Portfolio14

A forgotten diamond in the blind

2014-05-27T18:17:00.000+10:00

Inaction is action. It's easier said than done.

By the same token, boring is rewarding. But it's hard to get oneself excited about boring stuff.

It's very satisfying to hunt for and uncover undervalued stocks. The thrill is hard to resist. But the goal of investing is not to indulge one's adventurous soul or to satisfy one's ego. The goal is to compound one's wealth. Very often, the real gems are something we already know. It's boring to recycle old ideas. Yes. But being boring makes money. It compounds.

I wrote about Advant-e (ADVC) in 2012. That was actually the first post on this blog. (Now looking at my records, I realise I actually started buying ADVC in 2011.) I won't repeat all the details here. You can go back to read about it yourself. At the time, I believed ADVC was a quality business, a hidden champion. It should comfortably deliver 15% return per annum for very long time. In a more favourable business environment, it wouldn't be a stretch to get 20% p.a. return. Share price was then $0.20 and P/E was about 10x.

Fast forward to today. Price is $0.40 and it is still trading at a multiple of 10x. In between, ADVC has distributed some very generous dividends. My total return (on a constant currency basis) is about 100%. Annualised return is about 30% p.a.

Numerous value bloggers have written about ADVC over the years. The most recent spike of blog posts was seen towards the end of 2013, when ADVC decided to stop filing statements with SEC, coupled with a reverse-split and a force cash-out for the investors with less than 10,000 shares. Some investors were pissed off, believing the entire exercise was unfair towards minority shareholders. When the CEO Jason Wadzinski controlled over 50% of the company, they had reasons to worry. Eventually, the company went dark as planned but the reverse-split was called off, of which the true reason will probably never be known.

Since then, the company has been forgotten.

I hold a different opinion. In 2012, I said Wadzinski was shareholder friendly. My stance hasn't changed throughout the going-dark incident. Remember this is effectively his company. If he wanted to pay himself big salaries but distribute no dividends, he could have done so. But he hasn't. From ADVC's history, what Wadzinski has said and what he has done in the past, he strikes me as someone with integrity.

When a company goes dark, apart from being less liquid, the worry is: what will happen to its dividend policy and reporting policy? Now we have the answer. On April 28th ADVC sent its shareholders a letter from the CEO with a condensed annual report, declared a 5% dividend and announced a share buyback up to ~6% of its market cap below $0.37.

While the company is definitely less transparent than it was, my assessment of its business hasn't changed. Its moat in its own turf in the grocery market is solid. And it's slowly making inroads into the automobile market and the healthcare market.

Monish Pabrai said in a recent interview the holy grail of investing is to identify compounders with hidden moats. That's superior to buying cheap assets at 40c on a dollar. He didn't elaborate why. But it's self-evident. Instead of constantly and actively searching for your next preys, you collect money from a compounder when you are snoring.

ADVC is one such little compounder. It is my benchmark (or in Buffett/Munger's vocab, my "cost of capital") when I assess other investment opportunities. "Should I buy XYZ, or should I buy more ADVC?" This is my way to avoid making further stupid mistakes.

Indeed, I've bought more.

p.s. I respect the company's decision not to make their financials public. If you want to have a glance of their 2013 numbers, you can simply buy a few shares and ask the company for a copy.

p.p.s. ADVC trades over-the-counter and is very illiquid. Be wary of pump and dump promoters. Be wary of bullish articles like this very one you've just read. :-)

(Disclosure: Long ADVC)

When quality and moat are on sale

2014-04-25T15:44:00.000+10:00

Most people know CeBIT and CES, the annual trade shows for hi-tech products. Imagine now I challenge you to start an exhibition organiser (EO) to run a new trade show to compete with CeBIT and CES. Will you take up my challenge?

This will probably be your phone conversation with a potential exhibitor on one of the cool calls:

You: Would you like to book a booth at our new MobileTrend 2014 exhibition which will be held at Vegas this summer?

Vendor: No thanks. I will be at CES in January. I don't think I have the resource and energy to exhibit twice a year.

You: I can give you irresistible discount. I think you are paying $7,000 for your CES booth? You see, I can offer you the same 3-sided booth at MobileTrend for only $3,500.

Vendor: That's very kind of you and it definitely sounds very attractive. But I have no idea what foot traffic and what kind of visitors your exhibition will attract.

You:....

Vendor: How about this. You call back in 2 years. If your show turns out to be successful, I will drop CES and take up yours.

EOs are in very interesting businesses. Can you distill their businesses into a simple mental model? Can you see which another familiar business it resembles?

It's eBay.

Although eBay works at a much larger global scale and an EO works in very local vertical markets, both exhibit network effect. At eBay, you need buyers in order attract have sellers; and you need sellers in order to attract buyers. Similarly, in exhibitions, you need visitors in order to attract exhibitors; and you need exhibitors in order to attract visitors. Mature markets are dominantly by one or two big EOs. Once an EO incumbent has established its market position, it's virtually impossible to displace it. This is kind of first mover advantage that drove people nuts in the dot-com days.

So, here you are. EO businesses have moat.

Now, imagine I have this EO which owns a portfolio of exhibitions for various industries. They are not as big or as prominent as CES or CeBIT. Nevertheless, these exhibitions are profitable and are the market leaders. How much are you willing to pay for such business? What multiple will you pay?

How profitable, you ask. You see, EO businesses are asset-light businesses. There is no expensive machinery or significant hard assets. The ROE of this particular EO is north of 30%. And it is achieved without debt.

Got a valuation in mind yet? Great.

Let me reveal a bit more about this business. Its exhibitions are operated primarily in emerging markets with high GDP growth. To take advantage of the growing markets, it spends about 50% of its profit on bolt-on acquisitions, 15% on organic growth and it pays out the remaining 35% as dividends. Essentially, its strategy is to take its existing operations as a template and clone it across different industries, different locations and different countries.

Are you revising your valuation?

What if I tell you can buy this company at 15x ttm after-tax profit? Will you buy it? Take a pause and think about it.

Let me reveal yet a bit more about this business. Since it has been acquiring businesses over the years, it has to amortise certain acquired intangibles like customer relationship. Such amortisation is pure accounting treatment which doesn't reflect the actual economics of the business. As long as the exhibitions are well organised, the economical value of the acquired customer relationship won't fade away. There is no extra maintenance capex you have to spend to maintain this asset.

Adding back the amortisation, this company is actual available at 11x after-tax earning.

Will you buy it?

Wait, there is more! Since exhibitors prepay for their bookings, this company runs with negative working capitals. In other words, it has float. Net float makes up 20% of its assets. When the business expands, this float grows too. This company's expansion and operation are partially funded by its customers.

Where can you find such an attractive investment?!

The company in question is UK company ITE Group (ITE.L).

Too good to be true? What's the catch?

Here is the catch. Remember I said "emerging markets"? More the 60% of ITE's business is in Russia. ITE also operates in Ukraine and other East European countries. Since the outbreak of the crisis in Crimea and Ukraine, ITE's market cap has fallen more than 30%.

But the market's fixation on this crisis is our opportunity. It's time to be greedy when others are fearful.

ITE has been around since 1991. It has prospered through the 1998 Russian financial crisis, the 2008 Russian financial crisis and the 2008 Russo-Georgian war. Its bullet-proof balance sheet and the strength of its business model will give it the staying power to weather this political hurricane just like how it did it in the past.

ITE has the characteristics of the holy grail of Buffett-style value investing. It has moat. It has high ROE. It is asset light. It has float. It has a big enough untapped market in front of it to redeploy its cash flow and float, to recycle its business model. It is a compounding machine.

The real risk of this business is losing its key personnel on the ground in Russia. But this risk is forever present for ITE and has nothing to do with the current political uncertainty. (This will probably be the topic of another post.) Besides, growing by acquisition is risky; expanding into other countries is also risky. There is no guarantee this business won't stumble.

However, the current price offers enough margin of safety to overcome all these risks. With a time horizon of 5-10 years, we are in for a double-dip. When the fear of the war subsides, we will firstly be rewarded with a proper P/E expansion. But a quality business is still a quality business. It will continue to compound internally. We can sit back and be rewarded with satisfying return for many years to come.

p.s. Thankyou to Richard Beddard (@RichardBeddard) for the lead.

(Disclosure: Long ITE.L)

Nam Tai: A net-net with multi-bagger upside

2014-02-16T07:19:00.001+11:00

Nam Tai Electronic (NTE) is a contract electronics manufacturer with factories located in China. It has a market cap of $270m and no debt. It's been in business for 40 years and listed on NYSE since 2003. It business has changed and gone through many phases. Currently it assembles LCD modules (LCM), with Apple as the primary customer. It has always been profitable and has never lost a single dime in the last 10 years. However, it has warned investors in the recent years competition is intense and its contracts could end abruptly. On Jan 27, it confirmed it would receive no more orders and all production would be terminated for good in April. It also confirmed it would exit its existing lines of business completely.

Investment thesis

NTE is a net-net with a hidden asset worth multiple of its existing market cap. Its management is competent and aligns with shareholders. Catalyst is already in place. The management has committed to realise its value.

Downside

At the time of writing, NTE is trading at around $6. Current assets less all liabilities is $300m ($6.65 per share) and book value is $360m ($8.10 per share). In other words, NTE is trading at 10% below NCAV and 25% below BV. And most of the current assets is cash.

The number one risk investing in any company with any China connection is fraud. In the case of NTE, this risk is virtually zero. Every evidence indicates it's a legitimate business run by a legitimate businessman: Its primary customer is Apple. It sells real electronic components and receives real cash. In the last 5 years, it distributed $58m dividends in total with an average payout ratio of 70%. There was no capital raising nor debt.

Or we can look at it from the history perspective. Nam Tai was founded by Hong Kong entrepreneur Koo Ming-kown (as in Chinese tradition, the surname goes first; so, "Koo" is the surname). He is currently NTE's Chairman and CFO and holds 11.7% of NTE. Another director Peter R Kellogg holds 14.4%.

NTE's history shows Koo is an opportunist and capital allocator. NTE's business has gone through 3 major transformations in the last 4 decades. NTE started as a distributor of Japan-made calculators. At its peak, about half of the calculators used in Hong Kong were imported by NTE. In 1979, taking advantage of China's economic reform, Koo expanded the business into China and started manufacturing his own brand of calculators in China. Later, around 1985, economic environment became harsh and NTE's business went downhill. With its existing relationship with Japanese manufacturers, Koo seized the opportunity to transform the business again to export electronic components and raw materials from China back to Japan.

