The Value Trap (Part 2) / Platinum Roadshow

As ever, Platinum make a great presentation and the recent Platinum Roadshow (2016) was no exception. 

CIO Andrew Clifford discusses the big macro issue of the day, namely extremely low interest rates and the pervasive impact this has had around the world through causing asset price bubbles. This relates directly to the previous article I blogged about in The Value Trap: value traps are created where excess investment has been made in a particular area. Connecting the dots: lower interest rates forces capital into more speculative assets, which cause asset price bubbles, which causes future oversupply which causes more value traps. 

This is also joined at the hip by vastly improved IT systems which have increased productivity, which in it's own way is contributing to oversupply (capacity is increased if everyone can do more each day).

If you buy this argument, then life is tough for the stoic value investor - you just can't buy 'cheap' stuff and hope for the best. However - blame for poor returns has typically been pointed at momentum traders ignoring the market and just focussing on the few in-vogue growth stocks and ignoring everything else. While it is true there has been a handful of stand-out performers, I believe blaming momentum traders for poor value returns is largely incorrect. It's poor analysis (which I have been guilty of too) through confusing value with value traps. As Platinum go on to explain, while returns from Japanese equities have been dreadful as a whole, stand-out returns have been made by investing in reasonably priced growth stocks with high dividend yields.

This does mean saying 'no' more a lot more often - there just aren't a huge number of unique opportunities out there (but happily still plenty to go around). It also means being far more patient - it can take a very long time for oversupply to be soaked up - if ever. A few examples: Australia will probably never again have a 'shortage' of grocery shelves, and last year I holidayed in Rhode Island (US) where you could see plenty of old textile mill buildings - I wonder how many investors got burnt waiting for the turnaround. Being aware of these pitfalls has made a huge difference to my investing. 

Kristian 

The Value Trap

A friend recently forwarded me an article written by Edward Chancellor called The Value Trap. 

It's an excellent article, and one that would have saved me plenty of money on previous occasions. In a nut-shell: value investing works, but money can be lost through being seduced into value traps. What's a value trap? A superficially cheap stock (such as a low price to book) but where the underlying assets have already experienced a high level of growth and are now in deep oversupply. 

The common value trap is buying a mining company when it looks cheap. BHP looked cheap on simplistic valuation ratios at $40. But there was a lot of money spent on expanding production during the boom creating future oversupply. The maxim of buying mining companies when they are expensive and sell them when they look cheap seems to hold fairly true. Dare I say it, avoiding BHP was fairly obvious as the mining boom faded, however, value traps are often far more subtle and and far more ubiquitous than thought.

Boom Logistics (BOL) has been a first-class value trap. Too many cranes. Not enough demand. BOL does have other issues, but perfectly fits the bill of a group of assets (crane) in oversupply.  BOL has been 'cheap' for a long time but still the share price just keeps going down as the glut continues. 

Conversely, my mentors have taught me to look through the cycle of a company - look beyond current valuation measures to future supply and demand. The real trick comes from finding undiscovered companies that are experiencing more demand than supply in whatever they do - not just now, but in the future. Often this means buying a company that actually looks expensive based on current year financials but is going through a sustainable uptick in demand, industry rationalisation - whatever. I noted in the Feedback Loop post that cheap stocks can be very dangerous and also it is a mistake to write off stocks because they look expensive. Of my three biggest winners over the last 12 months, one was a deep discount, another had an infinite PE (no E) and the other on a PE of 31 (small E). My three biggest losers have all been of the value-trap variety.

Asset growth is slightly harder to quantify in service businesses, and is probably easier to re-deploy should an oversupply develop. It takes a long time to soak up excess housing and mining infrastructure (you can't just make it go away) but a bank can quickly reduce headcount. However I think the concept still holds true - be careful where a lot of resource has been allocated to something, regardless of price. The first cafe in a suburb probably makes great money, but after the tenth the profitability has been whittled down. The guys first to market typically make great money and then more resources (competition) follows and the industry matures and delivers more pedestrian ROEs. 

Perhaps this is why software businesses can provide outsize returns (for reasons over and above the obvious scale effects they can achieve). Because they can roll-out so quickly, it is difficult for competition to catch-up and therefore they achieve monopoly status and enjoy the outsize ROE).  I look at Pro Medicus (PME) and shake my head in wonder at fast it is capturing market share and the profits it will earn. Google has left its competitors for dust and I'm not aware of significant investment outside of a few obvious names allocating cash to catch them. The mining boom was different - massive amounts of capital were spent trying to capture the returns from higher commodity prices.

Kristian  

Clime Investment Management Ltd (CIW, CAM, CAMPA)

Trawling back through previous posts is always interesting. One stock I discussed back in May 2013 was the Clime Capital preference share (CAMPA). These shares mature next year so it's worth a quick update. 

CAMPA are issued by the listed investment company, Clime Capital (CAM). CAM are managed by Clime Investment Management (CIW). 

CAMPA were issued in 2007 at a price of $2.40. At the time of the review in 2013 the price was $2.14, and given the maturity conversion formula, I couldn't understand for the life of me why the price was still so high. CAMPA are now $1.1950. At maturity in May 2017, CAMPA shares will convert to CAM shares at a ratio of 1.36206* for each 1 CAMPA share held. CAM shares currently trade at $.77, so the notional conversion value is $1.05. CAM shares aren't popular at the moment - they trade less than NTA. If you apply the conversion calculation to the NTA value (i.e. assume CIW will trade closer to NTA), then we have a conversion value of $1.18, which is pretty close to the current CAMPA price. 

CAMPA pay out a big fat dividend - 18c p.a., fully franked. Given the timing, it looks like there will be another 18c or 25.71c including franking credits of dividends to be paid before maturity. That equates to a yield of 21.6% including franking credits. 

