Wednesday, February 21, 2018

Picking the Dogs- Round 2

I am quickly writing this post to illustrate the concept of inverting to solve problems.

I think we can neatly use the concept of inverting when we are trying to pick the Dogs, or any investments, come to think of it.

The core philosophy is that we are more likely to encounter inefficiencies and mispricings if we are willing to approach things differently from what the consensus is doing.

Let's start with the Darlings- ALU, APX, PME and WTC. What is it about these stocks that got punters so excited? Quickly off the top of my head, here is a list:

1. They are showing, and promising, lots of growth (more than 20% per annum).
2. They are all technology and software related.
3. They all appear to have a growing worldwide market with a long runway.
4. They have fabulous gross margins.
5. The above 4 allows them to weave a very simple but compelling narrative.

If we are to pick Dogs, it would be logical to look for the complete opposite:

1. They are shrinking, and not promising any growth whatsoever.
2. They are in old school industries- manufacturing, fabrication, trading, printing, etc
3. They have very limited markets.
4. They have terrible margins.
5. The story sounds horrible.

So with those clues, I have picked a portfolio of 4 Dogs. They are the hairiest bunch you will ever see. But they do have some adorable characteristics:

(a) No debt or no net debt, and excess cash plus other assets 
(b) Positive cashflow/profits
(c) Priced at less than 3x to 5x multiples of cashflow/profits

Yours One Legged

Tuesday, February 20, 2018

Dogs versus Darlings conclusion 4 years later

It is time to draw a close to this amusing exercise, started here with interim follow up here.

The result after nearly 4 years- the Dogs portfolio is up 40% (without accounting for dividends which would have added at least another 10-15%).  The Darlings portfolio broke even (without accounting for dividends, probably adding 10%).

The Dogs are COF, NWH, MND and LYL. In March 2014 and for a subsequent 2 years until the depth of the mining services crush in early 2016, these names were persona non grata in nearly every portfolio manager's book. Within my circle of friend's and colleagues, only one other investor shared my enthusiasm for these Dogs, and actually invested some money in them.

To recap, the Darlings are OFX, XRO, IPP and REA. They collectively underperformed not just the Dogs, but also the All Ordinaries Accumulation Index. It was also quite fortunate for the Darlings portfolio that IPP was taken over by REA (and subsequently written off to zero), and that REA got included instead of the original candidate FLN. Furthermore, I would also argue that the Dogs performance was crimped because of COF's takeover. Subsequent to the takeover, COF's financial performance improved many fold, and I am quite confident that the share price would have appreciated significantly more than the 62% premium gained on the takeover.

It is also worthy to note that the Dogs achieved this outperformance against the Darlings in a raging bull market, especially for technology stocks.

Some may say that 4 years is too early to tell, and that the Darlings will prove their worth over the long haul, say 5 to 10 years. So let's just check periodically.

The lesson here is that valuation matters and variant perception matters. Just speak to any investors who bought Microsoft and Cisco during the heights of the dotcom era in 2000.

To hammer the lesson home, we have a roster of another 4 darlings- PME, ALU, APX, and WTC. I am preparing a roster of Dogs. Stay tuned.

Yours One Legged

Thursday, February 8, 2018

A Happy Belated New Year

Just a quick note to my readers.

Missus and myself have both been struggling with a cold caught overseas which pretty much put a damper on what should be a restful and peaceful break.

We have both recovered, but I am now right smack at the start of reporting season and also in the middle of an intake for Castlereagh Equity. The increasingly wobbly financial markets make for interesting times.

To my readers, thank you for your patronage over the years. I will try my best to continue with useful and insightful posts.

To my investor partners, thank you for your continued trust and confidence in me.

To my fellow journeymen (or journeypersons) and friends, many thanks for your companionship and wise counsel through the good times and also the bad.

And to my dear missus, thank you for so many years of patience, care and love. I look forward to many many more.

Yours One Legged

Thursday, November 9, 2017

Xero and Intuit follow up

Xero recently published its half year report, so it is time to update our figures. The following table summarises the salient metrics:

R & D

Once again, the figures are headed in the right direction. Although the company announced operating cash flow positive, adding in the impact of capitalised R & D still resulted in cash burn of $34m, leaving roughly $84m left in the bank, implying a steady runrate of just over 1 year. 

As a matter of comparison, let's look at Intuit's 2017 metrics:

Revenue USD$5.18 billion up 10% from 2016 (note: XRO growth is much higher)
COGS 15.6% of revenue
R & D 19% of revenue
General 10.7% of revenue
Marketing 27.4% of revenue
Total 72.7% of revenue (versus 74% for 2016)
Operating cashflow= $1.6 billion

The current market cap for XRO is roughly NZ$4.6 billion (a rise of nearly 45% since my last update). Still too rich for my taste. As a matter of comparison, Intuit's market cap is currently USD$39 billion.

