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.

Mispriced Liberty Media??

Here's another idea which may or may not works.

Liberty Media is due to spin off its non-Starz related assets, i.e., its media investment assets in Sirius XM, Live Nation, Barnes & Noble, minority interest in Time Warner, Viacom, Sprint, etc.

According to this press release (http://ir.libertymedia.com/releasedetail.cfm?ReleaseID=732276), persons acquiring Liberty Media common stock in the market through Jan 11, 2013 will receive shares of Spinco common stock in the distribution. So people who buys LMCA at $122 today will still qualify for shares in the Spinco.

And the Spinco stock is now traded on as "when-issued" basis on Nasdaq under the stock code, LMCAV (http://www.nasdaq.com/symbol/lmcav). "When-issued" refers to the stock price as if the stock is selling on the day it is ex-dividend or ex-distribution or rights. It closed at $108.71 yesterday.

So if you buy LMCA at $122, and on Jan 14, 2013 (coming Monday) when it is ex-distribution and if the actual price then really tracks the "when-issued" price of $108.71, you are actually paying $13.29 per share of Starz stock.

Upon completion of spin-off, there'll be about 124 million outstanding common stock in Starz. Starz makes $240 million in 2011. Thus, eps is $1.93. At the price $13.29, it priced at 6.88x earnings - a value too low compared to other cable companies like AMC Network (>17x) or Discovery Communications (>20x). Even if we use a conservative valuation at 12x eps, it is worth at least $25.

So by paying $122 today for LMCA, you get 1 share of Starz on coming Monday. If you can then sell the non-starz stock on Monday at the same price as the "when-issued" price traded last night at $108.71, you are only paying $13.71 for each Starz shares which produces earnings of $1.94 per share.

Easily, you can almost double up your capital of $13.71 to $25 based on 12x earnings of Starz.

Disclosure: I bought some LMCA at $120.7.

Review of Portfolio for Y2012

Let's start with recent comments from Seth Klarman:

'The key watchword for the first half of the year [2012] was patience. We patiently sifted through scores of interesting investment ideas to find only a few really good ones. We patiently held cash while waiting for prices to hit our buy levels before accumulating. We stayed abreast of the U.S. markets where most of our investments reside, while patiently searching European markets for the occasional morsel, despite the frustrating reality that most sellers continue to cling tightly to their troubled assets--at least for now. All the while, we built up our knowledge of European markets, country by country and asset class by asset class, while expanding our base of relationships and developing price targets for many businesses and assets that we would love to own at the right valuation, awaiting a reckoning that we deem likely to come but at a date uncertain.' - Seth Klarman

We agree patience is key particularly in times when few investments are available to deliver an above-average historical return. But a lack of good investment opportunity does not mean the next move is downwards for the market. With huge liquidity flooding the system, we can understand why the market is going up. Fed, for one, is pumping $85b a month ($45b on long term treasury and $40b on mortgage backed securities) into the system, although in the latest Fed's minutes, it hinted that stimulus may be ended earlier than expected. That is over a trillion dollar of monetary stimulus that is rushing into the market annually. Couple with ultra-low interest rate which is expected to be near zero until unemployment rate reaches 6.5% or below, there is little places to stash one's cash for a decent but risky return. For those who keep cash, it has less buying power as time passes. Thanks to the Fed, savers find themselves subsidizing enterprises and corporations. It is essentially a transfer of wealth from savers to corporations. Just that it is done stealthily. Not only is it done stealthily, but it also punishes the responsible savers while rewarding and subsidizing those who took excessive risk, bought houses they could not afford or had otherwise ran up too much personal debt. For savers who realize they are “conned,” they may then opt to invest in other asset classes like corporate or sovereign bonds or even equities just so that they do not get “conned” again. That's why we hear more people saying it is better to buy dividend assets than to have cash. Eventually, these savers may find themselves getting “conned” again by the macroeconomic policies which had driven or “coerced” them to invest in such assets classes so just that they are able to maintain their real net-worth, which they otherwise would not have had interest rate been more normal, when things come to a head. This is exactly the time when things get more risky when everyone is heading in the same direction. In short, investors are hugely influenced by what Fed does. Today, Fed is telling us to go forth and speculate and I don't care what you buy as long as you buy.