Upside

One of NTE's factories locates in Bao'an, Shenzhen, China. NTE now intends to redevelop this land into a commercial complex and become a property developer and manager.

A quick discussion of the economic backdrop of this region is warranted here.

In 2010, Chinese central government extended the Shenzhen Special Economic Zone (SEZ) to include Bao'an and Longgang. Besides, Qianhai, the bay area in Nanshan, is earmarked to be turned into an international financial services centre. It is China's ambition to have its currency RMB playing a more significant role in global finance.

Expansion of Shenzhen SEZ (Source: China Daily News)

NTE's factory is 7km from Bao'an CBD, 12km from Qianhai CBD and 10km from Shenzhen's international airport. Local government has recently been rezoned the region from industrial use to commercial use.

"A" is NTE's site. Left box is Shenzhen's international airport. Middle box is Bao'an CBD. Right box is Qianhai district.
(Source: NTE new releases, Google Map)

In China, like Singapore and Hong Kong, lands are not bought. Instead, land use rights are leased. The total historical cost of land use rights is stated at $10m on NTE's balance sheet. Bao'an site makes up probably less than half of that. i.e. it makes up less than 1.5% of the its book value. In other words, it's not material.

NTE's site has a land area of of 52,600 sqm. It can accommodate a business complex with a plot ratio of ~6. That means, after redevelopment, it will have a 300,000 sqm gross floor area (GFA). How much is this land parcel worth now after the rezoning?

NTE's Bao'an site (Source: NTE new releases, Google Map)

We can look at comparable land sales (or more correctly, auctions of land use rights). Two parcels of land in Qianhai with plot ratio 6.5 & 7.8 (T201-0077 & T201-0075) were auctioned in July 2013 and sold for ~$2,700 per sqm (GFA). Sale prices were ~50% higher than the opening prices. But that's Qianhai, the red hot region in recent months. How about Bao'an? Two parcels of land in Bao'an CBD with plot ratio 6.0 and 8.1 (A004-0154, A002-0046) are currently listed with opening prices at around $2,100 per sqm. Two years ago, a parcel of land a couple of kms outside CBD (A002-0042) was sold for $1,600 per sqm in Jun 2012.

So, if NTE's land can command $1,000 per sqm, it will be worth $300m. If it can command $2,000 per sqm, we arrive at a more aggressive value of $600m. Adding this back to the book value, we are looking at a value of $14 to $21 per share.

Alternatively, we can look at cash flow. NTE has commenced 3 feasibility studies for the project from 3 different consulting firms. The recommendations centre arround building a mix-use complex consisting of a hotel, offices, R&D offices, retail space and residential apartments, and some combinations of these. With assumed rental charges in the range of $0.8 to $3.0 per sqm per month (if you consider the current rental market in the area, these rental rates are very reasonable), the expected net rental cash flow will be in the vicinity of $50m per annual. If you apply a very conservative 10% capitalisation rate, the complex will be worth $500m (in 3-4 years). Apply a more aggressive cap rate of 7%, you will get $700m. i.e. We are looking at $11 to $16 per share. Here, we haven't added back the book value because the development will consume cash. However, it is almost a certainty NTE will mortgage the land to fund the development. There will be un-utilised asset value not accounted for here.

Why is it cheap?

The main give-away is the 11% drop on Jan 27th when NTE announced it would cease all manufacturing and committed itself to develop its lands. Its existing shareholder base sees it as a electronic manufacturer with good dividends, not a property developer that won't be able to distribute in the next few years and needs to lever up the balance sheet.

Second, value investors who screen for cigarbutts will shun the stock with its China connection.

Third, its small $270m market cap is pretty much not on most fund managers' radar.

Risks

Koo is 70 this year. NTE is his company. Without him, the direction of the company is completely unknown.

Second, my contact in China who is familiar with its business environment and property laws told me there is a real chance the local government will not approve NTE's redevelopment plan. Typically, the local government will have a lot of financial incentive to take back the lands and then auction them off. It will pocket the hefty profits while the original property owners will only be compensated for what the lands were original designated for. e.g. Another industrial land in a nearby region. Besides, the local government favours established larger developers and give them significant advantage.

However, the feasibility studies indicate the local government is "supportive" of NTE's project. One possible explanation is NTE's project fits well in the government's overall agenda. They want to fast track the redevelopment of the entire industrial region. There are rivalries between different SEZs. They are willing to give up a very small value in the overall scheme of things in order to get a pioneer to create a showcase. In addition, Koo's 3 decades of business relationship will the local government should also count. Undoubtedly, we have to trust Koo's experience and judgment here.

But even if the project is rejected by the government, what do we lose? We are still holding onto $1 worth of asset value that we have paid only 75 cents for it.

Third, if the redevelopment goes ahead, we won't see any cash flow for 3-4 years and NTE will lever up its balance sheet. Besides, China's grand policy plan for the Qianhai and Bao'an will take years to materialise. So, you need a 5+ years time horizon to invest in NTE.

Fourth, I've said for years China will slow down in the coming decades. We now start to see this effect on Australia's mining sector and its currency. In addition, China's huge debts in its shadow banking system is destabilising its economy. The chance of a catastrophic collapse of its economy or property market is remote but possible. This can derail the planned economic development of the region for 5 to 10 years. Or more.

Closing thoughts

One way to look at this investment is, it is buying a property development project at a discount. Another way to look at it is, the property development project has tremendous option value. We are effectively getting paid to hold this option.

How often do we see management of companies operating in deteriorated business environments hanging onto their status quo, knowingly to lose money years in years out, hoping to "turn around" the businesses? When the market sees NTE's exit from its existing business a negative, we should see it a strong positive. Koo refuses to continue to operate a business that will no longer earn its cost of capital. It is Koo's brilliance to turn hindrance into opportunity. We have seen it happened before multiple times in NTE's history. Buying NTE is to bet that he will do it again. But strangely, this bet costs us nothing.

Resources

NTE's New Releases (in English) - including SEC filings and the 3 feasibility studies
Shezhen Land and Real Estate Exchange Center (in Chinese)
SoFun (in Chinese) - online rental markets and land transaction data
Brief bio of Koo and NTE (news piece in 2003, in Chinese)
Koo commented on its redevelopment plan (July 2013, news piece in Chinese) - He speculated the land was worth RMB 9 billion! (USD$1.5B).

*I didn't discover NTE myself. The credit goes to Batbeer2 who published an investment case on Gurufocus in July 2013. I also owe Batbeer2 a thank you for flushing out some of the details.

(Disclosure: Long NTE & AAPL)

What to learn from a broken investment thesis

2013-05-25T21:42:00.001+10:00

In April I wrote about the microcap HGL Limited (ASX:HNG). The investment case rested on three pillars:

HGL showed a long history of above-average profitability.
It was trading close to tangible book value (TBV).
Consumer sentiment had improved. HGL's financial result should catch up very soon.

This week, HGL released its half-year result. It was essentially breakeven.The new CEO conceded the company required further cost cutting and announced new restructuring initiatives that would burn $1m cash and require a $3-4m writedowns of its asset in the 2nd half of the year.

On the top of that, the management wanted to distribute $1m dividend. Last year the company paid dividends from the proceeding of the sale of a business unit. This year, it is going to pay dividends from its capital base!

(This shows the obsession of dividend yields in Australia. Continuous dividends support the share price of a company even when the business is in life support. To US readers: Australia has a franking credit system that prevents double-taxing on dividends. Thus, dividends in Australia are treated in a more favourable light here than in US.)

Now, examine the investment case again: Pillar #3 is broken. While the rest of the retail sector in Australia has recovered from it dark hours, no turnaround is in sight for HGL. Pillar #2 will be further weakened by the writedowns.

When an investment thesis is broken, I exit my position.

What can be learned here?

1. Write down your investment theses

Without writing down why you buy a stock, when the fundamentals change, you won't notice.

Human mind is an interesting thing. It's not good at remember things when the past is in dissonance with the new reality. It's very plastic. It will reconstruct a new history, making up a story to fit the new reality.

It's so easy to fool yourself. In the case of HGL, I could've fooled myself restructuring were a sign of turnaround I originally anticipated. But, no, it wasn't. I was expecting a swift shift jump of profit. There is no way to hide the mistake when it is written down black and white.

2. When an investment thesis is broken, quit

There is no "but" or "if". Regardless how painful the lost is, exit your position when the investment thesis is broken. The investment thesis that you have written will help you here to judge the situation rationally without being clouded by your emotion.

HGL may eventually turnaround. There is always the possibility I'm missing the upside if I sell now. However, the key point is, I bought HGL because of the reasons I listed above. If they are broken, my downside is more risky than I originally anticipated. In other words, this is a matter of risk control.

3. Process is more important than outcome

In investing, when you consider each individual action in isolation, good outcome doesn't necessarily mean good skills; likewise, good skills don't necessarily produce good outcome.

I first read about the significance of having a good process in Mausoussin's More Than You Know.

Source: Russo and Schoemaker, Winning Decisions.

At the time, I thought it was BS. Ask me to condone bad outcomes?! The endgame is always about returns, right? How the hell would the process be more important than outcome?! Yet, over the years, I gradually realised how fundamental and significant this wisdom is.

I think the best example to illustrate this is poker game. Poker and investing are very similar. Both skills and luck are important factors. Say you are watching a player playing a poker game. If you saw him losing a few hands in the last 15 minutes, can you conclude he has no skills? Or if he has just won a few hands, can you conclude he has skills? Apparently not. The only way to tell whether a poker player is a master or not is to follow him for a long time. Only long-term result can separate skills from luck. And how does a poker master achieve long-term result? He sticks to a good process consistently and painstakingly to allow the edge of his skills to play out. Each individual hand may produce bad outcome. But in long run, his edge will generate better than average result.

Look at the HGL case again. I lost 6% in this investment in real life. My original thesis estimated that the best case upside was 200%. So here we have a 30:1 reward-to-risk ratio. And I judged there was a fair chance the favourite case would play out. Asymmetric reward/risk plus favourable possibility. Even if it didn't play out this time, the decision to buy was the right one. So was the decision to sell.

(Disclosure: none)

My biggest mistake in the last 12 months

2013-04-19T13:05:00.001+10:00

It was a mistake of omission.

There is this startup with a promising but unproven technology. I spent weeks searching the business and the market. I got to point of pulling the trigger. It was at a price that I was comfortable with to put in a small stake based on my calculated risk/reward, knowing I could lose it all. I literally had my finger on the "buy" button when I hesitated, wanting an even cheaper price. The next week, price started running away from me and has never returned. If I'd bought it, it would've been a 3-bagger in less than 3 months and would've taken care of my 2013 return single-handed.

