Update No. 89 – 7/12/12

In the last 2 years, with interest rates at or very near historic lows, Australian holdings of “Term Deposits” have more than doubled. This was from a story in the Australian Financial Review perhaps Wednesday this week.  From memory, it showed since 2010 Australian TD’s have gone from around $300B to about $600B currently.  Looking at the graph, I was reminded of a pertinent quote from Warren Buffett and had a quick dig around last night before I found it in the 1978 shareholder letter:

“An irresistible footnote: in 1971, pension fund managers invested a record 122% of net funds available in equities – at full prices they couldn’t buy enough of them.  In 1974, after the bottom had fallen out, they committed a then record low of 21% to stocks”

I sincerely hope Australian savers aren’t committing the same heinous capital allocation misjudgement over the last couple of years that American Pension funds were in 1974, but I suspect as a group they are.  I would hazard at the very full 2007 prices, a meaningfully higher percentage of savers funds were being committed to the stock market.  Now, with prices quite depressed in comparison to both 2007 prices and historic measures, the capital savers are committing to stocks is a fraction of the 2007 proportion…

I don’t really worry too much about market levels when buying stock, in purchasing stock, we always invest with the mindset of a business owner.  We imagine ourselves as the owner of the whole business (when I do this with a business I am especially fond of, this is a particularly pleasurable imagining).  In fact, I can envisage a time in the not too distant future when EGP could become the whole-owner of some small business/es – should our capital levels ever become large enough that such a decision presented the most ideal path to wealth/value creation for our investors.  The key question is always ‘what amount of cash can be extracted from the business in order to acquire more low-cost sources of cashflow?’ If I cannot get the free-cashflow of a business for (at least) a 10% return on my purchase price, then I am probably (though not always to be fair) looking elsewhere.  It is a simple game of compounding.

To demonstrate, I will use the one stock we still own in EGP (though we have substantially trimmed due to recent more proper valuation), but which I have mentioned here previously.  When I researched Maxitrans (MXI) in early 2011, over the previous 5 completed financial years, the firm had generated 38.4 cents of cash per share; they had expended 10.2 cents per share on CAPEX in this time.  Free cashflow (FCF) was 28.2c (average of about 5.6c per year); the statutory earnings were 26.7 cents, so this level of earnings seemed kosher (i.e. conservatively accounted – the way I like it).  The company was plainly capable (through a harsh financial period which included the GFC) of generating about 5 to 6 cents per share per year of FCF.  At the 10% FCF return I mentioned in the first paragraph, I considered at that point in time that MXI would be pretty good value up to about the 50c share-price range.  I acquired our holding for 23.5c, so I was very pleased – over the next 2 or 3 months I could have acquired meaningfully more at between 18 – 22c as the market continued to misprice the stock (unfortunately I didn’t acquire more).  It was very obvious that MXI was in a cyclical industry at (or very near) the nadir of a brutal cyclical low as their client base deferred their own CAPEX.  Management had clearly enunciated a number of strategies that made sense for the business.  My actual calculation of intrinsic value was much higher than the 50c quoted above, but as a ‘rule of thumb’, the 50c valuation would have worked out well.

Our largest holding I should note is quite stingy on the cashflow metric, though there are a number of ways to derive a high intrinsic valuation; this one is based primarily on asset valuation.  They breach the rule above (greater than 10% FCF yield) and trade on about 4% FCF yield based on the last few years results.  It should be noted however, they are a property developer and have over the last 10 years compounded owners’ equity at over 30% per annum.  I suspect the rate of compounding of owners’ equity will slow to more like 15% (though hopefully more) in the future, but when you pay about 2/3 of book for a company growing its book value at about 15% per annum, well I believe the EGP share price will tell the story soon enough…

Our second largest holding, however, currently trades at (all yields calculated at time of writing of first draft – 01/11/2012) a 16.75% FCF yield (based on the averages of the last 5 years) and a 20.93% FCF yield based on FY2012 results.  Our third largest holding trades at a 16.95% FCF yield (based on the averages of the last 5 years) and a 27.14% FCF yield based on FY2012 results, I could go on down the list, but you get the idea – generating wads of cash is important to me…  By way of comparison, MXI – which are still our 7^th largest holding now trade on only a 5.4% FCF yield (based on the averages of the last 5 years) and about a 7% FCF yield based on FY2012 results, though in fairness to their current share-price, they are in a growth sweet-spot and probably trading on greater than a 10% FCF yield based on likely FY2013 results.

Comparing to a stock I have previously discussed (negatively) in these pages – Slater & Gordon (SGH) have a 2.75% FCF yield (based on the averages of the last 5 years) and about a 3.7% FCF yield based on FY2012 results, along with my other concerns (search SGH using the search bar at the top right on the site), on a FCF basis SGH are very expensive.

The FCF rule I’ve outlined does not necessarily mean a high dividend payout is needed, although most of our companies do pay handsome dividends.  If we can find a business that can pay a reasonable dividend from its cash generating capacity, and then reinvest any other capital back into growth at better than average rates, then we are usually confident we have a business which will generate good long-term returns.  If we can buy such a business (or a number of such businesses) at a good price, we expect to be very well rewarded in the long-run.

It is a surprisingly simple concept, and the fact that after fees over 80% of ‘professional’ money managers cannot beat their benchmark over the medium term after fees is, frankly, astounding.  I can forgive the average investor for looking at speculative stocks, trying to buy $2,000 of a stock that (they hope) will soon be worth $50,000 or $100,000.  The problem is that several times a year, just such a stock comes along, doing just that and reignites (almost) everyone’s unrealistic sense of hope.  As I say, I can forgive the amateur for this, with their own funds; there can be no such forgiveness for a professional running others’ money!  The well-constructed professional portfolio has scant room for such stocks.  When returns available from good businesses are sound, such speculations represent the height of some unholy combination of hubris and foolishness from professionals.  ‘Investment Funds’ should be exactly that, when someone has their money professionally managed they should expect ‘speculation’ will play no part in their results – Tony Hansen 7/12/12

EGP Fund No. 1 Pty Ltd. Up by 15.04%, leading the benchmark by 1.46% since July 1^st. Since inception, EGP Fund No. 1 Pty Ltd is Up by 18.20%, leading the benchmark by 16.62% all-time (April 1^st 2011)