Margin of Safety by Seth Klarman

During my two-week cruise to New Zealand (in which I surprisingly didn’t see a single sheep), I was delighted to find time to finish off Benjamin Graham’s seminal value investing treatise, The Intelligent Investor (fourth revised edition) and Seth Klarman’s 1991 book, Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor. I thought I’d briefly share some of my thoughts on the latter. 

Although he is now deemed to be one of the legendary value investors, Klarman hasn’t always been so popular. His first and only book so far, Margin of Safety was a commercial failure and has since gone out-of-print after an original run of 5,000 copies. However, as Klarman continued to produce superb results at The Baupost Group, the hedge fund he co-founded in 1982, people soon started searching for the secrets to his success. The laws of supply and demand have thus caused the price of his elusive work to skyrocket - on Amazon, a used copy will currently set you back at least $2,000 while new copies start from $3,800. You would be hard pressed to find this book in a library as most copies have been stolen. So Mr Klarman, I hope you’ll forgive me for opting to download a digital copy of your book.

Seth Klarman is no doubt an excellent value investor, but if I am honest, I didn’t find Margin of Safety to be an exceptional read. It seems unclear who his target audience is: most beginners will get lost as Klarman generally assumes prior knowledge of concepts and jargon such as discounting cash flows, while at a relatively paltry 250 pages or so, more advanced investors will probably find little to dig their teeth into. There really isn’t anything that you cannot find somewhere else. And unlike writers such as Peter Lynch, there is no humorous, conversational tone to be found within these pages. Having said all that, I still found Margin of Safety to be well worth my time as it was thought provoking to consider the nuances of Klarman’s approach, and it’s always interesting to read about case studies. Moreover, I was pleased that a few chapters in the final third of the book resemble the ‘special situation’ investing that Joel Greenblatt brilliantly describes in his title You Can Be a Stock Market Genius. Klarman gives readers a taste of the opportunities available in corporate liquidations, ‘complex securities’, rights offerings, risk arbitrage, spinoffs, thrift conversions, and financially distressed/bankrupt securities. In being able and willing to take advantage of these more obscure investments, I think this is where Klarman really shines as an investor, and it is an area that I would like to better understand. 

While all value investors share the common foundation of trying to purchase undervalued securities, there is considerable variation in the exact implementation of this approach. Although he often cites Warren Buffett, Klarman is more of a cautious Benjamin Graham style investor than a modern day Buffett as he gravitates towards tangible asset plays and discloses his wariness for the value of intangible assets. In fact, his values (if you’ll excuse the pun) are so similar to Graham that he had the honour of being the lead editor and a commentator on the sixth edition of Benjamin Graham’s Security Analysis. Klarman has notched up circa 20% annual returns since inception of Baupost Group, taking it from assets of $30 million in 1982 to $29.4 billion in 2012, and remarkably done so whilst often holding high levels of cash, another indication of his conservative style. On the debatable subject of how to value businesses, Margin of Safety outlines three different valuation techniques that he finds useful: net present value (discounting cash flows), liquidation value (what would be left for investors if the company were dismantled and the assets sold), and ‘stock market value’ (looking at prices on equity and debt markets to approximate value in some situations). He also mentions ‘private-market value’, which is where investors look at what kind of multiples that sophisticated, prudent businesspeople have recently paid to acquire similar businesses, however, he cautions that these multiples are not necessarily rational and prefers that investors determine what they themselves would pay instead. 

Unfortunately, like many parts his book, by cramming the important subject of valuation in just one chapter, Klarman doesn’t provide as much discussion or as many examples as I would have liked. For instance, he is extremely vague in describing what rate to discount cash flows at, other than saying that there is no single correct discount rate, and that it should be influenced by an investor’s preference for future dollars, the risk of the investment, and interest rates. Readers have no way of determining whether 5%, 10% or even 50% is appropriate, other than a sole case study where he applies a 12% and 15% rate without justification as to how he arrived at those numbers. Reflecting the indeterminate nature of discount rates, Klarman explains that it is impossible to come up with a precise value for a stock, but this is unnecessary if investors buy at a significant discount to a range of values obtained through one or more of the above valuation techniques. This is the crucial value investing principle of the margin of safety first proposed by Benjamin Graham, which Klarman has aptly used as the title of his book. 

Throughout Margin of Safety, Klarman advocates targeting absolute-performance and decries relative-performance, going so far as to declare ‘value investing is absolute-performance-, not relative-performance oriented’. Although I can see the logic in pursuing absolute returns, I have to disagree with Klarman here. If you decide to actively select investments in the share market, it makes sense to be measuring yourself against the ‘average return’ easily obtainable by buying into an index fund. An annual return of 5% over the long term may seem satisfactory to absolute oriented investors, but if everyone else is achieving 10%, I would argue that you have done a poor job and wasted your time, value investor or not. Buffett shares this view: ‘Relative results are what concern us: Over time, bad relative numbers will produce unsatisfactory absolute results.’ And speaking of index returns, Klarman also says, ‘I believe that indexing will turn out to be just another Wall Street fad’, calling it ‘both lazy and shortsighted’. Well he has certainly been proven wrong in the 22 years since he wrote that, and for good reason - endless studies show that over time, the vast majority of investment professionals underperform the broad market indices after fees are accounted for, and therefore an ordinary person is almost guaranteed to beat them by simply purchasing a low cost index fund. Once again, Buffett has the good sense to agree with me here. 

Despite the nitpicking, I have much respect for Klarman and can suggest his book to intermediate or experienced investors as a decent rundown of the value investing approach if they are in need of some investment reading. I’ll be adding both Margin of Safety and The Intelligent Investor to my recommended reading page, and I leave you with a selection of quotes from Margin of Safety that were interesting or insightful to me. 

