Kelpie Capital – An Update

To those who have been wondering what has happened to the blog over the last few months,  and remarkably there have actually been a few emails of concern, I thought I owed you all an explanation.

I am soon to start work at a new firm and due to my desire to maximise this opportunity I fear I will no longer be able to devote as much time to writing. I will still post occasionally if I have something that I believe is particularly worth saying however the frequency may drop to a quarterly comment on the portfolio/macro and maybe the odd stock idea if I have one.

Personal Dealing rules at my new employer also mean that I will have to trade substantially less and therefore I will be outsourcing much of my portfolio to fund managers and maintaining a few key long term holdings.  I have attached my remodelled portfolio below.

I will of course be staying on top of developments at the individual companies and therefore am more than happy to discuss with any interested parties.

Kelpie Capital July Factsheet – Value Will Out



Ouch!! That’s what this month felt like, particularly on the last day when the market enjoyed a face-melting rally into the quarter end with the Aussie Dollar, Euro and S&P moving very strongly higher and therefore against me.

The problem this month is that basically, everything went wrong. Kelpie was down 1% relative to the FTSE All Share which was up 3%. The largest holdings in the portfolio did poorly;

  • Third Point Offshore down 3%
  • Energold down 10%,
  • Zicom Group down 12%
  • Aberdeen International down 12%
  • Sandstorm Metals & Energy down 21%

Pretty tough in a rising market! The hedge book took some serious pain costing the portfolio several percentage points.

The only strong performer in the portfolio was Yukon Nevada Gold, up 13%, which made several major announcements particularly drawing a conclusion to their “turnaround” and announcing that they are up and running as a fully producing gold miner on track to achieve 150,000 ounces for the year. Should they meet this target the stock is very cheap on all metrics, they are a possible takeover target in the near future.

The underperformance of the portfolio is in my opinion due to many of the positions being “deep value” in a time where the market has been rewarding momentum and quality at any price and ignoring the cheaper segments of the market. The charts below from Cannacord Genuity demonstrate the wide gulf in factor performance.


Below we can see the quarterly performance of value relative to the market. This is demonstrably one of the longest and deepest periods of value underperformance we have experienced. What can be seen in August 03 and Feb 09 is that these periods were ended by very strong rallies where the market re-assessed the sustainability of these ultra cheap stocks and rewarded them with higher, more realistic valuations. It is my contention, and that of the analysts who put together the data, that we are due another one of these periods of outperformance soon.


Regular readers of the blog will probably know that there is a vast array of academic research on the long term outperformance of value factors but for those who don’t or those looking for a quick refresher, I recommend the following from Eyqyuem Investment Management.


The UK Economy & Housing – Last Post on the Bugle – The Bear Case

“It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair, we had everything before us, we had nothing before us, we were all going direct to Heaven, we were all going direct the other way.” Charles Dickens in 1859 “A Tale of Two Cities”

“Will the last person to leave Britain please turn out the lights. The Sun Newspaper, 1992 Election

“Britain’s economy is a must avoid….Gilts are resting on a bed of nitroglycerine” Bill Gross – “Mr Bond Market”

“Much has been written about panics and manias… but one thing is certain that at particular times a great deal of stupid people have a great deal of stupid money.” Walter Bagehot, ‘Essay on Edward Gibbon’


In this post I am going to venture into deep waters, discussing several of the macroeconomic headwinds facing the UK and ultimately why I think this is a very large negative for two assets I am trying desperately to limit my exposure to; the Pound Sterling and UK Housing. I will be testing the bounds of my limited circle of competence here as I am not a trained economist but hopefully for everyone’s sake I’ll be able to keep it simple and thankfully many of my sources have already done the hard work!


The UK Economy

The 2000s were a decade of growth for the UK, but that growth was an illusion. It was not borne out of productivity gains or of diligent savings but instead out of rising debt levels. Our seeming prosperity was, and remains, false.

From 1996 to 2010 exports and investments as a share of GDP declined whilst government consumption grew. The UK economy stopped selling things abroad, stymied private sector investment and instead focused on the expansion of its own government sector. As you can see below Public Spending as a percentage of GDP moved up from a trough in 1999 of 37% to today’s level of 46%.

From 1999 to 2009 public spending grew by 53% and public debt rose 73% (before including exceptional costs like the bank bailouts), despite all this spending, an effective stimulus or boost to growth, Real GDP grew only 16%. A painful example of the inefficiency inherent in government directed spending.

The growth that the UK has had over the last 10-15 years has been heavily reliant upon the extension of credit at every level of the economy; household, corporate, financial and government.

If you combine public and private borrowing, the UK has since 2003 borrowed an annual average of 11.2% of GDP, a clearly unsustainable amount. When the government deficit jumped from 2.4% to 11.2% between 2008 and 2009 all the government was doing was filling the void by replacing the private demand for borrowing which had been crushed by the global financial crisis.


Swimming in Debt

The chart below put together by Morgan Stanley serves to highlight the scale of the problem. The entire developed world is mired in debt but we really seem to be leading the pack, partly as a result of our banks failed attempts to take-over the world in the middle of the last decade. As a percentage of GDP our financial sector exposure is vast compared to other nations, even the apparently banking centric Swiss.



“Households took on rising levels of mortgage debt to buy increasingly expensive housing, while by 2008 the debt of nonfinancial companies reached 110 per cent of GDP. Within the financial sector, the accumulation of debt was even greater. By 2007, the UK financial system had become the most highly leveraged of any major economy…” (UK Budget Report, 2011)


Reliance On Ex-Growth Industries or the Public Sector

“Three of the eight largest sectors of the economy – real estate, construction and financial services – have enjoyed huge growth fuelled overwhelmingly by private borrowings. These three sectors alone account for 39% of economic output.

Another three of the ‘big eight’ sectors (accounting for a further 19%) are health, education, and public administration and defence, each of which has grown as public spending has ballooned.” Dr Tim Morgan

In my opinion there are still way too many financial sector jobs. The financial sector not only employs around 1.1m UK workers but they are often some of the best paid and the sector contributes massively to the UK tax take at around 12% of total tax revenue (PWC 2010 report) relative to their being around 5% of the workforce. The sector is shrinking inexorably but at a very slow pace, I see substantial downside risks to property and employment prospects in finance hubs like Edinburgh and London. However, the UK economy as a whole is highly geared to FIRE (Finance, Insurance and Real Estate) jobs so this shrinkage does not bode well.

The chart below shows the extent of the rebalancing on the UK economy that has taken place over the last 20 years with the “FIRE” sectors stealing share from the traditional industries.


Austerity is going to be a struggle given the current backdrop, the economy is already in recession whilst Europe implodes and the US slows dramatically. There is a comparison with Spain which also made commitments to harsh fiscal tightening to maintain the confidence of the bond market. The markets have not responded favourably, punishing the Spanish sovereign yield because they realise that the banks are heavily burdened with housing market losses which will eventually have to be socialised onto the sovereign balance sheet.


How does Financial Repression impact the UK?

“Financial repression includes directed lending to the government by captive domestic audiences (such as pension funds or domestic banks), explicit or implicit caps on interest rates, regulation of cross-border capital movements, and (generally) a tighter connection between government and banks, either explicitly through public ownership of some banks or through heavy ‘moral suasion’.

Financial repression is also sometimes associated with relatively high reserve requirements (or liquidity requirements), securities transaction taxes, prohibition of gold purchases (as in the United States from 1933 to 1974), or the placement of significant amounts of government debt that is non-marketable. A large presence of state-owned or state intervened banks is also common in financially repressed economies. In the current policy discussion, financial repression issues come under the broad umbrella of “macroprudential regulation”, which refers to government efforts to ensure the health of an entire financial system.” Carmen Reinhart


Regulatory changes like Basel require increased capital for non sovereign assets. The effect seems to be that in these times of extremely scarce capital banks are forced to own UK gilts as these are afforded a zero-risk weighting and therefore improve capital adequacy. The interlinkages between banks and sovereigns increase whilst the return on assets for banks is ground down by these low yielding holdings.


Price Discovery

House prices are interesting to me because price discovery is so slow to happen.

If people selling their house aren’t offered what they believe their house is “worth” they just don’t sell and therefore realised prices are always slightly better than the price at which you could sell on any short(ish) time horizon. Because there is no daily quote on property, there is also no volatility which makes property owners feel much more secure than they should. Your house is not subject to a constant bid like the stocks in your portfolio are. You are also not leveraged 10x on your stock portfolio like you might be on your house – something worth thinking about!


A Global House Price Bubble

As the chart below demonstrates the problem of a housing bubble was truly global, however it also shows that in the post bubble world the German and UK markets have not suffered anything like the declines that the other major markets have.

One might argue that part of this is capital flight from the European periphery nations flowing into the closest safe havens. If that were the case then hopefully my analysis above suggests that the UK’s safe haven status is misplaced and furthermore one might consider how permanent that capital is – what happens if the Greek shipping magnates decide in a few years that it’s to repatriate their wealth? Do you know many people who can afford a £8m two bedroom apartment in SW1? If so, do please point them in my direction.


Housing in the UK takes up a world leadingly disproportionate share of our income. Now an Englishman’s home is his castle but this has always been thus so why has the multiple of disposable income doubled since the 30s or 50s when I’m sure our predecessors were just as house proud?

“Comparing a typical dwelling price with per capita personal disposable income. Such a comparison shows a significant mean-reverting tendency) for real estate prices over time for most countries (the UK appears to be an exception here). It provides some important evidence that the US market is at a very low value in relation to income levels (also this is true for Germany and Portugal).”  Julian Callow, Barclays Capital


House Price to Earnings Ratio

The house price bubble in the 1970s in the UK was the result of 30% YoY increases but houses still only topped out at 3.8x average income, falling to 2.8x by the end of the mid 70’s. Today real wages are stagnant to declining and the price/income ratio remains elevated at 5x having peaked at 6.5x.

Now clearly there are only two ways for this ratio to mean revert – a sustained increase in wages so that we grow into housing affordability or alternatively a downward adjustment in house prices. Which seems more likely in a recessionary, over-indebted, 8% unemployment economy; a wages boom or a house price fall?




Repossessions – An Inventory Problem

Property market bulls point out that mortgage arrears and house repossessions have peaked at much lower levels than during the crash of the early 1990s.

(Source: FSA Dec 2011 Mortgage Report)


Repossessions and arrears have been less pronounced during this crisis because the economic crash was so much worse than the 1990s downturn. Because UK banks have been in such a fragile state, “extend and pretend” or “ever-greening” have been the tactics du jour. The government and mortgage lenders have gone to huge lengths to stop any tidal wave of repossessions.

