Fusing Business Momentum and Value

Business Momentum Look at Investing from a New AngleThe following article comes from one of the best discussion board posts I’ve read. The post is republished below with the permission of the author. This enriching and entertaining article exemplifies a style of fusion investing, the fusion of business momentum and value.

I hope you enjoy reading and thinking about this article as much as I did. It’s a fantastic example of looking at things from a new angle.

What did we do right in 2009?

One year of good return may be just a result of high tide lifting all boats or simply mean-reversion from a terrible year. Nevertheless, my biggest take-away from 2009 was a subtle but important change to my investment philosophy – I have changed my focus from “good and cheap” to “better and cheap”. I care more about change in fundamentals – I prefer a bad company that is getting better over a good company with no change in story. This new philosophy has led to solid stock picking, which generally out-performed the market with what I believe to be lower risk (“permanent loss of capital”). Equally important, this new framework gives me better guidelines to size my bets, especially betting heavily in situations where both the story is getting better and stock is cheap.

When I started investing a few years ago, I was firmly in the value investing school – concepts like “intrinsic value” and “Mr. Market”, coined by Ben Graham and popularized by Warren Buffett, clicked for me instantly. I spent time studying company fundamentals, coming up with an estimate of the intrinsic value, and trying to buy at a cheap or discounted price. In short, I was trying to buy “good and cheap”, and results were satisfactory.

Balancing between business and momentum

However, I have come to realize the quality of the company and absolute discount to intrinsic value are not everything – one has also to consider the time and factors it takes for the discount to narrow, which typically depend on the business cycle. Thus my new approach comes down to balancing between value and momentum. Value refers to the price paid for the business. Momentum, not to be confused with price momentum in quant and technical analysis, refers to business momentum, i.e. how well the business is doing. Improving momentum can come in the form of higher margin, accelerating topline growth, or improving ROIC. With the exception of select great companies in their growth phase, most companies’ stock price and business momentum move in cycles/curves similar to sine waves with peaks and troughs.

These two curves are closely related – when business momentum is good, stock price tends to go up, and vice versa. However, there is often a lag between the two curves, and depending on the part of the cycle, stock price will react to the change in business momentum very differently. I believe this is the crux of investing – how you identify which part of the cycle the company is in, which drivers to watch for and which valuation metrics to use. For example, earning revision is a powerful factor but completely useless at business peaks and troughs. P/E may be a good valuation metric in general, but unadjusted for margins, it is useless or even dangerous at extremes. [I stopped highlighting here as it’s all so good the entire article should be highlighted!]

For example, assume a retailer’s intrinsic value is $20, and buying at $15 may give an expected return of 33%. However, the same $15 price may correspond to two points on the momentum curve – one where the curve is turning up (story getting better) and the other where the curve is trending down. In the former case, you will probably get to $20 in 6-12 months. In the latter case, you may have to wait 18-24 months before the retailer corrects excess inventory and produces positive SSS (curve turning up again) to reach the $20 intrinsic value.

There are two obvious problems with buying at the latter point. First, time adjusted return is obviously inferior. Second, the stock price may first plunge to $6 before recovering. While a pure value investor may think a lower price makes it a better buy (even more margin of safety), reality is that an adverse price movement will slowly but surely inject doubt into my mind. Have I made a mistake? Is this a value trap? Very seldom does stock price move down without some deterioration of business fundamentals and some changes to the initial investment thesis. So unless one has an iron stomach (I don’t), it is very tough to keep calm during the price downdraft and continue to average down.

There is an even bigger issue – if you are prepared to average down, chances are that you will not buy a full position initially, and inevitably you will end up establishing similar-sized partial positions for all new ideas. Yet some of those ideas will have good business momentum and they are your surer bets, so you lose potential profits in positions that actually have the best risk/time adjusted return.

Does quantitative investing capture business momentum?

So doesn’t quant investing capture “better and cheap”, as preached by the noted quant investor Cliff Asness? Yes and no. I believe there are two problems with quant investing. First, it mistakes cause with effect – price momentum is the result of business momentum, and while the two will resemble each other at certain part of the cycle, they will diverge significantly at critical turning points. Second, the effectiveness of various factors differs significantly from industry to industry as well as at different parts of the business cycle. Quite simply, quant investors lack the domain knowledge of each industry and use the same factors or same weightings across sectors during different points of the cycle.

For example, quant investors will universally use factors such as earning revision, revenue/EPS surprise/breadth to capture business momentum. While this does a satisfactory job overall, it will not capture key drivers for each industry, which often cannot be retrieved from standardized financial statements, such as inventory/store for retailers, or asset inflows for asset managers. Often changes in these key drivers will long precede actual changes in earnings, so generalized quant investing could easily miss the turn. As another example, six months ago, both KIRK and ARO got the highest rating in our internal quant system, yet the two retailers could not be more different in terms of where they were in the business and margin cycle, and the subsequent divergence in stock performance illustrated the flaw in the quant investing approach.

Catching the turn

I certainly do not want to leave the impression that other investing approaches are inferior. Indeed, there are many ways to achieve success in investing, and everyone needs to find approaches to fit his or her own traits. I believe I have found mine by balancing between value and momentum. Put simply, I aim to invest in situations where fundamentals are about to turn or have turned while valuation is reasonable. I am certainly not reinventing wheels here, as this is the approach advocated by both Peter Lynch (“catching the turn”) and Warren Buffett (“What we really like to see in situations is a condition where the company is making substantial progress in terms of improving earnings, increasing asset values, etc., but where the market price of the stock is doing very little while we continue to acquire it”).

