EGP Fund No. 1 Pty Ltd Launches!

Finally, after so many years of planning, we have launched.  Our seed capital has been deposited and we commence from tomorrow in allocating the capital as per our investment principles.  Our Application form and Redemption form are available on request to those who have secured a spot in the initial operating format.

As promised, we launch alongside EGP Fund No. 1 Pty Ltd, the sample index the EGP20.  As mentioned previously, this is a composite of those ASX200 companies we think represent the best of the index we do not own (in EGP).  The constituents (representing 5% each) are:

Disclosure/Caveat - The selections below do not constitute investment advice.  They are simply a view we have taken as to a group of stocks which, based on our quantitative analysis we view as likely being better value than the broader ASX200 over a reasonable term.  Based upon a full and thorough qualitative analysis, there is a high likelihood some of these stocks would be excluded from such a list.  I cannot speak for Dave, but my wife and I own 3 of the stocks listed.

1. RSG
2. OST
3. PBG
4. HIL
5. PPX
6. OMH
7. SIP
8. RIO
9. DOW
10. KCN
11. MCR
12. ALS
13. MCC
14. CAB
15. SHL
16. JBH
17. HVN
18. PRY
19. TEL
20. ERA

The selections above are not advice, if you are at all interested in any of the stocks mentioned above; speak to your financial advisor or accountant.  We will not be held liable for anyone who acts on a list provided chiefly as an entertainment item.

I won’t comment too much on the reasoning behind the make-up of the 20 stocks above, you can see it is fairly heavy with miners, and has a couple of ‘turnaround’ businesses.  There were 7 stocks that also made the above list on a quantitative basis, but were excluded due to certain rules I cannot break (though I have bent them a little with some of the above).  Some of those excluded were for such reasons as insufficient profitable history in the case of some, too much debt or an overly complicated capital structure, the need to see a turnaround gain traction, or just for being an airline in the case of one.

The performance of EGP Fund No. 1 Pty Ltd and the EGP20 will be mentioned each week at the start of any web update we make.

The fund initially houses the seed capital from Eternal Growth Partners Ltd, the asset manager for EGP Fund No. 1, along with investments from our lovely wives and our children.  Our reasoning for starting with our own funds before taking on our other investors is the potentiality for underperformance in the first quarter due to the likelihood of taking some time to allocate all the cash into investments. By this I mean that in the event that the broader market runs upwards strongly whilst we cautiously (it is our default state) deploy our funds, underperformance is more likely. By the time we get to the end of June, it is likely that we will have allocated the majority of our initial capital and any fresh capital we take on will be allocated into an underlying equity base.  Proportionally, this means we will have less of our fund in cash at July 1^st (hopefully only about 10%) than we will at April 1^st (100%).

In respect of the EGP Fund No. 1, though we will post a price update weekly, we will make more thorough quarterly and six monthly updates.  As I have mentioned previously, discussion about particular holdings within EGP Fund No. 1 will be extremely limited and usually restricted to any holdings we have eliminated completely (which is unlikely to be for a couple of years, barring takeover).

I will run our first update to EGP Fund No. 1 & the EGP20 index will on Sunday April 3^rd, obviously there will be very little to report. I will try to update virtually every Sunday, and to let you know in advance any time I need to miss an update.  This doesn’t mean you should pay great heed to the weekly movements in either EGP No. 1 price, nor the index, we are targeting long-term out-performance, as such, in the short term, we won’t panic in the event we fall behind, confident in the belief that our views will bear fruit over the longer term.  Our target is benchmark out-performance in at least 75% of 6-month periods totalling 3-5% after performance fees over the medium-term.

For information purposes, the closing prices of the 3 measures we are interested in as at COB March 31 are:

1. EGP Fund No. 1 Pty Ltd          $1.00000 per share
2. EGP20 Index                           1000.00 points and
3. Benchmark                              35,632.05 points

We will be trying hard to effectively deploy our capital over the coming weeks, if you could all pray for declining markets, we would be much obliged – Tony Hansen 31/03/2011

Investment Principles & Shareholder Guidelines (or Dave's Lament)