According to the FSA, 5-8% of all mortgages are subject to some form of forbearance. This might mean moving to an interest-only mortgage, reducing your monthly payments, taking payment holidays or increasing the term of your mortgage. All of these steps help the borrower stay current and help the bank pretend they don’t own an impaired loan.

These clearly distressed but currently propped up mortgages aren’t included in arrears statistics and so the headline statistics.

Analysts at the FSA examined the payment patterns of these mortgages which are in arrears. Their report showed payments received as a percentage of normal expected payments due were down to 58.3% of the contractual amount.

Around 8.5% of mortgage borrowers in northern regions were in negative equity, where the loan amount exceeds the property value, in Q4 2011, compared with 3.3% in the south. Ratings agency S&P said that borrowers in the north were 30% more likely to be behind in mortgage payments than homeowners in the south.


Interest Only Mortgages

The chart below shows that in 2007 three quarters of interest-only loans taken out had no repayment plan backing them. This is nothing more than a call option on rising house prices. These interest only products just did not exist prior to the housing bubble.

Both parties to the loan are implicitly assuming that the house will at some point be sold for a higher price to pay off the principal. This is Hyman Minsky’s Ponzi finance in action.


MoneyWeek says “These mortgages are a big problem for lenders. They account for 36% of all mortgages outstanding (43% if you include buy-to-let mortgages). During the next ten years, 1.5 million interest-only mortgages with a value of £120bn (10% of all outstanding mortgages) are due to be repaid. How?

Who knows? Some will be backed by sensible repayment plans, but we wouldn’t be surprised if many have to be extended, putting further stress on lenders and borrowers….


The problem with the UK is that the housing market and the banks are two sides of the same coin. If the housing market falls to sensible levels of affordability, then the banks will be in trouble.”

Government policy has been targeted at protecting the banks and not requiring them to realise losses on housing related loans or securities. Because of this the housing market is taking longer to correct. The problem is that precedent suggests this may not work, Japanese banks were allowed to extend and pretend but it turned them into zombie institutions still struggling with the bubble hangover twenty years later. The housing market has been held up by cheap money and lax policy. For reference the Japanese property market is down around 80% since their peak.



Unwilling Lenders – The Banks

 “Ongoing economic uncertainties and high unemployment will likely cause many consumers to postpone moving home or buying for the first time, depressing demand for new mortgage loans. On the supply side, unsecured bank debt has fallen increasingly out of favour with investors, and lenders’ pursuit of secured funding alternatives – in the form of RMBS and covered bonds – has triggered a relative renaissance in these sectors.

But the costs of all types of funding remain high, and combined with tougher regulatory capital requirements, this may incentivise many lenders to curb lending or even shrink their balance sheets.” Andrew South,  Standard & Poor


If we pretend that the chap above doesn’t work for a ratings agency, his points are quite credible. Banks are looking to quietly and gradually offload their commercial and residential inventory in the hope they don’t flood the market and collapse prices, however they are cumulatively a huge weight of supply which will cap prices for years to come. We have a Mexican Standoff where no banks want to liquidate as it will damage prices and they would rather extend and pretend. However, each bank wants to be the first to liquidate because it knows the liquidations will force prices lower.

With unemployment rising and home values falling, lenders are less willing to provide new credit or refinance existing loans. Last year, £141bn of mortgages were originated compared in the U.K. with £363bn in 2007, according to the Council of Mortgage Lenders.

This all matters of course because without the extension of loans there is no-one to buy property. Rental yields are not yet attractive enough to provide compelling unlevered returns and the average family or FTB must get a mortgage to participate. In a deleveraging balance sheet recession world where financial repression is part of the policy toolkit it is completely rational that banks take the proceeds of loans that are repaid and roll that money into government bonds rather than their mortgage book. This will improve their capital base and risk weighted assets. There is however a fallacy of composition in that what is right for one bank to do becomes a systemic issue if all banks act the same way.

The growth of credit extended to the Private Sector is intuitively a very strong predictor of the changes in house prices in the UK.


Extreme Sensitivity to Interest Rates

Regulators are requiring banks to strengthen their balance sheets and make greater provisions against loans. The effect of this is a creep higher in all funding rates but particularly on standard variable rates which comprise almost 70% of outstanding mortgages in the country.

Low rates have masked the extent of the UK’s problems as they have forestalled consumer deleveraging. Lower rates have postponed and prolonged the emergence of mortgage and consumer loan delinquencies as they remain serviceable and current.

Fixed rate mortgages now equate to only 30% of the mortgage market as banks have shifted the risk of changes in interest rates onto the borrower via variable rates or “trackers”. The average Standard Variable Rate is 75bps higher than the average 2 year fixed mortgage. Using the average outstanding loan value this equates to an increase of £900 per year or almost 25% of UK average real disposable income.

The risk here is huge given the already stretched households.


More worryingly, the SVR spread over base has jumped to 300bps and creeping higher from a pre-crisis average of around 150bps.



The great thing about demographics is how predictable they are. We can say with near certainty that we know now how many 40 year olds there will be in 10 years time looking to move from their first home to their main family residence. Unfortunately the demographic pyramid tells us the answer is – quite a lot less than we might need. Now demographics are not destiny but without a major change in immigration policy they allow us a glance at the secular quantum of buyers and sellers in the future.

As the UK ages the demand for housing will decline, the velocity of transactions will decrease as people do most of their moving when they are younger, the under 25s move twice as often as the over 50’s. The eldest segments of the population also require fewer square feet per person than families do. Furthermore, older people are less capable or willing on average of bearing the debt burden of a large mortgage and are unlikely to lever up to buy a house. Although the UK’s demographic time-bomb is not as bad as some other countries like Japan’s or China’s it is considerably worse than the US’s young, dynamic and constantly evolving population. Rather than a middle age spread one would desire a pyramid shape to the chart below.


For each person that moves back into their parental home, or each elderly person that moves in with their children, another unit of excess inventory is created. Despite current record low interest rates most young couples cannot afford the average house – the most logical way for this re-adjust is with lower prices. The average age for a first time buyer in the UK is 35 years old; compared to 31 in the United States. Given the cultural similarities it is fair to assume much of this differential is down to affordability.

Home ownership is waning due to unemployment, inability to meet mortgage standards and a general disdain that is beginning to take root for owning an asset which is no longer guaranteed to appreciate. The fact it’s no longer a certainty to make you rich, a huge mindset shift from a few years ago, may make young people question if home ownership is worth the hassle – rent or stay with your parents instead. A secular shift to a realisation that houses are liabilities and not assets is perhaps afoot.


Unhealthy Growth – Rising Inequality

The gap between rich and poor is greater in the UK today than at any stage in the last 40 years. It is wider in the UK than in three quarters of OECD countries.


The Currency

No-one needs to own Sterling. Our fiscal largesse and austerity mirage would suggest that we have the benefit of being a reserve currency or a global trade currency – we do not.
The currency market will eventually reflect the reality that most of the fiscal austerity of the Conservative government is an elaborate ruse with government spending today £22bn higher than it was in 2008 and only down 1% or so on last year. Given the squanderous starting point this is hardly drachonian.

I believe sterling has benefited from being a comparative safe haven relative to the Euro over the last 24 months. Unfortunately, I think we have more in common with the Italians or Spanish than we do with the Germans.


I believe that we don’t just have an overvalued property market in the UK but that we are also facing many structural, societal and financial problems which does not justify the current premium placed on home ownership that assumes it is a productive asset rather than a liability in which we make a home.

The UK has serious problems with those that will become the property buyers of the next two decades. There is excessive youth unemployment, an oversupply of graduates possessing a skills deficit for real world jobs, an all pervasive entitlement culture and an intergenerational rift where parents appear to have spent their children’s inheritance and priced them out of their future.

Many graduates have been led to believe that because they possess a degree they have a god given right to highly paid, highly engaging employment in the industry of their choice but alas we do not have need for 25,000 Photography graduates each year or the thousands of degrees in Forensics driven by a generation brought up on CSI Miami. Not every graduate in “International Business Studies” is going to end up working as Richard Bransons right hand man.

Ultimately, the generation under 30s seems incapable of affording to buy their parents house having struggled through the Great Recession are stymied with patchy work experience and often substantial student debt that must be addressed before home ownership or saving even considered. A further 5-10 years of painful deleveraging and scarce growth is not going to help ease these painful adjustments to a harsher reality of lowered expectations and bruised egos.

If you have a plan to sell your house then I think you should do it pretty quickly (I sold an investment property last year) and if you are considering buying then you should perhaps consider the timing or whether you buying for profit or as a home.

It wouldn’t surprise me at all to see house prices at the same level they are today in 5-10 years time, the greater question will be whether they merely stagnate or whether we see a fall of anywhere up to 40% allowing the market to clear and buyers to swoop in.


Prozac Nation

  • Britain ranks 28th in the world for overall quality of its education system – behind Romania and Costa Rica – despite a doubling of spending since 2000.
  • Only 55 per cent of young people get a C or better in GCSE English.
  • The number of prescriptions written by NHS Doctors has risen 300% since 1997
  • 2 million Brits regularly rely on prescription drugs to have sex.
  • Britain ranks 89th in terms of regulatory burdens on business – behind Zambia, Saudi Arabia and Egypt.
  • Public spending on Advanced Technologies relative to GDP puts us behind Angola and Rwanda
  • The scale of our intractable tax system ranks 95th in the world behind Zimbabwe and Guatemala.
  • 1.8m households (7% of total) are currently on the waiting list for government housing.
  • estimates that in 2011 there were 930,000 empty homes across the UK.


Further Reading:


Third Point Offshore (TPOG.L) – An “Alpha Master” at a Discount



Price –  930p

NAV – 1166p

Discount to NAV – 20%

Third Point is the biggest holding in my portfolio because I believe it gives me exposure to one of the greatest investors in the world at a substantial discount to the value of his portfolio. Better still, I think his macro aware, event driven, value oriented process is one that will hopefully thrive in a poor broader market environment.

Third Point’s multi asset class, long/short approach also offers an attractive alternative to direct equity investment at a time when I believe broad markets are still looking expensive. Historically the fund has provided better than equity returns and Dan Loeb has commented recently that they feel they have become much better at managing volatility lower.