Well, this approach may sound good on paper, but how many of these “perfect” situations exist, given how efficient market is with so many hungry and smart investors poring over every corner of the market? I believe these opportunities happen more often than one may think, especially if one can invest in small-cap or micro-cap land. For example, I monitor about 50 names closely in the retail industry (which I shamelessly consider to be my circle of competence). This year alone, I identified 4 separate names that fit the criteria. They respectively returned 50%, 70%, 100% and 900%.

One may counter that retail stocks have done very well in general this year and question whether throwing darts randomly would have generated similar if not better results. I would argue that much of the return (especially the out-sized ones) was hope-based, and rational investors could not have predicted those returns ex-ante with any confidence to place a big bet, as some of those names could easily turn out to be zeros. Yet in all four names I identified, I was reasonably certain of the business momentum and earning surprise, and could accordingly place out-sized bets (10%+), with confidence that even if it did not play out according to plan, I would suffer very small losses due to valuation.

While hindsight is 20/20, I could also identify at least two retail names annually over the last few years that fit my “better and cheap” criteria. So they definitely occur, and one just needs to have the patience and courage to bet big when they do come along, usually when market is bad. Those situations can occur in large-cap stocks as well, such as FDX throughout this year. FDX had over $20B market cap, was followed by 25 analysts, yet the stock was at trough EV/sales, even though earnings had bottomed and was poised to recover through cost cuts and market share gains. Earning estimates have moved up 60% in 6 months and stock went up over 150%.

As with anything in investing, there are also drawbacks to my approach. One is depth vs. width – I need to be able to identify and evaluate key drivers for the companies and industries, and this takes significant amount of time. The rarity of these “perfect” situations forces me to turn over a lot of rocks. To date, I am reasonably comfortable with retail industry, and to a much lesser degree with software, asset managers and transport industries. I may soon reach (if not already) a point where I can not physically monitor more names. The other problem is scalability – most of my top ideas are in small to micro-cap land, so it is questionable whether my approach can really handle more than say $50-100M of assets. But that will be a nice problem to have, and I suspect I will just have to make the trade-off between absolute performance and AUM.


Originally posted Mar 4, 2010 

Falling knives cut deep

Don’t try to catch a  falling knife.

Do you know the game mumblety peg? As kids we called it knives and loved playing it.

Alas the mollycoddled generations will never know the thrill and the fear of throwing knives at their own and each other’s feet.

Most versions of knives involved two players and a pocket knife. Our favourite version of the game was stretch.

The object of the game is to make the other player fall over from having to spread their legs too far apart. The players begin facing each other some distance apart with their own heels and toes touching, and take turns attempting to stick their knives in the ground outboard of the other player’s feet.

If the knife sticks, the other player must move their foot out to where the knife stuck while keeping the other foot in place, provided the distance between foot and knife is about twelve inches or less. Play continues until one player falls or is unable to make the required stretch.

The ‘traditional version was also fun.

Two opponents stand opposite one another with their feet shoulder-width apart. The first player then takes the knife and throws it to “stick” in the ground as near his own foot as possible. The second player then repeats the process. Whichever player “sticks” the knife closest to his own foot wins the game.

If a player “sticks” the knife in his own foot, he wins the game by default, although few players find this option appealing because of the possibility of bodily harm. The game combines not only precision in the knife-throwing, but also a good deal of bravado and proper assessment of one’s own skills.

There is nothing quite like the fear of a knife in your foot to sharpen one’s skill assessment.

Anyway that’s  enough of a stroll down memory lane.

Falling knives

The major appeal of trying to catch a falling knives is rooted in anchoring. Coca Cola Amatil was $15 last year, it must be a bargain at $9!

Coca-Cola Amatil falling knife

Last week I confessed to anchoring when selling. Unfortunately I still occasionally fall in to the trap of anchoring with falling knives. I have been closely watching Coca-Cola Amatil (ASX:CCL) since it’s precipitous fall in April. It appeared relatively cheap. Relatively that is compared to its past multiples.

Fortunately Peter Phan of Castlereagh Equity pointed out to me there are other large Australian companies priced similarly that have better growth profiles and less execution risk than Coca-Cola Amatil.

Falling knives present numerous dangers, most of which are as painful as a knife in the foot.

  1. They can and often do keep falling. Cutting deep as they fall.
  2. Even when they eventually land they often turn in to value traps, that is the stock doesn’t rebound to capture past glory.
  3. Those stocks that do eventually bounce often don’t provide a good compound annual growth return. CAGR is the key return long term investors should focus on. If it takes too long for the investment to “work out” then a good absolute return can become a poor CAGR.

Coca-Cola Amatil is a good, but not great example of a falling knife. It has decent underlying businesses and negligible chance of falling to zero.

Speaking of zero, a much better example of a falling knife is Xero (ASX:XRO). Xero is a classic falling knife. Since XRO began falling in March, every single person who has tried to catch this falling knife has been badly cut. And those cuts could get a lot worse.

With no earnings and well heeled incumbents successfully fighting back there is no sign of the floor for Xero’s falling knife.

Xero closed today at $18. And just in case you think I’m jumping on the beat it while it’s down bandwagon, I’ve been screaming watch out below since Xero was $42.

xero falling knife xro asx

Falling knives are worthy of a place on your watch list. If they fall hard enough for long enough then they can provide sensational opportunities, with limited downside and massive upside.

Hopefully my recent purchase of Maverick Drilling at $0.16 will be a case in point.

