Dear Partners,
It has been another year of dramatic swings in the market with lots of market activity going on. It has already been one and a half years since our inception of this wonderful partnership with which we hope for it to be a going concern in the many years to come.
Our investment philosophy has not changed at all since the time of our inception. We have focused our efforts in finding businesses that satisfy these criteria:
1) Businesses that operate with low or no debt
2) Businesses that have a sustainable competitive advantage
3) Able to achieve high returns on equity consistently
4) Are available at attractive prices
Unfortunately, these type of businesses are rare and prove superbly difficult to find in the Australian sharemarket. We are restrained towards investing in listed public companies due to the size of our operations which remain to date small. Far too often, we find businesses that satisfy criteria 1) and 3) but rarely do they satisfy criteria 2) and 4).
In recent times, however, the Australian sharemarket and other sharemarkets around the world has been brought to much lower levels due to the Global Financial Crisis (GFC). This has made it much easier to find criteria 4), although criteria 2) remains a challenge. The difficult part is finding businesses with sustainable competitive advantages that are currently out-of-flavour in the market. We often find the companies that we like are also favoured by the market.
As fellow partners of our partnership, I am urging every partner to aid my fellow Officers and myself in helping us to identify good quality businesses. As I am aware of our diverse backgrounds of each of our partners, I have singled out Criteria 2) for our partners as it does not require much commerce skills but rather an intuitive sense of business opportunity for a person to realise that a business has indeed a durable advantage over its competitors. It also proves to be the most elusive of all 4 criteria as many businesses do not indeed have sustainable competitive advantages. Therefore, the finding of any of those special businesses would be highly appreciated.
On our performance
Our performance are as follows:-
From 1st July 2008 to 30th June 2009:
Market performance: -25%
Kenjisan Investments: -8.8%
The market performance is taken as the percentage change in the All Ordinaries Index from the beginning to the end of this financial year. Our performance is calculated based on our unit price as at each financial year beginning and end, and we then take the percentage change. Our unit pricing is based on a comprehensive formula that takes into account market values of all our holdings. Therefore this formula is highly subjected to the volatility of the sharemarket at any one given point.
To a certain degree, this formula may incorrectly represent the true value of our holdings as when we invest in parcels of shares, we invest based on an estimated intrinsic value of the business but we pay the market price. Hence, if our holdings are out of favour by the market and is brought down even further despite no change in the economics of the underlying business, then we are seen to have made a loss on paper even though we have no intention of ever selling those shares in the near term. In fact, we see the drop in share price as providing an even more attractive opportunity to further increase our holdings in the business.
We are delighted by the fact that we have done much better than the market, however, we are still disappointed over our progress. We realised that we could have done better by just holding cash and accruing interest. One of our believes when purchasing shares is that we cannot time the market properly. Hence, if we had bought the shares a week before financial year end, and at financial year end it drops to 50% of its market value, but right after it increases 200% in value, we will not regret buying it at the time we bought it. There is no one that can tell what share prices will do in the near future, but it is possible to tell for certain businesses what they will be worth 10 years down the road.
On our Accounts
At present levels, we are holding about 60% of our portfolio in cash. We currently hold about $9700 in cash and have about $7000 in market value of securities. We have zero debt and liabilities. We are anticipating to invest the money in attractive securities if they are found. In total equity terms, our operations have grown to about $19,000 from about $14,000 the year before. That represents a growth of about 36% per annum. If we continue at the same pace, then the following projections hold:
Total Size of Kenjisan Investments:
1 year ahead, 2010: $25840
6 years ahead, 2015: $120222.86
10 years ahead, 2019: $411284.82
However, achieving this growth will be very unlikely unless we utilise both increased contributions and increased return on investment, which highly depends on market levels in a particular year.
We would like to note that growth for growth’s sake is not the way to be pursued. We will not equate activity with progress and a bigger size with increase in underlying value. For example, if you have a 150 acre land and your neighbour has a 90 acre land, then combining under a 50-50 merger would increase total land under management to be 240 acres, but individually you would be worse off because you own only half of the total pie, in this case you own 120 acres, 30 acres less than before. Therefore, there are two types of growth, good and bad growth. We shall focus on achieving good growth.
In our Income Statement, we have produced a loss of $406.42 for the financial year end. Our income statement only takes into account net profit from sale of shares, expenses from operations, dividends and interest income. Therefore, quite often is the case in this market that even if we have a share that is below the price at which we bought it, the paper loss will not be recognised in the Income Statement until we actually sell it. Presently, all our share holdings are recorded at cost in our Balance Sheet.
Therefore, the Income Statement can be misleading in two scenarios. In scenario 1, we could have bought many shares that are subsequently worth only a fraction of what we paid for it. Yet the Income Statement would not record any of this decrease in market value of the shares. In scenario 2, we could have bought shares that subsequently appreciate in value to a very large amount. However, we would not have recognised this gain in the Income Statement until we have actually sold the shares.
Most of our loss comes from the realisation of shares we no longer believe to adequately hold for the long term prospects of our partnership. Our investments are further elaborated in the next section.
On our investments
At present, we are holding four securities, namely The Reject Shop (ASX Code: TRS), Saunders International (ASX Code: SND), Innamincka Petroleum (ASX Code: INP) and Blackmores Limited (ASX Code: BKL).
