Author: Jun Hao

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I read a story on Kiplinger about a fund manager who closed up shop after fifteen years managing money due to his poor performance in the last two years.

He pretty much sums up the problem with concentration:

Magnifying the problem was my decision to put too much money into my favorite ideas.

I totally bought into the notion that it was foolish to invest in my 60th-best idea.

What I overlooked was how bad things could get if I was wrong about my second-best, third-best and fifth-best ideas at the same time.

This brings me back to one of my old post which I’ve reproduced (the original was lost in the migration).

My thinking on the subject hasn’t changed.


Is Diversification A Defense
Against Ignorance?

There’s  a train of thought among people that concentration is the way to earn out-sized returns in investing.

Buffett probably helped popularize this idea by focusing on his “twenty punch card rule”, citing that diversification is really a guard against ignorance.

Charlie Munger is as much a proponent of concentration as Buffett, and is famously known for saying that 3 stocks is enough.

Personally, I think 99% of investors are better off with a reasonably well diversified portfolio of common stocks (20 – 25) than let’s say a portfolio of 5 stocks.

One can only have conviction to hold on in persistent market declines by way of research that is both borne out of experience and hard work.

You Need 10,000 Hours

Source: Key Leadership Academy
Source: Key Leadership Academy

Malcolm Gladwell often takes about the 10,000 hour rule, and the same applies to investing.

The challenge is that one not only needs to understand a single business well, but to be able to look at it in the context of the big picture.

Investors cannot simply focus on single trees, and have to be weary of the going-ons in the forest as well. This requires concentrated effort and time to pull off – along with a sound framework.

My own personal feeling is to embrace that there are really many things that we do not know anything about, much less control.

Diversification is simply a way of me saying that there are plenty of unknown unknowns.

¨We are obviously only going to go to 40% in very rare situations – this rarity, of course, is what makes it necessary that we concentrate so heavily.

We probably have had only five or six situations in the nine-year history of the Partnership where we have exceeded 25%..“

Buffett Partnership Ltd 1966

What about Activist Investors?

Activist fund managers like Bill Ackman of Pershing Square Management, Carl Icahn of Icahn Capital Management and Jeffrey Ubben of ValueAct Capital run extremely concentrated portfolios.

Their top 5 positions often compromise of more than 50% of their entire portfolio.

But one thing to bear in mind is that unlike us, these investors are activists.

Most investors on the other hand, are minority shareholders, with very little say over managerial discretion.

Taking an activist stance allows investors to become the de-facto catalyst, bringing light to undervalued situations, liquidating positions to return cash to shareholders, re-vamping stagnant management and unlocking the “value” within.

Tracking 13-Fs of Activist Investors

One extremely efficient way of sourcing ideas is to track the 13-Fs of activist investors. The nature of how their portfolios are constructed means a good deal of research has taken place before an activist investor decides to commit.

Furthermore, the presence of activists means that change takes place quicker than slower.

This is not to say that they will always be right; there have been well recorded blow-ups such as Bill Ackman’s failed attempt at a turnaround in JC Penny.

Their overall track record (so far anyway!) has shown however that in aggregate, activists are more often right than wrong, and that their ideas are a good source of ideas that will out-perform the market.

I’ve been following the news about Glencore the last two weeks, and its been a wild ride.

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Is there a mis-pricing here?

I remember hearing the pitch for a couple of commodity stocks over the years. One of them was for the embattled Noble Group by Eastspring (subsidiary of Prudential). Orbis, a fund management company I respect greatly owns a big chunk too.

While management once indicated it was a temporary setback, I am not so sure any more with even the titans of the industries coming to their knees.

One of the things that has always puzzled me is the business models of these business.

Plenty of revenue. Check. Net profits. Check.

Free cash flow? Well, that’s a different matter altogether.

glencore
Glencore’s 5 Year Financial Summary, Source: Morningstar

Every time I see a stock like that, I instinctively think about Enron (not indicating that Enron or Noble Group are frauds like Enron, just highlighting some similarities in their cash flows here..)

Coincidentally, I wrote about it six years ago here.

Enron 1996 – 2000, Source: Enron Annual Reports

Its a simple enough metric to calculate, but surprisingly robust. Cash rarely lies.

So how about our own Singapore listed Noble Group?

noble
Noble Group Financial Summary, Source: FT

 

Maybe its me, but I don’t understand businesses that seem to burn ever more cash as they increase their revenue.

Ten years is a pretty long time for me to see persistently negative free cash outflows.

Still, stock prices are down so much that I had a look at them again to see if I was missing something. However, I can’t wrap my ahead around what these businesses actually do.

Simply put, I can’t figure out how it is that they actually make money.

I think this tweet pretty much sums it up:

 

Chart of the Week:

BrpSyiKCEAAa3u-
Twitter, @PlanMaestro

Video of the Week:

Reading For The Week:

1. How the Superwealthy Plan to Make Sure
Their Kids Stay Superwealthy (LINK)

Passing on a fortune isn’t as easy as it seems. Their research [Preparing Heirs] found that 70 percent of inheritors failed in passing their fortunes on to the next generation.

2. Millionaire (Malaysian) investor uses wealth to help poor  (LINK)

Up until then, he was an executive director in Mudajaya/IJM but gave up his position and invested his time and money in shares.

He started with only RM200,000 to dabble around with and has made money to the tune of millions ever since.

Koon said his trick to mastering the market is to be a “contrarian investor” – one who buys when everyone is selling and who sells when everyone is buying.

3. SGX: 8 Things I Learned from its AGM 2015 (LINK)

Despite the challenges, SGX remains a highly profitable company and is likely to do so in the future simply because it has a virtual monopoly.

Simply said, public-listed companies and investors have no choice but to use the SGX as it is the only stock market exchange in Singapore.

