How and why did you get started investing? What is your background?
I grew up in a lower-middle-class family who never had very much spare money. I decided early on that being poor was not for me. I worked multiple jobs in a variety of industries, always saving as much as I could to build my capital base. As soon as I felt it was large enough to parlay into a career in the financial markets, I went ahead and did it. I started investing in the early 2000s and although I had very little capital then, the primary focus was on eliminating the mortgage on our family home. The mortgage was paid off in late 2007, and all efforts in terms of wealth-building since then have been in the equity markets. And 2009 was a year for the ages for our family wealth, we had some good fortune in terms of timing through the global financial crisis and very good results in 2009 set us up financially.
My background prior to starting the fund was a CPA working primarily in major projects in the infrastructure industry. I drifted into that career after completing my commerce degree, as it was the path most available to me whereby I could monetize my education.
Describe your investing strategy and portfolio organization. Where do you get your investing ideas from?
Glacial is the word I use to describe what we do at Eternal Growth Partners (EGP). We have a concentrated high-conviction portfolio. Customarily we will have at least 50% of our equity portfolio in our five best ideas and usually around 80% in our 10 best ideas. We have averaged around 24 stocks over the more than five and a half years we have operated.
Given we average a near 10-year holding period, our ideas tend to come very infrequently, but if we are convinced of their quality, we will act in scale. If we get four good ideas in any year, I would consider it a very successful one. We have a fairly wide network of associates bringing us ideas. Also, many of the fund's investors are self-directed investors, who occasionally ask my thoughts on some of their own ideas, which periodically leads to good opportunities.
What drew you to that specific strategy?
Like most value investors, Munger and Buffett were instrumental in shaping the way I think about investing. The relative inertia of our portfolio stems from the rarity of really high-quality opportunities. We take a very simple view that in order to sell one holding to fund a new one; the expected returns must be self-evidently vastly superior (see question 13). It is a hurdle that is seldom met.
What books or other investors changed the way you think, inspired you or mentored you? What is the most important lesson learned from them? What investors do you follow today?
If ever someone asks me what they should read as a starting point to learn about investing, the answer is and will always be to start at the 1977 annual report on the Berkshire Hathaway website and work your way forward year by year to the last one. If after starting this process, you do not consume every one like repressed housewives did "Fifty Shades of Grey," investing is probably not for you. I did not have any mentors per se, but I also subscribe to Munger’s fondness for the ‘Eminent Dead’. If I find someone who was successful in an interesting way, I will acquire and read their biography. The other great book, and the one I think had the greatest positive impact on my life, is "Poor Charlie’s Almanack." I keep several copies of this book, which I lend liberally and frequently give as gifts. I value other books about the tricks our mind plays on us such as Kahneman’s "Thinking, Fast and Slow." I read voraciously, and nearly every really good investor I know does the same.
The most important lesson from Buffett is simple. Focus on generating your own view as to the underlying value of the business. Everything else is noise. If you have a strong conviction about what a business is worth and find it selling at a meaningful discount to that figure, the rest is easy. If you have any uncertainty about its valuation, move on. From Munger, the lessons are primarily about psychological self-awareness. If you understand intimately the way your mind is prone to misleading you and use strategies to avoid such mistakes, your results will inevitably improve.
Most of the investors I follow closely are people you have never heard of, and probably never will. Private investors with investment records that would make you weep at their beauty, but that stridently avoid anything that would bring them into the eye of the public.
How long will you hold a stock and why? How long does it take to know if you are right or wrong on a stock?
As mentioned in question two, we average almost a 10-year holding period. This is measured by total annual sales divided by average annual portfolio size, but we are actually a bit more active than that might seem. Particularly around the smaller holdings we are more active than the long holding period indicates, mostly because we are trying to augment gains until a really good idea comes along. However, when we find a business we like, we will buy big and hold for an exceptionally long time. Our largest holding has been our largest holding since the fund began, and I owned it for years before that. Finding really well run businesses operating in industries with good economics is rare. If you find one, you should be very reluctant to sell.
Unfortunately, sometimes you find out very quickly when you are wrong. It usually takes longer to be sure that you are right. The important thing, which is where less successful investors come undone in my view, is that you need to spend the great bulk of your time trying hard to disprove your most strongly held convictions. It is not a natural behavior. But if you can master it, the payoff is enormous.
