Charlie Munger, Warren Buffett’s business partner for over 50 years, still has a great deal of wisdom to offer us younger investors. As he says, we have to keep learning everyday whatever our age.
So, here is one of his recent aphorisms, taken from one of his recent podcasts (Warren Buffett respects this idea so much that he included it in his recent letter to Berkshire Hathaway shareholders): “The world is full of foolish gamblers, and they will not do as well as the patient investor.” There is a great deal of impatience within the investing community, a drive towards get-rich-quick ideas. Not for them spending weeks getting to really understand a firm’s strategy, its competitive position and its pricing power. Not for them getting to know the managers well enough to make an assessment of their degree of competence and the degree to which they act with integrity regarding their shareholders. Not for them the quiet accumulation of knowledge about the profit history, the financial stability and the vulnerabilities of a company; nor the hard work of going through the notes to the accounts going back many years. No, they prefer to gamble on the next “big-thing”, or on a chart pattern, or on a sense of where market sentiment is taking a share, or on a macroeconomic projection. They are in such a hurry – and so over-confident in their “analysis” - that they feel compelled to gear up their investment punts either by borrowing to invest or by using derivatives. It’s one of the great ironies of investing that those who follow the path of sensibly striving merely for satisfactory returns, when combined with the other two characteristics of an investment operation of (1) a thorough analysis of the facts, and (2) a margin of safety, end up out-performing those who profess an ability to achieve extraordinary success by out-guessing the market. Be patient. Do the hard graft to understand what you’re investing into. Be patient. Remember investment has four elements (1) Preparation, (2) Discipline (stick to true investment rules and don’t start down the path of speculation), (3) Patience, and (4) Decisiveness. For the vast majority of the time you cannot be decisive, that is, actually buy something or sell something. There are long periods of “inactivity” on that score. But there should be a great deal of activity on the “preparation” front all the time. Be patient: wait for Mr Market to do something foolish and leave a juicy opportunity on the table offering a large margin of safety. These opportunities are few and far between, and so you will not find them everyday. Be patient: wait for Mr Market to recognise the intrinsic value of a share you hold. Sometimes it can take 2 or 3 years until the market starts to weigh its merits properly. Be patient: do not pull the flowers and water the weeds. There is a natural human tendency to want to sell something that has risen nicely. This increases bragging rights; going home to spouse and saying you’ve made say a 50% return. But if you had been patient you might have made 400%. Don’t rush. Conduct valuations as news comes out about a company and if it is still under-priced relative to intrinsic value continue to hold. On the other hand there is a human tendency to hold on to shares that have fallen; a reluctance to crystalise a loss - no bragging rights in that. People tell themselves that if they hold on then they might get to the psychologically important point of “breaking-even” on the investment. But if the share price has fallen because of a deterioration in the economics of the business or the quality of the managers then it should be sold even if the loss has to be reported to a spouse. Use the money for true bargains. Prof Glen Arnold now offers a Managed Portfolio Service at Henry Spain Investment Services under which clients’ portfolios contain the same shares as his (write to Jackie.Tran@henryspain.co.uk)
0 Comments
One of the golden rules for a value investor is to thoroughly understand the business you are investing your money into. A part of that involves the examination of the integrity of the managers.
And one of the indicators of their integrity is whether they have a penchant for manipulating profit numbers from one year to the next to perhaps “smooth” the rising trend, or to “match” or “exceed” expectations they had previous fed analyst. All of this fiddling is wasteful of their time and their juniors’ time; and suggests less than honest communication of the reality of their business lives. Profits can be lumpy, moving in fits and starts, even for companies with great long term prospects. And there might even be years of losses if negative surprise come out of the blue (e.g. Covid). In aiming at what they perceive as a “respectable” (but mediocre) rise in earnings year on year many managers sacrifice higher returns for shareholders over a span of say a decade, as they limit risky big-payoff projects that on average would be good for shareholders, but would make the managers look bad when one or two go wrong, as they inevitably will. Warren Buffett says that he and Charlie Munger, “prefer a lumpy 15% return to a smooth 12% return.” It's a pity so many managers prefer the reverse – a fondness for a smooth 12% to a lumpy 15%. So there are two problems with managers trying to “hit the numbers” they think desirable.
