While the World Worried

For the past two weeks the financial world has been worrying about falling share prices, and rising interest rates. But is it really all so gloomy out there? Let’s take a look at what has been going on in the real world, outside the share market echo chamber, over the past couple of weeks.

We’ll start with the big news. SpaceX, the company led by billionaire/entrepreneur/Iron Man inspiration, Elon Musk, successfully launched the most powerful rocket in the world. If you haven’t already, do yourself a favour and watch the launch video:

This launch was a test flight. Instead of taking the typical boring route of launching a block of concrete into orbit, Musk, in his usual style, launched a brand new Tesla Roadster. The image of a spaceman chilling in a shiny new electric car as he coolly circles the earth is what got the press’ attention. And that’s amazing in itself, hopefully doing it’s part to inspire a new generation of kids to imagine their place in the stars. But that wasn’t the most epic image of the broadcast; instead, it was this one:

To be clear, that’s not a picture of two rockets taking off. That’s two rocket boosters simultaneously landing back on their launchpads, after they have just launched a payload into space, and on the way to Mars.

It’s hard to underscore how much of a game-changer this technology is in terms of lowering the cost of space travel. Musk sums it up by asking us to imagine how expensive air travel would be if we built a brand new Boeing 777 every time we wanted to take a flight, then blew it up over our destination and parachuted down to the arrivals hall. The ability to land and re-use the entire rocket means the cost of space travel becomes just the cost of the propellant. What cost tens of billions of dollars to do in 1969, now cost just tens of millions today, and possibly, just a couple of hundred thousand tomorrow.

If you have children, there is now a very realistic possibility that they will grow up in a world where space tourism isn’t science fiction but science fact. #TravelGoals.

Even better? This is just the beginning. SpaceX have already announced that all their energy will now be focused on producing a new much larger rocket design (BFR) that will have the capability to put the first humans on Mars within a decade. Not a typo, Mars!

It’s up there as one of humanity’s greatest ever achievements. But it was far from the only step in the tireless march of human progress that occurred over the past few weeks.

Scientists at Stanford University in the U.S. have developed an anti-cancer jab that is about to start human trials. The injection promises to not only kill the original cancer, but also trigger a bodywide reaction that destroys cancer cells in unrelated areas.

As news.com.au reported: “Scientists in Scotland have produced the first fully-developed human eggs grown in a laboratory from the earliest stages in ovarian tissue all the way to full maturity”. This is a breakthrough that could significantly improve fertility treatment, and open the door to new regenerative medicines.

Researchers from the University of College London, unveiled a new memory test that can be used to detect Alzheimers up to seven years before symptoms first appear.

The NZ Herald reports that “A breakthrough discovery by New Zealand scientists could point the way to better treatment options for sufferers of allergies and asthma.”

And for the follicly-challenged among us, Japanese scientists have developed a way to rapidly re-grow hair.

The Takeaway

Whenever the news cycle gets too negative, take a moment to pause, and look around at the wondrous would we live in. The torch of human progress has never been extinguished. And if we keep our heads about us, it never will.

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How to Catch a Monster

To make money in stocks you must have “the vision to see them, the courage to buy them and the patience to hold them.” Patience is the rarest of the three. – Thomas Phelps (original quote: George F. Baker)

Do you have what it takes to catch a monster?

Thomas Phelps wrote one of the all-time great investing books titled ‘100 to 1 in the stock market’ after studying companies that had returned 100-fold or more to investors over the previous few decades (investing trivia bonus point: the legendary Chuck Akre names Phelp’s book as core to his philosophy).

These 100-to-1 businesses were so incredibly successful that if you had invested just $10,000 in one of them, it would have turned in to a $1,000,000 fortune over time. Phelps found 365 companies that reached the prized 100-to-1 level or higher, and among those incredible winners he found four common attributes.

First, they almost all started out small – giving them a lot of room for future growth. Second, they were relatively unknown at the outset – less analyst coverage meant lower starting prices. Third, they almost all had a unique product or competitive advantage – something which gave them an edge over other firms. Fourth, the companies were headed by smart, research-minded management teams.

