Current Reading- The Manual of Ideas

Confession Box 5 June 2013

On 4 June 2013, I sold my FGE holdings for $4.48.

This came in the aftermath of FGE's announcement of an acquisition. Despite massive cash holdings and a weakening AUD, management decided to fund the acquisition through a mixture of debt and equity.

My rationale for purchase of FGE was first set out here, and also in a subsequent post here.  Events subsequent to my purchase have eroded my margin of safety in this investment.  Nevertheless, I wish to make it clear that the purchase was an error on my part as it was based on inadequate due diligence.  If I had done some better due diligence, the events subsequent could have been mostly foreseen.

The half yearly results in February 2013 clearly disclosed severe margin crimp, given that revenues increased 120% yet NPAT only increased by 60%, with NPAT margins in single digits. This arose as a direct result of increasing reliance on low margin work from the power division.  Subsequent contract awards in this space only heightened the risks involved.  My attitude to this was blase to say the least.

Then Clough decided to sell all its shares in FGE, which further weakened the investment thesis. However, since the probability of a takeover at higher prices was a free option in my investment thesis, I brushed off this event without further investigation.

The unusual nature of the Taggart acquisition prompted me to do a much belated due diligence on the management team, particularly David Simpson, the MD.  One of my Google searches turned up several articles on the appointment of David Simpson on a very lucrative pay package, which was acknowledged by the FGE board (then) as being on the high side.  The sad thing is that all of these articles predate my purchase, and I did not read a single one at any time prior or at the time of purchase.

In a nutshell, Simpson was paid $750k to sign on, with a yearly salary of $1,000,000, together with short term incentives of 2 tranches of $500,000 payable on achievement of an increase of 10% EPS from one period to another.  This is such a ridiculously low hurdle for such a huge payoff, it amounts to a joke.

Briefly, David Simpson's bio:

Diploma of Law, Masters of Law and Management.  Progression through lawyering as corporate counsel in three previous companies. Started career as a paralegal in ABB in early 1990s, then corporate counsel in Leighton, and then moved to UGL as corporate counsel, then as manager of one of UGL's divisions, before taking on the post of MD in FGE.

In other words, you have a corporate lawyer with very little technical/engineering background leading an engineering company, with a $1 million dollar short term bonus dangling in front of him.  All he needs to do is increase diluted EPS by 10%. Upon his appointment, the old guard at FGE left and promptly sold all their shares in the mid $5s.

Once I saw this, everything fell into place:

1. The Taggart acquisition was structured with an upfront cash payment, funded by debt. Subsequent milestones payments are paid via 70/30 mixture of cash and shares. The upfront cash payment goes straight to the balance sheet, and does not affect earnings, but the target acquisition earnings are accretive immediately. Subsequent dilutive milestone payments in shares do not affect the MD's short term bonus.

2. Continual contract awards in the low margin power divisions.  Margins are being sacrificed for the sake of volumes, which is very dangerous in any business other than mature businesses with incumbent management with demonstrated experience in a low margin high volume environment. 

Given this trend, I see a distinct possibility of continual erosion of my margin of safety in this investment, with gearing up of the balance sheet and increasingly high capital requirements to maintain low margin businesses in the power area and underground coal mining, coupled with integration risks of Taggart, together with some massive headwinds hitting the mining services sector. Plus a huge risk with a corporate boardroom MD granted questionable incentives.  

Taken to extreme, increasing debt and low margins are recipes for very sudden implosion, which brings us back to Rule Number 1.

This investment yielded 19% returns over a 6 month period, which was again just down to pure dumb luck.  My penance was an immediate indepth management review of all portfolio holdings.

Getting Dumber Every Day

What happens when the one-legged investor meets Dumb and Dumber?

Voila!

This presentation is very useful as it provides a template for my analysis. If I can get my thoughts in some decent semblance of order, I will attempt a post of past investment experiences based on the framework set out by Zeke Ashton in his excellent presentation found in the link above.

I leave you, dear readers, with the following proposition: "stock selection is a misnomer, the investing process in the main largely involves stock elimination."

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.

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

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.

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.