Influence: The Psychology of Persuasion

As I've previously mentioned, in his speech titled The Psychology of Human Misjudgement, Charlie Munger discusses 25 tendencies that lead to irrational behaviour. He acknowledges that many of these ideas and examples in the speech came from a book called Influence: The Psychology of Persuasion, written by Robert Cialdini. After reading that Munger immediately sent copies of this book to all his children, and gave Cialdini a share of Berkshare Hathaway Class A stock as thanks, I knew that it must be something special.

Indeed, although this is a blog primarily about investing, I was so impressed by the book that I'm persuaded to recommend it here (pun intended). It is not entirely unrelated however, as some of the lessons it contains such as the consistency and scarcity principles are quite applicable to investment decisions, and it is curiously part of the Collins Business Essentials. Originally published in 1984, the 2006 revised edition is updated to reflect new findings about the process of influence, and at the end of each chapter, Cialdini discloses letters that readers have written to him about their personal experiences. 

Like many people, Cialdini admits that 'All my life I've been a patsy', so as an experimental social psychologist, he spent 35 years conducting experiments into how people think and what makes them likely to be persuaded. In addition, he spent three years going undercover by applying for jobs in fields such as real estate, user car dealerships, advertising, public-relations, fund-raising, telemarketing and restaurants. These insights into how the professionals get us to say 'yes' provide a nice demonstration that what works in experiments applies equally well to the real world. Cialdini's writing style is easily understandable and humorous, but fortunately doesn't patronise readers by oversimplifying. My only criticism is that he tends to be a little repetitive in drilling home the results of an example or the message he's trying to convey, but overall the book is a pleasure to go through. 

Influence: The Psychology of Persuasion details six very powerful principles, one per chapter:

1. Reciprocation

2. Commitment and Consistency

3. Social Proof

4. Liking

5. Authority

6. Scarcity

These principles usually work to our great benefit, but our regular reliance on them may cause lapses in judgement, especially when someone is intentionally exploiting them. Although some may seem obvious, I think you'll be surprised how powerful they are once you read example after example of their applications. By understanding how these principles work, you can use them yourself to help persuade others (hopefully with good intentions), or you can avoid being led into unwanted situations (Cialdini explains 'How to say no' at the end of each chapter). Interestingly enough, even though I'm planning on pursuing a major in psychology - as well as finance and accounting - my first few weeks of social psychology have made no mention of any of these principles. 

Using these principles, Cialdini explains why a woman in New York was chased and stabbed to death while 38 of her neighbours watched on without calling the police or intervening, why the number of airplane crashes and automobile fatalities shoots up after a highly publicised suicide story, and how a cult leader got more than 900 people to kill themselves in an orderly fashion by passing around a vat of poison. To find out the tragic and disturbing reasons for these extreme examples, you'll have to read the book! 

In summary, if this was a broker report, my recommendation would be BUY. 

Finally Sold Delta SBD

Delta SBD, an underground coal mining services business I bought shares in almost a year ago, has been by far my worst investment mistake of commission. Just as my cat learned very quickly not to pee on the carpet after my dad rubbed his nose in it, I believe that rubbing my nose in my mistakes is a good practice. Thus, today's rather unpleasant post.

Less than six months ago I mentioned the discomfort that this stock had given me in the context of psychological biases, but justified my decision to hold onto DSB as I thought it was still cheap. Well, it now seems that Mr Market (an allegory for the general share market) was right in his pessimistic appraisal of this business, and after the most recent half yearly results of DSB came out on Friday, I have come to agree with him. In fact, it took me all of around five minutes of reading the report before I knew that my valuation was wrong and that I should get out quick. 

I sold out in two parcels, one at $0.29 and another at $0.28, before the share price dropped further to close at $0.25 - an almost 22% drop in one day. After accounting for fully franked dividends and brokerage costs, my personal losses have been 61% and 44% for the two respective parcels, or a total of $845 in dollar terms. These are unpleasant numbers, but if it's any consolation to myself, they're not as bad as Delta SBD's results.

