Sold Thinksmart

Yesterday I exited my Thinksmart Limited (TSM) position after analysing the chairman's address at the AGM, 364 days after purchasing TSM and at a 25.4% gain after all costs.

The initial investment case was that Thinksmart was a fundamentally cheap stock that had been sold down disproportionately by the market - if you are unfamiliar with TSM, they provide financing solutions through services such as RentSmart for consumers to rent products rather than purchase them outright. At the time I viewed TSM's earnings downgrade as a temporary setback, caused largely by a switch to lease accounting which delayed the recognition of profits but was supposed to increase total profits over the life of the contract. TSM also suffered from poor consumer confidence, price discounting by retailers, the high Australian dollar and the closure of many Dick Smith stores, all of which I believed (mistakenly in hindsight) would improve eventually.

Management had given guidance of $5.6 million for 2012, compared to a profit of $6.8 million in 2010 and 2011, although downgraded the 2012 guidance to a cryptic 'full year profit, albeit at a level materially lower than our earlier guidance'. I was prepared to accept perhaps a 50% decline in earnings followed by what they called 'record annual profits in 2013' but it turns out Thinksmart would produce a loss of $1.4 million in 2012. This was clearly a sign that management were either overoptimistic or just plain tricksters but nevertheless I hung on, anticipating a sharp recovery. Until yesterday that is, which was the last straw.

Although the market seemed to like their announcement, I was less than impressed with their forecast of a $0.5 million profit for the first 6 months of 2013. For a business valued at $45 million, Thinksmart no longer seems cheap, unless earnings can magically reach the predicted record annual profits of a year ago. However, I no longer have faith in the management in either their forecasts or handling of the company, so selling is the rational decision. Furthermore, it seems consumer confidence in Australia isn't rebounding any time soon, falling 2% in March, 5% in April, and 7% this month. I may well be proven overly pessimistic but I think there are many better businesses to be in than Thinksmart.

So to sum up, I misjudged the quality of management and the state of the retail industry, but nonetheless managed to make a decent profit out of Thinksmart. This leaves me holding four stocks and 36% cash, which is hardly desirable, but I'd rather sit on the sidelines for a while than make a dumb purchase. Despite the recent stock market decline, value is still difficult for me to find. To the right is my updated portfolio.

How many baskets?

I'm sure you've all heard that proverb, 'Don't put all your eggs in one basket'. After all, it's taught as the secret to success in business schools and widely preached by financial advisors and commentators. I find this notion paradoxical - diversification is hardly the secret if everyone knows about it, and I don't see droves of investors speeding around in Aston Martins.

Some may disagree with that conventional wisdom. Mark Twain translated it to meaning 'scatter your money and your attention' and instead retorted, 'Put all your eggs in one basket and watch that basket'. Bear in mind that Twain, for all his talents, was not the wisest man in financial affairs, landing in bankruptcy largely due to bad investments.

So here I am to offer my opinion on the merits of a widely diversified investment approach as opposed to a concentrated one. Please note, I'm mainly referring to the field of common stocks, as some strategies such as arbitrage require wide diversification. 

Firstly, let's take a look at the fundamental basis of diversification. The logic goes that if you want to reduce risk, you should buy plenty of stocks (a commonly recommended number is 30) as this reduces the impact on your portfolio of any one stock turning bad. At first glance this seems a very reasonable argument, but this depends on your definition of risk. 

Risk is commonly defined in terms of volatility - either of an individual share price or of the whole portfolio - and in this regard, diversification does help to smooth out volatility and thus reduce overall portfolio risk. But as an investor with a long time horizon, volatility is hardly a risk, rather it presents opportunities to buy stocks when they are cheap. A more rational definition of risk is the chance of a permanent loss of capital over an investor's prospective holding period. If you look at it this way, constructing a huge portfolio of stocks doesn't necessarily reduce risk, diversifying for the sake of it may well increase your probability of permanent capital loss on individual stocks if you don't know what you're doing - Peter Lynch's term 'diworsification' aptly describes this scenario. 

A second justification for wide diversification is that it increases your chances of landing a winning stock. While true, it also increases your chances of picking a dead duck, and in both circumstances, the positive or negative influence on your overall results will be minimal by virtue of the number of stocks you hold. So through wide diversification, one usually edges closer to the average return of the market, which is certainly not a poor return, but there seems a certain irony in going through the effort of picking stocks with the intentional or unintentional goal of attaining average.

