Thursday, November 15, 2018

Why I Shorted the S&P500

The S&P 500 now has returned around 0% this year-to-date. This is Trump's second year in office and the euphoria from his economic policy changes has worn off. As I mentioned throughout much of the year I have had a significant short position on the S&P 500 index. So I have luckily come out slightly ahead in this position. So effectively I am running a long-short portfolio. Counting only my long positions, I am very much at less than 100% invested in stocks. And counting the short position, I am at even less exposed to the market. So, the purpose of the short is to remove my exposure to stocks since my primary market, the S&P 500, is way way overpriced. In this way I can still play the stock picking game while at the same time shield myself from the correction that I feel is just around the corner.

I have seen two major US corrections and I have come to realize, by living in the US, that the euphoria for the markets is bound to come once or even twice every generation. I am seeing another case now. The US is simply at an unsustainable level. My reason for this is grounded on the principle that a stock investment should be based on the value of the company. And this value is the present value of all future cash flows. This is a basic value investing principle.

So the S&P500 index should be priced at the present value of the cash flows from of its constituent companies. The latest TTM earnings of the S&P 500 is only 122 whereas the index is at around 2700 today. That means the entire index is trading at PE of 22! This is way over the normal traditional range of 15. And 15 is being very generous. I want to use this latter PE multiple to help get an estimate of the potential return of the S&P500 over the near future, say 10 years.

The future cash flows of a stock, which reflects the value, is somewhat reflected by the earnings of that stock. If the earnings grow by a certain percentage every year, then the value of the stock should grow by that amount also. I will be generous and say that the S&P500 will grow earnings by 5%. I will also be generous and say that the S&P500 will yield 2%. Therefore, from just this data, we can see that the S&P500 will return around 7%. Not bad but not great either considering I keep hearing returns have traditionally been around 10-12%.

But there is still a flip side to the investing reality: the index is at a very high PE multiple now. It must return to more normal levels. Say it returns to a more traditional, albeit still elevated, level of 15. That means for the same earnings, the stock prices will have to drop by 68%! If this happens in 10yrs that is an annual drop of 2.5%. That is a lot considering that the return I just derived was only 7%.

And wait, it gets worse.

All investors will constantly face three impediments: inflation, taxes and fees. So far, I have not mentioned them in calculating returns. Firstly, there is inflation. Inflation is a fact of life and is often ignored when talking about returns. The reason for this is that inflation varies from year to year and to simplify discussion, we talk in terms of nominal returns. Nominal returns are the opposite of real returns which fact in inflation. The 10-12% return commonly touted is always the nominal amount.

The second impediment is taxes. We can avoid this temporarily by investing in tax-sheltered retirement accounts, but there is a limit to how much we can put in such accounts. We can also reduce it by holding stocks for a long time, if not forever. And there must be many other creative ways of avoiding it, for example by cheating on taxes. Because of this variability, I will only look at dividends, which is forcibly taxed. Suppose the tax rate on dividends is 30% and suppose that half of one's portfolio is not tax sheltered. Then using the 2% dividend number, we will pay 0.3% of our portfolio into taxes.

Earnings growth +5%
Dividend yield +2%
PE shrinkage -2.5%
Expenses-0.2%
Taxes on dividends -0.3%
Net return 4%
10 yr net return 48%

Thirdly, there is the fees. This is the most manageable impediment. How much one saves depends on how much effort one expends. I depend on myself for all my financial decisions, I hardly own any funds or ETFs. Therefore, the only fees I pay are transaction fees, currency exchange fees and travel costs to visit companies. All this I estimate is only 0.2% of my portfolio. And subtracting all this up gives me a net return of 4% per annum or 48% per decade. See table. I bet this will be an incredibly low number compared to the average retail investor's expectations. In the long term, stock prices will be grounded by the PE ratio. When the current euphoria subsides and reality sets in, the mood of the market will probably cause prices to fall significantly below the 4% estimate, maybe it could even turn negative at the end of ten years! In the given calculations, I said that the PE shrinkage from 22 to 15 would result reduce returns by 2.5%. If the PE went from 22 to 11.5, the nominal return would not be 4% but 0%!

It is easy to see why I shorted the S&P500.

