My Investment Journey

[KnowThePast]

3 months update:

 

[Valued]

I didn't read this whole thread, just the OP and your last post. I don't own any shares in any companies you have in your portfolio. Why did you originally invest in CKL anyway? Was it because it's trading at a discount to book value?

SDI, NWH, and CKL are stocks I wouldn't have invested in so I am just curious as to why you did. LYL is something I would consider investing in for the right price (and if I conducted a bit more research into the company). CAB I would consider perhaps if the price was very attractive but I still avoid companies with gearing that high normally. It's also important not to be results oriented. I obviously do see that NWH and SDI delivered amazing returns but these are not companies I would find myself investing in.

 

[robusta]

You may have to read part of the thread, Know The Past has given a very clear and concise rationale for each of his investments.

What are the reasons you wouldn't invest in most of these companies?

 

[Ves]

CAB I would consider perhaps if the price was very attractive but I still avoid companies with gearing that high normally.

CAB isn't that highly geared.

Net Interest bearing debt is only 1.4x EBITDA.

Gross Operating cash flow (ex-interest) is $95.9m vs net interest of $7.6m. A coverage ratio of 12.75. Cash flow has been very stable over the last decade. Might be jumping at shadows a bit here given the nature of the business.

 

[Valued]

You may have to read part of the thread, Know The Past has given a very clear and concise rationale for each of his investments.

What are the reasons you wouldn't invest in most of these companies?

I had a quick look through just now. It seems he picked NWH based on a variety of factors, some I don't consider myself. I would not invest in NWH since it does not pass my initial screens. I just don't screen for companies with debt/equity ratios that high. At the time of purchase though I believe that was a sufficient discount to my calculation of intrinsic value to warrant it but I would then consider if there are better companies with brighter prospects to invest in. Forecasts look bleak but after I took some time to consider it, that price was attractive. I still have not researched the company fully though.

I consider SDI and CKL to be overpriced at the time of purchase. The companies arn't worth nearly their price. The reasons are simply poor returns that result in a low intrinsic value by my calculations.

I like CAB in some ways but I probably wouldn't invest since I consider it's growth opportunities to speculative on first look. I don't see much room for growth in Australia and its UK joint venture seems like a gamble. I would have to look more into its growth opportunities though. I would also have to closely inspect its intrinsic value to come to a better idea.

As for CAB gearing only being 1.4x EBITA well I don't look at EBITA since it seems to me to be "earnings before we calculate lots of other important stuff".

 

[Ves]

As for CAB gearing only being 1.4x EBITA well I don't look at EBITA since it seems to me to be "earnings before we calculate lots of other important stuff".

To avoid this problem you need to understand the how EBITDA compares to operating cash flow. This will be reflected in the quality of the accounting. You are correct in saying that the differences between EBITDA, EBIT and NPAT are important, and you will need to understand them any way to get an idea of the companies financials, so using EBITDA in debt ratios should be no problem whatsover if you do the correct due dilligence.

Perhaps it is a preference thing - but I never use debt to equity ratios either. The equity component in particular can be garbled by creative alchemy by willing accountants. The whole "book value" debate might be best saved for another thread, though. If you have a problem with EBITDA then you are compouding it greatly by relying on the equity line of the company financials in my view.

My main source of knowledge for the companies ability to pay its loan requirements is the cash flow statement. There is no getting around it.

 

[Valued]

The main problem I have with companies with a high debt/equity ratio is not necessarily the ability to pay back loans, but the effect it has on the intrinsic value. Obviously, I look for positive cashflow to make sure loans can be paid back though in the required time frame. Two companies equal in all respects but one has debt and the other does not results in the company with debt being worth less. I rarely find good opportunities in the current market where there is a high debt/equity ratio since not alot except unproven companies are trading far enough under intrinsic value to warrant investing despite a high debt/equity ratio.

I think CAB is trading enough below it's value though. Instead of issuing more shares they have seem to have taken the debt route which seems reasonable in order to not have angry shareholders. I would need to look deep into what they needed the extra money for. Their debt levels more than doubled between 2012 and 2013. If it's for their UK expansion plans well then I have to consider the prospects of success in that.

CAB might very well be a good investment but then I worry it may be a speculative one depending on the chances of success in the UK.

 

[McLovin]

Two companies equal in all respects but one has debt and the other does not results in the company with debt being worth less.

This doesn't make sense. A company with debt will not necessarily have a lower EV. And two companies equal in every other way except capital structure would in theory (ie ignoring things like taxes) have the same EV. Leverage can also turbo charge returns on equity and provides a tax shield, with all the usual caveats about risk etc.