“To some extent value, like beauty, is in the eye of the beholder; virtually any security may appear to be a bargain to someone.”

“Unlike return, however, risk is no more quantifiable at the end of an investment than it was at its beginning.”

“Information generally follows the well-known 80/20 rule: the first 80 percent of the available information is gathered in the first 20 percent of the time spent. The value of in-depth fundamental analysis is subject to diminishing marginal returns.”

“Since they are acting against the crowd, contrarians are almost always initially wrong and likely for a time to suffer paper losses. By contrast, members of the herd are nearly always right for a period. Not only are contrarians initially wrong, they may be wrong more often and for longer periods than others because market trends can continue long past any limits warranted by underlying value.”

“Huge sums have been lost by investors who have held on to securities after the reason for owning them is no longer valid. In investing it is never wrong to change your mind. It is only wrong to change your mind and do nothing about it.”

“Investors must recognise that while over the long run investing is generally a positive-sum activity, on a day-to-day basis most transactions have zero-sum consequences. If a buyer receives a bargain, it is because the seller sold for too low a price.”

“In times of general market stability the liquidity of a security or class of securities can appear high. In truth liquidity is closely correlated with investment fashion. During a market panic the liquidity that seemed miles wide in the course of an upswing may turn out only to have been inches deep.”

“Investing, it should be clear by now, is a full-time job. Given the vast amount of information available for review and analysis and the complexity of the investment task, a part-time or sporadic effort by an individual investor has little chance of achieving long-term success.”

Trouble at Forge Group

Shareholders of Forge Group (ASX:FGE) must be bracing themselves for the worst when it eventually resumes trading on the ASX, having been in suspension since 4th November due to serious problems with its Diamantina Power Station EPC contract, and its West Angelas Power Station. Pictured below, both contracts were inherited upon the acquisition of CTEC (renamed to Forge Group Power) in January 2012.

Diamantina is the more important of the two with a contract value of $430 million, compared to the West Angelas Power Station at $150 million. This makes Diamantina the second biggest project FGE has undertaken, with the largest being the recently announced $830 million Roy Hill iron ore joint venture. Although management have issued a further four requests to extend the suspension, they have provided few details around what went wrong, why and by how much. What is known is that they expect 'a material diminution in FY14 earnings', are in discussions with ANZ over its banking facilities, and are rushing to prepare a prospectus for a 'low document' accelerated rights issue (ie they need to raise capital desperately).

With a dearth of information, rumours have it that FGE may be forced to raise $50 to $100 million at a price as low as $0.50 or $0.625 per share, compared to its last share price of $4.18. In perhaps a worst case scenario of requiring $100 million at $0.50, FGE would have to issue 200 million shares. With 86.2 million shares currently outstanding, existing shareholders would be diluted more than they dilute the Coke at McDonalds. Whether or not these horrifying rumours are accurate, FGE is certainly in deep trouble and the share price will fall dramatically when it resumes trading.

After thanking my lucky stars that I sold out of FGE in February this year at $6.17, I thought it would be didactic to examine what investors can learn from this debacle. Although the announcement caught just about everyone by surprise, me included, one of the main reasons why I exited FGE was due to some concerns over the significant shift towards the lower margin Forge Group Power subsidiary. In June this year I wrote: Forge Group (FGE), the first stock I bought in my portfolio, was sold after their half yearly report in February. Forge continued to rack up stellar results with NPAT up 60% compared to the previous half and an even larger cash balance, leading many investors to believe that FGE could really defy gravity. However, I saw differently - if you take a close look at its order book, you'll see that the lower margin 'power' subsidiary is now far more important to future work than its traditional mining services business, which had struggled to secure new contracts. Hence, despite the appearance of a stable order book, I believe the slowdown had indeed hit FGE months ago and earnings will consequently decline if the power division is the main revenue driver. It seems Clough (another mining services business ASX:CLO), who held 36% of the company, see something similar coming as they sold their entire holding in March at a price just under me. 

It appears that Forge Group Power has indeed become the main revenue driver, with revenue from this segment growing 86% to $495 million in FY13, representing 47% of total revenue. While it might sound like I did pick up on the issues at Forge Group Power, I want to stress again that I absolutely did not anticipate large problems at the Diamantina and West Angelas power stations. What I did predict was declining margins and when you get into lower margin work, risks increase since a relatively small increase in costs can wipe out all the expected profit. Exacerbating this risk is the fact that FGE has significant leverage, not in the traditional sense with debt, but through its order book. Standing at $1.8 billion, FGE's order book is many times larger than its equity of $213.4 million. Large contracts such as the $430 million Diamantina Power Station have the potential to wipe out equity if something goes pear shaped, particularly when margins are small. In addition, sizeable contracts place a strain on the balance sheet of mining services companies as they require lots of new working capital and bank guarantees or insurance bonds. These guarantees to clients are essential for FGE if it wants to continue winning new contracts, but this also requires FGE to maintain a strong balance sheet. This fact likely washed over many investors who saw an excellent looking balance sheet with net cash of $78.3 million in FY13, despite the fact that this cash buffer was necessary to obtain those bank guarantees and insurance bonds. Subsequent to year end, the $US43 million Taggart Global acquisition would have also weakened this figure, leaving FGE in a more vulnerable position.

With perfect hindsight, I can also point out some red flags with management. The founding directors held a substantial amount of shares and did a great job in managing the company up until they commenced a transition plan in March 2011 where they eventually exited to make way for new management. After leaving FGE, they sold all of their shares. As I mentioned before, Clough also sold their 36% stake at $6.05 in March this year to institutional investors, who must be quite livid right now (although they may be getting their chance to exact revenge by pushing for a very low price in this upcoming rights issue). It may just be a coincidence, but it's a bad look when the people who know FGE intimately are selling everything. It's an even worse look when the new management don't buy either - the directors currently hold a laughable 11,000 shares in total.

