Update No. 99 – 08/02/13

I have posted the Audit confirmation from the first half of financial 2013 (.pdf).  I don’t really know how many of our readership has need for Accountants/Auditors, but I can highly recommend True Elite Business Services Pty. Ltd.  As a fellow CPA I have worked with many auditors, primarily with ‘Big 4’ auditors.  I have always found Shin and his team every bit as good as anyone else I’ve encountered (thorough, timely and efficient), with the bonus that you don’t feel like you need to audit your own wallet after the service is completed (that is to say their fees are far more reasonable than a Big 4 firm).  If you run a SMSF, or a business, out of Sydney or Melbourne, I’d hazard you would get a better service at a more reasonable price by giving him a call. I have met Shin only once, our interaction is usually via e-mail, so the recommendation is all business and not a personal relationship.

We have 2 of our current 15 holdings reporting this coming week; we are looking forward to being able to make a better informed assessment as to how well our investments are doing.  It’s a funny thing being a value investor.  We spend our time trying to poke holes in the consensus opinion about most things, primarily the valuations of companies.  Through years of conditioning yourself to think in such a way, you are happy when the prices of stocks you like stay depressed, especially while the business conditions and intrinsic values are clearly improving.  When you get the process right, after steady accumulation over a period of often two or three years, usually collecting a dividend all the while, the market comes around to your point of view and the price more fully reflects the value of the business and excess return (alpha) is generated.

Truth be told, in my experience at least it almost never happens that way.  Perhaps one in ten transactions unfold as described above.  More often than not something changes one way or another very quickly.  A recent example was a communication I had with a fellow who runs a similar fund to EGP regarding Codan Limited (CDA).  The following is part of my side of an e-mail interaction that occurred on 20 September last year:

“I am basically finished my review of CDA also.  I think there is value there, based on the usual DCF I run, I extract a current valuation of $2.72, using a hurdle rate well above the cash rate, an average of 6% EPS growth over the next 10 years & a terminal P/E ratio of 10.5x.  All these seem very conservative… Based on this valuation & assuming a 50% dividend payout ratio, I would say a 14 or 15% per annum return would seem the likeliest outcome, with probably higher upside than downside, the chance of capital loss would be, in my view, very low.

If they stay around $1.40, I might build a position in November, I certainly hold stocks with more upside potential, but I would concede I do have a couple that probably have less upside potential too”

You’ll probably notice two things from above.  Firstly, that I was holding out for November.  There was a simple reason for that which regular readers will recognise, a buyout of Mesbon China Nylon (MES) concluded in early November (I describe our sale of MES here) about 25% of our holdings were expected to be in the form of cash in early November, I was looking around for good places to apply our excess capital. The second thing is the impreciseness of the language, for although I selected a value of $2.72, it is very clearly demonstrated as the middle of a range of likely outcomes.  Valuing companies is not a precise art, I like many others use spread sheets and complex calculations to arrive at empirical values.  I can’t speak for others, but I do this for only one reason, which is to compare a current price of two (or more) investment options to see which one has the greatest valuation gap based on my inputs.  Bear in mind if my inputs are wrong, the figure is meaningless.  I use a number of different calculations based on price to earnings, free cash-flow yield and EV/EBITDA for example, all to one end only, comparing options.  When I find a mispricing, some will correct very quickly and some will do it by steadily eating away at the valuation gap.

I should point out EGP were and are not (unfortunately) holders of CDA stock.  By the time we had sufficient capital available to start building a decent position, the stock had advanced from just under $1.40 to around $2.20.  I would not right now regret having made that $2.20 purchase, as CDA shares presently trade at $2.78.  But when I say above a 15% return ‘would seem the likeliest outcome’ what I am saying is that the mid-point of my (as I stated very conservative) valuation, using a 10 year time frame was for a 15% per annum gain.  In simple terms, assuming there were no dividends, it implies I had thought CDA shares would probably be worth about $5.60 in 10 years.  Assuming that $5.60 valuation mid-point holds up, based on the increased $2.20 November purchase price (assuming there had been nothing major to cause a revision to intrinsic valuation) that 15% per annum gain had been crimped down to about 9.8%.  You’ll agree that stripping 5.2% annually out of the expected gain on an investment meaningfully changes the decision, hence why we are not CDA owners currently because at that price I found better applications for our funds – Tony Hansen 08/02/13

EGP Fund No. 1 Pty Ltd. Up by 12.23%, leading the benchmark by 5.22% since January 1^st. Since inception, EGP Fund No. 1 Pty Ltd is Up by 36.62%, leading the benchmark by 11.53% all-time (April 1^st 2011).