It's been really painful watching the price running further and further away from me on a daily basis. Trust me. It's painful. Even having reflected on the lessons learned, knowing probability plays a role here and drilling on it does me no good, I can't help agonising about it.

Emotion can kill an investor.

Another lesson: net-net mentality is sometimes wrong.

Is HGL Limited a cigarbutt?

2013-04-07T18:09:00.001+10:00

HGL Limited (HNG) is an Australian microcap listed on ASX with a market cap of $22m. Its current share price is $0.44. It has virtually no debt. Insiders own about 40% of the company. Its history traces back to First World War. It was originally founded in 1898 as Hancock & Gore, a timber mill operator.

Between 1985-2010, it was under Kevin Eley's leadership. Without a better word to describe it, I would call it a "micro-conglomerate". Eley copied Warren Buffett's Berkshire Hathaway model with 2 distinct operations: (1) investing in public listed companies and (2) buying and operating a group of private businesses. However, since 2009, HGL has shifted strategy and gradually exited its equity investments. In 2010, Eley stepped down and was replaced by then COO Michael Mahoney. HGL is now a pure operator of a bunch of unrelated businesses. (Eley remains to be a board member.)

While its businesses are largely unrelated with no syngery, they all follow a common theme: they are branded products and services operating in their very narrow niches. These niche markets are usually fragmented and allow HGL to exert some pricing power. HGL don't manufacture their products. Effectively, It is an importer/distributor.

HGL's wholly owned businesses (sale figures are FY2012's, in AUD):

SPOS - point-of-purchase marketing services ($23m)
JSB Lighting - high-end lighting ($15m)
Leuteneggar & XLN Fabric- fabrics for home sewing and craft ($17m)

Businesses with 50% ownership:

Anitech - large format printer products and services ($29m)
Mountcastle - school uniforms and headwears for police and defence forces. ($12m)
BOC - ophthalmic equipments ($7m)
BLC Cosmetics - skin care ($10m)
Biante Model Cars - collector model cars ($5m)

Business was tough in 2012. Persisting high Australian dollar caused price deflation and consumer sentiment was the worst since GFC. Both SPOS and JSB suffered huge setback. Management at SPOS had misjudged demand. It suffered large writedowns and impairments. HGL's revenue fell 28% and its net profit was negative. Excluding the writedowns and impairments, EBIT margin was 0.3%, effectively breakeven, while historically it was in the range of 7-9% in the previous 5 years.

Our investment thesis is based on a simple idea: reverse to mean.

Between 2008 and 2011, HGL's average ROE was about 10%. However, HGL has goodwill from its past acquisitions on its book. Use HGL's own preferred measurement, EBIT / Capital Employed averages close to 20%. HGL has never lost money in the past 10 years. HGL is an above average business. If HGL manages to control its costs and achieve a typical 5% net margin, using the 2012 trough revenue of $118m, it can achieve a net profit of $5.9m. With a conservative P/E multiple of 8.5x, each share will be worth $0.68, 50% above the current price. If revenue returns back to historical average of $160m and net margin 6%, with a more "normal time" multiple of 10x, it will be worth $1.3 per share, 200% above the current price.

(HGL has non-controlling interests on its book who have a claim on HGL's profits and assets. All the above figures except EBIT and Capital Employed have been adjusted to reflect what equity holders get. All figures are in AUD.)

How likely can HGL turn around its business?

The catalyst that is helping us out is a swift improvement of consumer sentiment in the first 3 months in 2013.

(source: tradingeconomics.com, Westpac Bank, Melbourne Insititute)

The chart below shows HGL's share price against 2 Australian retailers, Harvey Norman and Myer. (Harvey Norman is comparable to Best Buy in US. I'm not too sure what the US equivalence of Myer is. Maybe JC Penney?) You can see the dramatic recovery of HVN and MYR in the last 3-6 months, coinciding with the improvement of consumer sentiment. You can see HGL is lagging behind because improvement of its profitability is not yet in sight.

(source: Google Finance)

After deducted the minority interests, HGL has a net tangible asset (NTA) value of $0.41 and a net current asset value (NACV) of $0.35 per share. While the current share price is very close to NTA, HGL is definitely not a net-net. We have some safety from the value of the assets, but it's not bullet proof.

The opportunity here is the possibility of a quick turnaround. We are relying on its operating leverage to propel its profit (and share price) quickly when sales volume picks up.

Make no mistake. Turnarounds are risky businesses. Besides, there are few things I don't like about HGL:

Since each subsidiary operates independently with its own CEO, HGL has effectively 2 layers of management. It made sense when Eley was still around acting the capital allocator. But it's no longer the case. I think it's redundant and wasteful. (The corollary is: HGL will be worth more if it's broken up. The main it'll lose is the access of the capital market.)
The non-controlling interests act like preference shares: always standing in the front of the queue to take a cut before the equity owners.
Mahoney stepped down as the CEO because of "ill health" a few months ago. One got to wonder if HGL's poor result took a toll on his health.

On a balance, my view is the potential of a swift realisation of the upside is enough to compensate for the negatives. And I think HGL is qualified as a "cigarbutt". You quickly take your puff and then move on.

(Disclosure: Long HNG.AX)

Little accounting games and obscurity in conference calls

2013-02-09T14:59:00.000+11:00

Dolby (DLB) announced its 2013 Q1 result a week ago. It reported total revenue of $236.6m compared to $234.2m the same quarter last year. However, somewhere buried in the 10Q says:

Reclassifications
Beginning in the first quarter of fiscal 2013, we have recorded settlements from implementation licensees as licensing revenue rather than as an offset to sales and marketing expense. In order to conform to the current period's presentation, we have reclassified these settlements for the prior periods presented within our condensed consolidated statements of operations. For the fiscal quarters ended December 28, 2012 and December 30, 2011, licensing revenue now includes amounts recognized under settlement agreements of $6.6 million and $0.8 million, respectively. The reclassification did not impact our previously reported operating income, operating cash flows, net income, or earnings per share.

That means without the reclassification, the revenue of 2012Q1and 2011Q1 should be $230m and $233.4m respectively. Oops, a slight drop.

It's not a significant sum. Yet, you come out with the impression all these little accounting maneuvers were there to please the forever short-term focusing Wall Street, to avoid showing a drop.

Oh, well, an analyst did ask something in the conference call which I believe relates to this reclassification:

Steven Frankel - Dougherty & Company: Could you start Lewis with some clarity on the catch-up royalty payments that occurred in Q1? How much was that and what category did that come from?

Lewis Chew - EVP and CFO: First of all, I'd say that this is really a subset of all those items, so that going forward now, starting with this quarter, all of our catch-up, whether they settlements or back royalties, will all be classified in revenues. So that will get rid of any remaining – I know in the past we've talked about some of these that were recorded as credits to expense. The impact both year-over-year and quarter-over-quarter was about plus 5 and in terms of market categories, in any given quarter they are spread across and this quarter was the same. They happened in several of our different buckets, the normal buckets we talk about – set-top box, PC, TV, et cetera, but that's the impact is about plus 5 both year-over-year and quarter-over-quarter.

I said "I believe" because the languages used by both the analyst and the CFO were obscure. Why said "catch-up payments" and "classified" instead "reclassification"? If you haven't read the 10Q, you will probably miss it.You can't help but think the analyst was conspiring with the management to obscure this and, at the same time, had himself covered.

Sadly, that's the norm, not an exception. Sigh...

(Disclosure: Long DLB, but not too happy.)

R&D Expenses and Patents

2013-02-06T19:47:00.002+11:00

I put this together just for fun. I can't guarantee the accuracy. Patents acquired instead of generated in-house are not included.

As a percentage of revenue, Apple's R&D expense looks puny. And it looks like Microsoft Research is our modern day Xerox PARC lab, just what Nathan Myhrvold wanted.

(source: USPTO and Google Finance)

* Oracle: including Sun Microsystems patents.

I'm now a proud part-owner of Apple, Inc.

2013-02-02T22:34:00.000+11:00

When I sold down a significant portion of my RIMM (or BBRY now) last week at its recent peak before it took a 25% dive (it was luck, not skills), I thought I had to park the cash aside for some time. Yet, Mr Market handed me Apple straight away. How ironic it is. This was the time when Mr Market was very excited about RIMM but very grim on Apple. "Be Fearful When Others Are Greedy and Greedy When Others Are Fearful", said Warren Buffett famously. Usually you can only experience one half of this maxim. How rare it is that I experienced the whole thing back to back.

This is going to be a long post. Be warned.

The economics of mobile computing platforms

We all use the PC industry as a proxy to understand mobile platforms. The present war between iOS vs Android is so eerily similar to the war between Mac and Windows decades ago. Under this view, Apple is facing a serious dilemma. On one hand, Apple insists on making premium products without compromises and charging premium prices. On the other hand, the economics of platforms leads to "winner takes all". For a platform to survive, it requires market share. And only at a low price point and being open can a platform achieve mass adaptation. This was arguably the main factor that undid Mac 20 years ago.

However, this view is incomplete. There are subtle yet important differences between PC platforms and mobile platforms.

I argued before mobile platforms are less sticky than PC platforms. The stickiness of PC comes from the applications developed on the top of the platform's API. The API is the lock-in. But the nature of mobile apps is different and the switch cost of mobile devices is lower than PCs:

Price of the apps are orders of magnitude lower.
Most of the essential apps are cloud-based and the clients are free on all mobile platforms. Given the business models of these service providers (e.g. Amazon, Google Search, Facebook) who want ubiquitous access to their services, this won't change in foreseeable future.
In order to protect their investments, many businesses will utilise portable HTML5 instead of native APIs to implement their business apps when the applications are not consumer facing and "snappiness" isn't the priority. (This has already happened on desktop applications for years. If you visit a bank, very likely you will see their desktop applications run on browsers which communicate to their back-office servers.)

Besides, there is a different form of lock-in in the broader ecosystem: the (cloud-based) services available exclusively on one platform. Examples of Apple's iCloud, Face Time and iMessage and RIM's Blackberry Messaging (this is going to change with BB10). Here, Apple has the advantage. It's not in Google's business interest to limit their services only to Android. Apple can employ exclusivity. Google won't.

Lastly, mobile devices are so much an extension of our public persona. They are displayed prominently in public. They are like watches and diamond rings. Brand recognition and brand loyalty are important drivers of repeated purchases. The trust and emotion associated with the brand are so fluid you can't called them lock-in. Yet they do attract long-term followers. (I shall talk more about this brand issue below.)

In a nutshell, the risk that iOS will be marginalised by Android because of the asymmetric market share is lower than what it appears.

Valuation

Let's turn to the numbers.

Apple's trailing-twelve-month (ttm) earning is $41.75B. Current share price is $450 and total market cap $422B. Apple has $137B cash (inclusive of marketable securities). The way Apple structures it capital on the balance sheet tells us $97B of that is not needed for its operations. Let's assume all of this cash is trapped overseas and will incur a 20% tax in order to repatriate it back onshore. This leaves us $78B distributable cash. Removing this amount from its market cap gives us $344B enterprise value. This gives us a ttm P/E of 8.2x, or an earning yield of 12%. At this P/E, the market assumes Apple's earning will be going downhill from here.

Will Apple's earning go downhill?

Let's look at the bear case scenario that Apple won't introduce any new product categories. i.e. Apple will just rehash and incrementally improve its current product lineup. We further assume the profit centre is iOS products. We focus solely on iOS devices. i.e. iPhone and iPad.

We need to look at both sale volume and profit margin. Let's look at sale volume first.

Buyers of iOS devices fall in three groups: (1) non-consumers (i.e. people who never own a smart phone or tablet before), (2) existing iOS users who are upgrading and (3) buyers switching from different platforms (i.e. churning). At the moment a large portion of Apple's sales comes from non-consumers. But this will change some time in the future. When the market is saturated, the consumer mix will shift to mainly upgrades from existing customers. How about churning? Churning has been minimal. Apple users are immensely loyal. Satisfactory rate of iOS products is 90%. We assume the lost of existing customers and gain of new customers cancel out each other.

So we can rephrase the question: can Apple sustain the current sale volume if majority of the business is upgrades from repeated customers?

Apple sold about 200m iOS devices in the last 12 months. The lifespan of mobile devices is about 2 years. So we need a 400m install base to sustain a refresh rate of 200m units per year once an equilibrium is established. I've estimated the current install base of iOS devices is about 350m units. What this means is it isn't far off for Apple's sale volume to become self-sustainable. No doubt the lifespan of mobile devices will eventually get longer. And the assumptions and approximations I use here can be off. But the important thing is the scale of the magnitude. It is within Apple's reach to become self-sustainable in sale volume.

What about profit margin?

If we reduce Apple's gross margin from the current 38% to 28%, Apple's revenue will drop 15% and its profit will be cut in half. Suddenly Apple's 8.2x P/E becomes 16.4x which doesn't look cheap anymore.

Profit margin is the real deal here. It's not that far-fetched Apple's gross margin can shrink to 28% level if competition pressure intensifies or production costs increase.

What are not properly priced in?

After all, maybe Apple's 8.2x multiple is justified. Given the risk of margin compression, maybe Apple is fair value at $450.

But there are a few things coming with Apple that we don't see on the shelves, on the balance sheets nor on the cash flow statements. These are the intangibles that are impossible to quantify. There are the values not properly accounted for in Apple's current price:

Apple's brand
its DNA and organisational processes
growth potential in China
new products

Let's address them one by one.

How valuable is Apple's brand?

How valuable is Apple's brand? I frankly don't know how to put a price on it. However, I want to point out three observations.

When Steve Jobs brought Apple back from the brink of bankruptcy, Apple introduced a stop-gap product to buy itself enough time to develop more innovative products. It was the iMac G3. What's striking about iMac G3 is it possessed no major technological breakthrough. Its technical spec was not that different from its predecessor G3 All-in-one.

iMac G3

Mac G3 All-in-one

What iMac G3 had was a new look. Apple has mobilised its fans by just altering the look of a product. I'm not diminishing the importance of such industrial design. The creativity required is no less than the creative mind that conceived mass as energy. What I'm trying to point out, however, is that only a strong brand can utilise this to bring commercial success. (iPhone and iPad currently are available only in black and white. How much time can Apple buy if it merely offers different colours with only mild technological upgrades?)

The second thing I want to point out is triggered by an article I read on Financial Times about kids receiving iPods and iPads as their Christmas presents. This immediately reminded me one of Buffett's favourite businesses: See's Candy. Why See's Candy? Chocolate has no lock-in power. What See's Candy has is brand value. Let me quote Buffett: "[People] had taken a box [of See's Candy] on Valentine’s Day to some girl and she had kissed him… See’s Candies means getting kissed." It is not about the chocolate. It's about the emotion value and trust the brand brings. When you buy your nephew an iPad, it's not about the feature set, it's about the recognition of the Apple brand.

This brings me to my third observation.

Apple's products are more like fashion items than computers or consumer electronics. Take a look at this survey done in China recently:

Best brands for gifting by men (source: Hurun Chinese Luxury Consumer Survey 2013)

Best brands for gifting by women (source: Hurun Chinese Luxury Consumer Survey 2013)

Do you see what Apple's peers are in consumers' eyes? These are prestige brands deliver repeated sales on seasonal basis by altering "just the look". Apple is the only consumer electronic company on these lists. It is the monopoly in this market segment. And where is Android or Samsung? In terms of brand image iOS and Android are very different.

While we shouldn't read too much into the lists because they are not good representations of the whole market, they give us a different perspective of Apple's basis of competition. A $10 T-shirt I buy at Target is functionally the same as a $1000 T-shirt available at Louis Vuitton. But they are not directly competitors. That the $10 Tee has a 99% market share and the $1000 LV Tee has only 1% market share won't be a concern to an LV's investor. Similarly, to some extent, iOS and Android are not direct competitors.

In the hi-tech world, we are so afraid of disruptive innovations which result in better products. Yet no one is worried about such product disruptions faced by Louis Vuitton or Burberry. These companies have a product disruption cycles in months, not years, in the form of fashion cycles. Instead, what companies like Louis Vuitton will be worried about is disruption in the processes as what Zara has shown them, not disruption in the products. When we look back at Apple, don't we focus on the wrong thing if we are worried about the products? Shouldn't we pay more attention to the processes?

Organisational processes and Apple's DNA

Apple as an organisation excels in two things: operation efficiency and product development.

Apple is the king in efficiency. If you use cash conversion cycle as a metric, Apple is 50% more efficient than both Amazon and Dell. Stop for a moment and compare the logistic complexity that Apple faces with that of Amazon. Books don't involve co-ordinating multiple supplies. Books don't require assembling hundreds of components.

And I don't have to elaborate on its product innovation side.

Achieving where Apple is at now at such a scale isn't what a single person can do. A lot of the values come from Apple's organisational processes. Or you can call it DNA or culture.

Growth potential in China

When we say Apple is fair valued at $450, we assume there isn't much head room for iPhone/iPad's market to grow. Look at mobile phones alone. Currently smart phones penetration in US is about 50-60%. Some projections suggest it will become saturated in around 2 years.

However, that's just US. Worldwide, smart phone penetration is 20-30%. Apple has been actively pursuing the China market. China will surpass US has Apple's largest geographical segment in a couple of years. Yet, the current share price implies it doesn't exist.

Product Pipeline

Tim Cook said in the recent conference call that Apple's product pipeline was "chock full". Ok, no one takes what management says at face value. Let's discount the "chock full pipeline" to "have something in the pipeline".

No matter how you cut it, it's a certainty that Apple has some new products in its development pipeline. No one will dare to bet otherwise. Given Apple's track record, there is also a fair chance these new products will have meaningful impact on Apple's bottom line. The only thing we don't know is what they are and when they will be available. This is the key uncertainty here. This is the kind of uncertainty Mr Market hates.

I read about a comment by a fund manager that he sold his Apple stake because of the uncertainty in Apple's product pipeline. Over and over again, Mr Market mistakes uncertainty as risk. If you agree that Apple, with its current product lineup, is fair valued, then what this pipeline uncertainty gives you is not risk but a valuable optionality, coming for free.

How important is (the absence of) Steve Jobs?

The Brooklyn Investor blog has two insight articles on Steve Jobs and Apple. (see here and here.)

I agree with them on many fronts. However, I take a more "anything has a price" view. i.e. Jobs is important to Apple at $700; he is less important at $450. To put it differently, true, a Jobs-less Apple isn't as valuable as an Apple with Jobs around. But we as investors can still do well as long as we pay a low price.

Pre-mortem: What has gone wrong?

It is now 2015. My investment in Apple has turned sour in 3 parallel universes in one form or another and my capital is permanently impaired. What has gone wrong?

Universe 1: Without Jobs around, internal bureaucracy mushrooms and destroys Apple's ability to execute anything effective. Apple becomes Sony or Microsoft.

Universe 2: The upgrade cycle of mobile phones and tablets slows down too soon and too much.

Universe 3: I've completely misjudged Apple's brand power. Mobile devices are tools. A cheap and good tool trumps an expensive and flashy one. Apple's profit margin evaporates.

This investment isn't without risk. To me, it has enough margin of safety and enough upside potential. This is a high quality business worth paying a fair price. You need to make the judgment yourself.

Closing

While researching Apple, a lot of things Buffett said about quality businesses popped up all over my head. Let me quote a couple of things Roger Lowenstein says about Buffett in "Buffett: The Making of An American Capitalist".

After Buffett scooped up the ailing Berkshire Hathaway in 1962, he bet big in American Express in 1964. This is what Lowenstein said:

His sleuthing led to two conclusions, both at odds with the prevailing wisdom: (1) American Express was not going down the tubes. (2) Its name was one of the great franchises in the world. Amex did not have a margin of safety in the Ben Graham sense of the world.... But Buffett was a type of asset the eluded Graham: the franchise value of Amex's name.... The loyalty of its customers could not be deduced from Graham's "simple statistical data"; it did not appear on the company's balance sheet...

When I accompanied my wife to a shopping mall one day, I paid a visit to the Apple Store there. This visit remained me what Lowenstein wrote about Buffett's viewing of Disney's Mary Poppins in 1965:

He saw that [the audience was] riveted to the picture, and he asked himself, in effect, what it would be worth to own a tiny bit of each of those people's ticket revenues -- for today and tomorrow and as many tomorrows as they kept coming back to Disney.

Over many days, I asked myself over and over again: wasn't Buffet describing Apple?

(Disclosure: Long AAPL, RIMM/BBRY)

RIMM vs NOK vs AAPL

2013-01-25T06:59:00.000+11:00

The share prices of RIMM, NOK and AAPL in the last 12 months. This is telling:

RIMM and NOK moved almost in tandem up to 15 days ago.

It appears first 350 days of their price movements can't be explained by their fundamentals because the two companies did different things. It has to be market sentiment then?

