The Illusion of Market Indexes

The Illusion of Market Indexes

I ran across this on Keith Richard’s blog on technical analysis, Smartbounce…

“More than 20% of the S&P500 is comprised of 5 stocks: AAPL, MSFT, FB, AMZN, GOOGL. The NASDAQ’s top 5 stocks, making up some 40% of the index, are also AAPL, MSFT, FB, AMZN, GOOGL”.

This is why I largely ignore the market indexes when evaluating the current state of the market. These stocks have become so large they have become in effect commodities. All of the institutional money in the markets pour into them lemming like and it isn’t always for fundamental reasons. To keep your job on wall street, its important to do what everybody else is doing and in so doing you keep your job. Institutionalized thinking invests in institutions. When the markets turn as they eventually will, all of these guys will try to leave out the same door…all at once. Markets can go down harder and faster than they go up. Just a word to the wise. 

Rather than focus on the market indexes, try paying attention to your own stock portfolio. How is it behaving? Has it been eroding away while the SP500 continues to churn up? Getting a bead on what is happening to your own investments can be a good way of getting information on what is happening in the markets as a whole. In my own portfolio, Open Text (OTEX) has been consolidating for a year now, it just put in a lower top in late October. Descartes Systems Group (DSG) has dropped dramatically last week. These are both tech stocks. Is the underlying market weakening here? I wonder...Is there any market rotation going on? As the indexes continue to surge up, fed on their own mathematics and momentum, money is often siphoned out some of the overbought sectors. Is that money being allocated to more attractive opportunities elsewhere? Maybe to market sectors which  present a more value added proposition?

It's important to be an individual in a crowd and think for yourself.  Especially when investing in the stock market. Consider contrarian possibilities. Tune out the media. They have no clue and even if they did I doubt they would inform you. Try to emulate a Howard Marks, and manage your risk appropriately. Investing in the stock market is an art form, not a science.

Two things that seem to hurt me

Two things that seem to hurt me

Two things that seem to hurt me in my investing are impatience and getting so wrapped up in a certain investing idea that I fail to consider other alternative courses of action. I recently ran across a good definition of patience…

‘Patience is a highly sought virtue. To be patient is to wait, to be able to mentally insert a wedge between a linked stimulus and response and so place a stop on repetitive, habitual, often destructive behaviour. Patience gives you a moment to access, step back from the brink, and bring yourself back into balance.

The idea is that we restrain our will to stop an impulsive or destructive action (often based on short term relief from tension or instant gratification) and in doing so, turn our energy in a constructive or creative direction – to use our will in a directly beneficial way. Patience, then, is the mental reflection of the restraint of will.’

Dr. Gerald Epstein

That one line... ‘The idea is that we restrain our will to stop an impulsive or destructive action (often based on short term relief from tension or instant gratification)’, really resonates with my own experience of investing and probably my life as well.

What are enterprise valuations?

What are enterprise valuations?

 

I recently read a book called 'How to Pick Quality Shares' by Phil Oakley. It was an excellent read. Below is an article he wrote about enterprise values. I got it from this UK site where he discusses much more about researching stocks.

 

 https://www.sharescope.co.uk/philoakley.jsp

 

 

An enterprise value tell you how much a buyer would have to pay to buy a company as a whole, not just the equity part of it. To calculate a company's EV you need the following bits of financial information about a company:

• Its market capitalisation (the market value of its equity) - this is simply the current number of shares in issue multiplied by the current share price.
• Total borrowings - this can be found on a company's balance sheet.
• The total value of cash and cash equivalents. Again this can be found on the balance sheet.
• The value of any preferred equity shares (preference shares). This can be a balance sheet value or a market value of the preference shares traded on a stock exchange.
• The value of any pension fund deficit. These are real, debt-like liabilities that any buyer would have to take on or pay off. Again, this number can be found on a balance sheet.
• Minority interests - the amount of equity that does not belong to the company's shareholders. Minority interests occur when a company owns more than 50% but less than 100% of a business.

EVs can be seen as a total market valuation of a company's assets.

Calculating Booker Group's EV (£m)

 

Here's how Booker Group's EV is calculated.

Mkt Capitalisation (1782.5m x 200p)	£3,565m
Add: Total Borrowings	£0m
Take away: Cash & cash equivalents	-£161m
Add: Preferred Equity	£0m
Add: Pension fund deficit	£47m
Add: Minority interests	£0m
Total Enterprise Value (EV)	£3,451m

Anything added to a company's market capitalisation in the calculation of EV is effectively something that else that has to be bought or a liability that has to be taken on. The cash balance is deducted as it is assumed that the company can use this to pay some of its liabilities. This then lowers the purchase price or EV for a buyer.

How to use EVs

 

The important thing to remember when you are using multiples to look at the value of companies is that the numerators and denominators of them must match up.
So price multiples which concern the equity of a company must be matched with corresponding returns:

PE	Price	EPS (post-tax profit per share)
P/FCF	Price	Free cash flow (for equity)
P/NAV	Price	Book value of equity (net asset value)

The same applies for EV multiples. Because EVs are all about the market values of equity and debt they must also be matched with the corresponding returns: the sales, pre-interest profits and free cash flows that accrue to both lenders and shareholders.
If you don't match up the right numbers then you are effectively comparing apples with oranges. For example price/EBITDA per share or EV/net profit.
Taking this on board, it is possible to calculate the following EV multiples:

• EV/EBITDA
• EV/EBIT
• EV/FCFf
• EV/NOPAT (Debt-adjusted PE)
• EV/Sales
• EV/Capital Employed
• Earnings power value (EPV)/EV
•  

Just as with price multiples, the lower the number, the cheaper the valuation of a business and the cheaper its shares are deemed to be.

As with price multiples, they can be calculated on a trailing/historic basis using reported numbers or on a forecast basis (where forecast values are available). This article uses reported numbers.
Always remember that low valuations can often be a sign of a poor quality business and do not make very good long-term investments. Conversely, higher valuations associated with high quality businesses which have good growth prospects can be very good investments.
Let's take a look at these EV multiples in turn by using them to analyse the value of the UK food retailing sector.

If you are a less-experienced investor, don't worry if you get a bit bogged down. Pick one or two of these ratios and try using them alongside the usual price multiples. It's all about gradually expanding your knowledge and analytical toolkit.

EV/EBITDA

This is by far the most popular and widely used EV multiple.
EBITDA (earnings before interest, tax, depreciation and amortisation) is seen as a proxy for a company's pre-interest, pre-tax gross operating cash flow. It is favoured by some analysts and investors over measures such as the PE ratio because:

• EVs are better than PEs for comparing companies with different amounts of debt and cash. (This argument applies for all EV multiples). EBITDA is a pre-interest figure - unlike EPS - so looks at a number that can be claimed in part by a company's lenders and shareholders.
• Different companies have different depreciation, amortisation and tax - all of which distort EPS numbers. EBITDA gets rid of these distortions.
• Because of the deductions, EPS will be a negative number more often than EBITDA. EV/EBITDA therefore gives some way of valuing a loss-making company and comparing it with others.

