To my fellow shareholders,
I wish everyone a happy and prosperous new year.
Overall, 2021 has been a year of many economic challenges; China sanctions on Australia’s exports, lockdowns in Sydney and Melbourne during the Delta variant outbreak, significant fall in iron ore prices and continued border closure which significantly impacted tourism, hospitality and education sectors. The Federal Government has supported the economy by running its largest ever budget deficit in 2020/21 of $134.2 billion and is forecast to post an even larger deficit in 2021/22 of $161 billion and these figures exclude the stimulus from the State Governments. Working hand-in-hand with the government, the RBA has kept interest rates at 0.1% and has purchased $4-$5 billion government bonds a week throughout 2021. So despite the economic challenges, the amount of liquidity being pumped into economy has kept asset prices high. House prices were up 22% in 2021 across Australia according to Corelogic. The stock market also posted another good year with the ASX 200 recording a 13.0% return (excluding dividends) in 2021. Our benchmark STW posted 16% return (inclusive of dividends) for the year. One of the glaring lessons of this pandemic is the economy does not drive stock market returns (in the short run at least).
2021 was a pretty “boring” year for the fund. We did not purchase any large new positions as demanding valuations made it challenging to identify value in good quality companies. Most of our activity in 2021 was recalibrating existing positions and doing arbitrage trades.
We fully exited our positions in Kangaroo Island Plantations (KPT) and New Zealand Media and Entertainment (NZME). We lost 42.5% and 11.5% respectively on each position. These were both mistakes that I will make from time to time. I have discussed KPT and NZME in past reports here and here.
We further trimmed our position in Schaffer Corporation, we faired a bit better here making a 95% return over a 4 year holding period. We increased our positions in Bank of South Pacific, Boustead Singapore and Academies Australasia Group. The first two companies I have previously discussed in past reports. Academies Australasia Group (AKG) is an education service provider offering mainly higher education and vocational courses. Australia has been closed to international students for almost two years and this has negatively impacted AKG which relies on a large international student intake. As a result, its share price has fallen 63% from its pre-pandemic high. Management are significant shareholders in the business and they have continued to buy shares in AKG throughout the border closure period. We have a modest position of 4.6% allocated to AKG and I believe that Australia’s attractiveness as an education destination has not diminished despite closing our borders to foreign students. Good quality education, cosmopolitan society, safe environment, proximity to Asia, superb lifestyle will continue to attract foreign students. Our AKG investment is a play on the recovery of international student market and the government has already allowed international students back into the country from 15 Dec 2021. I estimate is that it will take at least 2-3 years before student numbers fully recover to pre-pandemic levels.
This year we were fortunate enough to be able to spot some good arbitrage opportunities. Arbitrage trading accounted for approximately 7% in returns for 2021. Given the crowding out effect of such activities, it’s probably best not to reveal too much detail other than say were able to profit from discrepancies in share prices of dual listed securities.
As at 31 Dec 2021, our top 5 holdings accounted for 54% of the overall portfolio value.
Cash and cash equivalents accounted for 9% of the portfolio. I’ve classified companies under a takeover offer that is supported by management to be “cash equivalent”.
Unregulated monopolies in small markets
When I started this investing journey, my goal was to select investments with the best risk return profiles. Theoretically, this is very appealing but my thinking has slowly shifted over time. I now feel that it is not easy to get a very good handle on risk given there are both known unknowns and unknowns unknowns. One can always handicap for the former but that is not possible with the latter as one is not even aware of the existence of such risk. Coupled with today’s high valuations, this creates a market with many pitfalls.
So rather than looking for investments with the best risk return profiles, my preference has shifted to looking for investment with low risk. My expectation is that going for the lower risk investment will increase our returns by eliminating the losers in the portfolio. Since inception we have made 29 investments (excluding arbitrage trades) and if we liquidated the portfolio today, 9 investments would be losers. So this current loss rate of 31% is what I aim to further reduce.
There are broadly two major risks in stock market investing: 1) business/ cash flow risk and 2) valuation risk. One way to reduce the business/ cash flow risks is to only select companies with a competitive advantage and a proven track record. This means that we won’t be picking the early Amazons of the world but that’s ok because we also won’t be picking the Amazon “also rans” which probably went to zero. And for every one Amazon there are thousands of “also rans”.
Moving forward, I’ll focus our efforts into searching for companies with a competitive advantage that can compound capital at high returns. Generally, unregulated monopolies exhibit these characteristics and my preference for these investments have grown given the business/ cash flow risk (aside from disruption risk) is extremely low relative to the run-of-mill company operating in a competitive space. But of course the problem is every investor and his dog knows this and valuations are usually bid up to levels where returns become ordinary.
The trick is to find these companies at cheap or reasonable valuations. This will involve patience (waiting for market corrections or temporary trip-ups) and searching for market leaders in less crowded areas (smaller segments of the market or smaller markets overseas).
I plan to populate say 60%-70% of the portfolio with unregulated monopolies (or companies with above characteristics) and this would form the core group in the portfolio. Currently, our top 3 positions fit this category (circa 40% of the portfolio). Over time this may mean that more of our portfolio could be invested overseas (currently, 24% of our portfolio is invested overseas). The remaining balance of the portfolio would be invested in bets that are asymmetrical, i.e. tails I lose $1, heads I win $3.
Companies with high returns on capital reduce valuation risk either through growth in earnings or payment of dividends. Future valuation in the context of an earnings multiple is difficult to predict. A company being valued at 20x multiple today maybe valued at 10x in the future simply because of external reasons outside the control of management (interest rates, investor sentiment etc). A company with a high return of capital can mitigate this risk. I’ll illustrate an example of this with Bank of South Pacific (BFL), a company that I have previously wrote about here. BFL is a market leader in South Pacific islands and PNG. Its return on equity is around 30% and dividend payout ratio is 60%-70%. The chart below shows the return experience for an investor if he/ she had bought BFL in Dec 2011 (share price K7.53) and held it to Dec 2021 (K12.30).
In Dec 2011, the market valued BFL at a price earnings ratio of 10.2x but over the next decade it fell and it’s currently sitting at 6.4x (37% decline). If earnings didn’t grow, this would be a pretty lousy investment. However, BFL was able to grow it earnings by reinvesting its profits back into the business at high returns of capital (30%). Growing earnings led to higher dividends and both earnings per share and dividends per share rose by 127% and 154% respectively over this period. The increase in dividends offset the compression of the price earnings multiple.
This meant that despite a 37% compression in the price earnings multiple, an investor owning BFL over the last decade would still have enjoyed an annual compound return of 14.9%. To me this is an example of the high returns on capital providing a margin of safety. Despite the market re-rating the price earnings ratio downwards the investor still made a very good return. If we assume a scenario where the price earnings multiple did not fall, the share price would be K19.64 at 31 Dec 21 and the investor’s annual compounded return would have been 18.4%.
Opportunities like this appeal to me because one can sit back and let the high returns of capital do its work over time. All is that is required from the investor is patience and reinvestment of the dividends.
CV Capital’s return for FY2022 (1 Jul – 31 Dec) is 4.1% and since inception is 14.7% on an annual compounded basis. We are in the midst of migrating to a new website and you can click here to view the complete performance table. In the future, we’ll move all the updates over to the new CV Capital site.
The share price as at 31 December 2021 is $1.52. Details are as follows: