Dear Reader,
Today the focus of discussion will not dwell on a fantastic investment idea we have developed at the office, nor a macro economic insight that we feel gives us an investment edge in determining how the world economy may develop. We will take a more mundane view on ourselves and reflect on a number of harsh lessons we learnt during the course of the last few months. They can be summarised as follows:-
1. One rarely achieves anything by getting angry with someone you need to do something for you (especially when no one else in an organisation can do it, nor is it relevant how silly or consistently silly past activities from that individual have been)
2. When one can achieve a slightly higher return with a complicated operation relative to a simple one, always choose the simple one
The first point is learnt at the potential cost of a percentage point of performance in the fund. We are deeply upset by this. There are fewer things that upset me more than losing performance for our clients, and admittedly, this could have been potentially avoided if my political skills were a little more developed. Though we remain deeply in profit in the operation involved, I repeat we are not in this business to lose points of performance over sloppy mistakes. Hence this blog is written to ensure this mistake is not repeated.
The issue is we have upset the settlement team at our custodian as we (admittedly, I) got upset with them for making four consistent large errors during the Berkshire Hathway buy out of Burlington Northern Santa Fe, the latter company being one of our largest holdings prior to the buy out offer in Q4 2009. The mistakes were 1. Our settlement team forgot to give us the option to exchange our Burlington shares for Berkshire shares. 2. When we called to confirm why they had not done this prior to the merger completion date, they said the paperwork will come. When we asked after the date, they said the shares will come in a month. When we asked after a month, they told me to go away. I came back with the detailed paperwork indicating my rights as a Burlington shareholder and providing details of all correspondence showing they never gave me (nor another client I manage in a separate account) the opportunity to make this decision. They later said we were not given the option because we were not eligible for Berkshire A shares. I informed them that is why they have Berkshire B shares, and that is why they split the latter shares so the vast majority of shareholders will be eligible for the share offer should they choose. They would later come with other stories which we would have to evidence were incorrect. To cut a long story short they eventually agreed we should have been given the option, and very kindly amended the mistake, two months after we had received the cash. 3. Instead of receiving Berkshire B shares, we received Berkshire A shares. There was great joy in my eyes and soul when low and behold there was a 25000% increase in the portfolio valuation within a single day. However, there was a little more frustration building up as it meant I could not sell the shares as the settlement team would have to change the paperwork to Berkshire B shares beforehand. On the day they were correcting this mistake Berkshire B shares fell more than 1.5%. 4. When we received the Berkshire B shares, we remain suspicious that the correct number have not been sent. This was the final straw and I blow up a hornets nest with the email that I sent to settlements with my opinion of how they handled the whole issue. We now have the settlements team working against us rather than for us. The only real solution is to leave this team and find another custodian, which is what we are doing now. Since then we have sold the Berkshire B shares, but at a cost less than the cash we originally received to get the shares. This is earth shattering for us. Though it is not even a few percentage points lost, losing money in this manner is totally not our approach to risk management. Our political skills are obviously just as important in managing risk as our valuation skills, and we better appreciate that sooner rather than later.
All of this means we have lost a small portion of the large profit we made from simply holding the cash they originally sent to us (the simple operation). We are currently pleading for a re calculation and making claims for the errors done, but cannot assume they will be processed to our advantage. This is in the domain of hope, which is not the land where consistent above average returns are generated.
We apologise sincerely for this mistake which we take responsibility for to our clients who entrust us with their wealth. We will be keeping these two points learnt vividly in our minds to ensure future mistakes will be avoided, and that we interview our custodians in a more thorough manner before agreeing to do business with them.
We thank you for your continued support in us and invite you ask any questions you may have.
Yours sincerely,
Alessandro Sajwani
Thursday 22 April 2010
Sunday 11 April 2010
Is the market cheap?
Dear Reader and Fellow Investors,
In the previous blog we have shown how long term pricing data for the standard and poor index suggests that equity investment returns oscillate around an average compounded annual growth rate (CAGR) of approximately 6.5 - 7%. However, this does not give us an intuitive feel of whether the index is cheap or expensive at the moment. We can use the data to do this.
Below you can see how the standard and poor index has evolved since 1927 by discounting past data with a rate of 6.53%. We use this number as we assume this to be the average CAGR of the index. Should we use a larger number, past values will be larger (i.e. the 1929 peak would have been even higher). Please note the data is up to January 2010.
At first glance the data would suggest that the index in January 2010 was not expensive, as the average seems to be approximately 1,250. This can go a long way to explaining why the markets have rallied so strongly in the last 12 months. Indeed, at first glance, the chart could be interpreted as suggesting the rally could still have sufficient steam to rise another 10-15% with a suitable probability of success. However, we could also note that when the S&P falls below 1,000, it usually hangs around for quite some time. The only other time that did not occur was in the great "bear market rally" of the early thirties. However, that rally was eventually totally liquidated. However, the rally lasted for 3/4 years.
Though we continue to buy the equity of companies that meet our strict criteria, we remain deeply sceptical and only buy opportunities we feel offer deep value and hence sufficient protection to reduce the possibility of a permanent loss of capital should an aggressive market decline occur.
As always, please feel free to post us any questions should you have any.