Detractors of EV/EBITDA (including me) would make the following points:

• EBITDA is not a reliable measure of a company's operating cash flow. This is especially true for a fast-growing company which requires lots of working capital cash outflows. EBITDA will also not take into account companies making large top up pension deficit payments.
• EBITDA does not take into account the amount of money needed to replace a company's assets. This is especially true for capital intensive sectors such as food retail, pubs, manufacturing and mining where assets need to be replaced (replacement capital expenditure or capex) in order to maintain sales and profits.
• EBITDA also ignores differences in accounting policies such as revenue recognition and the the capitalisation of costs. For example, software companies can choose either to fully expense or to capitalise and amortise development costs. A company capitalising and amortising development costs would have a higher EBITDA than one which fully expensed them against revenues even if they had spent the same amount of cash.

So unless a company has no replacement capex, no tax bill, no pension deficit or no working capital requirements. EBITDA is not a good proxy for cash flow that can be paid to investors which makes EV/EBITDA a poor valuation method in my view.
But this is how it might be interpreted for the UK food retailing sector:
Sainsbury's would be seen as the cheapest company on this measure trading on just 6.2 times its last annual EBITDA with Ocado the most expensive on 25.3 times.
6.2 times is a very low multiple and may be seen as a sign of a very cheap business or one that is facing a number of challenges. 25.3 is expensive and requires many years of strong profits growth to justify it.

EV/EBIT

EBIT (earnings before interest and tax), also known as operating/trading profit, is probably the best measure of profits for a company as a whole. It is subject to many of the same criticisms as EBITDA above but at least a deduction for the replacement of fixed assets in the form of depreciation has been made.

A thorough analyst or investor will spend some time looking at the quality of a company's accounting on issues such as working capital, depreciation, pension funds and revenue and cost recognition. This requires quite advanced financial analysis but if the analyst is satisfied that there is nothing dodgy going on then EV/EBIT can be a reasonable basis for valuing a company in steady state (ignoring the costs of growing the business)

Again low EV/EBIT numbers can be seen as a sign of cheapness and vice versa. EV/EBIT can also be turned upside down (EBIT/EV) to get something known as an EBIT yield. Expressed as a percentage, the higher the EBIT yield, the better value the share.
As with EV/EBITDA, Sainsbury's looks cheap on this measure but McColl's looks slightly cheaper. Ocado has a very high valuation of 86.5 times or a very low EBIT yield of just 1.1%. Again, this is telling us that very high rates of profit growth are needed to justify its current EV.

Generally speaking, if you can pick up a decent quality business with an EV/EBIT multiple of less than 10 and where there is the prospect of growth you stand a reasonable chance of making money. 

I have bought businesses with EV/EBIT multiples as high as 20 providing the quality of the company is very high and it has a good chance of growing strongly for many years to come. Of course, I'd rather pay a lot less.

EV/FCFf

Free cash flow for the firm (FCFf) measures the amount of surplus cash flow left over to pay lenders and shareholders after assets have been replaced, new assets have been invested to grow the business (capex) and tax has been paid.

Providing capex levels are not too low (considerably less than replacement needs or depreciation) and the tax expense is not too high or low then FCFf is a good number to value companies. Professional investors will often adjust the capex number for maintenance or "stay in business" capex to get a better feel for underlying free cash flow generation. SharePad deducts all capex when calculating FCFf.

EV/FCFf or 10 or less can be a sign of very cheap share. Morrisons looks interesting from this point of view. McColl's which looked relatively cheap to its peers on EV/EBIT looks less attractive on this measure.

Closer inspection of McColl's reveals that this is due to working capital cash outflows. An investor would need to reassure themselves that these outflows were temporary. The same approach applies to companies whose FCFf has been boosted by temporary inflows of working capital.

EV/NOPAT (Debt-adjusted PE)

NOPAT stands for Net operating profit after tax (or taxed operating profits). We call this Debt-adjusted PE in SharePad. It is very similar to EV/FCFf but with a couple of differences.

• NOPAT only includes a deduction for depreciation (replacement capex) whereas FCFf deducts all capex. Where capex is considerably more than depreciation, a company will have a lower debt-adjusted PE than EV/FCFf multiple.
• NOPAT makes no adjustments for working capital inflows or outflows whereas FCFf does. In some ways this is sensible if you want to look at the value of a business in steady state before growth is taken into account. EV/FCFf can be lower than debt-adjusted PE if there is a substantial working capital inflow (due to reducing stock or paying bills later).

In my view, companies should not be penalised heavily for working capital outflows used to fund future growth. If there are consistently high outflows - faster than the growth in sales - then this may be a sign of profit manipulation. Also, working capital inflows such as those from squeezing suppliers for longer payment terms are rarely a permanent source of value which can be mistakenly ignored if using FCFF.

I like debt-adjusted PE or EV/NOPAT as a way of weighing up a company's value. If I can reassure myself that the company's accounting is sound and profits are capable of growing then it is something I tend to use a lot in my own investing toolkit.
Ideally I look to see if I can buy high quality, growing companies for less than 20 times debt adjusted PE. That's not very easy in current stock markets.

The food retail sector is not looking very attractive on this measure with the possible exceptions of McColl's. That said, food retail is fiercely competitive with low profit margins and poor growth prospects. McColl's may not be a cheap share for this reason.

EV/Sales

Price to sales is commonly used to weigh up the value of loss-making companies or those with cyclically-depressed profits in a recession. It was a measure that was used extensively by technology analysts during the dot-com boom of the late 1990s.

As with all price-based multiples, a price to sales multiple ignores companies which are financed by significant amounts of debt. Some of the sales will be needed to pay interest on debts. EV/Sales gets round this problem.

When I worked in the City I occasionally used to come across analyst reports comparing the EV/Sales ratio with a company's profit margins. Broadly speaking, the argument was that there was a correlation between the two numbers - higher margins justified higher EV/Sales multiples and vice versa.

For example, an ex-colleague of mine used to argue that a company with a 10% EBIT margin should trade on a EV/Sales multiple of 1.0. The rough and ready rule was that you divided the EBIT margin by 10 to get the implied EV/Sales multiple. So if a company had an EBIT margin of 5% it should trade on an EV/Sales multiple of 0.5 times. If it was less than that the shares might be undervalued.

On that basis, supermarket shares are no bargains. Perhaps, Sainsbury's with an EV/Sales of 0.3 and a profit margin of 2.6% is worth considering.
I'm not a fan of sales-based valuations. Profits and cash flows are what matters when the valuation of a company is concerned. 

As for the EV/Sales versus profit margin argument. I can see where it is coming from, but would say that profit margins are not the sole determinant of company valuation. Crucially, they ignore the amount of money that has been spent to produce the margins.

EV/Capital Employed

This is the debt-adjusted version of P/NAV (aka price to book value). Here the company's EV is compared with all the money invested (capital employed) in the business.
You can adjust these ratios to take into account of off-balance sheet leases in SharePad if you want to. I have not in this example just to keep things simple.

This ratio is strongly linked to a company's sustainable return on capital employed or ROCE. Good companies with high ROCE will usually see their market valuations - their EVs - trade at a substantial premium to their capital employed.

This is because high returns on capital add value to that capital. Low returns destroy value.
As a rough rule of thumb, a company will need a sustainable ROCE of around 10% to justify the value of its capital employed. As you can see, Sainsbury's trades at a big discount to the value of its capital employed due to its poor ROCE.

