Wednesday, August 28, 2013

Portfolio performance update for 1H 2013

Here's our belated portfolio's performance for the first half for 2013. I apologized for the delay.

Our portfolio enjoyed a good first half. We managed to do our own things while at the same time, manage to keep up with the market with a slight outperformance. The slight outperformance is masqueraded by our relatively significant portion of cash (more on this later). Throughout the first half (even up to now – end of August), we hold a relatively substantial cash reserve of a minimum of 25% cash in our portfolio at any point in time. Our position in cash is not just for show at period-end. In fact, we have maintain such cash reserve since the third quarter of 2011 with the reserve varying between 19% to over 43%. On average, we maintain between 25% to 32%. We will have no qualms to increase it substantially. So we are about 70% to 75% long in stocks most of the time since the third quarter of 2011.

The reason why we say that our overall portfolio's performance is masqueraded by our cash reserve can easily be explained just by examining our pure performance in equities. The following table shows our performance in equities without taking cash into the picture.

The table shows our equity performance excluding the effect of cash which tends to be a drag to our overall portfolio. However, we are happy to hold a substantial reserve primarily to wait for a better set of opportunity to deploy our reserves. Cash, to us, is the safest hedge when 1) there is a turmoil in the market, 2) when rare opportunity arises. Without cash, or substantial cash reserves in relation to our overall portfolio, we cannot 1) take advantage when an opportunity comes along, or worse, we may need to force ourselves to chose from our existing holdings and decide if the alternative is better and make a wrong decision; 2) we wouldn't be able to make a difference to our overall result for the long term if our cash is only a small portion when opportunity arises. Importantly, our cash position is primarily dictated by what we can find in the market. For example, if we have only less than 5% of cash during January 2013, we will not be able to take advantage of the severely undervalued shares of Starz when it was first seperated from the core Liberty Media business. We subsequently bought about a 5% position in Starz. So if we had only 5% of cash, we would have depleted all our cash – but for most people, I don't think you would spend all 5% in a single stock if you have only 5% cash, unless it is selling for 10c on the dollar. So more likely, if you have 5% cash, you may use 20% of it or 1% cash to purchase the position? Or at most 2.5% of the remaining 5% cash which is 50% of your remaining last bullets. But since we have about 25% cash back in January 2013, we can afford to spend 5% of cash in that position or about 20% of our remaining cash/bullets back then. So if you have 5% cash and use 1% to buy, that 1% would not have much effect on your overall performance in the long run even if it returns 40%. But if you have 25% cash and spend 5% of it, a 40% return would be much more meaningful to your overall performance.

The following table shows the breakdown of our portfolio by asset classes and regions in which our equities are invested in.

A thing to note on our cash reserve - even though it is down a percentage point, our cash reserve in absolute amount is actually up by almost 10% in the first half, i.e., we were a net-seller of equities but not by much.

Here's our stock of significant positions:

From the table, our top 5 positions makes up almost 75% of our equities' positions, and 56% of our total portfolio. We hold a relatively concentrated portfolio for equities although we have a total of 22 stocks in our portfolio.

Of the 5 stocks, 4 of them, readers should be familiar with. We will discuss a little more in detail on why we like Overseas Education. OEL operates an international school in Singapore. The economics behind the foreign school system in this part of the world is highly recession-proof and low price sensitivity with high predictability in revenue. We wish we have discovered it early in February when it was newly IPOed at $0.48, but we only learnt about the business a few months later when it was selling for $0.69. But even at $0.69, it is only priced at 13.8x for last year earnings, and about 12.3x for our expected this year earnings. At a low teens multiple for a business that has high to low teens growth potential, we think it is a very good bet. In the latest quarterly report, OEL is increasing school fees by 8.5% starting from August for the new academic year. OEL has historically been able to increase fees over and above the general inflation rate as demonstrated by 1) about 10%, 7% and 6% increment for academic year 2012, 2011 and 2010, respectively.

So what drove our returns in the first half? The following table speaks for itself.

Over 81% of our return in the first half were driven by 5 stocks (4, if you will, as we view both Mastercard and Visa in combination viewed through the lens as “card network players”).

