Being skeptical of insiders' incentives

Perverse incentives that affect the average investor

The stock market can be regarded as a transfer of wealth mechanism from minority shareholders and investor to company promoters and managers. What has caught my mind recently is three different examples.

Pershing Square

The first is Pershing Square one of the most high-profile hedge funds in the world led by its enigmatic CEO and founder William (Bill) Ackman.

Pershing Square had an impressive track record compounding its returns between 17.6% - 20.8% p.a. net of fees depending on the structure between 2004/5 and first half 2014. This performance enabled Pershing Square to launch a large Listed Investment Company in the Netherlands raising $2.7B USD. This raising provided Ackman with permanent capital to invest and a guaranteed fee income stream. Pershing Square employee numbers also swelled as can be seen in the graph below.

What precipitated was a series of poor returns from investments including Valeant, Herbalife and Mondelez. This blog post is not questioning the merits of these investments but what has subsequently resulted is a significant amount of lost money. However, Pershing still likes to focus on its long-term compounding record as Pershing Square. What is more important though is Pershing Square’s money weighted return. These returns take account of how much $ return was generated. As Pershing generated most of its positive return when it was managing relatively smaller; amounts of money and generated negative return when it was managing larger amounts the money weighted return would be far lower than its time weighted return.

 

The other fund management trick that Pershing Square has pulled is that Bill Ackman has reincarnated himself as a fund manager but conveniently forgotten his past track record. Previously he was managing Gotham Partners where the funds shuttered due to redemptions from poor performance.

Investors must be cautious when investors raise large amounts of money off the back of a historical track record obtained under different conditions. Many fund managers right now are trying to raise as much permanent capital as possible as they have strong track records from the bull-market in equities due to compressed interest rates. Investors should beware the incentives of the managers behind such actions.

CBL Insurance

CBL recently listed in 2014. It has a great run as a recent IPO increasing from $1.55 to $4.00. CBL is an insurance company which specialises in niche insurance predominately in France.

CBL exceeded its prospectus forecasts, however it made a number of acquisitions which were not forecast in the prospectus forecasts. Adjusting for these acquisitions CBL still beat prospectus forecasts by $5.2m PBT or 8.2%. However, looking further into the result the FY16 result was aided by a release of provisions of $5.8m.

This would be fine, however the events that subsequently followed suggest that the timing of the release reserve to ensure prospectus forecasts were met was extremely convenient.

In April 17, little over 1 month post the FY16 result was released 20m shares were sold at $3.26 to NZ and Australian investors. This realised $65.2m for the Directors and Management. On August 18^th CBL came out with a surprise announcement, shortly before it was due to release its 1H17 results, that it would miss its internal operating profit expectations by $17.5m due to a $16.5m strengthening of its insurance reserves. This seemed strange given the reserves were released only 6 months prior. The stock subsequently fell from $3.75 to a closing low of $2.80. To add salt to the wounds CBL has recently updated the market again in February 2018 and has remained suspended from trading as it expects to make a future claims reserve strengthening adjustment of $100m to the reserves, it will also take a $44m write-down of receivables arising from SFS, a business that it acquired in 2016.

The observation is in businesses where significant accounting adjustments can be made which significantly affect the profitability of the business such as finance and insurance companies in situations where management have an incentive to produce a favourable result it is necessary to exercise increasing skepticism towards the results produced.

ITL Healthcare

ITL healthcare conducted a suspicious share buy-back which was announced on the 25^th of October. The company began buying back shares at 40.5c and purchased aggressively right up to December 29. Prior to this buy-back the previous buyback was conducted at less than half the price being 20c on 8 February 2016.

ITL purchased 4.11m shares in November at prices between 0.40 to 0.47 which was 72.5% of all volume traded in that month.

ITL purchased 7.99m shares in December at prices between 0.415 to 0.475 which was 71.3% of all volume traded in that month. The volume that wasn’t bought by ITL consisted of two director sales, conveniently at the high share-price of the month of 0.47. Andrew Turnbull sold 990,000 shares and William Mobbs sold 2,343,543 shares. Adjusting for these director sales ITL purchased 100% of all shares during the month and effectively pushed the share-price to a level that allowed the directors to sell down. The buy-back has now stopped and the share-price has fallen 22%.