Anyway, without knowing what makes up the equity in debt/equity the ration is near meaningless. A company jam packed with goodwill is not the same as one with a super clean balance sheet. So I agree with Ves, ability to service debt is far more important.

A company that can earn 50% RoE can carry more debt than one that can only return 10% RoE, all things being equal.

 

[Valued]

This doesn't make sense. A company with debt will not necessarily have a lower EV. And two companies equal in every other way except capital structure would in theory (ie ignoring things like taxes) have the same EV. Leverage can also turbo charge returns on equity and provides a tax shield, with all the usual caveats about risk etc.

Anyway, without knowing what makes up the equity in debt/equity the ration is near meaningless. A company jam packed with goodwill is not the same as one with a super clean balance sheet. So I agree with Ves, ability to service debt is far more important.

A company that can earn 50% RoE can carry more debt than one that can only return 10% RoE, all things being equal.

It must make sense. Perhaps I was not being clear or everything I know about the world is wrong.

If we have company A and we have company B. Assume a magical realm of no inflation and this happens in a vacuum.

Company A has $100 of assets and company B has $100 of assets. Company A makes $20 per year and company B makes $20 per year. Both have a 100% net profit pay out ratio. Therefore, every year company A returns $20 on their $100 of assets and this continues forever and every year Company B returns $20-interest every year and this continues forever. Company A has no debt. Company B has $50 of debt. Everything about each of the companies is the same. Company A must be worth more than company B when calculating intrinsic value because company B is worth $50 less.

Company B's EV will converge on Company As eventually since eventually company B will pay back their loan and then deliver the same returns. Given infinity company A is equal to company B (I am guessing they will converge together at infinity but maybe not, I am not that good at theoretical math). In a more realistic investment term though, company B is worth less than company A because we might only invest for say 20 years and therefore company B's returns will be lower than Company As.

 

[burglar]

It must make sense. Perhaps I was not being clear or everything I know about the world is wrong ...

The way I see it, the companies are equal until company B borrows $50.
If the return on the loan exceeds the interest on the loan, company B is expanding!!

 

[McLovin]

It must make sense. Perhaps I was not being clear or everything I know about the world is wrong.

OK. Let me ask you this question. Two firms both with $100 in assets, A and B, A is 100% financed by equity and B is 90% debt financed and 10% equity financed. Both earn $20 EBIT (ie they are identical businesses with different capital structures). Which firm is worth more?

 

[Valued]

On closer inspection I would not invest in CAB because the 10% surcharge is a complete rort. I doubt it will be allowed in the future. It has been looked at in Victoria already. I have an ethical problem in investing in complete rip offs to consumers. I dont want to own sucv a dodgy business.

- - - Updated - - -

OK. Let me ask you this question. Two firms both with $100 in assets, A and B, A is 100% financed by equity and B is 90% debt financed and 10% equity financed. Both earn $20 EBIT (ie they are identical businesses with different capital structures). Which firm is worth more?

Let me think about this and reply later. I am out for lunch and replying from my phone.

 

[Valued]

OK. Let me ask you this question. Two firms both with $100 in assets, A and B, A is 100% financed by equity and B is 90% debt financed and 10% equity financed. Both earn $20 EBIT (ie they are identical businesses with different capital structures). Which firm is worth more?

If they are identical in all respects Company A must have more shares than Company B. We can just assume $10 equity per share so Company A has 10 shareholders and Company B has one shareholder. Given that both have $10 equity per share with the same return it might tempt someone to say that the companies must be of equal intrinsic value. I do not see how this can be the case though. Company B will make less net profit and produce a lower return than Company A because they have to pay out interest on their loan and meet minimum repayments or repay the loan in a lump sum at some specified time in the future. Therefore, Company B is worth less than Company A.

If this is incorrect please tell me but I just don't see how Company B can be worth the same as Company A when Company B has to pay off a huge loan and make interest repayments.

 

[galumay]

......

If this is incorrect please tell me but I just don't see how Company B can be worth the same as Company A when Company B has to pay off a huge loan and make interest repayments.

The calculation of an implied intrinsic value is not an exact science, there are an infinite number of methods and formulas that help us as fundamental investors, make assumptions about our guesstimate for IV.

I guess what is important is that you are happy with the methodology you use, and the lengthy debate about debt and its effect on IV above just shows how different methodologies give varying weight to its effect on IV.

 

[burglar]

Company B has to pay off a huge loan and make interest repayments.

You get the huge loan up front!!!!

