Index funds

Since John C. Bogle launched ‘index fund’ idea, it has been steadily gaining ground and for many people is now the primary or only way to invest. There is solid evidence it is generally good to investors. But there are also ‘index funds are worse than Marxism’ arguments, papers pinpointing issues with efficient tracking of indexes and the key question - which securities should (selected) index contain and how additions/removals/buybacks/issuances potentially make the index overweight “worse” securities. I think some of that criticism is legitimate, from both results and society point of view. On the other hand, with their scale, they can be very efficient and sophisticated.

But there are also other reasons I don’t just put money into an index fund. The first is that I believe I can beat the market (necessary arrogance of each active investor). The second is that if I understand the underlying value of what I bought, it should be easier for me to stick to it even when the market prices of it keep declining. Having the same confidence in buying more abstract thing like an index fund would be harder for me.

ETF tracking polish stocks (EPOL)

I had bad results in some individual Polish stocks, which at the core were caused by government’s intervention and poor management. Of course the blame of making these bad investment is still on me. My point is that I find it harder to assess Polish businesses, just because many are heavily influenced by government actions, which are rarely shareholder-friendly. And in aggregate, the mid-size, privately-owned businesses are not cheap and can get mismanaged too, with last example being Alma (I actually consider buying Alma, but was put off by the fact it had a controlling insider and some evidence on spending money *on* management).

I still want to have significant exposure to Poland as I will be spending money in PLN and prefer equity to cash/bond investments. So I decided to index into the market, with half of my current position initiated just after brexit and the other half very recently, after significant drop of PLN which caused EPOL to drop as well.

VEUR

I bought VEUR post-brexit as a contrarian move, additionally inclined by weak pound (in which it is denominated). The pound depreciated even further, but the index rose and I have not added to the position since.

I am considering buying VXUS just because of the strength of the dollar, which in my opinion is not sustainable. And I have too much exposure in USD already (almost 100%), which was beneficial until now, but I would prefer to significantly reduce it. But my limit orders are still waiting.

Apple (APPL)

Intrinsic Value (IV): 168$, Current price (CP): $113

I was for long time an Apple skeptic, mostly because I perceived Apple gadgets as expensive and vulnerable to low-cost competitors. I also am not a fan of walled gardens. But my thinking on Apple’s competitive advantage was greatly influenced by stratechery.com articles and observations made based on them.

Apple is cheap relative to both earnings and cash flow and has enormous amount of cash. I think market believes (as I used to) that iPhone’s high margins are not sustainable, but now I disagree. Seeing to what extent many people value their phones, I expect growing number of them willing to pay a premium for the best, hassle-free experience on a device they spend hours and hours every day. Brand and ‘cool’ factors are also durable competitive advantages, especially after Samsung’s recent failures with Note 7 and I don’t think any Chinese brand will be perceived as ‘premium’ in the West or in Japan for a long time.

Last but not least, I think Apple’s vertical integration and scale will enable it to come up with the next personal computer after smartphone, no matter if it will be a watch, smart glasses, other wearable or chip under our skin. I believe once the time is right, Apple will rollout out a gadget that everyone wants and it will perform better than the ones from competitors.

I bought a small position for $128 in 2015. I did not think it is very cheap, but I wanted to keep track of the company as I finally appreciated the competitive advantage. After poorly-received earnings, I added a lot in April and May 2016, dollar-averaging my cost basis to $97, as I did not see anything alarming in the results. I must say it was comforting to see Berkshire also buy a stake when they filed their 13F.

I expect the iPhone 7 results to be very strong and positively surprise the market. The iPhone 7 Plus has still 2-3 week shipping dates. And I think Apple manages their supply chain and predicts demand much better than Google.

Oil price

Both general economy and stock prices of many enterprises depend on the price of oil.

The 2014 drop in oil prices helped or harmed many stocks. But also, some stocks seemed to be under constant pressure of oil prices (being low or being expected to rise).

On one hand, extraction companies are lower, perhaps rightfully so. Many firms have a lot of debt and even with low valuations are a risky bet. There are also refiners and other companies that market perceives as dependent on oil price (e.g. CBI - construction company that does some projects for oil-related industries, but not that much and not all could be hurt by low oil price).

I think car producers, which have record profits thanks to SUVs and trucks are thought to lose a lot of profitability once gas prices rise and car-buying cycle reverses.

I think that the shale revolution will keep oil prices in check for a long time because the extraction methods and tools will become less and less expensive, but also, with advancing technology, more oil can be extracted from current and already shut-down oil/shale fields.

