Xero and Intuit follow up

Xero recently published its half year report, so it is time to update our figures. The following table summarises the salient metrics:

	2014	2015	2016	1H2017
Revenue	143m	207m	295m	187m
COGS	30%	24%	23%	20%
R & D	50%	48%	41%	49%
General	20%	15%	13%	11%
Marketing	75%	72%	56%	38%
Total	175%	159%	133%	118%

Once again, the figures are headed in the right direction. Although the company announced operating cash flow positive, adding in the impact of capitalised R & D still resulted in cash burn of $34m, leaving roughly $84m left in the bank, implying a steady runrate of just over 1 year. 

As a matter of comparison, let's look at Intuit's 2017 metrics:

Revenue USD$5.18 billion up 10% from 2016 (note: XRO growth is much higher)
COGS 15.6% of revenue
R & D 19% of revenue
General 10.7% of revenue
Marketing 27.4% of revenue
Total 72.7% of revenue (versus 74% for 2016)
Operating cashflow= $1.6 billion

The current market cap for XRO is roughly NZ$4.6 billion (a rise of nearly 45% since my last update). Still too rich for my taste. As a matter of comparison, Intuit's market cap is currently USD$39 billion.

Pip Watching

Imagine a hypothetical portfolio. This portfolio has a very healthy performance of 15% pa. The volatility/variance of this portfolio is roughly 10% per annum. Despite this, the probability distribution of price moves for any short time periods between one second to one day is just slightly better than 50-50. If an investor is assiduously following the price moves of this portfolio more than once per day, the statistical expectation is not much better than watching the outcome of a flipped coin.

Various studies have shown that the emotional impact of a loss is nearly 2.5 times the impact of a gain. Accordingly, the consequence of pip watching is net emotional deficit. And the absolute net impact gets bigger with increased frequency of pip watching, and also increased number of portfolio positions.

Bear in mind that 15% pa with 10% variance over a long period of time is a great performing portfolio. This means that a lesser performing portfolio will not be any better for the constant price checker. It may in fact be far worse. Further, there is also a feedback loop in place. The net emotional deficit may feed through into deteriorating performance, which will increase the emotional deficit, leading to a vicious cycle. At the same time, the random nature of punishment and rewards in pip-watching gives rise to addiction similar to the process in gambling. 

The physical consequences of chronic stress from pip watching include high blood pressure, diabetes, hormonal imbalances, possibly brain damage, eye problems and a whole other variety of ailments. An investor that keeps at this bad habit for long periods of time may actually be accumulating money at the expense of health. Wealth, happiness and well-being arise from a well-lived life, not just the bank balance at the end.

In other words, pip watching can severely affect your health, and also your wealth. 

Don't do it.

Stay healthy, enjoy and prosper,

Yours One Legged

Howard Mark's recent G & D interview quotes

I enjoy reading the Graham-Doddsville newsletter.

Here is the latest one.

Some pertinent quotes, relating to the issue of indexing and quantitative/AI factor.

Howard Marks:

“If people take their money out of active management, then active managers would fire all their analysts, and then the market would not stay efficient. Then the necessary condition is satisfied for active to work. The point is, I don't think this move is permanent, I think it's rotational.”

“Because every dollar that goes into a truly passive fund is invested on autopilot, the fund must buy the stocks that satisfy its criteria, and that’s without regard to value. That suggests to me that prices can go farther in diverging from value before they get corrected. Think about what would happen if 95% of the money went into index ETFs or index funds. Who would be setting prices? There’s something called price discovery, and it’s done by thoughtful buyers and sellers. The price of a security in the marketplace is set by buyers and sellers coming together, and seeing if they can find a place to transact where the buyer thinks it has good upside, and the seller thinks it doesn’t. Who provides that function if all the buying are on autopilot? People put their money in index funds, with the presumption that they’re minimizing error, but how much of your money do you want to have managed in a fund where nobody’s thinking about the price of the stocks or the weightings within the portfolio? The thing about investing is that the efficient market hypothesis says that price equals value. Active management is about the assumption that price sometimes deviates from value, finding those deviations, and then taking advantage of them. It seems to me that the fewer the people who are looking at value, the higher the likelihood that price can diverge from value. But that’s just a hypothesis.”

“None of this stuff is easy. The greatest quote in my book is from Charlie Munger, who said, “None of this is meant to be easy, and anybody who thinks it’s easy is stupid.” All this stuff is really complex. It’s easy to talk about, but it’s hard to implement. How do you tell the ones who are good but unlucky, from the ones that are bad? It’s not easy. It takes judgment. That’s why I believe that this whole thing can never be completely computerized, because I think exceptional investment success requires judgment, and I don’t know if AI can be taught to make those judgments.”

