Update No. 134 – 20/10/13

A few things have happened over the last week or two that make me think the market is definitely at or above fair value. These are not empirical or technical things, but anecdotal ones that are a little disconcerting. As I have pointed out before, this doesn’t mean bail out, just take great care in selecting where to direct your capital.

The first was listening to an electrician on a building site explaining to his friends why they should buy CBA shares. Now he may have been a part time financial genius, but I tend to worry when regular people start noticing the stock market, this by itself is a useful but imperfect indicator, for when persons who have minimal experience in the markets start discussing stocks, it usually means markets are pretty fully priced. In my view, the market becomes interesting to the regular person when they can make simple extrapolations not based in anything fundamental. Such as “CBA has gone from $45 to $75 in 2 years, I don’t see why it can’t get to $100 in the next 2 years, that’s 33% profit plus dividends in 2 years”. That is not a valuation, that sort of thinking is a recipe for ruin… I give no view on the price of CBA shares by the way.

The second is the share price behaviour of Xero (XRO). I won’t go into valuation specifics, the software is apparently very good, but a loss-making company with only $40m in revenues (though admittedly growing at around 80% year on year) would have to have a lot go right (for a long time)if it’s ever to justify a nearly $3 billion valuation. A capital raising was conducted at above market prices and the stock continued to explode higher, almost 50% in a week. Such behaviour is a rarity in an undervalued market (especially without meaningful new information about matters material to valuation). When stocks are cheap, caution reigns.

Thirdly, and most pertinent for fellow owners is the IPO (Initial Public Offering) market. As I have mentioned a couple of times recently, I have been having a little trouble finding really good (i.e. clearly under-priced) opportunities of late to deploy our capital into. I am happy that our portfolio remains very good value compared to the market (this bears out somewhat by the fact we continue to keep pace with a fast rising market), but I usually have a couple of opportunities ‘sitting on the bench’ meaning they are at or within striking distance of a price I would be happy to buy at. This dearth of opportunity has led me to start to look closely at IPO’s of late, a couple piqued my interest. These couple looked to be fairly priced, with good long-term growth prospects. I discussed the offers with the brokers responsible and in both cases; they indicated the offers were going to be heavily oversubscribed. When this is the case, what some investors will do is subscribe for a great deal more stock than they really want, hoping the scale-back leaves them with a decent holding. I decided to wait until listing and hope the prices didn’t run away. They did, the first business was OzForex (OFX), which was trading at $2.86 or 43% above its IPO price at time of writing, the second was Sealink (SLK) which closed its opening days trade over 36% above the IPO price. In both cases, I would have happily paid the IPO price. In both cases, over a 5 to 10 year horizon, it was possible to see returns totalling perhaps hitting or exceeding 15% annually based on the listing prices.

However, if you think 15% p.a. is achievable over 5 years, paying 40% over the price you calculated the 15% return from halves the annualised return over 5 years to 7.5%. Over 10 years, the damage is less severe, reducing your 15% annual return to about 11%. Nevermind, what appeared to be cheap, is now like most of the market probably quite fully valued.

Our annual rate of compounding rose above 19.8% (after performance fees) this week, or over 21% before performance fees. Bear in mind a 20% rate of compounding leads to a doubling of capital approximately every 3 and ¾ years. In my view, the likelihood of maintaining this rate of compounding over a long period is very slim. Buffett has averaged 21.5% for 55 years, but neither that level of talent, nor the conditions that supported the results are likely to be repeated. So don’t be surprised if we slow down a little over the next few years. Were I to get to the end of EGP’s first 10 years (31 March 2021) and find I’d delivered 15% per annum to my investors, I would be quite delighted. Such a result would mean our original investors had quadrupled their original investment over the intervening 10 years. To continue at our current rate would end with a roughly six-fold increase, so there is a meaningful difference – Tony Hansen 20/10/13

EGP Fund No. 1 Pty Ltd. Up by 16.00%, leading the benchmark by 3.62% since July 1^st. Since inception, EGP Fund No. 1 Pty Ltd is Up by 58.44%, leading the benchmark by 34.92% all-time (April 1^st 2011).

^{*1 after 31May 2013 dividend of 2.333 cents per share plus 1 cent per share Franking Credit}

^{*2 calculated based on dividends reinvested}