General Motors (GM) and Ford (F)

Intrinsic Value: $43.8, Current Price: $34.2

Both Ford and General Motors are very cheap. I think market discounts the cyclical nature of the auto market and fear that easy money from selling high-margin SUVs and trucks will go away with increased oil prices. I think that low oil prices are hear to stay, primarily because the shale oil extraction will jump everytime price goes above the cost of extraction. And shale extraction cost will get lower with increased efficiencies and new technologies.

As I understand both Ford and GM can keep profitability even with ~10M auto sales in US, down from current ~18M. And they generate nice cash-flow.

The other concern might be self-driving cars. I think that self-driving cars (as a service) will be quite popular in US 5 years from now, which will negatively impact total auto sales. Still, the impact will be gradual and I think that ease of use and reduced congestion will significantly increase demand for ‘mobility’ services, and will partially offset greatly increased utilization of each deployed self-driving car.

Valero (VLO)

While Valero’s results are very volatile, the normalized earnings looked attractive and I bought a small position close to 2016 low. The dividend yield seemed attractive and safe and the long-term prospects of the business do not depend much on price of oil. Now sitting on 30% unrealized, I contemplate locking these gains.

Valuing Valeant

Departing for a moment from discussing existing investments, this post focuses on a new one I just looked at.

Valeant (VRX)

Valuing Valeant is an interesting problem, that valuation guru Aswath Damodaran recently tackled. I read a few articles about Valeant, but did not consider investment until reading the aforementioned valuation post. With so steep declines from highs, my contrarian instincts got triggered and I looked more closely on Professor’s valuation, not to criticize it, but to see if I can understand the business enough and own it.

Just from naive, sum-of-the-parts point of view, the $5.6B market cap for company that owns household brand Bausch & Lomb (bought for $8B+ and unlikely to lose value in the meantime) and so many other assets, seems like a bargain. But the $30B+ debt is a big red flag. In his valuation, prof. Damodaran computes firm value and subtracts debt to arrive at equity value. He assigns 10% chance to failure and adjusts firm value, but before subtracting debt. Because in distress the equity will be wiped out, I think the 10% adjustment should come after subtracting debt from unadjusted assets. In other words, we should allow debt holders to carry part of the default burden in addition to equity being wiped out, instead of assuming entire default cost on equity. After all, this is what company pays for in increased interest rates. This is a minor point though, as 10% probability is arbitrary to begin with, and valuation does not change much (and for the upside, actually).

The big problem I see is with credit rating plummeting from Ba1 to B3. Presumably, most of the debt was obtained with former rating in place and B3 carries much higher spread, according to Professor’s table. Rising riskless rates don’t help. If we roughly calculate interest for current debt as 3.25% + 2% = 5.25% and future interest on rolled over debt as 7.5% + 2.5% = 10%, we look at almost doubling the interest expense. Eyeballing the “10. LONG-TERM DEBT” section in the latest 10Q I see ~6% rates at outstanding notes which would confirm it. Extrapolating last 9 months gives $1.8B annual interest expense today and $3B after refinancing. Valeant says: “We believe our existing cash and cash generated from operations will be sufficient to cover our debt maturities as they become due”. But judging from “Payments due by Period” in “Long-term debt obligations, including interest” in their 2016Q3 10Q, and the ~$3B of earnings before interest in Professor’s calculation, they could be short on cash as early as 2017 & 2018 when $7.7B of interest and principal is due and even more in 2019 & 2020 when the number raises to $12.7B. Of course if they pay down principal and stabilize business they can get upgraded and roll over debt at less than 10%. They could also divest some businesses - but a few subsidiaries guarantee debt and there may be other covenants I am not even aware of.

Finally, the assumption of flat revenues in first years might prove to be optimistic, as the reversal of previous price gouging can reduce it, maybe even substantially.

I recognize the potential for non-trivial upside, elevated by the optionality of positive surprises on the business side and successful divestitures. But the downside is also substantial, potentially 100% with hard-to-estimate probability.

But I can also see other another possibility. Famously, Bill Ackman’s Pershing Square bet heavily on Valeant and even doubled down. His fund trades at 22% discount to NAV, I think one of the highest to date. Buying into PSH gives me exposure to Valeant, with more diversification but also leverage (through NAV discount, PSH’s $1B debt, their long-short strategy and IIRC them holding not only Valeant’s stock but also deep out of money options).