Given the current situation, we think it is hard to short the market given that the liquidity have to go somewhere, at least for the short term. With stimulus, not only monetarily but also fiscally, couple with low interest rate, many are enticed or “forced” to get invested so as not to see their “real” net worth gets decimated by the negative real interest rate. Negative real interest rate is likely to persist for some time and thus, we can understand why people are putting more of their savings in assets that provides better yield than normal savings interest-bearing account.

Although we doubt the market will suffer a big crash any time soon, that does not mean it would not. We are mindful that the possibility of a correction is always there. Washington has simply deferred the fiscal and debt ceiling issues. End of February, Congress must boost the federal borrowing limit. On March 1st, $110 billion of sequestration or automatic spending cuts begin slicing into defense and domestic spending if no deal is reached. By end of March, a government shutdown looms unless Congress approves funding for government operations for the reminding of the fiscal year, which ends Sept 30. Without action, many federal employees could face the possibility of being furloughed. Although Washington is dysfunctional and has provided band-aid fixes so far, we believe Winston Churcill is right when he said: “Americans can always be counted on to do the right thing after they have exhausted all other possibilities.” But we do not know if they are at the end of the road yet or still has more possibilities to exhaust and drag for more time.

So all these are affecting business decisions who typically plan on a 3 or 5 year basis. How do we expect businesses to plan if they do not know what is going to happen in a few months? But regardless, liquidity is flooding the market and there is some tailwind behind the U.S. economy driven by the housing and automotive sectors. Annual U.S. automotive sales may potentially even rise to pre-recession highs.

But what is likely to happen two or three years from now when unemployment hits 6.5% or even 6%, when monetary support is withdrawn, would the economy be able to stand up on its own, how about inflation, and how about when interest rate goes up? We do not know the answers and do not attempt to be part of the jury. We just play to our strengths which is to look on a bottom-up basis. For us, we think capital preservation is more important than to rush into deploying capital so just as to maintain our real net-worth. We fear the alternative may be worse when things come to a head. Because in times of chaos, cash is probably the only asset that is certain to hold up the best in terms of value which you can then use as the currency of choice to purchase what others deem as trash and risky, and thus rush to sell regardless of the underlying value.

An investor who invests just based on the relationship between interest rate and inflation in order to maintain their real worth is missing another ingredient to the equation: risk. Example, for bonds, prices are high but yield is low though it meets savers' goal of exceeding banks' savings interest rate but the proposition is risky with current bond prices. Part of the risk facing investors is that the math on bond prices and yields means it won't take much higher yields to inflict substantial capital losses. With 10-year Treasury yielding 1.7%, a one-point rise in yield would lead to a 9.2% decline in the value of bonds. For investment-grade corporate-bond index of 5 to 10 year notes, a one-point increase in yields would cause a 6.4% drop in bond value. So in chasing to maintain real “net-worth” may or will ultimately cause one to worth less.

So investors find themselves between a rock and a hard place, facing either the likely but limited erosion of purchasing power that originates from holding cash, or the uncertain but potentially disastrous impairment of capital that arises from owning overvalued equities or bonds. Both are unappealing choices but we prefer the former.

And what makes this choice harder is how long will the negative real interest rate last, this will make a difference to an investor's choice in equity or cash. There's no easy answers to the problem of real capital preservation in an age of financial regression, only difficult choices.

Depending on how long the financial regression lasts, if we assume it is short-lived, then it may be wise to be underweight equities and conserve capital and wait a riper opportunity set by out-compounding the drag of inflation and negative real interest rates.

We do not know when market will bust and neither do we intend to time the market. We just simply play to our strength and evaluate equity by equity and if the price is good, we will buy it, regardless of economic condition. That is why we build up our cash position in the second half of 2011, peaking at 43% at end of 2011. But our cash position has since dropped to 27%. Now you may question why did it drop so drastically when we think there is both a lack of good investment ideas and our intent to patiently hold cash until we find a good investment. Here's the caveat: a lack of good ideas doesn't mean there isn't any, we were fortunate to identify one area of interest. So, substantially all of the drawdown of cash were spent on two positions – Mastercard and Visa. Had we not spent on them, our cash position would have increased. Thus, if we exclude Mastercard and Visa, cash would have increased by 15 percentage points.