By the way, AAPL is getting more interesting everyday.

(Disclosure: Long RIMM)

Questions about options and LEAPS

2013-01-25T06:41:00.001+11:00

I'm pondering whether I should long some of my RIMM via options (or LEAPS). My experience with derivatives is limited.

So, here is a question to everyone: How should I size my position? And more importantly, how much out of money, and at what expiry date? I'm interested in using it as a risk control. I'm interested in the principles and reasoning.

Thanks.

(Disclosure: Long RIMM)

Update on RIMM

2013-01-23T23:50:00.000+11:00

This is a long overdue update on RIMM.

Since I wrote my original investment thesis 9 months ago, the stock price has been acting like a roller coaster, falling from $13 all the way down to $6.30 and has since recovered and climbed to $18. I accumulated more shares on the way down. I have also reduced my stake on the way up.

Assessing RIMM now

RIMM's management has done many things right. If you are familiar with Apple's history as depicted in Steve Jobs' biography, you will see what RIMM has done was straight from Jobs' playbook when he brought Apple back from the brink of bankruptcy in 1997. At the time, Apple was 3 months away from insolvency. Jobs cut cost, rationalised the supply-chain and cobbled up a stop-gap product iMac G3 to buy time. RIMM did all these. (Granted that RIMM's stop-gap products are not as intriguing as iMac G3. But they did refresh a couple of their BB7 models.) Because of all these tactical moves, RIMM has been cash flow neural.

Besides, what RIMM has done shows also RIMM has a clear understanding of ecology of the mobile industry. In the mobile space, you do not deal with just the end users. Instead you have this entangled triangular relationship: (1) the carriers, (2) the application developers and (3) the consumers. In order to get one group on board, you need to get the other 2 groups on board. This is a virtuous cycle, but going backwards when you don't have the base. To break this chicken and egg situation, RIMM has literally handed out free cash to court application developers. (If Alec Saunders can really pull it off to artificially build an ecosystem overnight and make BB10 a self-sustainable platform, it is destined to be an important case study at B-schools.) Besides, the restructuring of RIMM's pricing model revealed in their recent conference call is an evidence that RIMM is also buying carriers' support.

However, it's not all blue sky. RIMM has made a single most critical strategic decision that has fundamentally altered the value proposition of its turnaround. I'm not saying RIMM has made the wrong decision. They have no choice. They have selected the lesser of two evils.

What am I referring to?

RIMM has completely given up a pillar of its existing ecosystem. RIMM has given up their proprietary management protocol. Instead, both BB10 and BES10 will use the ActiveSync protocol.

The key issue here is old back-office BES can't manage BB10. Consider this: business users constitute a significant portion of RIMM's market. These existing users are still on BB7 only because their companies are still running the old BES. How to get them to buy BB10 phones? They won't buy the new phones unless their companies upgrade to BES10. But the upgrade cycles of information systems at corporations are notoriously slow. Businesses are inherently risk averse. They won't adapt new systems if the systems are not proven. Consumers will buy phones on an impulse. But it can easily take a company months or even years to evaluate a new system before committing to it. (Quick, is your company still using WinXP?)

So, RIMM has given up the lock-in power of their own franchise. It's not unlikely seeing Intel giving up their x86 architecture or Microsoft giving up their Win32 API. But as I said, RIMM has no choice. This decision to use ActionSync makes BES10 able to manage all other phones on the market. It makes BES10 a better value proposition to sell to CIOs.

If you remove this structural lock-in, for business users, what is left is RIMM's brand, its customer relationships and its history of delivering valuable solutions. These are by no means worthless. But without the lock-in, BB10 will be competing with Android and iPhone on equal footing, on features and prices.

(Well, I think one comforting sign is, there are reports that companies have shown up for BES10 testing and training. The uptake of BES10 can be faster than I foresee.)

On valuation and what to do next

At the current price of $18, the margin of safety has gone. Not only that. RIMM's break-up value has actually deteriorated as expected. The value of its BBM network and BES have both shrunk. Donald Yacktman aptly said RIMM's value was a melting ice cube.

RIMM was a net-net at one point. But it is now a pure turnaround story. Its P/B is back to 1.0. So I don't have the downside protection I once had. However, on the flip side, if BB10 manages to become a sustainable ecosystem, the upside is huge. RIMM can easily get back to $40, $50 or $60. But this is a big "if". I have no confidence in myself to handicap it. I don't have much insights on the odds. And I don't much insights on the bull case valuation. If the PC history is a guide, it's winner takes all.

When I bought RIMM, my investment horizon was 3 years. I didn't expect such a dramatic price movement. I didn't expect the price would go up this quick before RIMM turned a profit. Without the downside protection, the possibility of a break-up and real profit, I now have my eyes on the exit. Weighting up all the factors, the odds and my edge, I will probably sell down my stake gradually. I may hold a smaller stake for a long time as the upside is still too good to ignore. The upside still has a good chance to materialise even though I'm not capable to put a figure on it with confidence.

Lessons learnt

In retrospect, if there is one lesson learnt in investment, it is that I was not aggressive enough when averaging-down. I run an already very concentrated portfolio. And this single stock has been (and still is) the biggest position. I was too concerned about the concentration in one stock. In hindsight, my emotion overtook my rational thinking. When the stock was below $7, the probability of losing money approached zero. This should've been the time to back up my truck to load up. But I didn't. But my averaging-down was too timid. (And this is not the first time I make sure mistake...)

By the way, here another interesting thing I've observed.

There was this analyst covering RIMM who was able to move the market. When he changed his target price, the market followed. At various times, this analyst came up with his target prices by weighting different scenarios by their probabilities. There is absolutely nothing wrong with this. But what I disagree with is that he assigned a high probability to the $0 case.

RIMM is debt free. Management shows they are rational, doing all the sensible things to keep its cash flow neural. It has a book value. It has tangible assets. Every single desk at its Canada HQ can be sold for some cash. Its patents can fetch some money. After all, it has cash in the bank. $0? You are kidding me.

This shows the general bias on the Wall Street. Undoubtedly there is a fair chance RIMM will fail and disappear as a company. But they mix up the collapse of an identifiable business entity with the complete destruction of value. They think that when a company ceases to exist, all the value embedded in it will vanish. They think value can only exists if the business is a going concern in its current form. This is the reason why so much emphasis is placed on the P&L's while balance sheets get very little attention. They ignore the possibilities of what Martin Whitman called "resource conversions". [Ed: Reading this myself again, I realise I implied the management wouldn't drive the company to the ground if BB10 didn't turn out right. The confidence comes from that we have a major shareholder on the board who would steer towards an orderly liquidation. An orderly liquidation is resource conversion.]

Resource conversion is one important way values can be released.

(Disclosure: Long RIMM)

Ships, hogs, dirts and the shipbuilder called Conrad

2012-12-03T13:29:00.000+11:00

Ships, hogs, dirts and shipbuilders. What do they have in common?

Their economics.

Ships

A while back, the dry bulk shipping industry caught my attention. You can see why from the 3-year BDI index chart below. The BDI index is the barometer of the charter rates for dry bulks. The industry has been in recession since GFC. It is severe. Besides, I remembered one of my role models, Mohnish Pabrai, described in his book how he scored a multi-bagger win in his bet on the oil shipping company Frontline when the industry was in recession in 2001.


Source: Bloomberg

Were there values among the dry bulk shippers?

The initial look looked promising. Listed dry bulk operators like DSX and GNK spotted attractive ROAs, profit margins and P/B ratios. However, the more time I spent to understand the industry and its economics, the less sure this was a game I was capable to play.

Take a look at the supply/demand curve I reproduce from Martin Stopford's book Maritime Economics :

Source: Maritime Economics, by Martin Stopford

Let me point out the important bits:

Shipping is essentially a commodity business. (You generally don't care too much who is shipping you stuff as long as your goods arrives in one piece.)
In short term, demand is inelastic. (If you need to buy steel beams to build your Olympics stadiums, high shipping cost won't easily deter you.)
At the same time, worldwide shipping capacity is finite, because it takes years to build a new ship. Thus, supply becomes inelastic once you reach a certain point. Hence, the "hockey stick" shape supply curve. Freight rates can go from $6,000 to $44,000 in the space of a few months.
When freight rates skyrocket, shippers will decide to invest to expand their capacity. It takes 1-3 years to build a new ship. By the time the shipbuilders expand their shipyards and new ships are built, the demand is no longer there. We now have an oversupply of ships and freight rates tumble.

So, here we go. Boom and bust cycles. Because of the above structural reasons, the magnitude of boom and bust cycles is extreme. Consider this: BDI was at its highest 11,000 in mid-2008 before the GFC, tumbled to 700 in Dec 2008, recovered to 4,600 in Nov 2009 and is now hovering around 1,000. To get a sense of what this means in real life, just imagine bus fare tumbles from $110 to $7 and then climbed back to $40 in the space of months.

This means the usual metrics like ROA, P/E and P/B are all meaningless. Earnings and asset values are quick sand. They are extremely unstable. You can't rely on them to value dry bulk shippers.

I ended up not investing in any of them because I just had no particular insight into individual shippers. Nor had I any insight into the cycles and the macro environment surrounding them.

Hogs and Dirts

I've omitted a lot of details about maritime economics which contribute to the "hockey stick" supply curve. (e.g. Ship owners can slow down their voyage or lengthen their maintenance time in response to low demand.) But the above supply/demand captures the essence. Furthermore, there are 2 key factors underscoring this extreme economics: (1) The decisions to expand the supply (i.e. the fleet) take years to materalise. (2) Each player in the industry is making rational decisions, but only considers themselves in isolation. Some kind of prisoner's dilemma is at work here.

This pattern shows up in another industry that I'm been worried about for some time: the mining sector in Australia.

Professor Steve Keen at University of Western Sydney explained it the best in this Business Sepctator piece. He pointed out this is nothing new. This was long recognised in hog cycle, the volatile 4-year cyclical pattern of prices for pigs in the US. And there is a neat economic theory, the cobweb model, explaining it.

(This is a good example that knowledge is accumulative. You builds up your circle of competence organically over time. From time to time, Things I learned from one place would show up in another place in a slightly disguised form. Things learned from one domain are never wasted if they didn't lead to any investment idea.)

Conrad Industries

This brings us to CNRD, the shipbuilder that I'm investing in.

My original conservative estimation of CNRD's intrinsic value was $18-20 per share. The current share price has now fallen into this range. Isn't it time to take the money off the table? This is the question I've constantly had in my mind in the recent weeks.

