CV Capital – 30 Jan 18 update

To my fellow shareholders,

As one of my first post on CV Capital (CVC), I would like to talk about my investing philosophy. I think it is important that you have a good understanding of my investing strategy as I believe it will:

• Help you understand how I hope to achieve the investment returns
• Align your expectation of the investment returns and the timeframe for realisation of these returns
• Help give you the confidence to stay the course during the downturn when everyone is heading for the exit.

I’ll start with the basics. What is investing?

The simplest definition of investing is to outlay a sum of money today in return for receiving a greater sum of money in the future after adjusting for inflation.

Then the obvious next questions are how how to achieve these positive returns, what the level of risk to take in order to achieve those returns, what returns can we expect and when can we expect to realise these returns.

My investment goal

A high investment return is not hard to achieve. If you are lucky, you can double, triple or quadruple (or more) your money in a matter of hours by betting correctly in a casino. The problem with this approach is that not only have you taken a disproportionate amount of risk to make these returns but it is unlikely that you will be able to replicate your success on the second or third night. Playing in the casino is not a smart way to make money as the odds give the casino a positive expected return on every hand played. Statistically speaking, although the player can get lucky in the short run and win, in the long run the player is bound to lose.

Therefore, in my opinion, the trick with investing is to “be the casino” and find the investments which give you an expected positive return.

As it is impossible to completely eliminate risk (just like the casino can have a bad year – bad luck can strike), my investment goal is to maximise our risk adjusted returns.

How to maximise risk adjusted returns?

I am a believer in the value investing principles founded by Benjamin Graham and practised by many successful investors including the most famous of them Warren Buffett.

What is value investing? Simply put, value investing is basically paying $0.50 for an asset which is worth $1. Value investors don’t believe that the market is perfectly efficient and that price and value are not the same thing. As Warren Buffet famously said “price is what you pay, value is what you get”.

Value investors believe that the asset (stock) prices can sometimes deviate from their intrinsic values and they invest when the gap between the intrinsic value and asset price (margin of safety) becomes large enough. Assuming their intrinsic value calculation is correct, investing this way minimises risk as you tend not to overpay for the asset but rather buy it on a discount.

There are many ways to practise value investing. Some value investors look for “cheap companies”, these are usually mediocre businesses where the stock prices are trading below their net asset values or trading at low price to earnings ratio. Others look for good businesses which have durable competitive advantage and are more willing to pay a price which exceeds the company’s net asset value for quality and future growth.

I’m happy to invest in either cheap or good quality businesses. My investment selection is driven by the opportunities presented by the market. From my experience, when the stock market is buoyant (like it is now) there are less opportunities overall and the opportunities are even fewer in the “quality space” so I tend to find more opportunities in the “cheap space”.  However, if given a choice, I will always prefer the quality businesses. Opportunities in this space typically arise during a market downturn. So we have to be patient to get the opportunities in this space.

An investment needs to pass several filters before I invest. First, I have to understand the business well enough to be able to make a reasonable guess of its future. Second, it has to have honest, sound management which do not try to milk the minority shareholders (but you can never really be 100% sure). Thirdly, the stock must be trading at a large enough margin of safety.  What is the right level for the margin of safety? Obviously the larger the better but it also depends on the underlying asset. I would require a smaller margin of safety for say a real estate investment trust (which is backed by property assets) than compared to say a mid size service type business which is valued on earnings.

Investment Returns

The math in calculating returns is such that a big loss wipes out previous returns. For example, take a look at the table below. Portfolio B’s return trumps Portfolio’s A return mainly because of Portfolio A’s loss in Year 3. 

Therefore, my strategy is not to aim for the stars and face a risk of blowing up but try to minimise risk and avoid blowing up.

As with the opportunities, the market will dictate the returns. Returns are not something we as minority investors can control. All we can do is buy a stock below its intrinsic value and wait for the market to realise its value. When will this happen is usually unknown. However, there are forces which tend to drive the price to its fair value and it can occur due to either the market’s mean reversion characteristics, improving business results, takeover, privatisation of the company, etc.

Ben Graham said this at a senate hearing on the question of undervalued stocks rising to a level of full valuation.

“That is one of the mysteries of our business, and it is a mystery to me as well as to everybody else. We know from experience that eventually the market catches up with value. It realises it in one way or another”.

The stock market by its nature does not produce nice consistent returns. See table below for the annual returns of the ASX 200 price index over the past 10 years.

The compound annual return for the above period (price action only) is 0.7% but the individual yearly returns exhibited much greater volatility. Although the above return does not account for dividends, it was still a very poor decade for stocks.

Time horizon

My time horizon for realising returns is 3 – 5 years with a preference for the latter. There are usually reasons to why a security is undervalued, it may be due to the cyclical issues, business going through a rough patch, unfavourable market sentiment, market not realising its growth potential etc. These issues typically don’t change overnight, they need time to normalise. Even a growth company needs time to execute its plans and deliver the results.

Diversification

Although portfolio diversification is a risk management strategy, it is also a double edge sword. Over diversification tends to dilute your returns. Not only does it dilute your returns but it is challenging to keep track of a portfolio which exceeds say 30 companies. At the same time, putting all your eggs in one basket is risky. Not only is it very hard to know every aspect of a company but sometimes bad luck can strike.

How much to allocate to a single investment is a function of my knowledge and understanding of the company, how big the margin of safety, its risks, its ability to grow its intrinsic value over time and management’s capability.

Depending on the opportunities available, I would like to have 5 – 10 companies in the portfolio with the top 3 – 5 ideas making up the bulk of the portfolio’s value. Again this depends on the opportunities available and if there are more “cheap company” opportunities then I may take the portfolio above 10 companies.  On the other hand, if opportunities arise to buy good quality businesses at decent prices then I may concentrate the portfolio to say 5 investments.

Hopefully this gives you a broad understanding on my thinking and strategy.

CV Capital Update

Other than the stocks I’ve transferred from my personal portfolio, I haven’t made any new investments and we are still sitting on more cash than I would like. Given where the market is, there just isn’t that many interesting opportunities available on the ASX. So I’ve opened up a high interest account with Rabobank which at 3% interest rate should at least keep us level with inflation.

Feel free to contact me if you have any questions.