How has your investing approach changed over the years?
Like many budding value investors, much of my early focus was around looking at stocks that are at 52-week, or all-time lows. The bargain hunter mentality is strong for a value investor, but without a really well developed understanding of the intrinsic valuation of the business, the fact that a stock is touching lows means nothing. Nowadays, most of the effort is focused on figuring out what an excellent investor I know refers to as the "variant perception." Why is this wonderful opportunity obvious to you, but not being properly valued at market? The market is broadly efficient. So you need variant perception to find good opportunities. If a few times a year you can find a reasonable dislocation between your perception and that of the market, profits await. If your variant perception proves to be correct more often than the market, or by a wider margin, you will generate above-market returns.
Name some of the things that you do or believe that other investors do not.
It is rarely a case of doing anything that others ‘do not’ in my estimation. It is usually more a case of doing a handful of important things a little bit better than the average. You do not need to be history’s greatest genius to have good success as an investor, but if you find yourself consistently performing well, over time you will drift to the top of any pack. Landing in the 25th percentile every year for 10 years will inevitably see you end up in the top few percent of a group, possibly right at the top. Off the top of my head, we focus hard on (in no particular order):
- understanding (and avoiding) cognitive bias
- focusing on intrinsic valuation
- finding the ‘Variant Perception’
- retaining equanimity when the market moves sharply
- constantly trying to disprove your highest conviction beliefs
- being acutely aware of the limitations of your own knowledge
What are some of your favorite companies, brands, CEOs? What do you think are some of the most well run companies?
There are a number of Australian CEOs I have enormous admiration for. Ray Malone, CEO of AMA Group Ltd. (ASX:AMA, Financial) and chairman of Money3 Corp. Ltd. (ASX:MNY, Financial), comes immediately to mind. His single-minded focus on trimming excess when he gets involved with a business agrees mightily with my own views on avoiding waste. Recently when I was talking to him in Sydney central business district about when he took control of AMA after the rollup strategy had collapsed due to debt and mismanagement, he pointed to a building and said, “When I took over AMA, we had half a floor of staff in that building. By the time I had finished cutting costs, we had one girl working from home.” The gains he generated in that business through waste reduction, logistical improvement and improved purchasing were extraordinary. That type of laser focus can bring success to almost any business. Management with that level of quality and focus is desperately rare and needs to be celebrated more.
As to brands, an Australian company I have admired for more than 15 years, but unfortunately never owned is ARB Corp. Ltd. (ASX:ARB, Financial), which specializes in four-wheel drive accessories. Australia is a vast and rugged country and to those who spend time in the more remote areas, the ARB brand is synonymous with quality and reliability. Like most strong brands, this means they command a price premium and the consistency of their financial results bears witness to this. They have grown EPS and dividends by about 10% per annum, with not even a pause for the global financial crisis. The total shareholder return over the last 10 years has exceeded 20% annually. Andrew and Roger Brown (from whence the ARB name derives) should be Australian business legends, but outside of the fund management community are virtual unknowns.
Do you use any stock screeners? What are some efficient methods to find undervalued businesses apart from screeners?
We try to come at the market from different angles every day. We occasionally use screening tools to narrow the pool down, but as Australia has a relatively small equity market, the job of figuring out where to focus your analytic efforts is relatively easier than in some larger markets. There are over 2,200 companies listed in Australia, of which at least three-quarters are dreadful businesses barely worth a few seconds of consideration. Of the remaining one-quarter, we would consider ourselves intimately familiar with about 50 businesses, quite familiar with another 50 or so and have a sound working knowledge of perhaps 100 more. If we cannot make a good return out of such a group, we have no business managing money.
The most efficient method is to have a group of companies about which you have a strong conviction of their intrinsic valuation and wait for them to fall meaningfully below it. Or for their intrinsic valuation to grow fast enough to get beyond the current price by a sufficient margin. In both cases, patience is key.
Name some of the traits that a company must have for you to invest in, such as dividends. What does a high quality company look like to you and what does a bad investment look like? Talk about what the ideal company to invest in would look like, even if it does not exist.
