24 Jun 2016

Portfolio Review and Outlook

'In the short run, the market is a voting machine but in the long run, it is a weighing machine.' – Benjamin Graham

The reader of our monthly factsheet might have noticed that it is light on explanation for the performance over any month. 

There is a reason for this.  It is our firm belief that monthly performance of any equity fund can be almost fully attributed to market noise.  In fact, we would go further and attribute most of the over or under performance in any quarter, or even year, to market noise.   Market noise is essentially Ben Graham's voting machine, it is the fickle and easily spooked or excited Mr Market, who one day wants to buy and the next day sell the same stock. Even a casual watcher of CNBC will observe this phenomenon in action daily!

Outperforming Mr Market every month would require an investor to predict which way Mr Market might vote and vote ahead, often with total disregard to the intrinsic value of the investment (remember the Dot Com bubble, and CDOs).  As we tell our investors, we do not even try to play this game, rather focussing on their long-term wealth creation.

However, this can be painful in the short-term, and here we emphasise short-term, as no one likes to underperform either the market or their peers. Though, we have been here before (and will again) and each time the fundamental value of an investment always (repeat always) comes through as Ben’s weighing machine cannot be ignored forever.   

The most extreme examples of this can be found with deep value companies. As here you really cannot be sure how low the price may go in the short term.  Picking the bottom (as most investors can attest to) is very, very difficult.  So how do you manage this? With deep value investments we have a price target which ensures a large enough discount to asset backing for a considerable margin of safety, then we buy.  We don't try to second guess how much further down the price might still go (or one would never actually invest).

A recent addition, Macmahon Holdings, is a good example of this. At the time of investment, Macmahon, a mining services contractor, had a market capitalisation of $87m, net debt of $56m, and over $1b in Revenues.  We knew the short-term outlook was difficult but the large discount to its asset backing gave us a large margin of safety. Importantly, in evaluating the asset backing we do not just take the numbers in the balance sheet. Rather we conservatively adjust these to reflect actual realisable values, and consider the worst case of a fire sale. So for Macmahon we halved the book value of its assets (mainly, trucks, diggers and drills) and took 25% off its debtors.   

Subsequent to our investment, the company was hit by a trio of bad news events which was not received calmly by Mr Market.  So while we bought Macmahon at a 73% discount to its net tangible assets (after our conservative impairments), at one point, Mr Market had sold the price down to nearly 90% (meaning you could buy $1 of assets for 10c!!).  This is a big margin of safety for a company that is very unlikely to go bankrupt given its low levels of debt, high asset backing and positive free cash flow.  Interestingly, most broker research on Macmahon uses a discounted cash flow methodology for pricing the company, placing no actual value on its assets.  

So what did we do? Well after a few calm breaths and a further recheck of the asset backing we did what every true value investor should do – we bought more. While further short-term bad news can never be ruled out the longer-term upside is truly exciting.

While in hindsight, one can always time an investment better, we are genuinely excited about the fear that Mr Market is feeling for stocks like Macmahon and the mining services sector as a whole.  That sort of emotion often offers up investment gems, which we are particularly fortunate to be offered given the high prices Mr Market is paying for companies in most other sectors.  As we previously wrote in Mining Services, this kind of investing requires patience, and an acceptance of potential short term pain for long term gain.

This maybe best summed up by a quote from Michael Lewis “Graham and Dodd investors are people who place a very high value on having the last laugh. In exchange for the privilege they have missed out on a lot of laughs in between.” We are striving for our investors to have that last laugh.