Sunday, July 1, 2018

Portfolio Update


This blog is so devoid of recent entries that I felt compelled recently to post something, anything. Fortunately I have a lot of odds and ends I can update on my portfolio and the market in general.

After riding high under Trump for a year, I am convinced the US market cannot go any higher. The Shiller PE ratio is at a mind boggling 32.3! That is higher than anytime before the great depression and is only surpassed by the dot-com bubble in 2000. On the other hand, I have holdings that are still reasonably valued overseas and even some in the US. Plus I hate paying capital gains taxes. So, instead of selling a lot I settled on hedging the US market. After all, this is a perfect time to short the US market if I am convinced it cannot go any higher.

I hedged the US market by shorting the S&P500 mini futures. Each of these futures is a contract to buy or sell a contract that will pay out $50 times the S&P 500 index on the delivery date. So suppose on the contract expiry the S&P500 is 2700. Then the contract would conceptually pay out $135,000. In reality the contract settles financially everyday, so the original purchase amount and the settlement payout do not happen but instead the delta in the value of the contract is debited or credited at the close of each trading day. So far I am turning a profit shorting the mini futures. However, I really prefer that were not the case, as each gain means an overall downward bias in my portfolio. But it only confirms my belief that the market cannot go any higher.

 A Prussian general once said that "No battle plan survives first contact with the enemy". I feel that way looking back at my first merger arbitrage situation , between Anthem and Cigna. As it turned out, all the forecasts about its chances of success were too optimistic. The merger fell apart after various state governments voiced objections and sued to block it. Despite this, I fell into the golden period for managed care organizations and both companies rose handsomely. I have since sold my Cigna shares. So the moral of this story is that with careful thought and due diligence, even if I am wrong in my predictions, I can still come out ahead. The S&P 500 hedge is another play from this same playbook.

In addition to the hedge I have also reduced my exposure to US companies whenever he opportunity arose. This was the case with IEHC and Senvest.

While the S&P 500 and my US holdings have done wonderfully since Trump's presidency. My international holdings are a mixed bag There have been laggards such as Lewis Group of South Africa. And there are some wonderful stocks, such as Installux, European Reliance, Tachibana Eletech and Riken Keiki. I have listed the basic metrics of some of my international holdings below.


Tachibana Riken EUPIC Installux Lewis CMH
Price ¥ 2028.00 ¥ 2504.00 € 3.47 € 415.00 R 31.20 R 27.50
Marketcap
($Mil)
¥ 51105.60
($ 461.66)
¥ 58092.80
($ 524.78)
€ 95.43
($ 110.79)
€ 125.83
($ 146.09)
R 2602.08
($ 190)
R 2057.00
($ 150.2 )
ROE % 6.4 11.2 13.8 9.7 4.8 35.6
PE 13.1 14.1 6 14.5 9.9 8.3
PTBV 0.84 1.67 0.94 1.39 0.49 2.97
Div
Yield %
1.97 1.2 3.46 1.93 6.41 5.85


Note that all these companies, with the exception of CMH of South Africa, all have very little debt. The companies whose stock appreciated significantly did so with a combination of increased profits and multiple expansion. I am still waiting for that to happen in my South African stocks. I have not wavered in my belief that the long term future of world economy is in the emerging markets. But in the meantime while I wait, they are yielding 6%.

Thursday, March 1, 2018

Why I Bought Adrenna Properties

Once in a while a company a catches my eye because of its performance relative to price. But the company ownership structure makes it not feasible to buy. I remember one German company I saw once with very attractive returns relative to stock price, but it is 99% owned by a single entity. So I didn't want to buy because the price does not reflect the fundamentals but whatever a few small retailers value.

Recently I found Adrenna Property Group (ANA:JSE). Adrenna is a South African Property investment company. Its properties are business and residential held for rent buildings in the Cape Town area. Cape Town is the capital of South Africa and is a relatively affluent city in South Africa.

The whole Adrenna story started in 1999 when the Quyn Group first listed on the Johannesburg Stock Exchange in 1999. At first it was a recruitment and outsourcing company. Then Quyn acquired the Colliers group of companies in South Africa and changed its name to Colliers South Africa Holdings Limited. Initially the combined company struggled and decided to delist in 2004. Later, after some major restructuring and some decent results, the company changed its name to Adrenna Property Group Limited in February 2012, and it relisted on the JSE.

