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%.

Earnings on tap: McRea Industries, Senvest, EUPIC, CMH, Putprop

McRae Industries (MCRAA) recently reported H1 2015 results. Revenue in H1 was $57.31 M versus $58.26 M the previous year. And the gross margin was 28.1% versus 30.9% the previous year. This resulted in a H1 income drop of $3.80 M versus $4.55 M the previous year. Despite the slight disappointment, management tone was upbeat. They attributed the lower margin to two main factors. The first is higher costs associated with hiring and training new personnel, which is encouraging because it says they are expanding capacity. The second is due to higher import costs, which is worrying. One would expect that with the dollar getting stronger and stronger that import costs would decrease. On the other hand if most of their imports is from China then that would not apply as the Yuan is actually appreciating versus the dollar. The company did express optimism that demand remain strong in all product segments, so this year results should be on par with last year's record results.

Senvest just reported 2014 results which was as expected given the company posts the results of its funds monthly. Shareholder's equity at year end stands at CDN$738 M or CDN$264 per share. The company currently trades at 64 % of year-end book value. However, it should be even lower considering that after Q1 2015, the Senvest main funds Senvest Partners is up 7% and the Senvest Israel Partners is probably up around the same. The stock today probably trades at less than 60% of book!

Senvest	year end 2014	year end 2013	year end 2012	year end 2011
Common equity (CDN$ M)	738	565	331	263
yoy equity gain	31%	71%	26%
Employee compensation (M)	32	43	12.5
Compensation as a percentage of equity	4.3%	7.6%	3.8%

Senvest is a steal in my opinion. But, there is a lively debate in stock forums and the blogosphere whether the stock is indeed undervalued. The debate centers on whether the management deserves the compensation for the alpha, or lack of, that they generate for their portfolios. The above table shows the employee compensation (management fees) for the last 3 years and their percentages of equity. The fees are from the consolidated balance sheets which is shared by not just the common shareholders but also the outside owners of the Senvest funds and the minority interests. I estimate that the outside owners pay about 1/3 to 1/4 the management fees. And the minority interest is another 10%. So overall, the common shareholders directly pay around 60% of the total employee compensation. So, with this in mind, the fees are around 2.5% in a bad year, when incentive bonuses do not kick in, and it is around 5% in a good year, when incentive bonuses kick in. I think that is reasonable. Back in the day, when I was still buying mutual funds in Canada, the mutual fund management expense ratios could run as high as 2.5%!

I'll be watching the employee expense numbers closely in the coming quarters as the company also said it is expanding its work force in New York.

European Reliance of Greece (EUPIC:ATH) reported earnings of € 0.37 in 2014 versus € 0.35 a year ago. Equity grew to € 70M from € 58M a year ago. This means that the company is now selling for 1/2 book! No doubt the underpricing is due to the ongoing Greek debt crisis. I definitely need to think of the company's contingencies in the event of a Greek exit from the Eurozone, because if I can access the downside I can have a better gauge of whether this company should really be priced at 1/2 book.

Next up are my two South African holdings. CMH, an auto retailer, pre-announced that 2014 headline earnings would be between R2.04 and R1.88 versus R1.58 a year ago. Actual EPS would be between R1.73 and $1.57 versus R1.57 a year ago. Beyond that the company didn't give any more details. So it appears that the company has some one-time charges in the last year, which lowered earnings in a otherwise excellent year. Today the company trades at 9x earnings.

My other South Africa holding Putprop reported sales in line with last year. But a flurry of news made me just too scared and I sold. I think real estate companies are not for my style of investing and it'll be a while before I'll buy another. In the last six months Putprop reported its primary customer was in arrears with rent. It also announced it was doing a rights offer at R6.30 when the stock was trading at R7.00. However, when the rights offering time came, the stock was trading at R6.20! And several board members were replaced at around the same time. All these borderline red flags and the stock's poor performance made me give up on Putprop.

I Just Bought My Second South Africa Stock

In the last year or two the US economy has been looking stronger and stronger. It is quite clear by now that it is in the middle stages of a recovery from the recession that began in 2008. Unemployment is going down as smoothly as a plane coming in to land. The fiscal deficit is down from the abnormal levels at the height of the recession. Housing inventory is no longer full of bank-owned foreclosures. US manufacturing is making a comeback and US is producing record amounts of oil. Consequently the US dollar is at the highest level in four years. The market appears to be fully aware of this and the US market valuation reflects this economic situation. So though the economy still has room to run, US companies are probably fully valued. Indeed, I am finding it harder and harder to find those knock-out bargains of two or three years ago. That is why I have been buying outside the US recently. This is all a drastic change from 5 years ago, when news pundits were saying that the US will become a banana republic. Well I have a saying: You're never as good as everyone tells you when you win, and you're never as bad as they say when you lose.

