Overall Investment Strategy

[galumay]

I have documented my investment strategy for the share market in word documents, but it really makes more sense to put them up here and allow others to discuss or challenge if they so desire!

OVERALL STRATEGY

move free cash & dividends to SMSF to take advantage of tax benefits.

In reflecting on my portfolio structure the interesting thing for me is that of the 11 companies I have invested in, 8 of them have shown significant unrealised capital gains well in excess of the benchmark.

Just 3 of them have shown significant unrealised losses, and when I revisit my analysis of these 3 companies I am most comfortable with ITD, i expect the benefits of their growth strategy to start bearing fruit and I am confident that they will continue to provide a healthy yield in the mean time.

CDA was a mistake - with the benefit of hindsight - no one predicted the turnaround in earnings that CDA suffered with the collapse of their metal detector sales. But the saving grace is that they were in a good position to weather the storm, they have other profitable if smaller segments, low debt and management that have reacted quickly to gain control of the situation. It will take them a while to recover and for the results of rebuilding the business to flow through, and the dividends have and will suffer in the mean time. An increase in earnings back to about 9c per share would mean a price similar to my cost at a p/e of 14 which is not to difficult to imagine in the medium term.

NWH is obviously the worst performer of the portfolio, we all know the reasons mining services companies have had their share prices savaged, as I have expressed elsewhere, I hold a contrarian view about the extent of the impact in this sector going forward, nothing I am reading currently would support that view!! It probably comes down to a question of whether NWH can survive the cycle financially, and the concern with that is only the debt. When I first purchased NWH I failed to pay enough attention to the debt, particularly the interest coverage ratio - that was something I didnt even know about when I started and it was only ROE's help that expanded my understanding of the importance of considering this metric.

I expect the share price to drop further before it shows any sign of recovery, there is likely more bad news with the impairment that has been flagged and sentiment is so poor towards this sector that any negative news has a disproportionate effect.

I had a long hard think about averaging down into NWH, but I think the capital can be employed better elsewhere and the risk of them not surviving the cycle, while low, does exist.

I reckon MND would have been a better choice for my contrarian entry into this sector, and with what I have learnt from others about reading and analysing financial reports it would have been apparent to me. Either way its not going to be a quick turn around for the sector and it will require patience and nerves to ride it out.

So funny to read this in hidsight, 5 years later - CDA & NWH turned out to be the two best performers by far!!

[galumay]

I have adopted the strategy of paying all dividends from our personal portfolio into the SMSF, this will be the most tax effective way to use the dividends.

Looking at performance of the two portfolios at the end of January the personal portfolio continues to be dragged down by just a couple of companies, NWH is the worst culprit, now down to 30c from $1.14, which is a nearly $9000 drag on the portfolio, despite this we are up 5.45% for the FY - but underperforming the AXJO which has made 6.5% for the FY.

Having missed any opportunity to sell, and with so little skin left in the game with NWH, I will just hold and hope for a turnaround in the mining services sector! I suspect it will be a long wait. The main lesson here is the danger of investing in strongly cyclical sectors!

The SMSF performance is also lagging at the moment, I have adopted a Net Asset Valuation method such as a Fund Manager would use, this allows for the regular injections of capital and income stream rather than a straight indexing comparison. On this basis the SMSF on establishment had a NAV of $2.68 per share, (an arbitary amount defined by dividing the total initial investment by a 'share issue' of 100,000), this NAV is now $2.58 so a  decline of 3.75%. By comparison the AXJO is up by 1.24% for the same period - so an underperformance of 5%!

Once again its the mining services sector that is almost entirely responsible for this underperformance, MND and NWH are down 43 and 63% respectively - and thats after averaging down into NWH! So once again all I can do is wait and hope!

[galumay]

Something I have been trying to get my head around is how to understand my phycological reation to a share that has risen strongly in price and whether I should sell some or all to take a profit. My first level of analysis is to check whether it is still trading at a discount to my calculated intrinsic value and whether all the other assumptions and metrics hold true currently.

But I have also becaome aware that there is some anchoring bias present where I am reluctant to sell if its gone up stongly for FOMO (fear of missing out) on potential future gains. I am also always caught on the dilemma of trying to decide if the capital could in fact be better employed elsewhere - and often its easier to see the historical run up in price of the existing share as being an indicator that it will continue to run up, where as the price of a potential new position has no history for me.

So part of the challenge is to remove my emotional responce to the historical share price rise in an existing stock and simply focus on whether it is trading at a discount to value or not and whether the same or new potential for growth in the business (not share price) exists.

[galumay]

Interesting article here that outlines a well thought out strategy for avoiding really bad decisions,

CLICK

[galumay]

I realised I have never really articulated my strategy here, as a deep value, fundamental investor, my aim is to find businesses that i consider to be trading beneath the range of intrinsic value that i calculate, and where the business is within my circle of competence, I can simply explain what they do, the business has attractive metrics such as low or no debt, history of earnings and dividend growth, high ROE, ROIC, low E/EV,  directors with skin in the game, tightly held to the point of illiquidity, prospects for growth and a high conviction of the investment on my behalf.