Further rubbing salt in the wound for current shareholders is the rather generous remuneration. David Simpson, the managing director appointed in July 2012, was handed a $750,000 sign on fee, a base salary of $1 million, and a $500,000 bonus in FY13 for increasing earnings per share by more than 10%. However, it is the 'ex-gratia' bonus (translation: the remuneration committee is feeling extra generous) of $300,000 that must really sting given the serious questions that must be now asked of his management of the business. Was it another coincidence that no mention of the problems at Diamantina and West Angelas were made until after FY13 and the Annual General Meeting when all the bonuses had been paid? Speaking of bonuses, take a look at this from the FY13 annual report:

Shareholders were already very unhappy with the remuneration, as they voted 15,504,648 against the adoption of the remuneration report at the AGM, versus 22,709,503 for. This is over the 25% limit for a first-strike, and it looks like a good bet to assume that shareholders will vote with even more fury next year after learning of the Forge Group Power issues. Heads have already started to roll, with chief operating officer Brett Smith leaving FGE and Forge Group Power's managing director Kevin Robinson departing a few weeks earlier. I also note an interesting find by the Australian Financial Review, almost certainly referring to David Craig: Furious shareholders in a once-popular mining services company perhaps shouldn't be too surprised at the recent turn of events which has seen the group suspended from trading, pending a likely profit downgrade. By our calculations, the chairman has been involved at board level of no less than four other listed companies since 2010 where the shares have fallen by 90 per cent during his tenure. Which by our calculations means they only have another 80 per cent to fall. While I may have painted the current management in quite a negative light, I would like to remind readers that they inherited these troublesome contracts from the CTEC acquisition made by the previous management. Nevertheless, management has either been dishonest or incompetent in managing these contracts, perhaps both. I'm sure IMF (Australia), a litigation funding business I hold, would be looking closely at this for a potential class action lawsuit. 

A couple of other potential warning signs would have been the weak operating cash flow in FY13 of $17.9 million compared to net profit after tax of $62.9 million, and the vague explanation for 'inventories and construction work in progress' increasing from $11.3 million in FY12 to $150.5 million in FY13. While I've outlined a few aspects that may have pointed towards trouble for FGE and are useful to keep an eye out for in other investments, in the end I think that this announcement is really something that could not have been predicted. These are the risks you take when investing in businesses - and it reinforces the importance of having an adequate amount of diversification if events like this send you into a nervous breakdown. I feel for the shareholders who've been unfortunate enough to hold FGE at this time, especially considering the scarcity of information provided to them since the November 4th trading halt. 

Does the inevitable drop present a buying opportunity? That's much too early to say, although I would advise prospective buyers to be careful. As previously mentioned, the bank guarantee and insurance bond facilities will be hard to come by with a weaker balance sheet. Without adequate working capital and these facilities, the $830 million Roy Hill contract may not go ahead. While this contract may provide a big boost to revenue, it is another large risk due to its size - I've also heard the Roy Hill contracts have been competitively bid and subject to onerous conditions. FGE may also suffer a hit to their reputation as to their ability to successfully complete projects for clients, which will make acquiring work in the tough mining services space even more challenging. A goodwill write-down could be imminent since FGE picked up $23.6 million of goodwill from the CTEC acquisition, and this could affect banking covenants. There is also the cockroach theory to be mindful of - there may be more than just two bad contracts hiding underneath. Finally, there is the issue of whether one can trust management anymore, and whether a big shakeup might cause significant disruption to FGE at a critical time. It will be very interesting to see how this story plays out...

Google Trends

As any investor with a casual knowledge of the ASX would know, internet stocks such as Carsales.com (CRZ), Seek (SEK) and REA Group (REA) have been great stocks to own. If you owned REA for the last 10 years, you would have had a total shareholder return of 55.2% per annum according to Commsec, or in other words, a dollar invested in 2003 would be worth 81 dollars today. These phenomenal results are largely due to the network effect: buyers want to go to the website with most amount of X being sold, and sellers want to be on the site with the most buyers, thus creating a self reinforcing cycle for the most popular website. It seems that because of the power of the network effect, these kinds of markets gravitate towards being a monopoly or duopoly over time, the end result being that the winner takes all.

For these internet based stocks, getting pageviews is crucial to riding the network effect, and it is my hypothesis that since a major source of traffic comes from Google, having access to Google's information should provide a good indication of the general trend in website traffic, and therefore, provides clues to the future performance of the business. However, it must be noted that there are other important factors that influence whether views will translate into revenue such as the amount of time each visitor stays on the website, and that many of these businesses such as Carsales branching into different domain names in foreign countries so they are not solely reliant on their flagship domain anymore. In addition, mobile apps are increasingly playing a larger role in driving consumer traffic, so perhaps the importance of Google to these business is declining. With those disclaimers aside, I thought it would be an interesting exercise to compare some of the changes in website interest through Google Trends, with some more in depth information from Alexa.

According to Alexa, 23.8% of the traffic going to Carsales.com.au comes from Google, and of this, the top keywords searched for were 'carsales', 'car sales', and 'carsales.com.au'. It is ranked the 53rd most popular website in Australia and visitors spend an average of 9 minutes and 52 seconds on the site. The two largest competitors to Carsales in Australia are Trading Post (which also sells caravans and boats, amongst other things) and Carsguide. To keep things simple, I've limited the keywords to 'carsales', 'carsguide' and 'trading post'.

As the above graph clearly shows, Carsales has experienced a huge increase in interest since 2004, which is reflected in its business fundamentals, while Trading Post has suffered a continuing decline starting from around 2009. Poor old Carsguide is a very distant third place. Further compounding the woes of Carsguide and Trading Post is the fact that visitors only spend 3 minutes, 28 seconds and 3 minutes, 40 seconds respectively on each website, which would significantly reduce the number of sales produced for each visit compared to Carsales. However it seems that even interest in Carsales has plateaued and started to decline - I wonder whether this waning interest will see their domestic revenue growth start to diminish, or maybe it suggests a broader slowdown in the car industry.