Tuesday, November 7, 2017

Pip Watching

Imagine a hypothetical portfolio. This portfolio has a very healthy performance of 15% pa. The volatility/variance of this portfolio is roughly 10% per annum. Despite this, the probability distribution of price moves for any short time periods between one second to one day is just slightly better than 50-50. If an investor is assiduously following the price moves of this portfolio more than once per day, the statistical expectation is not much better than watching the outcome of a flipped coin.

Various studies have shown that the emotional impact of a loss is nearly 2.5 times the impact of a gain. Accordingly, the consequence of pip watching is net emotional deficit. And the absolute net impact gets bigger with increased frequency of pip watching, and also increased number of portfolio positions.

Bear in mind that 15% pa with 10% variance over a long period of time is a great performing portfolio. This means that a lesser performing portfolio will not be any better for the constant price checker. It may in fact be far worse. Further, there is also a feedback loop in place. The net emotional deficit may feed through into deteriorating performance, which will increase the emotional deficit, leading to a vicious cycle. At the same time, the random nature of punishment and rewards in pip-watching gives rise to addiction similar to the process in gambling. 

The physical consequences of chronic stress from pip watching include high blood pressure, diabetes, hormonal imbalances, possibly brain damage, eye problems and a whole other variety of ailments. An investor that keeps at this bad habit for long periods of time may actually be accumulating money at the expense of health. Wealth, happiness and well-being arise from a well-lived life, not just the bank balance at the end.

In other words, pip watching can severely affect your health, and also your wealth. 

Don't do it.

Stay healthy, enjoy and prosper,
Yours One Legged

Wednesday, October 18, 2017

Howard Mark's recent G & D interview quotes

I enjoy reading the Graham-Doddsville newsletter.

Some pertinent quotes, relating to the issue of indexing and quantitative/AI factor.

Howard Marks:

“If people take their money out of active management, then active managers would fire all their analysts, and then the market would not stay efficient. Then the necessary condition is satisfied for active to work. The point is, I don't think this move is permanent, I think it's rotational.”

“Because every dollar that goes into a truly passive fund is invested on autopilot, the fund must buy the stocks that satisfy its criteria, and that’s without regard to value. That suggests to me that prices can go farther in diverging from value before they get corrected. Think about what would happen if 95% of the money went into index ETFs or index funds. Who would be setting prices? There’s something called price discovery, and it’s done by thoughtful buyers and sellers. The price of a security in the marketplace is set by buyers and sellers coming together, and seeing if they can find a place to transact where the buyer thinks it has good upside, and the seller thinks it doesn’t. Who provides that function if all the buying are on autopilot? People put their money in index funds, with the presumption that they’re minimizing error, but how much of your money do you want to have managed in a fund where nobody’s thinking about the price of the stocks or the weightings within the portfolio? The thing about investing is that the efficient market hypothesis says that price equals value. Active management is about the assumption that price sometimes deviates from value, finding those deviations, and then taking advantage of them. It seems to me that the fewer the people who are looking at value, the higher the likelihood that price can diverge from value. But that’s just a hypothesis.”

“None of this stuff is easy. The greatest quote in my book is from Charlie Munger, who said, “None of this is meant to be easy, and anybody who thinks it’s easy is stupid.” All this stuff is really complex. It’s easy to talk about, but it’s hard to implement. How do you tell the ones who are good but unlucky, from the ones that are bad? It’s not easy. It takes judgment. That’s why I believe that this whole thing can never be completely computerized, because I think exceptional investment success requires judgment, and I don’t know if AI can be taught to make those judgments.”

Dear readers, any thoughts?

Yours One-Legged

Thursday, September 14, 2017

Book Review: Big Money Thinks Small

Big Money Thinks Small: Biases, Blind Spots, and Smarter Investing (Columbia Business School Publishing) by [Tillinghast, Joel]

An interesting read. In terms of concepts and philosophies, the reader will not find anything new that was not encountered before if one has been constantly reading up on the topic of investment.

The author ties together concepts of value investing augmented with experiences and practical applications of financial history and behavioural psychology. The main takeaway for me is his account of the travails of Dendreon and the dangers of investing in a "story." To summarise, Dendreon was a biotech which developed a treatment for cancer. The main bull story for Dendreon was that once FDA approval is obtained, earnings will rocket to the sky. The ending was that Dendreon did actually obtain FDA approval, and its share price went up tenfold, however sales were disappointing and the company eventually declared bankruptcy!

There are several stocks on the ASX in which investors are clearly enamoured with the "story", the most vivid example being Mesoblast.

The author also addressed the issues inherent in indexing, factor investing and macro investing.

The only gripe I have with the book is that it could be better organised. The way it was written looks more like a stream of thought cobbled together hastily without any overarching framework.

A reminder that there is a library of my reading here.

Enjoy and prosper
Yours One-Legged