Portfolio Performance (all results are based in terms of USD)

Figure 1.

We added a new table (figure 2) to show the performance purely on our equities:

Figure 2.

Our portfolio return 16.5% for the year versus S&P500 13.4% (as can be seen in figure 1). This is the 5^th consecutive year we are ahead of the most broad-based USA indices. We hope it is not fluke and we endeavor to keep our eyes on the ball and the field, not the scoreboard per se.

We changed the starting date to measure our performance in year 2008 from 1^st January to 1^st May because it is the actual inception month of our portfolio. Had we maintained January for comparison, our portfolio would outperform S&P500 by 26.8% in Y2008, compared to 23.1% from May 08 to Dec 08.

Although we perform well this year even with substantial cash position, we underperform the Singapore Straits Times Index by almost 11%. Most of the underperformance can be attributed to the fact that we are overweight on U.S. dollar assets. Figure 3 shows our distribution of assets:

Figure 3.

We are not concern about outperforming the benchmarks year after year, although we understand it can be irritating not to. Instead, we aim to outperform the major USA and Singapore broad-based indices over a full economic cycle. Even though, we may lag the STI index by a huge margin in 2012, we have however outperformed the index by an aggregate of almost 78%, even with 3 years of underperformance out of the 5 years since our inception in May 2008. We tend to outperform on the downside than on the upswing. Our portion of Singapore equities returned 23.1% against STI 27.4% (as can be seen in figure 2).

Capital preservation is the most important thing to us. We will grow it with the appropriate risk-adjusted return by managing risk rather than swinging for the fences to maximize profit at all cost. We do not have the gut to stomach significant losses. At times, we will make mistakes, we are sure of that, but we will try to keep it at bay.

What drove our returns?

Figure 4.

From figure 4, we can see the top 3 drove 66.8% of our equity gains in 2012:

• MasterCard and Visa – As a group, up 34.4% and makes up 43% of the total equities gain for the year. Individually, MasterCard is up 32.1% while Visa is up 47.3% and comprises 34.3% and 8.7% of our total equities gain for 2012.
• Berkshire Hathaway – Up 17.7% and comprises 19.3% of total gain.
• UOB – Up 31.4% and makes up 13.1% of total gain.

We started the year with Berkshire Hathaway, PepsiCo, and UOB as the top 3 equity positions – which makes up 69% of all equities held at the start of the year. We did not own any Mastercard or Visa then. So 2 out of the top 3 starting positions are the major drivers for this year performance.

Mastercard and Visa, which we bet aggressively by using almost 44% of our starting cash ended comprising about 20% of our total portfolio, at the peak (15% at end of 2012).

As for PepsiCo, we sold all of it by May, at a modest gain from our cost.

Portfolio Discussion

Figure 5. 

We ended 2012 with 21 equities, compared to 10 positions in 2011. Our top 3 positions makes up almost 40% of total portfolio; top 5, 49%. Excluding cash, top 3 makes up 54% of all equities, and top 5, 67% of all equities.

Discussion on equities

• Berkshire Hathaway: Our largest equity position comprises almost 17% of total portfolio. Berkshire is our longest holding stock. Although we adjust the position size from time to time, depending on value or alternative, we have maintained our current position size since May 2011. 
  
  
  We bought our first share in Oct 2008 at a cost of $57. We think there's not much downside to the current price. BRK is prepared to repurchase shares at 1.2x of reported book value which is about $89 – $90 based on 3Q numbers. In fact we think the stated book value is substantially below intrinsic value. For example, Burlington Northern Santa Fe was purchased in 2010 for $34 billion. BNSF is expected to earn $3.5 billion in 2012. Using a multiple of 15x earnings (same as Union Pacific), BNSF is worth $54 billion. If accounting rules allow writing up of goodwill, then BRK book value will increase by $20 billion. Based on BNSF alone, the stated book value as of 30 Sep 2012 is at least 10% less if we include the $20 billion increase in BNSF's value. 
  