Yours sincerely,
Alessandro Sajwani
In the previous blog we have shown how long term pricing data for the standard and poor index suggests that equity investment returns oscillate around an average compounded annual growth rate (CAGR) of approximately 6.5 - 7%. However, this does not give us an intuitive feel of whether the index is cheap or expensive at the moment. We can use the data to do this.
Below you can see how the standard and poor index has evolved since 1927 by discounting past data with a rate of 6.53%. We use this number as we assume this to be the average CAGR of the index. Should we use a larger number, past values will be larger (i.e. the 1929 peak would have been even higher). Please note the data is up to January 2010.
At first glance the data would suggest that the index in January 2010 was not expensive, as the average seems to be approximately 1,250. This can go a long way to explaining why the markets have rallied so strongly in the last 12 months. Indeed, at first glance, the chart could be interpreted as suggesting the rally could still have sufficient steam to rise another 10-15% with a suitable probability of success. However, we could also note that when the S&P falls below 1,000, it usually hangs around for quite some time. The only other time that did not occur was in the great "bear market rally" of the early thirties. However, that rally was eventually totally liquidated. However, the rally lasted for 3/4 years.
Though we continue to buy the equity of companies that meet our strict criteria, we remain deeply sceptical and only buy opportunities we feel offer deep value and hence sufficient protection to reduce the possibility of a permanent loss of capital should an aggressive market decline occur.
As always, please feel free to post us any questions should you have any.
Yours sincerely,
Alessandro Sajwani
Mean reversion of investment returns: Why we are long term investors
Dear Reader and Fellow Investors,
In a now famous presentation by Mr. Buffett in Idaho in 1999, he stated he felt the most probable return in the next 17 years for equity investments would be 6%. Upon reading this, I asked myself where did he get this number from?
The graph below I believe goes a long way in answering that question. It shows explicitly the 15 and 30 year compounded annual growth rates of the S&P index using data from 1927. The fifteen year CAGR average is 6.93% according to the dataset we collected. Realising the large premium to valuations relative to historic standards, Buffett was willing to bet markets would have to show below average returns in the next decade and a half to ensure earnings caught up with valuations. How right he was.
We can clearly see the mean reverting properties of the equity markets. The data seems to suggest that the equity markets exhibit a cycle like behaviour that requires 35 -40 years to go full circle. Seventeen years would be half the cycle: historically speaking, we seem to be about two thirds through this down cycle. We therefore find comfort in the fact we see markets being overvalued using our valuation techniques, they seem to be well aligned with what long term pricing data would suggest.
Going forward, we remain cautious in our estimates for earning growth due to macro factors (please see "rare macro view" entry in our sensible investing blog), the history of pricing patterns and the distorted increase in operating margins many sectors of the economy have experienced particularly strongly in the last 5/6 years. We remain focused on buying the equity of companies that are available at the market with pricing that considers such scenarios.
Yours sincerely,
Alessandro Sajwani
In a now famous presentation by Mr. Buffett in Idaho in 1999, he stated he felt the most probable return in the next 17 years for equity investments would be 6%. Upon reading this, I asked myself where did he get this number from?
The graph below I believe goes a long way in answering that question. It shows explicitly the 15 and 30 year compounded annual growth rates of the S&P index using data from 1927. The fifteen year CAGR average is 6.93% according to the dataset we collected. Realising the large premium to valuations relative to historic standards, Buffett was willing to bet markets would have to show below average returns in the next decade and a half to ensure earnings caught up with valuations. How right he was.
We can clearly see the mean reverting properties of the equity markets. The data seems to suggest that the equity markets exhibit a cycle like behaviour that requires 35 -40 years to go full circle. Seventeen years would be half the cycle: historically speaking, we seem to be about two thirds through this down cycle. We therefore find comfort in the fact we see markets being overvalued using our valuation techniques, they seem to be well aligned with what long term pricing data would suggest.
Going forward, we remain cautious in our estimates for earning growth due to macro factors (please see "rare macro view" entry in our sensible investing blog), the history of pricing patterns and the distorted increase in operating margins many sectors of the economy have experienced particularly strongly in the last 5/6 years. We remain focused on buying the equity of companies that are available at the market with pricing that considers such scenarios.
Yours sincerely,
Alessandro Sajwani
Saturday 10 April 2010
Long term investment advisors 2009 letter to investors
Dear Reader and Fellow Investors,
Due to popular demand (yes, we did have requests!) we include below the annual letter to clients for 2009. As always, please let us know if you have any questions or require further details.
1 Summary
Our gain in net worth during 2009 was 33.27% in USD terms. The S&P 500 gained 16.43% during the same period.
Our main performers were Chaoda Modern Agriculture and Burlington Northern Santa Fe. In the case of the latter, we had the pleasure of receiving a buy out bid from Mr. Warren Buffett, which was almost twice our purchasing price. This is as satisfying as life can get for any value investor who has the pleasure of kicking money around. Our worst performer by far was Kraft Foods, whose price has been effectively flat since purchase earlier in the year (we have received zero capital gains so far, but have received a dividend yield close to 4.3%). We believe this is primarily due to its headline hitting bid for Cadbury’s (we feel their is a higher probability it will proceed than not). Meanwhile, we remain happy shareholders of the stock and are not at the slightest concerned with its volatilty and relative poor performance in the short term. Indeed, we have been buyers of the stock on several occasions as the stock has suffered, and would continue to be should even better pricing become available.
