Yesterday was the last trading day of the year, so it's time for a portfolio update.
August 3, 2017
December 31, 2017
Since Inception
Annualised
G&W Portfolio
1.0000
1.0675
6.75%
17.23%
Benchmark
61,250.80
66,215.65
8.11%
19.72%
The month was a good one for the portfolio and the benchmark, which were up 3.24% and 1.81% respectively. The markets have continued their steady rise upwards. Speculation is rife: more and more people are "investing" in cryptocurrencies, or the "growth story" stocks trading on sky-high multiples. If this trend continues, the portfolio is almost certain to fall further behind the benchmark over the short term. In periods like this, I simply hope to keep up; when the benchmark performs poorly, I hope to do better. Over the long term, I expect such gains will result in an above-average performance.
I added one new stock this month, bringing the total to six. Of these six stocks, five were net cash as of June 30. If these five stocks were bundled together and sold at current market prices, the buyer would find 38% of his purchase price in the company tills and bank accounts.
Thanks to the summer holidays, I've just finished another book, Mohnish Pabrai's The Dhando Investor. For those who are unfamiliar with Pabrai, he's a true-to-label value investor in the Graham-Buffett mould. Earlier in his career, he founded an IT business, which he sold for about $20 million. (It was after this he started focusing on stock market investments.)
The Dhando Investor is a quick, easy-to-read book that, in my opinion, most investors or business people will find interesting and useful. At the heart of the book is Pabrai's concept of Dhando — making low-risk, high return bets. (This is, of course, exactly what we do as value investors.) He provides a number examples of Dhando at work: the story of the Patels and the US motel industry, Richard Branson and Virgin Atlantic, and his own business career. The philosophy, as Pabrai describes in the fifth chapter, is based on a few key ideas:
Invest in existing businesses;
Invest in simple businesses;
Invest in distressed businesses in distressed industries;
Invest in businesses with durable moats;
Few bets, big bets and infrequent bets;
Fixate on arbitrage;
Margin of safety — always;
Invest in low-risk, high-uncertainty businesses;
Invest in the copycats rather than the innovators.
In the sixth chapter, Pabrai discusses how to value a business listed on the stock market. As value investors know, the value of a business is the net-present value of its cash flows. Pabrai demonstrates a couple of simple NPV calculations for a private business — a gas station — and a listed company, Bed, Bath and Beyond. Despite the fact that they both businesses are relatively simple to understand, Pabrai ends up with a wide range of potential intrinsic values. This, of course, is one of the key problems with using discounted cash flow analysis: small changes in assumptions, such as the discount rate or terminal value, can lead to widely different outcomes. The key to investing successfully then, according to Pabrai, is to invest only in simple businesses — where conservative assumptions about cash flows are easy to figure out — and only when it is clear that, using these conservative assumptions, you stand to make a great deal of money and are unlikely to lose much. Sounds simple, right?
Pabrai, like many other good value investors, always writes down an investment thesis: "If it takes more than a short paragraph," he says, " there is a fundamental problem ... if it requires me to fire up Excel, it is a big red flag that strongly suggest that I ought to take a pass." This is excellent advice. If I had implemented it in my processes earlier in my investing career, I would have avoided some of my major mistakes. For his DCF calculations, Pabrai looks 10 years into the future and applies an appropriate multiple to expected cash flows in the final year to come up with an expected IRR. In chapter 15, Pabrai discusses the process of selling a stock. He suggests that investors should have a crystal-clear exit plan before ever thinking about buying a stock. He provides seven questions for investors to ask themselves before making an investment.
Is it a business I understand very well — squarely within my circle of competence?
Do I know the intrinsic value of the business today and, with a high degree of confidence, how it is likely to change over the next few years?
Is the business priced at a large discount to its intrinsic value today and in two to three years? Over 50 per cent?
Would I be willing to invest a large part of my net worth into this business?
Is the downside minimal?
Does the business have a moat?
Is it run by able and honest managers?
According to Pabrai, one should only consider buying a stock if the answer to all seven of these questions is a resounding yes. "If a well-understood business is offered to you at half or less than its underlying intrinsic value two to three years from now, with minimal downside risk, take it," he writes. "If not, take a pass ... There will be better chances in the future." He also discusses his rule of not selling stocks at a loss for at least two years, which was mentioned in Guy Spier's book and my previous post. There is an important caveat: Pabrai will not sell in this period unless both of the following conditions are satisfied:
He is able to estimate its present and future intrinsic value, two to three years out, with a very high degree of certainty;
The price offered is higher than present or future estimated intrinsic value.