The sole trait we are looking for is a deep discount to the intrinsic valuation. We own dividend payers and non-dividend payers, in fact if we think the company has really good growth avenues, we would prefer it to retain the capital, rather than pay it out. Value can manifest in a number of ways. Most commonly the growth prospects are underestimated by the market, and the valuation does not fully reflect the future earnings of the business. But sometimes in a business with a poor economic future, market pessimism can drive price down to such a level that the stock represents value despite the poor business outlook.
The very best quality companies have a wide range of high-return growth options on which they can use the great majority of the profits they earn to pursue. These are the businesses from which truly substantial fortunes are made, but unfortunately, to use a colloquial expression I am fond of, they are as “rare as rocking horse [manure]," or at least nearly as rare. Poor companies are often the simple inverse of that, companies with high working capital requirements that in order to grow profits at only a modest rate, will consume substantially all of the profits they generate and sometimes even demand additional capital.
The ideal company is one that has spent a number of years investing in growth capital expense, which has wrongly been assumed by the market to be maintenance capital expense. Ideally, the growth capital expense will have a payoff some substantial period in the future that leads to artificially depressed earnings in the present, which the market will punish with a low multiple. Such situations allow the time to build a meaningful stake and, if the analysis is correct, result in a multi-year lollapalooza effect driven by:
- Earnings increase at an increasing rate;
- The business moving from having a below market multiple to an above market multiple.
In such situations, the intrinsic valuation of the business can expand very rapidly, the hope as an investor is that it happens steadily enough that the market price does not get out ahead of the valuation and the business can be held for years and years as the favorable economics play out. This was the theory that had EGP buying Â SDI Ltd. (ASX:SDI, Financial) (dental supplies business) over the 30 months between January 2014 (first purchase) and July 2016 (last purchase). The two and a half years taken to build this position are a testament to the patience inherent in the way we invest at EGP.
What kind of checklist do you use when investing? Do you have a specific approach, structure, process that you use?
Our checklist is mostly about protecting us from downside. We generally avoid businesses with high levels of debt and industries with highly unpredictable futures. Especially with smaller companies, we have a couple of preferred items on our checklist too. For example, we much prefer high insider ownership, assuming the equity has been acquired with cash and not awarded via some undeserved equity grant.
Before making an investment, what kind of research do you do and where do you go for the information? Do you talk to management?
Because of our tendency to be very long-term holders, particularly of our largest holdings, our research tends to be very wide and deep. We want to understand the industry very well. Monitoring competitors is incredibly important to make sure you do not miss industry-wide trends. We will go anywhere we feel we can find useful information.
Whether we talk to management tends to be a consequence of either a) how well their strategy has been articulated and b) either how complex the business is, or how well we feel we understand it. The upshot of point a tends to be that the smaller a company is, the more likely we are to talk to them. Larger businesses tend to communicate their plans to market better and the time spent asking questions is therefore less likely to be well spent. With point b, some businesses, even if they are small can be very complicated. It is therefore hard to communicate all the pertinent information to market, or alternatively, if it is an industry where my knowledge is not deep, I will tend to have more questions until I can decide if I know enough to make a sound investment decision.
How do you go about valuing a stock and how do you decide how you are going to value a specific stock?
Our process is fairly simple in respect of this; although the technique can tend to vary significantly from stock to stock and industry to industry. In simple terms, when the mid-point of our modelled expected range of returns exceeds 20% annually, we will buy. If our expected internal rate of return drops below 10%, either through deterioration in the underlying business or through appreciation in the price being more rapid than the growth in intrinsic valuation, we will sell.
What kind of bargains are you finding in this market? Do you have any favorite sector or avoid certain areas, and why?
The last couple of new positions that we have taken where we expect to do extremely well over the medium term are consolidation plays in highly fragmented industries. We are usually leery of "rollup" businesses, as history is littered with the carcasses of poorly executed rollups, but these two have very high insider ownership and a good track record to date with the early phase of the process.
We are sector agnostic and will buy value wherever we can find it. As to what we avoid, there is a huge mining industry bias in the Australian equity market, but as we hinted in question 11, we generally eschew businesses with highly unpredictable futures and mining is definitely in this category. The few times we have ventured into this sector, it has tended to be when the businesses were priced so pessimistically that even the poorest future would have seen little downside risk. Any business that has no control over the sale price of what they produce is inherently risky.
