Theres always something.., p.13
There's Always Something to Do, page 13
THERE’S LOTS TO LIKE ABOUT JAPANESE STOCKS – PRICES, BALANCE SHEETS, & CASH FLOW.
Relative to earnings Japan is still expensive. But ASSETS......!
However, because this is such an important strategic move for us I want to move from the general to the particular. One of the Ben Graham tests was to buy securities at their lows – ideally close to their all-time lows, but certainly close to their five-year lows. In Japan today there are many securities that meet that test. I want to explore a case study but you must bear in mind that it is far from unique. Tokyo Style mainly manufactures and sells women’s clothing; it hit a five-year low of Y1,150 in early 1997 – down from an all-time high of just over Y3,000. It has cash and securities totalling Y138 billion which equates to Y1,367 per share – more than the current share price – and it has negligible long term debt – a mere Y166 million – less than Y2 per share. You would be hard pressed to find anything similar in Europe or North America even if you went back as far as the 1973/5 bear market.
But we do not just look at the balance sheet; in addition we look at cash-flow. Like many other companies in Japan Tokyo Style is generating lots of cash – Y5.5 billion of it – and its capital expenditure is less than 10% of this, so the majority is disposable cash-flow. We have also conducted an exercise looking at earnings using GAAP. To return to the case study, Tokyo Style’s return on equity is low – only 2.6% – but this is typical of nearly all Japanese companies. They have very low returns on equity partly because they take lots of depreciation. Adjusting their depreciation to US levels would push it up to about 4% – still pretty low. But across the board if you adjust the P/E ratios to US GAAP they are not actually that high and many are selling at 8 or 9 times cash-flow and while dividend yields do not seem high, surprisingly enough they are higher than many US Corporations.
I have always felt that cash was a terrific thing to have but Japanese companies earn less than 1% on their deposits and in some cases zero. The last time that you could get a dividend yield in the US in excess of the short term cost of money was in the late 40s and early 50s. So I have no misgivings about our major switch into Japan.
By this time Peter could fairly be considered an old hand at Japan. He had made his first visit to the country in 1969 and bought his first, and very successful, investments there in 1985, during the brief shake-out that happened prior to the Nikkei rising virtually without pause from 10,000 to 40,000 by 1990. One of these investments was Matsushita Electric, perhaps better known outside Japan by its brand names of JVC and Panasonic. He had bought the shares below book and liquidation value and sold them again in 1987 when they reached three times book value. He had bought them again steadily through 1989, 1990, and 1991 because they had again sunk below book value. He had done this at the very same time that he was shorting the overvalued Japanese index – so that he was buying more Matsushita at exactly the same time he was so painfully rolling over the Nikkei put options – the point being that, as always, his individual investment decisions were predominantly value driven and determined by the numbers. The fact that overall the Japanese market at the time was so grossly overvalued that he was shorting it mattered not a jot, as long as he could clearly see that essential margin of safety in a particular security. And the love affair continued: by 1995 Matsushita was again selling at a discount to liquidation value. He bought it again and bought more as the Nikkei fell through 1997 and 1998, finally buying the last of the position in January 1999.
Peter’s call on Japan may have been early but it was absolutely correct. In 1999 the previous year’s setback in the Value Fund was more than reversed with a 16% gain, followed by a further 20% in 2000. With nearly 50% invested in Japan, it was the prime contributor to these results. It had been a classic contrarian call, adding considerably to Peter’s reputation. Individually the investments were across a range of sectors from financials to pharmaceutical, the only common feature being that they had all been trading below liquidation value. Like all classic value investors, Peter had no concern whatsoever with what business a company was engaged just as long as it met the financial criteria.
A good illustration of this point was Tokyo Broadcasting System. It was the third largest television broadcaster in Japan and, along with its competitors, had suffered a sharp decline in its advertising revenues as the Japanese economy had stagnated through the 1990s. On the face of it, it was not very appealing except as a recovery situation, but there were plenty of those around that would in all probability reap more immediate rewards than TBS if the macro-economic situation in Japan improved. The TBS management was competent rather than imaginative or creative. Most investors would not have given it a second glance. Not so Peter. Someone had remarked that TBS might be cheap so he took a quick look and then a more careful one. He discovered that TBS owned valuable property and had lots of cash as well as an investment portfolio.
These were the sums:
Share price
Y1,500
Value of real estate per share
Y1,000
Cash and share portfolio per share
Y500
There was the margin of safety. At that share price you were buying the business for nothing and Peter valued this, on liquidation principles, at Y2,000, which gave him a “fair value” of Y3,500. He began buying in 1998 and accumulated the majority of his position through 2001 and 2002 at prices below Y1500. Most of it was sold at between Y2,500 and Y3,000, although the shares did in fact eventually reach Peter’s “fair value” of Y3,500.
There were, logically enough, some very positive side effects resulting from Peter’s latest success with Japan. In the fall of 1998 Mackenzie launched a new product: its Universal Select Managers Fund. The fund was to have an international focus and was to be invested by five separate fund managers with widely different strategies. Peter was to be one of these managers, which was a brave choice by Mackenzie at that date.
