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:

http://www.fool.com.au/2011/10/investing/road-map-to-riches-treasure-hunting-on-the-asx/

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.

Uncertainties

I spend quite some time today reflecting on the concept of uncertainty, after reading a quick tweet from Farnam Street.

In investing, uncertainty is distinct from risk. Investors have a difficult time dealing with uncertainties as the nature and magnitude of uncertainties cannot be defined. Ironically, many market participants fail to appreciate that profit making opportunities arise precisely because of the existence of uncertainties.

If you are not convinced, then try to invert the situation, and imagine a world devoid of uncertainties. In this fantasy world, trends in security prices are non-existent, an EMH nirvana. Scientists will know the exact position and momentum of quantum particles. Major religions such as Christianity, Judaism and Islam will not exist. Quite possibly, our brains will evolve in a completely different manner, as we no longer require short-cuts and instinctive reasoning. I can go on, but you get the picture.

Uncertainty is embedded in the nature of all things. This is the principal reason why we must always allow a margin of safety in our investments. Just as a good engineer builds redundancies into critical systems, we must allow for uncertainties inherent in businesses operating in a complex system where humans exercise free will.

By logical inference, we cannot be the master of a universe riddled with uncertainties. This is why Buffett and Munger repeatedly advocates the virtue of humility. Humility enables us to accept that there are things that we cannot know, which is the first step towards acknowledging the limits of our competence.  If we know where our boundaries lie, we can then take the next step of pushing out our boundaries through the accumulation of knowledge and wisdom.

And only thus, shall the meek inherit the Earth.

FFI Holdings Limited

I have kept an eye on FFI for quite a few years. Its main business is food manufacturing in Australia, mainly chocolate products, bakery products and small goods, both under its own brands and also contract manufacturing for house brands.

Given the dominance of the two retail chains in Australia, and the ongoing price war with the resurgence of Coles, not to mention inroads made by interlopers such as Aldi and Costco, it was always going to be a tough slog for this minnow. Over the last 2 years, FFI's NPAT has decreased by over 50% even though sales volumes have been maintained. Rising input costs and labour costs did not help. This is the main reason why I have not bought any shares in FFI, despite a fabulous special dividend two years back, and consistent dividends coupled with a long operating history with shareholder friendly management.

The open secret about FFI is that it holds a huge parcel of industrial/commercial land- 67000 square metres to be exact.  This is carried in the books at historical cost of $14m. With a market cap of $28m, if we back out the land, the business is actually trading at PE 7. Although this appears cheap, everyone knows that holding vacant land is a money chomping exercise, and coupled with the operating headwinds facing the business as described earlier, there is really no table thumping reason to get excited yet.

This all changed after trading hours on 5 November 2012, when FFI announced that it had sold a parcel of land (about 2700 square meters) for just shy of $1m.  I will leave readers to work out the valuation implication of this announcement.

This is evidence based investing at its purest. By my estimates, there is now some 30% to 50% upside based on valuation, assuming that the current headwinds faced by the business do not abate. I view this as unlikely, and in any event, the bad news have already been baked into the valuation (poor pun intended).  The more important thing is that given the healthy cashflows generated by the operating business, a market cap of $28m presents a very low downside risk to an investor.

Disclosure: interests associated with my family holds shares in FFI.

Disclaimer: the contents 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.

Investing as simple as ABC

On 2 November 2012, I grabbed a copy of the share tables in the Daily Telegraph and started trawling through the list, aiming to start at A and ending at Z. For several years, I have screened shares using rudimentary software provided by Etrade. I cannot help but feel I am playing a mugs game. Everyone will be screening for shares using popular criteria such as PE, ROE, Book Value, etc.

So I finally overcame my laziness and procrastination and took Buffett's advice.  There is really no other way, given that I am not blessed with talents of imagination and creativity, and that I am basically an introvert without a benefit of a wide network to draw information upon.

It was not as painful as I feared. As at today, I have finished all industrials up to G. At this rate, this exercise will be done and dusted well within a month. True to Buffett's experience, there are many names which I spent very little time on. There are also quite a number of decent companies which I already own or have kept on my watchlist for a good entry price.

As a matter of perspective, there are over 2000 listed entities on the ASX. Only 1/3rd of them are making profits. Let's see whether there are some gems hidden in there.

Like I said, simple as ABC.  I never said it will be easy.
 

It is Obvious, Stooopid!

I regularly re-examine my past investments. I look at moves where I lost money. I try to determine where a mistake was made. Trust me, it has always been mistakes, not bad luck.