So if a company has sustainable ROCE of 20% then a multiple of 2.0 (20% divided by 10%) might be reasonable for the underlying business. You could then adjust this multiple higher if decent levels of growth at a high ROCE were expected to continue.
You could argue that Tesco's and Morrisons' EV/Capital Employed ratios are factoring a big improvement in sustainable ROCE from current levels. If this does not happen, then there is a case for arguing that their shares are overvalued on this measure.

Earnings power value (EPV)/EV

EPV (Earnings Power Value) gives you an estimated value of a business - an EV - based on its current operating profits (EBIT) after tax continuing forever. By comparing this value with the current EV you can have a feel for how much a company's current valuation is explained by its current profits and how much is based on future growth in profits. This ratio is one of my favourite ways of using EVs - I've called it EPV yield in the table below.
For example, McColl's has an EPV yield of 95.8% which suggests that almost all of its current EPV is explained by its current trading profits. Sainsbury is similar. Your job as an investor is to try and work out whether that is reasonable. Ask yourself:

• Can these businesses growth their profits from their existing business?
• Can they invest in new assets at reasonable ROCE (more than 10%)?

If the answer is yes, then perhaps the shares are undervalued.
Tesco and Ocado are the outliers here. More than 80% of their current EPV is explained by future profit growth. Again, ask yourself whether that is a reasonable expectation.

Stock Idea…Guyana Goldfields Inc

Stock Idea…Guyana Goldfields Inc

Symbol : GUY

Exchange: TSX

Market Cap : 811.5 Million

Revenue : 187 Million
Three Year Revenue Growth :
Investment Type : Small Cap Value/Growth

Price/Earnings : 34.2

Forward P/E : 11.0

Price/Book : 1.8

Price/Sales : 3.5

Price/Cash Flow : 11.6

Price : 4.69
Investment Stem :

Guyana Goldfields Inc. (Guyana Goldfields) is a Canada-based mineral development and exploration company primarily focused on the acquisition, exploration and development of gold deposits in Guyana,

Guyana Goldfields Inc. (Guyana Goldfields) is a Canada-based mineral development and exploration company primarily focused on the acquisition, exploration and development of gold deposits in Guyana, South America. The Company's Aurora Gold Mine is an operating gold mine project, which is located in Guyana. The Company owns approximately 100% interest in the Aurora Project, which has total proven and probable reserves of approximately 3.04 million ounces of gold. The Company also holds an interest in a land package located in the Aranka district of Guyana approximately 30 kilometers northeast of the Aurora Gold Mine, known as the Aranka Properties, which consist of a number of separate properties, including Sulphur Rose. Within an area located northeast from the Aurora Gold Mine, the Company also holds an interest in certain additional properties known as the Other Properties. The Company's subsidiaries include Aranka Gold Inc. and AGM Inc.

The dreaded metrics from Morningstar…

http://quote.morningstar.ca/Quicktakes/stock/keyratios.aspx?t=GUY&region=CAN&culture=en-CA&ops=clear

The company’s website…

https://www.guygold.com/Home/default.aspx

An article from seeking alpha (just for a little perspective)

https://seekingalpha.com/article/4043945-guyana-goldfields-slated-50-percent-production-growth-2018

Another junior gold producer (I’m growing quite fond of this sector). The Baupost Group (yes that’s the house where Seth Klarmin lives) is a beneficial owner. The company itself owns lots of their own stock, strong Balance sheet with $65.4 million (US) cash versus debt of $68.8 million (US) as June 30^th 2017.

The company is a high grade gold producer with 15 plus years reserve with good cash flow generation and no by-products (100% gold exposure). Operating numbers over the last couple of years have shown dramatic improvement...While the market is going gaga over the US big cap tech stocks I'm finding value in the junior gold mining sector in Canada. As always this is just an investment idea, remember to do your own due diligence before putting your money at risk in the market. Investing in the stock of listed companies can be fun but it can hurt too.

An Interview with David Barr of PenderFund Capital Management

An Interview with David Barr of PenderFund Capital Management

Seeking Alpha recently conducted an interview with David Barr of PenderFund Capital Management, an investment institution I have followed for a few years now. I thought I would pass along this interview as it sheds light into his investing approach to the stock market...

David Barr, CFA, is the President and CEO of PenderFund Capital Management. He is also the Portfolio Manager of several of Pender’s funds. David began investing in 2000, initially working in private equity, which gives him a unique background to investing capital in public markets. He is an advocate of value investing and believes that investing in a company well below intrinsic value decreases the risk and sets it up for generating long-term performance.

He looks for value in unpopular places with a view to finding “quality at a discount.” David has been interviewed for his opinions on small cap, the technology sector and value investing by Bloomberg, Financial Post, The Globe & Mail, BNN and other media. We emailed with David Barr about major catalysts for a thesis, how to determine the private market value of a company and how he takes a private equity style approach to public markets.

Seeking Alpha: For two years in a row, your fund (Pender Small Cap Opportunities Fund) won a Lipper Fund Award for Best Canadian Small/Mid Cap Equity Fund – what are the key drivers for this performance? How does this apply on a go-forward basis?

David Barr: The fund’s performance since inception has been driven by two factors. First, our investment process and secondly, the sector of the market we invest in.

Our investment process is a private equity style approach to public markets. We like to dig deep on the companies we invest in and the industries they operate in. This gives us an in-depth knowledge of various aspects of the company which helps us to evaluate the opportunity.

We look at competitive advantage, what does the company do to differentiate itself and how sustainable is it? What is the operating landscape and what are the associated dynamics?

How big is the market being addressed, and how fast is it growing? What stage is the company at?

We assess the management team, asking ourselves how competent are they, can they execute on an operational and strategic level? What is their ability to allocate capital? We also like to assess the incentive system for management and the cultural integrity of the firm.

And of course, we look at fundamentals; what are the underlying economics of the business? What is the true, long-term earnings power of the business in terms of free cash flow?

Once we understand the business, we can make a better estimate of what we believe the intrinsic value of the company is and answer the question “what would an independent third party come and buy this whole company for?”

The second factor is the part of the market we operate in. Many traditional Canadian investors have a significant portion of their portfolios allocated to resource-based stocks. We have always gravitated towards non-resource stocks and more into technology, and technology has outperformed resources over the past five years.

On a go-forward basis, we don’t know which part of the market is going to perform well, particularly in the short term. What we do know is that we will continue to execute the same disciplined process that has underpinned our performance record to date.

SA: As a follow up, can you explain the reasoning behind the decision to cap the fund and the benefits of this? How much capacity is available in the Canadian micro/small cap space? How does this compare to the U.S. markets?

DB: We capped the small cap fund a couple of years ago to allow the fund to maintain the same investment strategy it had employed since inception. As funds grow, they become restricted from investing in small and microcap companies and we believe this part of the market contains some of the most compelling investment opportunities. Our view on capacity is that you can continue to operate effectively at $200 Million, but it becomes more challenging when you get to $500 Million.

We are spending a lot of time looking for US-listed opportunities now. The reality is that US markets have more companies to invest in, and in particular, non-resource ideas. Our view on capacity is the same for the US as for Canada. As long as you are running a fairly concentrated portfolio, the limiting factor is the size of positions in microcap opportunities.

SA: What are some of the most out of favor industries or stocks right now? How do you make the key determination between a security that is out of favor for a good reason compared to one that is merely oversold or misunderstood by the market?