“A manager who has become overconfident by using a bad process is like somebody who plays Russian roulette three times in a row without the gun going off, and thinks they are great at Russian roulette. The fourth time, they blow their brains out.”  Dan Loeb, October 2011


The Listed Vehicle

Third Point Offshore Investors Limited, was IPO’d on the London Stock Exchange in July 2007 and raised $523m, to be invested solely in the Third Point Master Fund via an Offshore Feeder Fund. This may sound complicated but it’s pretty standard hedge fund structuring.

2007 saw a raft of hedge funds listing closed end investment vehicles, some of which have proven successful (Brevan Howard, Bluecrest) and others which have not (Dexion Absolute and Thames River Multi-Hedge). The idea was a means to have permanent capital, with no need to worry about redemptions, and further to raise the profile of the firm through a public listing. There is no additional layer of fees so there is no tracking error between the movement of the company’s NAV and the performance of the offshore hedge fund.

The timing of these listings was poor from the perspective of someone who subscribed at the offering. The market was topping out and hedge funds globally were about to have a pretty tough time through the GFC. Third Point lost 32.6% in 2008 despite being short a large collection of RMBS and banks. It is worth pointing out that while Third Point faced the large redemptions that plagued many hedge funds during the financial crisis, it did not implement a gate or “side pockets”. They met all their redemptions without delay.


Dan Loeb

Interest in Dan Loeb and Third Point should increase on the back of his featuring in the new book “The Alpha Masters” by Maneet Ahuja.

In that interview he says “We’ve never defined ourselves as one kind of firm and we’ve never really deviated from that flexible approach. Instead, we’ve deepened our research process, and hired people who brought us expertise in different geographies, different industries, and different asset classes. Our philosophy is to be opportunistic all the way across the capital structure from debt to equity, across industries and geographies. We invest wherever we see some kind of special situation element, an event that will either help create the investment opportunity or help to realize the opportunity.”


The Track Record

Since inception in December 1996 the Third Point Master Fund has compounded at an annual rate of 17.6% relative to the S&P 500 at just 5.9% over the same period. $1m invested in the S&P compounded to $2.57m compared to $14.5m for the Third Point investors.

Fund returns are pretty lumpy and volatile, for example 48% and 53% in 1997 and 2003 or -38% in 2008. As AUM is now much bigger I would imagine that the returns will be a little bit less volatile as they deal in larger, more liquid instruments now.

In 2009 the fund returned 39%, in 2010 they achieved 35% and in 2011 they were flat. The performance in 2009 and 2010 won them consecutive “Event Driven Fund of the Year” awards presented by Absolute Return magazine.


Current Positioning

For the year 2012 so far the fund is up around 4%.The fund is currently 50% gross long equity with a net long equity of 40%. Third Point is 40% gross long credit and net 20% long. There is a particular focus on long MBS and long Distressed Credit.

Finally “Other Assets” are 21% long and 9% net long. I imagine that a large part of this is their holding in Gold which is the second biggest holding in the fund.



The shares currently trade at about a 21% discount to NAV. This discount was nil at the IPO, and even traded at a slight premium to NAV before the market crash. The discount was widest in late 2008 when all hedge fund investments and anything that seemed illiquid was getting dumped senselessly.


5 Year View

If we are to imagine that a combination of size, vast wealth and a very choppy macro environment makes it difficult for Dan Loeb and his team to generate the same quantum of returns they have in the past. Let’s assume that the CAGR over the next 5 years is reduced to 10% from the 17.4% CAGR since inception. I think this is a conservative forecast because the funds were still pretty large in 2009 and 2010 where they posted great returns.

From today’s NAV of 1166p at 10% CAGR we would get to a 2017 NAV of 1877p. If the discount remains at the current width then the share price will be just under 1500p. If the discount was to be fully closed to the NAV then we would be looking at a total return from today’s share price of 100%.

A bull case would say Third Point can use their large capital base and knowledge across the capital structure to generate great returns over the next 5 years and therefore maintain that 17% CAGR. That gets TPOG to a NAV of 2556p by 2017, a 178% premium to today’s prices.


Below the Radar

The stocks are fairly illiquid, particularly the Sterling denominated one (TPOG) but across the three major currency share classes there is trading volume of around $450,000 per day on average. Not enough volume for wealth managers to allocate across full client banks and this is often the key target market for these closed ended hedge funds.

Listed hedge funds have definitely become an unloved sector as large wealth managers move away from closed ended vehicles to open ended strategies where they don’t have to deal with the problems of liquidity, discounts and bid/ask spreads.

Furthermore, although Dan Loeb is a rock star in the US hedge fund community I have rarely come across a UK based investor who has heard of him! Third Point is not a well known hedge fund in the UK and therefore that must have some impact on the attention granted to “just another” listed hedge fund.

A further soft factor I would mention that I think keeps the natural buyers of Third Point away is the complexity of their strategy. Wealth Managers can tell clients that Brevan Howard’s listed vehicle is a Global Macro fund and that they trade interest rates and currencies; that can just about be communicated effectively. Allan Howard is also one of the richest men in the UK and therefore has a recognisable name.

Telling private clients that you are investing in a fund they’ve never heard of that “goes anywhere across the capital structure”, “invests in special situations”, likes “distressed credits and mortgage backed securities” and that “lost 30% plus in 2008” probably doesn’t play so well.

Kelpie Capital – June Commentary – “A Third False Dawn”

“Each politician pursues self-interest while the common cause imperceptibly decays.” Thucydides.

“Insiders might sell their shares for any number of reasons, but they buy them for only one: they think the price will rise.” Peter Lynch

“In short, the depression IS the “recovery” process, and the end of the depression heralds the return to normal and to optimum efficiency. The depression, then, far from being an evil scourge, is the necessary and beneficial return of the economy to normal after the distortions imposed by the boom. The boom requires a bust.” Murray Rothbard


Yogi Berra might say that the month was like “déjà vu all over again” as the market plunged after a strong start the year, just as it did in 2010 and 2011. This was the “Third False Dawn” of recovery. Furthermore, the worries remain the same: no self sustaining recovery, continued private sector deleveraging, financial sector balance sheets and of course the intractable European currency crisis. The driver of market returns in the short term will likely be driven by “Volitics” the uncertain interaction of Policy Uncertainty and Volatility.

More to Go?

Paraphrased from John Hussman….“Michael Wilson of Morgan Stanley noted “Make no mistake, institutional investors are all in.” Wilson reported that the monthly rolling beta of mutual funds (their sensitivity to market fluctuations) now exceeds 1.10 and is the highest since the previous record, just before the wicked market plunge in 2011.

Institutions hold their largest “overweight” in high-beta sectors than at any time since the start of data, and long-short funds are also near their most leveraged long positions in history. Of course, mutual fund cash levels also remain at record low levels.”

I have found the contrast between Positioning and Sentiment very interesting over the last few years and here we have another big divergence. Investors are panicked but fully invested. The rock bottom level of sentiment is definitely a short term bullish indicator.

Divergences in Index Performance

The valuation differential between the US indexes and European indexes is becoming quite extreme. The chart below shows roughly a 12% outperformance of the S&P 500 over the MSCI World since Q3 2011.

The currently Cyclically Adjusted Price to Earnings for the S&P 500 is 21.1x in contrast with the UK at 13x and the MSCI Europe at 12x.

Now the question is does the US deserve a 40% premium to the other major developed markets? Some European markets are trading at their 1982 valuation lows, levels from which spectacular future returns were earned. In contrast the US is trading at levels only exceeded at 2 or 3 times in the 130 years of historic data; furthermore each of those times would have been a disastrous time to invest. I am quite confident that on a reasonable time horizon these valuations will meet somewhere in the middle.

I recently attended a course with Andrew Smithers where he summed up this problem of valuation metrics defying gravity for extended periods.

“In the long run stock prices demonstrate negative serial correlation; however in the short run stock prices demonstrate positive serial correlation. The problem is determining at which point the short run becomes the long run.”

My short exposure remains focused on the S&P 500 and the Russell 2000 because I believe these indexes are much more overvalued than their European counterparts and that the emergence of a recession in the US is still perceived as a very unlikely event by the majority of market participants.

The “green shoots” (no mention of them since 2009!) in the US turning to weeds could really be the catalyst for the currently resilient S&P 500 turning lower. Elsewhere, HSBC’s China PMI, the earliest indicator of China’s industrial sector, retreated to 48.7 in May from a final reading of 49.3 in April. It marked the seventh straight month that the index has been below 50. The Euro Zone composite PMI, a combination of the services and manufacturing sectors and seen as a guide to growth, fell to 45.9 this month from April’s 46.7, its lowest reading since June 2009 and its ninth month below the 50-mark that divides growth from contraction. Official data also showed the UK economy shrank more than first thought between January and March, after the deepest fall in construction output in three years, while government spending made the biggest contribution to growth.

“Macro Friday” as some were calling it today was a washout. UK data was absolutely terrible with the UK Purchasing Managers Index posting it’s second sharpest decline in it’s 20 year history. The “new orders” segment was at a near catastrophic 42 down from 49 the month before.

US Non Farm Payrolls came in below the estimates of all 87 Wall Street economists at just 69,000 jobs when we need at least 120,000 to keep the unemployment rate stable.

Will QE 3 or LTRO 2 or a EuroBond Save the Day?

The most important question to answer is; can unprecedented, concerted global monetary policy action repeal the business cycle? Can central banks and politicians conspire to prevent a downturn in the economy? My answer to that would be no, because they have not managed it before. It’s not like the current set of leaders are the first to be extremely averse to a downturn on their watch, these things just happen, growth flows and then it ebbs – it is the natural order of things.

It seems quaint that only a few years ago the concern in Europe was that there would be “contagion” risk resulting from a Greek default. So worried were they that we had almost-daily pronouncements that Greece would not be allowed to default, that there was no need for a Greek default, the developed countries no longer defaulted, etc. Now that Greece has defaulted, the line in the sand is “That was just Greece; no other country will need to default.”

But just in case, European leaders created all sorts of funds, guaranteed joint and severally, to help bail out nations in trouble. First Greece, then Ireland and Portugal. Even with all the money that was raised, it was not enough to prevent a Greek default. And the “new” debt is trading at around 10% of its issue price.