Dear readers, any thoughts?

Yours One-Legged

Book Review: Big Money Thinks Small

https://www.amazon.com/Big-Money-Thinks-Small-Publishing-ebook/dp/B0743JNFBZ/ref=tmm_kin_swatch_0?_encoding=UTF8&qid=&sr=

An interesting read. In terms of concepts and philosophies, the reader will not find anything new that was not encountered before if one has been constantly reading up on the topic of investment.

The author ties together concepts of value investing augmented with experiences and practical applications of financial history and behavioural psychology. The main takeaway for me is his account of the travails of Dendreon and the dangers of investing in a "story." To summarise, Dendreon was a biotech which developed a treatment for cancer. The main bull story for Dendreon was that once FDA approval is obtained, earnings will rocket to the sky. The ending was that Dendreon did actually obtain FDA approval, and its share price went up tenfold, however sales were disappointing and the company eventually declared bankruptcy!

There are several stocks on the ASX in which investors are clearly enamoured with the "story", the most vivid example being Mesoblast.

The author also addressed the issues inherent in indexing, factor investing and macro investing.

The only gripe I have with the book is that it could be better organised. The way it was written looks more like a stream of thought cobbled together hastily without any overarching framework.

A reminder that there is a library of my reading here.

Enjoy and prosper
Yours One-Legged

Book Review: Priceless

https://www.amazon.com/Priceless-Myth-Fair-Value-Advantage/dp/0809078813

This is a very entertaining and easy read. Not much prior background knowledge required, but you will gain a lot more insights if you do.

Specifically relevant to investing, you will gain an insight as to why price trends occur in all markets, how and why market bubbles form, and how/why this has and will repeat themselves.

The reversal preference experiments show clearly why many investors (including myself) hang on to losses and cut their winners too early.

The anchoring and adjustment experiments will be known to many of us. However, I think many will miss the essential lesson- being that anchoring and adjustment is an artifact of guessing. With investing, there will always be a degree of guessing, so the challenge is to be able to deal with effects of anchoring and adjustment.

Enjoy and Prosper

Yours One-Legged

Musings on Passive Investing via Index Funds

The Basic Proposition

As per Buffett and Munger, Indexing makes sense if you do not know what you are doing. In aggregate, active managers cannot achieve a result better than the index. In fact, given the extreme skewness of the stockmarket, it is virtually guaranteed that over a long period of time, a majority of active managers will never do better than the index, especially after deduction of significant fees. Given that all long term records of stockmarkets show an upward trend, it makes sense to be invested in the whole market rather than betting on its discrete elements, especially if the attendant costs/fees involved are much lower.

The Problems

The first problem with indexing is that the market is self-correcting, and too much of a good thing becomes a crowded trade. Indexing becomes a problem when too much money is chasing after it. If this happens, prices are no longer tethered to values, and you will have a situation where asset prices rise purely because they are rising and vice versa. This means that asset prices no longer reflect actual business performance, which is unsustainable. Conceptually, index funds are intended to passively track the index. However, if too much funds are involved, the fund inflows by themselves will have a significant effect on the index levels. Index funds will no longer be passively tracking the index, rather, they would be a major factor affecting the index.

The second problem with indexing is the wide sweeping assumption that everything tends to average. An often used marketing angle of index funds is that a majority of fund managers cannot beat the market.  This is true, but it fails to address the main issue of how to select a fund manager who is capable of beating the market. A system with average values will often have wide non-random variability between its system participants. There are persistent winners, and there are persistent losers. Try to remember the kid that always comes first in class over your entire experience of primary and secondary school. And don’t forget the one that comes consistently last. We ask ourselves why? In every field of endeavour, there is a pecking order which is inviolate, and the top and bottom can often be identified very early in advance. Proponents of indexing sweep this away under the carpet.

The third problem with indexing lies with its basic proposition that equity markets inevitably rise over time, ostensibly at a steady rate of 7% per annum. This is true over a truly long time span, say 60-100 years. The reality is that market returns in discrete periods fluctuates greatly. The following are US Equity returns during the Post-War period:

1946-2012 6.4%

1946-1965 10%

1966-1981 -0.4%

1982-1999 13.6%

2000-2012 -0.1%

An investor invested in index funds in the year 2000 would have had made a loss over the next 12 years. The critical message- unless your investment horizon is truly long term over at least 50 years, there is no guarantee that index funds will do well.

