Below are some sections (slightly edited for public viewing) from a letter just sent to the investors of the fund I help manage.
Disclosure: I am a portfolio manager at Boyles Asset Management, LLC ("Boyles") and the fund managed by Boyles may in the future buy or sell shares of the stocks mentioned below and we are under no obligation to update our activities. This is for information purposes only and is not a recommendation to buy or sell a security. Please do your own research before making an investment decision.
News of China’s stock market and of Greece’s place in the Eurozone (as well as the closure of its banks and stock market) dominated the headlines as the second quarter came to a close. After surging by more than 100% in less than a year, China’s stock market fell by roughly 30% before the government then stepped in with actions we might call “weird” in order to try and stop the plunge. Though unique in its own way, it’s a storyline that has been repeated throughout financial history. As Jason Zweig wrote in a July 10 Wall Street Journal article, “Governments have been trying—and failing—to control markets for centuries. If the Chinese government succeeds, it will be the exception to that rule. If it fails, the results could be dire.”
While we claim no insight into how the situations above will play out, as a fund that began the quarter with roughly half of our portfolio in cash, we welcomed the volatility that these events and some Australia year-end tax selling created, which in turn allowed us to put some capital to work. After additional purchases early in the third quarter, our cash balance is now down to about 34% as of this writing.
The fund was able to acquire the vast majority of its position at A$.245 per share from what we believe to be a forced seller. At that price the fund was able to acquire the business at a multiple of 5.9x free cash flow (including that of the recently acquired business) and .82x book value. The dividend yield at the time of purchase was 7.1%. It was our judgment that given the nature of the business, the shares were quite a bargain.
Legend Corporation’s business is fairly attractive from a return-on-tangible-equity basis, returning 40% on average since 2008. Built intelligently through a series of acquisitions, return on equity has averaged 13% during that period. Relative to many distributors, and attributable to the owned brand and innovative products that Legend designs and sources internally, the company boasts fairly attractive consolidated margins, with underlying pre-tax margins averaging 9.8% since 2008. We see some scope to recover some margin over the next couple of years, as the rapid decline in the Australian Dollar during the last two years has been a headwind for margins. Underlying pre-tax margins peaked at 13.2% in 2012 before falling to the mid 9% range recently. If one assumes the company regains 50% of the lost margin, Legend would produce enough additional free cash flow to reduce our acquisition multiple of free cash flow to 5x.
Legend Corporation is run by Bradley Dowe, who founded the business with his wife in their kitchen in the early 1990s. Today he owns 28.4% of the company, worth A$15.6 million at our acquisition price. His base salary is about A$.33 million and so his stake in the company is worth 47x his annual salary. In fact, last year he received A$1.1 million in dividends, or more than 3.3x his annual salary. Needless to say, we think we and Dowe are on the same side!
Dowe has built the business through a series of acquisitions. Originally, when the company listed in 2004, it was a manufacturer of computer memory products, which it sold to OEMs. This business eventually ran into significant competitive pressures as Asia emerged as the dominant low-cost supplier to many of the world’s computer manufacturers. Dowe repositioned Legend through a series of acquisitions, completed at attractive prices, in the electrical distribution space it occupies today. The most recent acquisition, completed shortly before our share purchases, was a company called System Control Engineering. We believe the acquisition will continue Dowe’s history of attractive dealmaking. At the total maximum purchase price, the company will have paid a multiple of 4.7x earnings before interest and taxes. In and of itself, that is an attractive multiple, but the company has additional potential levers to reduce its working capital intensity and increase margins, which combined could reduce the multiple to 3.3x. In our judgment, the market is not paying attention to, among other things, this attractive acquisition.
Cheap and Dear, Quality and Value
“Nearly every issue might conceivably be cheap in one price range and dear in another.”
-Benjamin Graham and David Dodd, Security Analysis
While it has taken a bit longer than we would have expected (or hoped) to put as much cash as we have to work, and while we still have a decent amount of dry powder left, we’ve always felt it most important to remain disciplined to the margin of safety creed we follow. Like the quote above, we believe almost everything is a good deal at one price and a bad deal at another, and that belief has taken us in several directions in our search for value. Since the end of last year, we’ve purchased shares in what we’d consider good businesses with growth opportunities in the UK and Australia; additional shares in a couple of mining services companies as tax selling and a further decline in sentiment drove down prices; and a couple of Hong Kong-listed companies with decent businesses and real estate portfolios. In all of those cases, there is a well-incentivized owner-operator helping to steer the ship on our behalf.
As outside, passive, minority shareholders, there are things we can’t know about the inner workings of a particular business. Our job is to do as much work as we can to get to the point where we feel we have a clear edge in our understanding compared to most others, and where we feel the odds and payouts are extremely tilted in our favor. Sometimes the future path of a company is fairly predictable, and sometimes it is largely unknowable because it is dependent on things that can’t be predicted with any degree of reliable certainty. We prefer more predictability to less, but given that the human brain shares the same preference, market psychology often discounts uncertainty to such a degree that it’s worth venturing into areas where things are less certain. One historical example of this occurred with the economist David Ricardo, as told by Richard Zeckhauser in his paper “Investing in the Unknown and Unknowable”:
“David Ricardo made a fortune buying bonds from the British government four days in advance of the Battle of Waterloo. He was not a military analyst, and even if he were, he had no basis to compute the odds of Napoleon’s defeat or victory, or hard-to-identify ambiguous outcomes. Thus, he was investing in the unknown and the unknowable. Still, he knew that competition was thin, that the seller was eager, and that his windfall pounds should Napoleon lose would be worth much more than the pounds he’d lose should Napoleon win. Ricardo knew a good bet when he saw it.”
The keys in these situations, we believe, are focusing on one’s downside, and doing the work to come up with conservative estimates of what you can lose if you are wrong and what you can make if you are right. And while probabilities can’t be estimated reliably, one can look for situations that at least tilt the odds in one’s favor, such as by focusing on downside risk and buying from eager sellers. We discussed this in more detail in our Q2 letter last year, but we bring it up again because we believe that at least three of our main purchases during the second quarter, and continuing into the early third quarter, involved eager sellers on the other side of the trades, though maybe not as eager as the British government was in Ricardo’s time.