I believe buying a low cost index fund is the best approach for people who wish to participate in the historically attractive returns of the share market but don't have the time or ability to research individual stocks. While this kind of extreme diversification may appear to be a lazy attitude, tracking the index over time is better than the professional investment community can hope for - their size, fees and mandates see to that. The huge sway of these institutions explains in part their general advocacy of wide diversification for individual investors. Most of their clients aren't pleased to see huge swings in their account balance from the average return, hence institutions tend to 'hug' the index to avoid volatility and periods of significant underperformance (on the flip side, outperformance too). Although perhaps in an attempt to differentiate themselves, some amusingly have the chutzpah invest in 30 or 40 stocks and then label it a 'concentrated portfolio' or a 'high conviction approach'. 

That brings me to the other end of the spectrum, a highly concentrated portfolio. The principle behind it is simple but very alluring, why put money into your 30th best idea when you have 29 better ones with a higher expected return and lower chance of permanent capital loss? As Warren Buffett explains, 'We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it.' And as his pal Charlie Munger puts it, 'To me, it’s obvious that the winner has to bet very selectively. It’s been obvious to me since very early in life. I don’t know why it’s not obvious to very many other people.' He believes that 'The goal of investment is to find situations where it is safe not to diversify'. This is the same logic that one would use in poker. If you want to be any good, you don't bet an equal amount on every hand you get, it's only when you think the probabilities are stacked in your favour do you really raise the stakes. Some in favour of diversification would argue that it is too hard for them to determine which stocks have a higher likelihood of doing well, to which I would counter - then don't play. Again, unless you're confident in your stock picking abilities, you should buy an index fund. 

There are also a couple of sweeteners that come along with a focused approach. By holding a smaller number of stocks, investors reduce their transaction costs from buying and selling, which become quite significant if you're working with small sums of money. Furthermore, one doesn't have to keep track of a vast array of stocks in a concentrated portfolio, this time can be spent keeping a closer eye on existing holdings, searching for new ones, or maybe even not to research stocks. 

From my wording, you can probably tell I've adopted a concentrated style, but this doesn't mean that it is for everyone and that a widely diversified strategy cannot work (although the most successful investors tend to have a concentrated strategy). Take a look at Walter J. Schloss, widely regarded as one of the great investors. He favoured wide diversification, often holding over 100 stocks at a time, enough to start his own stock market index! And yet, his results were significantly above par, producing a 21.3% annualised return from 1956 to 1984, compared to the S&P (including dividends) of 8.4%. I believe the explanation for Schloss' results ultimately lies in his methodology, not the diversification. He strictly adhered to the teachings of Benjamin Graham, who advocated buying a big basket of statistically cheap businesses trading on the stock market. While Schloss' performance could have been improved by focusing on a smaller amount of stocks, each with a higher mathematical expectancy, he didn't like the stress involved in allocating large positions to individual stocks. 

This highlights an important consideration in choosing the appropriate level of diversification. Investing is an inherently psychological game and keeping check of your human instincts is absolutely crucial. You are better off going with a more diversified approach if wild swings in your portfolio value send you into a panic or if a large stock weighting causes you to miss out on a good night's sleep. Many investors adopting a concentrated style need to be wary of becoming emotionally attached to a particular stock they have a lot of money in, subsequently refusing to accept a bad decision. 

Just a couple notes diversification: I hope it is obvious that buying 30 stocks in the same industry is not good diversification as they are all highly correlated. The aim of diversifying is to limit the likelihood of a single bad event destroying your portfolio. I'd argue buying 5-10 stocks in different industries is far more diversified than the above. Also, I don't see much sense in rebalancing portfolios just because certain stocks have risen or fallen in relation to the original purchase price. The primary consideration in buying or selling should be: where is the current value of the business is in relation to what the market values it at? A stock may be justified in rising because the value of the business has increased, and vice versa with a falling stock. But if you rebalance to prevent stocks from reaching an uncomfortably high proportion of your portfolio, for example, because the volatility may make you uneasy, then go right ahead. 

So to sum up: every investor will be comfortable with a different level of diversification, depending on factors such as ability, time, size of portfolio and personal characteristics. However, in general, I believe that if you are serious about investing and know what you're doing, a concentrated approach will produce superior returns to a more diversified one. Mark Twain's guidance is extreme, as relying on one basket is dangerous, but so is stumbling over on too many. I believe in finding a middle ground. 