Revenue for the half fell 52% to $35.4 million, while the underlying profit of $5.2 million became an underlying loss of $1.0 million. All $29.2 million of DSB's goodwill was written off, and a couple of other minor items meant that the statutory loss totalled $30.7 million. Poor results were widely anticipated due to the severe downturn in the Australian coal sector, but evidently they were worse than what I, and the market had expected. The announcement was enough to send DSB's closest listed peer, Mastermyne Group (ASX:MYE) down almost 15%, even though Mastermyne's share price had already been punished from its similarly disappointing half yearly report three days earlier. 

Although the market capitalisation of DSB is $11.6 million and it has net tangible assets of $28.2 million, the bulk of its assets are in the form of plant and equipment, which in the current industry climate would almost certainly be worth less than the $37.6 million stated on the balance sheet (this amount reflects historical cost minus depreciation rather than what you could sell it for on market). Indeed, DSB sold some of its assets to provide cash, and recorded a loss as part of its statutory results from it. Therefore, it doesn't appear to me that there is sufficient protection if DSB were to go into administration, and although I am not predicting this will eventuate, there are some eerie similarities to the rapid demise of Forge Group that make me uneasy. 

For one, cashflow from operating activities has deteriorated dramatically, going from inflows of $2.9 million, to an outflow of $1.9 million in the current half, and as previously mentioned, the business has moved from an underlying profit to an underlying loss. Once you get into the world of negative compounding, it can be very difficult to dig yourself back out, and it seems to me that DSB won't be able to withstand the pain for much longer. This business has a worryingly high net debt to equity ratio of 51%, and a current ratio of just below 1.0, indicating that it will be having some funding issues over the next few months. To their credit, management have been working at reducing debt levels as fast as they can, but with the company now bleeding cash, it seems the only avenue for further deleveraging will be more asset sales. 

Buried in the 'going concern' section in the notes to the financial statements, there are some more worrying signs about cashflow and debt. The directors acknowledge the need for an additional working capital financing facility, which they expect they will have to start drawing down on in March 2014. DSB has been working to secure an invoice finance facility of $4.65 million from an external financier, but should this fail, the group's major shareholders - who I presume are the two founders of the business that own a collective 47% - have committed to provide a facility of $3.5 million. However, there are also strings attached to this shareholder funding, and the report ominously warns that it "will be conditional on achieving predicted revenues levels and appropriately managing the volume and profitability of the business. Should this not be achieved and the Group is unable to restructure existing equipment finance arrangements or raise additional capital, the Group may not be able to continue as a going concern." Further paralleling the signs of desperation that Forge Group displayed before it collapsed, management revealed that "the Group continues to negotiate with finance providers to extend the repayment terms of other existing equipment finance arrangements, and is considering a capital raising via the issue of new shares." 

And finally, whilst I rarely place much emphasis on macroeconomic forecasts (although I probably should have in the case of DSB), the environment for an underground coal mining services business seems pretty bleak to me. The big miners - BHP Billiton and Rio Tinto - have cut capital expenditure in their coal businesses, and in the face of lower prices, capex spend is set to fall further. I'm no expert, but with the rapid increases in the efficiency of solar power that I've been told are trending even faster than Moore's Law in computing power, and the rise of other renewable energy such as wind power, I can't see a bright long-term future for thermal coal. In addition, China, which is the world's biggest consumer of thermal coal, has been making moves to clean up its pollution by reducing its dependancy on thermal coal. As for metallurgical coal, prices are to a large extent dependant on China continuing to grow at a fast rate and build tons of infrastructure, an assumption that appears far from a sure thing to me. 

After all the above, you may be wondering why on earth I ever held shares in this business and why I didn't sell out sooner. I am too. But I think I can list a couple of factors that contributed to this result, many of them psychological. In response to the first question, I repeat what I said six months ago: "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." I figured that if DSB could withstand a short term downturn in the coal sector, I would make a fair bit of money. However, in light of the recent results that's a much bigger 'if' than it was almost a year ago when I first purchased shares. 