The trick is patience. Wait, wait, wait and then wait some more. Stocks can keep falling by yet another 20 percent over and over again. Take Xero for example, it’s closing in on its fourth 20 percent fall from its March high. From here it could easily fall 20 percent twice more in normal market conditions or even 5 more times if a bear market bites.

Here’s an old post on the footwear company Crocs that illustrates just how far falling knives can drop, $75 to $0.79.

Disclosure: Please seek expert advice before playing mumblety peg. I am not authorised to provide advice on knife throwing.
Long MAD. CCL is still on my watch list.

Does making financial predictions make you a dickhead?

The good news is making financial predictions won’t make you are dickhead, the bad news is you already are a dickhead!

Before I dive in to the very shallow pool of self congratulations that most financial pundits wallow in, allow me to recap part of my investment philosophy.

As a young lad my mother used to say, “According to you everyone is a dickhead except the Pascoes and Morels”. Bede Pascoe was my best friend and my mum was right. Bede and I thought most people were dickheads!

I was around 14 when I realised that I might also be a dickhead. I remember the incident well, which is unusual for me, and funnily enough Bede was the one who delivered my realisation.

My mantra changed slightly to “everyone’s a dickhead, including me”. The core tenant of my philosophy became that whatever theories or beliefs people held as truths were probably wrong. Yes 2 plus 2 equaled 4, at least most of the time, but I doubted most things, including lots I believed.

So when my interests turned to finance it was no surprise that I thought efficient markets theories were the spawn of complete smegheads.

Predicting the future

But what may surprise you is that I embraced predictions. Yes I have a crystal ball! It may be a tad cloudy, but all you need to make money in the markets is a slight edge. My crystal ball is one of the tools that delivers that edge.

When people believe in efficient markets or scoff at predictions they deliver me an edge.

My focus when investing is predicting the future. Predicting what a company is likely to achieve and how investors are likely to react. Predicting what is likely to happen over the next few years and how investors will respond. This crystal ball gazing works best when the market is mispricing a company, that is when the market focuses exclusively on either the good or bad news surrounding a company.

People are unable to entertain competing ideas let alone objectively price the outcome of those opposing ideas. The larger the herd the easier it becomes to predict the next move.  

Is making financial predictions unusual or bad?

Predictions have a bad wrap, but finance is all about making predictions.

Discounted cash flows are predictions. Not only that, they’re predictions of the worst kind. Predictions should be as vague as crystal balls are cloudy. But by wrapping a prediction in financial mathematics many fools suddenly believe they can predict to the cent what something is worth. They try to predict cash flows 10 or 20 years in to the future and worse yet try to accurately predict them.

Of course wise value investors realise that accurately assessing value in incredibly difficult to do, so they embrace the concept of margin of safety. Buying something for considerably less than you predict it’s worth gives you a margin of safety. A margin to compensate for your cloudy crystal ball.

Soon, I’m going to blow my own horn by showing you one of my predictions and how it played out. But before that here’s a few more predictions.

At around $41 when some analysts were belatedly jumping aboard the Xero (ASX: XRO) rocket and calling it a buy, I said it may be worth a nibble at under $30, but the load up time was around $19. Some people thought I was crazy and Xero would never again see such a low price. Well Xero has traded under $22 this week and you know what I now reckon that under $10 may be possible and under $5 not impossible.

I arrive at those figures by predicting the future based on the reliability of past events and investor reactions. In this case a major market correction or some other major event is likely to occur well before Xero is profitable. When that happens stocks without earnings will be taken the woodshed  and flogged to within an inch of their life. And that is the time to buy a company like Xero.

The wonderful thing is that it doesn’t mater if I’m wrong, it only maters if I’m right. I lose nothing if wrong, but am prepared to win if right. Compare that to those telling people to buy Xero at over $40. If they were wrong there was huge obvious downside, if everything went perfectly there was limited upside.

Here’s another prediction. The current yield chasing craze will end badly. Investors who are currently congratulating themselves on being masters of their own universe will be found to be naked as the yield tide goes out.

On to the main self congratulating event, here’s what I wrote in March 2013. Hopefully you can extract something useful for your future endeavours.

Finger Lickin’ Good

Collins Foods (ASX: CKF) owns, operates and franchises KFC and Sizzler restaurants…

A respected fund manager, Orbis Investment Management, continues to buy Collins Foods, and they now own 17.4 percent of outstanding shares. They’ve bought over 60 percent of shares traded in the last month.

Orbis has been virtually the only buyer of Collins Foods. The stock, a recent IPO at $2.50 per share, is seemingly hated and/or ignored by virtually the rest of the investing population.

Imagine how low the price may have fallen if Orbis had not been buying! $1 or less? Now that would be a one-foot hurdle!

We may still get $1, but at around $1.10 Collins is a good two-foot hurdle.

Orbis can only buy 2.6% more of Collins Food stock, so patient investors may soon be rewarded with a great entry price. Naturally there are no guarantees that we’ll get a lower price, but the odds are in our favour.

Over the medium term a rebound in Queensland trading conditions should stabilise the business and earnings.

Here’s a couple more comments I penned on Collins.

March 2012
Collins Foods (ASX: CKF) was close to being our top pick last month and again this month. If it weren’t for low trading volumes, this purveyor of grease and starch may have made the starting lineup. Institutional investors remain shy, and most retail investors are yet to notice the opportunity.

Investment arms of NAB sold down their holdings in December and January; respected Orbis Investment Management was a buyer. With bad news baked into its share price, any positive news will send shares rocketing, while further bad news is unlikely to have much effect. In sum, Collins presents limited downside risk with the possibility of a double within two years.