DB: To determine the merits of a security that is out of favour for good reason, compared to just being oversold, you need to distinguish between secular and cyclical forces. Wynn Resorts’ (NASDAQ:WYNN) problems a few years ago seemed cyclical. Sears Holdings’ (NASDAQ:SHLD) on the other hand are secular.

As for what’s out of favour? We ask ourselves what’s currently most popular and invert. The case right now is that ETFs and passive investing are in vogue, therefore we look for non-index names that appear either attractively valued or cheap. And small cap companies seem to be more chronically undervalued because they don't get an automatic bid from the inflows of index investors. Eventually, math matters. In the meantime, it's a great time to pick up undervalued securities in these ignored areas.

SA: What catalysts do you look for in value investments? How often are the projected catalysts realized? How do you determine when to sell if a catalyst is realized (or not)?

DB: As is our answer to so many questions, it depends. Let’s define a catalyst as an event that makes the share price go up. The most logical event is the sale of a company. For our part, we try to determine private market value or the price another company will pay. This process also helps us to assess the likelihood that company will be acquired and to do this you need to understand the shareholder base and management incentives.

Having a large assertive shareholder will increase the probability of acquisition, as will having a management team that is incented to create an exit for shareholders. These include companies that are increasing their market share and addressing new and large markets, or companies that have a wonderful product that fits into the product roadmap of a competitor. Not only do we think these types of companies are worthwhile to own over the long term, other companies tend to share our view.

The other major catalyst we see is when uncertainty becomes certainty. For example, when a company hits a significant inflection point such as going cash flow positive. In this situation, the uncertainty as a going concern is removed. Another example is an established company with a declining legacy business that develops a next generation product, and growth in sales of the new product eclipse those of the legacy product, making the business attractive again.

SA: How do you determine the private market value of a company, especially from an M&A standpoint? What metrics do you use to arrive at this value?

DB: Having been involved in the sales process of several companies, it gives you a lot of insight into what buyers are looking for when they buy a company. In determining private market value and the metrics used, again, it depends. So many variables come into play that every situation is unique. The bottom line is that you need to determine what the earnings power of the acquired entity will be within the acquiring entity. To assess this, you need to understand what drives the gross margin.

You need to understand the degree of general and administrative expenses that can be eliminated, similarly with sales and marketing overlap or R&D overlap. That drives the base earnings power and value. You can then layer in some additional assumptions, like whether the larger company will get an immediate revenue bump through increased distribution, or sometimes companies only want to buy from a larger, very well capitalized company so this will drive an increase in sales. When calculating our margin of safety, we use the base case, but we are always looking for additional optionality.

SA: Can you walk us through your thesis on GreenSpace Brands?

DB: GreenSpace Brands (TSXV: "JTR") is a Canadian organic food, consumer product company. Their brand development is done in-house or through acquisition, and their current brands include: Love Child, Rolling Meadows, Central Roast and Kiju amongst others. The company has recently traded with a market cap of around $85 Million.

We believe GreenSpace Brands has the potential to grow significantly as they consolidate the highly fragmented natural and near-organic food market in Canada. Smaller mom and pop brands naturally hit a growth plateau as it is very challenging to secure large distribution arrangements.

Large retailers dominate the Canadian grocery market and these companies prefer to deal with suppliers that have several brands. GreenSpace Brands has developed strong relationships with these national retailers and can introduce acquired brands quickly into their distribution channel. M&A can be accretive as a result of increased revenue growth and cost savings from M&A, G&A and manufacturing.

Two recent transactions, Love Child and Central Roast are shining examples of possible M&A accretion. GreenSpace Brands was able to double Love Child revenues in five months and turn $600K losses into profitability. And with Central Roast, the company was able to close two distribution deals (Costco and Loblaws) within six months of acquisition for a nearly 50% lift in revenue.

Management has a proven ability to execute. The CEO has an extensive background in natural foods, having founded and operated multiple brands of his own. There is also significant experience at the managerial level in retail product placement and marketing at the national level. On the M&A side, the team has already completed several successful acquisitions, proving their discipline on buying brands at the right price and their ability to integrate them into their existing business.

As previous shareholders of Whole Foods Market, we have spent a lot of time looking into the organic and natural foods market. In Canada it is a $10 Billion market and growing in the low-double digits. We see a great runway ahead as Canada ranks in the middle of the pack in organic food sales per person. In addition, lots of big players are scrambling to compete and the traditional CPG companies have been highly active on the M&A front, something we look for when trying to identify potential catalysts.

The current run rate for the business is around $40 Million of revenue and $1 Million in EBITDA. We are comfortable with some analyst estimates of $55-60 Million in revenue, $2-3 Million in EBITDA (year end March 2018) before any further acquisitions, and ~$65-75 Million in revenue, $3-4 Million in EBITDA (year end March 2019).

The stock is currently trading ~1.4X 2017 revenue, a slight discount to larger food manufacturing brands, which trade around 1.5X revenue and organic/natural brands, which trade around 2X revenue. We believe the discount is unwarranted due to the significant growth runway ahead of company, the lack of competition in its niche and an accretive M&A roadmap.

We see several potential catalysts for increased financial performance of the company. Operational improvement through continued integration efforts and a new warehouse facility coming online (1-2bps improvement to EBITDA); internal development efforts, especially New Love Child products, are gaining momentum and should drive company SSSG; and lower margin products, such as dairy, are naturally becoming a smaller portion of overall revenue. In addition the company has around $5 Million of dry powder for future M&A.

SA: Can you walk us through your thesis on BSM Wireless?

DB: BSM (TSXV: "GPS") is a hardware and software provider for commercial fleet tracking and asset management focusing on key verticals including rail, construction, government and service (utility, security, trucking).

The company is an industry leader with an attractive valuation and the upside of potentially being acquired. It’s a global leader in its key verticals such as the rail industry and has all seven of the Class 1 railways as customers. Its merger with Webtech in late 2015 is a game changer. The merger expanded BSM’s vertical and geographic footprints and catapulted the company into the top 20 commercial fleet telematics providers globally. Post-merger, BSM effectively doubled revenue to $60 Million, reduced costs by $4-$5 Million through cost synergies and moved its EBITDA margin up to around 15% from the low single digits.

BSM has continued to strengthen its core business by consolidating into one software platform and one hardware platform. It is also working on becoming more software focused and hardware agnostic. The company acquired Mobi in October 2016, adding higher margin recurring revenue on analytics to its subscription revenue. At the end of Q3 (June 30, 2017), BSM had 161,000 subscribers and approximately 70% of its revenue was recurring.

As BSM consolidates, organic growth has been slower. However, the company is starting to gain traction in converting its sales pipeline into revenue, especially in the rail and government sectors. Notable recent successes include a government agency signing monthly subscriptions for a potential fleet size of 6,000 vehicles, a Tier 1 rail customer adding 1,500 subscribers, and ongoing orders from the Company’s largest construction customers.

While the sales pipeline is growing, the churn rate is stabilizing. BSM’s churn rate was abnormally high in Q2 due to the 2G/CDMA shutdown of AT&T (NYSE:T) in the US, but it returned to 9% in Q3, a more normal annualized rate. Another 8,000 subscribers are potentially at risk as a result of the 2G/CDMA turndown in Canada: roughly 4,000 will drop off in 2018 and the remaining 4,000 subscribers will go by 2020.

