I have been reading Giverny Capital's annual letters for a period of time.
I have nothing but admiration for the good folks at Giverny. Their investment philosophy and process closely echo mine, but they expressed themselves much better than me.
Reading Giverny's letters will give you a snapshot into my thinking processes involved in operating Castlereagh Equity. Be kind and gentle, as the folks at Giverny has over 20 years of headstart over this one-legged newbie.
Giverny Capital Annual Letter 2013
Wednesday, March 19, 2014
Wednesday, March 12, 2014
Tuesday, March 11, 2014
Dogs versus Darlings
On Wednesday 12 March 2014, I have set up a tracking portfolio populated by 4 market darlings and 4 market dogs.
The market darlings are OFX, REA, IPP and XRO.
The market dogs comprised of 4 mining services companies which shall remain anonymous at this time.
We will revisit this portfolio on a periodic basis. Hopefully some lessons and insights can be gained from this very simple exercise in real time.
Yours Truly
One-Legged
The market darlings are OFX, REA, IPP and XRO.
The market dogs comprised of 4 mining services companies which shall remain anonymous at this time.
We will revisit this portfolio on a periodic basis. Hopefully some lessons and insights can be gained from this very simple exercise in real time.
Yours Truly
One-Legged
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, Adultshop.com 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
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, Adultshop.com 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
Sunday, March 2, 2014
Angels
Dear Readers,
For moments when you feel down and out, remember that human potential is boundless and limitless. It is true that angels do dwell amongst us.
Enjoy.
Amira Willighagen- O Mio Babbino Caro
Jackie Evancho- Nessun Dorma
Sung Bong Choi- Nella Fantasia
Wednesday, February 26, 2014
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
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
Wednesday, February 5, 2014
Recent Reading
A belated Happy New Year to all readers. I am currently making preparations in anticipation of the coming reporting season.
Here are some recent interesting reads:
Paul works as a middleman connecting (mainly US) corporations which outsourced their production to factories in China. He has lived for a number of years in China, and considers China "home" (much to the consternation and displeasure of his Chinese seatmate on a certain flight). The book is an easy and interesting read. Whilst anecdotes are not necessarily conclusive, most of his descriptions, especially "quality fade", square with the author's own experience. This book will bring a much needed reality check to those bullish on China for the long term. I have long hypothesised that a major impediment for China in terms of economic and social advancement lies in its culture. Paul's accounts appear to indicate that the problem is much more severe and deep-rooted.
A good follow on book to Poorly Made in China, reading more like a specific prologue concerning fashion and clothing. A two book compendium could well read "Poorly Made in China, Poorly Worn by the Rest of the World."
As Charlie said, "show me where I am going to die, and I will make sure never to go there."
An excellent book, with lots of links to further reading. If any reader is game, start reading the full book list of St John's College (Annapolis). Now to get my hands on a good edition of Iliad and Odyssey.
Here are some recent interesting reads:
Paul works as a middleman connecting (mainly US) corporations which outsourced their production to factories in China. He has lived for a number of years in China, and considers China "home" (much to the consternation and displeasure of his Chinese seatmate on a certain flight). The book is an easy and interesting read. Whilst anecdotes are not necessarily conclusive, most of his descriptions, especially "quality fade", square with the author's own experience. This book will bring a much needed reality check to those bullish on China for the long term. I have long hypothesised that a major impediment for China in terms of economic and social advancement lies in its culture. Paul's accounts appear to indicate that the problem is much more severe and deep-rooted.
A good follow on book to Poorly Made in China, reading more like a specific prologue concerning fashion and clothing. A two book compendium could well read "Poorly Made in China, Poorly Worn by the Rest of the World."
As Charlie said, "show me where I am going to die, and I will make sure never to go there."
An excellent book, with lots of links to further reading. If any reader is game, start reading the full book list of St John's College (Annapolis). Now to get my hands on a good edition of Iliad and Odyssey.
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