Sold Blue Sky Alternative Investments

In June last year, I described the rationale behind putting 16% of my portfolio into Blue Sky Alternative Investments (BLA) at $1.25 per share. Today, I'm quite pleased to report that I have sold out at $2.15, making this stock a 70%+ gain in just over seven months. It is true that this span of time is insufficient to determine whether my thesis about the business was ultimately sound, but I'm not going to complain about making a quick buck. 

Initially, I made the case that if assets under management (AUM) could reach $1 billion in four years' time, BLA might reasonably be valued at a market capitalisation of $132 million (three times higher than the then market cap of $40.6 million). Since then, AUM has grown from around $250-$300 million to $400 million at the latest count, which is well on its way to management's target of $500 million by the end of FY14. While this is good progress, I've been less happy about the two capital raisings conducted since I purchased BLA. 

There is something suspicious about raising $6.8 million from institutional investors at $1.40 per share and then going back less than four months later for another $25.6 million at $1.50. The stated rationale was to invest the proceeds in BLA's own managed funds, which is supposed to further demonstrate to potential clients that BLA has confidence in its own investment performance and therefore drive increased AUM. This may make some sense, but why the need for two capital raisings in such a short space of time? Then one needs to weigh up the dilutive impact of issuing new shares. In this case, BLA has raised significant amounts of money, which has resulted in the number of shares on issue rising from 32.5 million to 56 million currently, and therefore the market capitalisation has leaped up from $40.6 million to $123.3 million - almost the value that I had in four years' time!

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Consequently, the primary reason for selling out is due to a dramatically reduced margin of safety, which makes me uncomfortable to hold. Even if BLA manages to achieve a more than twofold increase in AUM to $1 billion over the next four years, the returns to future shareholders are unlikely to be commensurate with that increase anymore - as share prices rise, the returns of the future are brought forward into the present. Of course, it is quite possible that BLA will live up to the ambitious $2 billion in four years that management has cited, but banking on that level of growth to justify an investment at the current share price appears a bit too optimistic for me. I'm changing my forecast from blue skies to cloudy. 

This sale brings my level of cash to almost 28% of my portfolio, so it's back to the drawing board for new stock ideas. Fortunately, there are a few companies that I'm interested in, but it is quite possible none of them will find their way into my portfolio. The last time I felt I had too much cash, I went out and bought DSB, which has turned out to be a regrettable decision, so I'll do my best to exercise more patience this time around. At least it seems the Oracle of Omaha shares my weakness: I make my mistakes when I have a lot of cash around. 

Three Years On

Today marks three years to the day that I first purchased a stock under a value investing rationale. Since then I have learned a great deal about the challenges of investing, and also earned a chunk of money along the way. Of course, the journey of learning has only begun, but if it continues to be this enjoyable then I'll be sticking around for a while.

As I said the first time I posted my performance on this blog, I believe that for a value investor, the absolute minimum period of time upon which you can start to judge ability is three years, although a five-year test would be far preferable. The shorter the timeframe, the more that good or bad luck comes into the equation, but give an investor a few decades, and skill almost entirely accounts for the result. Please keep in mind that for the first 15 months, I only held one stock (Forge Group), so one could argue that period of time shouldn't count. With that said, judgement day has arrived, and I'm not all too worried.

In dollar terms, the biggest winner has been Forge Group, with a net $1124 gain (including brokerage and franking credits). Conversely, Delta SBD has been the major drag, as I currently sit on an $809 paper loss. All up, my portfolio started out with $5522 and is now at $8465, which is 53.3% gain. This works out to a compound annual growth rate of 15.3%. If I can maintain that trajectory, I'll cross the million-dollar level in around 33.5 years, and if I manage to hang on until age 100, my birthday present that year will be the attainment of a billion dollar nest egg. While these are obviously simple extrapolations, they make the point that just about anyone who saves a small amount of money and patiently invests it sensibly (either personally or through a fund manager) can end up quite wealthy.

These are satisfactory absolute results, but they need to be viewed in the context of the general market, which I have chosen to be the All Ordinaries Total Return Index. During the same period, the index has appreciated by 25.9%, or an annual rate of 8.0%. This happens to be slightly below the historical long term return of circa 9%-10% annually, so this hasn't been a particularly buoyant period. It is interesting to note that the Small Ordinaries Index Total Return Index - comprised of the smaller companies more representative of where I invest - has declined by 15.3% in the past three years, but I'm not about to go changing my benchmark to look better. The number I deem to be the most important is an investor's annualised outperformance/underperformance relative to the index, and I have previously stated my goal is to beat the All Ordinaries total return index by at least 5% per annum over the long term. So far this has been achieved at 7.3% annualised outperformance.

Although I think most people would view my set of numbers as quite good, and despite the arresting mathematics of compound interest highlighted above, I have occasionally felt that my performance hasn't been good enough. When you see or hear other investors producing extraordinary results in a short space of time, it is easy to want to change strategy and start betting on more speculative situations that offer the possibility of great gains, but also great losses. At times like these, I like to remind myself of one of my favourite Charlie Munger quotes: Someone will always be getting richer faster than you. This is not a tragedy. And then once again, I am content with being the billionaire centenarian.

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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.