February 2012
Collins Foods (ASX: CKF) has been trading in a tight range since its disappointing inaugural results as a listed company. Institutional investors remain shy of a company that has already burnt several of their brethren, and most retail investors are yet to notice the opportunity.

Collins has now doubled! And after hitting $1 as I said it might.

Collins Food Group ASX:CKF share chart

While it may appear I’m simply blowing my own trumpet, I’m really sharing this for the lessons that can be learnt. It’s basic stuff that most people simply don’t make part of their investing DNA.

  • If the bad news is priced then the upside potential is probably being ignored and mispriced.
  • Be prepared! Imagine what could happen based on the facts at hand and be ready to respond to what occurs. I predicted share price could hit a $1 when Orbis could no longer buy, it did.
  •  Think about companies from a future perspective rather than linearly extrapolating historical data.

It’s that simple logic that led me to Acrux (ASX:ACR). The downside was more than priced in. Today’s price jump is no surprise. It wasn’t rocket science or advanced financial maths — there’s an oxymoron — it was simply assessing whether the risks were being over-weighted. The downside was priced in! That puts you in the wonderful position of any good or even alright news will be an upside catalyst.

Acrux Axiron sales increase chart

Here’s another example from 2013 using pSividia.

pSivida is hoping third time’s the charm. Alimera has submitted  ILUVIEN for FDA approval for a third time. The outcome is expected in October. If rejected, watch out below, pSivida longs will be  crushed. Here’s the crucial point for those looking for better odds. A rejection would make pSivida worthy of attention as it will still have the growing European cash flow, a promising pipeline and the possibility of eventual FDA approval if Alimera coughs up and performs the additional trials the FDA have always wanted. It may also have a share price starting with 1 — ouch!

The approval was rejected and that proved to be a great time to go long. While pSividia didn’t drop below $2 it did get within the ballpark.

So the next time people laugh about crystal balls you might want to ask them what they’re basing their investment decisions on. DCF? That’s the worst type of prediction. Historical financials? While useful, it’s what is gong to happen that counts.

Whatever they’re basing their decision on its most likely a crystal ball going by another name. They’re simply dickheads without enough insight to know that.

My name is Dean Morel and I’m a dickhead! A lot of my predictions are wrong, but as they cost me nothing I can keep making them all day. Sometimes my guesses are right and I take a swing.

Disclosure: You’re a dickhead, but you’d be an even greater one to think this is anything more than the ramblings of an idiot.  I’m long several of above mentioned companies. Needless to say this ain’t advice. Here’s the advice, pull your head out of your arse, look at the future, figure out what is likely to happen and what is priced in. Or like me, if you discover your head is too far up your arse then keep forcing it further up until it finally pops back out your neck. I’m not sure mine has popped out yet, but it’s getting close ‘cos it no longer smells like shit in here.

Stockbrokers can cost you a lot more than high execution fees

Is Marcus Padley getting desperate?

In this article Padley attempts to intimidate self directed investors into using the over priced services of stockbrokers.

Whether a trade costs $19.95 or $79.95 will have less impact on your long term wealth than whether it was a sound investment to begin with. In my experience full service stockbrokers provide lousy advice that can cost you significantly more than the $60 extra bucks you pay for a trade.

So to counter Marcus Padley’s long list of attributes he believes investors require — many of which are spurious — I give you this list.

Use a full service stockbroker if you:

  • want to feel like you’ve been shafted with dud shares that your stockbroker is trying to off-load for their preferred clients,
  • wish to make a salesman — as that is what stockbrokers are — rich,
  • like to feel bad about your well reasoned and researched decisions because the salesman at the other end of the phone has conflicting incentives,
  • enjoy investing in “guaranteed sure winners” that don’t,
  • like being encouraged to trade too frequently, thus sending your costs skyrocketing as fast as the salesman’s new Porsche can go,
  • enjoy selling your winners too soon, as the salesman needs to hit his commission targets,
  • like to lock in losses with stop loss orders due to simple market volatility rather than a fundamental change in business prospects,
  • want to be guided more by someone’s past experience and existing beliefs than by logical thinking and rational decision-making — see here,
  • think it’s good to be directed by a salesman who has difficulties disengaging themselves from vastly anchored thinking patterns,
  • are unable to take responsibility for your own decisions and need someone to blame.

When investing, don't use a monkey throwing darts

Beware of incentives

Marcus Padley is the same as almost every person involved in finance. They are all either unable to or purposefully choose not to disentangle their ‘advice’ from their own incentives. Stockbrokers advise you to use stockbrokers, while newsletter writers advise you to be self directed so they can sell you advice. Banks, brokers and financial advisors all advise you to to use margin, not because it is financially sound, but because they are incentivised to do so.

If you’re above average intelligence then manage your own money. No-one is as strongly incentivised as you are to make sure your wealth grows.

Disclosure: My main incentive is to grow my family’s wealth. As alpha — market outperformance — is a zero sum game that may mean that I’m incentivised to give you a bum steer! Maybe I think I can beat you more easily than I can a stockbroker.
Of course this blog is simply for my amusement. I am not authorised to give advice.

It’s OK to be wrong

My father was never ever wrong, or at least that’s what he thought. It’s still is a running joke in our family to try and get dad to say “sorry I was wrong“.

We used to joke about his inability to admit he was wrong, but I stopped laughing when, while studying psychology, we learnt about narcissism. Things aren’t as funny when they have a label, especially if it sounds as bad as narcissism. I felt a little sad that my dad, who I love, may not be a strong righteous man. That instead his pride, insecurity, lack of insight and self reflection were probably behind his inability to admit being wrong.