BSM is in the early stages of working through these subscribers and it is likely that some of them will return. In the US, around 1,000 customers returned out of the 10,000 estimated subscriber losses. Gross subscription “adds” from increasing new business will also offset some of these subscriber losses.

The stock is trading at 1.6X revenue and 12X 2018e EBITDA at consensus estimates, a discount to its peers. Recent telematics transactions point to higher valuation multiples - Verizon (NYSE:VZ) acquired Fleetmatics at 6X revenue and 18X EBITDA forward multiples. Given the involvement of activist investor Crescendo (with over 10% ownership) and BSM’s increased scale, it is more likely to become an acquisition target itself for financial and strategic buyers.

Stock Idea…Caledonia Mining Corp PLC

Stock Idea…Caledonia Mining Corp PLC

Symbol : CAL

Exchange: TSX

Market Cap : 77.0 Million

Revenue : 65 Million
Three Year Revenue Growth : -0.7 %
Investment Type : Micro Cap Value/Growth

Price/Earnings : 8.4

Forward P/E : 182.5

Price/Book : 1.1

Price/Sales : 1.0

Price/Cash Flow : 3.0

Price : 7.30
Investment Stem : Cheap Small Cap Screen

Caledonia Mining Corp PLC and its subsidiaries are engaged in the operation of a gold mine and the exploration and development of mineral properties for precious metals. Its segments include Corporate, Zimbabwe, South Africa and Zambia.

Caledonia Mining Corporation Plc is primarily involved in the operation of a gold mine, and the exploration and development of mineral properties for precious metals. The Company's activities are focused on the Blanket Mine in Zimbabwe. Its segments include Corporate, Zimbabwe, South Africa and Zambia. The Corporate segment includes the Company and Greenstone Management Services Limited (UK) responsible for administrative functions. The Zimbabwe segments include Caledonia Holdings Zimbabwe Limited and subsidiaries. The Zambia segments consist of Nama copper project and cobalt project. The South Africa segment comprises a gold mine, as well as sales made by Caledonia Mining South Africa Proprietary Limited to the Blanket Mine. The Blanket Mine is located approximately 560 kilometers south of Harare and over 150 kilometers south of Bulawayo. It has exploration title holdings in the Gwanda Greenstone Belt totaling approximately 80 claims, covering a total area of over 2,500 hectares.

The dreaded metrics from Morningstar…

http://quote.morningstar.ca/Quicktakes/stock/keyratios.aspx?t=CAL&region=CAN&culture=en-CA&ops=clear

The company’s website…

http://www.caledoniamining.com/

An article from seeking alpha from 2016...

https://seekingalpha.com/article/3969581-small-stock-big-dividend-caledonia-mining-corp

Another company which came up in my cheap small caps scan of the Canadian market. Very cheap with surprisingly good operational metrics. Has a dividend yield of 4.80 percent which is very rare for a micro cap gold miner. Capex is expected to drop dramatically starting next year. Allan Gray (South Africa Institution) owns 19.8 percent of the company. There are risks of course but as far as I can see they have already been discounted into the company’s stock price. Not trading too far above its tangible book value. A very interesting investment idea especially for the longer term. Is listed on the NYSE as CMCL

Stock Idea…Ten Peaks Coffee Co Inc

Stock Idea…Ten Peaks Coffee Co Inc

Symbol : TPK

Exchange: TSX

Market Cap : 55.9 Million

Revenue : 84 Million
Three Year Revenue Growth : 15.0 %
Investment Type : Micro Cap Value/Growth

Price/Earnings : 12.6

Forward P/E : 12.9

Price/Book : 1.2

Price/Sales : 0.7

Price/Cash Flow : 8.0

Price : 6.18
Investment Stem : Cheap Small Cap Screen

Ten Peaks Coffee Co Inc is a specialty coffee company owning interest of Swiss Water Decaffeinated Coffee Co. Inc., a green coffee decaffeinator and Seaforth Supply Chain Solutions Inc providing green coffee handling & storage services.

Ten Peaks Coffee Company Inc is a Canada-based specialty coffee company. It operates through two subsidiaries, Swiss Water Decaffeinated Coffee Company Inc (SWDCC) and Seaforth Supply Chain Solutions Inc (Seaforth). SWDCC is a green coffee decaffeinator located in Burnaby, British Columbia. SWDCC employs the SWISS WATER Process to decaffeinate green coffee, which are sold to specialty roaster retailers, specialty coffee importers and commercial coffee roasters. SWDCC also sells coffees internationally through regional distributors. SWDCC's target market is the specialty coffee segment. Seaforth provides a range of green coffee logistics services, including devanning coffee received from origin; inspecting, weighing and sampling coffees, and storing, handling and preparing green coffee for outbound shipments. Seaforth provides all of SWDCC's local green coffee handling and storage services. In addition, Seaforth handles and stores coffees for various other coffee importers and brokers.

The dreaded metrics from Morningstar…

http://quote.morningstar.ca/Quicktakes/stock/keyratios.aspx?t=TPK&region=CAN&culture=en-CA&ops=clear

The company’s website…

http://www.tenpeakscoffee.ca/

An article from seeking alpha from 2015 (just for a little perspective)

https://seekingalpha.com/article/3275465-ten-peaks-coffee-wait-for-a-pullback

This company came up in my cheap small caps scan of the Canadian market a couple of months ago. It is presently trading at not much above its tangible book value so you are getting the operational side of the business for peanuts. The company is currently taking their free cash flow and investing it in a new plant to grow its business in the future. Stephen Takacsy has talked about this company on Marketcall (a phone in investment show on BNN), he has a large holding in the company. I expect much better operational results in the next year or so. Right now it is suffering from low expectations which is a good thing and very commonplace in the underfollowed Canadian small cap market.

Update on Ten Peaks Coffee Inc...as of June 18 2018

Based in Burnaby, B.C., the company is the world’s only third-party producer of decaffeinated coffee using a 100-per-cent chemical-free Swiss Water process. Also provides coffee storage and handling/logistics services. Customers are large chains like Tim Horton and McDonald’s, specialty roasters/coffee chains and global importers. Decaf is growing faster than coffee, and methyl chloride used to decaffeinate most coffee is being increasingly shunned worldwide. Competition is shrinking as two older chemical-free CO2 plants have recently closed in the U.S. and Europe. TPK is forecasting double-digit volume growth in 2018, and is opening a European office to meet additional demand there. It is currently building a new plant to increase capacity by 50 per cent, which will be ready in 2019. Stock is very cheap at 14x trailing P/E and 0.6x sales for a consumer-product company with high barriers to entry, strong free cash flow generation and global growth potential. Also pays a 4.1-per-cent dividend. We recently added to our position in the low $6s, and now own eight per cent of the company.

Interesting Comments from Leon Tuey

Interesting Comments from Leon Tuey 


Not too many people have heard of Leon Tuey, but he is a Canadian technical analyst, now in his eighties who has a good long term track record and is usually worth listening too.