The original investment thesis was essentially based on a single event, the oil spill, or the recovery from it. But I have since realised there is more with CNRD. CNRD's management is more competent than I initially thought. CNRD has also become less sensitive to the exploration activities in the Gulf region than it used to be as the management has diversified its client base. CNRD may not have any structural advantage, but it is a very efficient business. It has the appearance of a "hidden champion". It's more like Buffett's Nebraska Furniture Mart than his Coca-Cola.

The difficult question is: how to value it now?

CNRD isn't exactly Nebraska Furniture Mart. Even though CNRD's client base is more diversified now, the products it makes are still commodities. It is still at the mercy of boom and bust cycles. "When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact." More importantly, the longer I hold CNRD, the more important the cycles will become.

For a cyclical business, the concept of intrinsic value as in Ben Graham's way of thinking may not even be applicable. Even if it exists, it's close to unknowable. There is no stable earning. It will be dangerous to normalise CNRD's earning over many years to arrive at an artificial figure. If we do so, we will be like having one foot in a bucket of ice water and another foot in a bucket of boiling water and claim we feel good on average.

And it is equally dangerous to time the cycles. Stopford says in his book the average length of boom and bust cycles in the shipping industries is about 7-8 years. This is, again, just an average. These cycles don't come in as clock work. The constant changing macro environment has significant influences on the supply-and-demand.

Where does this leave us? Without an estimation of the intrinsic value, I don't have a rational basis to judge when to sell. And forcing an estimation may easily give me a precisely wrong figure.

I'll follow Keynes' doctrine: "it's better to be vaguely right than precisely wrong". Here is how I will approach it:

I mentioned in a previous post there are a few catalysts surrounding CNRD: the BP settlement, full recovery of its repairing/maintenance segment and a small possibility of some kind of corporate action. So, instead of getting obsessed with figuring out a valuation, I will wait for one or more of events to play out.
I will add one more event to my list above. There is an important observation from the discussion of the boom and bust cycles of the shipping industries: The length of the cycles is a directly consequence of the duration it takes to materialise the investment/expansion decisions made by the players. It is not precise and will never be precise because unpredictable macro events will push things around. But the general cause and effect is there. If it takes only one week to add capacities in an industry, you will expect to see the length of cycles in the order of weeks, not years. And here, we see CNRD is also buying land and getting government grants to expand its capacities. We can reasonably expect other players in the industry are doing the same within a similar time frame. (This will be a good place to do more scuttlebutt.) When all of these new capacities come online, we have to be worried. So, if we work backwards from here, the completion of CNRD's expansion program will be a signal the industry has passed its peak.
I will err on the side of being over-cautious. I will rather leaving too much money on the table than being caught in the downturn of the industry.

I mentioned in my previous post the Credit Bubble Stocks blog is an excellent source of intelligence on CNRD's industry. Credit Bubble has linked to an informative research piece Good Year for the Barges. Being a contrarian, I'm becoming more cautious, treading with my eyes wide eye...

(Disclosure: Long CNRD)

Internet heartbeat, the industrial giant approach

2012-11-30T10:14:00.000+11:00

A week ago, I wrote Internet heartbeat, the Canadian way.

Someone at General Electric must have read my blogspot, decided to take a time-machine to travel a few months back and told their colleagues to re-align their corporate strategies.

GE released a white paper this week on its industrial internet vision. The news was subsequently picked up and reported by New York Times and InfoWeek, among others. The piece by C|Net provides the best "at a glance" summary.

Again, we really have to give Sun Microsystems the credits. The current cloud computing movement is essentially Sun's "The network is the computer" vision, just re-branded with a silly name. And this "industrial internet" vision is essentially Sun's "internet heartbeat" vision.

Hemptonology: The art of spotting frauds

2012-11-26T17:58:00.001+11:00

If watching your downside is the defining characteristics of value investing; if it's more important to avoid costly mistakes than spotting multi-baggers; then spotting frauds is simply the flip-side of value investing.

If there is anything to learn from last week's HP-Autonomy saga, it is that, regardless whether it is a microcap or a large-cap, anyone investing doesn't do his own due diligence is a fool. (In case you missed the story, here is the abridged version: HP now thinks it was conned in its US$11B acquisition of Autonomy and has written this investment down by a whoppy $8.8B.)

John Hempton, the hedge fund manager based in Sydney who is short HP, shows how you can spot Autonomy's fraudulent accounts in 5 minutes. As a hedge fund manager, Hempton mainly goes long. He says shorting frauds is only his sideline. But throughout the years, he has dissected many frauds on his blog. If Buffett makes value investing look easy, Hempton makes uncovering frauds look like a child's play. But make no mistake. The look is deceiving. As with any intelligent approaches in investing, "it is simple, but not easy". Behind the scene, a lot of brain power and fact finding are involved. If it were that easy, John Paulson who made his name in betting against subprime mortgages wouldn't have been deceived in the Sino Forest fraud.

Every business is unique. Every fraud situation is also unique in its own way. If you look at how Hempton skillfully deconstructs the meaning of low capex here or high receivables there, you see that almost any single number worth scrutinising. There are infinite variations. So, I don't think it's useful to have just a catalog of fraud detection techniques. Instead, it's more important to internalise the underlying principles, the first principles.

Here are principles I distilled from Hempton's blog:

Visualise how the business operates from the numbers - Don't fall into the trap treating the numbers as abstracts. When seeing the gross margins going up every year, it's far too easy to tick the "this business has pricing power" box on your checklist and then move on. What is more important is to visualise how the physical goods flow from here to there and how the money flows in the opposite direction. The more vivid it is, the more powerful it is.
Cast a skeptical eye on any outliner - Continue from the previous point, always ask the question: "what does that very favourable metric mean in the context of the company's competitors and its industry? Is that economically or physical possible?"
The personalities behind a business are as important as the numbers, if not more important - If you catch 100 burglars in a year, how many of them have only done this once? None? Then, track down the histories of the CEOs, the bankers, the lawyers and the accountants!
Data point, data point and more data point - Ben Graham says "you are right only if your facts and reasoning are correct". Without the facts, you only have a hypothesis. Look at what Hempton did. He paid "spies" to visit local factories. He took note how often a founder-CEO flew 12 hours to see his mistress living on a different continent.
It's all about Bayesian reasoning - How to put the collected anecdotal evidence together? You have the evidence (E). You have the competing hypotheses (H), "this business is a fraud" vs "this business is brilliant". You apply Bayesian reasoning, reasoning things in Occam's Razor style, to find the hypothesis (or the theory) that fits the evidence the best, going from Pr(E|H) to Pr(H|E).

Yes, all these look so common sense and self-evident on paper. But no, it's not easy, it's not easy to have the mentality and emotional strength to apply these consistently in practice.

I'm writing this post not because I'm an expert in fraud detection or in shorting. Exactly the opposite. I'm a novice. I'm writing this as a reminder to myself.

Internet heartbeat, the Canadian way

2012-11-20T12:13:00.000+11:00

More than a decade ago, Sun Microsystems' CEO Scott McNealy had the vision that every household or commercial electronic device would have an "internet heartbeat". Things ranging from light bulbs to refrigerators would be networked and speak the same language. Of course, in McNealy's vision, the enabling technology was Sun's Java platform.

McNealy was ahead of his time. Sun has since been swallowed by Oracle.

But the vision lives on, And its form has morphed.

The internet heartbeat beacon is now carried by Android. At the moment, Android is still just the software which powers mobile phones. But it's slowly changing. Android is turning up in unexpected places. If you don't believe me, take a look at this array of (weird) espresso machine and washing machine , this platform for medical devices, this latest and greatest camera made by Samsung, or this Android-powered satellite built by NASA.

Okay, I've stretched my argument a bit too far. There is no cellular network in the space. NASA doesn't put Android into the satellite in order to connect it to the cloud. But my point is, Android is becoming the common denominator for everything electronics. Every electronic device requires a real-time operating system (RTOS), be it a dumb firmware burnt into the circuit or a smart one. If you are a manufacturer and someone is giving away a free RTOS which has baked in wireless cloud-connectivity, is proven to run well on embedded architectures like ARM and offers a whole array of other bells and whistles, it's an offer too good to refuse.

To give McNealy more credit, Android is actually a descendent of Java. (That's why Oracle sued Google for intellectual property infringements.)

However, I've been blind to one thing until I spotted a writeup on SeekingAlpha today. There is another contender to proliferate the internet pulse: Blackberry 10. Or more precisely, QNX.

When I decided to invest in RIMM, my focus was the downside protection. The beauty of this approach is there are more than one way the upside can unfold. High uncertainty, yes. But you don't need to predict precisely which way it goes. And out of all the possible paths, apparently, a sustainable BB10 ecosystem will deliver the true multi-bagger result. To achieve this, RIMM doesn't need to unseat Android or iPhone from the market. It just needs to have enough critical mass. This in turn requires a solid BB10 OS. So, as long as I knew QNX is a solid RTOS with good reputation, I stopped investigate further. (If you don't know what QNX is, it's enough to say that it's been powering cars, medical devices and even nuclear power plants.)

What has escaped my mind is the possibility RIMM has more far-fetched strategic plans for QNX. What will the possibility be if QNX is married to RIMM's secure network on which BBM and BES currently run? You get an end-to-end "smart grid" solution with some interesting mission-critical applications in vertical industries.

Will it be successful? I don't. In a world where everything is converging towards TCP/SSL, do we need a solution based on proprietary network? Again, I don't know. But I won't sweat it. I'm more than happy to have an additional way for the investment thesis to work out.

(Disclosure: Long RIMM, ORCL)

CNRD 2012Q3 Results - Many things are going right

2012-11-18T17:36:00.000+11:00

When I initially invested in CNRD 20 months ago, the investment thesis was a simple one: CNRD, a well-run shipyard located at the Gulf of Mexico, was adversely affected by the Deepwater Horizon oil spill. I reasoned it would only be a matter of time oil/gas exploration in the region would return to normal and CNRD's business would recover. This is a classic case where investment opportunities are created by temporary industry-wide downturns.