Last time I also listed confirmation bias as one factor that hindered a true objective analysis of the situation - I remember reading analyst reports that had big 'BUY' recommendations on them, and although my estimates were more conservative than theirs, we were both way off the mark. After recently reading Charlie Munger's brilliant speech, The Psychology of Human Misjudgement, I realise that I most certainly fell victim to what he calls Inconsistency-Avoidance Tendency (the brain naturally being resistant to change in ideas, once you make your thoughts known in public, as I did on this blog, the tendency becomes even stronger), and Overoptimism Tendency (fairly self explanatory). Eventually I recognised that the risks of my investment in DSB had gone up significantly, and deliberated many times on whether to sell out, but never did something about it, until of course this report came out, when my fears were confirmed. 

Another one would be Contrast-Misreaction Tendency, which is perhaps best explained through the boiling frog anecdote. Although the scientific background is shaky, the story goes that if you place a frog in boiling water, it immediately jumps out, but if you place it in cold water and slowly turn up the heat, it will boil to death. Thankfully, the consequences for me were not so serious, but this cognitive bias applies to the brain and the message is the same. I should have reacted to the little pieces of information that built up over time indicating this was a bad decision. Instead, it took a real splash of boiling water in the form of this half yearly report for me to jump out. 

There was simply not enough of the 'invert, always invert' that Munger espouses. Unfortunately, once I have sold out, inverting becomes so much easier to do, as the above paragraphs demonstrate. I should have listened more to the wisdom of Peter Lynch who said, "Rather than being constantly on the defensive, buying stocks and then thinking of new excuses for holding on to them if they weren't doing well (a great deal of energy on Wall Street is still devoted to the art of concocting excuses), I tried to stay on the offensive, searching for better opportunities in companies that were more undervalued than the ones I'd chosen." If someone had asked me a month ago if I would invest in DSB, my answer would definitely be 'no' because the risks were too high, so why did I hold shares in it? Because I made kept making excuses. 

Perhaps I should have also followed the advice of Buffett and Munger, in avoiding the 'cigar butt' style of investing that they had success with but eventually moved on from. But unlike Mark Twain's cat that sat on a hot stove and never sits on another stove, hot or cold, I haven't been burned severely enough by this cigar enough to dismiss cigar butt investing on my first attempt (my apologies for all this burning animal imagery).

Last time I concluded my discussion on DSB and investor psychology by saying, "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." I just wish it wasn't such an expensive lesson.

P.S. Not all is bad though, Warren Buffett's annual letter to Berkshire Hathaway shareholders was published over the weekend, and as has come to be expected, it is always a good read. To any value investor, his annual letters are required reading. 

Bought Boom

Today I purchased 7428 shares in Boom Logistics (ASX:BOL) at a price of $0.175 each. For those of you who have never heard of this business, it provides crane and lifting solutions to customers in the resources, energy, utilities and infrastructure segments. I had briefly taken a look at this company a few years back and passed, but it was brought to my attention again by a good friend of mine, Alex, who posted about Boom on his excellent blog The 8th Wonder.

After conducting my own research, I reached similar conclusions to Alex about the business, eventually deciding to stop sucking my thumb and to just pay a little extra for some shares. Since I don't think I can put forth the case for investment any better than he already has (and because I'm admittedly a little lazy right now), I recommend you go read his thoughts here and here. Alternatively, he's given me permission to simply copy and paste those posts right here for your convenience. Enjoy!

23 Cents on the Dollar

Boom Logistics (ASX:BOL), Australia’s largest crane and lifting solutions provider, caught my eye recently with its price trading at nearly one fifth of tangible book value. After further inspection and a phone call with management, I took a position at $0.12.



Times have certainly been tough of late for anything marred with the mining service brush, and it has been no different for Boom. While this is not a high quality business by any stretch of the imagination, it seems that the market is currently pricing Boom as if death is imminent. When the herd is avoiding a sector like the plague, this has the potential to create opportunities for the contrarians among us.



