John Stuart Mills - RIP

“Panics do not destroy capital; they merely reveal the extent to which it has been previously destroyed by its betrayal into hopelessly unproductive works.”

He who lets the world, or his own portion of it, choose his plan of life for him, has no need of any other faculty than the ape-like one of imitation. He who chooses his plan for himself, employs all his faculties. He must use observation to see, reasoning and judgment to foresee, activity to gather materials for decision, discrimination to decide, and when he has decided, firmness and self-control to hold to his deliberate decision.

No one can be a great thinker who does not recognize that as a thinker it is his first duty to follow his intellect to whatever conclusions it may lead. Truth gains more even by the errors of one who, with due study, and preparation, thinks for himself, than by the true opinions of those who only hold them because they do not suffer themselves to think.

Everyone who receives the protection of society owes a return for the benefit.

One person with a belief is equal to a force of 99 who have only interests.

Long term value....boring!

I often find myself under the impression I am in the entertainment business.

People don´t want to make business like investments, they want to be involved in the latest fad and feel they are living at the edge! If they make money, it´s a bonus!

However, I sympathise with a particaular view of criticising business like investing.

Many clients of private banks have generated wealth from developing a business. There interest in an investment portfolio with a bank may be to take advantage of the properties of listed securities of companies that non listed companies/businesses do not have.

If they wanted to make more money by making business like decisions, they could work on their business, where they have a track record of doing it.

However, this can be counter acted by suggesting that by buying the securities of listed companies they are diversifying their wealth in different businesses and different geographies in a more rapid way than if they did it directly with their own business. Also, they would be dealing with companies that in general would have more experience of working in a particular country or product, so there should be less risk involved.

A particular client made me feel that perhaps I am being too short sighted thinking too much on the potential of the permenant loss of capital and long term business investing decisions, and that a branch of short term strategies need to be included in the portfolio. Value investors usually appriach this by focusing on corporate actions - perhaps it was about time I did the same.


Yours sincerly,

Alessandro Sajwani

Price is what you pay, value is what you get.

By distinguishing the two, one can use a buy and hold strategy successfully.

"Though it is uncomfortable having a large cash position in an investment portfolio, it is more uncomfortable making a silly mistake...one does not always have to be invested - this is the primary difference between the speculator and the investor, in the view of your author. The former is always chasing a quick buck..."

Our in house method of accounting for stock options

Burlington Northern Santa Fe has the following stock option characteristics:-



We do the following calculation to determine the liability on the balance sheet for shareholders due to the stock options:-

=[10,020 * (our objective value – 68.24)] + [ ((2,500*5)*(our objective value – 68.24)]

The first part determines the cost to the shareholder assuming all stock options are excised at our objective value.

The second part assumes new stock options in the next five years will be issued and they will also be exercised at today’s estimated objective value. NOTE: strike price was taken to also be 68.24 USD/share as this was the approx. price of the stock prior to Buffett´s bid for the whole company).

= 720 million USD liability

For 2009, Burlington Northern Santa Fe inputed a compensation cost of 41 million USD through their income statement: 69 million USD in 2008.

We appreciate many could see this as an aggressive number.

We do not assume anyone forfeits their options nor that people will exercise at lower prices. However, we are conservative investors – hence we must be aggressive counters of costs.


Sincerely,

Alessandro Sajwani

"The market is risky, I don´t want to put my hard-earned money there!"

It is a point I hear often, and for many people, it makes good sense.

However, for me, this expression is akin to the following, which my dear girlfriend (and her mother) will attest to:-

"I don´t like doing the shopping in the market, they rip me off. It costs me more than doing it at the Mercadona (a local supermarket)"

The clear point here is you go to the market if you have the knowledge.

When you know what the the "real market price" of oranges are, you don´t get ripped off. If they offer a greater price, you don´t buy - you go elsewhere or wait another day. If they offer less - you buy lots.

If you don´t know the "real market price", people that shop at markets aren´t afriad to research to see what different stalls are offering and what informed buyers (my favourite are hard faced little old ladies with quiffed hair - for the fruit market) are paying.

If you do not qualify for either characteristic mentioned above, you are probably right in sticking to the fixed price of Mercadona fruit (or fixed deposits and bonds) - or get someone else to do your shopping at the market!

Sincerly,

Alessandro Sajwani

How competitor discounts evolve during a business cycle

In a time like 2006, people like me will not do well.

Markets will rally, but generally led by cyclicals and lower quality companies who are reducing their discount to their premium competitors.

Markets effectively rally out of sentiment rather than due to a proportional increase in the underlying value of the assets and cash flows they generate.

It is interesting to research how discounts of cyclicals and weaker competitors change over the period of a business cycle. Does the EV/EBIT simply raise in the up cycle: hence higher valued premium competitors drive up the value of secondary competitors as the market rally continues rather than vice versa. And the opposite happens in a down market?