From that time onwards, the Adrenna has steadily improved its results. And that caught my eye. The following shows the results in the years following the relisting. All monies are in units of millions. Note that the company has consistently reduced debt while increasing equity through fair value appreciation. The capitalization rate is the net operating income before interest and revaluation divided by the property value.

 
TTM 2017 2016 2015 2014 2013
Price R 1.00 R 1.55 R 0.65 R 1.45 R 0.80 R 0.40
Shares 55.9 55.9 55.9 55.9 55.9 55.9
Equity 151.1 146.5 125.4 117.6 110.1 98.2
Earnings TTM 19.5 21.1 7.9 7.8 12.2 10.5
Marketcap R 55.90 ($ 4.58) R 86.64 ($ 7.10) R 36.34 ($ 2.98) R 81.05 ($ 6.64) R 44.72 ($ 3.67) R 22.36 ($ 1.83)
ROE 12.9 14.4 6.3 6.6 11.1 10.7
PE 2.9 4.1 4.6 10.4 3.7 2.1
PTBV 0.39 0.62 0.3 0.73 0.43 0.24
Div Yield 0 0 0 0 0 0
BVPS 2.7 2.62 2.24 2.1 1.97 1.76
Debt 0.4 0.37 0.52 0.53 0.63 0.84
Cap Rate (%) 8.2 7 6.7 4.8 6 6.4


The company actually has high earnings through fair value reappraisal. So beware when looking at the incredible PE numbers!

The company's cash flow mostly pays for expenses and interest on debt.  South Africa is a country with high inflation and therefore interest rates are also high. The company's operating income is 2.5 times interest expense. This ratio is a bit lower than I'd like but it is still acceptable.

So Adrenna looks very cheap, but is there a catch? And indeed, there is a problem when investing in Adrenna. That problem is the company's market cap. The company's five largest shareholders own 72% of the company. They include two board member and affiliated entities. This is encouraging in that the board has aligned interests with the average shareholder but it also means there is very little float, possibly much less than USD $1 million. Still I have built as large a position as possible without excessively moving the stock price. Hence, I regard my position in Adrenna as only a trial run of my investment approach because this is not a stock I can buy in size.

Saturday, November 18, 2017

Latest Earnings from Four Holdings

I usually write about my investments' latest financial results once or even twice a year. Recently I haven't done that. So, I will catch up on four of these today.

McRea Industries is a shoe company that sells military footware, industrial footware, and ladies luxury cowboy boots. The company occupies a niche in the military footware space because US military boots must be made by US companies. So, McRea has a North Carolina manufacturing plant devoted to supplying the US military with boots. The rest of the company's manufacturing is in Asia. Obviously, Asia can manufacture footware cheaper than any American company. These boots include women's luxury cowboy boots, industrial footware and even military boots that soldiers can purchase as spares.

McRea's sales has been flat and its mix of military to luxury boots has tilted to military in recent years. This is bad news because the military boots have lower margin. The overall sales of the company has been $104 to $108 M for the last 3 years. So it is basically flat. And the net earnings is down to $5M from $6.6M 2 years ago.

MCRAA SEB PFHO Installux
Price 34 4350 13.45 € 415.00
Marketcap (M) 81.6 5089.5 10.76 € 125.83 ($ 148.60)
ROE (%) 6.9 9.6 14.3 11.2
PE 16 15.6 11.7 12.9
PTBV 1.14 1.5 1.67 1.45
Div Yield (%) 1.53 0.1 0 1.93
Price/NCAV 1.27 2.18 1.71 1.97
The table on the right gives the financial metrics for McRea (MCRAA) and three other companies. The company has had a recent run-up which I cannot really understand because the fundamentals have not changed. The only plausible explanation is the general change in sentiment towards tiny microcaps in our long powerful bull market. But overall, my opinion is that this company is quite fairly valued for a shoe company.

The way I see it, the company can only increase its earnings if it increases margins and efficiency in the military boot segment. And it appears to be doing that. Last year the company had $27M of inventory and this year it is only $18M. This helped to increase its cash position from $16M to $28M yoy.