The elephant in the room is the CAM share price - its performance has been sub par, thanks to an average performance of the underlying portfolio. If this trend continues, then the CAMPA value also diminishes. If the share price stays at $1.05 (e.g. the NTA stays flat and the discount to NTA persists), the net return drops to 11.7c or 9.8%. If the CAM share price trends down further then potentially all of the income is wiped out. 

Looks like money could be made from here - but not hugely interesting for me. 

Kristian 

No position in CAM, CAMP, own CIW

*not updated for any further share issues since 2013

Pay More Fees(?)

I find TED Talks a good way to pass the time, especially when sitting in traffic. I recently stumbled across a TED interview with Jim Simons - founder of Renaissance Technologies. Apart from being brilliant and incredibly successful, he also charges one of the highest (if not highest?) fees in the industry. Get this: Renaissance charge 5 & 44 (see around 15.40 in the talk). What the? That means they charge 5% of FUM plus an additional 44% in performance fees. That makes the standard 1-2 & 20 look like chicken feed.

I don't know the exact performance of Renaissance, however every number I've ever heard make you blush. Reportedly, their flagship fund has returned 35% for over 20 years - net of fees. You'd be happy to pay 5/44 for that sort of performance, and their pre-fee performance is off the charts. 

It reminds me of 2014 when a friend and I went and watched the Monaco GP. Right along the front of the harbour are the really big boats (as opposed to the guys worth just a few hundred $m around the sides of the harbour). One afternoon we Googled the owners of the monster boats and it turned out that Sea Owl (a 62m Super Yacht) was owned by Robert Mercer; one of the co-managers of Renaissance. No wonder he can afford that sort of boat with that sort of performance and fees.  

All of this makes the Australian union superannuation marketing around the benefits of lower fees just a little bit incomplete. Sure, a lot of hedge funds don't add value over the long term, but there are anomalies - there are some who charge exorbitant fees and deliver exceptional performance. 

Kristian 

The Big Short

The Big Short was a fantastic read and the movie truly does it full justice (I finally got around to watching it on the weekend). While The Wolf of Wall St was sensational for a laugh, it abysmally failed to acknowledge the damage done to clients and community and therefore probably inspired plenty of wannabe Jordan Belforts (I even know a few). The Big Short however manages to tell a complex and sombre story in a digestible and entertaining manner. You walk out both laughing at the one-liners yet also shaking your head at just how screwed up the financial system was (is?). 

Please go and see it if you haven't already done so. 

Kristian 

ThinkSmart (TSM)

Happy new year to everyone. 

TSM was a good investment last year, albeit I sold it a little while ago and therefore jumped off way too early. With the recent run-up in the share price, it reminded me of the Feedback Loop post I wrote last year where I analysed my decisions and identified key areas for improvement. TSM fits the 'getting bored with a situation' category to some extent however that is being a bit harsh given decent money was also made. 

A massive buy-back was undertaken toward the end of 2014 where shareholders could tender their shares in a price range of 31c to 42c. It reminded me at the time of Charlie Munger's tip to look for cannibal companies (companies that are buying back huge amounts of their stock). The founder had floated the stock back in June 2007 (just before the GFC hit) for $2.15 and was now offering to buy back a lot of stock for an absolute fraction of the price. There was some criticism about the move (and the threat to de-list the business), but I just figured the stock was incredibly cheap (PE of less than 4 from memory) and if a really smart guy is offering to buy other people's stock and not offering his own holding then the situation must be interesting. 

And boy has the business gone on a nice little tear since. Looking back over the announcements, it was only a matter of months before an upgrade was announced, an extension of the contract with Dixons Carphone and now another upgrade. Sure, some of the upgrades are FX related, but their business (now based entirely in the UK) has shot the lights out in GBP. I wouldn't be surprised to see another upgrade come and with the stock still cheap I wouldn't be surprised to see the share price march upward more. It just goes to show how buy-backs can be a great leading indicator, ignoring what the smart money is doing can be dangerous and yes - patience is a virtue.

Kristian 

Disclosure: no position in the above name.

PMP Ltd (PMP)

Charlie Sheen on answering a question as to why he used prostitutes - "I don't pay them for sex, I pay them to leave". And just like Charlie had a clearly defined exit strategy with women, we need a good exit strategy with stocks. 

PMP has been a wonderful investment over the last number of years, despite a business that is in long term decline. However, the business is in decline and unless something major happens like industry consolidation, it's hard to see the glory days returning. So this will probably remain a business that will not grow in value and therefore has a ceiling on its valuation. I modelled a basic scenario of declining revenues of 8% p.a. (it's average decline since 2012), maintaining EBITDA margins (which is probably generous - you can't cut costs forever!) and assuming the business has a terminal value in 5 years time of 4* PBT, and discounting back at 10% I get a valuation of 75c. This number of course is based on some pretty simplistic assumptions and could of course be wrong. 

But at 50c, and assuming my numbers are roughly right, the discount rate being factored in by the market is over 20%. Given PMP re-financed a bond at 6.43% p.a. plus generous terms in its favour, it looks like the equity market is treating PMP pretty harsh.  While this may be all true, what is also true is the market may never want to pay up for a declining business: it could easily be 'cheap' forever, and a stock trading at a discount to valuation alone without a catalyst is rarely a good enough reason to buy at least in my experience  - unless it is a huge discount. 

The other issue I consider far more these days is return on my time. I would prefer to spend my time on ideas that will yield a much bigger ROI such as companies that can grow and get re-rated by the market and value opportunities that represent massive value.  

Hence the reason for recently selling PMP. 

Kristian 

Disclosure: no position in the above name