Tuesday, September 13, 2016

Lessons of the Last Four Years

Wow, it has been a long time - four months - since I last posted. Well, no, I haven't stopped blogging but I have definitely slowed down. I have been busy with work while my investment activity has virtually halted until recently. Besides, I probably needed a break as I have been blogging for four years.

During the last few months, I have reflected on what I've learned in the last four years. For one thing, I am still learning new aspects of value investing. The value investing concepts seem to be straightforward, but different people can interpret the same thing differently and even the same person can interpret the same thing differently at different times.

I have heard from Peter Lynch and Walter Schloss, among others, that an investment needs about 3-5 years to play out. That is a long time to get the feedback on whether you are right. But it's the easiest way I know of to get outsized results. By now or soon from now I can see whether my investment ideas were sound.  One example is Installux. I bought it originally 3 1/2 years ago and it has more than doubled in addition to a nice dividend. Which is as good as I can expect. But I didn't believe this concept as much as I should have.  Take the case of Andrew Peller (ADW:TSX), which I bought 3 years ago at CDN$14. Today it is CDN$32.  But unfortunately, I got impatient and sold and barely eked out a gain.  This is a hard lesson learned. I will redouble my efforts to see my investments through the 3-5 year period.

A second investing concept I've genuinely learned is that buy and hold can mean forever. I read this from in Fisher's book Common Stocks and Uncommon Profits. What it means is that if a company's prospects grow with the price at any given time, then one should hold the stock until that changes. And if that doesn't change then one should hold on indefinitely. This is more of a growth investing approach but one can argue that growth is part of value. Stocks that used to undershoot can now overshoot beyond my wildest expectations. I've learned this lesson the hard way when I sold Phillip Morris (MO) after 12 years. By then this cigarette company had a PE in the low teens.  Who would have thought that cigarette companies now have PE above 20 and MO would triple in the last 4 years!

Thirdly, I often wonder what drives the market of months or years when it doesn't behave quite rationally. And from watching the market for almost 20 years, I have concluded that often there simply is no rhyme or reason for its behavior. Nobel Laureate Robert Shiller drove this point home to me in his book Irrational Exuberance. He points out example after example of long periods of mispricing in different times and different countries because it is human nature. For example, I've owned MSFT off and on for years while its PE was in the teens. Then, over the last 2 years, it expanded to over 20. This hasn't consistently happened since around 2000.  And I cannot see any significant change to the company's growth prospects.  And I cannot even see any good reason why the market changed its sentiment, other than the fact that investors feel bullish about the market.  The market is quite overpriced but I don't feel more money chasing yield is a good reason for a stock to go up. Or at the very least I don't think I can count on excessive multiple expansion for my gains.

The same anomaly can occur in the negative direction. Entire markets can be depressed for as long as a decade. I am not referring to Japan, which one can argue is depressed for good reason. But the Hong Kong market should be much higher because it's price to book ratios are extremely low. And Hong Kong does not have the demographic problems that plague Japan. That gives the Hong Kong investor like me a huge margin of safety.  And I hope this margin of safety will give an edge over other investors who may not be inclined to invest in such markets.  I am also buying and waiting for multiples to revert to more normal values in other markets like Russia.

Fourthly, while concentration is needed to maximize gains, don't overdo it! The concentration argument is that one should bet big when one has conviction. Extreme concentration is warranted only in a few types of situations. For example when Charlie Munger levered to buy BCP, or when Warren Buffett bought the Washington Post.  In the first example, Munger was waiting for the outcome of an impending court decision which would either determine if he breaks even or makes a profit. In the second, the Washinging Post was a diversified media company with many assets which are spread out in different media and different locations. And he knew he could get an offer on those properties if they were for sale. And the Washington Post was selling for a fraction of book.

However, very often people have more conviction than they should. When a person concentrates like this investing becomes gambling because a few events can make or break a portfolio.  The purpose of diversification is to prevent catastrophic loss of the entire portfolio. And often even successful investors make this mistake. And when that happens it isn't just bad luck, it is because they've been playing Russian roulette one too many times.  They may have been lucky for many years but eventually the odds catch up to them.  Earlier I said value investing gives feedback in 3-5 years, so a few feedback cycles can take over a decade, and maybe over that time they may have been lucky.