“Operating earnings figure[s]…can easily be manipulated by managers who wish to do so. Such tampering is often thought of as sophisticated by CEOs, directors and their advisors. Reporters and analysts embrace its existence as well. Beating “expectations” is heralded as a managerial triumph. “That activity is disgusting. It requires no talent to manipulate numbers: Only a deep desire to deceive is required. “Bold imaginative accounting,” as a CEO once described his deception to me, has become one of the shames of capitalism.” I recommend observing managers over a period of time (much of it using past statements, annual reports, videos as well as face to face meetings) to see whether they are the type of people who think manipulation is OK - say they throw in lots of "exceptional items" of the same nature every year. Restructuring is an old favourite - they "restructure" every year for 10 years while other managers are quite prepared to call that just normal business improvement expenditure to be written off as incurred. Prof Glen Arnold now offers a Managed Portfolio Service at Henry Spain Investment Services under which clients’ portfolios contain the same shares as his (write to Jackie.Tran@henryspain.co.uk) Sometimes the continuing shareholders benefit from share buybacks; and sometimes they lose. If the shares are bought by the company at a price low relative to their intrinsic value they are going to be value creating for continuing shareholders.
If they are bought at a high price relative to intrinsic value per share then they will reduce value for continuing shareholders. Here is Warren Buffett’s take on this issue (in latest Letter to Berkshire shareholders): “At Apple and Amex, repurchases increased Berkshire’s ownership a bit without any cost to us. The math isn’t complicated: When the share count goes down, your interest in our many businesses goes up. Every small bit helps if repurchases are made at value-accretive prices. Just as surely, when a company overpays for repurchases, the continuing shareholders lose. At such times, gains flow only to the selling shareholders and to the friendly, but expensive, investment banker who recommended the foolish purchases. Gains from value-accretive repurchases, it should be emphasized, benefit all owner....... ..............Of course, the difficult bit is estimating intrinsic value. As you have seen in my analyses of the companies I’ve bought into there is usually a range of plausible values, even when sticking to conservative assumptions. Prof Glen Arnold now offers a Managed Portfolio Service at Henry Spain Investment Services under which clients’ portfolios contain the same shares as his (write to Jackie.Tran@henryspain.co.uk) In his latest letter to Berkshire Hathaway shareholders Buffett wrote about Mr Market causing the stock market to frequently be inefficient in pricing shares. Mr Market throws up bafflingly high prices in some instances – way above intrinsic value – and in others baffling low prices, way below intrinsic value.
We value investors do not trust Mr Market to provide a valuation service. We have to do that ourselves. Mr Market merely “prices” through its “voting machine” mechanism; often it does not display intrinsic value in those prices through a rational “weighing machine” of the facts (as Benjamin Graham pointed out) “One advantage of our publicly-traded segment [shareholdings of market-traded companies that are not sufficient for boardroom control] is that – episodically – it becomes easy to buy pieces of wonderful businesses at wonderful prices. It’s crucial to understand that stocks often trade at truly foolish prices, both high and low. “Efficient” markets exist only in textbooks. In truth, marketable stocks and bonds are baffling, their behavior usually understandable only in retrospect.” Warren Buffett, 2023) So much for the “Efficient Markets Theory” beloved by many academics. Do not expect to perform really well with all share choices Buffett goes on to tell us that his experience has been that most of his share choices have been mediocre, some almost ended in disaster. This should give us some comfort when struggling with our own ........ Prof Glen Arnold now offers a Managed Portfolio Service at Henry Spain Investment Services under which clients’ portfolios contain the same shares as his (write to Jackie.Tran@henryspain.co.uk) In Warren Buffett’s letter published over the weekend he noted the vital importance of identify companies with good or bad economics. He wrote,
“Over the years, I have made many mistakes. Consequently, our extensive collection of businesses currently consists of a few enterprises that have truly extraordinary economics, many that enjoy very good economic characteristics, and a large group that are marginal. Along the way, other businesses in which I have invested have died, their products unwanted by the public. Capitalism has two sides: The system creates an ever-growing pile of losers while concurrently delivering a gusher of improved goods and services. Schumpeter called this phenomenon “creative destruction.” (Warren Buffett, 2023) To help us deal with the identification of businesses with “extraordinary economics” or “good economics”, some tools have been developed by those interested in the strategic positioning of firms. I’ll illustrate two today: (1) Porter’s Five Forces and (2) The TRRACK system (for more detail see The Financial Times Guide to Value Investing) Porter’s Five Forces applied to Coca Cola We can use Porter’s Five Forces (developed by Michael Porter of Harvard) to consider the competitive position of Coca-Cola’s industry. Porter emphasises that the average returns to companies in an industry are determined, yes, by the amount of rival between direct competitors in that industry, but also by four other power relationships. It might be that suppliers to that industry have a lot of power allowing them to increase prices and achieve high ROCE; or maybe customers hold a lot of power and so can push down price charged by the industry under consideration. With that, let’s look at the power relationships in the soft drinks industry:
What might change is social acceptability of sugar and caffeine. But then Coca-Cola has positioned itself to benefit from growth in other types of drinks as well as variants of Coke, e.g. sugar-free. A price war with Pepsi is a possibility. But this has been tried before to the detriment of both firms, so it may not have a high likelihood. It’s possible that governments/regulators may clamp down on Coca-Cola given its dominance of markets. But we have yet to see that happen to any great extent. Applying Porter’s five forces to a UK company in which I own shares – Dewhurst. Dewhurst mostly manufacture push buttons and various fixtures for lifts. They have a large percentage of the world market.