I also find it interesting that the market has taken the opposite view of the emerging markets six years ago and today. In the last year or two, money has consistently flowed out of emerging countries. The headlines are full of bad news everywhere you look. Greece has 20% unemployment. Russia doesn't respect shareholder's and will steal or confiscate at will. China has a colossal property bubble. Hong Kong is too close to China to be immune. In fact that goes for every other country in Asia. Japan is growing old and will forever be in recession. Brazil, Indonesia and South Africa all have their own problems which has resulted in high inflation and capital flight. This juxtaposition of emerging markets and the US may be partially based on fact but I think it is also very much a matter of psychology. Someone always has to be a darling and someone always has to be the dog.

One often overlooked market is South Africa. South Africa is the second largest economy in Africa, which is the most underdeveloped continent. Parts of Africa have the most potential to achieve spectacular growth in the coming decades, possibly like what China achieved in the 80's and 90's. South Africa is also friendly towards foreign shareholders. It has an Anglo-Saxon system of law and corporate governance. All financial documents are in English.

	CMH
Price	R 13.000
Market Cap	R 1216.80 M ($ 107 M USD)
P/E TTM	7.8 x
Div yield	6.0 %
P/BV	2.15
ROE	27.7 %
ROIC	12.8 %

South Africa does have the drawback that it is a relatively mature economy. Its GDP growth has slowed in the last year. And the country has suffered some major setbacks in the last year. South Africa is known for having a restive labour force. Strikes are common and can get violent. But this year has seen the most damaging strikes in South Africa history. The economy even shrunk in the first quarter because of the strikes. By now, however, the strikes have ended and the media seems to indicate that South Africa will have a more productive coming year. In view of this, I want to maximize my exposure to the South African consumer. And so I bought Combined Motor Holdings (JSE:CMH).

Combined Motor Holdings owns several related businesses, with the majority of revenue and profits coming from car retail. Car retail in a developing country caters to wealthy and upwardly mobile consumers. In any up and coming country, the people yearn for a taste of the luxuries that they have only seen from afar in the past. In addition, they want to differentiate themselves from their less well-to-do peers. Furthermore, cars in South Africa are even more critical than in more developed countries because South Africa has a primitive road and public transport system.

The Group's other subsidiaries are Car Hire, Marine and Leisure, Financial Services and Corporate/Other. These other businesses are 12%, 0%, 13% and 5% of profits respectively. The Marine and Leisure subsidiary is troubled and it accounts for only 1% of total revenue of the group. Management hinted that it may be sold or closed down.

In the the company report, the CEO describes the company philosophy:

The Group’s management style remains one of decentralised operating and marketing complemented by centralised cash flow monitoring, accounting controls and internal audit. Remuneration of management and staff is linked to performance benchmarks, all of which are closely monitored using internally-generated measurements, and peer group review. The Group operates in sectors which produce very low margins, so tight control over expenses and cash flow is vital to success.

This kind of operation reminds me of Buffett's operations and the businesses described in The Outsiders by William Thorndike. The company focuses on cash generation and increasing value for shareholders.

CMH is a company with good profits but also with a large balance sheet. At any given time the company has more than a billion Rand of inventory. But this is still just a month's turnover. The company has an impressive 27% ROE. And I estimate the company's ROIC is 13%. These numbers hint that the company is profitable in part because of a high debt exposure. However, management has said that all debt is short term. Most of the company's R$ 1.5 bil liabilities is accounts payable or short term borrowings. And all the borrowings are in Car Hire division, secured by its car fleet. I take this to mean that the parent CMH does not guarantee the debt. The rest of the liability is mostly payables for their cars held for sale.

I read the annual reports going back the last five years. The management consistently articulates the company's situation well. The CEO and Chairman have run the company since 1976 when it was a single car dealership.  The directors combined own 70% of the company. They have aggressively used cash to increase shareholder value; they pay a high dividend (6%) and earlier this year, the company bought back 15% of the float at R 13. Share buybacks is a second trait that Buffett likes, and it is the MO of The Outsiders . I think it is possible that this company can be the type of exceptional company described in The Outsiders.

The following shows the per share performance of the company:

CMH - units of Rand per share

As one can see, the company does pretty well for all shareholders even though it is very closely owned.