Book review: Good Stocks Cheap: Value Investing with Confidence for a Lifetime of Stock Market Outperformance: Value Investing with Confidence for a Lifetime of Stock Market Outperformance by Marshall, Kenneth Jeffrey

Book review: Good Stocks Cheap: Value Investing with Confidence for a Lifetime of Stock Market Outperformance: Value Investing with Confidence for a Lifetime of Stock Market Outperformance by Marshall, Kenneth Jeffrey

Finished reading: 1 January 2018

https://www.amazon.com/Good-Stocks-Cheap-Confidence.../dp/125983607X

The book covers the investing basics focussing on value investing which, as an experienced investor, I skimmed over, however I found it instructed in the structure how to think about investments.

1. 1. Do you understand the business and what it does?
2. 2. Is it a high quality business. Quantitatively measured from the past?
3. 3. Is it likely to continue to be a high quality business going forward? This requires a strategic analysis.
4. 4. Management
5. 5. Is this business undervalued?
6. 6. Are the decision being made being influenced by cognitive biases.

1. 1. Define the business along six parameters: 1.   Products      2.   Customers      3.   Industry      4.   Form      5.   Geography      6.   Status
2. 2. Various financial ratios are discussed.
3. 3. The second discipline, strategy, shows which companies with successful pasts promise to have successful futures. It’s qualitative. It involves thinking about what sets a company apart from its peers, and picturing it years onward. The first is what I call breadth analysis. It asks two questions. One, is the company’s customer base broad, and unlikely to consolidate? And two, is the company’s supplier base broad, and unlikely to consolidate? The business isn’t good unless the answer to both is yes. I define a broad customer base as one where no single customer accounts for over a tenth of revenue. Similarly, I define a broad supplier base as one where no single supplier accounts for over a tenth of cost of goods sold or operating expenses. A second qualitative tool is forces analysis. It’s my cheap rendition of the five forces model introduced by business school professor Michael E. Porter in 1979.

A third qualitative tool is what I call moat identification. A moat is a barrier that protects a business from competition. It’s a defense that lasts.

The first is government.

A second source of moat is network. Network is an accumulation of users or customers. It constitutes a moat if it yields a product benefit derived from the other users of a product.

A third source of moat is cost. Sometimes a company has a low cost structure that enables it to produce a product for less than competitors.

A fourth source of moat is brand. Some brands are so strong that customers rarely consider substitutes.

A fifth source of moat is switching costs

A fourth qualitative tool is market growth assessment. This is a straightforward view on whether a company’s market is growing or not. It’s important because a business with an expanding market—everything else being equal—has a brighter future than one that doesn’t.

4. 4. The first indicator is compensation and ownership. What executives and board members earn and own shapes their incentives. We’d like these incentives to be as aligned with ours as possible.
5. 5. Generally a business trading over 25x EV/Operating Earnings is considered expensive.
6. 6. The third, psychology, is about the restraint necessary to reject the misjudgments that naturally arise from one’s inborn biases. Humans think funny. It’s not that we’re silly or wrong. It’s just that we’re people. To be mindful of the bad calls we’re likely to make is to maximize the chance that we’ll catch them before they hurt us.
7. 
   

1.   Affinity         2.   Reciprocity         3.   Anchoring         4.   Authority         5.   Availability         6.   Cleverness         7.   Incomprehensibility         8.   Consensus         9.   Peculiarity       10.   Intermixing       11.   Consistency       12.   Confirmation       13.   Hope       14.   Lossophobia       15.   Scarcity       16.   Hotness       17.   Miscontrast       18.   Windfallapathy. Investor misaction is caused by one of two forms of akrasia:      1.   Impetuosity      2.   Weakness

The book provides a lot of commonsense  observations such as the below:

Stated differently, value investors know what’s going to happen, but they don’t know when.

The first three steps of the value investing model—do I understand it? is it good? and is it inexpensive?—form a row.

To do it is to decisively take action when it’s time to do so. It means, for example, to buy when an understood, good business is underpriced. This turns out to be impossible for most people. It requires one to commit capital to a stock at the precise moment when everyone else seems to be selling it.

It’s absurd to insist that lousy operating results from a cyclical company in a down cycle are permanent.

If I’m not comfortable putting at least a tenth of the portfolio into an equity, I don’t want the equity. If my conviction is lower I don’t buy less, I buy none.