  
  For more details on BRK valuation, we think Whitney Tilson provides a good presentation on it. You can google for it. In the past, we have made some money from Tilson's idea – Anheuser-Busch InBev, although we sold it early. He was spot-on on that, in fact, BUD went even further than what he thought will sell for – currently BUD is selling for $87 versus his target of $72 or so.

• Mastercard and Visa:

Figure 6

We bought Mastercard and Visa in two batches – January and May 2012. We allocated 56.4% of the total capital during January 2012, all on Mastercard at an average cost of $350.43. Subsequently, we added more and allocated the rest of the capital related to them during May 2012: at an average cost of $408.3 for Mastercard and $116.56 for Visa. Our average cost for the two batches of Mastercard is $368.15. Subsequently, we reduce some of the holdings, Mastercard was reduced by 33.9% and Visa by 12.8%. As a result, our average cost for the rest of the shares remaining at year end is $383.37 for Mastercard and $119.44 for Visa. In addition to selling our holdings, we did some rebalancing between the two counters during year: for example, when Visa is cheaper than Mastercard, we sell some Mastercard to hold more Visa, so it resulted in a higher reported average cost per share in Visa at $119.44 than the original cost of $116.56 but overall, it benefited our holdings than if we had not rebalanced. 


At year end, both the stocks comprise about 15% of total portfolio with Mastercard making up about 12.4% and Visa 2.7%. Both have about the same potential medium term growth – 15 to 17%. But Mastercard is priced slightly cheaper than Visa. At current price, we think both are fairly value at 19 to 20x forward earnings. We won't be expecting any outsize return from them. But they should still bring us reasonable return simply by rising at the same rate as earnings without relying on any expansion in earning multiples. Even if the price remains the same a year from now, we think it provides a good entry point to add more given that the then valuation is likely to be less than 17x on a forward basis. If either one of them falls, say by 10%, in a year time, we will shift more of our assets into them because valuation would likely be close to 15x forward earnings. 


We think the long term prospect is very bright – payment is in a secular growth market. More transactions in the future will be done cashless, especially for market outside of the U.S. where transactions are still largely done in cash. In U.S., 29% of all retail transactions are in cash, down from 36% a decade ago. According to Mastercard, 85% of all global transactions are in cash. The huge gulf in cash transactions between the U.S. and globally lies in the emerging markets. Cash still largely prevails in emerging markets because of the slow development in electricity and communication infrastructures. However, smartphones and wireless networks should help to bridge these physical restrictions. 


There are a lot of competition in the payment sector from PayPal operated by Ebay, Google Wallet, Square, among others. But all of them operates in the digital wallet space, essentially a locker of personal-payment data stored either in the cloud or on smartphones. None of them have made a dent to the network infrastructure that facilitates the actual flow and transfer of money between merchants and financial institutions in the credit and debit space. PayPal acts as an acquirer which is the institution that acts on behalf of a merchant to process debit and credit payments. And acquirers need the network infrastructure such as Visa to facilitate flow of payments between the merchant bank (acquirer) and the customer banking facility (the card issuer) – just like if you and me want to talk on the phone, we need the phone operator and Mastercard and Visa is the phone operator in the payment space. Mastercard and Visa also have their own operations in digital wallet, called PayPass and V.me. But when it comes to routing transactions, essentially the infrastructure that connects and sits between the merchants and banks, Mastercard and Visa are the dominant players. 


Digital wallet, despite all the hype, has thus far done little to alter the relationship that has been built around credit and debit. Compared to Amex and Discovery Financial, Mastercard and Visa have lesser business risk, though it may be riskier for an investor in terms of the higher stock valuation – Mastercard and Visa sells for high teens to low twenties multiple while Discovery and Amex sells for high single digit and low teens, respectively. Amex and Discovery, like Amex, in addition to providing a payment network also provides financing to their customers, so they have more risk associated with credit. Whereas for Mastercard and Visa, they are pure-play payment network. Their revenue comes from fixed per-transaction fees, service fees based on transaction size, and fees for cross-border transactions. Visa and Mastercard make about 10 cent for every $100 transaction. So even if there is inflation, we think Mastercard and Visa provides very good hedge. 