Spain is too big to save and too big to fail. The only way for Spanish debt to remain at 6% is for the ECB to basically buy it (or lend to Spanish banks so they can buy it, or whatever creative new program Draghi and team can think up). When Spain goes the bond market will look to Italy and then to France. The line must be drawn with Spain. The only outfit with a balance sheet big enough that can also do it in a politically acceptable manner is the ECB, and the only way they can do it is with a printing press. I had actually written the first part of this paragraph earlier in the month – on the 31st May the market turned around on rumours of an IMF rescue package for Spain. This is truly absurd, this is exactly the US led (as largest partner in the IMF) bailout of Europe that was categorically ruled out in the past. Another example why ignoring the politicians is the only logical strategy.

From my perspective the market is not yet fully weighing the situation of Spain or Italy becoming more fully embroiled in the currency crisis and/or capital flight via deposits. The Spanish Bond/Bund spread continues to widen.

In Germany, Merkel’s CDU party won 26% of the vote in the North Rhein (Germany’s most populous state) down from 35% in the previous election. Her rivals the Social Democrats got 39% and the Greens got 12%. The Dutch Prime Minister was unable to reach agreement with his government on budget cuts and therefore resigned.

The growing support for extreme parties at either end of the spectrum has been quite predictable. Nothing has been done to address the structural issues in Europe. Painful solutions are postponed and fudged whilst voters refuse to face reality and politicians refuse to speak frankly about the extent of the problems. The time that has been bought by LTRO’s and Quantitative Easing has essentially been wasted.

Videos to View

ECRI re-affirm Recession Call

Charles Dumas on Euro Crisis –

Russell Napier on Europe –

Gold & Gold Miners

Gold has really been dull so far in 2012 basically flat to the end of May. Yet despite this the case for gold is stronger than it was at the turn of the year. The Emperor has no clothes.  See this quote from Eric Sprott

“The fact remains that here we are, in May 2012, and Greece is right back in the exact same predicament it was in before its March 2012 bailout. Before the bailout, Greece had approximately €368 billion of debt outstanding, and its government bond yields were trading above 35%. On March 9th, the authorities arranged for private investors to forgive more than €100 billion of that debt, and launched a €130 billion rescue package that prompted Nicolas Sarkozy to exclaim that the Greek debt crisis had finally been solved.

Today, a mere two months later, Greece is back up to almost €400 billion in total debt outstanding (more than it had pre-bailout), and its sovereign bond yields are back above 29%. It’s as if the March bailout never happened… and if you remember, that lauded Greek bailout back in March represented the largest sovereign restructuring in history.”

In this context then, with the crisis proving chronic why has the gold price been so frustrating? I think it lies in the difference between the demand for paper gold and the demand for physical gold. Traders are liquidating paper gold in a “Risk OFF” play whilst long term investors are accumulating physical to protect their wealth. The net is a redistribution of the metal but no change in the price. Eric Sprott highlighted that China posted another record Hong Kong gold import number in March of 62.9 tonnes. Gold imports into China have now totaled 135.5 metric tonnes between January and March 2012, representing a 600% increase over the same period last year. These numbers are incredible!

Global central banks have also continued to accumulate physical gold, with the latest reports revealing another 70 tonnes of gold purchases completed in March and April by the central banks of Philippines, Turkey, Mexico, Kazakhstan, Ukraine and Sri Lanka.

Despite all of this gold only represents about 0.15% of global pension fund assets. The large institutional pools just do not have an allocation to this asset class. The total market cap of all precious metal miners is about 2/3rds of Apples.

Gold, gold mining and mining investment or royalty vehicles are a substantial holding in my portfolio at around 14%. These stocks are cheap on almost any measure, but the same could have been said a few months ago at 30% higher prices. One way to look at mining stocks is to compare them to the price of gold itself. See below from Sitka Pacific Capital…

While instructive, this measure doesn’t do you a lot of good if the price of gold is set to drop precipitously. Consider the case of 1980, when gold was experiencing an epic top and the mining stocks seemed to anticipate the lack of sustainability of the move, driving ratio of miners to gold to low levels. That said, the ratio has provided a pretty good clue to what future long-term returns will look like. Consider the following chart from John Hussman:

This final chart is something to get excited about – sentiment towards gold miner is now at 2009 lows. The combination of low valuations and terrible sentiment gets me excited.

Will Defensives Always be Defensive?

Murray Stahl made some very insightful points in his latest quarterly commentary regarding the perceived defensive nature of the Healthcare and Defence industries because of their lack of earnings variability.

They highlight that spending on national defence and spending on healthcare have grown year on year regardless of the state of the broader economy or market. This discretionary spending by global governments, particularly in the developed west has been the tide that has lifted all boats in these industries but there is no guarantee that this will always be the case, especially should governments catch austerity.

US government forecasts show that by 2017 they will be spending $104bn less on defence than they did in 2010. After eight decades of constant increases these are profound changes that long term investors must consider.

Kelpie Capital June Factsheet – Performance

For the month of May the FTSE All Share declined 7.3% and the Kelpie Capital portfolio declined 2.1%, a very strong relative result but actually one that disappoints me due to many stocks in the portfolio behaving “riskier” than I believe the underlying economics should dictate. Capital was protected but I still give the month a C+ grade.

Some of the more speculative positions in the portfolio went from cheap to what appears outrageously cheap.

Aberdeen International now has around half it’s market cap in cash and has a portfolio at a greater than 50% discount to NAV. The yield is now 5% and their is a buyback in progress.

JZ Capital Partners reported what I consider to be pretty strong results and addressed several of the issues holding the stock back, the share price barely moved. It has £180m of a £240m market cap in cash, Gilts and listed equities, this allows shareholders to pay only £60m for a £260m private equity and corporate debt portfolio. This doesnt factor in their history of striking profitable deals and growing the NAV.

Yukon Nevada Gold has been the most tortuous investment of my short career. The turnaround is seemingly 80% complete and the mill is running at levels which should allow the company to hit it’s target of >100,000 oz of production. I think they will get there and hopefully when they can confirm this and communicate it to the market the stock should at least double. If they can make a $400 margin on each ounce that would leave them trading on 6x current earnings with the capability to triple production in the next 3 years and the asset backing of a very recently completed $170m refurb on the strategic roasting mill which has conservatively been valued at $500m. Not bad for a stock valued at $270m.
Tullett Prebon is trading on around 6x earnings with a near 6% dividend yield. It is the 2nd largest player in an oligopolistic industry and sits with about a quarter of the market cap in net cash and the CEO with an enormous ownership stake. I get the impression that Terry Smith would find a way to make money in a nuclear holocaust.

Braemar Shipping Services offers it’s owners an 8% dividend yield, trades on less than 10x what could arguably be trough earnings and again has a robust balance sheet with no debt, some property and 25% of the market cap in cash. Despite the cyclical nature of the business, it is owner operated and remained profitable throughout the last downturn which was particularly savage to global shipping.

New Positions

Tullett Prebon

Cisco Systems

Axia NetMedia

Braemar Shipping Services

Positions Added To



British Empire Investment Trust

Positions Sold

Aware Inc



British Sky Broadcasting

Zicom Group (ZGL.AU) – Extremely Mispriced Growth Business


First off, I’d like to thank Joe at for alerting me to this idea, his site provides a great source of links/articles from around the web.

In my opinion, Zicom Group at around $0.20 offers investors a low risk and deeply undervalued exposure to a number of “GDP plus” growing end markets with a conservative and proven founding family operating the business. Whilst we wait for the market to re-evaluate the prospects of this business and it to trade at a premium to book value, like it deserves, we get paid a 5% plus dividend yield and allow management to opportunistically buy back shares to increase our ownership. The stock currently trades at a 20% plus discount to Net Tangible Assets.


Zicom has 3 main Divisions comprising the vast majority of revenues and profits.

1)      Offshore Marine Oil & Gas (circa 40% of revenues)

2)      Construction (circa 40% of revenues)

3)      Precision Engineering & Automation (circa 15-20% of revenues)


The Divisions

Offshore Marine Oil & Gas (circa 40% of revenues)

Zicom is one of the world’s leading manufacturers of high spec, heavy duty winches and deck machinery for use on large marine oil & gas vessels. They supply to shipbuilders and ship owners, some of their winches can weigh up to 300 tons and therefore are very large pieces of kit! The key variable for long term winch demand is deep sea oil & gas exploration.

Orders for deck machinery products lag orders for the production of new rigs or vessels by about 12-18 months, this means that the current weak orders still reflects a bit of a hangover from the implosion of demand during the financial crisis. The order book still looks weak at only SGD $42m, or around half of what it was a year ago. We might be hopeful that in 12 months time the order book looks much better.

The main competitor to Zicom in the manufacturer of winches is the UK’s Rolls Royce, obviously a giant in comparison which has its pros and cons. This is clearly a non core business for Rolls Royce and this perhaps allows Zicom to get an edge on customer relations/meeting client needs.

Demand for offshore products in general is likely to be relatively robust above $80 per barrel. The oversupply of vessels from the boom/speculation era and the subsequent slump is starting to clear and E&P companies are starting to spend on projects again.

In the 2011 Directors Report there is reference to a resurgence of demand for offshore rigs which they say has resulted in a “gradual build up” in enquiries which they expect to gain momentum in the next 12 months.


The “Offshore” Marine Oil & Gas division also designs, builds and installs “onshore” turnkey gas processing plants and gas flow regulation systems across Asia. This is a relatively new line of business and is still growing, orders are lumpy and can have a large affect on numbers. There is a goal to grow this part of the business so that is equal with the winch business in doing around SGD $60m per annum revenue.

Zicom supplies process plants for the recovery of gas from refineries. This captures the gas that is normally flared off as part of the process of extraction, separates it and sends it to the refinery. Each plant has a cost of around SGD $10m so they are substantial orders. Alas, the current natural gas price probably is a disincentive for these projects but they still could have a payback period of under 5 years.

As an example of the group’s long term focus and using their robust balance sheet in their favour, they used weakness in May 2008 to deploy SGD $5m into the building of a new factory in Singapore for this division to position it better for the future.

There is a further growth avenue available in “Remotely Operated Vehicles” which are increasingly required for offshore deepwater drilling. The construction division manufactures the frame and the offshore division tailors it to customer spec.


Construction (circa 40% of revenues)

I view the Construction segment as the boring, dependable part of the business. The core of this division is the manufacture of concrete mixer trucks for which they have a dominant 70-80% market share in both Australia and Singapore.

The secondary part of the construction division is the “foundation equipment” business which hires equipment like large vibratory or piling hammers or boring machines. Zicom owns the largest vibratory hammer in SE Asia weighing in at 42 tons!