You invest it in your business, where hopefully you will
get the same % return as your company's ROE (say 30%)

You make a repayment or twelve (Principal + Interest)

Hopefully your investment is appreciating!!
Company B is expanding/growing, whatever.
It will show up somewhere in the Balance Sheet.

Voila!

 

[Valued]

You get the huge loan up front!!!!

You invest it in your business, where hopefully you will
get the same % return as your company's ROE (say 30%)

You make a repayment or twelve (Principal + Interest)

Hopefully your investment is appreciating!!
Company B is expanding/growing, whatever.
It will show up somewhere in the Balance Sheet.

Voila!

In the example Company A and Company B are in all respects equal but have different capital structures. Company B can't expand or grow since it only earns $20 EBIT and will only ever earn $20 EBIT. It's based off the example given. It's called a "toy game" in which we use simple scenarios to gain intuition about complex analysis. It's a concept applied to games like poker by adopting a game theory approach. Company B's EBIT will always equal Company As since Company A and Company B are the same company basically but with different capital structures. One is 100% financed by equity and the other 90% financed by debt and 10% financed by equity.

 

[craft]

It must make sense. Perhaps I was not being clear or everything I know about the world is wrong.

It does not make sense.


Equity multiple will depend on borrowing costs verses return on assets funded and an assessment of risk arising from the borrowing.

If the risk premium plus the borrowing cost is less then return achievable by the business then the financial leverage will give the company with borrowings a higher equity multiple then the one without.

Enterprise value (market Cap + net debt)

You need to think in EV/EBIT terms to get comparative basis that eliminates the financial structure and you should be able to nut it out.

What is the intrinsic valuation calculations you are referring too?

 

[KnowThePast]

I had a quick look through just now. It seems he picked NWH based on a variety of factors, some I don't consider myself. I would not invest in NWH since it does not pass my initial screens. I just don't screen for companies with debt/equity ratios that high. At the time of purchase though I believe that was a sufficient discount to my calculation of intrinsic value to warrant it but I would then consider if there are better companies with brighter prospects to invest in. Forecasts look bleak but after I took some time to consider it, that price was attractive. I still have not researched the company fully though.

I consider SDI and CKL to be overpriced at the time of purchase. The companies arn't worth nearly their price. The reasons are simply poor returns that result in a low intrinsic value by my calculations.

I like CAB in some ways but I probably wouldn't invest since I consider it's growth opportunities to speculative on first look. I don't see much room for growth in Australia and its UK joint venture seems like a gamble. I would have to look more into its growth opportunities though. I would also have to closely inspect its intrinsic value to come to a better idea.

As for CAB gearing only being 1.4x EBITA well I don't look at EBITA since it seems to me to be "earnings before we calculate lots of other important stuff".

Hi Valued,

Thanks for the feedback.

We clearly use different calculations for IV, as well as different screens. Many different approaches work, I don't consider mine the best, but it worked for me.

Others, Ves in particular, gave a very good response on why I think CAB is not highly geared.

With NWH, if you subtract cash from their debt, you'll find that their debt is negligible.

Both SDI and CKL have a unique set of events that obscure their true earnings over the last 1-3 years. To calculate IV properly for them, one must use earnings as they would have been without the effect of those abnormals. Definitely not an exact science.

I have my own opinions about debt ratios but I think it's best discussed in a separate thread.

I don't know which calculation you use for IV, but I suspect you use current earnings as one of the inputs. This works in most cases, but there are some situations where numbers do not give a true picture. It's rare, but these have always worked out to be my best investments. In part, I suspect, because that makes these companies ignored by most filters/IV calculations. Tomorrow, if my order executes, I will write about another such company, where traditional metrics just don't make sense.

 

[KnowThePast]

Purchase of the month – PMP 5500 @ 0.35.

This is very much a “special situation” play, as this is certainly not a wonderful company. They’ve made a loss in 4 out of the last 5 years, with this year being the biggest being this year at $68m. A few very average years before that, and there was, of course, an epic $500m loss in 2001. It is ugly, very ugly.

So why am I interested? It is trading at less than half of NTA, which is what initially caught my attention. But that is no guarantee of a sound investment, even though buying anything at under NTA is not the worst strategy to follow. I prefer to buy things at well below NTA only if they have a very reasonable chance of not going bankrupt, and preferably, making some money. At this price, it does need to be an efficient operation. Any return whatsoever is a bonus that is not priced in.