Adding to Mastercard and Visa moat is the trust that exists between the banking institutions and them, which essentially allows them to reach into customers' banking accounts and subtract money. And banks like the status quo especially when the banks take most of the fees that flow through the card networks. In effect, the banks play a big part in protecting the domain of Mastercard and Visa. Moreover, their business model held up extremely well during the 2009 crisis, revenue for both rose - Visa by 9% and Mastercard by 2% - with operating earnings rising at a much higher pace. It was the first time their business model is tested as a public company and they passed with flying colors. Although the shares were sold off at that time, investors now know how resilient their business model is. So even if there's a recession, we think Mastercard and Visa is likely to hold up much better than the last time and better than most other businesses. 


 Even in a recession, we think they should be able to deliver growth in earnings per share because they have a number of levers to pull. For example, both of them are essentially free of debt, so if they want to orchestrate a huge repurchase of shares, it is one lever to use. In fact, we will be happy the shares plunge so that we can buy more while the companies are also buying back an undervalued share. Another lever is they can easily cut back on expenses especially marketing related – the kind of expenses that can easily be cut in a downturn – that is what Amex did during 2009, so if Amex can, we are sure Mastercard and Visa are able to as well.

• DirecTV: 57.4% of the positions are purchased at an average of $44.22 from Dec 2011 to May 2012, and the rest were acquired in October 2012 at an average of $51.43. We recycle part of the proceeds from Mastercard and Visa in DTV during October. At $51, stock is priced at 10x 2013 earnings. We think it trades at a significant discount to intrinsic value and offers steady, leveragable cash flow, exposure to Latin American growth and sound capital discipline. DTV started the year as our smallest equity position with less than 2% of total portfolio. But it ended as our 3^rd largest equity position with slightly over 10% of total portfolio. 
  
  
  We think DTV is one of the cheapest play within the pay-tv sector, whether we use the traditional PE or EV/EBITDA valuation. Dish Network, a pure satellite pay-tv play, is the closest comparable that sells for 15x earnings, almost 50% more than DTV valuation. For others, like Time Warner Cable, sells for 14x earnings. However TWC is more than pay-tv, it provides internet and phone services as well, which provides an advantage over pure CATV play since TWC can provide so-called “triple-play” package to entice new sign-ons and also provide a leverage to reduce churn rate. But is “triple-play” advantage worth to pay 40% premium more? We are cheap so we will play it cheap and hopefully, the difference in valuation will close up in DTV's favor.

• IBM: Makes up 7.1% of total portfolio. All of the positions were initiated in 2012 between $180 to $198, at an average cost of $193.18. We think IBM has a good chance of performing well in 2013 partly because of the easy comps which reset the forward benchmark to a lower hurdle to cross, in terms of the Street expectations. We also like that about 60% of IBM profit is recurring nature due to its large software (23% of revenue) and services (58% of revenue) that have longer-term multiyear contracts. As a result, its business performance have been less volatile and more predictable than most. 
  
  
  But one of the things we did not like is the way it reported earnings in Q3 when its reported adjusted operating earnings include a one-off gain from the sale of a line of business to Hitachi. If it is a one-time gain, why is it part of adjusted operating normal profit? We cannot understand except to the extent that the corporation try to mask the underlying performance and hope that others miss it. And none of the major news media spotted it, or at least reported it. Nonetheless, we still think IBM should perform decently for the next few years and has a reasonable chance to achieve its stated roadmap of $20 of operating earnings in 2015. But we will keep a close look on them quarter to quarter on the reporting and underlying fundamentals.

• Stocks that makes up 2 to 3% of portfolio: We hold 5 stocks which each makes up between 2 to 3% of total portfolio each. In total, these group makes up 12.1% of total portfolio. The 5 stocks are Visa, UOB, Dollar Tree, Johnson & Johnson, and IAC/Interactive.
  
  
  • UOB – We bought it during Q3 of 2011. We have reduce 2/3 of our UOB holdings this year. We don't think it is expensive, especially compared to most other STI components. It has roughly played out as what we think it should have. The bank has grown its asset base as we think it can. If return on asset returns to 1.2 to 1.3%, it can earn between $1.75 to $1.9 based on $230 billion of assets, valuing the current price at 10-11x earnings.
    