Boom’s derives the majority of its revenue through maintenance contracts with Australia's major mining companies (as well as energy, infrastructure and civil construction work) which bodes well as Australia shifts from a mining ‘capex’ cycle to one of operation and maintenance. An improvement in residential construction that is underway, along with the increasing trend of crane intensive high density buildings, is also a positive as it may help to soak up crane supply and boost utilisation across sectors. 



While Boom’s profit history has been disappointing due to asset write-downs and restructuring charges, its consistency of operating cash flow is attractive. Over the last 5 years, Boom has averaged $50m of operating cash flow per annum, almost as much as its current market cap. Management have guided they expect capex to be less than depreciation ($20m expected), which coupled with the $11m of asset sales, bodes well for free cash flow (FCF) in the vicinity of $30-40m for FY14. This places Boom on a FCF multiple of less than 2 times!



What is certain is that a stock is unlikely to remain at 2 x FCF or 0.2 of book for long, either free cash flow or book value will reduce or the price will rise. As I expect FCF to be resilient, this gives management optionality in terms of capital management.



Management are aggressively repaying debt (with $12m repaid in the first quarter and a full year target debt balance of $90m) and have stated the intention to buy back stock on market to capitalise on the discount. Boom’ s net debt to equity is currently 33% and is likely to reduce below 30%, which is less than half that of peers such as Ausdrill and Emeco who trade on similar discounts.



The currency sensitivity is also interesting. Boom invested $140m over the last 3 years when the AUD was close to or above parity with the USD. As cranes are sourced from international suppliers, Boom was able to take advantage of the strong currency and replenish its fleet at relatively good prices. However, with the AUD at $0.90 and with expectations that it will continue to fall, cranes are not getting any cheaper in Australia. This bodes well for Boom’s crane values and reduces the probability of future write-downs. However, given the size of the discount at which the price trades at, shareholders have a significant buffer even if write downs do materialise.



There are a number of catalysts which have the potential to provide a rerating: an on market buyback, continued debt reduction announcements, a return to bottom line profitability and a takeover offer from private equity or a trade buyer. Given that sentiment is so bad towards the sector, even a slight normalisation has the ability to provide a rerating.



As Boom trades at such a large discount to NTA, an acquisition creates interesting accounting implications for a potential acquirer. For analysis sake, let’s assume McAleese (ASX:MCS) (who has a large presence in the QLD lifting market and who also has been a substantial shareholder of Boom in the past) is successful at acquiring Boom at $0.20 per share. This represents a ~50% takeover premium for current shareholders. However, as Boom has NTA of $0.51, MCS is likely to record a profit on acquisition of $0.31 per BOL share, as they have acquired $240m of equity for only $94m. No doubt a large profit created by sound capital management would give MCS’s management a tick of approval from their new shareholders. Given its discount, operating cashflow history, relatively lowly geared balance sheet and open register, it seems plausible for Boom to attract some takeover attention.



To me, the epitome of an investment (protection of principal whilst also providing a sound probability of an adequate return) is often found in stocks that have very low expectations incorporated into the share price. If bad news eventuates, the downside is less severe as many were already expecting bad news. However, if good news eventuates, the price is way too low and must quickly rally, thus providing the return. It is these asymmetric opportunities that I love to fill my portfolio with.



Boom is certainly not a buy and hold forever stock idea, nor should one be expecting the price to revert to book value in the near term. My view is that buying at a P/B of 0.20 and waiting for one of the aforementioned catalysts provides a reasonable probability of selling at 0.40 of book (the medium term average) in the next 3 years. If it takes all three, that gives 26% annually. Any sooner is a bonus!

Half Yearly Result Update 

Boom Logistics reported its half year results last week which were on par with my expectations . However, with $319m of equity that is currently generating poor returns, management have some decisions to make.