Initially Peter’s share was a mere $200,000 but, as his returns began to be recognized by the Mackenzie sales force and the investing public, purchases of the Select Fund as well as the Value Fund began to gather momentum. Within the Select Fund new money was allocated according to the relative performance of the various managers and when the growth stock boom collapsed in 2000 both Peter’s absolute and relative performance were seen to be outstanding. By March 2001 his share of the Select Fund was about $1.5 billion. As Peter noted in a memorandum to his team at the time, the Mackenzie relationship had turned into a “win win” situation.
He went on to make some interesting more personal comments:
I am thinking about where I should like to go in my passage through life. This business has been very good to me. It has allowed me an extraordinary amount of freedom on many levels. In some ways the Cundill brand is established and getting to the point where it will not need the founder’s presence to prosper. I don’t think it’s quite there yet but if collectively we continue to work together, we can achieve the goal of long term continuity, nurturing the team we have built and the value based backbone of our investment philosophy, through which we have been able over the years to provide above average returns to our loyal investors. I have also reflected that I am myself one of those investors in that I now have about $75 million of my own money invested in Cundill products. I am not the largest client but I have a very direct stake in our ongoing success.
This is still the case.
16
There’s Always Something Left to Learn
THE EARLY YEARS of the new millennium were generally favourable for the value investor. It was never easy but, quite often during that period, it turned out that less patience than usual was required for a value investment to be recognized by the market. Nevertheless, pitfalls always abounded. Peter has an enviable gift for avoiding the majority of them and this is not just based on doing the numbers and adhering rigorously to the Ben Graham framework. It springs from an instinct resulting from years of experience – a nose for when, even though a set of accounts may have all the appearance of perfect rectitude, there is something that does not give off comfortable vibrations.
An excellent example of this is the tale of Brascan, in which he invested heavily, building up close to a 5% stake, and Nortel, in which he did not. Brascan was and still is (in its new guise as Brookfield Asset Management) a Toronto-based conglomerate made up of realestate, financial services, and power generation. Nortel was a high technology telecommunications company with a multi-billion-dollar market capitalization – the darling of the majority of the investment community. It no longer exists, having gone spectacularly bankrupt some years ago, leaving zero value for its stockholders. By contrast Brascan was viewed as very dull, if not actually risky.
In the latter part of 1999 Peter was giving a presentation to a large group of investment representatives and faced some quite aggressive questioning from the floor as to what he was doing with a substantial holding in a boring old stock like Brascan when he could be putting the money to better use in a high flier like Nortel – this, of course, was some time before the high technology crash. Never one to duck a challenge, Peter decided to run a comparison of the two companies, which he presented at the Cundill Conference in 2000.
As is clear from the table, Brascan at $18.00 was still trading at a small discount to its book value of $19.10. At $73, with a book value of $6.25, Nortel, equally obviously, was not. All of the comparative statistics are revealing, but one might focus on just two others that ought to have given the Nortel advocates pause. Brascan’s P/E ratio was 12.4, Nortel’s was 97, and Brascan had a dividend yield of 5.1% versus 0.10% for Nortel. The table was accompanied by a note from Peter to his investment team in Vancouver:
As you know I called for a brief comparison between Brascan and Nortel. Brascan is cheap; Nortel is dear. We all know that. I have spent time trying to understand the latter. When I was studying for my CFA in 1968, it was the heyday of the “concept stock,” the conglomerate based on the pooling-of-interest accounting, lofty multiples, and inspiring dreams. The backdrop was the Vietnam War: Treasury Bills in the US were slightly over five per cent and inflation was around the same number. Abraham Brilloff was writing articles on “Unaccountable Accounting” and “Dirty Pooling.” Nobody cared; accounting is a bear market phenomenon! On the face of it Nortel is not that bad. It seems to be writing off at least some purchased goodwill [Nortel had made a lot of high-priced acquisitions in the previous few years] through the Profit and Loss account, paving the way for better Rates of Return on equity in the future. My own view is that the company has been making big and uncertain technology bets, while the marketplace is convinced that these will all work. Such chickens have a tendency to come home to roost. I would like to leave you with two insights in finding a good investment and to tell you the story of the 100th monkey. First the insights:
Comparative statistics for Brascan and Nortel sent by Peter from Hong Kong to his investment team in Vancouver.
* * *
July 18, 2000
Good Morning:
CIR – I am attaching the brief statistical review of Brascan and Nortel. In addition, I am attaching the audited P&L statement for Nortel in the prior two years. On the face of it Nortel lost money in the last two years! Am I correct? Or am I just being a curmudgeon who knows nothing about anything?
• Every company ought to have an escape valve: inventory that can readily be reduced, a division that can be sold, a marketable investment portfolio, an ability to shed staff quickly. That sort of thing. However, no escape valve will provide a cushion in the face of a collapse in investor confidence.
• The business must be getting better, not necessarily by a lot, just honestly better.