I am also trying to develop an ability to assess competitive advantage or moats in businesses I invest in, in simple terms looking for price setters not price takers and then understand what drives that.

My goal is to accumulate more shares in these businesses if the market continues to under price them, or even averaging up if the growth in earnings and general prospects are positive. My intention is to sell if the share price substantially exceeds the range of IV I have calculated for the business and there is no compelling change in the business to explain the price. Otherwise my intention is to hold.

I am prepared to have some positions where earnings are not yet reflected in positive cash flow if I believe the business case is compelling enough.

I have no interest in try to time the market, macro economics, financial predictions etc - I consider all these things violate sticking to my circle of competence.

20% rate of return hurdle.

Keep as much as possible in an offset account against property, in the case of a market crash look to buy quality LIC's at a discount to NTA with this "line of credit"

[galumay]

fine tuning the strategy and simplifying,

* Buy good companies

* At a fair price or better

* Do nothing for a long time

Identify good companies -

* Must be undiscovered/not covered

* Must be financially successful or likely to become so.

* Must be understood by me

* Must be safe, no catastrophic risk, ideally asymmetric risk

* Must be durable

Good businesses have a high return on invested operating capital, businesses that have high levels of intangible assetts, they have the ability to grow by reinvesting cash generated by the business.

We estimate the free cash flow of every company after tax and interest, but before dividends and other distributions,
and after adding back any discretionary capital expenditure which is not needed to maintain the business. Otherwise we would penalise companies which invest in order to grow.
Our aim is to invest only when free cash flow per share as a percentage of a company’s share price (the free cash flow yield) is high relative to long-term interest rates and when compared with the free cash flow yields of other investment candidates both within and outside our portfolio.

[galumay]

Picked this up reading the Canadian firm Burgundy Assets

https://www.burgundyasset.com/wp-content/uploads/TheViewBook_2017_Web.pdf

• Invest in companies in which the estimated intrinsic value exceeds the stock price by a significant amount. This is what Ben Graham referred to as the “margin of safety.”

• Invest only in companies you understand. This is Buffett’s circle of competence concept.

• Invest in companies in which you have confidence in the management with respect to their honesty and competence. Examine in particular their capital allocation actions – when to pay out and when to retain.

• Seek out managements that stress share price performance and return on shareholder’s equity (ROE), rather than the absolute size of the company (many large Canadian companies fall into this trap of size versus per share progress).

• Pay careful attention to the quality of earnings, and the ability to generate free cash flow and its deployment.

• Seek out companies that have a strong competitive position or barriers to entry. If you don’t have wide “moats” around your “grand castle,” competitors will penetrate your territory, erode your profitability and eventually cause your downfall.

• Watch for brand names and natural oligopolies of various types. These are rare but extraordinarily valuable over time, especially if purchased when they are out of favour in the marketplace.

• Be a willing buyer of good companies when they are under pressure and when most investors are selling because of bad short-term news.

[galumay]

Buffett on Ben Graham - 3 basic principles,

1. that you should look at stocks as part ownership of a business;
2. that you should look at market fluctuations in terms of his “Mr. Market” example and make them your friend rather than your enemy by essentially profiting from folly rather than participating in it; and finally
3. the three most important words in investing are “margin of safety,” which Ben talked about in his last chapter of The Intelligent Investor – always building bridges that can carry 30,000 pounds but only driving 10,000-pound trucks across it.

[galumay]

Burgundy Assets

We look for companies that deliver high returns on shareholders’ capital consistently, which are well financed and run by trustworthy and competent people. We try to find a number of these investments and then hold them for the long term.

[galumay]

more from Burgundy assets

Four Underlying Investing Principles
The first step in our protocol development is to agree to the facts and assumptions underlying the Buffett approach. If we cannot agree on the basics, then the quality/value system is not for us.
1. Long time horizons are absolutely necessary. If we want to earn returns that are better than bond yields, then we need to adopt the very long time horizon that is appropriate when investing in stocks. If that is not possible, then this is a signal to opt out of the Buffett system.
2. Earning equity returns without being exposed to equities is impossible. We must own equities to earn equity returns. Expecting to jump in at market bottoms and out at tops is unrealistic and risky because equity returns are discontinuous. We don’t want to miss the few really big “up” days. While there may be many ways to get to heaven, there are no shortcuts.

Success at “timing the market” could only come from success at repeatedly predicting the short-term future. In a complex, adaptive world where any spontaneous order is temporary and many of our earthly systems are often operating at the edge of chaos, predictions about the future are more difficult than they seem. Repeatedly getting them right is impossible. In financial markets, as in life, surprise is the rule, not the exception.
We are not aware of any study or long-term track record concluding that anyone has repeatable expertise in market timing. Even Buffett likes to say he attempts to price, rather than time, his investments. Again, if we cannot agree with being long-term stock owners, here is another chance to opt out of this approach.
3. Quality stocks are the only way to go. While there are always a few who get lucky guessing on speculations, there are many more who lose it all. We must agree that only quality franchise companies with persistent competitive advantages and strong management will be owned.
4. A buy-and-hold approach is best. We will buy these quality franchises when they are cheap, with the plan to hold them forever if nothing changes.