Recently, the internet chatter has been buzzing with two big disasters: Valeant and Horsehead Holdings. Both were companies with big stories of potential gains. But Horsehead was betting on one plant coming online as the low-cost producer. If that did not happen, well it's complete equity wipeout. And that's exactly what happened.  Valeant was a company with a suspicious business model and it also came crumbling down with a 90% loss of shareholder value.  Those two situations wouldn't have been so bad except that some big fund managers put 20% or more into these stocks! And they threw in new money after the companies started to stink! I think putting in new money was an obvious case of denial.  This was a timely reminder to me that no matter how long I can have success, I should stay diversified.  Bad things happen at the most inopportune times.

I don't know whether my investing strategy will ultimately succeed. However, I will keep learning and relearning value investing concepts. I will also learn the mistakes of others and stay vigilant

Friday, April 8, 2016

2015 Year End Results

By March every year all companies with fiscal year end on Dec 31 should have announced their annual results. Six of my holdings are summarized below. Overall all results are reasonable and make all six stocks overvalued. But I don't know why the market trades these stocks so cheap. I am not one to think too much of catalysts so I have no clue when will it end.

(April 1)
€ 1.49 10.15 CAD$ 125.70 9.20 HK$ 9.20 € 240.00
Marketcap M € 40.98
($ 46.71)
8.12 CAD$ 354.47
($ 270.59)
384 HK$ 2616.20
($ 337.57)
€ 662.40
PE 3.66 4.84 loss 13.15 loss 12.40
ROE 0.14 0.33 - 0.04 - 0.15
PTBV 0.51 1.58 0.53 0.58 0.16 1.89
Div Yield % 0.00 12.32
(one time)
0.00 2.70 2.17 3.54
Vol (basis) 0.51 6.89 1.06 5.52 2.41 4.13

The table summarizes the key metrics. I mostly focus on PE and PTBV. And for each company, one or the other shows the company is cheap. The last row gives the average daily volume divided by the total shares. The fraction is showed in basis points units. So PFHO daily volume, which is 6.89 basis points, is actually 0.0689% of total volume. I have found most companies with healthy volumes should trade at about 20 to 30 basis points (0.2% to 0.3%). The table shows that all the six companies trade at extremely low volumes. None are at 20 or 30 basis points. This may explain why the stocks trade so cheap, they have extremely small interest.

European Reliance Insurance (ATH:EUPIC) continued its growth streak by increasing pre-tax profits by 6.6%. Even better is equity growth at 13.3%. The stock is still super cheap. I presume the reason is the ongoing crisis situation in Greece. Warren Buffett used to say he could find stocks that trade at 2 or 3 or 4 times earnings. They exist now and you just have to look. Well, I found one here trading at less than 4x earnings! On top of that it is trading at half of book. Now if only the market can cooperate.

Pacific Health Care Organization (PFHO) had a rough third and fourth quarter. The stock went from the high twenties to as low as $6.50 after announcing that they will lose their biggest customer Amtrust in Q4. But after their official annual report, the stock managed to recover to $10.15. Q4 results show that subtracting Amtrust's waning revenues in the quarter, the company still did $1.2M in business. So at that conservative trend, the company can do $4.8M for 2016. At their current profit margin of 20%, that is still more than $1 a share. The company said in the report that they employed 36 people in mid-March. That is still more employees than they've ever had except for their record year in 2014. And the company is continuing its IT expansion. I am cautiously bullish on PFHO.

Senvest Capital (SEC:TSX) reported FY15 EPS CAD$(35.39), which is pretty much expected. However, the book value per share increased because of a 19% rise in the Canadian dollar relative to the USD throughout the year. That would give per share book value of CAD$271 at year end. And also with estimated hedge fund losses from the company's 13F and its website, we can expect expect book value after Q1 to be about $237. Today it trades at $127. So the stock trades at 53% of book. That is too low even by Senvest standards. And one big reason for the huge discount is the market's view that the company charges excessive fees. This year has been kind of flat, and so there is little if any incentive bonus. The salary drawn should be all the employee expense on the books which is $12.5M. Other operating expenses, which may include costs for expanding their New York office is $16.8M. I am not thrilled about the expense. But for a company that manages about $1.4B in net money for common shareholders, minority interests and hedge fund holders. One can argue the cost is reasonable.