How do you feel about the market today? Do you see it as overvalued? What concerns you the most?
We do not spend too much time thinking about the general market level. But if pressed, I would say that given the very low interest rate environment that currently exists and the muted future outlook for interest rates, equity valuations in Australia are in the reasonable range. To a competent stock picker, even in overvalued markets, opportunities that promise a satisfactory rate of return will still come along, just not as often. Again, patience is key.
The biggest risk to the Australian market would be a substantial fall in our very hotly valued housing market as our “Big 4” banks comprise a huge portion of the Australian equity market, the flow-on effects could be enormous. The second major risk would be a Chinese crisis of meaningful size. Successive Australian governments have forward committed taxation expenditure that assume commodity prices will stay permanently high. The knock-on effects of meaningfully lower commodity prices would be cruel to the Australian economy, and we have just wasted the greatest commodity boom in history with little to show for it but an ever increasing debt burden.
What are some books that you are reading now? What is the most important lesson learned from your favorite one?
The last book I read was "Eaters of the Dead" by Michael Crichton. I rarely read fiction nowadays, but one of my sons had the book and I was looking for something to read. I read voraciously, but most of it would be market announcements, annual reports and the like. The rest of this question is best answered in question four I think.
Any advice to a new value investor? What should they know and what habits should they develop before they start?
The most important thing is, to the extent possible, especially when you are very young; underspend your income by the widest possible margin. At a 15% rate of return, the dollar you save at 20 is more than 16 times more valuable than the dollar you save at 40. Also, read for several hours every day. I do not know any really successful investors who do not.
What are some of your favorite value investing resources or tools? Are there any investors that you piggyback or coattail?
There are many LIC’s (Listed Investment Companies – the equivalent of a U.S. Closed Ended Fund) operating in Australia. Some of the better managed ones we keep an eye on at EGP. If we see major sales or purchases, it can cause us to review those stocks. As mentioned in question two, we also have a wide network of smart fund managers and private investors we communicate with. I think of these activities and relationships as important parts of our idea generation process.
But we "piggyback" or "coattail" no one. It is imperative that you own every decision you make. The minute you start to outsource your thinking is the minute you start to decline as an investor.
Describe some of the biggest mistakes you have made in value investing. What are your three worst investments? What did you learn and how do you avoid those mistakes today?
Almost all the worst mistakes we have made involve underestimating the danger of debt, because leverage magnifies everything. We were lucky to avoid a major disaster with an investment in NRW Holdings (ASX:NWH, Financial) when a major contract went into dispute; it was only the winning of another major contract and some fortuitous purchases around the lows that minimized the damage. Losses were also realized, but really major damage was avoided with sales of positions in Stream Group (ASX:SGO, Financial) and Hughes Drilling (ASX:HDX) not long before they went into long suspensions that it appears will probably result in total loss. To use some baseball parlance with which U.S. readers will be familiar, no one bats 1,000. Fortunately, when we have wandered into situations where debt or leverage is involved, we have kept position sizes appropriately small.
How do you manage the mental aspect of investing when it comes to the ups, downs, crashes, corrections and fluctuations?
The mental aspect is tricky. I am of the view that you are mostly predisposed to keep your head in a panic, or not. The mental aspect of investing is easily the hardest part to change or teach. You can learn lots of tricks about valuation, but if you are curled up in the corner in the fetal position when the opportunity comes, the learning will have been for naught.
If you would like to share, how have the last five to 10 years been for you investing wise?
The last 10 years have been extraordinarily good for our family net worth. The calendar year 2009, in particular, catapulted my family’s financial condition and allowed us to create the financial foundation on which everything that has followed was built.
The last five and a half years (we established the fund in April 2011) have likewise been very good for the fund and also for the people who entrusted their savings to us. EGP Fund Number 1 has generated more than 18% after fees and costs against the broader Australian market that generated barely more than 7% annually, and a small capitalization end of the market (where we focus) that has barely even generated positive returns over the period. If the next five years are nearly as good, we will be very pleased.
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