I also look at winners. I have found that with winners, the value was very obvious. I did not have to sweat it. I did not even need a back of envelope calculation.  In fact, when I found value, I usually have to do a quick re-check to make sure I have not made any mistakes.

Here are some examples:

IMF- I have explained this in previous posts. Just to recap, I found this in July 2008 trading at $82m market cap. It has just won the Aristocrat case, and the proceeds of that case would see IMF's net cash at $68m. I was paying $14m for a $1 billion case portfolio. Since then, IMF has paid dividends in excess of $82m, if you account for the imputation credits ie I have already covered my purchase price from dividends alone.

ASW- I found this in June 2009 trading at a market cap of $16m, with no debt and nearly $4m in cash. Cashflow exceeded $1m per annum, and it was growing from a small base, and paying a dividend. Market cap eventually flew to $40m, and this investment was sold as a 2.5 bagger in about 20 months.

EPY- in March 2011, this had a market cap of $7.2m.  Its net current assets totalled $13.5m, and cash stood at $12.5m. A bidding war ensued, and this investment was sold for 48% gain in 6 months. The sale may have been a mistake, as the company has paid $4.6m return of capital since then and is still trading at $7.2m.

UOS- in Feb 2011, this had a market cap of $330m. With very little debt, investment properties on the balance sheet already totalled $433m.  Within a year, the company floated a subsidiary on the KLSE and returned $80m in capital plus $20m in dividends to shareholders. Currently trading at $400m, this investment has returned 42% in capital returns and dividends within 2.5 years.

CTE- in April 2012, this had a market cap of $7.3m. It had no debt, had cash of $3.5m on the balance sheet, and management had just announced full year earnings update of $1m. Backing out cash, this was trading at a PE of 3.8. As at the date of this post, CTE is trading at market cap of $16.5m, with $4.5m of cash on the balance sheet.  A satisfactory 133% return in 6 months is not too shabby.

As you can see, the value was very obvious in all of these cases.  Yet someone was selling shares to me.

Now, a word of caution.  I do not believe in absolutes, as there are always exceptions.  At the time of writing, there are two companies looking very cheap at first glance.  Firstly, RIS is trading below cash.  Secondly, SSL is trading at half the value of its net assets. In both cases, unlike the above winners, I am not confident at all that the value will be realised in the hands of minority shareholders.

Disclaimer: the contents 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.

Back After Lengthy Hiatus

It has been nearly 3 years and 2 months after my last post. I wished I could say in that time, I have returned a market-stomping 25% per annum compounding on my portfolio. Alas, it is not to be.

Rather, what had happened was as follows:

In year 2008- X capital allocated to shares.

In year 2009- X capital became 1/2 X- you read that right. The portfolio declined by 50%.

In year 2010- portfolio recovered to 0.8 X.

In year 2011- portfolio recovered fully to X. A further 1.5X capital injected, thus portfolio totalled 2.5X.

In year 2012- portfolio of 2.5X gained 60%. Portfolio now 4X.

In hindsight, the mistake was simple. I did not buy when others were fearful. The most glaring example seared in my memory is FLT at $5.50, after Skroo Turner bought heavily at $3.50. This would have been a five-bagger in 3 years, not counting dividends.

The consolation is that it has not been time wasted. I have come to appreciate the huge importance of having a disciplined process. The resurrection of this blog is intended to ensure I keep to my process, and to share with readers the daily trials and tribulations of a value investor. Hopefully, we will all learn something in the process.

IMF a year on

Since I last wrote, IMF has moved to a high of $1.98. This was met by heavy selling...by a director, as it later turned out... and the reason given was that the shares were sold to fund a take up of a similar number of options. The sale pushed the price back to about $1.38, and at time of writing, the shares are at $1.57.

At 120 m shares, the market cap is $188 m. The company is in a stronger position, with funded claims of about $1 b. On 30 June 2009, it has 61 m of cash with no debt. It has since announced settlements which will boost cash by at least 20 m. Accounting for dividend payment in July, the company should have about 75 to 80 m in cash. It has since announced a buy-back.

My view is that IMF continues to be undervalued. The claim "book" I have estimated a probable value of about $150-200m. Add back cash, and we get $225m to $280 m, which equates to $1.88 to $2.30 per share, with the enterprise value as a free option. I would ascribe fair value to be about $2.00 to $2.50.

There has been no significant judgments or developments affecting the claims book. With an expected fully franked yield approaching 9%, I am only too happy to hold.