The Consequence

Human behaviour and the power of incentives will ensure that so long as investors want salt, they will be sold salt. It is not in the best interest of promoters and managers to sell a single index fund where investors are encouraged to stay invested indefinitely with no churn. If there is no activity and no churn, how are they going to earn their bread? Marketers know the basic behavioural problems of average investors and they will act accordingly, leading to a proliferation of different ETFs.

Investors want choices because each of them believes they are above average investors able to make superior choices than the average punter- hence a proliferation of ETFs will be created to satisfy this demand. If enough people want an ethical ETF which promotes social notions such as gender equality or white supremacy, then the market will surely create this ETF to satisfy demands. Given that the average investor is also unable to sit still and clamor action, there will be plenty of different ETFs to satisfy the need for action.

Investors are also greedy, so leveraged ETFs are created to turbo-charge returns. After all, over the long term, the sharemarket only ever rises.  Investors are also envious creatures. They will not be happy with a steady 7% per annum with a vanilla index fund when their neighbours are raking in 15% from the latest triple leveraged ETFs. Leveraged ETFs will then be in hot demand. 

As investors race up the risk curves, the market will continue to create products to satisfy this demand. Pretty soon, derivatives of ETFs will be created, and then further derivatives. They will all be marketed with great endorsement and validation- virtually assured returns with very little risks involved- whilst the promoters rake in fees and bonuses.

Does this sound familiar to you?  How would all these end?

The Solution?

In the tradition of Fermat, I am nearly finished with my suggested solution, but [insert suitable excuse].

Stay tuned. 

Yours One-Legged

Xero Follow-Up

Xero published its full year report today, so it is time to update our figures. The following table summarises the salient metrics:

	2014	2015	2016	2017F
Revenue	143m	207m	295m	410m
COGS	30%	24%	23%
R & D	50%	48%	41%
General	20%	15%	13%
Marketing	75%	72%	56%
Total	175%	159%	133%

Once again, the figures are headed in the right direction. Cash burn is still $71m, with $114m left in the bank, implying a steady runrate of 1.5 years. 

As a matter of comparison, let's look at Intuit's 2016 metrics:

Revenue USD$4.7billion up 12% from 2015 (note: XRO growth is 44%)
COGS 16% of revenue
R & D 19% of revenue
General 11% of revenue
Marketing 28% of revenue
Total 74% of revenue

The current market cap for XRO is roughly NZ$3.2 billion. Still too rich for my taste. As a matter of comparison, Intuit's market cap is currently USD$33 billion, trading on a historical PE of 33.

Stock Picking and Reality

I am currently gathering my thoughts on the current hot issue of passive investing via index funds. I have written quite a lengthy article which is not quite ready for publication yet.

This short blog post will appear to be another nail in the coffin for active investing.

It is not intended to be.

The main purpose of this post is to point out that the truth, as usual, is rather more nuanced than the black and white propositions presented daily in the press.

If you are a stock-picker or aspiring to be one, then it is imperative to understand the monstrous task required. Stock returns over the long term are extremely skewed. Crazily so. Studies of the US market appear to indicate that only 4% of stocks accounted for the entire market gain over the period starting from 1926 to 2015.

The relevant blog post with the article link is here.

These means that a randomly generated portfolio (the monkey dart theory) will fail to beat the market 99% of the time. It is now also easier to understand why active management, in aggregate, cannot beat the market. In fact, it is a logical inference that when the active management industry, in aggregate, gets larger and larger, it is doomed to fail in its collective quest to beat the market. That is likely to hold true even if we disregard fees.

It does make the case for passive indexing even stronger.

But that is not the entire story. Stay tuned.

Yours One-Legged

p/s astute readers will get a hint from the above. Just as nature abhors a vacuum, the market appears to abhor a crowded trade.

Book Review- Where Good Ideas Come From

My brief thoughts on reading this book:

New ideas arise from a synthesis of ideas, usually from unrelated disciplines. They do not just come out from a vacuum.

Connection of ideas within a body of ideas require a reasonably large body of ideas to start with, and the body of ideas must continually expand, hence requiring continuous learning.

But since the existing store of human knowledge is so vast, we. need to pick our spots. Distant ideas are more difficult to connect than adjacent ideas. Looking back, most if not all of my profitable ideas arose because of a synthesis of prior work. 

Relates back to circle of competence.

Giverny Capital Annual Letter 2016

Here is the link to Giverny Capital Annual Letter 2016. 