My focus on company quality reflects three of my other preferences: inactivism, concentration, and a long holding period.

Sequestered cash is best held in the same currency as one’s expenses. If it isn’t, foreign exchange rate fluctuations can hurt one’s ability to meet obligations.

Above subsistence and below gluttony, there’s little correlation between net worth and happiness. Money just doesn’t produce life’s great joys. Those come from those loved ones, from health, and from other sources that don’t care much about geometric means, depreciation schedules, or enterprise values. But an absence of money can keep one from the great joys.

Conclusion

Although the books stazrted off with basic concepts the second half of the book I took value from the simple and concise approach to thinking about investments using material originated from other thinkers. I will incorporate some of the thoughts to my own investment process going forward.

Pushpay - Does it deserve its valuation?

Pushpay - Does it deserve its valuation

 

Pushpay is currently valued at $1.15 billion New Zealand dollars with a share-price of $4.21 at 28 December 2017.

I find this valuation hard to justify for a number of reasons.

Revenue is overstated

Firstly the gross revenue number that the company's provides needs to be adjusted for the third party payment processing fees . Transaction fees amounted to 43% of operating revenue. While it is easy to make this adjustment many investors will value PPH like other Sass companies on an Enterprise value to gross revenue multiple which overvalues PPH compared to peers.

Annualised Committed Monthly Revenue (ACMR) – is not actually committed

Annualised Committed Monthly Revenue (ACMR) – is defined as monthly Average Revenue Per Customer (ARPC) multiplied by total Customers and annualised. It consists of subscription fees which are recurring and can vary based on the size of the Customer and Volume Fees which are a variable fee income generated from payment transaction volume (in the case of the faith sector, this is usually a percentage of total donations).

CAC is understated

The total sales and marketing, and customer success costs over the six months ended 30 September 2017 were $16.7 million, contributing to an ACMR increase of $33.2 million.

This is misleading as the ACMR increase relates to a 12-month period whereas the sales and marketing costs relate to the most recent six month period. In this same 6 month period to 30 September 17 ACMR only increased by $8.7m. This is a CAC of $16.7 / $8.7 = 1.9x or 23 months rather than the less than 12 months they are quoting.

If we then take the gross margins of 57% then it is $16.7 / $5m (57% x $8.7) = 3.34 years. Subscription revenue is likely to be very high (only hosting costs) but the transaction volume revenue is much lower GM of 38% ($12.3m cost and $19.8m revenue)

 

LTV indeterminate

Low switching costs and limited customer history is difficult to conclude customer retention will hold at 95% for the long run. For example it implies that on average a customer will stay with PPPH for 20 years, however most customers have been on the platform for < 18 months to date. This is why I don't think we can put much reliability on the lifetime value calculations. An analogy is a finance company that has the majority of its book as fresh debt on its books it is not likely to record high bad debts until the debt becomes more seasoned and the borrowers get into trouble.

Fee pressure

There is likely to be fee pressure on the volume fees charged. Other competitors in the market have lower transaction fees than the standard price: 2.9% + 30 cents per credit/debit card transaction while not charging any subscription fees.

https://blog.capterra.com/alternatives-to-paypal-for-churches/

Processing revenue was $19.8m for 6 months to 30 September 2017, if we assume an average payment fee of 2.9% as disclosed on their website this would assume payment volume was ($19.8m/2.9%) = $683m for 6 month period and it is now annualising $2.1B.

It is unlikely that the 2.9% payment fee is the realised rate due to discounts given. We can prove this by taking $2.1B x 2.9% = $60.9m revenue and the subscription revenue for 6 months was $10.8m for 6 months or at least $21.6m annualised. Therefore total ACMR should have been at least $82.5m whereas it was $67.5m.

To calculate the ACMR for subscription revenue when can use the average number of customers in 1H18 which was (6737+7121)/2 = 6929. This results in an average subscription revenue of $3117 ($21.6m/6929). So the annualised subscription revenue at 30 September 17 would be 7121 x $3117 = $22.2m. Therefore the payment volume revenue would be $67.5 - $22.2m = $45.3m. Taking the $2.2B run-rate of payment volume the bp would; be 2.06% ($45.3m/2.2B) rather than the 2.9% quoted rate. I think this is a number that PPH don’t want disclosed as I would assume it is likely to fall over time as increased competition puts pressure on margins.