Now for the story:
“In the 1950s scientists were studying Japanese monkeys on the island of Koshima. They provided the monkeys with sweet potatoes dropped in the sand; the monkeys liked the sweet potatoes but hated the sand. Then a young female named Imo found she could solve the problem by washing the potatoes in a nearby stream. She taught this trick to her mother. Her playmates learnt it too and taught their mothers.
In the following years, all the young monkeys learned how to wash the potatoes and taught their parents. Those adults unable to learn from their children carried on eating dirty potatoes.
Then something startling took place. In the fall of 1958, a certain number of monkeys were washing potatoes – we don’t know exactly how many. But let’s suppose that as the sun rose that morning there were ninety-nine monkeys washing potatoes and let us then suppose that later the same morning, the hundredth monkey learned to wash potatoes.
That’s when it happened.
By that evening the whole tribe of monkeys was washing the potatoes before they ate them. The additional energy of that hundredth monkey had somehow created an ideological breakthrough and everyone jumped on the band-wagon.”
Now this tale may be mythical but its implications are not, as we shall no doubt learn, in due course, in respect of Brascan and Nortel and much else!
Peter never at any stage bought Nortel; he did make a significant amount of money out of Brascan and its satellites.
Surprisingly enough, however, the worst investment that Peter ever made was in the telecommunications business. Over the years he had made some very big gains in that industry, Telefonos de Mexico and Philippine Long Distance Telephone to name only two. But Cable & Wireless was another matter and even more surprising, if only because in its acquisition strategy and technological ambitions it bore some similarity to Nortel.
The company had a very long history. It had started life in the nineteenth century as the establisher of telegraphic connections across the British Empire, which had once straddled the planet and governed the lives of over a third of its population in fifty countries. Marconi had been a director of the company and, as the world moved from telegraph to telephone, C&W had laid the necessary cabling and in many cases ran the networks.
It had been a leading player in the rapidly growing and ever-evolving industry. However by the late 1990s the company had surrendered most of its networks as colony after colony had become independent and was largely confined to the Caribbean and as a secondary player in the deregulated British domestic market. It appeared tired and to have lost its way. There had been unseemly boardroom squabbles between the CEO and Lord Young, the executive chair – a “Thatcherite” ex-Tory minister who had been parachuted in. The shares had gradually drifted down from a high of £15.00 to about £6.00 by the end of 1998. In spite of C&W’s popular acquisition of MCI Communication’s internet backbone business, analysts took the view that the company’s balance sheet was too stretched to exploit the opportunity.
At the beginning of the following year a new CEO, Graham Wallace, was appointed. Wallace was a finance man and quickly set about addressing the balance sheet problem with a series of well negotiated disposals at good prices; One2One, the mobile phone business, went to Deutsche Telecom for £3.75 billion and the Cable & Wireless Optus business was well sold to Singapore Telephone. The effect of the sales was to transform C&W’s balance sheet from net debt of £4 billion to a net cash position of £2.6 billion.
By this stage C&W was coming up on the radar for value buyers, including Peter, for whom it now had a lot to recommend it: no debt, cash on the balance sheet, profitable established networks, and a concentrated degree of market scepticism driving share prices down across the entire sector. A thorough analysis revealed a net asset value of £4.92, calculated on the basis of a conservative estimate of the realizable value of the “sum of the parts.” The margin of safety was cash and marketable securities of £3.25 billion. The concern was that the company was in a highly competitive business but, as Peter had so often said, “we always look for the margin of safety in the balance sheet and then worry about the business.” He began buying in March 2000 at just over £4.00.
In October he gave an interview in which he touched on the subject of C&W:
There are two distinct points of view on this one. You can perfectly well make the case that the management has demonstrated its competence, having made highly satisfactory strategic sales, but there is a sense that maybe they will waste resources, and there is investor pressure, which is being resisted by the company, to give a fair amount of the proceeds back to the shareholders. This is a company with $20 billion of market capitalization, really large. The old institutional investors have gotten pretty beaten up and feel disinclined to give the new management much leeway and there are the other investors like ourselves who have bought in recently at significantly lower levels. As a general comment, we have never invested in high tech companies but now we do find ourselves buying things like Cable & Wireless, which are so low that they are trading below the amount of cash on hand. So, even though some of them have what we call “burn rates,” meaning that they are spending cash as they go along for investment, marketing, and so on, a number of them are very interesting, including Cable & Wireless.
A modest burn rate, supplementing the free cash flow from the mature, low growth businesses in order to fund a planned investment program to promote C&W’s ambitions to become a global provider of voice and data services to the business community and thus transform top line growth, was one thing. What actually happened was quite another.
Until this point Graham Wallace had been generally regarded as a relatively safe pair of hands unlikely to be tempted into the kind of acquisition spree overseen by his predecessor. This view entirely failed to anticipate the corrosive effect that a relentless stream of investment bankers, management consultants, and brokers, all preaching the same message, might have, even on an individual with a fairly balanced commercial sense. The pitch was simple – the market for internet-based services was growing at three times the rate for fixed-line telephone communication and the only quick way to dominate that market was by acquisition. Establishing a highly visible presence fast was more important than the price one was required to pay to achieve this.