The division has been revolutionised by the opening of a new production facility in Thailand which consolidates their Australian and Asian facilities and which allows them to increase efficiencies dramatically helping margins. The new facility was a SGD 10m investment to improve the long term prospects of the business and this is already starting to show in margins.  Concrete mixer and foundation equipment demand is of course quite cyclical due to a dependence on construction activity but their geographical diversity and market share helps.

The Australian subsidiary has further diversified into the distribution of gas generators and is looking into waste digesters and biogas generators.


Precision Engineering & Automation (circa 15-20% of revenues)

This division is a specialist equipment manufacturer and niche engineering service provider to customers who require a high degree of specification in their goods, ranging from inkjet cartridges to fully automated production lines to biomedical equipment.


The precision engineering division secured “ISO 13485” accreditation in 2010 which means they can now manufacture entire medical devices in house rather than only being able to make component parts. This accreditation also marks them out as a high quality operator. This competitive advantage has a margin and earnings impact due to pricing power too. The aim here is for the business to partner in co-designing biomedical devices and to make sure that the manufacturing is all done in house too.

Zicom has focused on using its scale to its advantage, focusing on niches and only accepting business that is likely to be profitable and ideally recurring so that a relationship can be built with the customer and revenues become more predictable.

In the last 2 years the group has made a substantial commitment to this part of the group by doubling the floor space of their factory and by making three strategic investments in start up companies which possess “disruptive technologies” which can be manufactured and monetized through this division’s expertise. Zicom has targeted “high valued added synergistic products” that have the potential to revolutionize their industries, these are clearly high risk/high reward targeted investments in areas close to their existing operating circle of competence. Any one of these products being a “hit” could result in exponential earnings growth and they already have the factory capacity to grow into.


3 Shots at a Home Run within Precision Engineering

1)      BioBot Surgical (46% ownership for SGD $3.5m)

This is a surgical robot for taking prostate samples for biopsy. This robot has been proven to increase sample accuracy and minimises patient embarrassment and invasion.  A study in Singapore’s largest hospital showed that over 4 years it doubled detection rates. The product has received regulatory approval in Singapore, Australia, Europe and the USA.


2)      Curiox BioSystems (40% ownership for SGD $3.2m)

Pharmaceutical research and diagnostic testing scientists require plates for their assays. Curiox has developed a “drop array” technology which has proven to be more accurate, increase the speed of the cleaning process, improve productivity and lower costs. Testing with a “leading US Pharmaceutical company” showed a reduction in cost of use of 85% and a 60% saving in time. Curiox has sold 2 units so far (as of June 2011) to the US company and to a Japanese pharma who are now using it for real production.


3)      Orion Systems Integration (54% ownership for SGD$2.55m)

Progress has led to computer users expecting greater power on smaller devices over time which requires chips to be smaller and lighter too. Orion possesses a technology in “Thermal Bonding” which overcomes the limitations of conventional bonding whilst improving performance.

The attractive thing about this basket of investments relative to the share price is that most of the investment is complete having purchased the equity stakes and secured regulatory approvals/testing. The cost of failure from here is minimal but yet the upside is potentially very high.


History of the Company

Zicom was established in 1978 by the Chairman GL Sim and took itself public in 2006 by way of a reverse takeover. The business has grown via small acquisitions and organic growth. This is, and has always been, a family business with a focus on long term, profitable relationships and a strong internal culture. GL Sim owns 35% of the business and is Patriarchal figure which ensures very low staff turnover and a collegiate approach. Both of his sons are in the business after completing their education at prestigious US Schools

JK Sim also owns 10% of the company. The Chairman’s two sons own 1% of the company between them.

Insiders have purchased 1.3m shares over the course of 2012 so far. Looking further back, they have purchased 15.6m shares (7.3% of shares outstanding) in the open market since May 2010. This is a very strong signal that those closest to the company believe it is substantially undervalued. Some of these purchases were done 50% above current prices and 500,000 were bought at double the current price. I couldn’t find a single insider sale in that period. Either the family are just totally wrong about their business, which is possible, or they are really taking advantage of Mr Market’s myopia.


Capex done, now for the rewards?

Capex has been at a high level for the last few years with the investments and new floor space in Precision Engineering, the Thai factory in Construction and the factory in Singapore for the Marine business. Going forward, management have guided that this will be lower although they retain flexibility to make strategic acquisitions/investments into the disruptive technologies they are starting to favour.

In the 2011 annual report management highlighted that they had forecasted $3m of capex in the current year, the reality is likely to come in below $2m, an indication of their prudence.

It is worth highlighting that the cash pile within the company and the quality of their PPE has been growing and improving throughout the last 5 years which has included dividends, all that expansionary capex and a global financial crisis. If they were to start to run the business for current profits or cash flow the effects could be remarkable.


Ownership Structure – Long Term Family Business

The comments of the Chairman GL Sim ooze conservatism and suggest a broad macro perspective, giving me great comfort that he is the steward of this business. From his November 2011 Chairman’s Address

“The world’s global economic situation has deteriorated with the possibility that the fall-out could be worse than the 2007-2009 Global Financial Crisis.”

“It is therefore prudent to assume that the current financial crisis that follows seamlessly from the GFC can be expected to inflict serious damage that may last for some years to come…..(economic) cycles for changes have become shorter and sharper.”

“The key planks of the Group’s sustainable growth strategy consists of continuous focus on strengthening our organic growth while embarking on synergistic acquisitions and investments in disruptive technologies fully financed by internal resources. These form the buttressed foundation of our growth platform, to position us to weather economic adversities rearing in our horizon.”

“The group is continuously looking for opportunities for expansion….Such opportunities may arise during periods of adversity. We position ourselves to be ready for it.”

From the 2011 Annual Report

“The group achieved record revenue and profits for the year just ended. These results have been achieved from the groups focused efforts and directions. The Group’s focus in continuously growing organic growth and, at the same time creating avenues for horizontal growth, by investing in disruptive technologies from its internal resources has buttressed the Group to achieve sustainable growth into the future.”

GL Sim, the chairman, has committed to the business for a further 5 years with his salary frozen at 2007 levels – something that even more closely aligns his interests with the performance of all the equity he owns.


Balance Sheet Strength – Trading Below Tangible Book Value

The last time the shares were trading at this level in September 2010 coincided with the company initiating its first buyback programme. The share buyback programme was renewed on September 1st 2011.

It’s worth remembering too that the A$28m of Property, Plant and Equipment on the balance sheet is supported by the substantial investments made in 2008 and 2010 in large, new factory space which will likely still be worth around the same amount. The point being that these book values are not unrealistic prices.



Knowing that Zicom Group is trading below Net Tangible Assets we already know that we have a margin of safety in the stock, now we can make a conservative assessment of what the stock might be worth if the market afforded it a reasonable valuation.

To be conservative, we will assume that all three investments in the disruptive technologies flame out and produce no earnings. This seems extremely unlikely since they have already started generating sales and seem to provide genuine advantages over their incumbent technologies but let’s run with it.

Over the last 6 years which includes the GFC the average earnings for Zicom were A$0.045 per share. Six years ago Zicom had a much smaller capital base and had revenues of only A$35m which is only about 30% of 2012 expected revenue.

Putting an 8x multiple on these cyclical earnings we get to a share price of A$0.36 which is almost a double from here. I think we can agree that these are very conservative estimates.

It is also worth re-iterating that the company has remained profitable throughout the crisis and has the balance sheet strength to capitalise on economic weakness rather than fall victim to it.


Exchange Rate Risk in Earnings

ZGL earns the majority of its revenue in Singapore Dollars but yet the listing and earnings will be in Australian Dollars. Therefore there is substantial conversion risk each quarter to make earnings more volatile than they truly are. Weakness in the Australian Dollar will make earnings appear better than they actually are, strength in the Aussie will make earnings appear weaker than the economic reality.


Way Below the Radar – Sloppy Analysis

“Overseas Discount” – one of the very few research reports I could find of Zicom stated that the fact that management are based in Singapore and operations are based in Thailand and Singapore that this is sufficient to justify a permanent valuation discount. Ehm, the last time I checked Singapore was pretty “first world”, I don’t think this makes any sense at all. The rule of law is very much applicable in Singapore.

One broker ceased coverage of ZGL despite previously having a price target of $0.85 (a four bagger from here!) because they have a lack of confidence in forecasting earnings due to inconsistent outlook statements. I suspect that it might be more to do with a “what’s in this relationship for us?” though process.

The stock “will not appeal to many investors” due to the smaller market cap and limited liquidity. Unfortunately, this is probably correct but just because it doesn’t appeal to institutions that like to play on the safest of grounds doesn’t mean that it doesn’t offer an attractive opportunity.

The “share buyback should be suspended”, this was justified in that it makes an illiquid stock even more illiquid by retiring shares that were once in the free float. However, at such a steep discount to tangible value there is a substantial value add to buying back shares at current prices and this mindset has no consideration of an ownership mentality.


Why has the Share Price collapsed?

One large passive owner (Ventrade Pte) owned 8% of the company and has been liquidating their stake over the last year, this has resulted in an uptick in volume and a consistent, fairly inconsiderate seller.

The tiny market cap of only $40m AUD ($20m free float) means that anyone with a capital base of more than $10m will struggle to pick up sufficient stock or bother doing the due diligence.

The most recent earnings report was very weak with revenues, margins and profits all declining substantially. This means that the stock has seemingly poor operating momentum and doesn’t look particularly cheap on a multiple of current year earnings basis. These factors above plus the cyclical nature of their business operations means most investors will stay well clear until there is greater clarity on the outlook.


Kelpie Capital – May Factsheet


“The temptation to quit will be greatest just before you are about to succeed.” Chinese Proverb

“Many shall be restored that now are fallen and many shall fall that are now in honour”  Horace


Over the month of April the value of the Kelpie portfolio fell by 4.4% relative to the FTSE All-Share which was down 0.7%. The portfolio was damaged by large declines in major holdings Energold, Yukon Nevada, Gigaset De, IDT Corp, Genie Energy, Sandstorm Metals & Energy and SanDisk. It was a month where my idiosyncratic portfolio just looked idiotic.I sense a strong contrast between operational performance and share price performance; Gigaset, Energold and Aberdeen all posted good results and their share prices declined from what I already consider undervalued levels. The only bright spot was Aware Inc which was mentioned in a previous monthly for having valuable IP assets – these were sold for a sum roughly equivalent to the market cap causing a 60% rise in the share price on one day.