The purpose of this restriction is that it stops investors from selling out of a stock during times of peak pessimism. Cheap stocks don't usually grow at a steady 15 or 20% per year as one might like — they might, for instance, drop 50% in the first year and grow 200% in the second. The rule helps us avoid selling out for psychological reasons at the low point.
All in all, I think the Dhando Investor was very good. It has given me much food for thought. There were no new ideas in the book, but Pabrai illustrated the precepts with great examples. If you are interested in learning more about Pabrai, I suggest you check out his excellent channel on YouTube. Here's one of his most recent videos, a lecture given to students at Boston College in November.
I recently finished reading Guy Spier's book The Education of a Value Investor. The book was interesting but unremarkable: there won't be a whole lot new for well-read investors.
Spier himself seems rather unlikeable. He comes across in parts as vain and self-conscious and driven by ego and status: what Mr Buffett might describe as an "outer scorecard". He does, however, do a great deal of reflection about this in the book. Nevertheless, the book was interesting in parts and worth reading.
Some of the best parts were when Guy was discussing his good friend Mohnish Pabrai. (Spier and Pabrai famously paid $650,100 to have lunch with Buffett in 2008.) The real takeaways, in my opinion, were in the chapter about Spier's investing process. Here he describes eight rules, routines and habits he has developed over the years with help from Pabrai.
Many of these principles make a good deal of sense, and as someone still developing a sound investment process, I intend to incorporate them into my decision making. So here they are — Guy Spier's eight investing rules.
Stop checking the stock price. I have a terrible habit of constantly checking stock prices. This habit is dumb and pointless — and I intend to break it as soon as possible. We know from the great psychologists Kahneman and Tversky that investors feel the pain of loss twice as acutely as the pleasure of gain. We also know from psychology that humans have limited willpower. While a stock market portfolio with average volatility is typically up in most years over a 20-year period, there is a much higher probability that it will be down on any given day — which exposes us to making bad decisions due to our psychology. My concentrated portfolio will have above-average volatility, which amplifies this situation and the risk of making bad decisions. So from now on, I'm going to limit myself to checking stocks once a week. Peter Phan has written an excellent blog post on this topic for those interested in reading further.
If someone tries to sell you something, don't buy it. Spier has developed a heuristic to avoid being conned: he won't buy anything from people trying to sell to him. Whether it's technology for his fund or an IPO, if there's someone on the blower with a sales pitch, Spier simply says "I'm sorry but I don't allow myself to buy anything that's being sold to me". This is eminently sensible: buying something from someone who has a self-interest in your buying can be a recipe for disaster. From time to time, this will mean you might miss a good deal or two, but you're certain to come out much better in the end.
Don't talk to management. Spier did a lot of talking to management in the early days of running his fund. His experience taught him that close contact with management is more likely to be detrimental to his returns than the opposite. This might sound unintuitive, but managers tend to be charismatic and this can muddle our thinking. This is not to say managers aren't important to a business's prospects, but that first impressions can be misleading. Charlie Munger points out, when it comes to thinking about management, the paper record should count much more than any interview. I haven't done much talking to management yet and don't intend to change this in future. However, investing in small companies means that talking to management can be extremely useful from time to time. Buffett, of course, was always one to talk to the managers and it worked out pretty well for him.
Gather investment research in the right order. There are a couple of points here. Firstly, as Munger's misjudgement speech points out, we tend to give more weight to ideas that enter our brain first. In investing, we might for instance, hear a stock pitch from a fellow investor that muddy the waters of our thinking. Spier makes a few suggestions: he says if someone starts suggesting a stock to investigate, he stops them in their tracks until he's had some time to do his own reading and investigation. At that point, but not before, he's happy to have a conversation about it. The second point is that we should be careful about the order in which we read materials about a prospective investment. Spier's process is to start with unemotional public filings such as the annual and half-yearly reports, especially notes from the auditors. After that, he'll turn to less objectives sources: for instance press releases, news articles, presentations and the like. If the business is a well-known one, like Berkshire, there might be a good book to read. In some cases, they might be thorough enough to read even before the corporate material. Equity research should never be relied on and should be read only once you have formed your own impression of a company or industry. It can be useful to know what the consensus is in the market, but reading others' research early on will only muddy your thinking.