During 2009 we processed twenty one security transactions: eighteen purchases and three sells. At year end, we were owners of 11 separate securities (all common stock). We averaged less than 2 security transactions per month (many transactions involved buying more of a stock already owned): that’s the way we like it. We want to focus more time on researching many ideas to distil our best ideas, rather than trade our 45th best idea.
We would like to highlight that the above mentioned performance is likely be viewed as ridiculously good when placed into a historical context. Please note that since World War II, the S&P 500 has averaged a compounded per annum growth of a little over 7.5%. We cannot continuously out perform this index in such spectacular fashion, but you can bet your bottom dollar we will be trying year in, year out. Though we cannot guarantee performance, we can guarantee your experience will be the same as ours. Your author has a substantial amount of his net wealth involved in this investment strategy - we believe in eating our own cooking.
We believe our outperformance originated from aggressive buying of stock throughout the year, but more so in the first six months whilst most people were deeply worried about taking on risk. We felt that risk was actually considerably smaller during this period for the specific range of companies that have attributes that we specifically look for (please see section 3), than it has been over the last five years. This is because when placed in a historical context, risk premiums were very small over the last few years. This was most certainly not the case for most of 2009, hence we were net buyers (unlike 2006-2008 when we where 100% in cash, satisfying, but it didn’t win us many friends back then!).
2 How well did the strategy really do?
It was pleasing to see the fund almost double the performance of the S&P 500, which is not likely to happen many times in an investor’s career. However, let’s ask ourselves what the performance was relative to the following strategies:-
1. Buying the worst performers of 2008
2. Buying the best performers of 2008
The worst performing stocks of 2008 were not surprisingly financials. If you had bought the stocks of those companies that did not go bankrupt/disappear in 2008 (which were 5/15, please note PNC Financial Services purchased National City for about $5.2 billion in stock with funds from the U.S. Treasury in October 2008. The acquisition was described as a "take-under", meaning the purchase price was below National City's market value) you would have gained approximately 107% during 2009 (2 of the remaining 10 disappeared during 2009).
With this basic information you may ask yourself, why bother with paying people to look after your monies? Simply buy the companies that did badly last year, and this year they seem likely to do better! There seems to be a mean reversion character to the markets that any astute person should be able to take advantage of. May I take this opportunity to include a word of caution, and compare our personal investment style to this rather crude, but what seems to be, non trivial method.
Note that many of the stocks included in this list had fallen more than 90% at one point in 2009. One questions whether many investors of this strategy would have had the "stomach" to hold on. Furthermore, such volatility is to be expected from highly leveraged companies, which financial institutions often are. We view companies as leveraged when they have a debt load that is greater than 70% of shareholder equity. Many of the companies/financial institutions in the worst performing stocks of 2008 had outstanding debt greater than thirty times their shareholder equity! We must note that this debt is senior to stock, which means the shareholders would be the last investor to get paid should the company not be able to fund its debt through cash flow generation, and be forced to meet payments via a forced liquidation. Many of these companies, in our opinion, had a liquidation value less than there financial debt outstanding. This means there isn’t enough money to pay back in entirety the senior debt holders, so you can be sure the shareholders will get nothing in such a scenario! We, as investors, don’t like to be last in the queue when it’s close to closing time. There is a real risk of suffering a permanent loss of capital, which we find totally unacceptable. When something goes to zero, it does not matter how "cheap" you bought it – you lose all your money! Of the list included only one stock caught our attention: E W Scripps, a diversified media company with interests in newspaper publishing and television. This company had virtually no net debt and was trading at a fraction of its book value. It was an interesting balance sheet play and not surprisingly, it was the second best performer on the list.
With regards to the best performing stocks of 2008, as you can see below, the majority were acquired. If we look at the companies still trading in the public markets at 2009 year end (eight), than holding that portfolio of stocks would have performed approx. 4.81%.
On this occasion, we can see the performance of the 2008 worst performing stocks was considerably better than our own performance. Whilst our performance was considerably better than last years winners. We are happy with this scenario. Should one or two more of the worst performing stocks have gone bankrupt (which was very possible without state support), the performance of that basket would have been awful. This element of good/bad results changing drastically dependent on factors we cannot estimate to any great degree of confidence, and resulting in a permanent loss of capital (you can hold the stock to infinity, but you will still receive zero return!) we do not want to be involved with. As a result, we primarily invest in companies with low debt, which meet our quality conditions and are available at prices below our estimate of their objective value. We therefore aim to get a return that is consistently higher than yesterday’s leaders, and on average greater than yesterday’s worst performers. We feel we can achieve this by reducing considerably our possibility of suffering a permanent loss of capital.
As a final note with regards to our performance this year, we feel much of the gains are illusionary - stolen from the future to look good today. The market, in our opinion, seems to be currently distorted by the impact of governments and central banks. There is no doubt this distortion can create a new reality, which will mean current pricing may become "accurate". However, we don’t feel this is probable. In our opinion the major market index is not fairly valued anymore due to this influence, and as a result we are now finding it more difficult to add equity and bond positions. We are therefore likely to accumulate a greater cash position during 2010 unless market prices fall. Indeed, we would not be surprised if many of the companies we currently own will be priced lower at the end of 2010 than they were at the end of 2009. Here’s to dividends!