First, let's revisit the thesis. My attraction was based around the ability to buy lots of tangible assets cheaply, and as the group’s cranes were under employed, disposals and reduced capex were two likely drivers of significant free cash flow. Steve Johnson from Intelligent Investor said it best, 'these businesses have been cash sinks as they grow, they should spew out cash as they shrink'. While it is still early days, it seems management are beginning to gain some traction and the wheels are turning in the right direction. 



Operating cash flow for the half came in at $11m, which was a little below par. It seems clients have been stretching out payments as Booms receivables only decreased 5% while sales fell 23%. Asset sales of $8m were achieved which contributed to $13m of free cash flow, with the majority directed to reduce the debt balance to $102m on a net basis. Importantly, there was no asset impairments and NTA increased to $0.52 per share. To refinance its banking facilities, management were required to conduct a thorough assessment of its assets and to come through without an impairment certainly adds confidence. I will be eagerly watching the full year result for an improvement in operating cash flow and further debt reduction.



I caught up with CEO Brendan Mitchell last week and we discussed an interesting opportunity for further assets sales. There is currently $65m of assets which lay under utilised with the majority idle due to the BMA contract loss. While it seems the preference is to get them re-employed into another contract, management will consider selling the entire fleet if this doesn't occur in the reasonably near term. While conditions remain tough and there is plenty of surplus equipment for sale in the market, prices for cranes haven't plummeted as far as Booms share price would lead you to believe. Indeed, $1.6m of assets were sold for a profit in January. Here lies the opportunity. $65m is nearly 90% of Booms current market cap, however for the sake of conservatism, if we assume a 50% haircut, management could still repay a further $10m of debt and buy back $22m (30%) of stock. This would most certainly reduce balance sheet risk and create immense value for ongoing shareholders.



It seems odd, but I think missing out on further contract wins could work out to be better for shareholders. And if Boom does win work, its not a negative either, creating somewhat of a win-win situation.

Farewell Forge

This week has been a bad one for just about everyone involved with Forge Group, which has officially gone into voluntary administration. 'Sad' and 'mad' are probably a couple more words that employees, shareholders, creditors and counterparties would use to describe how they feel about this extraordinary turn of events. Even though I don't belong to any of those groups, it's depressing to be reminded of how ruinous things can get when companies fail. 

In my last post on Forge, when it was in the middle of its 24 day long trading halt, I speculated on what might happen, and already started to draw some lessons to be learned. Eventually, management spilled the beans, and it wasn't pretty: they would incur a $127 million profit downgrade on the two troubled power contracts, with a net cash outlay of $45 million required to complete them. It seems to me like management didn't have any good reasons for the downgrade - they just completely stuffed up in managing these contracts. Instead of raising money at around the rumoured $0.50 or $0.625 per share level, ANZ came to the rescue by waiving debt covenants, increasing Forge's working capital facility from $11 million to $60 million, and deferring principal repayments. The string attached to the deal was that ANZ would receive 11.2 million warrants (equivalent to 13% of the shares on issue), exercisable at a comical $0.01 each. Essentially, shareholder dilution was far less than expected, but the increase in debt raised the risk profile of an already weakened business. 

Shares started trading again on 28th November, opening at $0.38, dropping to a low of $0.285, rising back up to a high of $0.865, and then settling down to close at $0.685. That's what the price range for a normal stock looks like over a year or two, never mind a single day! From the $4.18 prior to the trading halt, $1000 invested in Forge would have plummeted to just $68 at the low, and $164 at the end of the day, which is one of the sharpest declines I've personally witnessed. Here's what the one year chart looks like.

At that point in time, I think a sensible argument could have been put forth for a very high risk, high reward punt on Forge. If it were to survive and in a few years recover even to a fraction of where it was before, an investor might make 3x or 4x their money, while the most they could lose would be 1x their money if Forge went bankrupt. Were you to apply a 50% probability to each scenario, the mathematical expectancy would compel you to invest. Despite the seductive logic of the numbers and the attractiveness of contrarian bets to value investors such as myself, I decided against an investment (again I thank my lucky stars with Forge), as the situation was just too risky for my liking. 