My Performance So Far

I believe in being fully transparent about my investment record, good or bad. I find it unfortunate that the public is largely left unable to make informed decisions about the merits of investment managers, advisors and the like - the less competent ones are not too forthcoming about their past. Neither do I feel that they are held as accountable for their actions as they should be. Substandard decisions or performance seem to be forgiven and forgotten too easily.

You need only look at the story of John Meriwether, who played a significant role in the near collapse of Salomon Brothers in 1991, nearly causing a financial disaster if Warren Buffett had not risked his reputation to save the investment bank. In 1994, he founded Long-Term Capital Management (LTCM), a highly leveraged hedge fund. Four years later, it blew up spectacularly, almost bringing down Wall Street again, prompting 14 financial institutions to inject $3.6 billion. Surely people would have learned to avoid Meriwether at this point, but alas, they didn't.

The next year he raised $250 million to start another highly leveraged fund which closed down in 2009 after taking a beating from the global financial crisis. I must give the man some credit, he's certainly persistent - in 2010 he started a third highly leveraged hedge fund, although with far less interest from investors. If someone as high profile as Meriwether can get away losing billions of dollars with minimal consequence, surely there must be thousands of others like him hiding in obscurity.

But I digress. Below is the record that I use to keep track of my performance, as of 14/05/13. If my performance turns out to be decent, you may decide to pay some attention to my ramblings, if it is poor, then I expect you'll immediately browse elsewhere, unless you wish to delight in my financial misery.

Now you may be rather sceptical about the veracity of these results so far, after all, I could have plucked the figures out of thin air. I would be too. Short of looking at all my paperwork or auditing my brokerage account, I'm afraid you'll just have to take my word for it. My intention is to provide periodic updates and post any significant events, such as a buy or sell, so that the authenticity of all future results is unquestionable.

I should add that this is only a record of 2 years and 4 months of investing, which I deem too short to form a definitive opinion of any long term investor's ability. I think 3 years is the absolute minimum whilst a preferable timeframe would be 5 years of results. Nevertheless, the early numbers are encouraging, comfortably surpassing my target of a 5% p.a outperformance of the All Ordinaries Total Return (Accumulation) index. The annualised outperformance currently stands at 11.3%.

You may infer from the figures that my investment style is quite a concentrated one. That would be true: for the first year and a bit, I held only one stock, although I now view that as extreme and unlikely to occur again. This explains the initial volatility depicted in the chart, however, since diversifying into 5 or so stocks (which is still quite concentrated), results have been much smoother. But my views on the topic of diversification vs concentration are too long to expound upon here. Perhaps another time.

Please click on this image and zoom in for a better view

The Most Powerful Force in the Universe?

Albert Einstein is rumoured to have said that 'the most powerful force in the universe is compound interest'. That may seem a strange conclusion coming from a physicist who dedicated his life to unravelling the mysteries of the cosmos, but I believe he was certainly onto something.

The table below depicts what happens to $1000 when subjected to the force of compounding:

Nice table. But how does this relate to investing?

Well, firstly it should be clear that as the time period lengthens, the final result increases exponentially (this is evident by looking at the compound interest formula). So it is advisable to save and invest as early as possible. That 100 year milestone is only getting closer.

Secondly, take note that relatively small increases in the compound rate produce tremendous differences, particularly over long periods of time. This means that every percentage point counts when making investments.

So the secret to getting rich seems to be saving up money (or better yet inheriting a pile of cash), compounding it at a high rate and most importantly, staying alive. Easier said than done, but those that pull it off are handsomely rewarded.

If you look back at history (which is not a guarantee of the future), the Australian share market has produced quite satisfactory results over the long run, in the range of 10% pa depending on the selected timeframe. Any average Joe or plain Jane could have achieved this result by sticking their money into a low cost index fund and forgetting all about it until retirement.

And if you can do better than average, say an extra 5% pa over 50 years, you'll end up with over 9 times more cash than Joe. Personally, my goal is just this - to achieve at least a 5% advantage over the All Ordinaries Total Return index by investing in my spare time. If investing were my full time job, I think an extra 10% would be a good number to strive for.

Out of interest, I decided to extend the table and see what happens to a dollar over 1000 years. If you could invest it at just 5% pa, and your descendants had the mental fortitude not to splash out, eventually they'd be sitting on $1,546,318,920,731,950,000,000 - enough to buy everything produced in the world last year. More than 20 million times over.