3 The Objective of the Investment Strategy
The primary objective of the strategy is to ensure that the purchasing power of its participants is increasing faster than the cost of living, i.e. what is often labelled inflation. True inflation is often significantly larger than what official statistical indicators suggest, as any individual already knows from experience. We aim to achieve this by applying two principal concepts:-
Have a base case scenario on how the value of money will evolve over the next five – seven years. All financial assets are measured in currency, hence understanding how the value of money will evolve is critical to appreciating how financial securities will be priced. This means understanding the conditions that are currently developing and how these fare for cash, bonds, equities, commodities and property assets.
Distinguish between the price and value of a financial asset. We remain primarily focused on purchasing the securities of companies that have:-
1. Dominant market position in their particular sector
2. Large barriers of entry
3. Strong balance sheets (little leverage)
4. Respectable returns on capital
5. Leading margins in their sector
6. Available at a large margin less than our estimated objective value
Though we appreciate our requirements seem demanding, and the difference between price and intrinsic value is not easy to calculate, opportunities do exist and particularly so within certain sectors at any one point in time. Furthermore, our results are likely to be more fruitful if we stay within certain fields where our methods are likely to be more accurate. We therefore rarely stray from these areas. It is for that reason we did not invest in financials or insurance companies during the last few years, though they were branded as being cheap.
For example, one investment strategy involves buying the stock of a company whose physical assets are worth more than the market price of the stock. This may seem ridiculous, but I can assure you it happens more often than you care to believe. Take for example Kingfisher, a well known DIY retailer primarily based in the UK. This company saw its stock value drop from a high just shy of 3 GBP, to a low of 1 GBP due to its exposure to the UK (and to a lesser extent European) housing market. Buying stock at 1.20GBP ensured you were buying the entire company for approx. 70% of its recorded property purchases (including deductions from depreciation)! Similar strategies were used for the purchase of Steinway’s Musical Instruments, whose price for a number of months was quoted at a ridiculous price relative to its balance sheet value.
4 Errors with hindsight
We include this section to balance all the great praise we give ourselves with an open discourse on some of our errors. We do this for a learning exercise, so we make sure we don’t do the same mistakes (yes, it was more than one!) again. The biggest whopper was that we should have invested even more when the bells were ringing at the start of 2009. But like everyone else, I was also scared I might be wrong. Career risk is behind everyone’s mind making them behave more like their peers so one does not stand out in case things go wrong. However, if more people agree with you, it does not make you more right. Interpreting facts correctly is what makes you more likely to be right. Nothing is for sure in this world - I tried to react assessing the probabilities of success: Conclusion: I undervalued them. Unfortunately, you will see me copy and paste this entry many times in the future. I will generally tend to under value than over value any asset to introduce a “margin of safety” that reduces the possibility of a permanent capital loss.
5 Macro factors
Our investment approach is not based on our beliefs on macro effects in a symmetric manner. We only apply them to our investment decision making process if they indicate a negative environment. They therefore play an important role in helping us appreciate how the different asset classes may perform relative to each other.
In summary, our principal macro thoughts are the following:-
Saving rates will increase in developed economies as asset price inflation will not be relied upon as heavily as it has in the past for wealth accumulation. This will come at the cost of reduced consumer spending. Greater uncertainty for job security and large debt positions will also act as catalysts to save. We feel asset price inflation has simply played too strong a role in GDP growth for developed economies for too long. This has stimulated large consumer spending due to the feeling of being wealthy in financial and property assets. The important fuel that was ever increasing bank debt has been firmly shut off for now due to careless lending leading to fears of capital inadequacy within the banking sector. This decreasing volume of debt is not supportive for asset prices. Hence the huge government support increasing the money supply and reducing the cost of money. Such an increase in currency will likely lead to a reduction in that currencies value in the future, a symptom of inflation. However, it is important to continuously follow different variables to see how the situation is evolving. In particular how:-
1. The velocity of that currency is evolving
2. How money with zero maturity (MZM) is evolving
3. Who is receiving the money being created i.e. how the transmission network for the financial system is working
4. Default rates for prime mortgages, also considering the distortionary affects of mortgage modifications
The government cannot support the economy in the manner it has in the last 12 months indefinitely. The question is how will it support itself when the drugs run out. We feel the debt that existed previously is still mainly there, acting as a weight to the economy, which implies growth rates cannot be strong. In this sense, we feel a strong affiliation with the PIMCO view of the world endorsed by Bill Gross – a new normal with weak growth for a number of years. As a result, we are even more pessimistic than usual when looking at the growth potential of franchises we may be interested in owning.
We thank you for your continued confidence in us.
Yours sincerely,
Alessandro Sajwani
Due to popular demand (yes, we did have requests!) we include below the annual letter to clients for 2009. As always, please let us know if you have any questions or require further details.
1 Summary
Our gain in net worth during 2009 was 33.27% in USD terms. The S&P 500 gained 16.43% during the same period.
Our main performers were Chaoda Modern Agriculture and Burlington Northern Santa Fe. In the case of the latter, we had the pleasure of receiving a buy out bid from Mr. Warren Buffett, which was almost twice our purchasing price. This is as satisfying as life can get for any value investor who has the pleasure of kicking money around. Our worst performer by far was Kraft Foods, whose price has been effectively flat since purchase earlier in the year (we have received zero capital gains so far, but have received a dividend yield close to 4.3%). We believe this is primarily due to its headline hitting bid for Cadbury’s (we feel their is a higher probability it will proceed than not). Meanwhile, we remain happy shareholders of the stock and are not at the slightest concerned with its volatilty and relative poor performance in the short term. Indeed, we have been buyers of the stock on several occasions as the stock has suffered, and would continue to be should even better pricing become available.
