Capital Allocation

In October last year I wrote a post called Feedback Loop. As discussed in that post, I keep a detailed record of all decisions to look for areas of improvement. This research provided some key insights that have laid the foundations for me to become a significantly better investor.

Of the process review, I initially spent the majority of my time on individual stocks: looking at winners and losers and my rationale for taking or not taking trades. Over time another factor also became apparent: capital allocation. What I have caught myself doing, and seen others do, is make capital allocation decisions inconsistent with the investment idea.

The text book example is doing some good analysis, deciding a stock is going up, and then buy an insignificant amount. If the idea is good, the risk is low and there is plenty of upside, it makes no sense to get gun shy and just buy a little bit.

It's easier said than done. The preferred format that works for my psychology is to build into a position. I'll buy an initial amount and then just keep buying - either because it has got cheaper, or even buy more as it is going up and I have more evidence to support the investment case.

However there are times when you just need to pile in. A good company may be getting sold off for no particularly good reason, so you may not get the chance to buy more if you just dip your toes in the water. Or, if you know decent buying is about to arrive, then chances are it is best to get more aggressive. So there are times for building and times for piling in - it depends on how fast things are moving.

Since establishing Sapient Capital to run family money, I have been a lot more assertive with allocating more capital when the odds really stack up: with good results. A friend recently forwarded me an article from Stanley Druckenmiller outlining the importance of betting big when the right opportunity comes up. Druckenmiller notes that he and George Soros bet 21.4% of their fund on the British Pound short in 1992 and the great investors like Icahn and Buffett allocate aggressively when the time is right.

This all sounds good, but what happens if it all goes wrong. The key question I asked myself was "what do I need to do to get the confidence to allocate decent amounts of capital?" This is far more than assessing the upside and downside: I needed to have the confidence the assessment of upside and downside was pretty reliable. It's easy to get seduced by thinking the downside is X. The downside could be 2X if you are wrong. Malcolm Gladwell notes it takes 10,000 hours of deliberate practise to become world class. So my confidence came from researching and reviewing over five hundred previous decisions. It's not fun going back and looking at losers (I've had plenty), but it's a lot more fun than losing money now. This provided a much clearer insight into winning stocks and understanding where I could have an edge. Building different templates of winning situations and losing situations makes it much easier to make good quality and confident decisions when they come along.

Kristian 

Elders Hybrids (ELDPA)

The above photo from Reservoir Dogs was taken from the Elders Ltd (ELD) v Elders Hybrids (ELDPA) post, written back in 2013.  I was intrigued by the stand-off between ELD and ELDPA holders and why the ELDPA share price was being discounted so aggressively ($15 at the time of writing) while the ELD share price itself was performing 'okay' (around 8c or 80c following the 1-for-10 consolidation in 2014).

Since then, life has actually worked out well for both ELD and ELDPA. Really well. Thanks to a major improvement in the fundamentals of the business, ELD has marched up to $3.76; an Internal Rate of Return (IRR) of 70% p.a. Even more impressive is the performance of ELDPA. The company has recently offered to redeem ELDPA for $95 equating to an IRR of 88% p.a - truly outstanding. 

The initial logic of preferring ELDPA was correct. But far more importantly, it was the actual business performing well that has saved the day - NOT any decision between ELD and ELDPA -both ELD and ELDPA has been massive performers.  A very similar stand-off has been in play for years now at Paperlinx/Spicers. The big difference is the Spicers business is still struggling and both SRS and PXUPA flounder. You would be technically correct in thinking PXUPA sit higher up in the capital structure, but if the business never recovers then it doesn't matter. 

Kristian 

Disclosure: no position in the above names, except a nominal holding in SRS to gain attendance to the AGM. 

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