Brickbats and bouquets – Part 2

In part 2, Gaurav Sodhi, Graham Witcomb, Jon Mills and Andrew Legget discuss winners and losers, while John Addis draws the lessons from them.

Gaurav Sodhi, deputy research director

There’s no avoiding my biggest losers of the past few years. No doubt members will be almost as familiar with them.

From mid-2011 to late 2014 Origin Energy found a place on our Buy List. Since the original recommendation on 19 May 11 (Buy – $16.09) the company’s share price has tumbled 66%. Much the same has occurred with Santos. It’s down 68% since the original Buy recommendation on 19 Nov 09 (Buy – $15.02).

Were these mistakes? With an oil price around $50 a barrel, which is where the price is now, they’re an unmitigated disaster. At $80 these recommendations may well have worked out but had the oil price stayed above $100, members would have made a bonanza. Unfortunately, we got the first rather than the last outcome.

Key Points

  • Don't anchor on past valuations and share prices

  • A long-term perspective offers better chances to get lucky

  • Buy cheaply, acknowledge and interrogate your mistakes

What are the lessons? First, I’m now more careful about buying a business going through a heavy capex phase, as these stocks were. Spending huge amounts of money upfront, and taking on debt to do so, for an unknown quantity of revenue should have prompted more caution from us than it did. It will in future.

Second, we should have been quicker to react to the changing environment. Oil prices fell quickly but that didn’t change our underlying assumptions or widen the price range in our models until too late. Had we acted more quickly it would have been clear that the risks had increased. Every investment case hinges on two or three variables and, when one of those changes, we need to get to work. In this case, we didn’t respond quickly enough. 

On to more satisfying outcomes. Between 22 Oct 13 (Buy – $18.68) and the time we got out on 26 Feb 15 (Sell – $36.48) Caltex almost doubled. This was classic value investing. Not because it relied on simplistic metrics like low PERs but because, after a detailed examination of the business, we saw it was changing and were able to value what the business was likely to become rather than what it appeared at the time. Then all we had do was wait.

Graham Witcomb, analyst

By the time I took over coverage of blood products manufacturer CSL in late 2013, it had already more than doubled since our original upgrade on 19 Jan 10 (Long Term Buy – $31.30). That left me in a sticky situation. The company was only a few percent below our recommended Sell price.

But the more I got to know the business, the more I liked what I saw: economies of scale and operating leverage; patent protection and pricing power; shareholder-focused management; and mouth-watering margins and returns on capital. Our valuation and price guide has since doubled and a good thing, too – a two-bagger has turned into a three-bagger. CSL now trades above $100.

It’s a difficult lesson to learn but anchoring to past share prices or earlier valuations can be extremely costly. I think CSL will always be prone to mis-pricings as it is a complex business with many moving parts. I’m hoping we’ll get a chance to buy in again at some point.

As for Vision Eye Institute, Australia’s largest network of ophthalmology clinics, it was one of those annoying stocks with a barely moving share price. After upgrading it on 3 Mar 14 (Speculative Buy – $0.58) it was pretty flat for more than a year and then went through the roof. Before downgrading to Sell after a bizarrely generous takeover offer, the stock had returned 88% since our original upgrade.

The reason I look back on this situation with some satisfaction is that when we first looked at it the stock was trading at around 75 cents. That was cheap but not quite cheap enough. Our patience was rewarded. Waiting for a wider margin of safety added an extra 30% or so to members’ total returns. Of course, it doesn’t always work out like this but the discipline of waiting for a share price significantly lower than our estimate of value has its own merits, whether it eventuates or not.

Hansen Technologies is another stock that has far exceeded expectations, returning 147% including dividends since we upgraded it on 29 Oct 14 (Buy – $1.52). Unlike CSL and Vision there was no need for patience. As soon as I began delving into its financials and history I knew this was a stock I wanted to own, with the high returns on capital typical of a software business and the customer captivity and pricing power of a utility. It also has plenty of potential for growth.

Today’s share price is a very different proposition and the investment case is shifting, although I’m reluctant to let such a good business go. Perhaps that’s a future mistake in waiting but management has an excellent track record of capital allocation and the benefits of Hansen’s economies of scale and operating leverage have a long way to run. We’ll be hanging on for a while yet.

From a few big winners to one big mistake. I managed to (mis)time the market perfectly on the way in and on the way out of The Reject Shop. That takes some talent. Buying in on 1 Apr 14 (Buy – $9.89) I locked in a 4% loss for members by selling too early on 9 Oct 15 (Sell – $9.50). The stock now trades at $12.41.

My first mistake was to underestimate volatility of same-store sales. I thought flat sales would be a lower bound, and they promptly fell 5%, which led to a 24% drop in net profit. Yes, this is a low margin business. Shaken, I cut the valuation drastically to reflect what turned out to be overly pessimistic assumptions for future growth. When the business went on to beat them, the share price … well, you know the rest of the story. This was never a high-quality business, which always amplifies the capacity for and extent of mistakes.