Taking a look at the job market, Seek is the dominant player in the space and the 26th most popular website in Australia. 24.1% of traffic originates from Google, and visitors average 8 minutes, 8 seconds on the site. The rise and dominance of Seek when viewed against its competitors looks quite similar to Carsales:

Again, Google search interest in Seek hasn't increased since the start of 2011, but unlike Carsales, Seek is facing the threat of LinkedIn which is gaining traction in Australia. Although LinkedIn is a social network more focused on people in professional occupations, the size of this global business and the more social approach has got the Seek CEO, Andrew Bassat, quite wary. Even with the competitive advantage of the network effect, leaders such as Seek can't afford to become complacent lest they end up with the same fate as the newspapers (who've failed to gain a foothold with Fairfax Media Limited's MyCareer and News Limited's CareerOne joint venture with US company Monster).

While I can't find a breakdown of revenues for the carsales.com.au branch of Carsales, Seek is nice enough to show 'look through' revenue for each of its segments. The Seek domestic revenue from FY2011 to FY2013 provides confirming evidence for the link between flat Google search interest and flat revenues.

The usefulness of tools such as Google Trends and Alexa don't just apply to these kinds of online businesses. In this day and age, driving visitors to your website is an important goal for most companies, and investors can gain insights as to what is gaining popularity and what is not, long before it is reflected in any financial statements or recognised by the market. I recall reading about an American who noticed that a particular Hollywood film was very popular, and after researching the production company behind it, concluded that the financial benefit from the movie would be very significant compared to the small size of the company. He made a ton of money out of it when the market eventually realised this, and has continued to do the same in similar situations when he recognises a growing trend that others have yet to discover. One could gather similar insights through Google Trends about movies, toys, restaurants etc. Or, you can just play around with it out of interest - contrary to popular belief, dogs are actually searched more than cats!

Musings on Investor Psychology

After spending a few years in the investment game, I now have a firsthand appreciation for the difficultly in completely filtering out the impact that share price fluctuations and other market noise have on your decision making, which can also be inherently flawed on its own. More and more I realise that having an awareness of, and being able to control cognitive biases is just as important as understanding business. Many great investors have warned against the psychological challenges involved - Charlie Munger says: Above all, never fool yourself, and remember that you are the easiest person to fool - and I would second that. It would be very interesting to see some experts in psychology try their hands at investing. 

If you can spare 10 minutes or so, I would highly recommend you read this extensive list of cognitive biases on Wikipedia. While many are clearly applicable to investing, such as loss aversion and outcome bias, there are many other social and memory biases that it would be useful to be aware of for day-to-day life. But be careful that you don't pick up one or two extra biases in reading that list - 'bias blind spot' is 'the tendency to see oneself as less biased than other people, or to be able to identify more cognitive biases in others than in oneself.'  

As it relates to investing, misjudgements due to these biases can be very costly mistakes, which is a factor that is often overlooked. While nobody is completely immune to these cognitive biases, I believe they can be reduced by continuously scrutinising one's decisions and thought processes, and having an understanding of what the various types of biases are. On the latter front, I intend to read some books on psychology after my higher school certificate exams are over, which I expect will prove fascinating and rewarding. I think that the best thing about this blog is that it has forced me to clearly argue why I have done what I have, and since it is all there in black and white, I can look back to assess why I bought or sold something without any fear of memory bias. Both of these have helped expose psychological biases in my own thinking. 

Perhaps the stock that I have had to be the most careful with in terms of cognitive biases is Delta SBD (ASX:DSB), an underground coal mining services company I bought in late February this year. While I'll try to outline my thinking, I must first warn you that my judgement of the situation is likely to be quite biased since I still hold shares in it, so as always, I encourage you to be critical of my thinking.

I initially bought in DSB late February this year at $0.76, however it has since dropped to a low of $0.33 a couple of months ago, and is now back up to $0.53. Incidentally, the day I bought was the very peak, and ever since it has been a rather painful trip down. I knew going in that this was a fairly mediocre business (current normalised return on equity of 14%, net debt to equity of 32%, and a net profit margin of 5.5%), and anticipated a less than impressive earnings outlook, but the price looked cheap enough to offer a significant margin of safety - less than 5 times FY2013 earnings. In addition, I liked that the founders of SBD and Delta were still managing the company, and held a majority stake.

Unfortunately, I underestimated the speed and extent of the downturn in the coal sector, with news day after day reporting hundreds or thousands of job losses due to declining coal prices that made many mines uneconomical. Perhaps the widespread and sudden change in sentiment towards the sector is explained by the 'availability cascade', which is 'a self-reinforcing process in which a collective belief gains more and more plausibility through its increasing repetition in public discourse'. 

I will admit that in response to this outlook, I probably fell into the trap of confirmation bias - tending to read more articles that had positive views on China and the coal sector in an attempt to justify my initial investment. After losing 31.5% in a couple of months, I decided to double my initial investment by purchasing more shares at $0.52 since I believed that the market was being unnecessarily pessimistic and thus DSB had become cheaper. Eventually I recognised my confirmation bias mistake and started listening more to the bearish arguments (although I still have a healthy scepticism for any macroeconomic forecasts). In combination with the falling share price, it soon became hard to decide on what course of action to take - should I sell, buy more or wait for more information in the annual report? My value investing framework told me that despite the poor outlook, a share price in the 30 cent region was most likely too low so I ruled out selling at that price. However, neither did I have enough confidence to buy a third time, so in the end I opted to wait more information from the company, which had been deafeningly silent in its announcements.