Kansas City Life Insurance (KCLI) reported for the first time after delisting from NASDAQ. The company revealed it bought back 1.1M shares for an average price of $51.13. The shares included normal buybacks and the odd-lot tender offer of 906,500 shares at $52.50. There are now 9.6M outstanding shares. The company earned $29.2M for the year, which is flat compared to the previous two years. However comprehensive income was $(9.0)M due to unrealized losses in fair value of securities. The comprehensive loss along with the 1.1M reduction in shares, minus the dividend, meant that the book value per share was flat from 2014 to 2015 at $68.55. I anticipate that unrealized gains will be much higher in 2016 because interest rates will be lower than expectations at late 2015. Lower interest rates mean a higher valuation on the company's stock portfolio, with the drawback that the company may receive less revenue as people avoid the company's products due to their low yield.

Soundwill Holdings (HK:878) is a real estate company that renovates and develops buildings as well as lease properties, primarily in Hong Kong. It is dirt cheap on a price to book basis. But last year it turned a small loss mainly due to fair value adjustments on its investment properties and almost no property sales.

Soundwill owns some of the best retail properties in Hong Kong. But rents were ridiculously high. I heard some of their properties were the highest retail properties in the world! But now that less tourists are coming from China, rent prices have fallen. Along with rents the fair value of Soundwill's properties have also fallen.

In 2014, the company sold HK$2.5B worth of properties for a $1B gross profit. But last year they had virtually none. But that could be a simply a quirk of timing. The following table shows the company's yearly property sales as well as the total money held as deposit on properties under development. The sales seem to oscillate every two years, with a high amount on year followed by a low. But the amount under deposit on the low years does seem to foreshadow good sales the following year. So, I expect 2016 to have significant property sales as in 2014.

2015 2014 2013 2012 2011 2010
Property Sales (HK$ M) 10.40 2466.00 199.00 1310.60 483.20 591.20
Deposits 735.00 421.00 1277.00 482.00 529.00 422.00

Karelia Tobacco (ATH:KARE) reported year end earnings of € 19.35 versus € 22.44 a year earlier. Revenues were up 15% and gross margins, net of excise taxes, were up to 14% from 12.7% a year ago. The difference in the bottom line is from a previously mentioned € (14M) adverse tariff decision. The appeal is ongoing which, if successful, would return € 14M to income.

Sunday, January 31, 2016

Playing Anthem-Cigna Merger Arbitrage

The managed care industry is under pressure by shareholders and regulators and the public to decrease costs while increasing coverage for the needy. It has done a lot to that end but the next step looks to be consolidation. Anthem (ANTM) last year announced plans to merge with Cigna (CI) last year. Similarly Aetna (AET) last announced plans to merge with Humana (HUM). These two mergers have the potential to change the managed care industry from five big providers to three big providers.

Revenue Members Notes
United Health$154 B 45.7 M Big on Medicare and Medicaid
OptumRx for perscription benefit
ANTM + CI$117 B 53.8 M ANTM: BCBS provider in 14 states and public exchanges
CI: Medicare and international and national accounts
AET + HUM$115 B 33.5 M AET: strong in Medicare and public exchanges
HUM: Big on Medicare

In this deal, Anthem would give $103 plus 0.5152 Anthem shares for each CI share. The potential value to CI shareholders is shown below. Anthem last year traded in the $125-170 range. The last ANTM and CI values are also shown in the chart. Note that CI is trading $35 below the merger price if the merger is consummated with ANTM trading at the most recent price. This huge discount reflects the high uncertainty of the merger passing regulatory scrutiny. However, in CEO's of both companies said in conference calls they were confident of success.

The deal also has a lucrative $1.85 B breakup fee payable by Anthem to Cigna if the deal cannot consummate by next year due to regulatory snags. That is about $6 to each CI share! In the event that the merger fails due to regulatory snags, I conservatively estimate the CI price to be 13x the expected $8.50 year-end earnings guidance, plus the $6 breakup fee minus taxes. That works out to about $115 per CI share. That is the bottom limit of the chart.