"Short-term, the major market indices and their internal measures are overbought.  Moreover, short-term sentiment backdrop has deteriorated.  Hence, a pause would not be surprising.  After a minor pause, however, the rally will continue as the intermediate gauges are far from overbought.  Moreover, momentum is re-accelerating.  Long term, the primary trend remains powerfully bullish and the end is nowhere near in sight as the six major factors (monetary, economic, valuation, sentiment, supply/demand, and internal/momentum/technical) continue to give bullish readings.  One of the most amazing aspects of this great bull market is sentiment.  Although the bull market is in its ninth year and most stocks are up several hundred to several thousand percent, investors remain skeptical and pessimistic.  Note that many hedge fund managers are bearish.  Seth Klarman’s Blaupost holds 42% of its assets in cash.  In terms of asset allocation, funds are sitting on a mountain of cash and very low in equities.  In fact, funds are the most underweight in U.S. equities in ten years.  Also worth noting is the shrinkage in the supply of stocks.  In 1996, over 8000 stocks traded in the U.S.  Today, that number has been halved.  This supply/demand imbalance creates an explosive situation for the market.  When the prevailing bearish sentiment recedes, that huge hoard of cash will find its way back to the equity market.  I can hardly wait!

In conclusion, evidence continues to suggest that investors are witnessing the biggest bull market on record.  The first leg of this great bull market commenced on October 10, 2008 and ended in May 2015.  As always, it was driven by an easy/accommodative monetary policy.  The second leg commenced in February 2016, which was driven by improving economic conditions caused by the monetary easing of the last 8.5 years.  Hence, earnings momentum accelerates.  Accordingly, it is always the longest and strongest [segment of a secular bull market].  Investors should emphasize industrials, technology, healthcare, and resource issues and other economy-sensitive areas.

One of the biggest mistakes investors make in a bull market is selling too soon.  Accumulate favored areas when they are oversold and hold for the long-term.  The time to liquidate is when the Fed starts to tighten meaningfully, i.e., when the Fed drains liquidity from the system; raises the discount rate many times in succession; and inverts the Classic Yield Curve (13-week T-bill Yield vs. the 20-year T-Bond Yield).  Do not be distracted by the “noise” and the black headlines."

Stock Idea…Metanor Resources Inc

Stock Idea…Metanor Resources Inc

Symbol : MTO

Exchange: TSXV

Market Cap : 48.4 Million

Revenue : 60 Million
Three Year Revenue Growth :
Investment Type : Micro Cap Deep Value

Price/Earnings : 5.1

Forward P/E :

Price/Book : 0.7

Price/Sales : 0.6

Price/Cash Flow : 3.2

Price : 0.77
Investment Stem : Cheap Small Caps Screen

Metanor Resources Inc is engaged in acquisition, exploration and development of mining properties. The Company operates a gold mine in Quebec and exploration & evaluation properties in the area.

Metanor Resources Inc. is engaged in the acquisition, exploration and development of mining properties, as well as the commercial production of the ore reserves of its Bachelor Lake and Hewfran properties. The Company operates through three segments: the mining site (Bachelor mine), exploration and corporate. The Bachelor Mine is located approximately 90 kilometers northeast of the city of Lebel-sur-Quevillon, Quebec, Canada. The Bachelor property consists of approximately 240 claims and over two mining concessions covering an area of approximately 7,566.73 hectares. The Company is conducting surface drilling program on its Moroy Property. The Company's properties also include Barry project, Wahnapitei Property, Dubuisson Property, Hewfran-2 Property, MJL-Hansen Property, Barry United Property, Barry Extension Property, MJL-2 Property, Nelligan Property, Barry-Souart Property, Geonova Property and Coniagas Property.

The dreaded metrics from Morningstar…

http://quote.morningstar.ca/Quicktakes/stock/keyratios.aspx?t=MTO&region=CAN&culture=en-CA&ops=clear

The company’s website…

http://www.metanor.ca/en/

An article from seeking alpha from 2015 for added information.

https://seekingalpha.com/article/2793385-metanor-resources-a-high-grade-gold-producer

Sometimes an investing thesis can be quite simple. This company is a small gold producer in Canada that trades at below tangible book value. The much larger Kirkland lake Gold Ltd. (KL on the TSX) took an initial position last April and is now a beneficial owner of this company. When larger companies become beneficial owners (owns more than 10 per cent of tradable stock) of smaller companies, it usually means they are interested in buying it outright sometime in the future. The management team at Kirkland Lake Gold obviously think that the stock of MTO is trading at a discount to its net asset value. Free cash flow can be very volatile with junior resource companies but MTO currently has a cash return of 8.3 percent.

Stock Idea…Supremex Inc

Stock Idea…Supremex Inc

Symbol : SXP

Exchange: TSX

Market Cap : 127 Million

Revenue : 166 Million
Three Year Revenue Growth : 7.6 %
Investment Type : Small Cap Value

Price/Earnings : 8.9

Forward P/E : 7.0

Price/Book : 1.5

Price/Sales : 0.8

Price/Cash Flow : 7.0
Dividend Yield : 5.27

Price : 4.46
Investment Stem : Cheap Small Caps Screen

Supremex Inc is engaged in manufacturing and sale of standard and custom envelopes, labels and related products. Its products portfolio includes Stock envelopes, RFID card protector, File folders, Bubble mailers and Degradable window film.

As market leader, Supremex competes effectively within its local markets and nationwide. The Company is currently expanding its reach in strategic markets, quickly gaining market share in the United States, the world’s largest envelope market and strengthening its packaging and specialty products offering

The dreaded metrics from Morningstar…

http://quote.morningstar.ca/Quicktakes/stock/keyratios.aspx?t=SXP&region=CAN&culture=en-CA&ops=clear

 The company’s website…

https://www.supremex.com/

an article from seeking alpha…always useful

https://seekingalpha.com/article/4107223-supremex-envelope

Looks like an interesting company with good institutional sponsorship with Burgundy Asset Management, Norrep Capital, Hillsdale Investment Management, Jarislowsky Fraser and Beutel, Goodman & Company all holding positions in this stock. Has a great cash return of 8.1% with a dividend yield of 5.3%. Another one of Peter Lynch's "Blossoms in the Desert" stocks (a good company operating in a lousy industry). Management have been recently buying back a lot of their stock indicating that they think the stock of their company is cheap.

As always this is just an investing idea. And remember it is wise to buy a basket full of these small cap value stocks so as to spread your risk.

The Best Asset Class to own for the Long term…Small Cap Value

The Best Asset Class to own for the Long term…Small Cap Value

Studies have shown that over time the best asset class to invest in is small cap value. Why? Well first of all small caps fly under the radar of most investors. The attitude is usually, who cares? Investment bankers have little interest; they can’t make any money doing business with them. They are never in the news. But therein lies their attractiveness, they have wager value (little used or known information). Focusing on under used information has got to be a good thing as there is less competition in this area of the stock market. If small cap value is such a good place to invest why not invest in small cap growth? Small cap growth stocks carry with them high expectations for the future and are usually priced accordingly and being small caps to begin with there is more risk in investing in them as there are more inherent risks in investing in small caps to begin with.

To help improve your odds of investing in the small cap value area, an investor should focus on balance sheet quality, positive cash flow and the experience and quality of the management team. These stocks are often takeover candidates providing their investors with liquidity events for the management of their investment portfolios. To avoid value traps, check to see if revenues have been growing over the last three years.

In the macro world where periodic debt crises and instability occur, these companies are often in a position to not only survive but have the resources to capitalize on growth opportunities.

If investing in this area scares you too much you might want to compromise and consider the mid-cap area of the market. The long term returns are a little less but they can be more liquid and have a greater scale in their operations. 