Eventually, the annual report came which was largely as I expected, with a great FY2013 but with an expected drop in revenues and compression of profit margin in 2014 onwards. While there is now considerable uncertainty over the future earnings of DSB, they certain to be substantially lower, with a greater than 50% drop in earnings next year looking quite likely to me. That would take DSB from a bargain basement P/E of 3.1 currently to a still quite cheap P/E of 6-7, but there is considerable downside risk to that if China well and truly blows up sometime soon, which is a risk that makes me uncomfortable holding DSB for the long term.

To break-even on my two parcels, I would need a share price of around $0.59 (including fully franked dividends and brokerage). While it is tempting to hope to sell at a break-even price, this is another psychological pitfall known as 'anchoring' that inhibits rational decision making. As Phillip Fisher put it: More money has probably been lost by investors holding a stock they really did not want until they could "at least come out even" than from any other single reason. If to these actual losses are added the profits that might have been made through the proper reinvestment of these funds if such reinvestment had been made when the mistake was first realised, the cost of self-indulgence becomes truly tremendous. Instead of calculating whether you will come out even, what needs to be asked is - 'where is current share price in relation to its intrinsic value?' If the answer is 'lower' then it usually makes sense to hold, unless as Fisher reminds us, you have found a better opportunity that you require funds for. While I am aware that my judgement may still be clouded somewhat by owning shares in DSB, for now my valuation work suggests the answer is 'a little lower' and so I continue to hold for the time being. 

The verdict is still out on what the future of DSB, the coal sector and China is, but regardless of the outcome, I hope that I will have at least taken away some valuable lessons about investor psychology that will improve my decision making going forward.

Antares Energy

Amidst the barrage of results in reporting season, I think one announcement has gone a little unappreciated. That was the news that Antares Energy (AZZ) had moved from a Letter of Intent to a binding Purchase and Sale Agreement to sell all of their Permian oil and gas assets for $300 million USD (for this post, I'll use the current exchange rate of 1 AUD = 0.903 USD, so that's $332.1 million AUD). I couldn't believe my eyes when I saw that the market capitalisation was $131 million, and this price had fallen over 6% on that day. Well it turns out that I was right not to trust my eyes, as further inspection reduced the attractiveness of this investment, but not enough to hold me back from purchasing.

First, a little background to AZZ. Back in around 2007, the management had almost sent the US focused oil and gas company bankrupt as their 'three year Strategic Plan' failed, recording a loss of $37 million, negative equity of 5 million, and negative cash flow. Shortly thereafter, the share price fell from over $1.00 to below 4 cents, and a shakeup of management occurred. A reversal in fortunes occurred as debt was brought under control and the operational side improved, with the share price rocketing back upwards to over 80 cents at one point. In FY2010, they announced that Chesapeake Energy was going to buy out the Yellow Rose and Bluebonnet assets that Antares Energy held for $200 million USD, of which $156.2 million USD would go to Antares for their proportional ownership. Further bolstering financials, 50.5 million shares were issued at an average price of $0.62, and management soon bought back 20.5 million shares at an average price of below $0.40. This action essentially netted them a profit of $4.5 million on the shares they bought back, which is a big tick in my book. And they've continued to do this, repurchasing 43.3 million shares in total for an average price of $0.413.

With a newly found cash pile, AZZ spent around $160 million on three projects in the Permian basin of West Texas in 2011 which are shale plays, and as you may know, the United States has benefitted from a shale gas boom in recent years. Reserves have grown significantly since then and this brings us to the present, where AZZ is expected to sell these assets on or before 15th January 2014 to an unnamed company (for commercially sensitive reasons). How much of the recent success is attributable to the shale gas boom and how much of it is due to good management I'm not sure, but either way, I give credit to their foresight in buying into the Permian basin when they did. From a terrible position in 2007 to being offered $332.1 million is quite an achievement.

Now, that $332.1 million isn't entirely going to be in the hands of shareholders. To begin with, AZZ currently has debt of $41 million USD and according to their most recent quarterly report, cash of $7.5 million AUD, giving net debt of $37.9 million AUD. Upon sale, the entire debt facility will be reduced to zero, leaving the only other major liability being the convertible notes. There are 10 million convertible notes on issue which have a face value of $2.00, with each note being convertible into 3 shares - i.e. it becomes economical to convert into equity at a share price above $0.66. If none of these notes convert into shares, that's an extra $20 million of debt that will have to be paid eventually (total conversion adds 30 million shares to the existing 255 million, having a similarly negative impact through dilution of shareholder interests). Although some brokers have been trying to guess about the tax consequences of the sale, throwing around figures of $25 or $35 million or even $60 million, I spoke with the chairman and CEO James Cruickshack over the phone, who surprisingly indicated to me that he expects Antares to pay zero tax from the sale. This is because Section 1031 United States Internal Revenue code allows businesses like Antares to dodge the capital gains tax if they purchase another asset within 180 days of the sale. Even if they don't purchase something else within that timeframe, Antares has until December 31 2014 to utilise any production/exploration costs as a tax deduction, so that in either scenario, no tax will be payable. And finally, there are the transaction costs, which I'll take as an extra $15 million (Mr Cruickshank mentioned the difficulty in determining the transaction costs, but confirmed that this number was in the ballpark range).

So there are a few scenarios which could happen:

1. The deal goes ahead and AZZ finds another asset in the Permian region or elsewhere to purchase (no convertible notes change into equity). Their net cash would be 332.1-37.9-20-15 = $259.2 million, or with 255 million shares on issue, net cash of $1.02 per share, double the current share price of $0.515. Should AZZ trade at this price when the sale is completed, a doubling of your money in 4-5 months is nothing to sneeze at.