Discuss your investment ideas only with people who have no axe to grind. This is another good tip. If you have an investment idea, it doesn't make a great deal of sense to talk about it with someone who already owns it or someone who has come out publicly as a bear. Trust is another important thing: Spier suggests that discussions about investment ideas should be strictly confidential, that no party should tell the other what to do, and that the parties shouldn't have a business relationship that could skew the agenda. Investing is largely a solitary activity for me at present, but over time, I expect that I'll discuss ideas with other like-minded investors. I'll be keeping these ideas in mind when I do.
Never buy or sell stocks when the market is open. This is an idea Spier has appropriated from Mohnish Pabrai. By limiting trading until after trading hours, we can help detach ourselves from price action that can stir up our emotions. The market needs to be our servant not our master. (Spier admits that he breaks the rule occasionally when there are particularly compelling reasons to trade during market hours.) Once again, I think this ideas makes a great deal of sense and I intend to incorporate it into my own process.
If a stock tumbles after you buy it, don't sell it for two years. The hardest part of stock market investing is selling. Another hard part is seeing a stock you've recently bought tumble. This experience can be emotionally fraught and lead to bad decisions. To counter this, Mohnish developed the two-year rule to deal with the psychological forces at play. I intend to adopt this rule for the G&W portfolio, which will have wide-ranging consequences. The rule works in two ways: first, the two-year minimum makes you think especially hard before laying down money on a stock; secondly, it'll prevent situations where stocks are sold too early simply due to the psychological impacts of price action. Obviously, I will retain the right to sell out before two years if the investment was a mistake or it is impacted by a major development. I haven't had to sell any stocks in the G&W portfolio yet except for a couple of arbitrage opportunities. Selling is an important topic so I hope to write a blog post about it when I do finally make a sale.
Don't talk about your current investments. This has to do with our well-documented bias, as humans, to be consistent with our prior statements. Simply put, it is emotionally difficult to back away from what we've said, even if we come to regret that opinion. This is described in Robert Cialdini's great book, Influence. I'm a bit conflicted about this, because while I agree with Spier, writing posts about stock picks could be a useful exercise for me to develop my skills. I am yet to write a post explaining my reasons for holding any particular stock and after reading this, I'm not sure if I will. It may be that writing a post-mortem is a better option.
Finally, I'll leave you with a deeply insightful interview with Charlie Munger, where he discusses business, Bitcoin and everything in between. You'll learn much more from this one-hour video than you ever will from me.
In this post, I will examine the performance of my direct shares portfolio over the past four months. As I mentioned in my first post, I bought my first ever stock about three years ago. I have had satisfactory returns over that period, but I feel this has as much to do with luck as any particular skill. Over those three years, I did a great deal of reading and started taking my investing more seriously.
In August this year, I felt my knowledge and skills had improved to the point where I might be able to beat the broader share market over a period of, say, three to five years. So, on August 3, I set out towards the goal and bought the first shares in the Generals and Workouts (G&W) portfolio. My results over the four-month period are summarised in the table below.
August 3, 2017
November 30, 2017
Since Inception
Annualised
G&W Portfolio
1.0000
1.0340
3.40%
10.43%
Benchmark (SPAX2F0)
61,250.80
65,037.65
6.18%
18.96%
I unitised the portfolio to assist in calculating performance. (There is a good post on the Monevator blog explaining the process.) There are two reasons for doing this: firstly, it makes tracking performance against a benchmark simple; second, it's free. Portfolio software like Sharesight can be neat, but I prefer not to spend hundreds of dollars in subscription fees.
A few other things to note:
The returns are pre-tax, include franking credits and assume dividends are reinvested.
The benchmark I have chosen is the SPAX2F0 — the S&P/ASX 200 Franking Credit Adjusted Annual Total Return Index (Tax-Exempt).
The SPAX2F0 is simply the ASX200 index adjusted for franking credits. By using it, we are able to fairly compare our returns including franking credits to the experience of investing in the ASX200. Franking credits are an important, and often under-appreciated, component of the returns of Australian investors.
As of November 30, the G&W portfolio is trailing the benchmark by 2.78%. This is neither surprising nor concerning. I suspect, as is often the case with investment programs focused on capital preservation, that outperformance will come in periods where the broader market declines. I hope to keep updating the portfolio's performance monthly.