[galumay]

from a friends post about his investment strategy,

The Gent's Pre-Investment Checklist

Economic Moats: are there signs that the company already has, or could develop an Economic Moat (a structural advantage that can insulate the company in the future against competition)

Network Effects: Does each new customer make the network more valuable for existing users? The least likely moat source, but IMO the most valuable and lucrative from a future Return On Invested Capital (“ROIC”) and margin perspective

Intangibles: Increased pricing power emanating from proprietary technology, patents, brands or regulation (i.e. licences)

Switching Costs: Does the cost of switching to a competitor’s product/service outweigh the benefits of doing so (due to risk, integration with the customer’s systems (mission criticality), hassle and distraction). Higher customer retention/lower churn = increased pricing power and potential future ROIC

Cost Advantages: The ability to price below competitors due to cost benefits arising from cheaper processes or manufacturing economies of scale, better buying power, proximity or access to infrastructure or a low-cost resource, or low-cost financing

Efficient Scale: Does the company operate in (dominate) a smaller/limited market which is unlikely to be attractive to larger rivals?

Management: How high quality does management appear and what is its track record for building lasting larger companies?
Does the management team have significant skin in the game (I like to see management owning at least 10% of a company, and I love it when 30% and higher)

Industry dynamics:
Favourable tailwinds driving structural growth (such as a new technology or migration of customers from one platform to another)?
Porter’s 5-Forces: power of customers and suppliers, threat of future substitutes making the company’s product/service redundant, existing competition and threat of new entrants? How do these forces impact on industry and company profitability?

Presence of larger well-capitalised competitive gorillas which could squash the company? Could this company become a monopolist/oligopolist in the future?

Strategy:

Is there a long runway for growth? Is this a disruption play which has a solid chance of succeeding?
Is the company targeting a niche where it can be the dominant player (preferable to aiming to be an Also Ran in an industry with many behemoths)?
Does the company have a strong market share and continues to take share from rivals?

Financials:

Is the company self-funding? Can it continue to grow organically – but also via acquisitions – without continually coming back to shareholders for dilutionary capital raisings?
Are gearing levels low? Has growth been funded by operating cashflows (not debt)?

Are revenue, margins and profitability growing over time? What is the company’s ROIC, is it growing and how does it compare to other industry players?

For companies which are loss-making, how far away is the cashflow and profitability break-even inflection point? Does the company have sufficient cash on hand to fund operations through to this point, or will a capital raising be necessary?

Other factors:

What level of institutional ownership is there already? (I personally prefer low – means the company is relatively undiscovered, and if possible I want to be finding companies before institutions realise they need to own it)

How liquid is the stock (prefer illiquid versus highly liquid stocks – higher risk, but *if I’m right* on the investment thesis and people need to own the stock later, the stock price can soar).

[galumay]

Re-reading most of the posts above, I feel like that is a detailed description of where I have developed as an investor. I feel some urge to summarise and simplify my strategy,

We seek to invest capital in the partial ownership of businesses, at a price that if we had sufficient capital, we would be happy to buy the whole business.

Our intention is to partially own them as long as they continue to be businesses we would be happy to own in entirety.

[galumay]

Had a reality check today, went back and did a theoretical exercise of looking at the portfolio at the end of 2014-15 FY and projecting forward if I had simply held the same portfolio up to the present day without selling or buying anything.

Amazingly we would only be about 3.5% worse off over the 6 years if I had done absolutely nothing - instead of thousands of hours of reading, writing, research, analysis, deliberation and effort! Of course as someone on twitter pointed out, the sample size makes any conclusion impossible. Its interesting to note a few things though, 4 winners made up almost all the gains by multibagging, 4 losers went to nothing basically, the rest muddled along.

So something like only 30% of positions outperforming strongly was enough to offset 30% going to nothing, 40% doing bugger all and still give superior returns over the time period.

 

[galumay]

In terms of measuring the performance of the SMSF on an absolute basis, long term the stated goal is returns of at least 10% on invested capital. My  belief is that measuring the unrealised gain once per year is a necessary if undesirable activity for reporting purposes, measuring the CAGR of those unrealised gains over the life of the SMSF is preferable. The second part of the returns come from actual cash returns, we are inactive enough to ignore capital gains and losses realised and just measure dividends paid. There is a necessary blurring of these measurements because in general the dividends have been reinvested into the fund. We track these metrics each year for the SMSF.


We seek total returns of at least 10% CAGR over the life of the SMSF.

[galumay]

Filling in the gaps,

how do I identify these businesses? Most of our investments are characterised by being small or micro cap businesses, often with founders who have significant holdings, profitable, high ROIIC, very low debt, positive FCF, financial stability (history of earnings, FCF & dividends). I have created a spreadsheet that helps to quickly check whether a business is worth deeper research to determine if it is investible for us. The final criteria is price, the business needs to be trading at a discount to value, or have a compelling catalyst for rerating. To summarise,

We look for good businesses we can buy at a fair price.

Finally, invert, always invert!

We look for a business good enough that we can get the valuation a little wrong and cheap enough where we can get the quality a little wrong.