2. Same as scenario 1 but all notes are converted into equity instead. Net cash would be $20 million higher as this convertible note liability would be gone, but shares on issue would be 285 million, giving net cash of $0.98 per share. (note: if only some of the notes are converted, the net cash per share will lie between these first two scenarios).

3. The deal goes ahead, and the entirety of the proceeds from the sale are returned to shareholders as a capital return. I consider this scenario rather unlikely given that management has previously bought more oil and gas assets with their proceeds, extended the maturity date on the convertible notes to October 2023, and after all, who voluntarily puts themselves out of a job? A more likely situation is the continued buyback of shares if they are cheap. (see *)

4. The deal falls through, perhaps due to shareholders not voting in favour of the sale, although I view this cause as unlikely. Another reason may be that the secret counterparty won't be able to pay, although the Board of Antares is confident that "they have the financial capacity and desire to complete the transaction". They also remind investors that they have a "100% perfect history in closing all transactions announced to the market". If for whatever reason it does fall through, the share price may drop substantially, but I am speculating that the market won't continue to assign such a low valuation to AZZ now that someone has offered them $332 million for their assets. There is also a purchase price adjustment clause in the agreement which says that if an adjustment is to be made to the purchase price if there is a 'Defect' found (eg. non compliance with environmental regulations), it will be no more than 10% of the purchase price. This means there is a $33.2 million downside to the figures I have outlined above, or $0.13 per share.

I would be quite happy with any of the first three scenarios, but there are some extra risks involved. Most obvious is the possibility of an adverse change in the AUD/USD exchange rate. If the exchange rate were to reach parity again, the net cash to AZZ would be $216.5 million AUD under scenario 1, or $0.85 per share. On the other hand, if the Aussie dollar continues to depreciate against the US dollar, net cash in Australian dollars would increase.

The second risk entails a bit of speculation on what the market will do in the short/medium term, which is something I try to avoid. Will the market value AZZ at precisely the net cash figures I have calculated? I went back to the last time Antares sold their assets and found that it traded at almost exactly its net cash per share. However, one cannot assume that this will be the case again, with the likelihood being that a discount will be placed on the valuation of AZZ since it will probably purchase another asset rather than pay out the cash to shareholders. In any case, I don't believe for a second that the market should value AZZ at just $0.515 and I expect that this mispricing will be corrected as January 2014 arrives.

The final risk is that the new acquisition/s will be a bad one, as acquisitions so often tend to be. I think this risk is somewhat mitigated by the fact that management are playing from a position of strength, not weakness (for example due to debt), in selling their Permian assets, and therefore are able to be opportunistic with their purchase. Who knows, the reason for this sale may have been because they have already identified a better opportunity. And as I highlighted above, current management have shown they are able to add considerable value through the acquisition of the Permian assets, so perhaps the market should in fact be placing a premium on the value of their net cash. Furthermore, directors hold 14 million shares, giving them an incentive not to squander shareholder money, and impressively, no director has sold a share since 2004. Nevertheless, an overpriced acquisition is certainly possible. I won't be around to see the next oil and gas play succeed or fail as I view this sector as out of my circle of competence, but I feel that I know enough in this situation to feel fairly confident about a short/medium term investment which relies on the market recognising fair value soon.

While this may not be a typical long term value investment for me due to the shorter time horizon and valuation based on net cash rather than future earnings, I still feel comfortable with this purchase given the considerable margin of safety provided by the cash in the bank. In the end, it is quite simple: if someone offered you a bank account with $259 in it, would you refuse the opportunity to take it off their hands for $131?

* Mr Cruickshank expressed his preference to me for continuing to buying back shares over a capital return or paying dividends as the easiest and most effective way to return money to shareholders, as long as the net tangible assets of the company exceed its share price and there are sufficient sellers on the market to repurchase shares. I agree with this approach taken, and see it as a sign of good management. To illustrate, lets assume a business has a share price of $1.00, 100 million shares outstanding, and its sole asset was net cash of $200 million, giving net cash per share of $2.00 (not dissimilar to the share price/net cash disparity that exists for AZZ). If management were to buy back 20 million of those shares at $1.00, that would reduce shares outstanding to 80 million, net cash to $180 million, and therefore increase net cash per share to $2.25. This really is buying $1.00 bills (or coins in the case of Australia) for 50 cents. The converse is also true: if shares were being bought back at a share price higher than the net cash, value would be destroyed. This gives me further confidence that management won't do something exceedingly silly with the funds they will receive. You might expect these principles to be obvious to CEOs and directors, but all too often I see shares being bought back at any price, without a justification as to whether the shares are undervalued or not.

** After giving further thought to the possible downside risk, and concluding there was little to no risk of significant capital loss, I subsequently bought an additional 1943 shares in AZZ at $0.515 on the 6th of September, 2013. 

Quick Portfolio Update

It's been a little while since I've updated my portfolio here, primarily because there has been nothing noteworthy happening. That is, until today, when I allocated 10% of my portfolio to Antares Energy (AZZ) at $0.515.  It is a rather unconventional purchase for me in that I do not intend to hold it for the long term, and I am valuing this business on its prospective net cash position instead of its prospective earnings. This situation involves a little more speculation than I am accustomed to, however it seems that there is an adequate margin of safety at the current price to cover any downside, with the prospect of a decent return in a relatively short period of time (less than 6 months). Unfortunately, I'm quite busy these next couple of days so hopefully I will be able to properly outline my rationale for buying AZZ soon. Yes, I can almost hear your squeals of excitement, quieten down please.

Smiles All Around

Today I noticed the 1300SMILES annual report (ASX code: ONT) came out, which unsurprisingly was a pleasure to read. Just to give you a brief overview, 1300SMILES relieves self-employed dentists of administrative hassles and provides them with dental surgeries in return for a fee, allowing them to concentrate on actually being a dentist (ONT also has some employed dentists too). I remember stumbling across this business a couple of years ago and after reading the managing director's letter, came away impressed with the level of transparency and the efforts taken to emphasise that this truly was a long-term shareholder oriented business. Regrettably, I thought it wasn't quite cheap enough to buy at the time, and have since missed out on a nice doubling in share price.