Since then, instead of passively waiting for tide to turn, CNRD has proactively replaced its revenues from the energy sector with revenues from other commercial and government clients. Now, from their third-quarter filing, we can see a few tailwinds are in play:

Backlog is growing healthily. If we assume the run rate of first 9 months continues, annual earnings will come in at about $3/share. Shipbuilding is a cyclical business. Anecdotal evidence suggests we are now entering the up-cycle in inland water transport. CNRD is now riding this high tide. (For anyone interested in intels in the barge industry related to CNRD's operations, check out the Credit Bubble Stocks blog.)
CRND is preparing to submit claims to the BP Settlement Fund. The claim amount is expected to be around $22-23m. Remember that CNRD's market cap is about $110m. So, we are looking at an potential one-off 20% (pre-tax?) boost to its intrinsic value.
Oil/gas exploration at the Gulf is recovering but not in full swing yet. While revenues from oil/gass industry has improved to 12% of its total revenues, it's still far below the 27% before the oil spill or 40%+ before the GFC. Gross margin from its repairing and maintenance segment has improved to 15%, but is not yet back to long-term average of 20-25%. When oil/gas operations in the region are back in full force, there will be a continuous supply of repairing/maintenance work. But vessels which have just been moved into the Gulf won't need maintenance immediately. There will be a time lag.
The company has repurchased about 2.5% of its shares in 2012 so far.
Since Jr Conard took over the CEO role in 2004, this is the first time the company has engaged a financial adviser "to assist in its evaluation of strategic initiatives in order to determine potential alternatives that will enhance shareholder value and provides us with flexibility to respond to potential future business opportunities and risks." This can mean anything. It can also mean nothing. One possibility: Senior Conrad is in his 90's, well past his retirement age. The likelihood that CNRD will put itself up for sale is higher than ever.

I am patiently waiting for the plots to unfold.

(Disclosure: Long CNRD)

Quick thought on Microsoft's write-down

2012-07-03T11:31:00.001+10:00

Microsoft announced a $6.2 billion goodwill write-down for the fourth quarter of fiscal year 2012 related to its aQuantive acquisition in 2007.

Howard Marks always talks about second-level thinking. So, when we deconstruct this announcement, what do we see?

What I'm wondering is, why the fourth quarter? The management has a lot of leeway to shift this kind of charges around. Why did the management select the fourth quarter? Are they preparing a clean slate for FY2013? Or an even more bullish thought: are they expecting outsize profit in FY2013 and don't want the write-down to mar it?

Just a thought.

(Disclosure: Long MSFT)

What I wrote to Steve Ballmer and Bill Gates in 2010

2012-06-20T19:37:00.000+10:00

I'm risking to embarrass myself here.

In 2010, the consensus was Windows platform was at risk falling into obscurity. This was the time before iPad/iOS became a real force. The main threat was cloud-based computing: If everything could be done on web browsers, Windows would become irrelevant. It was Microsoft against the entire world.

I looked at Microsoft's portfolio of technologies from an investor's perspective. I believed I had a strategic solution for Microsoft. So, what did I do? I wrote an email to Steve Ballmer and Bill Gates.

As you would guess, busy top executives are surrounded by layers of personnels and won't have the time to entertain unsolicited emails. I didn't get a reply from either of them. Instead, I got a reply from a manager with their Opportunity Management Center (OMC).

I am a Business Development Manager with Microsoft’s Opportunity Management Center (OMC), which reviews unsolicited proposals and recommends specific resources and programs that may help you meet your business objectives. Since we do not consider ideas as a basis for business proposals; I'd like to redirect you to resources for submitting and sharing feedback.

Connect - http://connect.microsoft.com/

I appreciate your interest in working with Microsoft and wish you the best of luck with your initiatives.

No complaint here. And I didn't follow it up from there onwards.

What I want to bring up here is what I proposed in the context of what Microsoft brought out this week.

I asked myself, "Assume this cloud-based paradigm shift is unstoppable. If every application is really moved to the cloud, how could I still make my OS platform relevant?" I figured if I could offer some killer human-computer interfaces (HCI) that was unique on my platform, I would give people a compelling reason to continue to use my platform. As long as I could maintain the proliferation of my platform, I would have enough leeway to make my platform sticky.

At the time, Microsoft had 2 offerings which were (and still are) unique: Microsoft Surface (now branded as PixelSense) and Kinect. So, here is what I wrote:

Hi Steve and Bill,

The existing disruptive technical shift is that more and more applications are moved to the cloud which is based on open standards like HTML and Javascript, thus, diminishes the value of the WinAPI franchise. The solution to maintain MSFT's competitive edge is not to move all MSFT's offerings to the cloud. It's a commodity market. The business models are untested, margin is lower and customer acquisition is expensive. Instead, we need to reverse the exodus. We need to find computations which people don't want to move to the cloud but naturally reside on the client PCs, and build these into the OS and provide API for them.

The solution lies in Microsoft Surface and Kinect. I can imagine a world 10 years from now we will interact with computers mainly using voice, touches and gestures instead of keyboard and mouse. Surface/Gesture computing will become a naturally extension of GUI. MSFT has the technologies today and ahead of everyone else. What needs to be done is to drive the price down and build the API into the Windows OS. Then, we can harness the creativity of 3rd party software vendors to create the next generation of kill apps which will only be available on the WinAPI platform.
....

Fast forward to today. I read an article which discussed the technical details of the keyboard used on the new Microsoft Surface.

(Source: www.techradar.com)

It's a clever piece of engineering. It looks more like something coming from Apple or Miele than Microsoft. The underlying enabling technologies are patented. (We'll see if someone can create a close copy.) So, here we are, an unique HCI offering which is not available on any other platform. There will be buyers who select Microsoft's tablets over Android or iPad solely because of this unique keyboard. This is a key selling point, if not "the" key selling point. And when Windows gains enough traction and market share in the tablet market, it will have the critical mass to become self-sustainable.

(So, naturally, I will disagree with the idea that Microsoft is only acting as a beacon and will withdraw from the market later.)

We can imagine Microsoft didn't decide something like this lightly. To offer vertically integrated products which may alienate your business partners is a significant strategic shift. It is a watershed moment for Microsoft.

No, I don't think what I wrote in 2010 had any influence on Microsoft. I also have no delusion that the keyboard is only one small part of its entire strategic package. Also, whether Microsoft Surface can suceed will have a lot to do with upcoming execution, not just the initial inception. I just get excited that Microsoft's action validates part of my thinking in 2010.

Information technologies are now in this great convergence phase. Regardless which set of products offered by which players (Microsoft, Google, Apple, Facebook, Amazon, etc.), I foresee they will all become a great mash (or mesh?) of related and intertwined services. Looking at the PixelSense and Kinect I mentioned in the original email again, I won't be surprised they will have their places in this huge puzzle Microsoft tries to solve.

(Disclosure: Long MSFT)

Apple has made Microsoft more relevant, not obscured

2012-06-19T21:41:00.000+10:00

No, I'm not referring to the latest and greatest Microsoft Surface announced yesterday. No doubt, its announcement has once again showed Microsoft is at its best when it's the second mover, when it has an opponent to imitate. But this is not what I'm going to talk about in this post. What I want to talk about is something more subtle but fundamental to Microsoft's business model.

At its core, Microsoft is a platform provider. What threatens the commercial viability of a platform most? True portability. What keeps Microsoft executives awake at night is when a copy of software runs exactly the same on any device, any OS. The Java platform was (and still is) one such threat. The threat was serious enough to prompt Microsoft to revamp its rather dated Win32 API with its .Net initiative. But Java wasn't the only serious threat. Another serious threat is the HTML/Javascript open standard (or the current incanation, HTML5). If all applications are browser-based, there is no reason to get a Wintel box. This threat prompted Microsoft to try to crash Netscape by any means and get itself into trouble with the antitrust cases years ago. But even Netscape has disappeared from the scene, the threat is well and alive. Otherwise, Microsoft doesn't have to invest so much resources and money to keep Internet Explorer alive.

But a strategic decision made by Apple five years ago -- and to a less extent, by Google -- has neuralised this threat to some extent.

When Apple released its first iPhone/iPad, it made the decision not to make iOS a pure HTML5-based platform. Instead, in order to develop an application on iOS and take full advantage of the underlying hardware, a developer needs to develop the application on the top of Apple's proprietary Cocoa Touch platform, not HTML5. There are practical reasons for such decision: on a device with limited computing power, maintaining adequate performance is important. However, its true strategic objective is control and lock-in. Apple wants to lock you in on its iOS/Cocoa Touch platform as much as Microsoft wants to lock you in on its Windows/Win32 API platform. When you are the dominant player, you want everything proprietary, everything based on your proprietary platforms. Only when you are the marginalised player, you want everyone to adapt open standards. In a similar fashion, Google has also gone down the same path with Android.

However, I would argue that this supposedly self-serving decision has actually benefited Microsoft. If other dominant players had fully embraced HTML5, Microsoft would have had no choice but to embrace it. Then, no one could lock anyone in. But now, because everyone goes proprietary, the playing field is now leveled in a way that both developers and users won't demand true portability. This in turns has validated Microsoft's "proprietariness". Windows can now compete on an equal footing with iOS and Android for developers.

Actually, if you look at an even bigger picture, the sad truth is Apple's decision has pushed back the advance of system openness by a whole decade.

(Disclosure: Long MSFT)

The 10% FCF yield club

2012-06-18T21:40:00.000+10:00

When a company's business is easy to understand, offers a 10% FCF yield, provides steady and predictable profit year-in-year-out without oversize Capex, I get excited. If it can grow its cash flow in line with nominal GDP growth, it can easily offer 15% p.a. return. 15% has been Buffett's hurdle rate throughout his investing life. This is the "good enough" mentality that both Warren Buffett and Ben Graham advocate. If it's good enough for Buffett, it should be good enough for me.

What's interesting here though is I started looking at one company which led my thoughts onto another company which led me onto another one... And I ended up indecisive....

Let's start with Lamar Advertising.

Lamar Advertising

Company: Lamar Advertising (NASDAQ:LAMR)
Market Cap: $2.55B
TTM FCF yield: 9%
Business: The 3rd largest billboard advertising provider in US
Moats: Nothing can replace billboards for brand-awareness advertising. Highway Beautification Act (1965) limits the number of billboards that can be built. This is pretty close to Buffett's "toll booth" type of business.
Positives: A gradual recovering US economy will improve both occupany and rates. LAMR will also be able to refinance some of its debts in the coming years with lower interest rates.
Negatives: Cyclical business. Very high debt. FCF interest cover is only 2.2x. But the mgmt has been prudently using all of the FCF to pay down its debts in the last 3 years. Yet, there is no gaurantee the mgmt won't do another debt-fueled acquisition in the future.

My biggest hesitation here is the 2.2x interest cover. It is quite a stretch on my comfort level. While LAMR's cashflow was pretty stable through the GFC, considered that its advertising contracts are typically less than a year long, I'm not sure how much shock such a highly levered balance sheet can take. My issue here is safety.