Yes, I think Einstein had it right.

Please keep in mind that to simplify discussion, I have not taken into account the effects of inflation, taxes and fees on investment results, all of which detract from, but far from nullify the power of compound interest. Also, the example over 1000 years is purely theoretical, one would end up owning the world long before reaching such ridiculous sums.

Socks n Stocks

First things first: I should explain how I go about investing in the share market. I'm afraid I can only give a summary of the basics but I have found that this intellectual framework is sorely lacking by many, if not most investors. 

The most important idea is to realise that stocks simply represent part ownership in a business. When you buy shares in the Commonwealth Bank of Australia (currently the largest Australian business), you really do own a fraction of this $113 billion business and as an owner, are entitled to your proportionate share of its profits - just as if you owned 20% of a family business or a farm. If CBA flourishes financially, as an owner, you will too. 

So in effect, the issue making money on the share market comes down to buying businesses that can pay out higher and higher profits whilst avoiding ones that are headed for a crash landing. This is simple to understand, but not easy in practice. Even the very best investors regularly fail in their predictions, so you must to research, research, research about any stock that you want to buy before pulling the trigger. 

Now, you may sit back after doing all this hard work analysing what the company sells, its competitors, its management, its profitability, its debt levels, why you believe it will do well in the future etc, but that is still not enough. You need to determine how much the business is worth - this is the critical factor that separates true investors and speculators. 

'How on earth do you do that?' you may be asking. Good question. Nobody on earth knows exactly what a current business is worth, unless I'm mistaken and someone is sheltering a crystal ball that can predict the future profits of a business for the next 100 years. Absent that, investors must make guesses. Some will concoct highly sophisticated models to predict the value of a business to two decimal places, but often these investors get so beguiled by their mathematical wizardry that they incorporate assumptions that make no sense to rational people, resulting in huge misjudgements. They forget John Maynard Keynes advice, 'It is better to be roughly right than precisely wrong.'

To illustrate, imagine you found a spare $100 million hidden in the couch one night. Making this scenario even happier, the next day an elderly businessman proposes to sell you his sock manufacturing business for $100 million, which just last year earned $20 million. After finding out that the business model is strong, customers are happy, and the likelihood is that profits will increase in the years to come, what would you say? 

'No thanks, I'd rather put my money in a 5 year term deposit at my bank and earn $4.5 million a year.'

I don't think so.

If the sock business was earning $4.5 million, then you'd have to start thinking hard about the price, but as you can hopefully see, it doesn't take any complex formulas to realise that at an asking price of $100 million, this deal is a no brainer - you get a 20% return from day one (20/100 = 20%), with the expectation of future increases in profits. Holding onto this business for many years would work out quite well as it pays you a great return - with free socks too. Furthermore, sooner or later someone is going to realise that the business is worth much more than you paid, giving you the chance to sell at a higher price in a shorter period of time. 

Of course, there is always the risk that the business disappoints and produces poor results. Yet by purchasing at a low price, you create a 'margin of safety' which mitigates your risk in making a bad decision. For instance, instead of earning $20 million, the sock business may experience a dramatic halving of its earnings the next year to $10 million, but you would still be effectively earning 10% per year, hardly what one could call a tragedy. So any way you slice it, the deal seems too good to be true. 

Indeed, in the real world, such an offer is rare. But in the stock market, people regularly offer to sell you a part interest in a business for a ridiculously cheap price. Aside from how much influence you have, there really are not many differences between buying 100% of a private business and a fraction of a business on the share market. And fortunately, you don't need a $100 million couch to invest in the latter, nor an elderly man to pass your way offering you his business - there are more than 2100 businesses on the ASX for sale at the click of a button. 

This practice of finding undervalued businesses has been called 'value investing' over the years, but I, and many others think that the 'value' moniker should be dropped. Valuation is essential. After all, if you don't even look at the business, instead drawing lines on charts of the share price and whatnot to predict the future price, you're clearly not an investor, you're ignorant. Worse still, if you paid a billion dollars or a trillion dollars for the sock manufacturing business above, you're crazy. Combine ignorance and craziness and you end up with some pretty interesting results. 

It reminds me of Bertrand Russel's remark, 'Most people would rather die than think; many do.'

The 906 words above can be summarised in 17 by Warren Buffett: 'Whether we're talking about socks or stocks, I like buying quality merchandise when it is marked down.'