4. Buy Emerging-Market Stocks as Pessimism Peaks, Barclays Says (LINK)-1x-1

-1x-1-1

5. Traders Flee Emerging Markets at Fastest Pace Since 2008 (LINK)

Investors have pulled $40 billion out of developing economies in the third quarter, fleeing emerging markets at the fastest pace since the height of the global financial crisis.

The MSCI Emerging Markets stocks benchmark has declined 20 percent in the past three months, on track for the biggest retreat in four years.

 

Rusmin from the Fifth Person did a great re-cap on the SGX (Singapore Stock Exchange) AGM 2015, which I was not around to attend this year.

SGX: 8 Things I Learned from its AGM 2015

I would like to talk briefly about his first point which I’ve reproduced here

SGX has a dual-role as a regulator which protects the interests of shareholders of publicly listed companies in Singapore and as a profit-driven enterprise that is held accountable to its own shareholders.

I’ve previously been critical of the failure for the authorities to protect minority shareholders. Investors in S-Chips have seen little recourse. The Blumont Saga has dragged on with little updates to minority shareholders.

Justice
Has Justice Been Served?

One of the few updates on it is a case involving Goldman Sachs, and Quah-Su Ling, CEO of IPCO who indirectly involved in the penny stock rout.

So imagine my horror when I read in the newspapers that the SGX was actively seeking more listings from Chinese firms. Considering the sad and sorry tale of financial and corporate fraud of Chinese firms listed overseas, this was depressing.

Still, its hard to blame the SGX, and Rusmin’s point highlights it:

The only stable recurring business for SGX is market data which contributes 10% of the revenue and corporate action services (i.e. processing dividends) which contributes 4.6% of revenue.

A lot of SGX’s revenue derives from activity. The same inherent problem with getting non-bias advice from a barber arises.

If you ask him whether you need a hair cut, what can he say?

SGX must perform its regulatory role, in protecting shareholders. And yet, if listing requirements are too strict, firms will find it increasingly harder to list, thereby reducing their own profits.

Who is going to complain?

The shareholders of the SGX board which are there for a profit sharing motive.

In a way, I pity the whoever takes the role of the CEO of the SGX. As Prof Mak Yuen Teen wrote in his article

A couple of years ago, I met the retired CEO of a listed stock exchange which, like SGX, has dual roles of a regulator and operator. I asked him whether he thought there was a conflict between the two roles.

He replied: “Of course there is, but I couldn’t say it when I was the CEO.”

I think the problem with the current situation is pretty clear.

What puzzles me more is why haven’t the authorities moved to rectify the situation by simply seperating the regulatory role of the SGX into an independent body.

After all, that’s the standard operating practise of most countries.

2

I used to do these presentations regularly during my time in UCL (University College London). Its always great fun to share what I’ve learnt over the years. I get to review and re-look the concepts that deal I with daily.

 

Teaching has always been the best form of learning for me.

One of my favourite parts about these sharing sessions is the Q & A.

There’s a huge gap between theory and practise. Something which I struggled with when I first started too. I remember having an accounting related question on Free Cash Flow vs Owners Earnings that was unresolved for over two years.

I touched about how big that gap can be briefly in my podcast on the perils of index investing, and why its so hard.

You can check it out here:

One of the members of the audience had a great question which commonly comes up:

Is it better to buy cheap companies at good prices,
or wonderful companies at fair prices?

What Warren Buffett Thinks

He’s said this a number of times over the years in various interviews. Here’s the thing though.

I don’t think this is an end all be all statement that conclusively settles the debate. Let’s consider a few things:

  • Academic research shows that investors who invest in “wonderful companies” tend to under-perform “terrible value companies” 
  • Buffett’s track record running his investment partnership far exceeds his track record when he changed styles at Berkshire Hathaway in the last 2 decades
  • He has bought “cheap stocks” from time to time in his own personal account

I tend to find that wonderful companies are easy to spot. Markets tend to be very good at identifying such companies.

What they are not so good are at pricing them appropriately, and investors often end up paying too much for growth.

Not to mention that companies with true “competitive moats” are not easily identifiable.

The Only Thing That Is Constant Is Change

Industries change. Technology changes. What’s a moat might not be one 10 to 20 years from now. Buffett has invested in plenty of companies that have seen their moat being eroded over time.

That’s probably why Buffett tends to stick with things that tend to change glacially.

Like food & consumer products (Kraft, Gilette, Coca-Cola), transport (BNSF), and retail banking (not investment banking!) operations (Wells Fargo, Bank of America).

He’s gone out on a limb to say that he doesn’t invest in technological companies. IBM doesn’t count in my book. If you read his interviews, he tends to see it more as a service provider. But that’s a story for another day.

At the end of the day, I think the peril of investing like Buffett is that we are not Buffett.

He took decades before he slowly shifted to his current style of investing, has an unparalleled network, incredible intellect and a vast amount of knowledge accumulated from decades of non-stop reading.

So Why Does Buffett Buy Good Companies at Fair Prices?

My own opinion is that is a constraint he faces in his opportunity set. He has tens of billions to deploy, and billions more coming in yearly. A good problem surely, but his universe of stocks are limited to those in the S & P 500, and maybe some private companies.

Buying cheap stocks wouldn’t move the needle for him at all. 

His lack of investment opportunities at his size is really shows in his relative under-performance compared to his early days managing small sums of money.

Finally, I think there’s a huge distinction between buying a company and buying a stock. If I were a CEO, I wouldn’t want to buy a lousy run-down company too. Think about the headaches of turning it around.

But as the last post highlights, investing in stocks is very different from investing in a business.

Investing in “cheap cigar-butt stocks” might not be fanciful, but where they excel in are the relative ease in which a determined investor can succeed.