Update No. 73 – 17/08/12

I mentioned last week that 2 of our 10 holdings were expected to report this week; the only holding of the fund I have mentioned by name in the blog previously is Maxitrans (MXI), a builder of truck bodies and seller of related parts we have owned since the funds inception.I mentioned the holding here and here, it originally comprised only 7.1% of our assets, despite having grown our assets substantially since then and having disposed of 58% of our holding, for a price over 50% above the entire original cost of the positions acquisition, our MXI holding still represents nearly 7% of fund assets.  As I said, we still retain 42% of the original holding, but of all our holdings, MXI are valued most closely to intrinsic value and so we sold an amount on Friday which we will likely re-deploy into more deeply undervalued stocks.  Based on their stellar 4E released Friday, that intrinsic valuation has risen substantially in the last 12 months and appears likely to continue through FY2013, as such we retain a meaningful interest and with it an expectation of continued sound performance.  Based on the 4.25c annual fully franked dividend payout for FY2012, we are being paid over 25% of our original purchase price (grossed up) to see if they can continue to produce.  If you are wondering what attracted us to MXI, in this case, above all else, it was operating cash flows.  Look back through the last few annuals and even when they were declaring ‘accounting’ losses, such as in FY2009, there was a very strong underlying cashflow.  It is a very cleverly run business, exposed to the right industries, on the upside of cyclical industries that neglected CAPEX through the GFC and must make up for it now.  One thing I will comment on in the negative (and will do so at every opportunity) is the dumping of such important information into the middle of a trading day.  Given MXI intended to report on a Friday, I truly believe the correct action for directors would have been to report after close and give all holders or potential holders the opportunity to digest the information over the weekend, allowing a fully informed and considered market to open on the Monday morning.  Truth be told there was nothing specific or new announced in the report that could have justified a 15% spike, that is just ‘Mr. Market’, but I just believe important earnings documents need proper consideration.  If the two recent acquisitions perform as expected and organic momentum continues, it is likely MXI will have NPAT of around 9cps in FY2013, so even at around the 80c current price, it is not a particularly challenging valuation.

The other holding that was scheduled to report this week (based on last year’s schedule) did not in fact report, so we will now expect 2 reports next week.  I will give some guidance as to how they went in relation to my expectations.

To a company we don’t own – I found rather amusing the triumphant nature of the announcement by Wesfarmers of a $1.356B pre-tax profit for Coles.  This equates to post-tax earnings of about $950M, say $1B if they had some tax-breaks.  Woolworth’s trades at 16x trailing earnings, if we were to value Coles at the same valuation, it would be worth about $16B, throw in some earnings/savings from the acquisition that are flowing to other areas and maybe you get to the $18B they paid in 2007.  So for all intents & purposes, Wesfarmers have had $18B tied up for 5 years in a business that is now worth $16B to $18B if we value Coles on the same multiple as Woolworths.  Coles has performed extremely well over the last few years, but most sensible analysts would still apply a P/E premium to Woolworths in the same way the CBA is rated at a premium to its banking peers, for years of steadily superior performance.  All I can say, given how well the turn-around appears to have gone at Coles is that there must have been some extraordinarily heroic profit growth projections made at the time of the acquisition! The foregoing is a simplistic view, but I would love to see a metric whereby the acquisition could be described as reasonably priced.  I still haven’t seen one, but there was a lot of ‘buy-in’ in the financial press this week saying Wesfarmers has finally ‘justified’ the price they paid.  If Coles can double earnings again over the next 5 years as they have over the last 5, only then will I be able to say a ‘fair’ price was paid, but not a ‘good’ price.

And now for something completely different… I am a believer that the rise in prosperity in China is sustainable, probably for many years to come.  There are an increasing number of commentators who are spotting patches of trouble in China, there are indisputable risks.

I don’t think that there is any question that growth is slowing, but that is inevitable, trees cannot grow to the sky.  Chinese citizens I do not envy, but it must be acknowledged that an authoritarian government has a number of distinct advantages when it comes to planning; primarily the advantage is that you don’t have to worry about not being re-elected at the next election if you make unpopular decisions.  This allows for long-term capital allocation that democratic governments would be unable to consider.  It also creates an environment where misallocation of assets is far more likely, I’ve read in a variety of different places that as many as 64 million apartments sit empty in China.  Regardless of any long-term plan, that is inefficient.

China’s growing middle class are starting to look around for investment options and this Reuters article alludes to the rise of a class of questionable investment options being promoted to unscrupulously exploit this new wealth.  You would think an authoritarian government would have some special advantages in this area too, rather than the ‘slap’s on the wrist’ Western countries tend to hand out to their perpetrators of fraud, in China, there could potentially instead be a brutal enforcement regime that genuinely acted to stamp out such behaviour.  I think that is unlikely, even the largest government cannot have the type of reach required, and inevitably ends up acting reactively more than proactively.

If China wants to achieve genuine, sustainable and long-lasting prosperity though, they do need to focus on building as open & transparent a financial market structure as possible.  There are a great many lessons that could be learned from the failings of the western markets over the last 100 or so years.  People operating within the Chinese stock-market acknowledge that it is a bit of a ‘wild-west’ situation at the moment.  I follow the work of a number of short-sellers who have had a great deal of success finding and profiting from fraudulent Chinese companies.  But to derive the greatest benefit from a capitalist society, people have to believe that on balance it is more likely that they are entrusting their funds to a ‘Warren Buffett’ than a ‘Bernard Madoff’, otherwise the capital ends up stashed away unproductively.  A level of relative trust in your regulators is the only way this can happen – Tony Hansen 17/08/12.

*Link to External Audit

EGP Fund No. 1 Pty Ltd. Up by 6.29%, lagging the benchmark by 0.6% since July 1^st. Since inception, EGP Fund No. 1 Pty Ltd is Up by 9.47%, leading the benchmark by 13.76% all-time (April 1^st 2011).