February 2017 | Lumenary Investment Management

Pleasant outcomes of a concentrated portfolio

Posted on February 21, 2017May 14, 2018 by Lawrence Lam

Finance theory tells us diversification reduces risk – we subscribe only partly to this theory. We believe in diversification across asset classes (eg. cash, property, stocks), but not within an asset class.

A prudent risk management approach can be implemented with a concentrated stock portfolio.

Diversify across different asset classes, but not within each asset class.

Imagine you’re given a $1m inheritance. But before you can spend it, the inheritance has a condition to it – in exactly 10 years to the day from now, the $1m must be worth at least $3m. You ponder this daunting task – the condition implies that in exactly 10 years, the portfolio must have generated an average return of 11.6% p.a over the next 10 years.

Ideally, there would be an investment that guaranteed you 11.6% over the next 10 years with no risk. We know there are no such investments. If we invested it all in cash, we know we would not achieve 11.6% growth. We could invest it all in property, but we would need to be certain that we’ve picked the right property and even then, 11.6% is a high hurdle.

Investing all of the money in stocks gives us the best chance of achieving this target – over the long term, stocks generate the highest returns of these 3 asset classes, given they are inherently more volatile. However before we invest it all in stocks, there is a possibility that there could be a stock market crash in exactly 10 years time that leads us to fail the condition on the last day. Given our preference for stocks, how can we best duly mitigate risk, whilst attaining our targeted 11.6% return?

We need to balance risk protection, without being so conservative that we are inhibited from generating adequate returns. From our experience, the answer to this question lies in a 2 tiered approach. First, we should spread our investments across cash, property and stocks. Diversification across these asset classes gives us an initial level of protection against potential crash in any one of these markets in 10 years time. In a stock market crash, all stocks crash. Not one sector or industry is immune. Therefore diversification through buying different stocks does not give us much comfort. However, it is less likely that interest rates, housing prices and stock prices all fall simultaneously together on the same day. Therefore, diversifying across asset classes (ie. cash, property, stocks) gives us much greater protection than diversifying in just one asset class (ie. buying many different stocks in the hope of immunising against a stock market crash).

Second, we should look to manage risk within each class. Once we are comfortable with our asset class allocation, we have minimised a large proportion of risk. The smaller portion of risk that remains is how each asset class performs. Conventional financial theorists will argue that diversification within each asset class provides further risk reduction. That is, for cash, we would buy several different bonds. For property, we would aim to buy different property in different suburbs. For stocks, we would buy stocks in different sectors and industries. From experience, we consider diversification to be one such technique when it comes to risk management within an asset class, but not the most effective.

Managing risk in a bespoke way

Diversification within an asset class, for example stocks, is a scatter-gun approach that poses too great an impost on returns. In our view, it is a crude way of approaching risk management that produces average returns.

In contrast, an investor should delve into the detail of each stock to analyse the risk of the underlying business. How prudent is the management team? Do they have a genuine interest to see the business succeed over the long term? Is the business operating in a viable industry? How much debt does the company have? Is the business profitable? These are the pertinent questions that ultimately manage risk, not a scatter-gun approach. Analysis and detail should be used to protect against loss, not broad sector generalisations. We much prefer to carefully select one solid basket to keep our eggs in rather than wantonly select a lot of different baskets in hope that on average they will be good enough. We only invest when we are confident in our understanding of the risks within each business. On the other hand, diversification implies a certain level of uncertainty and lack of conviction in one’s analysis.

Risk management is at the forefront of our investment approach. Thinking back to our example, imagine how hard it would be to generate the required return if we were to lose a significant portion of our capital at the start. Wealth can only be generated over the long term if we first protect ourselves against potential losses. In our search to mitigate risk, we often find that a pleasant benefit of our approach is that we discover great businesses along the way that produce outstanding returns over the long run.

One of my best (but unfortunately shortest) investments

Posted on February 20, 2017May 14, 2018 by Lawrence Lam

Count Financial (ASX:COU) is no longer a listed company on the ASX, but it was one of my best investments. I only wish that the investment could have lasted longer.

Until it was taken over by CBA in 2011, Count Financial was Australia’s largest independently-owned franchised network of financial planning/wealth accountants and advisors and had over $14 billion of client’s funds and loans under advice.

There were many great qualities about Count. First, it was a great franchise with consistently increasing revenues and profits combined with a long term track record of profitability stretching back to 1980. The below table from the 2010 annual report shows the EBIT and EPS trend over time. Earnings decreased in 2009 due to the effects of the global financial crisis (‘GFC’), however rebounded strongly 2010. By 2010, EPS was back to pre-GFC levels.

Second, the business had a passionate founder who started the business in 1980 and remained a key shareholder of the business almost 30 years later. The leadership of Barry Lambert has been nothing short of spectacular. Barry Lambert started Count as a side business whilst still working full-time and grew it from a small side business into a key player in the Australian financial services industry over 30 years. Barry’s outstanding impact on Count is a profound demonstration of how a founder can instill the heart required to consistently increase business profitability over the long term. Today, he remains a giant in the wealth management/advisory industry.