For whatever reasons I’ve swung the other way. I find it easy to admit I’m wrong and spend a lot of time trying to determine if I’m wrong and why I was wrong. I consider focusing on the downside and trying to figure out how you’re wrong important attributes for an investor, hence I’m often both stunned by and intolerant of other investors who are unable to admit being wrong. Before I get to my negative example I’d like to call out Cullen Roche at Pragmatic Capitalism for his shining example of self reflection. Even the title of Cullen’s article Three Things I Think I Think illustrates his humility.

I score Cullen 1.5 out of 3 this time on the things he thinks he thinks. I’m also pretty certain that he’s open minded enough to consider the excellent replies he has received and to perhaps change his mind. I’ll simply say you shouldn’t use outliers to form a general view. In this case the Forbes 400 rich list to form a view on social mobility. There are always exceptions to rules and while it’s good to think about them it’s also important to realise that exceptions don’t negate the general rule. In this case, it’s a bloody tough road if you come from a poor family and those of lucky enough to come from a middle class Western family or better should always remain humble enough to realise we’re lucky.

I loved Cullen’s second point. ‘Value’ investors all too often overlook the voting machine, but unlike Cullen I see no inconsistency in the concept that in the short-run the market is a voting machine and in the long-run it’s a weighing machine. Here’s what I said back in 2009.

In the Intelligent Investor Benjamin Graham commented on the market, “In the short-run it’s a voting machine, but in the long-run it is a weighing machine.” For some reason most market participants focus on the second part of that statement, they concentrate on the weighing machine. As a fusion investor I find equal value in both parts. In the short-run the market is a voting machine. In the short run the market is a voting machine. Come on say it with me 21 times a day for the next 21 days. Then you’ll no longer expect the market to ‘do something’ or to be in-line with your economic reality, you’ll no longer think the market is crazy.

People are driven by fear. They sold out on the way down out of fear of losses and now they’re buying back in out of fear of missing out. Understanding basic human nature is why psychologist are one of the best performing professional groups in the market. They understand the voting and respond to it.

Back in 2009 I said it was time to focus on the voting. Now it is time to focus on the weighing machine.

As I said in that 2009 article “Hopefully, you’re not surprised when I say there is no point in making [market] calls. You simply want to know where the game is at and the probability of each side winning.” It’s time to update my comment from back then. While I was on margin back then I’m now carrying a lot of cash. Why? Because bargains were plentiful in 2009 and now…well if you know any bargain please let me know.

My own view is there remains way to much focus on calling a bottom top and looking for signs of a market bottom top based on historical analysis. While it is important to be versed in the market’s history and use that knowledge as a rough guideline, my focus is on the here and now. Selling fully valued stocks and buying undervalued has been and remains my strategy.” [As an aside, I love this saying, if history was the key to financial success, librarians would be the richest people in the world.]

Finally this graph by Meb Faber via John Hussman brilliants illustrates why it’s not wise to disregard value. In the short-run anything can happen and the market is indeed often irrational, but in the long-run value counts.


If you don’t like ‘bitchy Dean’, it’s time to stop reading.

Equity markets are not zero sum

Over the weekend I tried to correct well known blogger/tweeter Tren Griffin on what I thought was simply a sloppy mistake. Tren said “Mr. Market is bi-polar. There’s a winner for every loser since the game is zero sum after fees. When muppets lose, someone else must win.

I’m sure most of you know, but for those who don’t “zero sum” is a simple concept that means exactly what it says on the can, that is, losses and gains equal zero. As equity markets return on average 10 percent a year they are clearly not zero sum. I’ve seen other bloggers go to some length to illustrate that equity markets are not zero sum, but for my money it doesn’t get any simpler than a 10 percent average annual gain is not equal to zero. Not even close.

In my book Tren then committed so many ‘crimes’ I feel obliged to call him out.

1. Rather than use his own logic and arguments he quoted others and stated they all agreed with him.

2. He was wrong. I’m not sure if it was a lack of comprehension or, more generously, if we were talking at cross purposes, but the linked articles highlighted that alpha is mostly a zero sum game. I agree with that and pointed out to Tren that he’d extrapolated the idea of alpha being zero sum to the entire equity market. Please let me reiterate, 10 percent annual returns clearly proves that gains and losses in the market do not sum to zero.

3. Tren continued to post links to articles that circled even further away from the point, e.g. active vs passive management. My dad used to do that, if he wasn’t winning an argument he’d change the framework rather then admit he was wrong.

I also disagree with the concept that for every winner there is a loser. Yes in aggregate market out-performance must come from under-performance.  But people sell and buy stocks for myriad reasons and to think in such simplistic terms as winner/loser is unlikely to be of any benefit to an investor. Except to think why they may be the loser! In this post Peter Phan provides a good anecdote of why this dogmatic rationality is problematic. Yes I know I’m linking to an article rather than using my own logic, what can I say, I love irony. Also Peter illustrates my point rather than highlights my mistake.

Further, market returns to individuals/institutions are not equally distributed. It’s closer to reality to say that for every winner there are 2-3 losers. It’s also worth considering that a 7 percent annual return, which some may call a loser, may actually be a winner on a risk adjusted basis. I could go on, but I doubt anyone is still reading.

Of course I could be wrong about all the above and I’m clearly out of sync with the majority of investors, as 16 people re-tweeted and 16 favourtied this tweet by Tren “Tech stocks are down from when they were up, but are still up from when they were really down. This up and down pattern will continue.” I read that to my 10 and 12 years kids and they laughed as much as I did. I thank Tren for giving us a lovely family moment. In fairness Tren may have simply been trying to better explain his point of view and I appreciate the time he took to reply to me, but wonder if that was driven by pride or selflessness.