During 2009 we processed twenty one security transactions: eighteen purchases and three sells. At year end, we were owners of 11 separate securities (all common stock). We averaged less than 2 security transactions per month (many transactions involved buying more of a stock already owned): that’s the way we like it. We want to focus more time on researching many ideas to distil our best ideas, rather than trade our 45th best idea.
We would like to highlight that the above mentioned performance is likely be viewed as ridiculously good when placed into a historical context. Please note that since World War II, the S&P 500 has averaged a compounded per annum growth of a little over 7.5%. We cannot continuously out perform this index in such spectacular fashion, but you can bet your bottom dollar we will be trying year in, year out. Though we cannot guarantee performance, we can guarantee your experience will be the same as ours. Your author has a substantial amount of his net wealth involved in this investment strategy - we believe in eating our own cooking.
We believe our outperformance originated from aggressive buying of stock throughout the year, but more so in the first six months whilst most people were deeply worried about taking on risk. We felt that risk was actually considerably smaller during this period for the specific range of companies that have attributes that we specifically look for (please see section 3), than it has been over the last five years. This is because when placed in a historical context, risk premiums were very small over the last few years. This was most certainly not the case for most of 2009, hence we were net buyers (unlike 2006-2008 when we where 100% in cash, satisfying, but it didn’t win us many friends back then!).
2 How well did the strategy really do?
It was pleasing to see the fund almost double the performance of the S&P 500, which is not likely to happen many times in an investor’s career. However, let’s ask ourselves what the performance was relative to the following strategies:-
1. Buying the worst performers of 2008
2. Buying the best performers of 2008
The worst performing stocks of 2008 were not surprisingly financials. If you had bought the stocks of those companies that did not go bankrupt/disappear in 2008 (which were 5/15, please note PNC Financial Services purchased National City for about $5.2 billion in stock with funds from the U.S. Treasury in October 2008. The acquisition was described as a "take-under", meaning the purchase price was below National City's market value) you would have gained approximately 107% during 2009 (2 of the remaining 10 disappeared during 2009).
With this basic information you may ask yourself, why bother with paying people to look after your monies? Simply buy the companies that did badly last year, and this year they seem likely to do better! There seems to be a mean reversion character to the markets that any astute person should be able to take advantage of. May I take this opportunity to include a word of caution, and compare our personal investment style to this rather crude, but what seems to be, non trivial method.
Note that many of the stocks included in this list had fallen more than 90% at one point in 2009. One questions whether many investors of this strategy would have had the "stomach" to hold on. Furthermore, such volatility is to be expected from highly leveraged companies, which financial institutions often are. We view companies as leveraged when they have a debt load that is greater than 70% of shareholder equity. Many of the companies/financial institutions in the worst performing stocks of 2008 had outstanding debt greater than thirty times their shareholder equity! We must note that this debt is senior to stock, which means the shareholders would be the last investor to get paid should the company not be able to fund its debt through cash flow generation, and be forced to meet payments via a forced liquidation. Many of these companies, in our opinion, had a liquidation value less than there financial debt outstanding. This means there isn’t enough money to pay back in entirety the senior debt holders, so you can be sure the shareholders will get nothing in such a scenario! We, as investors, don’t like to be last in the queue when it’s close to closing time. There is a real risk of suffering a permanent loss of capital, which we find totally unacceptable. When something goes to zero, it does not matter how "cheap" you bought it – you lose all your money! Of the list included only one stock caught our attention: E W Scripps, a diversified media company with interests in newspaper publishing and television. This company had virtually no net debt and was trading at a fraction of its book value. It was an interesting balance sheet play and not surprisingly, it was the second best performer on the list.
With regards to the best performing stocks of 2008, as you can see below, the majority were acquired. If we look at the companies still trading in the public markets at 2009 year end (eight), than holding that portfolio of stocks would have performed approx. 4.81%.
On this occasion, we can see the performance of the 2008 worst performing stocks was considerably better than our own performance. Whilst our performance was considerably better than last years winners. We are happy with this scenario. Should one or two more of the worst performing stocks have gone bankrupt (which was very possible without state support), the performance of that basket would have been awful. This element of good/bad results changing drastically dependent on factors we cannot estimate to any great degree of confidence, and resulting in a permanent loss of capital (you can hold the stock to infinity, but you will still receive zero return!) we do not want to be involved with. As a result, we primarily invest in companies with low debt, which meet our quality conditions and are available at prices below our estimate of their objective value. We therefore aim to get a return that is consistently higher than yesterday’s leaders, and on average greater than yesterday’s worst performers. We feel we can achieve this by reducing considerably our possibility of suffering a permanent loss of capital.
As a final note with regards to our performance this year, we feel much of the gains are illusionary - stolen from the future to look good today. The market, in our opinion, seems to be currently distorted by the impact of governments and central banks. There is no doubt this distortion can create a new reality, which will mean current pricing may become "accurate". However, we don’t feel this is probable. In our opinion the major market index is not fairly valued anymore due to this influence, and as a result we are now finding it more difficult to add equity and bond positions. We are therefore likely to accumulate a greater cash position during 2010 unless market prices fall. Indeed, we would not be surprised if many of the companies we currently own will be priced lower at the end of 2010 than they were at the end of 2009. Here’s to dividends!