Barry Lambert, Founder of Count Financial

Third, Count had developed a strong brand and a unique way of connecting with its customers through technology that competitors found hard to challenge. Count provided software platforms for its franchisees to enable them to be more effective in servicing their clients. In addition, Count had a unique business model as it did not service the public directly. Instead, it established a network of franchisees consisting of accountants and financial advisors that serviced the public. Count provided background support to these franchisees. Count had a strong captive market – a network of accountants and financial advisors that used its software platforms to provide advice to a growing client base. Strong branding and its software platforms provided Count with robust barriers to entry to protect it from potential competitors.

Fourth, Count was operating in a growing and profitable wealth services industry. The wealth services industry was growing substantially as the wealth of Australians increased from the mining boom, the popularity of Self Managed Super Funds (SMSF) increased significantly, and the effect of the GFC was not yet widely felt. Australia’s economy came away relatively unscathed from the GFC and the stability of its financial industry was highly regarded globally.

Count’s share price had suffered a large decline during the GFC. From a high of $3.50 at the end of 2007, the market’s negative sentiment towards financial stocks saw Count’s price fall to under $1.50 by early 2010. Despite earnings rebounding strongly in 2010, Count’s share price did not rebound and instead continued to decline below $1.20. The market had a negative view of all financial stocks and the fear of other ‘skeletons in the closet’ had taken over.

In addition, there was growing uncertainty with its future financial planning revenues. The financial planning industry was under government scrutiny for its remuneration structure which some argued was against the best interests of the public. In response, the Rudd government proposed a series of legislated amendments known as the Future of Financial Advice (FOFA) which, if effective, would have been detrimental to the entire revenues of the financial planning industry.

As a result, the share price of Count continued to decrease. Despite the market’s view, it remained apparent to me that Count was a great business that was priced very reasonably and was overlooked out of fear. Whilst others feared financial stocks, I judged that Count had a robust business model and a strong market position to be able to adapt to legislative change. I subsequently purchased significant amounts of Count shares on 28 July 2011 for $1.02, which I thought was a fair price.

A week later, on 6 August 2011, S&P announced that it would downgrade the US credit rating from AAA down to AA+. This was an unprecedented move given that the US had held a AAA rating since 1917. The announcement sent shockwaves through the market and led to a further decrease to financial stocks, including Count. On 8 August 2011, I capitalised again by investing another significant amount of funds at an attractive price of $0.90.

A few months later, I was not the only one to see Count’s true value. On September 2011, CBA announced that it would buy all of Count’s shares for $1.40 each, a premium of 40% over the price at the time. Although a purchase premium was paid, I would have preferred Count to remain a going concern business. In my opinion, Count was a great business and would have brought its shareholders even greater long term profitability had it not been taken over. Nevertheless, over a period of 5 months, I had made a 52.3% return on Count Financial.

Through times of uncertainty, it is paramount to remain objective – great companies with great founders will remain great. Provided the independent conclusion is based on sound analysis, pundit opinions should be treated as exactly that.

Why small to medium sized companies may not be as risky as larger stocks

Posted on February 3, 2017May 14, 2018 by Lawrence Lam

Risk is dependent on each individual business and its activities, not whether the company is large or small.

Great small to medium sized companies are more likely to be overlooked by large institutional investors, and have more potential for growth.

The risk of investing in a company is determined by the strength of its business model and how well the business is run. Not by its size.

We are often asked for our opinion on whether investing in smaller stocks is riskier than investing in larger ‘blue chip’ stocks. To us, risk is the potential of losing the capital you have invested and from our experience, this is not dependent on the size of a company. Rather, risk is a result of its inherent business model, the competitive industry in which it operates, and how well the managers run the company. We can recall many examples of large ‘blue chip’ stocks which have gone bankrupt. Large Australian companies such as Ansett, HIH and One-Tel were once thought of as safe blue chip stocks. Lehman Brothers and Enron were amongst the world’s largest companies but failed due to excessive financial risk and mismanagement. These examples demonstrate that the riskiness of an investment cannot be generalised by the size of the business. In fact, our best investments have been in small to medium sized businesses that we have analysed with detail. The detail of the financial statements tells us the story of the business, its strengths and possible weaknesses. Only the detail can give us an objective measure of an investments’ true risk.

Pleasant outcomes of searching for small to medium sized businesses

Our definition of small to medium sized companies are those with a market capitalisation of less than $1 billion. Provided we have examined the detail, we favour small to medium sized companies. We have found several pleasant outcomes of doing so.

First, these companies have more potential for growth. These small to medium sized companies are usually younger businesses that have found a competitive advantage in a new industry niche. Compared to large, established businesses (think Telstra (TLS:ASX), big 4 Australian banks) which are established and grow slowly, smaller companies haven’t plateaued yet. They aren’t as heavily regulated and have more potential for upside.

Second, these companies are more likely to have strong founder ownership. The founder may still be involved in the day-to-day operations of the business and has not yet sold off their stake in the business. They are still hungry to see the success of their business. Conversely, large companies have complicated ownership structures and have many conflicting stakeholders to align and manage.

Third, these companies are more likely to be overlooked by institutional investors. Large institutional funds focus on larger companies because they have a lot of funds to deploy and smaller companies are too small for the size of investment they are after.

Provided that we are satisfied with the quality and risk of the business, our experience of investing in smaller companies has been a positive one and we continue to favour them in our search for quality long term investments.

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