It seems the situation today is not dissimilar with Dr. Daryl Holmes still at the wheel, and ONT trading at a fairly rich 24x FY2013 earnings. As the founder of this $152 million company, Holmes owns 62%, and it is these owner run businesses that tend to produce exceptional results over the long term. You may be wondering why this is so. Well, as the largest shareholder, Holmes has a huge incentive to act in the best interests of shareholders, in contrast to many businesses with high-flying CEOs with little equity ownership that happily take their multi-million dollar pay packages, and simply jump ship when things flounder. This year, Holmes took in just $111,663, less than another executive who received $173,916! However, as he has pointed out, most of Holmes' financial reward comes from dividends and share price appreciation - I calculate he would have received over $4 million in grossed up dividends over the past year. But often more important than money in these businesses is the desire to see them succeed - it is the blood, sweat and tears that founders pour into their company that explains their zealous determination to protect and enhance the company.

Indeed, Warren Buffett recognises this formula for success and generally prefers to buy businesses in which management who are not in it for the money but are have plenty of passion. I think Holmes' shareholder letters exemplify his passion for dentistry and Buffett fans will likely find more than a few commonalities in their business philosophy, perhaps more than any other ASX listed company, which is the highest compliment I can pay a manager. I suspect Holmes may have been taking notes. ONT would probably make a great fit for Berkshire if only it were larger.

To fully understand why I like the management so much, I would recommend you read their most recent annual report here. But I'll try to pick out some key points that literally left me smiling. If you pay attention to the wording, many insights can be garnered as to how management really views their role. In the case of ONT, Holmes begins with "Dear Shareholders," before emphasising the need to read the entire report to "help you understand how your company has managed..." (emphasis mine). Not "the" company, not "our" company, as he could rightly call it, but "your" company.

He then clearly explains important business matters such as what the Chronic Disease Dental Scheme (CDDS) was and how its end affected 1300SMILES this year, the introduction of their Dental Care Plan, brand awareness, and new acquisitions amongst other issues. But this bit stuck out to me: "I have always stressed the fact that 1300SMILES is managed to deliver the best possible results over the medium and long term. Good results in the short term are always agreeable, but I believe that most 1300SMILES shareholders take a long term view and expect management to focus always on stable and growing Earnings Per Share and dividends." And these aren't just empty words, with earnings per share increasing at 15% pa since its IPO in 2005 (also keep in mind ONT pays out the majority of its earnings as a dividend), while dividends have risen by 22% pa.

Holmes believes the future looks quite good too, anticipating it seems likely that the years ahead will offer "more favourable acquisition opportunities than the years just finished. We remain totally focused on making acquisitions which make an immediate positive contribution to our results. We won't be rushed, but we will be ready to act decisively as and when suitable opportunities present themselves." This is music to my ears as all too often managers are too eager to pay for an overpriced acquisition, and it seems so far acquisitions have been very sensible. Since 1300SMILES only has 24 dental practices primarily in Queensland, there is tons of room to expand geographically to one day operate throughout Australia. In addition to the patience highlighted above, this acquisition strategy is further de-risked as the business model has been proven to work quite well - ONT could be in the 'rollout' phase, similar to retail stocks like JB Hi-Fi and The Reject Shop that have lifted earnings dramatically by simply expanding their business geographically. 

Unlike many other boards, ONT "do not seek to influence the price of shares in the company. We strive always to deliver the best possible results and leave the share market to its own activities." This is precisely the role of management: to manage the business, not the share market. 1300SMILES' management seems to be hard at work doing this: "This situation proves once again that the harder you work, the luckier you get. 1300SMILES had been working on arrangements with Queensland Health and the HHS boards for a long time, since long before there was any hint of the end of the CDDS. We didn't go looking for a replacement deal with a government when we heard about CDDS; rather we had been pursuing this obvious need and opportunity for a very long time." Through this deal, "waiting times have been reduced from ten years to a still-shocking two years, but we're working to reduce this just as fast as the various boards authorise us to go."

And they're not getting complacent about costs either: "Long term shareholders will be aware that 1300SMILES has always maintained an intense focus on cost control. Despite that, the unusual circumstances following the demise of the CDDS created opportunities for further improvement in this area." This relentless focus on costs reminds me of what Buffett said: "The really good manager does not wake up in the morning and say, 'This is the day I'm going to cut costs,' any more than he wakes up and decides to practise breathing." 

So what does excellent stewardship result in? A return on equity of 23.6%, zero debt (cash of $8 million), a net profit margin of 17.6% and a very healthy cash flow. These great numbers have been maintained over a significant period of time, resulting in a total shareholder return of 26.5% pa over the last 5 years.  As previously touched on, the future also looks bright for 1300SMILES, which wouldn't immediately require a huge capital expenditure program either - Holmes reckons the company could increase its revenue by 50% with no significant capital expenditure since they always build in extra surgery capacity in anticipation of expansion. Without going into details, ONT has a number of other tailwinds going for it.

After reading the managing director's letter, one is able to gain a thorough understanding of how the business works, how it performed, and where it is likely headed - something I cannot say about most businesses. I must admit it is very tempting to go in and purchase shares and hold forever, but once again, I just cannot stomach the price tag. 1300SMILES will likely stay on my watchlist for a long time, as I pray to the stock market gods for its share price to fall. And to Daryl Holmes and his team, keep up the great work. Not only is this how annual reports should be written, this is how businesses should be managed. Bravo.