The biggest change in the portfolio positioning for the month was probably an increase in gross exposure via adding some long positions and increasing short exposure to offset that market risk. The reason for this is the loosening in what have been pretty high correlations between all stocks and also the sharp decline in investor sentiment as shown below. My personal view on this is that a 4% peak to trough decline in the S&P causing this much damage to sentiment demonstrates a dangerously skittish and myopic market with particularly weak and flighty investors. This makes me think the internal dynamics of the market are not sufficiently robust. However, this much pessimism usually presents potential opportunity.

In what were much more turbulent markets in April it was easy to become rattled and start to worry about holdings as their value fluctuated substantially on a daily basis.  I went through a piece of quick and dirty analysis where I examined the financial position of some of my holdings by looking how much of their current value sits in readily deployable liquid assets net of liabilities. This back of the envelope, look through analysis gives me comfort that many of my holdings have the flexibility and cash on hand to use weakness to buy back stock or to make strategic acquisitions to expand their footprint.

In general, the calculation I used was (Cash & Short Term Investments – Total Liabilities)/ Market Capitalization as of 10th April.

Some of the stocks I had to make adjustments for things like restricted cash etc but this table is not exhaustive, merely instructive and re-assuring.

Unfortunately, judging whether the market is going to go up or down on even a 12 month horizon is exceptionally difficult. As you extend that time horizon out however it becomes, somewhat counter-intuitively, easier to determine the general direction. Returns are a function of only 3 things, starting yield, growth in dividend and a change in the valuation or multiple afforded to the earnings.

From this very simple model we can sense check the predictions of the bulls who proclaim valuations are at 20 year lows and destined to perform well from here. Many market participants are currently predicting 10% per annum type returns going forward we can work backwards and see what assumptions are “baked in” to that enticing claim.

The current yield on the S&P 500 is just below 2% so we know that 8% per annum must come from dividend growth and a change in the multiple. Now if we ignore that the Shiller P/E and Q Ratio suggest 40% overvaluation and just use a fairly generous 15x multiple on current earnings of 88 we get to 1320 on the S&P 500 which is 5% below current levels. So as far as I’m concerned the best we could hope from the valuation factor is that it’s gravity like pull of mean reversion will not detract from returns.

So that means the 8% should come from the income growth element of returns but this seems optimistic relative to the long run real growth of just 1%.

Further context would consider that S&P 500 earnings are at all time highs and therefore might moderate for a while, corporate profit margins are also at extremely elevated levels and corporate profits/GDP are at levels not seen since the depression suggesting long term unsustainable inequality.


A Q2 Stall for the 3rd Year in a Row?

Multinational profits have benefited since 2009 from a potent cocktail of emerging market growth, global labour and tax arbitrage, sustained government deficit spending.  Many of these tailwinds have slowed considerably and we are leaving the sweetspot of 2012.


Analyst estimates have been moderating for a while but they have further to go, in the UK for example the consensus currently expects a rise of just 0.9% in non-financial earnings for 2012 relative to 7.9% in the US.


In 2013, US EPS growth is forecast at 12.7% relative to the UK at “just” 9%. These numbers suggest to me that expectations have further to fall in the US and my increase in short exposure there reflects that.

Analysts are obviously expecting a massive growth pick up into the latter half of the year.  The stockmarket is pricing in 4% GDP growth and I think we’ll be lucky to avoid a global recession. Now that is a variant perception. It seems unlikely to me that the P/E multiple can expand from already somewhat elevated levels at a time when analyst estimates will be coming down and growth might disappoint. Who is really going to shoot the lights out this quarter with great growth rates apart from maybe Apple (which is down 10% from its recent peak)?


Policy Driven Markets

A recent McKinsey Global Institute report reviewed 36 examples of balance sheet recessions since 1900. The standard response in about 50% of cases was a mix of belt-tightening, currency depreciation, modest inflation and export led growth based on that devalued currency. Whilst this option may be open to an individual nation it is not available to the developed world as a whole; not all currencies can devalue simultaneously and who drives the export led growth?

In the remainder of balance sheet recessions the resolution was by either high inflation or default. Defaults tended to occur in countries that borrowed in foreign currencies and high inflation in those countries which had the ability to create their own currency.

“I have absolutely no doubt that when the time comes for us to reduce the size of the balance sheet that we’ll find that a whole lot easier than we did when expanding it.” Mervyn King, Governor of the Bank of England

“One hundred percent.”  Ben Bernanke, Chairman of the Federal Reserve in response to a question asking what degree of confidence he had in his ability to control inflation.

Q4 2011 marked a clear shift in policy emphasis towards the high inflation option. As I stated in last month’s factsheet central bankers have chosen their path. The Bank of Japan, the European Central Bank and the SNB are coming under increasing political pressure from beleaguered politicians and embattled electorates to “do something”. If we have another growth scare they could move further towards promoting growth and protecting the banking. Markets have proven to be extremely reactionary and policy driven over the last few years. There doesn’t seem to be any major intervention on the cards for the next 3 months so where do the markets go?


A short in the Aussie Dollar against the US Dollar represents one of the largest positions in my portfolio at around 18%. The rationale was explained here

As demonstrated below there is an obvious relationship between China Power Output and Chinese GDP growth. What is perhaps less obvious but more interesting is the relationship between Chinese power output and AUD/USD. In Jan 2012 Chinese electricity generation was down 7.5% year over year which seems pretty significant to me even allowing for the Chinese New Year.


The Most Incredible Chart of the Last 5 Years

Anyone who knows me has been sent this chart over the last few years and this is the most recent update I could find. What is absolutely amazing is not only how unprecedented the 2007 recession is but also how recessions since 1981 have been getting consecutively worse.

This would possibly vindicate my long held belief that “the jobs aren’t coming back”, the problems are structural not cyclical, the blue collar industries and lower middle class jobs of the US and Europe are gone, outsourced and automated. New industries (Shale Drilling, Healthcare, IT?) will eventually replenish most these jobs but this may take a decade for re-training and re-orientation. In places like the Euro-Zone we just don’t have that much time.


Positions Added

British Sky Broadcasting

The Weir Group

Astra Zeneca

SanDisk Corp

Positions Increased

Gigaset De

Aware Inc

British Empire Investment Trust

Berkshire Hathaway


Positions Decreased

Physical Gold ETF


Positions Sold

Investors Title Insurance Company

British Empire Investment Trust (BTEM.L)


“It was luxuries like air conditioning that brought down the Roman Empire. With air conditioning their windows were shut, they couldn’t hear the barbarians coming.
Garrison Keillor

“Look to the past and remember no empire rises that sooner or later won’t fall.
Al Stewart


British Empire Investment Trust has been added to my portfolio because it is uniquely positioned amongst funds at the crossroads of a number of themes that appeal to me.

-          Discount to NAV

-          Owner Operated Businesses

-          Strong Track Record

-          European Equities

-          No Sell-side coverage/ Institutional Sponsorship

-          Concentrated Portfolio

The British Empire Investment Trust managers believe that their edge is maintained by keeping a very small investable universe relative to most of their “Global” investing peers. They focus on conglomerates, investment holding companies, asset backed investments or investment trusts trading at a discount to their own NAV. They think that this area of the market is particularly susceptible to inefficiencies and mispricing because their universe doesn’t possess any “natural owners” in the institutional world and often the stocks are quite hard to categorize or pigeonhole into sectors.


Price – 413p

NAV – 467p

Dividend Yield – 2%


Discount to NAV

The trust currently trades on an 11.5% discount to NAV which is as wide as it has been since inception.  Because of the nature of many of the conglomerate or investment holding companies, BTEM offers what can be considered a “double discount”. For example, Jardine Strategic is an Asian family holding company of which BTEM is a long-term owner, they believe that this stock trades at a 40% discount to its own NAV; so purchasing this via BTEM allows you to get an 11.5% discount on a portfolio containing Jardine Strategic on a 40% discount. Getting a dollar for sixty cents is good but buying it for 54 cents is better.

Asset Value Investors calculate a “look-through” NAV on their portfolio which they currently estimate at around 40% which is the highest level since their calculations began and has widened from 23% in 2010 and 39% as of the Annual Report in Nov 2011. They calculate this “look-through” NAV by using either tangible NAV, peer comparison or sum of the parts analysis, it is not exact but they have proven prescient enough in their calculation of business or asset values in the past. At the widest discount in their 26 year history, I believe that we can take comfort in the level of undervaluation. To quote Strone Macpherson in the Chairman’s Statement this year “These underlying discounts have historically proved to be an excellent source of good returns for shareholders as markets stabilise and start to improve.”


Strong Track Record

The track record of the BTEM managers Asset Value Investors (AVI) is a very strong one indeed as demonstrated below. AVI was founded in 1985 to manage just £6m and the majority of the increase in funds under management up to today’s £1.2bn (of which BTEM is £800m) has been the result of internally generated compound growth rather than gathering new assets. In 2003 the company was involved in a management buyout from owners Aberdeen Asset Management meaning it is now wholly owned by the small team of investors who run BTEM ensuring their skin is well and truly in the game. I found it quite hard to get data on insider ownership but what I found amounted to £16m worth of shares across the staff and the board. This seems plausible however the transaction data I found shows lead manager John Pennink buying £1.2m of shares in January 2012. This is listed as his only holdings in the trust which I just don’t believe given how long he has been managing it for and the track record. I’m sure he owns substantially more but cannot verify it.


I believe that BTEM will prove to be an excellent steward of my capital over the course of these lean years. I will quote from John Pennink’s 2010 Annual Report.

“What concerns us is that the challenges to economic growth are in many cases structural issues that require difficult and painful reform and are not going to be solved by QE and low interest rates. Central Bank reflationary policies may turn out to have harmful side effects that outweigh their benefits. The beneficiaries of low interest rates and QE are banks and other financial institutions but the average person is hurt by low returns on savings, a stagnant job market and higher inflation. It is hard to build sustainable prosperity on this basis.

As long as reflationary policies are seen to be working, however, the equity markets may continue to rise but we foresee periodic sharp corrections as market participants realise that developed economies remain stubbornly weak.

Overall, the equity markets may not make much progress. In this sort of environment, the equities that we find appealing are those with strong balance sheets, high dividend yields and high discounts to NAV. It will pay to find those companies that have their own catalysts in terms of restructuring potential and unrecognised value. We are trying to find a mix of assets to allow us to ride out the as yet uncertain effects of this experiment with monetary easing.”