If investing in this area of the market still seems too risky, you might want to consider a barbell approach to managing your investment portfolio. Put half you investment capital in stable dividend growth stocks and the other half in under valued small cap stocks. You can season this idea to your own personal taste and adjust the ratio of these assets as you see fit...50/50...60/40...70/30 and so on.

A Dozen things I’ve Learned from Charley Munger about Capital Allocation

A Dozen things I’ve Learned from Charley Munger about Capital Allocation

(I came across this somewhere on the internet. I was so impressed by it I had to include it all in this blogpost which is more than anything else, a diary to myself.)

1. “Proper allocation of capital is an investor’s number one job.” Capital allocation is not just the number one job of an investor but of anyone involved in any business. This is a core part of why Buffett and Munger say that being an investor makes you a better business person and being a better business person makes you a better investor. Making capital allocation decisions is core to any business, including a hot dog stand. Everyone must decide how to deploy their firm’s resources. Michael Mauboussin and Dan Callahan describe the core task in allocating capital simply: “The net present value (NPV) test is a simple, appropriate, and classic way to determine whether management is living up to this responsibility. Passing the NPV test means that $1 invested in the business is worth more than $1 in the market. This occurs when the present value of the long-term cash flow from an investment exceeds the initial cost.” Of course just passing the NPV test is not enough since the investor or business person’s job to seek the most attractive opportunity of all the opportunities that are available. Building long-term value per share is the capital allocator’s ultimate objective. Buffett puts it this way: “If we’re keeping $1 bills that would be worth more in your hands than in ours, then we’ve failed to exceed our cost of capital.”

2. “It’s obvious that if a company generates high returns on capital and reinvests at high returns, it will do well. But this wouldn’t sell books, so there’s a lot of twaddle and fuzzy concepts that have been introduced that don’t add much.” Munger is not a fan of academic approaches to capital allocation. He would rather keep the analysis simple. One issue that concerns both Buffett and Munger is that many CEOs arrive in their job without having sound capital allocation skills. The jobs that they have had previously in many cases do not provide them with sufficient capital allocation experience. Buffett has written: “Most bosses rise to the top because they have excelled in an area such as marketing, production, engineering, administration or, sometimes, institutional politics.” The best way to learn to wisely allocate capital is to actually allocate capital and get market feedback on those decisions. Allocating capital requires judgment and the best way to have good judgment is often to have experienced some effects of bad judgment. This lack of capital allocation experience can create problems since many people tend to focus on short-term stock prices and quarterly results. Munger believes that if an investor or CEO focuses on wise capital allocation and long term value the stock price will take care of itself.

3. “In the real world, you uncover an opportunity, and then you compare other opportunities with that. And you only invest in the most attractive opportunities. That’s your opportunity cost. That’s what you learn in freshman economics. The game hasn’t changed at all. That’s why Modern Portfolio Theory is so asinine.” “It’s your alternatives that matter. That’s how we make all of our decisions. The rest of the world has gone off on some kick — there’s even a cost of equity capital. A perfectly amazing mental malfunction.” “I’ve never heard an intelligent discussion on cost of capital.” Munger has on several occasions expressed his unhappiness with academic approaches to finance. Buffett describes their approach as follows: “Cost of capital is what could be produced by our 2nd best idea and our best idea has to beat it.” All capital has an opportunity costs – what you can do with the next best alternative. If your next best alternative is 1%, it is 1% and if it is 10% it is 10%, no matter what some formula created in academia might say. Allocating capital to a sub-optimal use is a mis-allocation of capital. As an example, if you are a startup founder and you are buying expensive chairs for your conference room the same process should apply. Is that your best opportunity to deploy capital? Those chairs can potentially be some of the most expensive chairs ever purchased on an opportunity cost basis. I have heard second hand that if you drive an expensive sports car Buffett has in the past on the spot calculated in his head what your opportunity cost is in buying that car versus investing.

4. “We’re guessing at our future opportunity cost. Warren is guessing that he’ll have the opportunity to put capital out at high rates of return, so he’s not willing to put it out at less than 10% now. But if we knew interest rates would stay at 1%, we’d change. Our hurdles reflect our estimate of future opportunity costs.” “Finding a single investment that will return 20% per year for 40 years tends to happen only in dreamland.” The current interest rate environment is a big departure from the past. Andy Haldane has pointed out that interest rates appear to be lower than at any time in the past 5,000 years. These very low interest rates driven by a “zero interest rate policy” or ZIRP have created new challenges for investors and business people. One issue that seems to exists today is a stickiness of hurdle rate at some businesses. Hurdle rates that were put in place in the past may not be appropriate in today’s world. Buffett has said: “The real test is whether the capital that we retain generates more in market value than is retained. If we keep billions, and the present value is more than we’re keeping, we’ll do it. We bought a company yesterday because we thought it was the best thing that we could do with $3 million on that day.” In 2003 Buffett said: “The trouble isn’t that we don’t have one [a hurdle rate] – we sort of do – but it interferes with logical comparison. If I know I have something that yields 8% for sure, and something else came along at 7%, I’d reject it instantly. Everything is a function of opportunity cost.” Warren also recently said that he wasn’t just going to buy using today’s very low rates just because they were his current best opportunity. These sorts of questions are very hard to sort out given the economic environment we are in now is new. The last point Munger makes is that when someone promises you a long term return of something like 20% for 40 years hold on to your wallet tightly and run like the wind.

5. “There are two kinds of businesses: The first earns 12%, and you can take it out at the end of the year. The second earns 12%, but all the excess cash must be reinvested — there’s never any cash. It reminds me of the guy who looks at all of his equipment and says, ‘There’s all of my profit.’ We hate that kind of business.” Munger likes a business that generates free cash flow that need not be reinvested and not just an accounting profit. Some business with an accounting profit require that you reinvest all or nearly all of any cash generated into the business and Munger is saying businesses like this are not favored. Coke and See’s Candies are attractive businesses based on this test. Airlines by contrast are not favored. Munger calls an airlines “marginal cost with wings.” Munger is also not a fan of creative accounting’s attempt to hide real costs: “People who use EBITDA are either trying to con you or they’re conning themselves. Interest and taxes are real costs.” “I think that, every time you see the word EBITDA, you should substitute the word ‘bullshit’ earnings.” Buffett says: “Interest and taxes are real expenses. Depreciation is the worst kind of expense: You buy an asset first and then pay a deduction, and you don’t get the tax benefit until you start making money.”

6. “Of course capital isn’t free. It’s easy to figure out your cost of borrowing, but theorists went bonkers on the cost of equity capital.” “A phrase like cost of capital means different things to different people. We just don’t know how to measure it. Warren’s way of describing it, opportunity cost, is probably right. The answer is simple: we’re right and you’re wrong.” “A corporation’s cost of capital is 1/4 of 1% below the return on capital of any deal the CEO wants to do. I’ve listened to many cost of capital discussions and they’ve never made much sense. It’s taught in business school and consultants use it, so Board members nod their heads without any idea of what’s going on.” Berkshire does not “want managers to think of other people’s money as ‘free money’” says Buffett, who points out that Berkshire imposes a cost of capital on its managers based on opportunity cost. One thing I love about this set of quotes is Munger admitting that Buffett is only “probably” right and that they don’t know how to measure something others talk about. It indicates that Munger is always willing to consider that he is wrong. While he has said that he has a “a black belt in chutzpah,” he has also said that if he does not overturn a treasured belief at least once a year, it is a wasted year since it means he is not always looking hard at whether his beliefs are correct. In his new book Superforecasting, Professor Philip Teltock might as well have been writing about Charlie Munger when he wrote: “The humility required for good judgment is not self doubt – the sense that you are untalented, unintelligent or unworthy. It is intellectual humility. It is a recognition that reality is profoundly complex, that seeing things clearly is a constant struggle, when it can be done at all, and that human judgment must therefore be riddled with mistakes.”