Of course buying PSH also exposes me to high hedge fund fees, their bet against Herbalife (I think and hope HLF will fail, but I am wary about unlimited downside of shorting) and the risks that their leverage brings. But there are also additional upsides - if Ackman ‘wins’ Valeant or Herbalife the NAV discount may turn into premium and his overall performance/luck might also ‘revert to the mean’. I was actually considering QSR, MDLZ and CMG which were his other bets, as of Sept 30th. These seemed to be good businesses, but I didn’t spend enough time to value them. I am sure he did.

Lastly, as I understand PSH might currently have a headwind of performance fees for the successful 2014. I assume that poor performance of 2015 and 2016 will reduce the performance fees in the next couple of years, should the fund perform well.

I decided to pull the trigger and try to buy a ~4% position in PSH. I set limit orders for 13.9, 13.6, 13.3, 13.0 and 12.7. Should it go even lower, I will probably add above 4%. Early today, the first order got fulfilled, hopefully a few of the lower ones will as well.

Berkshire-inspired investments

IBM

I bought a modest chunk of IBM around $133, inspired by Berkshire holding it and encouraged by strong cash generation and the established position in IT departments. For non-tech companies, IBM can still be THE partner to handhold them into the world of (public, hybrid or private) cloud and machine learning. I sold it in two chunks, for approx. $155, primarily to free up funds for other investments (VEREIT and EPOL). I will surely consider buying IBM again after a dip or if business performs better than expected.

Wells Fargo (WFC)

Intrinsic Value: $81.5, Current Price: $52.8

This is another investment inspired by Berkshire’s holdings. While not cheap, the ROE is impressive and I was also convinced that downside is limited, given that interest rates will rather go up than down, and therefore business performance can mostly improve. Then the scandal with unauthorized account openings broke out. I increased my position, and I have decent post-Trump unrealized gains (cost basis %45.5), but far from what they would be, should I buy JPM/C/BAC or financial sector ETF instead. I still think by downside is more limited with the best-of-breed bank, and yield is still attractive. And I always have BAC exposure through BRK.B.

Kraft Heinz (KHC)

I was tracking Berkshire’s acquisition of Heinz and subsequent merger with Kraft and I was amazed how Buffett and 3G have turned ~$10B into ~$30B each in 3 years. I think this leveraged buyout indeed created lots of value by making the underlying business leaner and efficiently using the underlying cashflow to pay the acquisition debt. And the stable nature of the underlying business minimized the risk coming from leverage.

I recently bought a token position in KHC, primarily because of a large post-election drop in price as a contrarian, “impulsive” buy. The intrinsic value depends on achieving (or exceeding) the planned $1.5B of savings and I plan to track progress of this business.

VEREIT (previously known as ARCP)

Intrinsic Value: $11.38

Current Price: $8.40

I first learned about VEREIT (back then known as American Realty Capital Properties or ARCP) in 2014 from an article on Seeking Alpha. The very concept of REITs and reliable income is appealing, but usually also implies limited upside. ARCP was more reasonably priced than peers then. Still not cheap enough for me to buy.

In October 2014 the infamous accounting scandal broke out and stock dropped from $12 to $8. It suddenly started to look attractive and I initiated a relatively large position. I kept the stock since then, collecting dividends and sometimes doing small sells, realizing modest profits. After REITs got much cheaper, with increasing treasury rates after Trump’s election, I bought quite a lot, and currently I have cost basis of $8.3 and ~6.5% dividend yield on cost.

I have considered a few other reasonably-priced REITs in the meantime (SOHO, LXP, WPC), but when I looked at the first two, I was a bit worried about the debt levels. And WPC got more expensive than my orders. I still need to revisit them and maybe place an order.

Berkshire and Lookalikes

Berkshire Hathaway (BRK.B)

Intrinsic Value: $222, Current Price: $158.7

This is the company I read most about. Primarily from Warren Buffett's shareholder letters, but also financial filings and multitude of articles and a few books. In May 2015 I even made it into the famous shareholder meeting in Omaha.

The stability of earnings from various wholly-owned businesses, stock portfolio of strong companies and $20B of cash held at all times is fairly unique. Even more unique is the liabilities side of balance sheet: insurance float, deferred taxes on unrealized investment gains and depreciation of long-lived and intangible assets. Finally I strongly believe in the business and investment acumen of Buffet, Todd Combs, Ted Weschler and all the managers of operating businesses. I see them making smart decisions within their businesses and even more so in deployment of cash that they generate.