If you compare to our earlier table showing our top equities' positions, Starz is not there because we have divested fully our stake at an average of about $22.2 after trading cost for a gain of 42%, over a period of 4-5 months. In fact, our gain could have been much higher had our brokerage not had some rules which restrict certain stocks to be purchased. In Singapore, the local brokers maintain a list of restricted foreign stocks, and this includes newly IPO stocks or new spinoffs (which includes big names like Mondelez which I think is ridiculous). Ok, anyway, we wanted to purchase Starz on the very first day it was traded as an independent company during mid January. It was selling for lower than $14.2 on the first day. However, we couldn't make a purchase then. We did not know that Starz is on the restricted list. So the very next day, we called our broker to make arrangement for us so that we can purchase Starz. But guess what, on the second day, it was selling for over $15. We managed to buy at an average of about $15.6 after cost. It is heart-wrenching to pay more than 10% more than what we originally could have. So besides us having to pay more, we also purchase less. We would have deployed close to 10% of our assets in this position, but we ended up with only 5%. Psychology really plays a big part in that it prevented us from making a decision from a 100% logical point of view because even at $15 or $16, it is a very good bet. Not only was it selling for less than 9x earnings but it was also selling relatively much less than any of the media firms. But to have to pay 10% more than what we could have the previous day, it is extremely very tough emotionally and psychologically to overcome. So we ended with a 5% position.

Now remember, we discussed about having a substantial cash position to take advantage of unseen and unpredictable opportunities that may come along. So with a substantial cash reserve, we have the resources to deploy a meaningful amount to a single position – a 5% position in Starz which contributed to almost 15% of our total gain during the first half. So if we had only a very small percentage of reserve, and imagine, if we only deployed 1% of cash, then Starz would not have contributed 15% but only 3%.

The following table shows the return of our major contributors to our return in the first half.

As a class, this motley crew delivered an average return of 23.6% in the first six months – 11% over S&P500.

We also took advantage of one opportunistic situation (besides Starz) during the first half:
  • 1) McGraw Hill - Stock plunged when the AG sued MHFI for a reported $5b. We bought some at $45.8. We have since sold at $62 sometime after the first half. But even at $62, it is not expensive, in fact, we think it is still cheap and that we may have made a mistake selling too early. So we may buy it back. At $62, although based of price to earnings multiple, it is about 16x for next year. But if we based on EV/EBITDA, it is selling way too cheap at below 9x (MCO is 12x, Equifax, Dun & Bradstreet are all way over 10x). So, even if MFHI is liable to pay $5b without being criminally indicted of course, MFHI will not disappear. They already have about $1.5 to $2b net cash, so if they raise all the rest through debt, the EV/EBITDA would brings them roughly in line to the rest as mentioned at 11 to 12x. So if any fine that is less than $5b or none at all, MFHI is really undervalued by a fair bit.
In our last letter, we said we like 3 stocks – America Movil, Baidu and Valeant Pharmaceuticals – although we never make any purchase of any of them. We also said we are most confident on Valeant. Valeant has strengthened our belief in the quality of its management. At that time, VRX was selling for $70 (in fact, we have like them since they were $45 but we never make any purchase), now it is over $90. We still think fine of its prospects.

For Baidu, we recommended them when it was $100. It has been a volatile ride for Baidu in the past one year, and also since the time we recommended them. It went to $80 early in the year, but has since surged to $130. We think, though Baidu is volatile, they are very entrenched in China though competition is very cut-throat and they lag in mobile arena.

For America Movil, it is below the price at which we recommended them. It is now in the $20-21 range. I think we did not make more margin for errors in their susceptibility to governmental/political risk.

Expansion of our list of shortlisted stocks

We have been very eager to shortlist more stocks (especially those in which there are exceptional managers) so that we track both their performance and the stock price. In the first half, we found four more companies with exceptional managers (though price may not be compatible to what we want). The four companies we will track for a long time are 1) Transdigm, 2) Credit Acceptance Corp, 3) Jarden, 4) Danaher. To understand why we love some of these companies, we recommend you to read some of their shareholders' letter and also their investors' presentation and compare to what they say with what they delivered. We strongly recommend you to read the shareholders' letters of Credit Acceptance Corp – it is truly in a class of its own.