3 The Objective of the Investment Strategy
The primary objective of the strategy is to ensure that the purchasing power of its participants is increasing faster than the cost of living, i.e. what is often labelled inflation. True inflation is often significantly larger than what official statistical indicators suggest, as any individual already knows from experience. We aim to achieve this by applying two principal concepts:-
Have a base case scenario on how the value of money will evolve over the next five – seven years. All financial assets are measured in currency, hence understanding how the value of money will evolve is critical to appreciating how financial securities will be priced. This means understanding the conditions that are currently developing and how these fare for cash, bonds, equities, commodities and property assets.
Distinguish between the price and value of a financial asset. We remain primarily focused on purchasing the securities of companies that have:-
1. Dominant market position in their particular sector
2. Large barriers of entry
3. Strong balance sheets (little leverage)
4. Respectable returns on capital
5. Leading margins in their sector
6. Available at a large margin less than our estimated objective value
Though we appreciate our requirements seem demanding, and the difference between price and intrinsic value is not easy to calculate, opportunities do exist and particularly so within certain sectors at any one point in time. Furthermore, our results are likely to be more fruitful if we stay within certain fields where our methods are likely to be more accurate. We therefore rarely stray from these areas. It is for that reason we did not invest in financials or insurance companies during the last few years, though they were branded as being cheap.
For example, one investment strategy involves buying the stock of a company whose physical assets are worth more than the market price of the stock. This may seem ridiculous, but I can assure you it happens more often than you care to believe. Take for example Kingfisher, a well known DIY retailer primarily based in the UK. This company saw its stock value drop from a high just shy of 3 GBP, to a low of 1 GBP due to its exposure to the UK (and to a lesser extent European) housing market. Buying stock at 1.20GBP ensured you were buying the entire company for approx. 70% of its recorded property purchases (including deductions from depreciation)! Similar strategies were used for the purchase of Steinway’s Musical Instruments, whose price for a number of months was quoted at a ridiculous price relative to its balance sheet value.
4 Errors with hindsight
We include this section to balance all the great praise we give ourselves with an open discourse on some of our errors. We do this for a learning exercise, so we make sure we don’t do the same mistakes (yes, it was more than one!) again. The biggest whopper was that we should have invested even more when the bells were ringing at the start of 2009. But like everyone else, I was also scared I might be wrong. Career risk is behind everyone’s mind making them behave more like their peers so one does not stand out in case things go wrong. However, if more people agree with you, it does not make you more right. Interpreting facts correctly is what makes you more likely to be right. Nothing is for sure in this world - I tried to react assessing the probabilities of success: Conclusion: I undervalued them. Unfortunately, you will see me copy and paste this entry many times in the future. I will generally tend to under value than over value any asset to introduce a “margin of safety” that reduces the possibility of a permanent capital loss.
5 Macro factors
Our investment approach is not based on our beliefs on macro effects in a symmetric manner. We only apply them to our investment decision making process if they indicate a negative environment. They therefore play an important role in helping us appreciate how the different asset classes may perform relative to each other.
In summary, our principal macro thoughts are the following:-
Saving rates will increase in developed economies as asset price inflation will not be relied upon as heavily as it has in the past for wealth accumulation. This will come at the cost of reduced consumer spending. Greater uncertainty for job security and large debt positions will also act as catalysts to save. We feel asset price inflation has simply played too strong a role in GDP growth for developed economies for too long. This has stimulated large consumer spending due to the feeling of being wealthy in financial and property assets. The important fuel that was ever increasing bank debt has been firmly shut off for now due to careless lending leading to fears of capital inadequacy within the banking sector. This decreasing volume of debt is not supportive for asset prices. Hence the huge government support increasing the money supply and reducing the cost of money. Such an increase in currency will likely lead to a reduction in that currencies value in the future, a symptom of inflation. However, it is important to continuously follow different variables to see how the situation is evolving. In particular how:-
1. The velocity of that currency is evolving
2. How money with zero maturity (MZM) is evolving
3. Who is receiving the money being created i.e. how the transmission network for the financial system is working
4. Default rates for prime mortgages, also considering the distortionary affects of mortgage modifications
The government cannot support the economy in the manner it has in the last 12 months indefinitely. The question is how will it support itself when the drugs run out. We feel the debt that existed previously is still mainly there, acting as a weight to the economy, which implies growth rates cannot be strong. In this sense, we feel a strong affiliation with the PIMCO view of the world endorsed by Bill Gross – a new normal with weak growth for a number of years. As a result, we are even more pessimistic than usual when looking at the growth potential of franchises we may be interested in owning.
We thank you for your continued confidence in us.
Yours sincerely,
Alessandro Sajwani
Long term investment advisors Q1 2010 results:+2.22%
Dear Reader and Fellow Investors,
The gain in net worth of the portfolio under our management during the first quarter of 2010 was +2.22% on a bid to bid basis (denominated in USD).
Considering that during this period we held approx. 20% of assets under management in cash, we are mildly satisfied with our performance. However, our cash load during this period helped ensure we under performed the S&P 500, which achieved +4.87% during the same period.