What will PPH earn if they reach their goals

In 2016, $123 billion was given to religious organisations in the US and PPH process just under 2% of that currently. PPH state their goal is to reach the milestone of $10B in Annualised Monthly Payment Transaction Volume. PPH does not give a timeframe but this is 4.55x greater than the $2.2B annualised payment transaction volume at 30 September 2017. The ACMR was $67.5m, the breakdown between subscription revenue and transaction revenue is not stated by the company.

If PPH was to get to $10B of volumes this means $206m of revenue. With a GM of 38% = $78m GP. Subscription revenue is harder to forecast as it won't be 4.55x larger as payment volume will benefit from increased take-up from existing customers.

I am making an estimate that half of the growth in volume comes from new clients that will pay for more subscriptions and the other half will be from current customers that won't necessarily need to pay higher subscription revenue. This will mean that subscription revenue would increase by 2.27x (50% of the 4.55x) to $50m (2.27x$22.2). Lets assume this is at 100% GM (aggressive) so $50m GM.

In total $128m GP could be achievable at $10B of payments. Operating expenses were $29.9m for 6 months to 30 September 17 so doubling that would be $60m (it is likely operating cost will be much higher if transaction volume is 4.5x higher though). This results in a PBT of $68m and using the new US corporate tax rate of 21% (could be higher) a NPAT of ~$54m. This is a PER of 22x earnings. I’ll let you decide whether you are comfortable paying 21x earnings given this scenario is good risk/reward.

Where could we be wrong

a.               PPH are indicating they will be at $100m ACRM by 31 December 17. THis is a large jump from 30 September 17 where ACMR was $67.5m so if it is achievable that will very high sales result and produce a low CAC. This is possible given there was a large jump last year in the December quarter.

b.               Transaction fee margins may decline further. It is hard to see how the improve.

c.               Operating expenses may increase at a faster rate. IT is hard to see them falling however they may do so if marketing spend is pulled back.

d.               The $10B of transaction volume may prove to be conservative given the market size of $123B.

e.               Subscription revenue may increase faster than what we expect and may be at a higher run-rate than $50m by the time the company is at $10B of payments.

f.                Tax rate is much different to 21%. PPH will have tax losses to shelter income for some time as well.

Netflix, Amazon and Xero: The unprofitable monsters

Today I thought it is worth discussing the success of three companies in particular Netflix (NasdaqGS:NFLX) Amazon (NasdaqGS:AMZN) and Xero (NZSE:XRO).

All of these companies have performed extremely well despite not producing consistent or any profitability.

As many value investors anchor to profitability metrics to base their investment decisions it is worthwhile discussing how these companies can be so successful without being profitable as it is outside the typical value investing framework.

I will first discuss the benefits of this approach and then the downsides.

Positives

The positives are there is no tax paid to the government as the companies are investing significant amounts of cash flows such that they typically will be making losses. This is beneficial as it allows for more capital to be used for investment than if taxes were being paid. Arguably that capital is being used to deepen their economic moat.

Previously companies would invest in plant and equipment which would be depreciated over many years, however it is more tax advantageous to invest from an operating expense perspective whereby the tax deduction can be claimed immediately

This tax efficient investing has also used by entrepreneurs such as John Malone when investing in Cable TV assets which were protected by a depreciation shield. His companies often recognised accounting losses while reporting strong cash.

Secondly companies can outcompete their rivals by lowering prices or investing more to develop a better product or obtain more customers than their competitors which are trying to maintain a particular positive profit margin.

Importantly Amazon Netflix and Xero have also managed to minimise the dilution from issuing extra equity and increase sales in a much faster rate than their share issue count. This is extremely important as maintaining a tight shareholder register will ensure greatest share price appreciation and enable equity to be raised at a higher price in future equity raises. Amazon and Netflix have also utilised debt to minimise dilution. Minimising dilution could be a atgtributable to the large insider ownership these stocks have and the people to benefit the most from minimising dilution are the founders.

Amazon's book value per share since 1997 has increased at 37.1% p.a, sales by 42.5% and its share count by only 3.3%. For every $1 of incremental equity retained sales have increased by 6.54x compared to Netflix at $3.29:$1 and Xero at $1.36:1.  