In Phelps view though, more important than what made the companies special, is what made the investors who hung on special. The shareholders that, despite all the noise, and despite all the emotion, were patient enough to hold on throughout the share market’s volatility to reach that prized 100-fold return. These were investors that managed to master their inner monkey brain.

Let’s look at what it would have taken to hold on to a modern version one of these mega-winners as detailed in ‘100 Baggers’ by Christopher Mayer.

Over the 21 years through last October the shares of Monster Beverage (NASDAQ:MNST)— the beverage company best known for its large cans of Monster brand energy drinks — increased in value by a mind-numbing 2,400-fold. That is almost too big of a number to wrap our heads around, so let’s put it like this: for every $10,000 investment in 1994, shareholders that held on would be sitting on $24,121,512.

In 1994 that $10,000 might have bought them a decent second-hand car, after investing in Monster Beverage it would buy them a helicopter to go with their cliff-top mansion.

How did Monster Beverage do it? The company started off very small and was overlooked by Wall St for a surprisingly long time. Monster also invested heavily in marketing and innovated in product, being one of the first companies to recognise the demand for a larger energy drink can (a part of the market that red-bull had neglected). The management team were also incredibly savvy, building a capital-light business model that allowed them to iterate and scale quickly.

The biggest question though, is how did the investors do it? Think of all the times a shareholder had to resist selling if they wanted to reap those 2,400-to-1 long-term gains. Even assuming they could resist selling somewhere along the line for a gain of 40%, 400%, or even 4,000%(!), they also needed to deal with all the volatility that came along with the ride.

During Monster Beverage’s run there were 10 separate times where its share price fell more than 25%. Even worse, in three different months Monster Beverage’s shares lost more than 40% of their value. Think of the courage it took to hold on to your huge winner when the shares fall by 40% – in a month!

Returns of the kind that Monster Beverage reported are extremely rare. But the lessons of such mega-winners apply to all great long-term investments. To catch a monsterwe need the vision to find, the courage to buy, and the patience to hold. Patience is often the toughest of the three.

Review: Deep Survival

Deep Survival

In 140 characters or less:

Incredible (true) tales are distilled to the core mental models that determine who survives. Big lessons for investing models and mindset.

Why you should read it:

While Deep Survival is about extreme survival situations, the parallels to effective investment decision making are rich and deep.

Investing lessons aside, the book is also chock full of incredible survival stories that make for a compelling read. People set adrift at sea for months, that survive by catching fish and collecting rainwater. A 17 year old girl that survives a plane wreck (without a parachute!) in the jungle and then marches out to safety over 11 days. In each story there are lessons and recurring themes.

There is a saying that all great marriages are the same, but all terrible marriages are terrible in their own unique way. So it is with survival. In all the stories of survival the survivors take similar actions and most importantly have similar attitudes and mental models for how they think about the world.

Key lessons: 

#1: Stay focused on the present (a.k.a ‘Be here now’)

“Even in the initial crisis, survivors’ perceptions and cognitive functions keep working. They notice the details and may even find something humorous or beautiful [imagine the vast Atlantic ocean beneath a starry sky]. If there is any denial [of their plight], it is counterbalanced by a solid belief in the clear evidence of their senses. They immediately begin to recognize, acknowledge, and even accept the reality of their situation.”

Being present in the situation not only removes a big mental burden, it frees their faculties to consider the opportunities for survival around them. There are obvious parallels for investors when there is a market crash. Instead of getting caught up in the self-pity of the herd, they should focus on looking for the opportunities that are still available.

But the lesson is broader than just dealing with the extremes of a market crisis. Every day is a new opportunity for investors, yet it is easy to become trapped in the past. If our company’s shares are up 20% we can easily anchor on the past price and avoid buying more. Or, conversely, if the shares are down we may hold on solely to avoid the pain of selling. Instead we should stay present, the past price paid is irrelevant, all that matters is the future.

Remaining present is not always easy. Deep survival suggests that the best survivors are able to retain an insulating sense of humour, often a dark sense of humour. They keep their thinking light and flexible, freeing the brain to operate at its highest level. We should find ways to build playfulness and levity in to our own investing processes. There is something beautiful, funny, or interesting, to be found, in even the darkest places.