7. “We’re partial to putting out large amounts of money where we won’t have to make another decision.” Attractive opportunities to put capital to work at high rates of return don’t come along that often. Munger is saying that if you are a “know something investor” when you find one of these opportunities you should load up the truck and invest in a big way. He is also saying that he agrees with Buffett that their preferred holding period “is forever.” Buffett looks for a business: “where you have to be smart only once instead of being smart forever.” That inevitably means a business that has a solid sustainable moat. Buffett believes that finding great investment opportunities is a relatively rare event: “I could improve your ultimate financial welfare by giving you a ticket with only twenty slots in it so that you had twenty punches – representing all the investments that you got to make in a lifetime. And once you’d punched through the card, you couldn’t make any more investments at all. Under those rules, you’d really think carefully about what you did, and you’d be forced to load up on what you’d really thought about. So you’d do so much better.” When he finds a really great business the desire of Charlie Munger is to hold on to it. Munger elaborates on the benefits of not selling: “You’re paying less to brokers, you’re listening to less nonsense, and if it works, the tax system gives you an extra one, two, or three percentage points per annum.”

8. “We have extreme centralization at headquarters where a single person makes all the capital allocation decisions.” Centralization of capital allocation decisions at Berkshire to take advantage of Warren Buffett’s extraordinary abilities is an example of opportunity cost analysis at work. Why allow your second best capital allocator or 50th best do this essential work? Here’s Buffett on his process: “In allocating Berkshire’s capital, we ask three questions: Should we keep the capital or pay it out to shareholders? If pay it out, then you have to decide whether to repurchase shares or issue a dividend.” “To decide whether to retain the capital, we have to answer the question: do we create more than $1 of value for every dollar we retain? Historically, the answer has been yes and we hope this will continue to be the case in the future, but it’s not certain. If we decide to retain and invest the capital, then we ask, what is the risk?, and seek to do the most intelligent thing we can find. The cost of a deal is relative to the cost of the second best deal.” As was noted in the previous blog post in this series, nearly everything else other than capital allocation and executive compensation is decentralized at Berkshire.

9. “We’re not going to put huge amounts of new capital into a lousy business. There are all kinds of wonderful new inventions that give you nothing as owners except the opportunity to spend a lot more money in a business that’s still going to be lousy. The money still won’t come to you. All of the advantages from great improvements are going to flow through to the customers.” This is such an important idea and yet it is often poorly understood. Many investments in a business are only going to benefit customers because the business has no moat. In economic terminology, the investment produces all “consumer surplus” and no “producer surplus.” Some businesses must continue to plow capital into their business to remain competitive in a business that is still going to deliver lousy financial returns. Journalists often talk about businesses that “earn” some amount without noting that what they refer to is revenue not profit. What makes a business thrive is profit and absolute dollar free cash flow. One thing I am struck by in today’s world is how hard nearly every business is in terms of making a significant genuine profit. The business world is consistently hyper competitive. There is no place to hide from competition and potential disruption. If you have a profit margin, it is someone else’s opportunity. Now more than ever. People who don’t think this contributes the inability of central banks to create more inflation are not living in the real business world.  Making a sustained profit in a real business is very hard.

10. “I don’t think our successors will be as good as Warren at capital allocation.” There will never be another Warren Buffett just as there will never be another Charlie Munger. But that does not mean you can’t learn from the way they make decisions, including, but not limited to, capital allocation decisions. Learning from others is strangely underutilized despite its huge rewards. Some of this aversion to learning from others must come from overconfidence. This overconfidence is good for society since it results in a lot of intentional and accidental discovery. But at an individual level it is hard on the people doing the experimentation. Reading widely about how others investors and business people approach capital allocation is wise. As an example, Howard Marks and Seth Klarman are people who have learned from Buffett and Munger and vice versa. Having said that, we are all unique as investors. There is no formula or recipe for successful investing. But there are approaches and processes that are far more sound than others that can generate an investing edge if you are willing to do the necessary work. These better decision making process are applicable in life generally. If you are not willing to do the work that an investor like Munger does in his investing, you should buy a diversified low cost portfolio of index funds/ETFs. A dumb “know nothing investor” can transform themselves into a smart investor by acknowledging that they are dumb. Buffett calls this transformation from dumb to smart of they admit they are dumb an investing paradox.

11. “All large aggregations of capital eventually find it hell on earth to grow and thus find a lower rate of return.” Munger is saying that the more assets you must manage the harder it is to earn an above market return. Putting large amounts of money to work means it takes more time to get in and out of positions and for that reason it becomes hard to effectively invest in relatively smaller opportunities. Buffett puts it this way: “There is no question that size is an anchor to performance. We intend to prove that up to the point that it really starts biting. We can’t earn the same returns on capital with over $300 billion in market cap. Archimedes said he could move the world with a long enough lever. I wish I had his lever.”

12. “Size will hurt returns. We can only buy big positions, and the only time we can get big positions is during a horrible period of decline or stasis. That really doesn’t happen very often.” There are times when Mr. Market turns fearful and huge amounts of capital can be put to work even by Berkshire as was the case in 2008. To be able to take advantage of this requires that the investor (1) be patient and (2) be aggressive when it is time. Jumping in when things are falling apart takes courage. Not jumping is during a period of investing frenzy takes character. Bill Ruane believes: “Staying small in terms of the size of fund is simply good business. There aren’t that many great companies.” The bigger the fund the harder it is to outperform. Bill Ruane famously closed his fund to new investors to be “fair” to his clients.  

In terms of an example of outperforming during what for others was a horrible time, the following example of Munger in action below speaks for itself. Bloomberg wrote at the time: “By diving into stocks amid the market panic of 2009, Munger reaped millions in paper profits for the Daily Journal. The investment gains, applauded by Buffett at Berkshire Hathaway’s annual meeting in May, have helped triple Daily Journal’s own share price. While Munger’s specific picks remain a mystery, a bet on Wells Fargo (WFC) probably fueled the gains, according to shareholders who have heard Munger, 89, discuss the investments at the company’s annual meetings. ‘Here’s a guy who’s in his mid-80s at the time, sitting around with cash at the Daily Journal for a decade, and all of a sudden hits the bottom perfect.’”

Munger having the necessary cash to do this investment in size at the right time in 2009 was not accidental. You don’t have the cash at the right time by following the crowd. As Buffett points out holding cash is not costless: “The one thing I will tell you is the worst investment you can have is cash. Everybody is talking about cash being king and all that sort of thing. Cash is going to become worth less over time. But good businesses are going to become worth more over time.” That available cash was a residual of a disciplined buying process focused on a bottoms-up analysis by Munger of individual stocks. His ability to do this explains why he is a billionaire and we are not.