All of these companies have compounded book value at a significant rate, despite not producing much profitability as they have been able to raise equity at higher and higher valuations.

Investors have been willing to look past the losses or breakeven position as the NPV of new customers signed up is greater than the cost to acquire those customers. This is a difficult exercise as the churn rates for the customer's lifetime are unknown and also the pricing that is achievable. We must take a short timeframe and extrapolate that behaviour out over the life of the customer. For the services that have been priced at an attractive level to obtain customers may experience a higher churn as prices are increased to try and increase profitability.

Negatives

The downside to the strategy is that it requires capital to be raised at some point and to some extent this puts fate outside the control of the company. Although the owners of these companies suggest that they can slow down the growth rate and return to a cash flow positive situation this would be often regarded as negative by the investment community as the share price and revenue multiple is correlated to the level of growth and it may mean competitors could obtain the upper hand.

To date it hasn't been so much of an issues as these companies have benefited positively from strong equity markets and have not needed to raise capital in a depressed equity environment.

There have been other examples of companies that have been reliant on the capital markets which have withdrawn support and the companies have perished into receivership such as Wynyard formerly (NZSE:WYN) etc.

The difference between Wynyard and Xero is Xero has a much more predictable revenue profile as its revenue was subscription based whereas Wynyard was contract based license sales which were are much more lumpy.

Conclusion

The approach to reinvest significantly can be very worthwhile as it allows companies to gain a first mover advantage and widen their economic moat. However, it doesn't get away from the fact that these companies will need to earn positive cash flows in the future to justify their valuations. THe length of time investors are willing to wait until positive cash flows are delivered is unknown but is likely to be more acute when capital becomes more expensive as interest rates increase and risks appetites wane.

Book review: The Match King: Ivar Kreuger and the Financial Scandal of the Century by Frank Partnoy

Book review: The Match King: Ivar Kreuger and the Financial Scandal of the Century by Frank Partnoy Book review

Finished reading: 30 August 2017

https://www.amazon.com/Match-King-Kreuger-Financial-Scandals/dp/1586488120

The Match King

The Match King is a historical account of Ivan Kreuger who perpetrated one of the largest financial frauds in history.

The book is a thorough account of how Ivan Kreuger went from being a nobody in Sweden to one of the largest players in global finance prior to the Great Depression rivalling The Morgan banking dynasty. Ivan initially started off by acquiring monopolies to produce matches in various European countries

Ivan manages to keep his empire intact for much longer than anyone would expect, however it finally comes undone through the great depression and Ivan eventually commit suicides.

Ivan comes across as a extreme financier who manages to fend off ever-increasing concerns and questions over the legitimacy of his Match King Empire by maintaining an ere of confidence which enables him to raise increasing amounts of capital to ensure that distributions to existing shareholders and bondholders can continue to be made.

On a positive note Ivan was responsible for many of the financial innovations that we use today such as having various classes of shares that entitled holders to different economic returns.

Ivan’s Match King empire was a mix of a ponzi scheme that required increasing greater amounts of capital to pay distributions, however the underlying busineses were not fictious and made real returns such as when the companies within his Empire were liquidated the returns to shareholders were much greater than zero.

The takeaways I got from the book were that in times of easy money and euphoria people continue to turn a blind eye to the rest and do not even enquire about the most basic common sense financial questions. Ivan attracted capital by offering high returns to investors similar to what the finance companies in NZ did prior to the GFC to attract funding.

The lax financial reporting requirements at the time men that investors we're not provided with adequate financial information but even information they were provided with was not being analysed in an independent and objective manner instead I even used his Charisma to allay any concerns invested may have.

It also shows the slippery slope that humans can encounter once they let their ethics slip. It is easy to keep making further and further transgressions that, although seems small at the time, become increasingly ethical trespasses.

There are also a number of traits that Ivan experienced in his youth that were born out in later years such as even cheating on examinations and forging documents work she also did on a much larger scale near the end of his career.

Conclusion
A good book about human emotions and the euphoria at the time pre-great depression which helps to recognise patterns that may exist in conduct in the financial market in today's frothy environment.