#2: It’s all your fault

“They [survivors] may initially blame forces outside themselves, too; but very quickly they dismiss that tactic and recognize that everything, good and bad, emanates from within. They see opportunity, even good, in their situation. They move through denial, anger, bargaining, depression, and acceptance very rapidly.”

The people that make it out alive are the ones that take full responsibility for their situation. By doing so they instantly transform themselves from victims to survivors. Their mentality has shifted. No longer are they at the whim of forces beyond their control, instead they begin the arduous task of bending those outside forces to their will.

Note that this does not mean they have caused their horrible situation. A passenger in a plane that explodes over the jungle, or a sailor that is struck by a whale, these people did not cause their predicaments. But, by believing that they are solely responsible for their survival, they have taken back their power.

The opposite approach is to blame others for your situation, to despair at how unfair the world has been to you. While it may be true that you have been dealt a horrible hand, believing that outside forces are responsible for your situation also means believing that you are powerless to change it. Accepting responsibility means taking back the agency to dig your way out.

Not all people with this survival mindset will make it. Many times the forces working against them are just too insurmountable. But by taking responsibility for their situation, no matter how dire, they have given themselves the best chance of surviving it.

#3: Take bold action while exercising great caution

With all the tales of things going wrong it would be easy to think the best approach to survival would be to avoid taking risks. But the author is quick to point out that smart, decisive, risk-taking is actually the key to survival.

Steven Callahan, was an extremely experienced sailor that was crossing the Atlantic solo in his well equipped yacht when in the middle of the night he was suddenly struck by a whale and woke to find his cabin flooding with water. His quick reactions allowed him to make it out of the cabin and deploy his life raft. But then, sitting in his life raft in the middle of the Atlantic ocean, he quickly realised that there would be no rescue party. His meager survival rations would not last long. If Steven wanted to survive he would have to dive back in to his sinking yacht:

“The next step was to take bold action while exercising great caution, which is but one of the many delicate balancing acts necessary for survival. So he dove back in to the flooded saloon to retrieve his survival bag. He made it out and returned to the raft. When he eventually let go of Solo [his yacht], he was very well equipped, considering the circumstances. He had just saved his life by risking it, which is the essential task of every organism. No risk, no reward. No risk, no life.

Steven Callahan went on to survive after being adrift in his life raft for an incredible 65 days. As with investing, the best survivors are willing to take smart, calculated risks when necessary to ensure their own survival.

The last word:

Deep Survival by Laurance Gonzales is often a thrilling read, stepping from one incredible survival scenario to the next. If the book were just a collection of these awe-inspiring stories it would be well worth the price of admission. But Gonzales goes much further, providing dozens of excellent insights into the mind of a survivor.

As investors we aren’t dealing with life and death, but seeing a position down 50% can easily trigger similar deep emotional responses. Deep survival gives us the tools to not just cope with anything the market throws at us, but take the strong decisive actions that will enable us to seize the opportunities that are always in front of us.

30 Aussie Magic Formula Picks

Joel Greenblatt is a first class super-investor that should need no introduction. Over a 19 year stretch Greenblatt’s hedge fund generated compound annual returns of an astounding 45%.

Over 19 years that turns a $10,000 jet ski in to an $11,641,046 private yacht.

Today, Greenblatt has pivoted 180 degrees from his origins in special situations. He is now managing over $5 billion with a quantitative value approach that is based on an expansion of his famous Magic Formula.

The premise of the Magic Formula is simple: buy good companies at a cheap price. Quality is measured by return on capital employed, while cheapness is measured by the earnings yield (EBIT/Enterprise Value).

Applying this test to the Australian market, and filtering out financials we arrive at the following list.

Magic Formula 23-12-14

(Data Source: Capital IQ)

This list will always be full of names that make investors squeamish. There is, after all, a reason that these companies are cheap.

But that is also why Greenblatt advocates a mechanical adoption of the Magic Formula strategy. When we add our own human biases to the process we are more likely to under-perform, not less.

There are two companies within this list that are recent additions to my own portfolio: Vocation Limited (ASX:VET) and Reverse Corp (ASX:REF).