Seaboard Corp (SEB) is a food conglomerate that I have owned for over 15 years. I have always seen it trade at about 10x earnings. But in this bull market it has jumped to 15.6x. The company's management has proven itself to be disciplined and shrewd capital allocators. But it is still a commodity producer. The company currently still drives 75% of the operating income from pork. We have had food deflation for the last several years. But pork has actually benefited as the cost of feed (i.e., corn) has dropped much more than the cost of pork products, hence the decent earnings in recent years. But commodities are always cyclical and things can and will turn. I just don't see how this stock can go any higher.

Pacific Healthcare Organization (PFHO) is in a two-year recovery after losing Amtrust, a huge customer in 2015. Thus far it is doing just fine, earning about $0.30 a quarter for the last three quarters. And it has a great balance sheet, with $7 per share in cash and no debt!

And last but not least on my list today is Installux (PAR:STAL) . Installux has been a star performer in my portfolio. In the five years that I have owned it, the French maker of aluminum building products has increased sales marginally. But profit has increased by about 9% per year in those years because of increased gross margins and increased profit margins. The company's metrics are still quite good and it has € 130 per share cash and no debt.

Sunday, October 22, 2017

Calculating Lifetime Returns Using XIRR

I feel that one big purpose of the many investing forums, blogs and financial articles is to bring basic financial information to the masses. Consequently there can be a lot of repetition of information. In this post, I will describe a useful financial tool that is known to seasoned investors. So, this post is for those who may not be familiar the topic.

In the investment world we need a simple way to measure the performance of a portfolio. People in finance often refer to it as the compound annual growth rate (CAGR). This is for example very important measure when a investor chooses his mutual fund. From my experience almost all investors look at the 1, 3, 5 and 10 year CAGR that are mandatory in all official fund reports.

The definition of a CAGR is easy to understand in the mutual fund literature. They describe the growth of a $10,000 investment in a fund from, say, 5 years ago to today and calculate the average annual return of that investment assuming all distributions are reinvested. This CAGR is the equivalent annual interest of a daily compounded savings bank account over the same 5 year period.

For example, as of their annual report ending June 30, 2016 the Bruce Fund reported a CAGR with dividends and distributions reinvested of 9.7%. This means that a $10,000 investment fives years ago would be worth $15,866 on June 30, 2016 because 1.0975 is 15866.

So far so good, but real-life investors have cashflows in and out of their investment portfolios. How does one find a CAGR of their portfolio to see how they are performing as their own portfolio manager? To do this we need a clear definition of the CAGR of a portfolio with arbitrary cashflow. I see my own CAGR as given above. It is the the equivalent annual interest of a daily compounded savings bank account over the period in question given that the hypothetical bank account receives the same cashflows as my real portfolio account.

I find this result extremely useful because it tells me how much return I will need if I save diligently and I have some retirement goal in mind. For example, suppose I am 60 years old and I want to retire at 65. Over the next 5 years I will contribute $20,000/year to my retirement fund. My retirement fund now has $200,000 and I want to have $400,000 at 65. What return do I need?

The answer is simple using the xirr() function available in all spreadsheet programs such as MS Excel. The xirr() describes the returns given cashflows. The following is the way to enter the data.
  • Each cashflow entry should have a date and an amount in one row.
  • Each cash flow entry into the retirement amount should be a negative amount.
  • Each cash flow entry out of the account should be a positive. 
  • The final entry should be a withdrawal of the remaining balance on the account.

So in the above example, assuming that I begin on 4/15/2017 at the age of 60 my initial account balance is $200,000. And on each anniversary I add $20,000. Then on the 5th anniversary, my account has a $400,000 balance. The cashflow entries are entered in order each on a row. As shown below. The xirr() function takes two parameters. One is the region containing the dates of the cashflows, and the other is the amount of the cash flows. I entered the following in my example: =xirr(a1:a7,b1:b7).

And the xirr result is 8.55% in the example shown in yellow.

      A B
14/15/2017-200000
24/15/2018-20000
34/15/2019-20000
44/15/2020-20000
54/15/2021-20000
64/15/2022400000
7
8XIRR:8.55%


The xirr() function can also tell me how much money I will have at retirement given that I can achieve some return. In the above example, I can calculate how much I can have if I can improve my returns to 10%. To do so, I would simply replace different values for the final withdrawal until the xirr value is 10%. The current final withdrawal value in this case is 400,000.

Note that the values of deposits and withdrawals can be any amount and at any time.