And finally, it’s OK to be wrong, just don’t stay wrong.

Fusion Fund finally stumbles

As I said last month Fusion Fund had been enjoying an unparalleled winning streak of seven consecutive up months. Well all goods things come to an end. Our fund dropped 0.4 percent in March, under-performing the ASX200 total return index by 0.7 percent. Compared to the abysmal returns April will deliver, that feels like a win to me!

Due to Prana’s disastrous PII trial results for PBT2 April will probably set a new all time performance low for us. But hey that’s getting ahead of myself, so let’s dive back into March results.

March was a wild ride and the 0.4 percent drop does not reflect the intra-month volatility. Year to date the fund is up 12.9 percent compared to the ASX200 TR index of 2.1 percent.

fusion fund performance March 2014

This month’s comparative returns graph, see below, highlights just how ludicrous snapshot performance returns are.

March 2013 was a poor month for the fund. Consequently our one year return has leapt to a staggering and unreflective 71 percent. If I was a running a public fund and only cared about assets under management I’d be taking out full page adds featuring these ‘amazing’ returns. But hopefully you can see and realise that these snapshot returns are close to meaningless. Further, a multitude of studies have shown that investing in funds with recent good performance results in significant under-performance. And as mentioned above, we’ll certainly prove that correct in April!

Tip 47: Don’t chase hot returns!


There was virtually no change in our cash position this month. But that is a poor reflection on the activity within the fund. While this results looks like all calm on the water, I was furiously paddling below the waterline. Fully valued telecommunication companies were trimmed and one new position added.


Finally. I was extremely disappointed and surprised by the terrible PBT2 results.

While it’s only money to me, the outcome robs millions of AD sufferers and their carers of what was the best potential disease modifying compound around. Those gloating over the failure are a sick depraved bunch who only care about money. There is something so wrong in wanting to be right for the sake of it, without any thought  to those suffering from a disease. I hope one day they discover empathy and realise that there are many thing more important than either money or being right.

Volatility is my friend – Fusion Fund February performance

Last month I wrote about my Buffett inspired performance. At the end of February our 5 year annual returns leapt from 26 percent to an incredible 30 percent. Unfortunately that jump in return was more a reflection of poor results in February 2009 than strong February results.

I’m pleased, but not excited about our results. As Joe Kunkle said last week “stay humble – Helen Keller can pick winning stocks in this market – don’t get complacent”.

The first two charts show my performance, but it is the last two charts I want to talk about this month, so see you down below.



Love that volatility

Could you stomach 20 percent monthly declines? How about a 10 percent draw-down? Since July 2008 we’ve had three roughly 20 percent monthly declines and six declines around 10 percent. This volatility is a result of my move back to running concentrated portfolios, after temporarily flirting with diversification.

Do what I say, not what I do.

I still believe in the mantra to concentrate to accumulate, diversify to protect, and strongly believe most people should automate their saving and investment plans by long term averaging into low cost index funds. This excellent article succinctly summarises the path most people should take to wealth creation.

4. Automate everything. When it comes to saving and investing, you are your own worst enemy. So remove yourself from the equation. Automate your savings, bill payments and investments. You’ll save time and hassle–and be less inclined to impulsively spend your retirement savings on a hot tub.

February marks our seventh straight month of positive returns. We twice hit our prior record of four consecutive up months, in 2009 and 2012. So we’re way out in uncharted waters, yet we’re certainly enjoying these green seas!

With half yearly reporting now over here in Australia, whether we record an eight up month or not mostly depends on one company. Fingers crossed Prana Biotechnology delivers good results for their IMAGINE trial.

Show me the money

Our cash balance is increasing. As I’ve said before the cash piling up is predominately a result of limited investment opportunities rather than a macro call. Still as we enter what is likely to be the last leg in this cyclical bull market I take comfort from our cash weighting. If you’re not concerned with the preservation of your capital, then by all means remain 100 percent invested.


If you’re still 100 percent invested or worse leveraged, then you simply must read these extracts from Seth Klarman’s latest investor letter.  Lots of people jawbone about focusing on downside risk, Seth Klarman actually does. So what’s your cash weighting?

As mentioned, there is a high probability we’re in the final stages of a cyclical bull market, so as Klarman says it’s time to concentrate on return of capital rather than return on capital.

Every Truman under Bernanke’s dome knows the environment is phony. But the zeitgeist so so damn pleasant, the days so resplendent, the mood so euphoric, the returns so irresistible, that no one wants it to end, and no one wants to exit the dome until they’re sure everyone else won’t stay on forever.

Just because the music is playing, there is no need to keep dancing.

One last thing, if you haven’t read this post by Peter Phan I encourage you to do. Buying highly speculative stocks with little or no earnings at this stage of the cycle is not rational. I’m confident that a smidgen of patience will let me purchase some current high flyers for a fraction of their current price tag. I just hope you’re not one of the fools I buy from when you can’t stand your losses anymore.

What’s a Fundamental Setup

Most investors know about technical setups, even if they dismiss them. But fewer investors know about fundamental setups.

I trade fundamental setups. While there are many tools on my investing tool-belt, fundamental setups are definitely the hammer.

But before we can get to fundamental setups we must discuss forecasting.

Forecasting gets a bad rap. However, done well forecasting clears that crystal ball which you’re always bitching is cloudy.

The reason forecasting is so maligned is due to singular forecasts. 32 Celsius and sunny next Tuesday, 12 month price targets, the list is endless. It’s not the forecasters fault, as they provide what the majority want, the highest probability outcome.