Neither are pretty businesses. Vocation faces a class action lawsuit regarding its disclosure practices, and Reverse Corp’s reverse calling 1-800 number faces long term structural decline. The bear case is easy to make for each, but that is the nature of deep value investments.

What matters is the price that we pay for a given level of quality. Reverse Corp’s main business may be in structural decline, but with $6 million in cash and expected half year EBITDA of $1.35 million, it doesn’t take much to justify the current $12.5 million valuation.

Following a mechanical quantitative-value approach empowers us to avoid the gag-reflex that these type of companies typically engender.

I back tested this approach over the past 12 months. The results were encouraging. The December 2013 portfolio of 30 companies is up 8.01% for the year, compared with the All Ordinaries which is down -1.07%.

However it must be noted that this back test is subject to survivorship bias. I have taken a list of the 2,144 companies that currently make up the ASX and then selected based on what their rankings would have been a year ago. This excludes any companies that would have been selected a year ago but which have since stopped trading under that name (bankruptcy, reverse listing etc).

I will be revisiting this list throughout 2015 to see how it is doing, and  re-balancing the portfolio. I am also looking at a couple of ways to tweak the algorithm and underlying data to better target what Greenblatt is reaching for.

It is easy for us to dismiss the Magic Formula as too simple to be taken seriously. But with one of the world’s all time greatest investors now managing over $5 billion using a modified version of this strategy, it’s about time the Magic Formula gets the attention it deserves.

Review: The Manual of Ideas

MOI1

In 140 characters or less:

An excellent and detailed review of 9 of the most popular value investing styles. Why they work, and how to apply them.

Why you should read it:

While there are many investing books available to help beginners there are precious few that add value for those that have already mastered the basics. The Manual of Ideas steps in to the breech, providing a concise survey of the best value investing has to offer. It is written with the intermediate-advanced investor in mind.

The bulk of the book is 9 chapters, each reviewing a different value investing approach and asking the same questions of each. Why do they work? How can they be used and misused? How can we find these type of opportunities? How should we analyse these opportunities once they are found?

The value investing approaches covered:

  1. Deep Value: Ben Graham Style Bargains
  2. Sum-of-the-Parts Value: Investing in Companies with Excess or Hidden Assets
  3. Greenblatt’s Magic Search for Good and Cheap stocks
  4. Jockey Stocks: Making Money alongside Great Managers
  5. Follow the Leaders: Finding Opportunity in Superinvestor Portfolios
  6. Small Stocks, Big Returns? The Opportunity in Underfollowed Small- and Micro-Caps
  7. Special Situations: Uncovering Opportunity ini Event-Driven Investments
  8. Equity Stubs: Investing (or Speculating?) in Leveraged Companies
  9. International Value Investments: Searching for Value beyond Home Country Borders

Despite being less than 300 pages, The Manual of Ideas took me a surprisingly long time to finish. The content wasn’t particularly tough, but it was so jam-packed with value and thoughtful insights that I found myself re-reading paragraphs several times over.

Key lessons: 

I endeavor to follow Farnam Street’s (and Mortimer Adler’s) guide ‘How to Read a Book’ and scribble down my key takeaways as I read a book. The Manual of Ideas makes this even easier by breaking down 10 key takeaways for each chapter. Rather than recreating that exhaustive list I will just point out a few key ideas that stuck out for me personally. There are literally hundreds more great insights that could have made this list.

#1: Cast yourself as the world’s chief capital allocator

This was my biggest take away from the book. If you can stick to this, you avoid most of the pitfalls of the market, and are never holding a poor investment while in search of a greater fool

“While most investors do have a negligible impact on the overall market, the accompanying small fish mind-set does not lend itself to successful investing. Even when I invested a timy amount of money, I found it helpful to adopt the mind-set of chief capital allocator. I imagined my role as distributing the world’s financial capital to activities that would generate the highest returns on capital.”

“If I directed the allocation of the world’s capital, I would not be able to rely on the market to bail me out of bad decisions. The greater fool theory of someone buying my shares at a higher price breaks down if the buck stops with me. Successful long-term investors believe their return will come from the investee company’s return on equity rather than from sales of stock”

#2: Your process must be tailored to the value investment strategy you are pursuing.