Book review: The Money Code: Become a Millionaire With the Ancient Jewish Code by H.W. Charles

Book review: The Money Code: Become a Millionaire With the Ancient Jewish Code by H.W. Charles

Finished reading: 16 April 2017

https://www.amazon.com/Money-Code-Become-Millionaire-Ancient-ebook/dp/B009ZIU2QA

"The Superinvestors of Graham-and-Doddsville" is an article by Warren Buffett promoting value investing, published in the Fall, 1984. The article highlights how it is more than just coincidence that a group of investors who invest using particular value philosophy have outperformed the market and a value investing approach can deliver higher than market returns over a long period of time.

However, following a value investing approach is easier said than done and requires a terrific amount of discipline and fortitude to keep adhering to the philosophy even in times when it is out of favour.

Having read the article I thought what are the traits of investors that are likely to lead to outperformance and the obvious one to me was race.  Through my readings on business and investment I continue the come across a large number of Jewish people who are extremely successful in building large amounts of wealth.  My gut feeling was that Jewish people are severely over-represented on a per capita basis in both income levels and absolute wealth, however I have not seen much publicized about this perhaps because the Jewish people have had a long history of being persecuted and would rather not raise attention to this observation.

When looking into the richest people in the world  I found an article that suggests more than 100 of the 400 billionaires on Forbes' list of the wealthiest people in America are Jews. Six of the 20 leading venture capital funds in the US belong to Jews, according to Forbes.

Since the mass immigration some 100 years ago, Jews have become richest religious group in American society. They make up only 2% of US population, but 25% of 400 wealthiest Americans.

Eleven of the 50 richest people in the world are Jewish, according to the 30th annual Forbes billionaires list released Tuesday. The list features five Jews in the top 15 and seven in the top 25 spots.

In 1957, 75% of US Jews were white-collar workers, compared to 35% of all white people in the US; in 1970, 87% of Jewish men worked in clerical jobs, compared to 42% of all white people, and the Jews earned 72% more than the general average.

These statistics make it clear that my gut feelings were correct the question from here is why the characteristics of Jewish people make them extremely wealthy and on average much more wealthy than the average person.

Again I would start with my hypothesis that the Jewish people were treated very poorly historically especially during World War 2 and had many assets repossessed.  Therefore when Jews were forced to relocate to new countries they only had one option to work extremely hard and focus on education to improve themselves.

In trying to answer this question and let me to the book the money code which attempts to explain why so many Jews are millionaires and extremely successful.

In this book, H. W. Charles laid out 7 practical money code (tips), each in their own chapter.

The first code is wisdom which basically professes that the more you learn and the more that you can apply practically those learnings the more fulfilled your life will be and as a byproduct of that the greater your wealth will become . Wisdom can be achieved through practicing humility reading books and from interacting with others

The second code is tradition and the Jews view wealth and success is a blessing and gift from god and not something that should be shied away from. What a man thinks of himself that really determined his fate and because the Jews think of wealth and prosperity as positive and something to strive for many achieve that status. There is a focus on working hard and then accumulating wealth and then making that money work hard for you through wise investments that yield passive income.

The third code is work. The takeaway from this chapter is that most Jews work for themselves and hire employees instead of being employees.  There is also a focus on perseverance and I believe that success is achieved and maintained by those who try and keep trying.  Whatever you do should be with complete focus with no interruptions as interruptions break our train of thought.  

The 4th code is investing highlighting a focus on building your wealth through making successful investments.

The 5th code is law and placing importance on honesty and business matters and don't try to get rich quickly. Wealth obtained by ill gotten means will be lost or as well again by hard work will be kept. It is also encouraged to take care complete day of rest on the Sabbath.

Code 6 is Tithe which is a practice where you should give away at least 10% of your earnings regularly.

Code 7 is charity and the Jews are very charitable with the population making up in the approximately 2% of the US American population, however they represent 30% of America's most generous donors. There are different levels of charity from the lowest to highest level the lowest being giving begrudgingly and the highest being in a beam the recipient to become self reliant

To sum it up it is earn as much as you can save as much as you can invest as much as you can give as much as you can. Money is a great treasure that can the only increases as you give it away.

Conclusion

The Jewish people have overachieved in a variety of industries & countries. They have some very sensible philosophies which like the value investors highlighted in Warren Buffett's Superinvestors of Graham and doddsville article lead to above average wealth accumulation. Furthermore, their philosophies extend wider to  seek ultimately a more fulfilled life which all races could learn from.

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