I used a 13x multiple for CI because CI has a better than average profit margin (6%) than other managed care companies such as ANTM. While managed care companies now typically have multiples in the mid to high teens. Based simply on the CEO's comments, I give the deal a 60% chance of success. So to me, CI looks like a easy way to get a good one year return. In addition, I had a large ANTM position coming in. So it was most logical to do a merger arbitrage. Merger arbitrage typically calls for shorting the acquirer and buying the acquiree. So, I sold part of my ANTM position and bought CI. If the deal does happen I grow back part of my ANTM position. If the deal does not happen I own CI which is a sound company in an industry I like, albeit I paid a higher price than I liked.

Monday, January 25, 2016

Buying the Correction: KCLI

I first bought Kansas City Life Insurance (KCLI) almost three years ago simply based on cheap price to book ratio. The stock has yoyo'ed between 38-50 for about 2.5yrs that I owned it. I bought and sold it twice but in July last year they did a odd-lot tender so anyone with less than 250 shares will be bought out for $52.50. It was selling at $44 around the time of announcement. Management did the tender to reduce the number of investors so that they could delist from the NASDAQ. The company began trading OTC on January 1. The company generated a lot of buzz on the blogsphere because it was an easy way for a trader to make up to an $8 spread on 249 shares in short time. That is up to $2000 on each open account. I failed to do so because I was out of my KCLI position and failed to notice it until it was too late!

I am sure many who took advantage of the tender thought it was a really neat trick they pulled on a big corporation. But I bet KCLI management thought they got the last laugh. They were consistently buying their shares back last several years and getting a whole bunch at $52.50 was a steal.

The management hasn't revealed how many share were tendered but their estimate was for about 600,000 shares. That would bring down the outstanding shares down to 10M shares, and raise equity per share to about $70.50. This is an 3.5% annualized growth over the last five years. In addition the company pays 1.5% of equity as dividend. Which brings a total 5% return on equity. And Berkshire Hathaway grew equity by only 4% last year. Still that is pretty sub par for a business but then again, life insurance is like that. KCLI operates with a 6.5% after tax margin. I think KCLI is an average performer. But the stock recently traded in the $36-38 range, which is just 52% of equity. That was the catalyst for me to jump back into KCLI for the third time. If feel the current price is just too cheap. Clearly the management feels the stock is worth more than $50. And there is no reason for it to fall so much lower than before the tender. The company is basically still the same. It now trades on OTC and in its first month there, the trading volume is actually higher than before on NASDAQ. So liquidity is not an issue. The company no longer files with the SEC, which was to save about $1M a year, or about $0.10 per share. But I am sure the quarterly reports and shareholder communication will be the same quality as before.

The half price share discount means the 5% per share equity return is 10% shareholder return. Admittedly this is helped greatly by stock buybacks. The company has reduced share count by 13% in the last 5 years, so it isn't shy about using cash for buybacks. But at 50% of book, buying back shares is getting even more effective.

Deciphering the risk of the company's insurance policies is difficult for me. But I sense the company is extremely conservative. The company is run by the fourth generation of Bixby's. The company separates their policies into two types. The first is premiums on traditional life insurance and immediate annuities, plus a small portion of disability and dental. These have guaranteed payout. The immediate annuity, which has longevity risk, is historically less than 10% of yearly premiums. The second is deposits type insurance such as universal life, variable life, variable annuities which have a surrender value and depend on market conditions. These have guaranteed interest rates which may cause KCLI losses if interest rates change violently. But that is a very unlikely scenario.

The company's investment portfolio is also very conservative with 77% in fixed-income.

Overall, this is a very conservative company that is at the virtual bottom of any reasonable valuation. So, I think of this as a very safe investment with upside, almost like cash with benefits. Such an alternative for cash is very useful in this down market where I want liquidity handy to buy really depressed stocks in case the markets drop further.

Sunday, December 13, 2015

Warren Buffett's 1962 Short Positions

I have collected number of article on long positions from the Buffett Partnership Limited in 1962. But that year he had also a few short positions. He explained them in his 1963 letter to shareholders:
You will note on our yearend balance sheet (part of the audit you will receive) securities sold short totaling some $340,000. Most of this occurred in conjunction with a work-out entered into late in the year. In this case, we had very little competition for a period of time and were able to create a 10% or better profit (gross, not annualized) for a few months tie-up of money. The short sales eliminated the general market risk.