Our fear of asset markets tipping the balance from being fairly valued to slightly over valued has reduced our appetite for equities in a macro environment that remains fragile due to the debt burden that continues to exist. Hindsight would suggest we have been over defensive during this quarter. However, as many of you already know, we do not judge our abilities by quarter to quarter performance. I hope you also do not judge performance by this metric, otherwise we are likely to disappoint you (repeatedly).
In such a situation we must ask ourselves what could we have done differently. Often the answer lies in the psychology of the market - our approach requires us to remain as distant as possible from the sentiment of the market - focusing only on our perceived difference between price and value. It is because of this we will often, if not always, miss out on the end of a bubbles spectacular return in favour of hoarding cash to buy when prices collapse. As a result, we are likely to underperform competitors when the market is strongly positive and over valued. However, we strongly believe that if you want to finish first, first you have to finish. In the long run, those that buy expensive securities will realise they will burn more than their hands. However, on this occasion, we may be guilty of not placing sufficient emphasis on a major force that is pushing up the valuation of risk assets - near zero interest rates.
It seems the fear of the return of capital has been overcome by the demand for return on capital. We did not feel the market would make this adjustment so quickly. How short it’s memory can be: all is safe now that Ma and Pa have said they will create money at ease to dilute yesterdays problems...and so happily ever after they lived... we feel this is just that, a fairy tale. The creation of capital from nothing to support non productive capital can only be useful if overall the return on the capital invested increases. With the government responsible for allocating that capital, we find it hard to believe using history, and the current incentives of our political system, that this will be the case. As a result, it is more likely than not that the excesses of years past will still be a drag on our global economic system (especially, it seems, for developed economies that have a number of other negative factors in parallel, such as demographic issues). We appreciate that if the return on this new capital is greater than the current rate of interest, the new debt can start to be reduced immediately. However, whilst the receiver of the new debt will be working to pay the new debt back, the old debt remains where it was before, accumulating dust and waiting to eat a chunk of future profits, should they exist. Recall, it was the old debt that caused the problem!
Consequently, we feel economic growth if left to fend for itself, would be weak. We appreciate that if enough stimulus is added, and for long enough, sufficient momentum can be created that economies can grow, even flourish. However, just like the tired student who drinks coffee all night can be viewed as being bright eyed and ready in the morning, the reality is his body yearns to rest. He may even do his morning exam well, so his judges will be silenced for some time. But eventually, the tiredness will catch up with him, the only question is when, not if. Debt can be reduced/removed by only two means: default or inflation. Both bring pain when out of control: since the debt level still remains high on a historical level, our perception is that our due of pain has not been fully invoiced as of yet.
In essence, we feel the asset markets are being distorted by the governments actions. Interest rates at near zero are forcing investors to move out of near cash assets to generate any respectable yield. As a result, capital is moving out of money market funds and cash deposits into equities, bonds and other risk assets. Eventually, the yield on government bonds will have to increase so that sufficient funds will move to the public sector to pay for the stimulus that is allowing asset prices to rise today. If it seems a little circular, you would be right in thinking that. This new capital is likely to be buying only one thing - time. Time that generates little value and hence exacerbates the low return of unproductive capital as it increases the cost of interest.
To return to our principal point, we felt that government bond yields would have started to increase by now, and they haven’t to the extent we felt they would. We must appreciate that this paradigm shift may not occur overnight. If it does take time and the current circumstances remain, risk assets could continue to rally, not for any fundamental reason in terms of the quality of the businesses underlying the financial assets, but because certain variables are being distorted to ensure risk assets remain on morphine. We have reacted to this scenario by continuing to use our approach of buying good companies at good prices. However, today we are clearly finding fewer opportunities than in early 2009 due to the strong rally in the price of almost all risk assets. Having said that, only in the last two weeks we have purchased the stock of three different companies that we feel the market have left behind and are currently offering good value for money. In total, for Q1 we have executed five trades: two sells and three buys. We continue to spend a considerably greater amount of time researching good ideas rather than trading mediocre ones. We try to ensure only our finest ideas become part of the portfolio.
Over the last six months we have also started placing more focus in generating income as well as the potential of capital gains as a means of returns for our investors. We feel the market (S&P 500 as a reference) at current prices close to 1,200 is approx. 25% over valued. As a result, we feel there is a significant probability that the S&P 500 can close the year lower than the current market price. Should this occur, we like the idea that we have an ever increasing cash component accumulating in the portfolio. This will allow us to have the armoury to buy more good companies at even better prices. We estimate the current dividend yield of the portfolio is approx. 2.5% in USD terms. Though this is better than current cash rates for most developed country currencies, and better than bond yields for good companies for paper less than 2 to 3 years in duration - it is clearly nothing impressive when compared to average interest rates over the last hundred years. We like the idea of having this closer to 3.5% on a consistent basis for the portfolio. However, we will not push for this if we see that companies with lower dividend yields are trading at a significant discount to companies with high dividend yields because they may retain earnings to take advantage of higher returns on capital.
We conclude this brief review by thanking you for your continued confidence in us. If you would like further details or have any questions, please feel free to ask them on this blog or send them to my personal email address at alessandro.sajwani@gmail.com
Yours sincerely,
Alessandro Sajwani
The gain in net worth of the portfolio under our management during the first quarter of 2010 was +2.22% on a bid to bid basis (denominated in USD).