We whole-heartedly believe that The Reject Shop is one of those businesses that satisfy all of the four criteria above at the time of our purchase, and it still continues to satisfy criteria 1) to 3) albeit not criteria 4). They run their business on low debt, which is not a capital intensive business, achieving high returns on equity and at the same time maintaining their cost advantage over their competitors due to their economies of scale. In their industry, when we buy low-priced goods, for the customer it does not matter where they purchase it from. As long as it works the customers are happy. Hence they operate in a very commoditised product market. In this type of market, it is very similar to insurance. In this industry, the type of business that will stand out from the pack would be those businesses that have a cost advantage over their competitors. If sustainable, that will enable the owners of TRS to continually achieve above average profits for the long-term benefiting shareholders the most.
Blackmores, on the other hand, operates in a market where referrals and product differentiation are very important. They have one of the most recognisable brands in South East Asia, which is good for their business. It takes a long time to build up a brand from scratch and they have done a good job in promoting and maintaining it. However, the only downside is that their products are priced expensively, which is a norm for many Australian products. Their main competitor is Nature’s Own but they have an edge over them due to their superior brand. I believe that in this current market downturn, it is a wonderful opportunity in disguise for the shrewd investor to take opportunity of. They have recently changed CEO, news of which I am still monitoring the company to see the results of such a change.
The last two holdings however, I believe have been a mistake on the part of your Officers. We got lured into investing into them due to their high prospect for profit. Things unfolded and the GFC hit us, which dampened their prospects greatly. Our best response to the situation is to continue holding onto them and hopefully the economy turns out better which will cause their prospects to improve as well. I am highly grateful if they continue to survive at the very least. We have learnt that investing in prospective companies never pay off. It is highly beneficial, however, to invest in a company with certain earnings that are currently selling for a valuation far below what they would justifiably carry.
Throughout the financial year, we have made a profit on some of our previous holdings. We bought and sold BHP Billiton, Woolworths and JB Hi Fi all for a profit. On the other hand, we bought and sold Westfield and ASX all for a loss. They have been investing mistakes for which our mistakes have been inaccurately forecasting their business prospects. Note how all these links to criteria 2) which is ever elusive. We have sold them for we feel that there are better prospects out there for which can justify our investment more than our holdings in the respective shares at that time.
On Valuation
Many partners have indeed shown interest in business valuation. Valuation is the art that takes into account consideration of many variables. It is simple to master but implementation requires accurate business judgment by the person valuing the business.
In a nutshell, valuation is taking the Earnings and multiplying it with an appropriate Price to Earnings Ratio(PE) ratio. I will now demonstrate why growth in high Return on Equity businesses constitute good growth and growth in low return on equity businesses constitute bad growth.
For example, if you have two businesses, A and B, each achieving a return of equity of 20% and 10% respectively. Return on Equity is calculated as Net Profit/Retained Earnings. Each business retains half of its profit each year and distributes the other half as dividends to shareholders. Each business earns a dollar in profit initially.
You are given the following table:
| | Business A | Business B |
| | Year 1 | Year 2 | Year 1 | Year 2 |
| Opening RE | $5 | $5.50 | $5 | $5.25 |
| Return on Equity | 20% | 20% | 10% | 10% |
| Net Profit | $1 | $1.1 | $0.50 | $0.525 |
| Dividends | $0.50 | N/A | $0.25 | N/A |
| Undistributed Earnings | $0.50 | N/A | $0.25 | N/A |
| Closing RE | $5.50 | N/A | $5.25 | N/A |
| Valuation with PE=10 | $10 | $11 | $5 | $5.25 |
| Change in Valuation | - | $1 | | $0.25 |
Legend:
RE – Retained Earnings
Formulas:
Undistributed Earnings = Net Profit - Dividends
Net Profit = Opening RE * Return on Equity
Closing RE = Opening RE + Undistributed Earnings
Valuation = Net Profit * PE
In Business A, notice that 50 cents of undistributed earnings causes an increase in valuation of 1 dollar. What that means is that, each dollar invested in the high return on equity(ROE) business eventually translates to 2 dollars of market value of the business.
In Business B, notice that 25 cents of undistributed earnings causes an increase in valuation of just 25 cents. In Business B, retaining a dollar would not cause any difference to the dollar being invested, and it will not be worth more. Therefore, putting the dollar into high ROE businesses is what Kenjisan Investments is trying to achieve. That is achieving criteria 3).
Assuming Business A is currently selling for $8. That is a discount of 27% to its intrinsic value in year 2 of $11. Buying a business at attractive prices, that is, at a price substantially lesser than its intrinsic value is achieving criteria 4). If the business can continually achieve abnormal profit levels, that is achieving criteria 2). Finally, if they operate with low or no debt, that is achieving criteria 1).
Future Prospects of Our Partnership
If the current market is to improve, it will undoubtedly bring us sure profit and increased market valuations across the board for all our holdings. It will definitely be favourable for our portfolio. However, the lack of attractive prices might actually harm our long term prospects because we are unable to find a home for our cash that is sitting in the bank. No doubt that it will continue to earn interest, but over the long-term shares will outperform any bank deposit account.
We also hope to have increased cooperation from our members in the future. Our vision of an ideal partnership would be that of great contribution from each partner and more communication between partners and between partners and Officers. Our investing ability depends highly on the contribution of each partner towards the partnership. Due to time constraints, your Investment Officer might not be able to fully research and analyse companies because that is very much a time consuming activity. There are full-time jobs for research analysts (what your Investment officer does) in the finance industry. However, we will do our best in avoiding costly investment mistakes and focus towards investing in quality businesses that are available to invest in Australia.
Our hope is that we can use Kenjisan Investments as a vehicle in which it will someday be worth millions and that it will be a major shareholder and owner in quality businesses. We hope to achieve that of course with the original 13 partners having the majority stake in this vehicle.
Your Investment Officer,
Joshua Ng
July 2009
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