I had said I wouldn't make a post this Sunday, but I am finally able to submit the Investment Principles & Shareholder Guidelines, those who have secured one of the initial places in the foundation format can contact us to receive the form. The contact details for Dave and I are in the document, please call us before committing cash, because we are limited to 20 shareholders under our foundation (Pty Ltd) structure, and we don't want the cash for the July 1 issue to hit our account until the last part of June.
I have to report Dave and I find ourselves in a slightly upsetting position at the moment, whereby the 2 shares that were going to be two of our heaviest holdings have appreciated substantially of late. In fact since January 1 this year, what was to be our No. 1 holding is up nearly 40% and what was to be our No.2 holding is up nearly 85% since January 1.  These 2 holdings combined were likely to make up over 40% of our asset allocation, and now we have to decide if they still make the grade...
This burns especially, because since January 1, the indices have moved by a much more modest 1.18%, so we have foregone the prospect of substantially augmenting our performance track-record.  I am not completely upset though, these are the 1st & 3rd largest holdings in my family portfolio, and while I've liquidated substantial holdings in order to contribute to the start of the fund this week, I retained all of the No. 1 and 2/3 of the stock that was to be No. 2.  Spare a thought for Dave, though.  About 1/3 of his equity-holdings were in this stock that was to be our No. 1 holding, and in order to have the cash available for the launch of the fund, he had to liquidate this holding, it has subsequently risen over 22% in the 8 days since.  He tries to console himself that he had already booked a 57% profit on a stock he had held barely 18 months, and in a period that the market has traded sideways, but I know his secret pain... We expected that having this cash out of the market for less than a fortnight would not cost us too heavily, well it seems it may have, selling, I maintain is the hardest part of owning stocks.
I will describe the difference these movements have made to my expected return.  On January 1 with stock No. 1, at its then price, it was my favourite stock in the market, now I always view a purchase with at least a 10-year time-frame and at January 1, I expected that every $1 I put into my favourite stock, in 10 years time, I would have about $8.88 to show for it at the end of 10 years (you see why it was my favourite).  With the intervening nearly 40% increase in price, every $1 of this stock, I now view as likely being worth about $6.45 at the end of 10 years.  That is still pretty compelling in my view, but given that this stock was earmarked to make up at least 30% of our portfolio, this basically means if I still proceeded with this 30% allocation, I would expect to make 1.3% less per annum for my investees (over a 10 year measuring period), as I now expect this stock will appreciate by 3.92% less annually.  So that is the bad news, the good news is that I have a few other 'Aces' up my sleeve, and it is my job as the asset allocator to now redesign my portfolio, to snatch back as much of that 'lost' 1.3% per annum as I can.
I will post next on 31 March, the eve of the launch of EGP fund No. 1 Pty Ltd - Tony Hansen 27/03/11

P.S. Dave wanted me to mention that one of the shareholdings I liquidated in the process of compiling my share of the seed funds announced only 58 minutes after I sold the last parcel that they had been subject to a takeover offer they'd declined.  Their share price subsequently & rapidly rose nearly 12% and cost me more than $6,500 in foregone profits.  I had to console myself with the handsome profit I crystallised instead.

The EGP20 index

As I have mentioned previously, the vast majority of our energies in respect of valuations are concentrated outside of the ASX200.  The reason of course being that we seek to look where very few other eyes are going and in this way, hope to find value others have missed.

The results of our investment company EGP Fund No. 1 Pty Ltd will be the thing most people are interested in tracking on the site.  These will be the companies we are actually invested in, and the results of this fund will be the actual returns to our investees.  We will not disclose the stocks we hold, because if we give clear directions on our holdings, our investors could instead hold the stocks directly and would find no use in subscribing for shares in our company.  We are already presenting an investment alternative with no annual management fee.  If we then also disclosed our holdings, we would have nothing to offer prospective investors.  After an investment has been realised, such as by sale, or take-over, only then will we disclose our holding and our thinking behind it.

I have always maintained, that even restricted to investing only in the ASX200, we could outperform the index (S&P/ASX200 TR).  In order to (we expect) demonstrate this, Dave & I have instead proposed that in order to keep our non-investor followers entertained, we will track a selection of 20 businesses from the ASX200, which we do not hold in our fund (because we believe we have superior alternative opportunities), but which we rate as some of the better prospects in the ASX200 (on a margin of safety basis).  We will do this in order to present a pre-determined, trackable index of investments for our followers.

It is my expectation that over time, The EGP20 will do better than the S&P/ASX200 TR, and that our EGP Fund No. 1 Pty Ltd will do better than both, given a reasonable timeframe, say 3-5 years.

The 20 holdings in the EGP20 index will be equally weighted at their announcement (i.e. 5% of the index attributable to each).  The index will be re-balanced twice a year (the first weekend after June 30^th & December 31^st) to include the 20 companies (which we do not hold in EGP Fund No. 1 Pty Ltd) from the ASX200, which we believe, on a chiefly quantitative basis (we will not spend as much time on the qualitative factors as we do with our own investments) represent those with the greatest margin of safety in the ASX200.