Forecasting done well recognises multiple outcomes with probabilities assigned to each. At it’s simplest a weighted range.

Here’s an example using Prana Biotechnology ($PBT, $PRAN).

Within 8 weeks Prana should announce results for 2 pivotal trails, one is a company making event the second is even bigger, a major pharma pipe-line ass-saving blockbuster.

The first trial will be reported any day now. Let’s say it has a 50 percent chance of good results, while the second $10 billion plus blockbuster trial has an 80 percent chance of success. Prana’s share price is up a whopping 500 percent in the last eight months on anticipation. Yes I’ve enjoyed the ride!

If the results of the first trial are so-so or worse, the share price could easily halve.

In the unlikely (10 percent) event the results are bad then you’d loose three quarters of your investment. In case 3/4 doesn’t sound too bad, invert it. While a 50 percent loss only takes a double to make you whole again a 75 percent loss take a home-run — a 400 percent gain — to make you whole.   

If the results are good then the share price should quickly double. Good results would also provide a substantive floor under the share price in case the blockbuster results are disappointing, while simultaneously increasing probability of success for the blockbuster to 90 percent.

If the second trial results are excellent then Prana should be a ten bagger, a 1000 percent gainer, over the next couple of years.

Should you buy?

Prana Biotechnology $PRAN $PBT

The current risk reward profile based on the above simplified forecast is a risk of 55 percent of capital to make a double, that is roughly 2:1 reward to risk — 10% chance of a 75 percent loss, 40% odds of losing 50 percent and a 50% likelihood of doubling your money with an accompanying higher likelihood of further large returns. We could quantify those potential future returns, but we’ll keep this simple.

A 2:1 reward to risk is not great when dealing with speculative opportunities so I would not be a buyer now.

The fundamental setup I’d now look to buy is a failure at the first hurdle, so long as it is a stumble and not a glue factory fall. The share price will get hammered, yet the probability of success in second trial should only fall slightly.

Let’s say the share price falls the forecast 50 percent and at the same time the probability of good results from the second trial fall to 70%.

The risk reward then becomes a 10% chance losing 75%, 20% chance of losing 50%, 30% chance of 200 percent and 40% chance of 500%. That’s a risk of 58% for a possible 370% gain or over 6:1 reward to risk profile. That’s a much better fundamental setup than the current opportunity provides.

Alternatively a buy on thirds approach makes a lot of sense in this type of situation. That is, buy a third now, a third more after the HD results and then a final third only if the AD results are good. Your gains will be less, but importantly your risk will also be considerably less.

A third approach is to explore options as a means to play Prana.

Other fundamental setup examples

Here’s an example of a fundamental setup for pSividia last year.

A Peter Lynch favourite setup was the out of favour stalwart. A good example of the stalwart setup was QBE in 2012. I recommended QBE to TMF Share Advisor because there was very high probability of a getting a quick 30-40% gain out of QBE. That’s the type of return to expect from a stalwart setup, staying longer simply ensures your returns will quickly approach market averages.

One of my favourite setups is the fallen market darling. A great example here is CROX — remember Crocs? I recommended CROX as a turnaround play back in 2009. Another is when Netflix was taken out to the woodshed in late 2011 and 2012. If you forecast these events as having a probability of occurring then you’re prepared to buy if and when they do.

In summary, forecasting is good, nay essential, in fundamental investing. Forecasting clears my crystal ball helping me think more clearly about the future and thus assists me in finding the type of fundamental setups I like to invest in.

Disclosure: Long Prana – but have been a seller recently.

Fund managers I’d trust to manage my money

There are two basic ways to invest in the share market. Via low cost index funds or active management.

Low cost index funds are a low cost means to get slightly below market average. Humm, I don’t know what you think, but paying for guaranteed under-performance seems bizarre to me. If you must settle for bottom half performance, then at least time the market to ensure you finish in the top half at the end.

If your brain is exploding due to my heresy of commonly accepted wisdom, all I can say is look at the trees not the forest. Statistics tell a general story, but in investing it’s the individual stories that count.

So, that leaves active management as the only sensible basic approach. The decision then becomes, should I be the manager or hire someone? For the vast majority of people the answer is you should hire someone.

How to choose the best fund manager for your money.

Play the man not the ball. The ball is the game, the share market. The man or woman is the individual fund manager.

Collectively, active fund managers suck. Active investors pay a higher price for worse performance than index funds. You of course know that, as the poor average performance of active fund managers has been the major marketing thrust of index funds for decades.

Fortunately, as with most human endeavour, there’s a rough bell curve in ability and expertise. Our task is to find those top managers.

Sadly this is where most people trip up. But they shouldn’t feel bad as selecting a top fund managers is bloody hard to do.

Top criteria for  picking a fund manager

Here’s my list.

  • Go with a  boutique manager. You want a manager making final investment decisions not an investment committee. Do not go with a major ASX listed company. That includes the legendary Kerr Neilson’s Platinum Asset Management. Investing with one of them is investing with the crowd, and the crowd always finishes in the bottom half. Platinum is an exception, but I’m not sure it will be for the next decade or two.
  • Go with someone with almost all their own funds invested alongside you.
  • Someone 30 to 50. Perhaps older if you have good reason to believe they still have passion and will continue to perform for another decade.
  • Make sure they have reputable back-end companies. The companies then ensure the safety and integrity of your money.
  • Give preference to a value investing philosophy – intrinsic value, business focused investing.
  • Bonus points if they have a track record of picking growth companies.

Are you one of Australia’s best fund managers?