Finally, some stocks we think are worth a look at current price – 1) AT&T, 2) IBM, 3) Oracle, 4) Spectrum Brands, 5) Ebay, 6) Crown Castle International, and 7) Thai Beverage. Out of the 7, we have vested interest in all except AT&T & Crown Castle.  

Here's a very brief discussion on the 7 stocks:

1) AT&T - not far from its 52-week low. Sells for 12.5x of next year earnings. Pays over 5% yield in the meanwhile. You may also like to consider Verizon though VZ is priced higher at almost 15x next year expected earnings but potential growth rate is much higher than T. If VZ managed to buy out the remaining stake from Vodafone (say at the current price reported by the media), it'd likely be accretive to earnings.

2) IBM - at 52-week low, in fact, have added a little more to my position today. Sells for 11x this year eps. Still on track to hit $20 in 2015.

3) Oracle - though off from the recent lows of $30, it is selling for less than 11x multiples and 10% free cash flow yield.

4) Spectrum Brands - highly leverage but revenues pretty predictable. Management guides for $5 fcf for 2013 (think $4.6 is more accurate). And $7 fcf in 1.5 years.

5) Ebay - not exactly cheap in the traditional sense but management guides for over mid-teens growth and with stock selling for 16x multiple, think is a good bet.

6) Crown Castle - expected AFFO of $4 for 2013, up from $3 last year. Likely to grow at low to mid teens. Highly predictable recurring revenue. 87% of revenue & 95% of operating profit are from tower rentals and related. Tower related revenues are all on contractual basis and thus are mostly recurring. Such contractual are long-term in basis and the average is 8 years remaining with yearly price escalation built in with typical 3 to 5% increment. There is typically no way a customer can break or terminate the contract. However, one should note that business is highly leverage at 6x ebitda. But given the highly recurring and predictable revenue, and cost are also largely fixed and grows generally at inflation rate, it shouldn't be much of an issue, and loans are quite well spread out and don't come due in the next few years. EBITDA covers more than 2x of fixed charges including interest expenses.

7) Thai Beverage - THB has been very volatile of late. Our initial purchase was $0.40 late of 2012. It went up all the way to a high of $0.70. Within the past two months, the stock drops like a stack of potatoes, to a low of $0.415. In all of this drama, so what is the true worth of THB and the risk? From the many views from the media and also individuals' comments from forums online, the risk of the most concern seems to be the high debt and leverage taken on by THB to acquire a stake in F&N. And coupled with that, the poor financial performance in the last quarter exacerbated the decline and was further push over the cliff with recent worries on emerging markets. So what are the numbers behind THB? First on THB's acquisition on F&N and related debt. In some of the comments online, we saw that a number commended that THB is underwater since its purchase of FNN. But I think they have wrongly assumed that THB had paid $9.55 per share for FNN. Instead, the average price paid by THB is $8.77, not $9.55. The figure $9.55 was paid by TCC, not THB. THB was the party that bought into FNN before TCC came into the picture last year. So since the acquisition, FNN had return a total of $3.435 (both capital reduction and dividends) to shareholders. Currently, the last transacted price for FNN was $5.72, so if we add $3.435, the total comes to $9.155, a gain of 4.4% for THB. Now on debt, although debt has increased significantly compared to the pre-FNN acquisition, it is still manageable for a consumer stock type of business. Moreover, the current market value for THB's stake in FNN is worth about Thai Baht $58.8b, this is compared to about net debt of Thai Baht $67b (after THB repaid a portion of loans with the FNN's capital reduction). THB's ebitda is probably going to be in the Baht25b range which is about 2.7x net debt to ebitda - a pretty manageable ratio for a consumer business. Now, what are we paying $0.415 for? The crown jewel in THB is the spirits business. Although this year, it is poised to decline by at least teens level, it should be still able to earn $0.025 a share - so it is 16.6x just based purely on the spirit business. Of course, this is the simple way of valuing by not taking into other aspect of the business. But since it was listed, the market has priced THB from 11x to 21x of its spirit business. So 16.6x is at the mid range.

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