PMP have taken on a heap of debt, acquired a bunch of things, and invested a lot of money into things that were either making a loss or provided a dreadful return on capital. The debt, of course, is the problem that suddenly put a stop to all this in 2008.

Since then, instead of spending their way into diversification of earnings, they’ve completely turned the focus around. They are now writing off anything in sight and selling under-performing assets. And focusing just on cash, they’ve been positive for all those years.

They’ve been steadily paying down debt over the last few years and reducing their operations. A big thing for me, is that they’ve done it without excessive share issues. A company in a bad position usually has a very low price, and issuing shares to raise capital at that point digs a deep hole that is very hard to climb out of.
Here’s an interesting comparison between their reported profit and cash flow over the last 4 years:



In total, cash flow outperformed reported profit by $222.7m over the last 4 years, or $0.68/share.

I have done a similar analysis about a year back, but at that point, I felt that it was too risky for me. Now, their debt levels have been substantially reduced, most of the goodwill has been written off, and the company seems not too far away from a reduced asset base that they can resume profitable operations off.

I mention NTA value quite often in my valuations, although I never really use it to put a price on the company. It is an important metric, however. Company trading at a substantial discount to NTA is generally an indication of a good margin of safety. The only exception to that are companies that go broke. When evaluating these sub-NTA opportunities, that is the biggest question I ask – what are the chances of this company going under? PMP has reached a point where I think it is very unlikely in the next few years. Their operations are profitable, debt-cash is much lower and paying it off completely is an obvious priority for management.

Earnings and dividends are a much more important factor in determining valuation. In cases like these, where price is so far below NTA, or replacement asset value, any earnings in the future are a welcome bonus, and a catalyst of a re-rating. Doesn’t matter how good they are, as long as the market no longer prices the company for liquidation, and has some confidence in earnings being maintained, no matter how poor they are. The picture here is still muddy, but some conclusions can be drawn.

Earnings for 2013, before significant items were $20.5m. Operating cash flow - $7.6m. Difference explained by one-off restructuring charges, no issue there. Goodwill has been largely written off, so no large write downs are expected in the future. PPP reduced by 22%, I will roughly assume the same reduction in depreciation charge next year, giving a saving of $8.3m. Debt has been reduced by 27%, which should give an interest saving of $3.7m. Management claims $13.6m annual savings from 2013, with $23.5m to come in 2014. I have to assume depreciation + interest saving is included there, leaving another $11.5m. Considering that they’ve closed some business lines and fired over 400 people, this doesn’t seem too excessive.

So, assuming no more significant items and the same underlying performance, I would expect NPAT next year to be around $44m, or ~$0.135/share, placing the company on a PE of 2.6. While trading on half of NTA backing, giving a significant margin of error.

I think there is a good chance there will be more restructuring charges next year, and the one after. In this case, however, and at the current price, that can only be a good thing.

The next big question is what will happen to the printing industry in the future? I think it will continue declining. I think it will always be around, but it will become less and less relevant. This process will take a long time to play out. With PMP, as long as they don’t go back to leveraged acquisitions to force growth in an industry where there is none, money can still be made for many years. They’ve been scaling down their operation for a few years now to match that of demand, and I trust them to continue doing so in the future. As I mentioned before, absolutely any sustainable profit should result in a significant re-rating of the company. With a little bit more of an improvement, they should also be very close to being included in the All Ordinaries index, which should help.

My current buying is based on analysis that the market is pricing the company for liquidation and a significant re-rating will occur once that is clearly not a short/medium term threat. Whether I will continue holding after that, will largely depend on the price and what management does after the transformation phase is over.

P.S. There’s a great discussion thread on HC for PMP in case anyone wants to read up more about it.

 

[McLovin]

If they are identical in all respects Company A must have more shares than Company B. We can just assume $10 equity per share so Company A has 10 shareholders and Company B has one shareholder. Given that both have $10 equity per share with the same return it might tempt someone to say that the companies must be of equal intrinsic value. I do not see how this can be the case though. Company B will make less net profit and produce a lower return than Company A because they have to pay out interest on their loan and meet minimum repayments or repay the loan in a lump sum at some specified time in the future. Therefore, Company B is worth less than Company A.

If this is incorrect please tell me but I just don't see how Company B can be worth the same as Company A when Company B has to pay off a huge loan and make interest repayments.

Like craft said, you need to think in EV/EBIT or EV/EBITDA. By using either of those ratios you get an idea of the unlevered cash flows of the business v the amount of capital (debt and equity) used to fund the business. If the unlevered cash flow of two assets is identical and the assets themselves are identical, then you'd pay the same price to buy either of those assets.