The $340,000 worth of shorts were in four securities. The bulk of the amount was in Insurance Company of North America (INA) and Hartford Fire Insurance Company. INA has a long history going back to 1792 and it is known today as CIGNA. Hartford Fire still exists today and is simply known as the Hartford. The two companies were very similar. Both were large insurance companies with long unblemished histories. Both had rock solid balance sheets. Hartford traded at $68 1/8.[edit] Its liquidation value was $56 per share. It wrote about $50 of premiums per share at the company level (non-consolidated). INS traded at $94 1/2 and had $58 of equity per share. It wrote about $40 of premiums per share at the company level. Both companies consistently had combined ratios of close to 100%.

Clearly, Buffett was looking for large companies whose stocks weren't volatile and would not rise as much if the overall market climbed. But it isn't fully clear to me what he meant, especially when I don't know which workout he was referring to. There are a number of candidates. One is British Columbia Power (BCP). Another is Texas National Petroleum (TNP). Another is Lehigh Coal and Navigation. For more about these refer to my master list of Buffett Partnership Investments. And there could be others that I don't know about.

But Buffett has said that workouts are supposed to bring gains that are independent of the market overall. So, he doesn't need the exposure to market risk, be it to the downside or upside. So his shorts were positions designed to negate market movements on $340,000 of workout exposure. Plus the shorts give him leverage; he has $340,000 more to put into the workout situation. But I don't see how his workouts are exposed to market risk. Both BCP and TNP pay out fixed amounts of cash regardless of market conditions.

I will probably discover more about Buffett's workouts as I research more of his investments from 1962. And if anyone has any suggestions to add, please put them in the comment section.

Saturday, November 28, 2015

A Look Back at British Columbia Power

British Columbia Power was a interesting story back in 1962. It was one of the biggest positions of the Buffett Partnership at 11% of total assets. It was a Canadian company going through an acrimonious court battle with the British Columbia government. At issue was the company's very existence.

The newly formed British Columbia government of WAC Bennett wanted to expropriate the assets of BCP, which was the largest electricity generator in BC at the time. The Bennett government wanted to control and expand hydro power generation in British Columbia by constructing new dams along the Peace River and eventually exporting the power to the US. To this end the government expropriated BC Electric which is BCP's wholly owned subsidiary. The government paid BCP $110M for BC Electric. And it promised BCP that in the event BCP ceases to be a going concern because of this action, it will pay a further $62M. By 1962 it was clear that BCP wanted more for its assets before it would dissolve. At 1962, the BC government was already in control of BC Electric for a year. And BCP was fighting the Bennett government in the courts for all that time. The BC Supreme court was due to render a verdict sometime in 1963. BCP had already received $110M in 1961 and distributed $89M of that to its shareholders in 1961. The company received the remainder of the $172M in 1962 but under protest. The BC Supreme court was to decide whether $172M was enough compensation, or whether it should be closer to the $225M BCP was asking. By 1962, the equity on the books was $95M. That works out to $20 per share — in this post all currency are Canadian dollars, which was equivalent to $0.925 USD back then. The 1962 high price price for BCP common shares was $20 58. In other words, the company was trading at book value without any money making assets. It simply had the half of BC Electric proceeds that it hadn't yet distributed plus the hope of additional compensation the court would award.

It is against this backdrop that Buffett bought his large position based on Charlie Munger's recommendation. The following is an excerpt from The Snowball by Alice Shroeder:

Munger did enormous trades like British Columbia Power, which was selling at around $19 and being taken over by the Canadian government at a little more than $22. Munger put not just his whole partnership, but all the money he had, and all that he could borrow into an arbitrage on this single stock —but only because there was almost no chance that this deal would fall apart. When the transaction went through, the deal paid off handsomely.

I don't think that description is totally accurate though. BCP was trading at around $19 USD but there was no guarantee the court would rule in its favour and even if it did no one knew exactly how much. But Munger, being a lawyer, probably had a hunch that the company would get a favourable ruling and bet heavily. In any case, there was no downside. The money for BC Electric was in the bank; so, BCP wasn't going to get BC Electric back.

In the end the court ruled that the expropriation was illegal and the two parties eventually settled on a $197M price. This is $25M more than the expropriation price. Each share would eventually get $25.50 or $22.20 USD before disollution.