Valuation - The Odds and Ends

After three posts about DCF analysis, you may be under the impression that is the only way I value stocks. While I certainly like its mathematical logic, one needs to be vary careful with its inputs, it doesn't work nicely in all scenarios, and usually isn't possible to do on the spot. Time to explore some other approaches. 

It may come as a surprise to learn that less than a third of all businesses listed on the ASX made a profit last year. Valuing the other two thirds on an earnings basis is quite difficult. I generally stick to researching profitable companies, but there is certainly value to be found in some loss making businesses if you compare their market value to the equity or net tangible assets (NTA) that they have. The logic is intuitive: if a business is selling for $100 million on the share market, and it has $200 million of equity (assets minus liabilities) on its balance sheet, how can you go wrong?

Indeed, Benjamin Graham, the father of value investing, employed a similar balance sheet technique known as his 'net-nets' approach: 'The type of bargain issue that can be most readily identified is a common stock that sells for less than the company's net working capital alone, after deducting all prior obligations. This would mean that the buyer would pay nothing at all for the fixed assets - buildings, machinery, etc., or any goodwill items that might exist.' He aimed to buy stocks that were selling below two thirds of their net working capital (an even more conservative measure than NTA), reasoning that a group of stocks adhering to such a strategy would produce results that are 'quite satisfactory'. Graham's performance was certainly satisfactory, but he achieved it in an environment where information was hard to access and stocks were more often neglected. Nowadays, finding a net-net is rare and these businesses are often only priced cheaply because they are plagued with severe problems, so such a strategy is limited in its application. However, outside of Australia, some stock exchanges offer a return to the net-net days - I hear Japan is good hunting ground at the moment. 

Although I recognise that buying net-nets or stocks significantly below their NTA has proven to be a valid and successful approach, I don't like to view every business through this lens of liquidation value with the mindset that they will go broke soon so investors can get their hands on those assets (unless of course, they are actually going bankrupt and there is a mispricing). Most businesses that look very cheap compared to their current NTA are haemorrhaging cash, so you could be waiting a long time before the market revalues the stock, and in the meantime NTA is evaporating. Another danger is that the assets on the balance sheet may not be quite as tangible or valuable as they seem if the business were forced to sell, perhaps due to bankruptcy. Personally, I don't have the skills or confidence yet to determine what assets would be worth under a fire sale scenario. Instead of this rather stagnant outlook, I prefer to buy compounding businesses, and the only way to compound money is to be earning it, hence my emphasis on earnings over the balance sheet for valuation purposes. This doesn't mean I wouldn't make exceptions if I thought an NTA situation was particularly attractive, but these investments would be the minority. 

As time goes on, I've increasingly favoured the simplistic measure of the price/earnings ratio (P/E ratio) and its reciprocal, the earnings yield. I know there many value investors who object to the P/E since it assumes current earnings are forever maintained and doesn't account for a host of other important factors, but it provides a very rough indication of whether something is cheap or overpriced, and that's all I really need. I'm not interested in buying stocks that are trading 10% or 20% below a calculated intrinsic value, instead I like to wait for the fat pitch, where I believe there is a high likelihood of doubling my money or more over a 5 year period (ie at least a 15% pa return). For instance, if a business is sound and its normal earning power puts it on a P/E of 5, no DCF is necessary. Looking at this example from an earnings yield perspective, if you owned a business that could pay you a 20% return from day one, and these earnings were sustainable, it's a no brainer. There's a large margin of safety just from looking at it. At the 1996 Berkshire Hathaway Shareholder meeting, Charlie Munger noted: 'Warren talks about these discounted cash flows. I’ve never seen him do one.' 'It’s true,' replied Buffett, 'if the value of a company doesn’t just scream out at you, it’s too close.' 

So after all that effort discussing DCF analysis, was it worthless? Well, I don't think so. While accessible measures like the P/E ratio provide rough clues as to the true value of the business, DCF yields the actual answer. In practice, I can generally decide very quickly whether a particular stock is a bargain or not just by looking at its P/E, but confirm this initial conclusion by doing a DCF valuation. By understanding how intrinsic value is derived from a DCF, further pitfalls of the P/E ratio can be gleaned and addressed. For instance, although many companies trade on a low P/E, DCF tells us that unless earnings are maintained and are reinvested at a decent rate of return on equity, these businesses may not be as cheap as they appear. This is often the case, so keeping such caveats in mind enhances the usefulness of the P/E ratio rather than blindly buying stocks with the lowest P/E. Another added benefit of the P/E is that it can be used to crudely test a whole range of scenarios very quickly in your head. For example, if you think earnings per share are likely to be between $1.80 and $2.00 in a few years time and that when compared to peers or the market, a P/E multiple of 10 to 12 is reasonable, the share price range is anywhere from $18 to $24. If the most conservative outcome of $18 still produces a good return, then investors may favour purchasing the stock. 

Aside from the P/E, there are many other simple value indicators that may be helpful for investors, including the price to book ratio, enterprise value, and free cash flow multiple/yield. But this final post wouldn't be complete without a quick trashing of another popular metric used in valuation. This time it's the EBITDA multiple, which stands for 'earnings before interest, taxes, depreciation and amortisation'. I can see why managers routinely choose to focus on EBITDA to make their acquisitions and their own numbers look better, but it is beyond me why investors would also choose to ignore these very real costs. Sceptics would say a better term for this metric is 'earnings before all expenses'.

In the end, valuation is as much about art as it is science. Having an understanding of how DCF analysis works is important, but even more so is common sense and the ability to stay rational. Investors should realise that assessing risk and predicting the future is difficult but necessary to attempt themselves - although many services offer to crunch numbers and value every stock automatically, no computer program can incorporate the multitude of qualitative judgements that good investors can. As Munger once said, 'People calculate too much and think too little'. I hope some of the ideas presented have made you think a little more.