The reward for patience is outsized investment returns

“I strive to discover the proverbial dollar bill selling for 50 cents,
preferably with enough volatility such that I have the opportunity
to buy at 40 cents or less.”

Michael Burry, Scion Capital

In 1996, around the time that Cannon Asset Managers was conceived, we started building an investment portfolio called “SuperDogs” that was intended to capture what we believe to be the essence of investing: finding good assets – that’s the “super” part – at unloved prices – that’s the “dog” part.

The first portfolio was built using a simple and uncomplicated process with four key elements.
i. We ensured that we built a diversified portfolio by investing in companies from each of the main financial and industrial sub-sectors on the Johannesburg Stock Exchange (JSE), which made for 18 sectors in total.
ii. The stocks we bought had to represent established companies, with at least a three-year history on the market.
iii. These firms had to be solvent, with respectable balance sheets and viable operations.
iv. Further, these businesses had to be profitable, ideally underpinned by a regular dividend stream.

We then added one more filter to this broad basket of stocks: the companies had to be “unloved”, with the market’s disinterest in the business reflected by modest valuation multiples. In the portfolio’s early years, we used low price-earnings (p/e) multiples as the barometer to measure investors’ disinterest. Later, we broadened our valuation measures to include low price-to-book (p/b) multiples and low enterprise value-to-earnings (EV/EBITDA) multiples.

The result of this process was the birth of the SuperDogs portfolio: a 54-stock portfolio of “good companies” at “unloved prices” that started life in January 1996. The first SuperDogs portfolio was born with a p/e multiple of 6.8 and a dividend yield of 3.0% versus the JSE Financial and Industrial Index (FINDI) on an earnings multiple of 16.0 with a 1.9% dividend yield.(1)

It is impossible to know just how much time is needed for investment ideas to turn into investment results. But “sooner” is always better than “later”, and 1996 delivered an exceptional result. The 54 stocks that made up the “SuperDogs Class of ’96” produced an average return of 31.0% against the index’s return of 2.1%.

This result was enough to convince us at the end of that first year that we should repeat the process, and we have been doing exactly that every year since, with 2019 marking the portfolio’s 24th anniversary.

“Good” businesses at “unloved” prices: The investment result (2)

“…investing is at its core the marriage of a contrarian streak and a calculator.”
Seth Klarman, Chief Executive, Baupost Group

Starting 1997 on a p/e multiple of 6.5 compared to the market’s 15.6, the investment result for the year was impressive, as the SuperDogs portfolio generated a total return of 18.9% versus the FINDI’s 3.1%.

Put back-to-back, over two year our “unloved portfolio of good companies” had returned 55.8% versus the FINDI’s return of 5.3%.

However, as is the way of investment markets, the heady returns of those first two years were dealt a sobering blow by the Asian and Russian crises of late 1997 and 1998, which saw the SuperDogs portfolio fall 17.6% in 1998 compared to the market’s fall of 9.9%. And even though 1999 witness a strong recovery in financial and industrial companies, the SuperDogs portfolio lagged the FINDI by 12.9% in that year.

From then until now, each year has brought its share of drama and tension. Through this, we have stuck to the process of buying good companies at unloved prices, with the expectation that, in time, the unloved prices of our decent businesses will “come good”.

We are relying on the process of mean reversion, which demands endurance through all kinds of trials, challenges, frustrations, tribulations, annoyances and provocations. This can make it difficult to stay the course. But the rewards for patience and endurance (not to be confused with dogmatism or pig-headedness) can also be “outsized”. Jack Ma, the co-founder of the multinational technology conglomerate Alibaba Group, with a personal net worth of $37.2bn, puts it well:

Today is brutal, tomorrow is more brutal. But the day after tomorrow is beautiful. However, most people will die tomorrow night.

True to Jack Ma’s principles, SuperDogs has persisted and persevered with discipline. We have endured, repeating the investment process to build the portfolio in search of outsized opportunities over a period of more than two decades.