    
  • Dollar Tree: We acquired during Oct 2012. Up less than a percent. Stock is down quite significantly from the high. In fact, all the Dollar stores are way off from the high, and valuation are roughly the same among all the three – Dollar Tree, Dollar General and Family Dollar – valued at about 14x forward 12 months earnings. For us, we are more attracted to Dollar Tree because it is the least leveraged and has the lever to pull on that basis if needed or maybe it will appeal to certain private shop given the low leverage and strong cash flow.
    
    
  • IAC/Interactive: Acquired in Q4 at an average $48.27. Down 2% so far. Usually we do not invest in technology but we think IAC provides good value for the type of growth it guides for. Sells for 13x earnings, and 11x ex-cash for 2013 earnings. We also like that Barry Diller is the head of the company. We think of Barry Diller in the same breath as John Malone – both of whom have proven to unlock value and deploy capital efficiently.
    
    
  • Johnson & Johnson: JNJ is the second longest holding in our current portfolio. We have held them since 2010. Up 6.9% in 2012 and up 14.6% from acquisition.

• We own another 12 equities which in total makes up 14.9% of total portfolio. Following are the equities:
  • Tesco: Acquired in January 2012 at an average cost of US$4.94 – up 13.3%. If we did not elect to take one of our dividend in script, we will up 9.8% instead.
    
    
  • CSX: Acquired in Q3 2011. Up 2.6% for the year and up 9.3% from cost. We reduced over 60% of the positions during February 2012. Results has been tepid mainly due to the depressed natural gas prices which drive lower demand for coal. Although coal makes up a huge chunk of CSX business (over 30%), strong growth in automotive and intermodal has largely offset the decline in coal volume.
    
    
  • Celgene: Acquired in May 2012 at a cost of $71.34. Up 10.2%. We reduced 46% of the positions in October 2012. However, we think still Celgene should provide decent return. If EMA approves Revlimid as a first-line treatment for Multiple Myeloma, it should give some tailwind to the stock. Even if it doesn't, Revlimid is already prescribed off-label as a treatment for MM in Europe. Also, Celgene has some recent success in clinical trials for the cancer drug, Abraxane, resulting in approval for extended use in metastatic non-small cell lung cancer. There are other trials in the pipeline for Abraxane for other form of cancers, for example, pancreatic. We think there's a decent chance in will sell for $90, for 16x 2013 earnings.
    
    
  • Norfolk Southern: We initiated NSC in the first two months of 2012 and ended comprising over 5% of our portfolio at that time. Subsequently, we reduced 70% of our holdings in the middle of 2012, at a modest loss of 1%. The cost for the remaining shares is $71.4, down -13.4%. Inclusive of the shares sold, we are down – 4.7%. Norfolk Southern has basically the same business model as CSX in which coal is pressurizing the underlying business. We think a lot of the bad news are priced into the current price. To go much lower, we think the economy needs to stop in its track.
    
    
  • Coca Cola: We sold all of our Coca Cola shares in the middle of the year and then again initiated a small stake in Dec 2012 for $36.49. The earlier stakes were sold at a gain of 12%, which were acquired in Nov 2011 and Jan 2012 at an average price of $33.38. We think the current price is a reasonable entry point to pay for a business of Coke quality at 16.7x 2013 earnings. Together with the earlier stake, Coke returned 8.9% for the year, and 11.2% from cost basis.
    
    
  • American Express: Bought in Oct 2012 at $56.75. Up slightly at 1.3%. Valuation is not particularly demanding at 13x 2012 and 12x 2013 earnings.
    
    
  • National Oilwell Varco: We did not pay much attention to the oil and gas sector (especially contractors that serve the exploration of oil) until August this year when Berkshire Hathaway initiated a position in the stock. The stock then was selling for over $80 a share and peaked at $89.95 in Sep 2012. Then it fell to about $80 and generally sells between $77 to 83. It took a big correction in December 2012, falling to a low of $64.82. During the time from August to December, we spent some time familiarizing with the oil and gas sector, particularly on the upstream operations including on and off-shore drillings. Fortunately, our time spent paid off somewhat when NOV fell below $70, a price we think provides a good entry. We finally took a small bite and acquire some at $66.9. NOV is the dominant equipment provider for oil and gas drillers, both onshore and offshore. Its share grew by 5-folds in the past decade largely due to its success in persuading drillers in the early 2000s to shift from custom-built rigs to rigs built around its own standardized components, according to Morningstar analyst Stephen Ellis. Today, an overwhelming majority of rigs use NOV's parts. Vendors cheekily called them: “No other vendors.” NOV is largely dependent on energy prices which drives drilling activities. If oil prices doesn't support drilling activities, NOV business will be adversely affected. However, NOV is among the safest energy plays because it serves both the oil and natural gas explorers and drillers, and also both on and off-shore drillers – they are kind of energy agnostic. At $67, it is selling for 11.4x 2012 earnings and 10x 2013 earnings.