Owner Operated Businesses

Investing in owner operated businesses is a favourite tactic of mine because you are more likely to find management act in a shareholder friendly manner if they are major shareholders themselves. Family controlled holding companies like Groupe Bruxelles Lambert (GBL) or Jardine Matheson have numerous advantages for long term value investors.

-   Diversification across various industries

-  Focus is truly long term, these businesses are often dynasties with a multi-generational management.

-   Exposure to assets which are unlisted/unavailable to normal investors.

-  They are often illiquid and institutional investors seem unwilling to do the analysis on them.

These stocks are currently despised by the market, hence the massive discount to NAV but this has not always been the case. In 2006/7 these stocks were very much “in play” with hedge fund arbitrage and the discounts narrowed dramatically. There is no sector wide catalyst but eventually the discounts tend to narrow as a result of investor attention or corporate actions unlocking value. As you would expect, valuations dictate the level of exposure the portfolio has to these stocks, in 2006 after the discounts had narrowed substantially only 25% of the portfolio was in these companies as opposed to 55% today. The allocation reflects the opportunity set.


European Equities

I laid out the case for turning relatively bullish on European Equities in a previous post here…

Ultimately, much of Europe is now at a level of CAPE valuation where returns are very good almost regardless of what is going on in the macro environment. The holding companies that BTEM owns are often European (Vivendi, Investor AB, Orkla, Aker, Deutsche Wohnen) and some contain relatively cheap European equities with the additional conglomerate discount layered on top.

About 41% of the portfolio is in Continental Europe and 4 of the Top 5 holdings are European (totalling 27%).


No Sell-side coverage/Institutional Sponsorship

A cynic would say that research analysts from sell side firms are only assigned to cover stocks and sectors where the investment bank or brokerage divisions can leverage their work to make good commissions or fees.

Investment Bankers must be sick of these conglomerates and family owned holding companies, they aren’t particularly acquisitive, they don’t take on much leverage because they don’t want to jeopardise their reputation or their hard-earned wealth.

Brokers can’t make much money from them either, the volume in these stocks is quite thin and the average holding period is a lot longer than your average stock so they don’t get the turn or churn in clients portfolios either. It’s difficult to justify a quick buy and sell of a stock like Jardine Matheson or Jardine Strategic, the owners of which can trace their involvement in the company back to 1832. Furthermore, the controlling Keswick family have had five generations of the family in the business – these companies are about much more than a stock price, they are a family tree, an inheritance and they are legacy.

Because of this awkward reality, a browse through most sell side research databases would have you believe that these companies do not exist or an in some way inferior, the lazy “conglomerate discount” tag being used to keep price targets unnecessarily low. This is the reason why the investment holdings companies and conglomerates are mispriced.

A second angle to this institutional disinterest lies on the “buy-side” and explains why I think Investment Trusts are attractive going forward. The Wealth Management and Asset Management industries are undergoing great change. Wealth Managers and private client stockbrokers have traditionally been the holders of investment trusts but “fashion”, size/liquidity constraints and desire to minimize benchmark risk have meant that there is a wholesale move across the industry out of “old fashioned” investment trusts and into the newer style of unit trusts or OEICs which are open ended and do not have premium/discount issues. They are also attracted to the hidden fees/remittances available through OEICs rather than investment trusts.

So I think that means we have a structural, but not particularly time pressured, non-economic seller slowly liquidating their shares in Investment Trusts. Personally, I think BTEM is particularly likely to be sold by these large firms because it is particularly hard to put in a “style box” – what is it? Global Growth? Property? Equity Income? Alternatives?  It’s nothing in particular and for some reason, these institutions seem to hate that!


Concentrated Portfolio


Description of the Top 5 Holdings

Vivendi – A French telecommunications and media conglomerate that trades on a discount of over 40% to the sum of its parts. Vivendi owns stakes in companies operating in the music, games, television, films and telecoms industries.

Orkla – A Norwegian conglomerate operating in the branded consumer goods, aluminium and energy sectors. A streamlining of the business may narrow the discount to NAV which currently stands at 35%. Orkla could be the Norwegian Unilever.

Jardine Strategic – Controlled by Jardine Matheson, an investment vehicle for the Keswick family, trades on a 38% discount to an attractive collection of Asian listed companies including Hong Kong Land, Dairy Farm and Mandarin Oriental.

Investor AB – A Swedish industrial holding company that owns significant shareholdings in major public multinational companies as well as private companies in the healthcare sector. Investor AB takes an active owners ship role in many of the companies and currently trades on a 37% discount to estimated NAV.

Aker ASA – A Norwegian conglomerate whose interests range from oil and gas exploration to seafood processing. The company currently trades on a 32% discount to estimated NAV.


SanDisk (SNDK.O) – Uniquely Positioned to Win?


SanDisk was founded in 1988 by Dr Eli Harari who remained Chairman and CEO until the end of 2010. The company is a world class, pure play, technological innovator in NAND flash memory storage which is used in a wide range of devices for which traditional spinning disk storage isn’t appropriate such as digital cameras, USB drives, tablets, smartphones and certain high end laptops. The company also receives royalty streams from various competitors such as Samsung for the use of their technology.

I first came across SanDisk when researching the industry of a previous holding Western Digital, but I didn’t dig too deeply until I saw it mentioned in the T2 Partners year end letter as one of their top 10 holdings. Of course the reason that Western Digital was so cheap was because the HDD business is in secular decline, mostly because of the increasing capacity and affordability of the products produced by SanDisk and its peers.

SanDisk stock presents an excellent buying opportunity because the current price meaningfully underestimates the future cash flow potential of a company that is intertwined as a vital facilitator in the growth industry of smartphones, tablets and increased data storage globally in enterprise and in our private lives. I view SanDisk as a high quality Growth at a Reasonable Price idea. It is also a “Magic Formula Stock” which means that it is attractive on a purely quantitative basis. I can see the stock trading well into the $60-70 range over the next year or two offering 50-70% upside.

You probably recognise the name from memory cards for your digital camera or USB stick but that was the SanDisk of 2008, the rest of the world has begun to catch up to their technology which is increasingly embedded in all high end computer devices.

Product Descriptions

Imagine 128GB of memory inhabiting something smaller than a penny. SanDisk has just made it a reality, in its relentless, market leading pursuit of better, smaller, faster flash memory storage solutions.

SanDisk specialises in NAND Memory which is a type of non-volatile storage technology that does not require power to retain data. NAND flash has found a market in devices to which large files are frequently uploaded and replaced. Mp3 players, digital cameras and USB drives use NAND flash. Flash memory is much more expensive than traditional HDD memory, but it is more compact, durable, offers faster access and uses less power, so its usage has grown dramatically with the proliferation of mobile computing and the increasing sophistication of peripheral electronic gadgets. A consensus is emerging that flash drives will be used for requirements of speed and power efficiency and older HDD’s will be used for needs of capacity. Online transactional processes and high frequency trading are two good real world examples where SSD has a functional advantage worth paying for.

To quote Whitney Tilson in T2 Partners year end letter…

“Historically, the flash memory business has been commodity-like, with chronic excess capacity and rapidly declining prices. Due to industry consolidation and explosive growth in end demand, however, we think SanDisk is on the verge of very strong secular growth, with improving margins, which should lead to explosive profit growth and a meaningful revaluation of the stock. The best stocks are ones that combine high earnings growth and an expanding multiple on those earnings, and we think SanDisk is poised for both.”

SanDisk is an industry leader and has two very important strengths that should lead it to sustained success: its distribution channels and its low cost leadership. First, it has a strong global reach with 57 percent of its sales being international and has at least a 28 percent market share in all parts of the world including a 34 percent market share in the United States and a 32 percent market share in Europe. Second, the company has a lot of relationships with consumer hardware companies including Apple, Samsung, HP, Dell, Nokia, Motorola, and HTC.

When these companies’ products are bought, they come embedded with a SanDisk storage device, so consumers become familiar with the SanDisk brand and are more likely to use the SanDisk memory devices. Third, the company’s products have a very strong retail presence. SanDisk reports that its products are available at over 250,000 stores worldwide and are available at 19 of the top 20 consumer electronics retailers in the United States.

SanDisk is able to use its high cash flow and position at the front of the market to fund research to cut costs and stay ahead of its competitors. This way, it can outprice them, maintain and expand on its market share, and increase revenues and profits.

Industry Summary

The NAND market is mature and oligopolistic with a few major players dominating supply (Samsung, SanDisk, Micron and Hynix). Furthermore Apple currently constitutes around 30% of global demand for NAND storage and has the influence to move prices based on their new product releases.

The NAND market has doubled in size in the past 5 years, going from $12bn in 2006 to $25bn in 2011. The multi-year growth story looks likely to continue due to growing demand from smartphones, tablets, notebooks etc.

To emphasize the rate of change and growth we are seeing here, we can pretty much say that tablets didn’t exist 3 years ago and now they are an integral part of many lives.

A slide below with a selection of consumer end products that SanDisk memory is embedded within.

SanDisk is probably the industry leader for innovation and technology as evidenced by their being the first to produce sub 20nm scale of miniaturization, something which was previously thought impossible. The jargon at this point begins to bamboozle me but I read that they were the first to design, patent and sell a “4 bit per cell architecture at 43nm node” and that a greater proportion of their production and sales are done at the cutting edge of technology than their peers. This is demonstrated in the use of their “X3 Technology” which has a 15-20% cost advantage over what the competitors are using and is in around 50% of SNDK production.

One of the biggest concerns to pricing power in the industry is that supply outstrips demand, due to a downturn or exuberant expansion of capacity from suppliers. Pricing is volatile in these markets and this was one of the problems faced by HDD producers leading to volatile quarterly earnings. The participants in the NAND market appear to be behaving rationally and all are talking about cautious expansion of capacity in line with demand and no-one seems willing to slash prices to take market share. On top of this, only SanDisk (35%) and Samsung (40%) have sufficient scale to materially affect the capacity growth of the total industry. SanDisk has also indicated they will use “non-captive” supply which essentially means outsourcing production as that retains flexibility, enhances cash flow and protects them from building out excess capacity in house. This is prudent although it is not profit maximising, non-captive supply has margins of around 10% relative to 40% for their own supply.

In summary, it seems that the participants are all acting rationally and although supply growth will be healthy as manufacturers expand their facilities, it will be not be sufficient (on current ramp up forecasts) to remove the tightness in the market due to the superior demand growth. This means that margins and profitability are likely to protected and the curse of excess capacity is less likely to plague the industry.