There have been some exceptionally hard yards, including the 31.6% collapse in portfolio value during the global financial crisis of 2008. And there have been some extraordinarily generous years, such as the 75.3% gain in value in 2004 and the 58.7% gain in value in 2005.

The past four years have proven to be particularly challenging. The SuperDog’s average annual return of 2.8% has lagged the financial and industrial market’s return of 5.4%. The return has also lagged inflation of 5.5% over the four years.

Picture1

Source: Cannon Asset Managers (2019)

Four lean years in investment markets would lead many to give up. But this is not the first time we’ve seen lean years. The period between 2006 and 2008 produced an average return of 8.8%, below the FINDI’s 10.3% and barely ahead of inflation of 8.4%. However, staying the course yielded an outsized reward, with a portfolio gain of 72.8% over the next three years.

Going the full distance has given investors an even better result. Over the 23 years from 1996 to 2018, the SuperDogs strategy has returned an average of 19.8% per year, substantially ahead of the financial and industrial average of 13.9% and more than three times the average rate of consumer price inflation of 5.8% per year.

Picture2

Source: Cannon Asset Managers (2019)

An investment of R100,000 put into the index in 1996 would be worth R1.4 million today. By contrast, the SuperDogs strategy would have grown the same investment to R3.9 million over the 23 years.

Picture3

Source: Cannon Asset Managers (2019)

At least two arguments follow from the investment record produced by SuperDogs:

  • While Warren Buffet’s extraordinary investment career has been built on the back of buying “wonderful companies at fair prices”, the results produced by the SuperDogs portfolio suggest that there is an equally strong case for buying “fair companies at wonderful prices”. Over the period 1996-2018, the average p/e multiple on the SuperDogs portfolio is 7.1 compared to the average financial and industrial multiple of 15.8. For every rand that the market is paying for earnings, we are paying 50 cents.(3) In addition, the SuperDogs portfolio has carried an average dividend yield of 3.7% versus the index’s 2.6%. This higher dividend yield offers investors the further benefit of being “paid to wait”.

  • Year-on-year returns are almost impossible to anticipate. Buying fair companies at wonderful prices, and then giving mean reversion time to work, translates into a powerful compounding machine. In the case of SuperDogs, this compounding machine has produced 39-times initial capital over 23 years, while the market index has produced just 14-times money over the same period.
1 Screenshot 2019 02 14 at 22.18.23

Source: Bloomberg and Cannon Asset Managers (2019)

Have we done the hard yards?

“We want to buy dollar bills at 50 cents or less.”
Mohnish Pabrai, Pabrai Investment Funds

There is no way to know whether 2019 will deliver the type of outsized return that characterises the SuperDogs portfolio. What we do know is that we’ve done the hard yards and the dice are loaded. The process that we have built and refined over more than two decades gives us a highly diversified portfolio of 46 stocks from 15 sub-sectors that range from industrial engineering firms to technology businesses.

At formation in January 2019, the portfolio traded on 7.3 times median earnings. Each business in the portfolio is profitable and most are dividend paying, with a median dividend yield of 5.5%. This compares to the FINDI’s 16.2 times earnings multiple and dividend yield of 3.1%. These attributes give the portfolio a margin of safety with the prospect of outsized upside. To borrow from Walter Schloss, “If a business is worth a dollar and I can buy it for 50 cents, something good may happen.”

2 Screenshot 2019 02 14 at 22.20.41

Source: Bloomberg and Cannon Asset Managers (2019)

Investment guru Mohnish Pabrai notes that there will always be arguments, evidence and events that lead to distressed stock prices. South Africa has an abundance of macroeconomic and microeconomic factors that feed Pabrai’s point, including a decade of anemic economic growth, stretched budget deficits, elevated unemployment, deeply troubled state-owned enterprises, infrastructure backlogs and more. The net result is an environment that is replete with “50-cent rands”.

With history as a guide, our fair companies at wonderful prices will deliver good results. The ask is that we need the catalyst; and on this point, mid-cap manager Stan Majcher offers a clear guide to every investor: “Valuation is always the best catalyst.”