The question of course is trying to answer whether it is the same at the moment. Though we appreciate their is a catalyst for volume sales to increase due to the huge de stocking that occurred in 2008, we feel it is very difficult that earnings surpass those recorded in 2007 (or even volumes unless they are export driven), when credit was flowing in the levels it was then.

We sit and ponder.

Our approach to investing

"In terms of survival, it pays not to be brilliant at anything, but good at many things." AS

We have finally developed a method of approaching our investment style in a manner that is flexible, yet consistent, that attempts to kill instinct, yet explores freely.

We will approach investing by:

1. Using in great detail the financial numbers to come to an approx. numerical valuation (using various valuation methods)

2. Understanding the economics of the business in a numerical and non numerical manner

3. Combining a macro economic overlay to appreciate what macro stresses may exist and how they may affect a bottom up valaution

It may sound terribly simple, but connecting the three has denied me for many years. They are, in our mind, as close to being independent and mutually exclusive as we can get (for the moment).

I was considering placing the role of catalysts, be them negative or positive, but they are natural consequences of appreciating point 2 and 3.

I now feel comfortable (the word for me is clean) in our mental approach.

Different valuation methods for different company and market characteristics

Today a client asked a question that sparked much interest. The individual was a seasoned investor who queried whether different valuation processes were required to estimate the fair value of different companies in different sectors. We strongly believe so. One has to appreciate where assets and liabilities may lie in different businesses by appreciating their different competitive landscapes, business models and accounting practices. Indeed, we try and categorise companies in a flexible way to try and determine how these factors may affect valuation and hence the price we would be willing to pay for the equity of a publically listed company.

Below I include one way we could perceive the intrinsic value of the highest quality companies (this method is not as relevant for other company categories). This category includes companies such as Coca Cola, hence we will use it as our example.

Coca cola is a company that has been doing the same business for over one hundred years. We think their is a credible possibility that it will continue to do so in the next one hundred years. If this is the case, what would be the present value of all the companies future owner earnings during that period should we discount them by 10%. How would the results vary as we altered our assumption for the compounded annual growth rate of the owner earnings during that period. The results are interesting.












We can see that at the current Coca Cola stock price of 54 USD (which is a market cap of approx. 126 billion USD), one is inherently assuming an owner earnings growth rate of 5% in the next 100 years. That may seem low, but I certainly wouldn´t feel comfortable betting that over a 100 year period.

However, assuming a 2% per annum CAGR is a bet I would be willing to play because this is the inflation target for most central banks around the world (in a world of fiat currencies we feel this stated inflation target should be met with ease). A company is not really growing if earnings increase by 2%, this would be purely an inflationary effect. Indeed, more astute investors may suggest that as historic interest rates average approx. 4.5% over the last 100 years, one should feel comfortable betting that region of CAGR for a high quality company over the next 100 years. They may be right - but the real assumption lies in what is a high quality company. As a result, should todays high quality company not be so good in 100 years, we would like to take a lower bet - 2% is fine for us.

At this minuscule rate of growth, you will be suprised to see the market cap of Coca Cola would still be estimated at 80 billion USD by discounting the owner earnings over the next 100 years. This is very close to the lowest price Coca Cola shares traded at in March 2009, approx 38 USD/share. By using this method as a reference, we were keen buyers of this companies stock as it traded between 40 - 42 USD/share.

We remain poised to purchase the common stock of other high quality companies as they approach values we feel comfortable in achieving a satisfactory return on our investment.

Sincerely,

Alessandro Sajwani

Industrial gases and railroads our current focus

If we were to heed the wise words from the often quoted and well known investor Mr. Warren Buffett, "When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact," the methodology of most investors would be diffferent.

At the moment we are investing time and energy to look at two particular sectors that we feel have good business economics: industrial gases and the railroads. The former seem to be a little over valued at the moment looking at our conventional methodology. However, we hope to find some accounting discrepancies that can allow us to find hidden assets on the balance sheet.

With regards to railroads, their is no simple methodology to assess their value as each has different assets recorded and unrecorded on their balance sheets. Simple digging will reveal the facts.

Opportunities for the RAIL SECTOR

Todays news of a bond issue from Russian Railways reminds me that European governments are likely to privatise more assets in the future as they try and play down large budget deficits and heal huge borrowings they have undertaken. The railway industry is one sector that will be particularly interesting due to its market structure. Indeed, one can build up knowledge today of listed railway companies and may even find opportunities within the Emerging Markets in this field. Having had our Burlington Northern Santa Fe stock bought out by Mr. Warren Buffett, we are on the hunt.

A rare macro view

Dear Reader,

As my first post, I feel somewhat obliged to start with a macro theme. Experience suggests cocktail parties rarely start with intricate stocks picks...folks are often more opinionated on macro issues and hence find the theme more entertaining. I should point out immediately that our investment style is not macro orientated. We take the stance publicized by the First Eagle Funds - we invest bottom up, but consider top down risks, and their affect on bottom up valuations.

I therefore start by attempting to put a personal light to an often heard quote expressed by clients:-

"But my money is doing nothing, we must invest it now or we will move it!"