This is both obvious and easily overlooked. All too often investors will talk themselves out of a deep value opportunity because the business is in turmoil. Or out of a fast growing company because it has a relatively higher valuation.

The core premise of The Manual of Ideas is that a distinct investment process, screening tools, and analytical framework must be used for each of the 9 investment approaches discussed. Mixing and matching tools between different frameworks is a recipe for disaster.

Case in point, a business with high returns on capital provides the investor no advantage if it pays out all of its earnings as dividends.

“The return on capital earned by the business is irrelevant when the payout ratio is 100%. As the payout ratio declines, the economics of the business becomes increasingly important.”

#3: Capital light businesses are the most easily threatened 

“When something other than capital employed drives the profits of a business, that something can change quite easily unless the business has a sustainable moat. Businesses with low capital intensity may be more likely to exhibit winner-take-all dynamics, as capital is not a barrier to scale. Consider how quickly Apply crushed well-established companies Nokia, Research in Motion, and even Sony.”

#4: Investing might be a zero-sum game, but investors decide the average return

The idea that investing is a zero-sum game gets a lot of airtime. But this ignores the role that investors, as capital allocators, have on the average return.

“Many investors [have a] correct but incomplete view that public market investing is a zero-sum game. While not all investors can earn above-average returns, the average return is far from predetermined. If investors consistently made terrible decisions, for instance by investing only in money-losing Internet companies, there might be just as many relative underperformers and outperformers as there are today, but the market return would be considerably lower.”

The last word:

On top of these key lessons there were literally hundreds of excellent insights in to the best way to pursue the 9 strategies. I am sure this will not be the last book that we see from John Mihaljevic and I look forward to the next.

Read this book!

Review: The Dragon’s Tail (The Lucky Country After the China Boom)

QE54-cover-(online)

In 140 characters or less:

An insightful yet concise review of China’s boom, its huge effect on Australia’s economy, and why it is ultimately unsustainable.

Why you should read it:

China’s boom, and correspondingly, Australia’s double-decades of unbroken growth are anomalies that have seemed to defy laws of economics. This has led many people to question long-held beliefs about how an economy should be organised.

Can governments really allocate capital better than markets? Does an authoritarian regime’s power make it a more effective form of government for economic growth? Can Australia keep its recession-free streak going?

The author, Andrew Charlton, addresses all these topics and more while offering an excellent framework for understanding China’s growth.

The lessons of economic history are ominous for both Australia and China. Charlton stops short of forecasting impending doom, but the implications are clear. The current model of growth for both countries is unsustainable. If something can’t go on forever – it won’t.

Key lessons: 

#1: Australia’s recent commodity driven boom and its impact on our standing in the world should be understood in the context of prior booms. Australia’s position as one of the world’s top few wealthiest countries is not a given.

Australia long term1

#2: This commodity driven boom has been underpinned almost entirely by China’s growth, and importantly, its huge investments in property development and infrastructure.

China19902013

#3: China is often held out as a unique and exceptional case. Many have even gone so far as to suggest that China has created a new blueprint for how to manage a modernising economy.

economist

This is wrong.

In truth, China is the latest in a long line of economies to modernise through an authoritarian growth model. Each country that has successfully applied the model has tended to achieve a faster rate of economic growth than those before it.

Interestingly, the success of those countries has often led to their growth being heralded as evidence for a new ideal economic template. Economic commentators have short memories.

Germany used this model prior to World War II to modernise. Soviet Russia successfully applied the model for decades, even outpacing the United States. Leading to some hubris from Russia, and fear in America.

“The time is not far distant when we shall catch up with and surpass the United States” – Nikita Kruschev, 1957

“We stand today on the edge of a new frontier; are we willing to match the Russian sacrifice of the present for the future?” – John F. Kennedy

We know how that ended up working out. (As a sidenote, by the late 1980s Soviet Russia was spending 50% of its national budget on the military to try and keep up with the United States. 50%!)

In the 1980s it was the ‘Asian Tigers’ of Japan, Korea and Taiwan that were applying the model, again it was heralded as a revolution – until the 1997 Asian Financial Crisis.

#4: The authoritarian growth model has three key components

1. The country must have a strong government – authoritarian regimes or one party states only please (the next two points explain why).