Notes on some of our best 50 cent ideas

“It’s not about the dog in the fight, it’s about the fight in the dog!”
50 Cent: Curtis James Jackson III, American Rapper

Leaning on a “canine quote” from American rapper Curtis James Jackson III – better known as 50 Cent – to make a case for 50-cent-in-the-rand investments in the SuperDogs portfolio might be a bit slapstick. But the quote makes the key point that our 50-cent-in-the-rand investments are filled with fight. The SuperDogs portfolio is filled with good businesses bought at wonderful prices. In fact, it would be remiss not to make the point that many of the businesses that we are invested in are more than “good”, and several of them are “great”.

The portfolio weights give some insight on our views. The current top 10 holdings by weight in the 46-stock portfolio are shown below.(4)

3 Screenshot 2019 02 14 at 22.22.34

Source: Cannon Asset Managers (2019)

Sabvest: A deep discount on a high-quality investment portfolio

Sabvest has been a favourite holding in the portfolio over several years. Listed as an investment company on the JSE since 1988, Sabvest has generated a return to shareholders of 54 times capital over its 30-year history under the management of founder and chief executive officer, Chris Seabrooke.

Despite this prodigious long-term result, Sabvest is generally unknown to South African investors and flies under the radar – explained to some extent by the stock’s illiquidity. However, recent corporate action resulted in 36.8% of the company’s total issued share capital being placed in the market, which increased the company’s free float to nearly 60% of issued share capital. We used this opportunity to acquire additional shares for the portfolio at R34.60, which represented a substantial discount to the reported net asset value (NAV) of R54.58. In effect, we paid 60 cents in the rand, and this was for a suite of high-quality assets that have grown at a compound rate of 21.9% per year over the past decade, and at a similar rate over the past 30 years as a listed company.

Telkom: Here’s a new number

Telkom is a leading information and communications technology (ICT) services provider in South Africa, offering fixed-line, mobile, data and information technology services. The company trades on 11.3 times earnings with a dividend yield of 5.3%. Telkom further displays utility-like attributes in terms of performance, with a return on assets of 9.2% per annum and a return on equity of 11.7% per annum.

We value Telkom’s earnings stream at R79.50/share against the current stock price of R66.30; along with a 5% dividend yield, this points to 25% upside in the value of a large, stable and well-run business.

However, alongside the telco assets, Telkom also owns Gyro, a property portfolio company. Gyro’s subsidiaries manage Telkom’s portfolio of 1,332 properties, which includes offices, client-service centres, residential dwellings, land parcels and 6,500 masts and towers.

The insured value of this property portfolio is in the region of R24.0 billion, compared to Telkom’s market cap of R36.0 billion, and it seems that this property asset is being entirely overlooked by the market in pricing Telkom. Our maths suggests that an investment in Telkom at the current price of about R69/share gives you ownership of assets worth more than R100/share.

OneLogix: A valuable delivery

OneLogix Group is a niche logistics provider with logistics experience gained over 27 years of operation. It was listed on the JSE’s AltX market in 2004, and in 2013 transferred to the transportation services sector on the main board.

The group operates in three clusters, namely: (i) OneLogix Vehicle Delivery Services, which is the entrenched market leader in local and cross-border auto logistics; (ii) OneLogix Trucklogix, which specialises in auto logistics for commercial vehicles; and (iii) OneLogix Projex, which has become a key player in the local harbour freight logistics market, project managing the movement of large shipments of abnormal and general freight.

OneLogix recently released interim results for the six months ended 30 November 2018 in which they reported strong organic growth in a weak economic environment, with revenue growth of 26%, growth in earnings per share of 28% and growth in net asset value per share of 22%. Over the course of its history as a listed company, OneLogix has demonstrated an ability to generate strong cash flows (1.8 times operating profit over the last three years) and to sustain an elevated cash return on total assets (15.6% over the last three years).

The strategic Umlaas Road Phase III development is under way; and this should add to Ian Lourens’ impressive record as an astute capital allocator in his role as chief executive officer since 2002. The p/e multiple of 9.1 and dividend yield of 3.1% make for attractive entry points.

