Below are some sections (slightly edited for public viewing) from a letter just sent to the investors of the fund I help manage.
Disclosure: I am a portfolio manager at Boyles Asset Management, LLC ("Boyles") and the fund managed by Boyles may in the future buy or sell shares of the stocks mentioned below and we are under no obligation to update our activities. This is for information purposes only and is not a recommendation to buy or sell a security. Please do your own research before making an investment decision.
News of
China’s stock market and of Greece’s place in the Eurozone (as well as the
closure of its banks and stock market) dominated the headlines as the second
quarter came to a close. After surging
by more than 100% in less than a year, China’s stock market fell by roughly 30%
before the government then stepped in with actions we might call “weird” in
order to try and stop the plunge. Though
unique in its own way, it’s a storyline that has been repeated throughout
financial history. As Jason Zweig wrote
in a July 10 Wall Street Journal
article, “Governments have been trying—and failing—to control markets for
centuries. If the Chinese government
succeeds, it will be the exception to that rule. If it fails, the results could
be dire.”
While
we claim no insight into how the situations above will play out, as a fund that
began the quarter with roughly half of our portfolio in cash, we welcomed the
volatility that these events and some Australia year-end tax selling created, which
in turn allowed us to put some capital to work. After additional purchases early in the third
quarter, our cash balance is now down to about 34% as of this writing.
The
fund was able to acquire the vast majority of its position at A$.245 per share
from what we believe to be a forced seller.
At that price the fund was able to acquire the business at a multiple of
5.9x free cash flow (including that of the recently acquired business) and .82x
book value. The dividend yield at the
time of purchase was 7.1%. It was our judgment
that given the nature of the business, the shares were quite a bargain.
Legend
Corporation’s business is fairly attractive from a return-on-tangible-equity
basis, returning 40% on average since 2008.
Built intelligently through a series of acquisitions, return on equity
has averaged 13% during that period.
Relative to many distributors, and attributable to the owned brand and
innovative products that Legend designs and sources internally, the company
boasts fairly attractive consolidated margins, with underlying pre-tax margins
averaging 9.8% since 2008. We see some
scope to recover some margin over the next couple of years, as the rapid
decline in the Australian Dollar during the last two years has been a headwind
for margins. Underlying pre-tax margins
peaked at 13.2% in 2012 before falling to the mid 9% range recently. If one assumes the company regains 50% of the
lost margin, Legend would produce enough additional free cash flow to reduce
our acquisition multiple of free cash flow to 5x.
Legend
Corporation is run by Bradley Dowe, who founded the business with his wife in
their kitchen in the early 1990s. Today
he owns 28.4% of the company, worth A$15.6 million at our acquisition
price. His base salary is about A$.33
million and so his stake in the company is worth 47x his annual salary. In fact, last year he received A$1.1 million
in dividends, or more than 3.3x his annual salary. Needless to say, we think we and Dowe are on
the same side!
Dowe has
built the business through a series of acquisitions. Originally, when the company listed in 2004, it
was a manufacturer of computer memory products, which it sold to OEMs. This business eventually ran into significant
competitive pressures as Asia emerged as the dominant low-cost supplier to many
of the world’s computer manufacturers.
Dowe repositioned Legend through a series of acquisitions, completed at
attractive prices, in the electrical distribution space it occupies today. The most recent acquisition, completed
shortly before our share purchases, was a company called System Control
Engineering. We believe the acquisition
will continue Dowe’s history of attractive dealmaking. At the total maximum purchase price, the
company will have paid a multiple of 4.7x earnings before interest and taxes. In and of itself, that is an attractive
multiple, but the company has additional potential levers to reduce its working
capital intensity and increase margins, which combined could reduce the
multiple to 3.3x. In our judgment, the
market is not paying attention to, among other things, this attractive
acquisition.
Cheap and Dear, Quality and Value
“Nearly every issue might conceivably be
cheap in one price range and dear in another.”
-Benjamin Graham and David Dodd, Security
Analysis
While
it has taken a bit longer than we would have expected (or hoped) to put as much
cash as we have to work, and while we still have a decent amount of dry powder
left, we’ve always felt it most important to remain disciplined to the margin
of safety creed we follow. Like the
quote above, we believe almost everything is a good deal at one price
and a bad deal at another, and that belief has taken us in several directions
in our search for value. Since the end
of last year, we’ve purchased shares in what we’d consider good businesses with
growth opportunities in the UK and Australia; additional shares in a couple of
mining services companies as tax selling and a further decline in sentiment
drove down prices; and a couple of Hong Kong-listed companies with decent
businesses and real estate portfolios. In
all of those cases, there is a well-incentivized owner-operator helping to
steer the ship on our behalf.
As
outside, passive, minority shareholders, there are things we can’t know about
the inner workings of a particular business. Our job is to do as much work as we can to get
to the point where we feel we have a clear edge in our understanding compared
to most others, and where we feel the odds and payouts are extremely tilted in
our favor. Sometimes the future path of a company is fairly predictable, and
sometimes it is largely unknowable because it is dependent on things that can’t
be predicted with any degree of reliable certainty. We prefer more predictability to less, but
given that the human brain shares the same preference, market psychology often
discounts uncertainty to such a degree that it’s worth venturing into areas
where things are less certain. One
historical example of this occurred with the economist David Ricardo, as told
by Richard Zeckhauser in his paper “Investing in the Unknown and Unknowable”:
“David Ricardo made a fortune buying bonds
from the British government four days in advance of the Battle of Waterloo. He was not a military analyst, and even if he
were, he had no basis to compute the odds of Napoleon’s defeat or victory, or
hard-to-identify ambiguous outcomes. Thus,
he was investing in the unknown and the unknowable. Still, he knew that competition was thin, that
the seller was eager, and that his windfall pounds should Napoleon lose would
be worth much more than the pounds he’d lose should Napoleon win. Ricardo knew a good bet when he saw it.”
The keys
in these situations, we believe, are focusing on one’s downside, and doing the
work to come up with conservative estimates of what you can lose if you are
wrong and what you can make if you are right. And while probabilities can’t be estimated
reliably, one can look for situations that at least tilt the odds in one’s
favor, such as by focusing on downside risk and buying from eager sellers. We discussed this in more detail in our Q2
letter last year, but we bring it up again because we believe that at least three
of our main purchases during the second quarter, and continuing into the early
third quarter, involved eager sellers on the other side of the trades, though
maybe not as eager as the British government was in Ricardo’s time.