Warren Buffett wrote a very short letter to Berkshire Hathaway shareholders this year, it was short because it was a distilled description of key things all us value investors need to keep in mind.
First of all, we are not market-watchers, market-traders or stock-pickers, flitting from share to share because we think the stock market is going to do this or that. No, we are business-pickers. We analyse, in detail, real, living, breathing businesses: “Our goal…is to make meaningful investments in businesses with both long-lasting favorable economic characteristics and trustworthy managers. Please note particularly that we own publicly-traded stocks based on our expectations about their long-term business performance, not because we view them as vehicles for adroit purchases and sales. That point is crucial: Charlie and I are not stock-pickers; we are business-pickers." (Warren Buffett 2023) There you have it. To be a successful value investor you must learn how to:
Now, I use the knowledge base I’ve built up to invest other people’s money in a Managed Portfolio Service at Henry Spain - people who have lives to get on with and simply cannot spend all day thinking about company analysis. They get to invest in the same shares (or rather I invest it for them) as me. If you are interested in joining us contact Jackie.Tran@henryspain.co.uk. It is because I’m investing through Henry Spain – and still investing – that I haven’t been able to comment so much recently on good investments I’ve found here at ADVFN. I’m sorry about that, but I hope to make up for it with my analysis of NatWest which will be in a series of Newsletters here. NatWest is sufficient large that even if a large number of my followers on ADVFN buy its shares that won’t disrupt our plans at Henry Spain. The next newsletter will discuss Buffett’s tendency to make mistakes – errors are an inevitability for an investor – but nevertheless produce a satisfactory return overall. J Smart (LSE:SMJ) is a family-run firm. John M. Smart worked 50 years for the company and dominated it for the 29 years to 2017 as Chairman. He presided over an almost unbroken record of profit. John M. Smart has now retired, but his legacy lives on, in terms of extreme conservatism on the balance sheet, dividend levels and strategic direction.
His sons, David W. Smart, Chairman and Joint Managing Director, and John R. Smart, Joint Managing Director, now dominate the board David, at 49, has been with the company for 23 years and on the board since 2010, and owns 12.8m shares (31.4%). Dividends received from the company in 2022 £0.41m; 2021 £0.41m. John R Smart, 52, joined in 2002 and has been a director since 2013. He too has 12.8m shares. Dividends received from the company in 2022 £0.41m; 2021 £0.41m. Both have experience elsewhere, one in quantity surveying and one in property surveying. They are thought of as slightly more progressive than their father There are two other executive directors: Alasdair Ross, 60, joined the company in 1989 and was appointed a director in 2012 (owns 0.15m shares), and Patricia Sweeney, 53, joined 2011, and was appointed director in April 2017 (owns 0.15m shares). All directors earn the same salary of £123,800, with just a few benefits and pension scheme payments tacked on. No element of their remuneration is based on performance metrics..... ..... Integrity The hiring of non-executive directors is seen by these down-to-earth builder types as unnecessarily increasing costs and administrative burdens for no discernible benefit. Thus, there is no protection for minority shareholders from NEDs should the executives turn on them. 2022 Report: “The Board recognises that it has not complied fully with the Code in the areas of appointment of Non-Executive Directors and the establishment of Nomination, Audit and Remuneration Committees and the re-election of executive Directors. It also has not complied with the principles relating to division of responsibilities, evaluation of the Board and individual Directors. The Board considers that due to the nature of the company including its size, lack of complexity and the ownership of the Company that to follow all the principles of the Code would be onerous and would provide no discernible benefit to the Company or shareholders.” In my experience with these family-dominated firms the NEDs are of limited value. Protection comes from the character of those with power. Are the instinctively decent? Do they have habits of fair dealing? Are they loyal? On this front we have some supportive evidence: Exhibit 1: Waiving dividends. The family have forgone millions of pounds in dividends over the years, simply by refusing to take them. When asked why they do this they express the view that they don’t need it and by waiving “shareholders cannot accuse them of self-dealing” – this shows an extreme impulse to behave well. The former chairman and father of the joint MDs has said of his family’s dividends that they were better off if they were reinvested in the business, and “How much money do you need?!” (an interview by Duncan MacInnes) Exhibit 2: They run a tight ship. Their office is a dated non-descript 1960s o Clearly J Smart (LSE:SMJ) has more money than it knows what to do with. The cash in bank accounts, shares and other liquid assets is generally not needed for operations.