I going to list my top three below as a benchmark. If you believe you’re a better fund manager or know of one, then please drop me a line. Comment below on at the bottom of this page.

I’ve had some funds invested with OC Funds Management for nearly a decade now. I choose the OC Dynamic fund in 2004 based on an article I read while still living int he UK, plus a read of everything on their website. Both the performance and communication has been outstanding.

OC funds management performance

My current favourite  fund manager is a young Kiwi guy called Mike Taylor. This guy may even be better than me! LOL.

Mike founded and manages Pie Funds. Bummer, checking his site he’s soft closed his flagship funds, so getting in would be difficult. The global small companies fund is till open, but I believe that is predominately managed by external fund managers. 

I’ll sub Smallco in for Pie Funds.

smallco investment fund performance

In the young guns category of my top three fund managers is Tony Hansen of Eternal Growth Partners.

I think Tony is highly likely to continue beating the market over the long haul. But if he doesn’t at least you know he’ll go hungry! Here’s how Tony puts it.

Over the course of the last few years, I have actively and unsuccessfully sought a product which is accessible to the average investor which has two desirable characteristics – 1. no management fee & 2. fee for performance only. I have found no suitable product, and so decided to create one.

One final word of advice.

It’s no coincidence Mike Taylor of Pie Funds has soft closed his funds. Good investments are very difficult to find now.

Good fund managers are even harder to find. This is a good time to be reducing debt and building cash reserves.

Disclosure: I continue to target 50 percent invested. I’ve been selling down our units in OC Dynamic Fund. I just bought a new house and have taken on a mountain of debt. I am not you, and what’s right for me is not right for you. You may be the unnamed Star Trek security officer beaming down to the alien planet with me. This is not advice.

M2 Telecommunications – high risk low return investing

From the emails I’ve received a lot of you clearly want to discuss M2 Telecommunications Group (ASX:MTU). Pester power pays off yet again! I’d be flattered if I wasn’t a grumpy guy.

It seems many of you are wondering about The Motley Fool’s recent recommendation of M2 in Share Advisor. At the same time as I’ve been selling telecommunication stocks, Share Advisor has been adding more telcos to its portfolio.  Strange that. Fear and Loathing on the high risk low return road

Let’s jump straight in. In short, M2 is now a low reward high risk stock. While there are many paths to successful investment returns, that’s not one I’d choose to take.

I much prefer a low risk high reward path. That’s the roadmap I laid out when I launched Share Advisor. I’m puzzled as to how M2 could be considered either low risk or high return.

M2 was a low risk high reward investment when I recommended and bought it at around $1.30 in 2009. It was still very attractive when I picked it as Motley Fool’s Stock of the Year for 2011-12 at under $3. It was no longer a great investment when I sold my final parcel in the $6 range in May 2013. And M2 is not a great investment now.

What’s changed with M2?

Debt. Debt is what’s changed.

Debt is the number one shareholder risk and M2 is only a couple stumbles away from debt being its undoing.

In issue 5 of Share Advisor I highlighted three important debt metrics. M2 fails on two of those metrics and an earnings hiccup would see it fail on all three.

  • Debt to equity. M2 debt to equity is over 1. Debt of $325 million to $297 million in questionable equity. That’s a fail. The equity is questionable as it could be decimated with a couple quick strokes of an accountants or auditors pen writing down the massive $459 million of goodwill.
  • The EBITDA coverage ratio (EBITDA/interest  expense) indicates how capable a company is of paying the interest on its debt. The higher the number, the better — I prefer a value greater than 5. With 2013 EBITDA of $108 million and interest of $12 million — ­­interest will rise due to debt taken on in 2013 — I’ll call it 7 and a pass.
  • The third ratio is net debt-to-EBITDA. This is similar to the coverage ratio but shows how much debt the company has relative to its earnings. In this case, lower values are better, and I prefer them to be less than 3. At $325 million debt to $108 million EBITDA, this ratio is 3x. That’s high and a second strike against M2.

It is critically important not to ignore debt. Debt, more than any other element cripples companies and destroys shareholder wealth. Debt creates a possible future with huge downside, 100% downside for equity investors!

If you doubt this, then you need look no further than some of M2’s best acquisitions. How did they snap them up so cheap? Those once high flying telcos were crippled by debt. Commander was purchased in June 2009 out of receivership for $19M, it had annual sales of $100M.

The debilitating nature of debt is especially true for an acquisitive company with 71% of its assets comprised of intangible assets and goodwill. That’s right, M2 owns diddly squat. While asset-lite is a create business model, having over 50% of your assets as goodwill has the potential to be a disaster.

Ask yourself this. Are M2 brands worth $635 million? Management and auditors clearly believe so, and I’m sure their calculations back this up, but what about the real world. With $635 million, could you create a handful of telco brands and associated businesses?

Of course you could and hence M2 has no moat. M2 has no competitive advantage.

One bad year of earnings from those brands would see a massive write-down of goodwill. That would see equity and earnings plummet and M2 enter a world of pain.

While destruction by debt is not the most probable outcome for M2, it remain a risk I’d prefer not to take.

What is M2’s upside?

All going well, M2 is likely to outperform over the next few years. However, it’s unlikely to thrash the market as it has in the past.

M2 does appear cheap on both relative and fundamental valuations, but there are other companies that are relatively cheaper, have less risk and more upside potential.

If you own M2 you’d be well served by performing a Hewitt Heiserman style earnings power chart. That’ll show you just how much or little value M2 is really creating.

Disclosure: No position in M2. This is, of course, simply my humble opinion and is for entertainment purposes only. This is not advice.

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