2. The model requires the government to confiscate resources from its people. The model works by suppressing consumption, forcing people to accept lower living standards in the present in exchange for higher economic growth.

Policies that explicitly or implicitly confiscate resources:

  • High taxation
  • Suppressed wages growth (e.g. through banning or controlling trade unions)
  • Currency depreciation (effectively a consumption tax on ordinary people)
  • Powerful State-owned enterprises
  • Financial market intervention

3. The model requires the government to use resources confiscated from its people to fund rapid growth of investments (often exports).

Policies used:

  • State subsidies
  • Low wages
  • Subsidised borrowing
  • Direct investments in infrastructure
  • Direct investments by State-owned enterprises

#5: Unfortunately the success of the model can not be sustained.

There are two problems with the model that ultimately make it unsustainable.

First, the distortions introduced inevitably start to lead to poor capital allocation decisions.

“(Countries) start by powering the economy with investment by the state to build manufacturing capacity and infrastructure. However, the gap between what the country has and what it needs closes quickly, and then it is difficult to recognise what isn’t needed.” – Michael Pettis

This model works well during the ‘catch-up’ phase as capital deepening improves productivity. Once capital intensity starts to approach developed market levels the model breaks down as capital allocation efficacy becomes more important.

Second, the problem of overinvestment ultimately ends in a debt crisis.

Wasteful investment continues until the whole financial system chokes on bad debt. With their capital locked up in underperforming investments, the banks have to lend more to the developers, some of which they will use to fund the next project, and the rest to repay old debt.

More and more of the new credit starts to be eaten up paying imaginary returns on the growing pile of bad debt.

Eventually the lenders, realising they will never be repaid, stop making new loans. At that point the investments stop, and the whole cycle of expansion starts to operate in reverse. Less loans, mean less investment, mean less growth, mean less loans.

#6: There is some good news. China is more resilient than most countries, and the debt crisis doesn’t need to lead to a financial crash.

“If this is starting to sound dire, note a few pieces of good news. The first is that while an investment-led growth strategy always ends in a painful adjustment, it doesn’t always end in disaster. Countries can unwind some of the policy distortions that led to excessive investment and eventually put their economies on a more balanced growth path”

“A number of East Asian economies in the 1980s and 1990s experienced painful adjustments following the bursting of their government-induced investment bubbles, but each pulled through and established a foundation for future growth and stability. In particular, Korea, Taiwan and Singapore emerged from the Asian crisis in 1997 as stronger economies and more democratic nations”

China’s US$3 trillion of reserves would allow it to bail out its banks during a debt crisis, and lower the rate of investment. The author makes the point that this would lead to a reduced rate of economic growth, but it would not necessarily involve a financial crash.

Given the scale of China’s investment boom, and the vested interests of Party officials that it has fostered, I am less optimistic than the author about China’s ability to sidestep a financial crisis. However, given the immense control that the government has, and its currency reserves, it can’t be ruled out.

If China is able to engineer a smooth transition from an authoritarian investment-led growth model to a more open consumer-led society, it will deserve to be regarded as an exceptional case.

The last word:

These few key lessons have barely done justice to a great essay. For anyone interested in Australia’s future, or China’s growth (and that should be all of us) I highly recommend giving it a read.

Where to buy it:

The essay format makes this is a quick but insight-packed read. You could easily get through it in an afternoon. Kindle versions are the cheapest bet. http://www.quarterlyessay.com/issue/dragons-tail-lucky-country-after-china-boom 

The economics of New Zealand politics

During an election cycle political news is overwhelmed with punditry. We hear multitudes of different theories for every tiny poll shift. The latest NZ national elections were no different. ‘Dirty politics’, spying, lying, tax policy, asset sales, the list goes on. But is there a simpler driver of voter behaviour?

If you want to know how New Zealanders will vote, just ask GDP:

Elections and GDP2

Since 1990, no New Zealand government that has kept GDP growth above 1% has failed to be re-elected.

P.S. For all my kiwi friends living abroad that have vowed to not return home until there is a change in government – make sure you’ve got some cash saved. There’s a good chance it will be during a recession.