Knowing the CAGR for all cashflows is an extremely tool that can answer what a return really translates to in terms of wealth. And it can also be extended to compare the value of future cash streams such as annuities or defined benefit plan such as social security. In doing so, this tool gives the average consumer an objective way to compare different types of retirement products. It can make more clear many financial products that, I feel, are designed to obfuscate the and confuse the consumer through complexity.

I hope you will find this as useful as I do.

Saturday, September 30, 2017

My 6th Annual Schedule of Investments

So five years on, I am still posting. On each anniversary of my blog I list my dozen or so largest holdings. See this link for my past year holdings.

Position Category Business
Senvest Capital (TSX:SEC) Canadian SmallcapInvestment Company
Anthem (ANTM) US Large capHealth insurance
Seaboard Corp (SEB) US Mid capFood Conglomerate
Installux SA French microcapManufacturing
Tachibana Eletech (TSE:8159) Japanese SmallcapElectronic Distributor
European Reliance (ATH:EUPIC) Greek smallcapInsurance
IEH Corp (IEHC) US MicrocapManufacturing
Kansas City Life (KCLI) US Small capLife insurance
Riken Keiki (TSE:7754) Japanese smallcapManufacturing
McRea Industries (MCRAA) US MicrocapFootwear
New Century Hong Kong (HK:0234) Hong Kong Small capHotel, cruise line
Pacific Healthcare Organization (PFHO) US MicrocrapHealth insurance
Bruce Fund (BRUFX) Mutual fundMid-cap value


I am posting less now because I have been busy with other things and because I have less new things to say. I also don't have much to comment on my holdings. I have not found anything new in the last two years. The above table is basically a reshuffling of my past year holdings because of changes in their value and, to a lesser extent, some trades. In particular, I have sold a chunk of Mcrae and PFHO. I sold Mcrae because the company hasn't grown sales much and their stock experienced a recent spike. PFHO I sold at $10 after buying a bunch below $10. Of course I regret that one as it is now almost $15. But I remind myself that in a bull market, every sell you make is a regret in the short term. In the long term, well that's another story.

Thursday, June 22, 2017

Anne Scheiber, the Secret Millionaire


I first heard of Anne Scheiber from a magazine article about her in 1995, shortly after she passed away aged 101. Anne Scheiber was the first example I have heard of a hidden millionaire.  Hidden millionaires are low profile people who grew up in average circumstances and did not rise up very high in their careers, who lived very ordinary frugal lives. They are the sort that others never expect to be rich. But when they die, people with something to do with their estate are surprised to find out they were multimillionaires.

Scheiber died with a $22M fortune.

Because Scheiber was low profile and did not have any close relations, there isn't a lot known about her century of life. She got attention in the news because she donated her fortune to the Yeshiva school to help women like her. The school had never heard of her. What is known is that she spent her entire working life as a IRS auditor. She was great at weeding out corporate tax cheats. But despite her contributions, she never got promoted at the IRS. After she retired in the 1940's she lived a simple life in New York until her death. According to the article, she learned from years of auditing that the wealthy all invested. And that inspired her to focus on investing in retirement.  The articles described Scheiber as a miser and a recluse.

The part of the story that estimates her returns gets a bit fuzzy. The story is that she started with only $5000 in retirement and turned it into $22M which would give her a 17.5% rate of return!  That beats the like of Walter Schloss!  But after digging around in Wikipedia, I read that she probably started out with much more at retirement. And her return was probably around 13%. Her return is still phenomenal because out-strips the US market by about one percentage point. Incidentally, that's exactly the type of returns I want. Her investment style is the Warren Buffett style of buying quality companies and holding for the long term, like a lifetime!

I read about her before I had ever invested. And that article had a tremendous influence on my thinking towards investment. It helped me to start early down the investment path. Although value investing and stock picking didn't come until much much later.

I've thought about her many times since I first read about her, and my burning question is whether she was happy in her retirement years while she was accumulating her secret millions. My best guess is that she felt a tremendous sense of purpose and it was that purpose more than anything else that helped her to live to such a ripe old age.

Although Scheiber was the first secret millionaire I've heard of, she is not the only one. Every once in a while I hear of others. Like Ron Read of Vermont who was a veteran and who worked as a janitor and gas station attendant. He died at 92 worth $8 M. And I am sure there are many more that we have never heard of.