Enterprise Market

SanDisk has taken steps to move away from the retail/consumer market which it traditionally served with its USB sticks and memory cards towards servicing businesses, a market which is currently growing faster. With their May 2011 acquisition of Pliant Technology for $318m, SanDisk is ready to exploit the full range of possibilities in the market by producing high performance solid state drives (SSDs) to transform cloud and data center applications by reducing physical office space requirements, purchase cost and power usage.

Within the mass storage market there is increasing focus on “speed of access” to data rather than purely cost per gigabyte, this switch obviously favours NAND over traditional HDD. This adds just another element to the potential growth story in the flash storage market.

Toshiba JV in Japan

SanDisk does not directly produce their flash drives, they do so via a JV with Toshiba in Japan. The benefit of this is cost sharing and a reduction in the capital intensity of SanDisk’s business. These high volume manufacturing facilities allow the company to ship more than two million flash products every day, and have contributed to a 50,000-fold reduction in the cost of flash memory over the last 20 years.

This is listed as an asset on the balance sheet marked at a value of $2.2bn however in reality it produces no profits to SNDK and costs them money each year as it is essentially their factory. The properties and capacity is clearly worth a substantial sum if they were to sell their share back to Toshiba however.


SanDisk has a portfolio of patents and is not shy about litigating to protect them. In addition to its NAND products SanDisk benefits from IP royalties it receives to the tune of around $350m per year from licensees like Samsung and Hynix for using their patented technologies. Because of the nature of these revenues they cost SanDisk nothing and come in as near pure profit.  The fact they receive these royalties is testament to their technology leadership within the industry.

Balance Sheet

SanDisk has a rock solid balance sheet with $5.5bn of cash, short term investments and marketable securities against long term debt of $1.6bn equating to a net position of $3.9bn, 39% of the market capitalization or $16 per share. SanDisk has the strongest balance sheet amongst the 20 largest semiconductor companies according to Nomura.

In October 2011 SNDK announced a buyback programme totalling $500m over the next 5 years. They have previously completed a 2 year $300m program over just 12 months in 2006 so I am hopeful they will be accelerating the purchases at current prices. In Q3 2011 they also retired $222m worth of convertible debt, further strengthening the balance sheet.

The Apple Opportunity?

Apple is the most important individual customer to the entire NAND market accounting for 30% of global demand and around 10% of SNDK revenue (does the market even know this?). Apple is popularizing the benefits of flash memory in its many consumer products however it is possible that Intel will advance the cause further by adopting them in their ultrabook for the consumer and enterprise spaces. Is this the first sign of a move away from HDD for even laptops? Once you have experienced the immediacy of flash memory it is quite evident that HDD is an inferior product.

Apple has an increasingly litigious relationship with Samsung which has the potential to put their major strategic NAND relationship in jeopardy, throwing up an opportunity to steal the market’s biggest customer.  It could be argued that only the SanDisk/Toshiba JV has the scale and expertise to step up and take Samsung’s place as supplier number one to Apple – Micron and Hynix are just too subscale. News on this could be a major catalyst.

Certain people have even suggested that it makes sense for Apple to just buy SanDisk to secure supply and use some of its massive cash pile. Certainly the SanDisk earnings would be awarded a much higher multiple under the Apple banner. Seems unlikely but something to think about.

The Cloud – Opportunity or Threat?

In 1999, the idea of a new paradigm pushed the multiple on anything related to the computer industry or the internet to dizzying highs. Since then it has been a relentless grind lower and it’s simple to explain why; the industry had no revolutionary themes for investors. Tech investors are by their very nature growth orientated innovators, they don’t like the incumbents, they like the disruptors. As Ben Rogoff of Polar Capital’s Technology Fund joked to me once regarding my value orientation “Don’t bring your sh*t to MY party!” Interestingly, he observed that historically tech investors have seldom made money after the multiple on stocks in the sector has contracted, the money is made when these growth stocks go from expensive to extremely expensive during the adoption phase. Now, the industry and investors have found a new revolutionary theme: cloud computing. The “marquee” cloud name is and it trades on something like 600x earnings.

“Cloud Computing” is defined as “The practice of using a network of remote servers hosted on the Internet to store, manage, and process data, rather than a local server.” The threat is that we no longer need hundreds of gigabytes of storage in every home as we download everything we need from a central library in the cloud. If network speeds are high enough, why would anyone need local storage? This would mean the total storage required would vastly reduce and the storage market NAND and HDD would shrink dramatically. This is the reason that SanDisk trades like a stock in run-off mode.

YouTube quoted their database at 45 Terabytes in 2006 and by 2011 they were saying 9000 Terabytes. This growth seems likely to remain exponential for the foreseeable future as more leisure time is spent online. The one thing we can all probably agree on is that “content” will continue to be produced, arguably at an increasing rate due to the democratization of dissemination that home studios, webcams, YouTube, blogs etc have all brought about. Furthermore the quality and size of the content is increasing, whereas previously a movie video file was 700MB now an HD movie can consume 4 or 5 gigabytes, a six-fold increase. Content is cumulative too, books written 300 years ago are getting digitized and adding to a global library alongside blog posts and video diaries created today. Content production of any sort requires storage, and whether it is stored on the cloud, on an external hard drive, on a tablet, on a smartphone or all of the above – it WILL be stored somewhere.

We should also remember that there are major security issues involved in cloud storage. How safe really is it? Can it be relied upon 24/7, 365 days a year as most businesses will require? What you might find is that the cloud is viewed as the great big back up drive in the sky and all data is still duplicated on the ground for daily and immediate use/security – good news for SanDisk and their total addressable market. I think it will take years before we all truly trust “the cloud” to be our one and only source for data.

Remember, it was once thought that the development of the PC would lead to a “paperless office”, clearly reality has borne out something quite different! The threat of “the cloud” might be similar.

Sensitivity to Yen Weakness

For the past 5 years SanDisk has been suffering due to relentless Yen strength which has consistently surprised macro commentators. This Yen strength against the Dollar acts as a major headwind to SanDisk earnings as their wafer purchases from the JV with Toshiba which are denominated in Yen. It has been estimated by analysts, and commented on by the CFO, that roughly 1% depreciation in the Yen drives a 1% increase in EPS. SanDisks investments into the JV are also denominated in Yen and therefore their future funding exposure will cost less in a weak JPY environment. Given the overvaluation of the Yen and the arguably extreme fiscal/demographic issues the country faces I would expect material Yen weakness at some point over the next few years. To quote John Mauldin, “Japan is a bug in search of a windshield”. At some point, “speculators” and “bond vigilantes” will turn from the Euro crisis and they are far more likely to look East than to look to the US.

Liquidation Value?

SanDisk management have suggested that they believe the stock is currently trading below liquidation value – this is why they have in place an aggressive buyback programme to reduce the share count and maximise shareholder value. Their breakdown of value is below with one adjustment I made to make it more conservative; they used just Debt of $1.6bn rather than Total Liabilities which I swapped in. Management calculations result in a liquidation value of $42 per share.

JV Wafer Capacity at 50% of value   – $2.9bn

Accounts Receivable at 50% of value  – $0.119bn

Inventory at 50% of value  – $0.24bn

PPE at 50% of value  – $0.135bn

Cash  – $5.5bn

Royalty Value ($350m x 10 multiple) – $3.5bn

Total Liabilities  – ($3.2bn)

Total   = $9.194bn

Shares Outstanding = 243 million

Liquidation Value per Share = $37.83



Given the Margin of Safety demonstrated above in the Liquidation Scenario we can approach looking at a target price with some conservatism. In general, I think if you can’t find that a company is cheap on the back of an envelope it’s not worth doing more work on it. If you do enough Gerrymandering and “assuming” you can make anything look cheap. You can also lose a lot of money.

Analyst estimates for 2013 FCF per share is $7.70 which we can reduce by 20% to account for analyst optimism taking it to $6.16.

Taking the current share price of $42.

$42/$6.16 = 6.8x 2013 FCF or a Free Cash Flow yield of 14.7% per annum.

Let’s also assume that the cash and marketable investments stays flat at $16 per share which is again, probably conservative.  If we net off this from the share price then we are looking at $26/$6.16 = 4.2x 2013 FCF or an ex-cash Free Cash Flow yield of 23.8% per annum.

If we use the analyst estimate numbers without reducing them for their optimistic bias then we are looking at an ex cash 2013FCF multiple of just 3.4x!

Based on a reasonable multiple of 9x a conservative FCF estimate plus the cash & investments gets you to a share price of $71.44 or a 70% premium to today.

There may even be upside to these numbers based on the effective deployment of buybacks at low prices, a substantial weakening in the Yen and the potential for the acceleration in the rate of change in technological adoption by enterprises and consumers.

I see a lot of similarities between SanDisk and my investment in Western Digital last year. The industry is generally seen as unattractive due to the requirements of constant innovation to keep pricing stable, cyclical demand, threats of “the cloud”, the commodity nature of the product etc. I would make two differentiating points – SNDK operates in a much faster growing industry than WDC or Seagate, they are in a sense the disruptors and furthermore, at the price WDC was offered at last year it was a good investment regardless of growth, I think SNDK is priced just as cheaply today despite a much rosier outlook.


The bear argument on SanDisk is that the company’s margins will erode as current and new competitors offer cheaper versions of similar products that SNDK provides. I would address these concerns twofold

1)        SanDisk has the scale and technological expertise to make it the low cost producer in the industry, it would be difficult for someone to maintain profitability whilst trying to steal share via price. For example, in their retail business SanDisk has a 15% price premium to competitors as customers are willing to pay for the brand.

2)        The market for flash memory cards and SSD’s will continue to grow at a fairly spectacular rate and growth can hide a multitude of sins.

SanDisk would have to lose a lot of pricing power and market share to experience large declines in their profitability.


It is comforting to see that SanDisk is a stock where a number of high quality hedge funds have a stake. This is re-assuring because it shows that their analysts (whom I assume are of a pretty high quality given the funds historical performance records) are obviously similarly attracted to SanDisks GARP qualities. Viking Global own $160m of stock, Third Point own $35m of stock (down from $70m in 2011), Balyasny Asset Management own $10m worth and finally T2 Partners own $8m, which I believe is around a 4% position for them. Finally, Joel Greenblatt also owns the stock for his Magic Formula fund.

Insiders also own a substantial amount of the stock too, founder Dr Eli Harari owns $162m worth of stock which he added $3m to in February 2012. CEO Sanjay Mehrota owns $1.8m worth of shares. Catherine Lego, a director, owns $12m and the Chairman, Michael Marks owns $2m.


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