range of customers, aided by tailwinds and trends that could easily be accessed through public databases. No debt, fat margins, low capex, positive cashflow, lots of cash, big insider ownership.

3. Company three has recurring revenues from a diverse range of customers, providing a service that is deeply embedded in the customer's business process, hence occasioning very costly switching costs. No debt, fat margins, positive cashflow, low capex, big insider ownership.

4. Company four is similar to company three. It has recurring revenues from a large number of independent customers, providing a service which is deeply integrated into the customer's business process, with very high switching costs. No debt, fat margins, low capex, positive cashflow, big insider ownership.

None of the above share any similarity with FGE, which features zero management ownership, very low margins, high capex, concentration of customers, heavy debt, no recurring revenues, and no competitive moat.

Anonymous said...


Anonymous said...

Hi Peter, I am deeply intrigued by the 4 companies puzzle :) could u hint just a little bit by telling the mkt cap range? Could u recommend a data sourest where information such as net debt is easy to use as screening criteria? I use eTrade and the screening tool is pretty poor... Or do actually go through the 2000 companies yourself?

Thank you.

Peter Phan said...

Every Tom Dick and Harry is doing screening. There is no competitive advantage if everyone does the same thing using the same tools.

And yes, as i have published before, I go thru the whole list, starting from A. I am now going through the list again for the third time.

The prices for these 4 companies are now different, not by much though. I sincerely believe that their identity is irrelevant. My aim is to deliver a specific message, not publish stock tips. Plenty of newsletters fill that role much better than me.

If my message leads you to find a company with similar characteristics which is within your own circle of competence, my objective would have been achieved. And you would probably have gained much more than just monetary profits.