One of the reasons I decided to start this blog was to force myself to publicly account for my investment decisions and the returns of my portfolio. As physicist Richard Feynman put it:
"The first principle is that you must not fool yourself — and you are the easiest person to fool."
I have been putting off this post, which requires me to divulge some information about my personal finances, for some time. It would be much easier — and pleasant — to keep the wool over my eyes and simply believe that I'm an above-average investor. The truth is that very few investors are able to beat the average return of the stock market over long periods, and it may be that I'm simply not good enough. If that's the case, I'd like to know, despite the potential for damage to my ego. As I pointed out in my earlier post, small changes in the compounding rate add up to a great deal over years and decades.
While I'll mostly be talking about my own direct stock investments on this blog, it's important at this stage to discuss everything I own. There are two main reasons for this: firstly, because I have outside investments, I size positions differently than I would if my entire portfolio was in direct stocks. Secondly, because I have investments with fund managers who I think I will beat the average return of the stock market, it will influence my assessment of my returns over reasonable periods. In short, if my returns are above average but lower than the after-tax returns of my outside investments, I will still have lost due to opportunity cost.
Because of this risk of opportunity cost, and the uncertainty as to my merits as an investor, I have limited direct shares to a relatively small portion of my total wealth. It is important to note that I am willing to bear something of an opportunity cost while I improve my investing skills. But, if the evidence in a few years suggests that I am substantially worse than proven and available alternatives, I'll be happy to throw in the towel.
As of November 30, 2017, my total investments were as follows:
Partnership investing in stocks with two family members — 5.88%
Cash — 6.45%
As of the time of writing, December 4, 2017, my direct shares portfolio consisted of five stocks:
Spicers Ltd (ASX:SRS) — 39.92%
Undisclosed NSX stock — 16.54%
Kangaroo Island Plantation Timbers (ASX:KPT) — 16.13%
Undisclosed NSX stock — 14.14%
Global Construction Services (ASX:GCS) — 13.27%
I won't go into much detail about the family partnership, but I will note that I'm responsible for investing the funds and that it also holds SRS and KPT. I don't intend to track the performance of the partnership in the blog, but may mention it from time to time.
A note on position sizes
When I size positions, I think in terms of my total investable capital, not any given portfolio. So while SRS is about 40% of the portfolio above, and also held in our small family partnership, it only accounts for 5.64% of my total wealth (excluding any stock which might be held by EGP or CE), which I think is reasonable. KPT shares in the direct shares portfolio and partnership account for 3.25% of my total wealth. (KPT stock is also held by EGP and I suspect CE, which almost certainly makes it my largest position in total.)
I will continue to size positions in this way, because it's sensible from a wealth-creation perspective. Occasionally it will result in wonky positions, such as the 40% in SRS at present, but over time the portfolio will start looking slightly more "normal". I'm not too concerned about any of this, but it's worth noting as I'd almost certainly do things differently if I was only investing in a portfolio of direct shares.
In my next post, which is hopefully not too far away, I'll examine the returns of the direct shares portfolio since its inception in August.
In this post, I hope to explain why I invest and why you should consider investing yourself. (Assuming you don't do so already.) It can be boiled down to a single word: compounding.
Albert Einstein is said to have described compound interest as the "most powerful force in the world". As Jason Zweig points out, we should be concerned about the veracity of this quote — nevertheless, compounding is very powerful.
Warren Buffett provided the table below to his early investment partners in the 1950s and 60s. It shows the gains from a $100,000 investment compounded at different rates over 10, 20 and 30 years.
4%
8%
12%
16%
10 Years
$48,024
$115,892
$210,584
$341,143
20 Years
$119,111
$366,094
$864,627
$1,846,060
30 Years
$224,337
$906,260
$2,895,970
$8,484,940
Compounding involves constantly reinvesting the interest earned from an investment. Over a long period of time, this interest on interest adds up to a great deal. Because we are all impatient, compounding is deeply under appreciated.
When Buffett started his partnerships in 1956, at the age of 26, he was already independently wealthy — having about $174,000 in personal savings, $1.6 million in today's terms. When you consider that the Buffett partnerships — of which Warren was the largest investor — compounded at 29.5% between 1957 and 1969, and that shares in his subsequent investment vehicle, Berkshire Hathaway, compounded at 20.8% between 1965 and 2016, it is unsurprising that he is now one of the richest men in the world.