Excellent writing and clarity as usual.

I will post comments later, if any.

Li Lu 2015: The Prospects of Value Investing in China

Note: Do not skip this post even if you are not interested in investing in China. You will be much the poorer for it.

This is a translated version of a talk given by Li Lu in 2015 at Peking University.

Readers might know that Li Lu is one of the few managers that Charlie Munger has invested with.

The transcript is a rare gem as Li Lu does not publish a lot.

In the great tradition of multi-disciplinary learning, it is apparent that Li Lu has drawn upon and synthesised a lot of major ideas from other areas. I am sure I will not be able to identify everything, but I can see ideas from Yuval Harari and Jared Diamond clearly being applied.

Enjoy and Prosper
Yours One-Legged

p/s It appears that the link to the document no longer works. If anyone wants a copy of the talk, please email me.

UOS another year

The juggernaut keeps on rolling, despite some currency headwinds:

	2H16	1H16	2H15	1H15	2H14	1H14	2H13
Cash	$398m	$462m	$487m	$469m	$400m	$353m	$435m
Receivables	$218m	$230m	$196m	$179m	$169m	$171m	$158m
Inventories	$385m	$416m	$395m	$388m	$358m	$348m	$310m
Land held for property development	$143m	$134m	$123m	$84m	$84m	$26m	$22m
Property plant and equipment	$94m	$100m	$57m	$61m	$62m	$57	$28.2
Investment properties	$823m	$718m	$668m	$683m	$679m	$621m	$649m
Total of Asset Items above	$2061m	$2060m	$1926m	$1862m	$1752m	$1576m	$1602m
Total liabilities	$460m	$488m	$486m	$435m	$367m	$333m	$344m

Transcript of Charlie Munger's DJCO meeting 2017

Here is this year's DJCO transcript.

My learning from giants continue.

The author has already highlighted the important points, so I will not repeat them here.

It is currently reporting season, and things are looking pretty pricey. DLX 30x, RWC 30x, COH 35x, IVC 30x. I look on forlornly and cannot help thinking that the number 30 is this year's financial equivalent to fashion's black. It is a perilous environment, as things trading at 15x starts to look interesting, just when cash is starting to pile up. This is an example of how our brains are wired to think and judge matters on relative terms, rather than on absolute terms. Pretty soon envy will be driving market prices, as everyone strives to do better than the Jones'.

The make-up of the market comprises of over 90% of spots where all capital goes to die, and only a handful of spots where capital is protected and thrives. If you avoid the bad spots, you cannot help but do well.

Enjoy and Prosper,
Yours One-Legged

Book Review: A Man for All Markets

https://www.amazon.com/Man-All-Markets-Beating-Street-ebook/dp/B01N4LB3LK/ref=tmm_kin_swatch_0?_encoding=UTF8&qid=&sr=

A Happy New Year to all.

Readers of this blog will hardly be surprised at my excitement and enthusiasm for this book. I finished the first reading of this book in 2 sittings over 2 days. I am now on my second reread.

Initial takeaway points, relevant to both investing and life in general:

1. What matters most in life is what you do, how you do it, and who you share it with. Note: cross refer with Guy Spier's book. Essential for all seeking a better life.

2. Understanding and dealing correctly with the trade-off between risk and return is a fundamental, but poorly understood, challenge faced by all gamblers and investors. Note: I have bleated about this ad nauseam, but I will stop now, as it is to my advantage that participants continue to misunderstand this. To recap: high risks do not equal high returns.

3. The surest way to get rich is to play only those gambling games or make those investments where I have an edge.

4. The Ten-Count System had shown moderately heavy losses mixed with "lucky" streaks of the most dazzling brilliance. I learned later that this was a characteristic of a random series of favorable bets. Note: read this again carefully- it is a goldmine.

5. If the market does a good job of using today's public information to set current prices, then the only investors who have an edge are those with material private information. Note: I am not sure I agree with this. There is often great variability between system participants irregardless of system average values.

6. Because you can't get out in time when trouble is coming, the excess returns you expect from illiquid investments may be offset by the economic impact of unforeseen future events. Note: very relevant to those focused on small caps.

7. Economists have found that one factor has explained a nation's future economic growth and prosperity more than any other: its output of scientists and engineers. To starve education is to eat our seed corn. No tax today, no technology tomorrow. Note: important message for our political leaders, and also forming a seed for my own personal end-game in life.

Reporting season is coming up- busy time ahead.

Enjoy and Prosper,
Yours One-Legged