• Singapore Telecom: Bought in Oct 2012 at US$2.58 or SG$3.15. Up 4.6% since or up 6.8% if we include the dividend that just went ex-div in December 2012. We think SG$3.15 is attractive relative to other Singapore stocks. The price was also temporarily driven down when Temasek sold part of their holdings. The selling is now over and price has recovered a little. But we are not a long term holder in Singtel. It is just a relatively safer alternative in a market that is otherwise expensive.
  
  
• OCBC: Acquired in August 2011 at a cost of US$7.56 or SG$9.11. Singapore banks staged a remarkable recovery in 2012. We sold half of it in June 2012. Our holdings is up 24% for the year, but is down 1.3% from our cost.
  
  
• M1: Bought early this year at US$1.95 or SG$2.43. Up 14.5% for 2012. We sold half of it in Dec 2012.

• Thai Beverage: We purchased the shares in November 2012 for US$0.33 or SG$0.40. We don't usually invest in stocks which have surged a lot in a year or is near to the all-time high. However, for Thai Bev, we have always like the stock since it was listed but we have never own it until now. In fact, we nearly bought last year when it was selling for SG$0.24 but we were cheap and queued to buy at SG$0.235. For half a cent difference, we miss a huge gain. The other comparable mistake of such is how we miss buying Mastercard and Visa during Dec 2010 and during part of 2011 when we were sucking our thumbs. For Thai Bev, even though the stock is close to its all-time high, we think the valuation is not demanding. It is selling for 16x earnings. What we like is their spirit business which is growing at a good clip, although other parts of the business is holding them back. Compared to other spirit businesses like Brown-Forman and Beam, they are selling well in excess of 20x earnings.
  
  
• Marvell Technology: Our biggest loser for 2012 in terms of percentage, and ranks among our all-time biggest losers. We bought at $10.05 and is down by -27.8%. If there is any consolation, it is one of our smallest equity positions. However, we will be holding on given that the price has likely priced in a lot of the bad news which we failed to factor into our analysis. What we thought initially as cheap is perhaps cheap for a reason and probably a value-trap at the time of our purchase. MRVL has about $3.5 a share in cash, so we thought at $10, is selling for 7-8x earnings ex-cash, and if demand for MRVL products recover, it is selling for 5x earnings ex-cash. 
  
  
  But what really went wrong for us is not so much on being wrong on the earnings but because we were surprised at how much MRVL is fined when it lost its suit on patent infringement and was fined $1.17 billion for actual damages. Because the infringement is deemed willful, the fine could increase by 3x. In any case, MRVL is appealing, and could overturn the order eventually or lessen the fine tremendously. However, if it doesn't, MRVL hands will be weakened. But we think the fine is outrageous in relation to MRVL revenue and profit. It is one-third of MRVL revenue or 100% of revenue if the punitive damages is levied at 3x of actual damages awarded. We think there's a good chance the actual damages will be eventually reduced.

Google

We foolishly sold our Google stock as it went up. We fail to get the entire rise. We bought well but we need to improve our selling. But we did decently for the short holding period. This is the second time we held and sold Google. We hardly invest in technology companies primarily because of their often high stock valuations due to rapid growth, and potential for obsolescence due to rapid change in technology. The last thing we want is to pay a high price for a rapidly growing business that gets swept aside by new technology shortly after we buy it. Bearing this in mind, it doesn't mean we wouldn't buy it at all costs. We will buy at the right price, especially at a bargain price. Any time if Google gets back to $600 - $650 range, we will be there to buy. At $650, we will be paying about 14x earnings, less if we exclude the cash. Even at $700, it isn't expensive at 15x eps or less than 13x ex cash. It is hard to find companies with market leading positions secured by strong competitive advantages in secular growth markets because such companies do not usually sell at market multiples. And Google is one such find today. And this is a business that has top line growth of 20% per year. We will discuss more if we ever get another chance to purchase Google. Sometimes we make silly mistakes selling our holdings where we will be much better, in fact, a lot much better, if we had not sold. Google is another stock we made a mistake selling in addition to our recent other mistakes – Davita, Anheuser-Busch Inbev and Amgen. All of which we bought well but sold atrociously.