While we obviously aren't going to be able to touch Buffett's record, we can still take away a few important things from his success. There are three important parts, which the table above helps illustrate. Firstly, to best take advantage of compounding, we need to start early. (In the womb, if possible.) To maximise our wealth, we need to try to compound it at the highest possible rate. Finally, like Buffett, we need to live a long and happy life.
All of this brings me to another important question: why invest in stocks? Over the long-term, Australian stocks have compounded 8–10 per cent per annum, depending on which dates you look at. Over the last 20 years, the gross return (i.e. before tax) has been 8.5%. Unlike property — unless you are very rich — you don't need to borrow to get started, either. If we assume that rate stays the same, $1,000 invested now will grow to $60,000 over the next 50 years. If we can invest better than the market — either through a good fund manager or our own stock picks — and boost the compounding rate to 11%, that $1,000 turns into $184,500.
Something to remember next time you're considering a big purchase.
I should start my describing my investment philosophy and my motivations for starting this blog. Value investing has its roots in the teachings of Benjamin Graham and David Dodd. It has four central ideas that I'll touch upon briefly. Here, I borrow from Li Lu, who described these key ideas in a speech to students in 2015.
The first and most important concept of value investing is that stocks represent fractional ownership of businesses. It might seem obvious, but many, if not most, individual investors don't invest this way — they focus instead on stock prices and their movements. Investors, as Li Lu rightly points out, should expect to "earn what they deserve". If a business is flourishing, as owners, they will benefit from their participation; if it is foundering, the inverse is true.
Second, value investors see the stock market as servant rather than master. The best way to understand this is through Benjamin Graham's concept of Mr Market. As Jeremy Miller writes in his book "Warren Buffett's Ground Rules":
"The idea is that a securities market can be thought of like a moody, manic-depressive who stands ready to buy or sell you a half stake in his business every day. His behaviour can be wild and irrational, and is difficult to predict. Sometimes he's euphoric and thinks highly of his prospects. Here he'll offer to sell you his stake only at the highest of prices. At other times he's depressed and doesn't think much of himself or his business. Here he offers to sell you the same stake in the same business at a much lower, bargain price … While you can never be sure what mood you will find him in, you can be sure that regardless of whether you trade with him today, Mr. Market will be back again with a new set of prices tomorrow."
In other words, while the market can tell you the price of a security at any one point, it can't tell you its value. You have to work that out yourself.
The third idea is that investing relies on predictions about the future. The future is uncertain and humans are inherently bad at making predictions. To counter this, we need to leave a large buffer between the price we pay and the company's intrinsic value — this is known as a "margin of safety". As Li Lu says:
"Because we have the first principle, we know that the stock is a fractional interest in a company, and that company itself has an intrinsic value. And because we also know that the market is there to serve us, we can wait to buy until the price is far, far below the company's intrinsic value. And when the price far, far exceeds the company's intrinsic value, you can sell. This way you won't lose much money if your prediction of the future is wrong … And if you do turn out to be right, your return will be much higher than others."
The fourth key idea is that investors should stick to situations where they can make reasonable, conservative assumptions about a business's future worth. Once again, this seems obvious, but many investors stray far beyond their circle of competence. People like myself, with very basic investment experience, should stick to the few businesses, industries or situations they can adequately understand. This might seem dull for the many market participants who look for "action", often in the most overvalued and risky places, but it is the only course for the value investor. Buffett, for instance, famously eschewed technology businesses for most of his career — it didn't stop him from amassing the greatest investment track record of all time. To return once more to Li Lu:
"If there are things you don't understand, or if you have any kind of psychological or physiological weakness, there will be a situation in the market that exposes you."
Having outlined my investment philosophy, I'll now turn to my motivations for starting a blog.
The truth is, I haven't always followed the wisdom of value investing that I've outlined. While I have had satisfactory results in the three years since I bought my first stock, I suspect this is largely due to good fortune rather than my skill. Indeed, when I first started out, I could barely read a balance sheet or income statement. This blog will help my keep my decision making, and investment results, accountable. By keeping a written record, and revisiting my mistakes and my successes, I hope to hone my investment skills and processes over time. Perhaps others interested in value investing will be able to glean something from my writings, too.
Thanks for reading. Hopefully my next post isn't too far away.