Indequity: The market will pay you to buy this business

Indequity is a specialised short-term insurer that operates under its own licence to provide risk products to the professional market, affluent private client market and business market. With 12.45 million shares in issue and a stock price of R4.00 per share, the group has a market value of R50 million. This means it is off the radar of all institutional investors.

We do not imagine the business growing into an industry giant; if anything, we regard the small size as an attribute that allows Indequity to build niche solutions. The small size has also allowed us to build a meaningful investment in a well-run and wonderfully priced business.

In terms of performance, the group has grown its top line without interruption for ten years. In terms of price, the stock is on a dividend yield of 6.1% and a p/e multiple of 5.4 times. We especially like that the company has been buying back its own shares – this is often a catalyst that unlocks value. But even more than this, the company has little debt to speak of and the cash and investments on its balance sheet exceed the market price. This business is not trading at 50 cents in the rand, it is trading “for free” as a classic Ben Graham net-net investment, where we are being paid to buy the business.

Even if the value unlock does not appear, and the market price continues to run sideways, we are perfectly happy to be invested in a growing business that pays a 6% dividend yield, grows earnings, buys back shares and earns a return on equity in the order of 20%. In time, the market will price the asset fairly, and we value the fair price as materially higher than the current market price.

Will 2019 see our good companies deliver outsized returns?

“…never give up and good luck will find you.”
Falkor the Luckdragon, The NeverEnding Story

How does a luckdragon find its way into a serious investment note? Luckdragons don’t have immense physical strength, nor do they have great magical talents. In the world of fantasy novels, this perhaps makes them fair creatures, rather than wonderful creatures. But their persistence, perseverance, wisdom and dignity in the pursuit of good is what sets luckdragons apart.

These attributes bring them incredible luck in everything they do. In Michael Ende’s The NeverEnding Story, the luckdragon Falkor, with his white furred body and canine features, reminds Bastian: “… never give up and good luck will find you.”

Of course, successful investing is never about luck. Rather, it is hard work and perseverance, carried out with a coherent philosophy and through a sound process, that produces outsized returns. These returns might “feel like luck” when they happen, but they are no such thing. These outsized returns are the result of discipline and good process. Buying good businesses at wonderful prices, and staying the course, is exactly such a process.

If history is a guide, the companies that make up the SuperDogs portfolio will deliver good results. What will unlock the trapped value in these businesses is the wonderful prices at which we have bought them. The cases vary and include the Indequity Group as a Ben Graham net-net and the quality of Sabvest at 60 cents in the rand. The net result is a portfolio of 46 good companies that we have bought at 50 cents in the rand.

To borrow from Falkor, our task now is to stay the course, and investment success will follow.

End notes:
(1) The SuperDogs portfolio is built from financial and industrial stocks only. For this reason, the benchmark is the JSE Financial and Industrial Index (FINDI). Consequently, all references to the “market” benchmark or comparator in this note are to the FINDI, unless noted or suggested otherwise.
(2) Note, all returns on the SuperDogs portfolio and all market returns are reported gross of fees. Investment management fees on the SuperDogs portfolio are 1.5 percent of net asset value per annum plus a performance fee of 15% of performance ahead of the FINDI with a high watermark principle.
(3) To be more exact, we are paying 45 cents in the rand for earnings. This is calculated by dividing 7.3 by 16.2, which equals 0.45.
(4) The full portfolio is available from info@cannonassets.co.za.

About Cannon Asset Managers
A member of the Bidvest Financial Services Group, Cannon Asset Managers has built a reputation for results since the company’s founding in 1998. We are true investors, seeking out the best investment opportunities across all asset classes locally and internationally. Through our rigorous research process, we look to buy the right assets at the right prices, rising above speculative thinking, with the knowledge that a sound philosophy, patience and resilience are rewarded. Cannon Asset Managers is committed to fairness and integrity in all investment activities, and attempts to align the interests of its investment team with clients. Consequently, members of the investment team may have a personal interest in the shares or portfolios mentioned within this article.