Based on our current valuations, we believe the EGP20 stocks will outstrip the broader markets performance by about 3 – 5% per annum, this is our expectation, and obviously the market rarely performs exactly in the way that we expect.  We have stated this (3 – 5% out-performance) is our target for EGP Fund No. 1 Pty Ltd, so the fact we will not own these 20 stocks implies we have found something we believe has even greater upside. The EGP20 index will launch alongside the launch of EGP Fund No. 1 Pty Ltd, our fund at the end of the first quarter (31 March 2011).  We will announce the 20 constituents around then.  Bear in mind, the EGP20 index will be completely passively managed.  That is to say, we will nominate the 20 holdings at the start of the period and regardless of any moves in intrinsic value, or reduction in the margin of safety, we will commit to retaining those same 20 stocks in the index until the next adjustment period.  The 20 selections therefore do not represent investment advice and followers are advised to do their own research in respect of the selections if they are interested.

My next post will be on March 31 and will be the launching post for both EGP Fund No. 1 Pty Ltd and for the EGP 20.  Tony Hansen 20/03/2011

Return on Equity

Return on equity (ROE) is usually considered something of a ‘Holy Grail’ for many investors, particularly those, like us with a “Value Investment” disposition.

ROE is the return (by way of profits) on the original capital used in the business (plus retained profits) shown as a percentage.  To demonstrate for those less familiar with the concept, imagine I decide to open a hot-dog stand on a street corner near my home.  Further, imagine that I need to invest $10,000 in the stand/equipment (cooler/cash-register/umbrella/bun-steamer/boiler etc) required to establish the business.  Now after deducting cost of sales (wages/buns/sauce etc) from sales (and depreciating the assets), assume at the end of 12 months I have profits of $2,000, then my ROE for that year was 20%.  Assuming all profits are paid out as dividends, and the business returns $2,000 again the next year, the ROE was stable. Assuming all profits are retained, then in order to maintain a 20% ROE, the business would need to earn $2,400 the following year.

From the above example, assuming 50% of profits are distributed and 50% retained, profit would need to grow at 10% pa in order to maintain the 20% ROE.  Generally speaking, for me, if ROE is likely to decline as a consequence of retaining earnings, then it is preferable to pay the earnings out as dividends.  Provided, however, that a business can maintain or grow their ROE whilst retaining earnings, it is far preferable that it retain the earnings, in fact, this is the sort of business we fervently seek.

What ROE focussed investors often fail to realise, however, is that when you buy shares on market, you are not paying the original equity price.  Assume in the ‘Hot-Dog Stand’ business above could be conservatively assumed to grow EPS at 10% pa (in perpetuity – or something like it) by retaining 50% of profits.  Such a business (provided we can be confident of the growth assumptions) would likely eventually trade at about something like 18x earnings (depending on many factors). On this basis, my $10,000 equity & $2,000 earnings above, the business would likely be valued at $36,000.  So very rapidly, the market would choose to pay $3.60 for every $1 of equity (due to the sound prospects of the business).  Assuming it makes that 10% growth for 10 years, pays out 50% of earnings and still trades at 18x, the investor who paid $3.60 (say per share for one or more of the 10,000 shares) after 10 years would own a stock priced at $8.49 and would have been paid $1.59 in dividends.  In this case, ‘over-paying’ for the equity was quite profitable, a return of about 10.85% pa (despite not having re-invested the dividends).  Depending on inflation levels, this might be a relatively sound result.

Imagine instead a business very much like the above, but it has had disappointing results and recently earned $500 on its $10,000 in equity (an ROE of 5% instead of the 20% above).  Now if due to its disappointing ROE and prospects, the business traded on say 8.5x earnings (Benjamin Graham indicates this is an approximately reasonable price for a business that is likely to neither grow nor shrink earnings), then instead of paying $3.60 per $1 for equity, I would be paying $0.425 for each $1 of equity (granted the original $1 payer has lost – that is not our problem).  Assume in this case, that for 10 years earnings grow at 5% pa and again, 50% of profits are paid out as dividends.  Based on similar factors as used above, a business that consistently grows it profits by 5% pa for 10 years would likely trade at about 11.8x earnings.  On this basis, our 42.5c shares would after 10 years be worth 91.5c and we would have received about 31.5c in dividends.  In such a situation, despite a significantly weaker ROE (in this example, in the 10^th year, the company was still producing an ROE of less than 6.1%) and half the annual earnings growth, we would have earned 11.21% pa (again without re-investing dividends), more than the better ROE and growth business above.