Blaise Pascal said that all humanity´s problems arise from his inability to sit quietly in a room alone. We couldn´t agree more. There are times when it is simply better to do nothing than something, anything. But there seems to be a fear to doing nothing - perhaps a feeling that someone may be doing something and you are helpless to stop them advancing relative to you? This feeling can be reduced by taking decisions with a clear criterion. Investment is as much to do about discipline as information loading or raw intelligence.

In later blogs we shall present our own investment portfolio, but over the last three months we have processed only two transactions - a single sell and a single buy transaction. It is frustrating as a dedicated investment advisor to do such little business, but as I say to my colleagues, it may be uncomfortable holding so much cash, but it is more uncomfortable to make a silly mistake. Let me highlight why we are overweight cash at the moment:-

If someone asked me what two macro factors should combine to provide a great environment for stocks, I would probably say a perception of long term low interest rates and a fear of short or medium term inflation rising starting from a low base...

One can´t help thinking we are close to that general perception at the moment. Indeed, this was one of the reasons we were heavy buyers of stocks at the start of 2009. Though this reasoning may suggest we are positive on stocks today, using a bottom up approach we are finding it increasingly difficult to buy stocks at attractive prices. We will not buy, in today’s economic environment, the equity of companies having to assume a growth rate greater than that demonstrated on average over a business cycle. Therefore, though macro factors may be positive for stocks at the moment, current pricing carries a growth rate we feel uncomfortable in assuming. Should the macro conditions change, or there be a perception that they may change, we feel they are more likely to be negative than positive for the valuation of risk assets.

What could trigger a negative change in the macro factors? We cannot help fearing the consequences of a weak credit expansion environment in the developed economies, which it still burdened by a heavily leveraged private sector. In short, the most probable consequence of this in your author’s eyes is a higher saving rate. This will reduce consumer spending, the life blood of many developed economies in recent history. This reduction in demand is likely to be negative for the operating margins of corporates, meaning they will make less profits from selling the same volume of goods. We do not feel this is being factored into stock prices at the moment. Indeed, analyst forecasts are generally assuming large earning increases as economies recover over the next year, leading to higher sales and margins. This opinion has generated much momentum over the last year, fueled spectacularly along the way by government money and moral support. The authorities have shown explicitly to the market that they are willing to do all they can to ensure growth is back. But we need to see evidence of demand growing which is not government led – weakening currencies are helping developed economies receive that demand from abroad. We see this scenario continuing but feel this is a zero sum game. Not everyone can gain equally from devaluing their currency. We wait and see. What we do believe with great conviction is that over the next few years there will be a large divergence amongst countries as some recover faster than others. This will be evident in the results of different countries government statistics and the performance of the financial securities of that country.

An interesting question is which macro factor will change first? We suspect the authorities of developed countries will not be keen to increase base rates due to their huge debt burden. It is more probable they will increase when the market forces them to do so. We feel this will be led by the market demanding a larger yield on government bonds. However, though we feel this is a very probable scenario, the time it can take to occur can be slow - as we are currently finding out having started saying this over a year ago.

What can change more quickly is the perception of future inflation. We feel this can generate more violent changes in asset prices. Much has been written over the last two years about the de leveraging process now occurring within developed economies. This has led to the private sector borrowing less and banks lending less, as a result, this has affected business volume in a negative way. The authorities have attempted to compensate by borrowing and printing money to ensure growth can continue during this period. As a result, public fear of de leveraging has been reduced. One particular example we find of interest, and we feel has contributed to this uneasy calm, has been the decision to change the accounting methods of banks with regards to the recording of loans and other financial assets on their balance sheets, relative to the methods used prior to the economic slowdown. Though we do not suggest this accounting change is better or worse - we do not have a better solution as an alternative - we do highlight that this authority led change has helped financial institutions receive capital at a lower cost. Such authority led changes have altered the market’s perception of what a bank is worth. Should accounting do that? Should governments do that? Indeed, we believe the aggressive role the government has played recently in the market has created a distortion in the valuation of risk assets in general.
However, we ask ourselves, will those bad loans disappear as a result of a change in accounting, will it make banks give more loans to customers? We suspect in the long run the accounting changes will do little to change the economics of the situation, though in the short term it may add a valuation boost. We do not want to buy during this short term boost because we are long term investors who buy because of the economics of the business; we try and steer clear of the business of economics.

As a result of this, we feel one dollar in cash today is likely to buy more than one dollar of assets in today’s pricing, tomorrow. Let´s see if the authorities can stop this from being the case. They have done a brilliant job so far in developing a macro scenario that is positive for risk assets and positive for developing a growth environment. But our bottom up approach suggests that the growth rates one needs to assume to purchasing the average company are too high for us to feel comfortable, especially in the highly leveraged environment we find ourselves in today. Richard Koo was famous for saying that during a balance sheet recession (when asset prices fall) companies move away from “profit maximization” to “debt minimization”. If the macro picture we paint becomes even partially true, you can rest assured market prices will adjust (probably too aggressively) to ensure this is reflected.