Considering that during this period we held approx. 20% of assets under management in cash, we are mildly satisfied with our performance. However, our cash load during this period helped ensure we under performed the S&P 500, which achieved +4.87% during the same period.
Our fear of asset markets tipping the balance from being fairly valued to slightly over valued has reduced our appetite for equities in a macro environment that remains fragile due to the debt burden that continues to exist. Hindsight would suggest we have been over defensive during this quarter. However, as many of you already know, we do not judge our abilities by quarter to quarter performance. I hope you also do not judge performance by this metric, otherwise we are likely to disappoint you (repeatedly).
In such a situation we must ask ourselves what could we have done differently. Often the answer lies in the psychology of the market - our approach requires us to remain as distant as possible from the sentiment of the market - focusing only on our perceived difference between price and value. It is because of this we will often, if not always, miss out on the end of a bubbles spectacular return in favour of hoarding cash to buy when prices collapse. As a result, we are likely to underperform competitors when the market is strongly positive and over valued. However, we strongly believe that if you want to finish first, first you have to finish. In the long run, those that buy expensive securities will realise they will burn more than their hands. However, on this occasion, we may be guilty of not placing sufficient emphasis on a major force that is pushing up the valuation of risk assets - near zero interest rates.
It seems the fear of the return of capital has been overcome by the demand for return on capital. We did not feel the market would make this adjustment so quickly. How short it’s memory can be: all is safe now that Ma and Pa have said they will create money at ease to dilute yesterdays problems...and so happily ever after they lived... we feel this is just that, a fairy tale. The creation of capital from nothing to support non productive capital can only be useful if overall the return on the capital invested increases. With the government responsible for allocating that capital, we find it hard to believe using history, and the current incentives of our political system, that this will be the case. As a result, it is more likely than not that the excesses of years past will still be a drag on our global economic system (especially, it seems, for developed economies that have a number of other negative factors in parallel, such as demographic issues). We appreciate that if the return on this new capital is greater than the current rate of interest, the new debt can start to be reduced immediately. However, whilst the receiver of the new debt will be working to pay the new debt back, the old debt remains where it was before, accumulating dust and waiting to eat a chunk of future profits, should they exist. Recall, it was the old debt that caused the problem!
Consequently, we feel economic growth if left to fend for itself, would be weak. We appreciate that if enough stimulus is added, and for long enough, sufficient momentum can be created that economies can grow, even flourish. However, just like the tired student who drinks coffee all night can be viewed as being bright eyed and ready in the morning, the reality is his body yearns to rest. He may even do his morning exam well, so his judges will be silenced for some time. But eventually, the tiredness will catch up with him, the only question is when, not if. Debt can be reduced/removed by only two means: default or inflation. Both bring pain when out of control: since the debt level still remains high on a historical level, our perception is that our due of pain has not been fully invoiced as of yet.
In essence, we feel the asset markets are being distorted by the governments actions. Interest rates at near zero are forcing investors to move out of near cash assets to generate any respectable yield. As a result, capital is moving out of money market funds and cash deposits into equities, bonds and other risk assets. Eventually, the yield on government bonds will have to increase so that sufficient funds will move to the public sector to pay for the stimulus that is allowing asset prices to rise today. If it seems a little circular, you would be right in thinking that. This new capital is likely to be buying only one thing - time. Time that generates little value and hence exacerbates the low return of unproductive capital as it increases the cost of interest.
To return to our principal point, we felt that government bond yields would have started to increase by now, and they haven’t to the extent we felt they would. We must appreciate that this paradigm shift may not occur overnight. If it does take time and the current circumstances remain, risk assets could continue to rally, not for any fundamental reason in terms of the quality of the businesses underlying the financial assets, but because certain variables are being distorted to ensure risk assets remain on morphine. We have reacted to this scenario by continuing to use our approach of buying good companies at good prices. However, today we are clearly finding fewer opportunities than in early 2009 due to the strong rally in the price of almost all risk assets. Having said that, only in the last two weeks we have purchased the stock of three different companies that we feel the market have left behind and are currently offering good value for money. In total, for Q1 we have executed five trades: two sells and three buys. We continue to spend a considerably greater amount of time researching good ideas rather than trading mediocre ones. We try to ensure only our finest ideas become part of the portfolio.
Over the last six months we have also started placing more focus in generating income as well as the potential of capital gains as a means of returns for our investors. We feel the market (S&P 500 as a reference) at current prices close to 1,200 is approx. 25% over valued. As a result, we feel there is a significant probability that the S&P 500 can close the year lower than the current market price. Should this occur, we like the idea that we have an ever increasing cash component accumulating in the portfolio. This will allow us to have the armoury to buy more good companies at even better prices. We estimate the current dividend yield of the portfolio is approx. 2.5% in USD terms. Though this is better than current cash rates for most developed country currencies, and better than bond yields for good companies for paper less than 2 to 3 years in duration - it is clearly nothing impressive when compared to average interest rates over the last hundred years. We like the idea of having this closer to 3.5% on a consistent basis for the portfolio. However, we will not push for this if we see that companies with lower dividend yields are trading at a significant discount to companies with high dividend yields because they may retain earnings to take advantage of higher returns on capital.
We conclude this brief review by thanking you for your continued confidence in us. If you would like further details or have any questions, please feel free to ask them on this blog or send them to my personal email address at alessandro.sajwani@gmail.com
Yours sincerely,
Alessandro Sajwani
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