So to put it simply, ROE is a useful metric, but must be used with caution, as like virtually every other financial metric available, we must be mindful of the circumstances around which we use it.  Just because someone, somewhere in the history of the company paid too much for the equity doesn’t mean at its current cost, the equity is overpriced.  Tony Hansen 13/03/2011

What If?

One of the statements I've often heard used by those who try to justify their compulsive ‘undersaving’ or ‘underinvesting’ is “what if I get hit by a bus tomorrow”, or some such morbid, doom-saying prediction.  The inference here is that life is full of uncertainty, so better to enjoy the full measure of your discretionary income in the here and now, than to sock some money away and risk the prospect of leaving behind some inheritance by accident should an unexpected disaster befall you.

I concur with the sentiment of living for now, but my reply to such a statement (“What if I get hit by a bus?”) is “What if you don’t?”. The Australian Bureau of Statistics tells me a baby born in Australia in 2009 had a life expectancy of 79.3 for a male & 83.9 for a female.  Someone turning 40 in 2009 had a life expectancy of 81 for a male and 84.9 for a female.  Furthermore, someone turning 65 in 2009 could expect to live a further 18.7 years (male) and 21.8 years (female).  So my question remains “What if you don’t?”  A fair expectation is that you will quite possibly live until 80, 85 or longer.  In view of that likelihood, I think it is reasonable for someone who has under-saved to this point to find this prospect considerably scarier than being hit by a bus.

For the record, my current life expectancy is 80.6 and I’m quite determined to be ‘above average’.

I really fail to see in a wealthy society why the vast majority of people can’t put away 10% of their after-tax income.  My income was until fairly recently, less than the average Australian weekly wage.  We have 3 children, in their teens and despite this, through the last 10 or 12 years, have managed to accumulate a handsome nest egg, simply through prudent saving and investing.  We are admittedly a 2 income family (some don’t or can’t have this advantage), but we have really wanted for nothing in this period, perhaps holidaying more frugally (and infrequently) than our preference would have been, though in respect of holidays, we have been more generous with ourselves in the last couple of years.  My point is that you don’t have to give up very much in order to establish financial security.  But it is up to you, as Ben Franklin said “He that waits upon a fortune, is never sure of a dinner”.

To demonstrate, I have a friend, who recently as he approached his fortieth birthday, had come to the realisation that with continued inaction, his retirement was likely to be a very (financially) tough one.  His earnings are less than the average Australian wage (about 75% thereof), and in-fact by saving 10% of his after-tax income, he would only be putting away $75 per week, or $3,900 per year.  Bearing in mind, this man lives alone (that is to say, bears all marginal living costs) on an income of about $1,000 per week (pre-tax).  As I pointed out to him, by saving this amount, adding to it by 4% per annum (this is the approximate quantum of historic Australian wages growth), and equalling the approximate historic returns of the market (about 12.5% pa over the last 30 years) he would retire at 65 with just short of $1m in his savings account.  Given his current superannuation position (about $150k) and assuming a continued 9% pre-tax contribution (and this is likely to increase through future legislation) and returns of 8.5%, between personal savings and superannuation, my friend will have about $2.8m to sustain him through what is statistically likely to be about 19 years of retirement.  Assuming he moves his whole nest egg to cash that generates only 5% pa thereafter, in order to deplete this $2.8m in his 84^th (and statistically final year), he will need to spend approximately $233,000 per year.  If he wants to leave behind $1m, he need simply cut back to about $200k in annual income.  When considering this, consider the fact that the current aged pension in Australia is $329.20 per week.  Assuming it grows at CPI (about 2.5% pa) the aged pension in 25 years is likely to be in the range of $595 p/w or about $30,950 pa.  Makes $233k look pretty juicy doesn’t it, and besides that, do you really want your retirement income left to the whims of a Government?

Being already in a position where a comfortable retirement is likely, it might be easy to ask “what is the use of generating a good deal more money than you are ever likely to desire to spend?”  To such a question, I am likely to reply as Benjamin Franklin did when questioned at the first manned flight in 1783 (a hot-air balloon) “Sir, frankly, what’s the use of flying in the air?” His reply “Monsieur, à quoi peut bien servir l'enfant qui vient de naître?” or “Sir, what’s the use of a newborn baby?”  Depending on how much we can accumulate will depend on what good we are able to do with it.  With sufficient capital, I may just be able to make a great contribution to the betterment of society.  For now, suffice it to say I thoroughly enjoy the process of accumulation, and with (statistically) 46 and one half years to decide, I don’t need to worry too much about it yet (unless I get hit by a bus…) - Tony Hansen 06/03/2011