Opportunistic situations

We only managed to find take advantage of one opportunistic situation when Monster Beverage took a big heat to its shares in October 2012 when there were some complaints to FDA that Monster drinks led to some death on over caffeine consumption. We think it was a “tempest in a teapot,” to borrow Jamie Dimon's infamous quote. So we purchase some shares at $42.8 and sold within the same month when the price recovers some of its losses and lock in gain of 10%. Stock has since surged to almost back to the pre-plunge price of $51 to $55. Again, we were early in selling.

Stocks we are considering

Baidu

We do not usually talk about companies we like that we do not have a position. Baidu is selling for about $100, down by a third from the peak more than half a year ago. Now, it has come to a price we are comfortable in for a growing business. Baidu business is likely still to be in the early innings. Earnings is expected to grow in excess of 20%. Valuation is less than 17x for the next 12 months earnings. If we exclude cash, p/e comes to 15x. For a business that can grow at mid to high teens level for the medium term, we think paying 15 to 17x earnings is a good deal. One of the concern was its market share is eaten up by competitors like Qihoo. Baidu's market share is down to about 60% from its peak of over 70%. Baidu's market share used to be in the high 50s to low 60s prior to Google's exit a couple years ago. Upon Google's exit, Baidu market share went to over 70%. Now it is back to where it is.


American Movil
Stock is having a rough time and is selling close to 52-week low below $23, priced at 13x earnings. Its domination in Latin America is under pressure from government encouraging more competition, including its homes market, Mexico. We think the price is pretty attractive.

Valeant Pharmaceutical
We think the business is well managed led by one of the smartest mind in the pharmaceutical industry. Valeant pursues a different path from most other large pharmaceuticals. VRX does not spend a large percentage of its revenue on research and development (low single digit versus low to mid teens for major drugs discovery firms) but instead grows through savvy acquisitions that accretes to earnings, sometimes, significantly. They have had much success in the acquisition arena. Even at $60, its all-time high, it is priced at 14.5x 2012 adjusted earnings. It is a rare pharmaceutical that is growing top line and bottom line at such a fast clip at over 20% and 30%, respectively. Although most of the most of the revenue growth came through acquisitions, organic growth is still an industry-leading one at high single to low teens level. Effectively, VRX is a master value investor within the pharmaceutical space. The reason VRX is able to do that it is led by the able Michael Pearson, who has been an extraordinary and aggressive CEO. VRX is a rare find in any industry, which is both a value investor and a savvy operator. The other comparable we can think of are Berkshire Hathaway, any of the Liberty-related companies and Barry Dillar-related companies.

VRX is able to generate the types of returns it drives through acquisition largely because of the cost cutting it can achieve in the range of 15% to 20%. As an example, when Valeant merged with Biovail, Biovail was doing a billion dollar sales and in 2012, VRX is targeting to eliminate $300 to $350 million (35% sales) through synergy. So a lot of the $300+ million flows to the bottom line because of the company's low tax structure. In 2011, VRX acquires a number of bolt-on acquisition which in aggregate adds another billion of sales and targets for 25% synergy. Again, a lot of the $250 million is going to flow to the bottom line. So in effect, VRX is generating really high returns by acquiring other businesses in the pharmaceutical industry. VRX has also announced its plan to acquire Medicis which will close in 2013 in a friendly, all-cash deal. The deal will make VRX the largest player in dermatology in the U.S. We like it at $45, and we like it at $50, and now even at $60, we like it, although we have never own it. We intend to and at $60, it is priced at 11x cash earnings.

Of all the 3 stocks listed here where we are interested in, we are most comfortable with Valeant the most.