Securing $40 million in asset management works in North America, reaffirming the $830 million Roy Hill contract was still on track to go ahead, and BlackRock Group (the world's largest asset manager) buying up shares, all served to push the share price to a high of $1.96 on 30th December. There was some serious volatility on this day, opening at $1.10, rising to an intraday high of $1.96 and closing at $1.585. The newfound optimism was cut short with a trading halt on 10th January, followed by the announcement of a further $23 to $28 million writedown on the troubled West Angelas Power Station project. 

Ten days after coming back onto the market, Forge went back into another trading halt. Again, the news wasn't pleasant: instead of the $45 to $50 million pro-forma EBITDA guidance for FY14 given after the first trading halt, it would now be a loss of $20 to $25 million. In other words, the underlying business was expected to lose money. This downgrade was attributed to two more contracts becoming unprofitable, tougher market conditions, and the necessity of managing the business for short-term cash flow. In a sign of the dire situation, management arranged for a shareholder meeting on 4th March to renew their capacity to issue up to 15% of the shares outstanding without prior shareholder approval. Various third parties were disclosed to have taken an interest in acquiring Forge, but in the end all of them walked away. 

Thirteen days later, and Forge is in another trading halt, but this time it isn't coming out. The financiers withdrew support for the company on 11th February, with the inevitable result of administrators being appointed. Forge must have been bleeding so much cash that ANZ had to put an end to the business. Indeed, according to the Australian Financial Review, debts had built up to a staggering $500 million, with creditors such as ANZ and insurance bondholders expected to lose money. With their estimated $200 million exposure and now worthless warrants, ANZ are no doubt kicking themselves for replacing NAB as Forge's main lender in mid-2013. Of the 1753 staff in Australia, more than 1400 employees were retrenched, and it will be difficult for them to find jobs in a weak mining services sector. On the plus side, the sale of Forge's assets, and the Federal Government's scheme will ensure they receive their basic entitlements, while some of them may be able to find work with new contractors. The international businesses in South Africa, Asia and the US will operate as usual until a buyer can be found, so the 814 overseas employees might have a bit more luck. Shareholders are very unlikely to be receiving anything, perhaps a sincere apology from management is all they can hope for. 

Even after going through all these developments, I'm still dazed at how this came to be. If you take a cursory look at Forge's last annual report for FY13, you see a very decent set of financials for a mining services business: return on average equity of 33%, a current ratio of 1.4, $90.7 million in cash, another $10.5 million in term deposits and debt of just $25.7 million (ie. net cash of $75.5 million compared to equity of $213.4 million). One lesson to be learned is that a perfunctory glance at a few numbers or ratios will not cut it - as I outlined last time, there were some warning signs in the financials, and if investors understood how Forge made its money, they would see a much larger degree of leverage. Nevertheless, if someone told me Forge would have $500 million in debt within seven months and had gone into administration I probably would've laughed. 

This business had a very fast rise, with net profit rising from $2.7 million in 2007 to $62.9 million in 2013, but an even faster decline. It reminds me of the pendulum that Howard Marks speaks about in his book, The Most Important Thing, where he tells investors to keep in mind that almost everything moves in cycles and that eventually the pendulum will swing the opposite direction. For a time, the mining services sector was doing quite swimmingly, helping businesses like Forge to produce excellent results, and luring investors into thinking that the mining boom was the new norm. Most people forgot about the cyclicality altogether, but now we have an unpleasant reminder of its distorting effects and that investment adage: what the wise man does in the beginning, the fool does in the end. 

Maybe another lesson to be learned is the role that luck plays in investing. While you could sit here all day and try to scrutinise every piece of evidence with perfect hindsight, I think the biggest factor here was just bad luck. It all started with the problems at the two power contracts, which without inside information, would have been impossible to foresee. This kind of blow up could have happened at many other mining services companies, but Forge shareholders had the misfortune of being in the wrong place at the wrong time. 

My best wishes go out to all those affected by Forge Group's collapse. 

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.”