Jon Mills, analyst

With the possible exception of Ainsworth Game Technology, it's probably too early to label my Buy ideas successes or stuff-ups. There are, however, a few stocks of note that I took over from other new team members.

Two delivered returns no-one could have expected, demonstrating the value of merely being sensible and taking a long term perspective. We upgraded BWP Trust on 1 Feb 13 (Long Term Buy – $2.34) as part of the High yield and safe mini portfolio mentioned in part 1. Including dividends and capital growth it delivered returns of 56% before we sold out on 7 Aug 15 (Sell – $3.28). BWP is the owner of 82 Bunnings Warehouse stores, where rents grow commensurately with the rate of inflation or are fixed at around 3%. We never anticipated the returns we eventually got.

We’ve had a similar experience with Event Hospitality & Entertainment, formerly known as Amalgamated Holdings. After upgrading it on 21 Feb 13 (Long Term Buy – $7.76) we expected most of our returns would come from dividends and franking credits but ended up with a return of 77% (including dividends) by the time we sold out, too early as it happens, on 20 May 15 (Sell – $12.75).

In Event’s case we hoped for an improved operating performance and the company certainly delivered. But as with BWP, it was really the yield and mispricing that got us aboard. Both illustrate an important point: if you buy value rather than hope, not only do you get downside protection but sometimes Lady Luck rides in and hands you a free lottery ticket.

We would not have got the returns we did were it not for the fall in interest rates that made stocks like these look so much more attractive. When you buy cheaply, you become overexposed to good fortune. When you pay a high price for modest value, that deal frequently reverses.

Shareholders in Slater & Gordon are now more familiar with that lesson. We received many, many queries on this stock as its price fell through 2015, pushing up the dividend yield and reducing its price-earnings ratio. I first addressed it in Will shareholders sue Slater & Gordon? in early July when the price was at $3.77 and again in Shooting the messenger at Slater & Gordon in November, by which time the share price had slumped to $0.68. It's now at $0.25. At no time were we tempted.

Why? In a word, debt. Unless in the next few weeks management can convince its banks that it has a realistic chance of repaying $750m in net debt, this company is likely to go bust. The apparent cheapness of the stock was an illusion. Oodles of debt and the lack of any hard assets placed this company in serious peril. It was the very opposite of the situation with BWP and Event, and one to be avoided at almost any price.

Our new analyst Andrew Legget makes the point about the value of simplicity over complexity regarding ALE Property, another stock featured in our high yield and safe mini portfolio. ALE has almost doubled since our first recommendation on 2 May 12 (Buy for Yield – $2.08) when it was yielding 7.7%:

‘The biggest reason behind our success in this stock is our ability to take an extremely long-term view on a company. Each article we wrote made the point that the company’s properties were under-rented, which was the biggest driver of value, but that this wouldn't be resolved until rent reviews in 2018 and 2028. For most investors, including many who claim to have a long-term perspective, that would have been simply too long. They missed the opportunity. It also helped that ALE's business is about as simple as you can get. A simple business will have far fewer risks than complicated ones.’

It isn’t just winners, though, that will determine your investment success; avoiding the losers is as important, and here it’s crucial to be able to recognise your own fallibilities and ’fess up to your stuff-ups, although not necessarily in public as we are obliged to do. We cannot learn from our mistakes unless we acknowledge them.

James Carlisle offers a salient example. We upgraded SMS Management on 16 May 14 (Buy – $3.25) but bailed just over a year later on 19 Aug 15 (Sell – $4.08) after accepting that we misjudged the IT industry.

As James explains: ‘My mistake was to look longingly at past consultancy margins and imagine what might happen if revenues recovered a bit. But the market was right: this was a value trap and the IT consulting business has been seriously compromised by the cloud, which is giving companies the opportunity to buy software as a service piecemeal from overseas, rather than pay consultants for big root and branch projects.’

Even after accepting the mistake in Is SMS Management a value trap? on 4 May 15 (Hold – $3.24), we decided to hold on for a higher price. Here’s where we got lucky, because the price duly nipped up above $4, which was enough to persuade us to Sell. It was in the nick of time, because the stock now trades at about $1.70.

Why close on this example? Because making money on a stock is not necessarily a sign of being right and losing it is not necessarily an indicator of being wrong. Markets are funny things, which is why our yardstick should be business performance and not whether the share price reflects that performance at any point, because often it won’t. That’s why having a long-term perspective is so critical – it gives us more chance for the market to correct the mis-pricings we aim to take advantage of.

Note: The Intelligent Investor Growth Portfolio owns shares in Ainsworth Game, Hansen and Origin Energy. The Intelligent Investor Equity Income Portfolio owns shares in Ainsworth Game, ALE and Origin Energy. You can find out about investing directly in Intelligent Investor and InvestSMART portfolios by clicking here.

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