Indeed, the investment property holding division could easily take on some borrowing to finance itself and/or add to the cash pile in what I call the “Cash-Land-Shares Division” – after all, investment property produces £4m rent annually so could support a fairly high level of bank debt. The capital held in liquid form produces very poor returns. We can conclude that the directors run a very inefficient balance sheet. We can also conclude that one day that money might be handed to shareholders. The directors have been on the path of distribution for some time, but they have room to accelerate this – see table. If the directors continue to make good profits from rental income and the occasional capital gain then annual pay outs to shareholders could rise far above the current £3.1m. After all, there is £37m in the form of net cash, shares and a pension surplus payment due. Then there is another £12.3m in development land and active developments as well as £77.7m of offices and industrial units collecting rent. Market capitalisation is £1.66 x 40.7m shares = £67.6m.... .... Musing on the future of that cash NCAV is £120.8m and the number of shares is 40.7m therefore NCAV per share is £2.97. By buying-in 1% - 3% of its shares each year at a price below NCAV per share the controlling family and the other remaining shareholders gain an increase in net current asset value per share. Average profit after tax over the last nine years is £4.84m – see below at bottom of the table (the other numbers are before deduction of tax).... .... An attempted valuation – conservative approach Assume to start that the company produces £4.84m after-tax profits in all future years. Assume in each future year that this £4.84m is allocated as follows:
Shareholders who do not sell any shares benefit from,
Call this Scenario one. Scenario one extended: what if J Smart (LSE:SMJ), as well as holding a large portfolio of industrial units and offices to rent out has very large sums stored in bank accounts, in stock market shares, in land, in half-finished buildings and in a pension fund. I regard this capital allocation as if it were to a business largely separate from the core property holding division. Most of this money could be paid out to shareholders without much impact on the investment property holding division.
The cash pile is very large, at £31.2m, for a business with a market capitalisation of £67.6m. Land held for development and work in progress is valued at the lower of cost and net realisable value). The Construction division This generally engages in building social housing when a deal can be made with a housing association, and in private housing. Much of the time there is no project. The directors describe this industry as “competitive”. So, despite having good relationships with potential clients and a good reputation they seem to have gone through long periods of either low activity resulting in a large group of underemployed tradesmen receiving full wages or periods of work on low margin. When John M Smart was in charge (he retired in 2017) there was a philosophy of holding onto around 170 full-time employed tradesmen rather than outsourcing the main parts of a project – this approach improves quality but pushes up fixed costs horrendously. The new generation of Smarts now in charge say they expect to do more subcontracting, lowering the numbers of full-timers. Between July 2016 and July 2022 the number of employees across the Group fell from 298 to 147. A large element of the drag on the construction division, concrete slab making was closed four years ago – it had 70 workers. We could be getting to the point where J Smart employs about 25 people in head office plus another 100 or so on building sites, often building more industrial units for J Smart to rent out, or in managing rented offices, etc. The numbers from the last eight years show why radical surgery was needed – see table. Construction revenue and operating profit....... I bought into J Smart (LSE:SMJ), the Edinburgh-based property company, at a price of £1.66 a share or a market capitalisation of £1.66 x 40.7m shares = £67.6m. The main attraction, apart from being well-run and nicely profitable is the exceptionally strong balance sheet with 297p of net current asset value per share providing a good margin of safety.
Net current asset value The company classifies its office holdings and industrial units as “non-current”. I regard this as unreasonable in the case of a company which invests in commercial property to receive a rental income and is always open to selling buildings if the price is right – they are tradable assets. So, in the table below I include all its “Investment properties”. These are revalued each year. I have followed Benjamin Graham’s automatic distrust of the receivables by deducting 20% as unlikely to be paid. However, I have not reduced the inventories number because, in this case, the inventory is mostly recorded in the balance sheet as the cost of developing land and half-built industrial units and offices. It is reasonable to suppose that the market value of these is at least the expenditure laid out on them so far........ ...... The current share price is at a 44% discount to NCAV. But we still need reassurance on financial stability; managerial ability and integrity, and; business soundness. J Smart’s investment property holdings At one time J Smart concentrated on being a constructor of commercial property for other organisations. Today, that business is diminishing after years of losses. Now the main attraction for share investors is the large collection of industrial units and offices it owns and rents out in the Scottish Central belt. The company holds about 1m sqft of property available for letting. Three-quarters of the value is in industrial units; the remainder offices. Investment property is revalued by the directors each year, with a sample checked by professional valuers.................................................................. |
Glen ArnoldI'm a full-time investor running my portfolio. I invest other people's money into the same shares I hold under the Managed Portfolio Service at Henry Spain. Each of my client's individual accounts is invested in roughly the same proportions as my "Model Portfolio" for which we charge 1.2% + VAT per year. If you would like to join us contact Jackie.Tran@henryspain.co.uk investing is about making the right decisions, not many decisions.
Categories
All
Archives
May 2023
|