While I was thinking about LAMR's advertising business, I remembered another advertising related company.

Omnicom Group

Company: Omnicom Group (NASDAQ:OMC)
Market Cap: $13.2B
TTM FCF yield: 10%
Business: Advertising agent
Moats: Ad agent is a service business.When marketing campaigns get more and more complicated, the value of an Ad agent increases. Its moat resides in its sticky customer relationship. (e.g. Apple has been staying with one agent since Jobs returned. You can't say that for its semi suppliers. Btw, Apple's ad agent belongs to OMC.)
Positives: Although debt/equity is ~1.0, interest cover is a comfortable 10x.
Negatives: This is cyclical business and profit moves in tandem with the economy. OMC has significant exposure in Europe. This is both a plus and minus. When Europe's problems fade, we shall see growth. But it may take years.

Next, I remembered Dun & Bradstreet Corp, which was beaten down badly in May after it released its disappointing FY2012 guidance.

Dun & Bradstreet Corp

Company: Dun & Bradstreet (NYSE:DNB)
Market Cap: $3.22B
TTM FCF yield: 8.75%
Business: Data provider of business records and credit history
Moats: When the database you provide is essential to other people to conduct their businesses and when its size gets to a certain critical mass, its economics benefits from a form of network effect and becomes self-sustainable. This is the kind of business an idiot can run.
Positives: But DNB's mgmt are not idiots. They don't chase unattractive growth for the sake of it. They return cash back to investors in the form of share buybacks.
Negatives: Business isn't growing in the recent years. Can it really grow in line with the economy?

At this point, I asked myself, why all these troubles? Why don't I just add more to my existing Microsoft position?

Microsoft Corp

Company: Microsoft Corp (NASDAQ:MSFT)
Market Cap: $252B
TTM FCF yield: 11%
Business: software
Moats: MSFT has 2 undeniable franchises: Windows and Office. Both are essentially annuity kind of business.
Positives: Truck load of cash. ROE in the range of 40% without using debt. Growing steadily 8-12% p.a. over many years. On the corporate front, Windows 7 upgrade cycle will accelerate in these 2 years. On the consumer front, Windows 8 sales will provide additional revenues.
Negatives: Given its size, growing will become harder and harder. Cloud-based computing and mobile computing both threaten MSFT's franchises. There is also the risk the mgmt will destroy value on poor acquisitions.

I'm pretty comfortable MSFT can defend its turf. It may even be able to leverage its dominance into offering more cloud-based solutions and mobile solutions than everyone can imagine.

No matter how I cut it, MSFT looks like a superior investment to the rest. My conviction is high.

Charlie Munger always says diversification is diworsification. My dilemma here is whether I should diversify in order to reduce my exposure to one single company. No matter how high my conviction is, there are always "unknown unknowns". There is also this unhelpful thought urging me to divest: "Earning outstanding returns requires hardwork. If I keep on adding to just the same old position and not spending time to dig deep into other companies, I'm not working hard enough." (I haven't yet done in depth analyses of some of these other companies. If I end up staying with MSFT, this won't be the best use of my brain power and time.)

I'm really interested in your thoughts!

(Disclosure: Long MSFT)

Value of the century - the Aussie edition

2012-06-17T21:52:00.000+10:00

I spent some time last month combing through the bottom end of the ASX market, looking at companies with market cap less than A$300m. I haven't found anything worth investing so far. Then, last night I saw Whopper's post ACGX: value of century? I just couldn't resist and decided to write this up for your amusement.

Details at a glance:

Company: Richfield International Limited (ASX: RIS)
Market Cap:A$1.6m
NACV: A$6.3m, mostly cash!!
Business: It operates shipping services in Singapore. It used to operate trucking services years ago.
Profitability: Mildly profitable or break-even most of the years.
Dividends: Never in the last 8 years.
Insider ownership: 72% controlled by the directors

So, here you are. A crazy pile of cash. Buying a share of RIS is buying 25 cents dollar. Or, to flip it around, you are getting an instant 4 bagger. While the value isn't as extreme as Whopper's ACGX, RIS is a listed company with audited accounts and regular filings.

What's the catch?

I have serious doubt the company exists mainly for the purpose of running a business. It looks more like the directors' tax shelter. It's basically their family's piggy bank. The most likely end-game I can foresee is, when the business dries out, they will shut down the operations and gradually draws down the cash pile as salaries until it reaches zero. Well, there is no certainty. They may declare a surprise special dividend or announce someone tendering for the company. But I won't bet on it.

(Disclosure: No position)

Will PGNT become a mini replica of BRK?

2012-06-14T08:13:00.000+10:00

No, Paragon Technologies isn't Berkshire Hathaway. But the current situation shares some interesting aspects of the old BRK when Buffett bought it in 1960s.

PGNT is a $4.3m microcap. It provides conveyor systems for assembly lines and order fulfillment operations. It lost money 7 out of 10 years between 2001-2010. Current share price is ~$2.8 while it has a NCAV of $3.25 which consists mainly of cash.

Normally I would quickly dismiss companies without a track record of making money. However, I noticed Sham Gad, a value investor, was involved. I took a closer look.

Downside protection

Gad was elected to the board in 2010. He subsequently built up his position to 25% throughout 2011. In March this year, he didn't only take over the chairmanship, he also got the 2 directors elected. These are the 2 directors that he originally recommended in the proxy fight back in 2010. So, effectively, Gad has the complete control of the company.

Why is this important? This is important because it puts a very solid floor on our downside. Gad intends to bring the business back to profitability. After he gained a seat at the board, he managed to reduce cost and steer the business to break even in 2011. What will happen if he senses he can't achieve it? As a value investor, he won't have any emotional baggage. He will immediately liquidate the business. The liquidation process may not be smooth. But since the bulk of the assets is in cash, we should get back most of the $2.8 invested. The presence of a value investor collapses the range of possible outcomes to almost a single point if the business fails to deliver. This wouldn't be the case if it were the founder controlling the company.

Valuation

And what is our upside? We should consider this a turnaround and handicap it. I take a stab at this in the spreadsheet below:

(If your rss reader doesn't show the spreadsheet, you need to visit my blog directly.)

Under the "turned around" scenario, I assume it requires a 1.0x quick ratio to keep the business running. Hence $2.75 cash can be distributed. I assume it can double its revenue, back to the level before GFC. I assume it can earn a generic 5% net margin. And I give it a conservative 8.5 P/E multiple. This gives us a valuation of $7.13 per share.

Next, we need to guess how likely the business can turnaround. Again, this is a wild guess and a pretty aggressive one. But one thing that helps is the recovery of the US economy is on our side. I put down a one-fifth chance. The rest of the calculation in the table is self-explanatory. We end up with an expected return of 42%. You can try to plug in different numbers in different places. But the general risk/reward profile doesn't change much.

(Another thing to be aware of is, the 42% return or the $3.99 value won't exist in the real world. We will either end up with one of the possible scenarios. There is nothing in between. The expected value is only indicative.)

Capital allocation

Why did I make reference to BRK at the start? This has to do with how Gad intends to use the cash in PGNT. I don't believe Gad will actually distribute the cash if the turnaround fails. Gad has lay down his intent in his chairman letter published in March:

Through a disciplined capital allocation process, we will examine ways to utilize the Company's assets to increase the intrinsic value of the Company.

This is how I see it. He will try to keep the business breakeven and plow any operational cashflow back into the business (e.g. in R&D) while waiting for recovery of revenue. At the same time, he will invest the cash pile in any opportunities he can find. If you are familiar with the history of BRK, this is effective what Buffett did to BRK.

Gad is a Buffett disciple. Investing in PGNT will feel like investing in BRK in its old days. You need to be comfortable to be Gad's junior partner to invest in PGNT.

Final thoughts

So, we can look at the investment case this way: At $2.8, we are basically taking a stake in Gad's managed fund and at the same time getting a free option on the PGNT's business.

The asymmetric risk/reward profile here is a classic "tail I win, head I don't lose much" case. This is "high uncertainty, but low risk". I think the market misprices it because everyone focuses on the middle scenario. I imagine many value investors don't dare to dream wildly on the turnaround possibility because this is not usually how one will reason a net-net.

p.s. I have no position because my capital is deployed and locked up in other places.

(Disclosure: No position)

SODI shareholders

2012-06-01T14:33:00.001+10:00

If you are a SODI shareholder, please look at this post at Oddball stocks.

(Disclosure: Long SODI)

My naive and fishy view on deleveraging

2012-05-23T17:03:00.001+10:00

I'm writing this in response to a Barron's piece about Ray Dalio. I'm writing this because I'm puzzled about the 3 strategies for deleveraging that I heard about over the years. To me, there is only one strategy. (I'm not sure if the Barron's article is behind their paywall. If so, you can also find a snipplet quoted at Frank Voisin's blog.)

* * *

In the distant land of Asgard, the currency unit was "cans of sardines". And sardine hunting was Asgard's major economical activity.

One day, an entrepreneur called Loki visited the Central Bank of Sardines. He wanted to borrow 1/2 of the nation's sardine reserve, which had been accumulated as a preparation for the next ice age. He had this grand vision. He wanted to use the proceeding to employ many engineers and scientists to create an automatic sardine harvesting machine.

Loki eventually got his loan. But on his way back to his office, he bumped into a gigantic green monster and all the sardines were lost.

Now, after this incidence, Asgard didn't have enough sardines for the nation to go through the ice age. What could they do? What were the options?

Could they "inflat" their way out? They could repackage each can with only 70% of original volume of sardines, and they could repeat doing this every year. That inflated the number of cans. But, it didn't address Asgardians' hunger... 30% less sardines was 30% stomach unfilled.

Could they go on austerity?

Well, I think austerity = hunger.

It's apparent that the only sensible option was to ramp up their sardine hunting or improve the yield (by really inventing a harvest machine!) to make up for the lost.

This means they had to grow, to improve their productivity.

Did inflation have a place? Probably. If Asgard labour and goods were cheaper, they could probably sell more stuff to other nations and thus accelerated the build up of their sardine reserve.

Did austerity have a place? Probably. For one thing, sardines (i.e. money) should not flow through Loki's hands anymore. In other words, austerity should be applied selective at the places where waste would occur.

But, without growth, austerity and inflation were useless.

* * *

I don't have any rigorous economic theory to back up my story. I am pretty sure you can poke holes in this "analysis". I am looking forward to comments on the fallacies of my reasoning.

(Don't ask me why "Asgard" and "sardine". I just had these random thoughts in my head while I was writing this.)