From the individual investor’s standpoint the stock repurchase plan with 1.2 book value limit provides almost a hard downside protection. I am convinced Buffett (or his successor) will buy back a lot of stock at significant discount to intrinsic value, or find even better ways to deploy capital elsewhere.

I am not certain why market undervalues Berkshire. Maybe it is because it is old and boring? Maybe they are worried about Berkshire after Buffett? Or maybe consistent selling from Bill and Melinda Gates foundation drives the price down. Neither thing worries me.

Leucadia (LUK)

I think of Leucadia mostly as ‘baby Berkshire’ with the same principles and source of funds (insurance float). Their wholly-owned businesses did not do great in last few years which caused them to be undervalued - I jumped in then and added on a dip. With price close to book value, I am confident in the long term prospects of this investment. Recently it tracked higher, perhaps partially because the businesses improved and because US-focused businesses overperformed after Trump election.

Markel (MKL)

Markel is another ‘baby Berkshire’, with a better track record and therefore with market capitalization at non-trivial premium over book value. Given its consistent performance I am happy to pay this premium. I was even happier to pick up more of Markel after the post-earnings dip. Unfortunately, only one of my orders got fulfilled, and then market run away.

Alleghany (Y)

Yet another example of baby-Berkshire. Another shareholder-friendly company, with value-investing principles and sensible capital allocation approach. Bought around book value and holding for the long term. I expect all baby-Berkshires to be consistent ‘compounding machines’ and having all of them provides some diversification for my otherwise very concentrated portfolio.

Fairfax (TSE:FFH)

The most recent addition to my portfolio - I bought a small position today after checking on performance of ‘discarded’ investments I wrote about yesterday.

Fairfax dropped heavily post US election and is now well within what I was ready to pay when I evaluated it the first time. The drop presumably comes from Fairfax hedging all (or even more than all) of their equity positions in expectation of market’s decline. They seem to be wrong for the time being, with post-election gains in the market. But I see this rather as an attractive entry point, given the proven record of management’s good judgement and the fact that company is diversified by having great insurance underwriting record and wholly-owned businesses. The potential losses from these hedges do not justify the drop, and current premium over last reported book value is in the order of only 10%.

My stock portfolio

I strongly believe in value investing principles, as defined by Ben Graham and all his successors. This approach not only has great track record, but most of all, simply makes sense. I try to focus on understanding the underlying business as much as I can, but being a small investor, I can only work with public data and the time I can spend on stock analysis is limited, no matter how interesting it is.

All of this causes me to hold a very concentrated portfolio (as of 2016-11-18):

Two largest, 'permanent' positions are vested Google equity and Berkshire Hathaway. I have high belief in both, and although they are not very cheap (and one might even argue that Google is expensive), I see bright future ahead of both, especially after adding Ruth Porat as a capital allocation expert at Google.

I have spent quite a bit of time studying APPL, VEREIT and most of the other positions. There might be a confirmation bias (I spend time studying companies I consider promising, and usually I can easily find evidence justifying an investment). But there were also some that I considered and rejected, such as RCAP, XOM, LXP, O, SOHO, PSX, C, FFH, etc. In hindsight, sometimes it was a good call, but in some cases I missed some gains. I think that's to be expected. But I felt comfortable with my choices and I still do. This will hopefully allow me to stick to them even through large market declines and even add to them.

In the following posts, I am going to shortly explain an investment thesis behind each investment.

Almost 8 years have passed since my last post here. A lot has happened in my personal life - we built a house, have two kids and recently moved to Zurich, after my company’s office in Krakow was closed. It was an exciting and busy time.

It is interesting to revisit my thoughts from such a long time ago. Not so much have changed in my thinking since then, but certainly time has corrected some of my predictions, such as that Nord Stream will never be operational or that we are close to the bottom of the stock market in January 2008 and then again on 13th of October 2008.

I am still interested in investing, perhaps even more so than before. I have had mixed results in the meantime, with some significant realized losses on WIG20 during the financial crisis, but also very nice gains on Google’s equity that I hold for the long term, with first small sales only in November 2014. And I am still holding most of my Google stock grants.

I have a bit of exposure to Polish stock market, but I mostly moved my investments to US, starting with Berkshire Hathaway (BRK.B) purchases in February 2014. Since then, I have been increasing this position, and also started diversifying into other stocks.

As one of my main motivations for writing this blog is to be able to reflect back on my thinking from the past, I will try to regularly post a list of stocks I own, with a short investment thesis and estimate of fair value.