I think this case shows merger arbitrage with minuscule risk. And how Buffett and especially Munger would bet big in such a situation. Buffett got a 15-20% annualized return on his investment and Munger did much better with leverage.

Friday, September 25, 2015

Hong Kong and Greek Portfolio Update

I haven't posted the results from my holdings for a while. And there has been a slew of them. Almost all of them have not disappointed. But their stock performance has been disappointing. I guess that is the hard reality of investing in out of favour markets.

The Greek crisis that has resurfaced this year has stained my nerves. But my two Greek holdings have held up very well. European Reliance (EUPIC) reported H1 revenues up 7% yoy. Such revenue numbers are very encouraging considering how the Greeks are strapped for cash. On the other hand, I am not surprised that a consumer insurer does well in Greece because it fills a void left by the very cash strapped government. The H1 earnings are down slightly from $0.15 to $0.125. The difference was mainly due to higher operating expenses, in part because the company hired more staff. The company currently trades at 1.9x book and 4.2x TTM earnings. This company is one of the cheapest stocks I own. And I am very pleased that the company recently has begun to publish all their investor information in English.

Karelia Tobacco (KARE), also based in Greece, also did very well in H1. This one is less surprising considering that the company gets most of its revenue from exports. In addition, smoking is a mostly recession-proof industry. The company report H1 revenue up 15% yoy. Net revenue (without excise tax) was up an incredible 28%. Earnings went up only 3% mostly because of an adverse court decision regarding duties. The company said that they will appeal the decision even though they have already expensed the loss. Without this decision the H1 profit would have been around $12 per share instead of the $8.52.

In following Greek news through the crisis I also learned that Greece is a society with an all powerful elite. The Karelia family sure counts as part of that group and that is wonderful. They will defend their business interest from all the nonsense happening in the country. So that if the country somehow implodes, the company will find a way to do fine and protect its wealth, and by extension my shares also.

The Hong Kong stockmarket is down in sympathy with the turmoil in China's markets. I feel Hong Kong has some of the most undervalued stocks anywhere today. My two Hong Kong stocks are currently trading at very depressed values. Soundwill Holdings (HK:878), which owns some of the best retail properties in Hong Kong, reported H1 earnings that were similar to last year. Considering the China turmoil I am very happy it wasn't worse. Soundwill typically depends on the mainland China shoppers to to buy the luxury products and dine sumptuously at their prime rental locations. So, there will be downward pressure on rents now that the Chinese government has clamped down on illicit income and China's economy is slowing down. Anecdotal evidence says that some rents in prime locations are down 10-15%. That said Soundwill's rental income has actually increased yoy, albeit slightly. So, I don't see why the stock is trading at a ridiculous HK$9.50 today! Below I show how much the balance sheet is worth per share. Compare that with Hk$9.50 per share!

Soundwill HK $ per share
Assets Property under development12.00
Other current Assets3.39
Investment property56.00
Other non-current assets1.00
Liabilities All Debt8.08
Other liabilities4.88
Equity to shareholders58.34
Minority Interest1.09
6 Month EPS1.02

Someone who is still turned off by the stock can point to the overpriced real estate market. An overpriced real estate market means Soundwill's assets are overstated. Still the margin of safety is so big I believe Soundwill is a steal. And the company is regularly turning over its real estate. In the H1 report, the company said it will convert HK$0.75 per share of this investment properties into cash through a sale that is expected to close in the latter part of 2015.

My other Hong Kong stock is New Century Group (HK:234). The company is profitable and also has a tremendous balance sheet. It trades at 14.1 ¢! Below shows the balance sheet and note that the vast majority of the debt is an interest free loan from the majority owners.

New Century Group HK ¢ per share
Assets Equity investment6.6
Other current Assets1.3
Investment properties10.9
Other non-current assets1.5
Liabilities All Debt2.7
Other liabilities1.1
Equity to shareholders25.5

The company announced recently that it will acquire a cruise liner in addition to the two it already owns for about HK$170 M. That is approximately 1/3 of the company's available cash. But the purchased cruise liner has generated charter income of about HK$20 M in each of the last two years. So that is a greater than 10% return on investment if it continues. I think it is a very reasonable way for the company to deploy its cash.