Seeking Alpha

A World Where Money Is Free (My Little Conglomerate Q2 2019 Update)

by: Gene Chan, CFA

Free money lowers investors' required rate of return and causes multiple expansion, leading to stretched valuation and malinvestment in some pockets.

But rather than trying to time the market with sales, we rather sit back, let long term compounding do its work, and opportunistically use market corrections to acquire more shares.

Q2 2019 results and outlook.

This market must be frustrating a lot of investors.

Despite tepid growth and a messy geopolitical climate, the indices stubbornly hit all-time-high after all-time-high, to the dismay of pundits, naysayers and worrywarts. This continues to be one of the most hated rallies in history despite the market just had its best 10 years ever by many measures.

Now I'm not saying we should be complacent. Investing is never without risk and we should always expect a correction to eventually happen.

In fact, we should root for one.

I, for one, would welcome stocks to go down even though My Little Conglomerate portfolio is currently (more than) fully invested. As long as I am still earning, my biggest problem is reinvesting the cashflow I receive from my employment and my investments, not the price at which I need to sell my assets. I long for a market correction so I can deploy more cash into My Little Conglomerate and other portfolios.

And this should be the attitude taken by by any readers who are not of retirement age - not looking for higher prices to sell, but looking for lower prices to opportunistically invest cash.

Free Cash

One of the main drivers for the monster rally of the last decade or so is, of course, the low cost of money. The US yield curve has been flat to inverted for a while now, with paltry returns of around 2% in 10 years and 2.5% in 30 years.

US Treasury Yield Curve Elsewhere in the world is steep in negative yield - in many places, such as Europe and Japan, you need to pay interest to the government have them hold your money!

Source: MENAFN

In a world where money is essentially free, alternatives to money become more attractive. This drove the advent of crypto-currencies and mini-bubbles in some other commodities like precious metals.

However, if monetary policies are truly going full bonkers, owning an asset that produces hard value (e.g. a farm, a house, or a company) is still strictly superior to owning an asset that doesn't produce anything (e.g. Bitcoin (BTC-USD), gold (GLD)). Where the value of both productive and non-productive assets may track inflation in the long run, the former produces a stream of cashflow that enables reinvestment and wealth compounding while the latter just sits there.

To illustrate with a concrete example, in my previous update I described the Required Rate of Return by which we evaluate investments for My Little Conglomerate.

Our RRR is defined as the risk-free rate, plus an equity premium to compensate for risks of investing in equities, plus a country premium to compensate for investing in foreign countries. Risk-free rate is a key component - the lower it gets, the lower our RRR goes, which makes productive assets such as a piece of business more attractive in comparison.

Many market participants go through a similar process, where they compare investment alternatives to the rate on cash or leverage. This explains the multiple expansion in the equity market, as investors demand lower earning yields from equity (and thus higher P/E) given the low yield on cash.

Could this lead to over-extension and mal-investment? Time will tell.

As long-term value investors with a business-owner mindset, we should be very stingy when buying something new, but lazy when it comes to selling. You wouldn't trade in and out of a business you own and operate in full - it is preferable to sit there and let the earning power compound. Likewise, the same mindset should be applied to stocks which represent partial ownership of businesses. The cost of missing out on a life-long compounding is much higher than the benefit of going to cash in hopes of buying back the shares later at a slightly lower price.

That's not to say we will never sell, but the decision will mainly be driven by company-specific micro factors. we will dispose of a company if its business materially deteriorates, or if Mr. Market offers an extraordinary valuation to buy us out. Valuations, while stretched in some pockets (e.g. certain IPOs), aren't anywhere near extraordinary for the businesses we own.

Macro factors matter to our decisions in that if and when a general correction finally comes, we will be ready to acquire more assets and earning power for My Little Conglomerate, but not so much in terms of playing a part in our selling decisions.

As we speak, My Little Conglomerate still hasn't sold a thing since inception, although we do have China Mobile Limited (CHL) on watchlist for disposition due to several factors related to their business (as discussed in a previous update) - namely the recurring state mandated price cuts, and potentially involuntary capital expenditure for 5G. The ongoing trade spat certainly didn't help this situation as China Mobile is barred from operating in the US, but that was always just a nice-to-have and small part of the picture compared to what they're doing domestically.

We took VanEck Vectors India Small-Cap Index ETF (SCIF) off our sell list, as the recent correction in the India market has turned valuation favorable again. The India economy suffered election paralysis earlier this year, but now that's over, it is working through some liquidity issues at non-bank financials caused by increased scrutiny of lending, and the generally sour global mood caused by the trade war. We see these issues as transient and solvable - we may consider adding to SCIF at these levels.

Meanwhile, we also have Microsoft Corporation (MSFT) on watch to buy, as disclosed in my recent article Big Tech Oligopoly, but we are waiting for a better entry point.

Aside from potentially disposing China Mobile to free up cash, My Little Conglomerate has room to lever up further. When money is nearly free (like it is these days), we rather lever up slightly than selling too much of our businesses to fund acquisitions.

Without further ado, let's cover the recent quarter's performance.

My Little Conglomerate Results and Outlook

My Little Conglomerate's Owner Earnings increased this quarter to $4,078 from last quarter's $3,753, mainly driven the add-on purchase of 150 share of CAI International (CAI) during Q2, as disclosed at the end of our Q1 update.

Here is a summary of our current year numbers as of June 30th, 2019:

Investment Quantity Acquisition Cost Market Value Owner Earnings* Earnings Yield Owner Cashflow* Cashflow Yield
CAI 400 9,488 9,920 1,296 13.1% - 0.0%
CHL 150 6,562 6,794 573 8.4% 278 4.1%
GILD 150 10,196 10,134 906 8.9% 378 3.7%
RCL 100 11,016 12,121 986 8.1% 280 2.3%
SCIF 150 5,950 5,691 416 7.3% 7 0.1%
Cash & Accruals - 2,508 -3,212 - 2,508 - 98 3.9% - 98 3.9%
Total 40,000 42,151 4,078 9.7% 845 2.0%

*Expected annual figures for the current year calculated from per share data

As a reminder, "Owner Cashflow" is the cash distributed to parent company by the underlying investments, usually in the form of dividends from our subsidiaries, but can also come as interests or return of capital from other investments. Owner Earnings and Owner Cashflow are expected annual figures for the current year.

The cash outflow on our negative cash balance is mainly the margin interests charged by our broker.

And below is a time series of My Little Conglomerate's performance since inception:

Date Market Value Owner Earnings* Owner Cashflow*
Q2 2018 29,554 1,506 516
Q3 2018 32,712 2,367 553
Q4 2018 29,944 2,698 579
Q1 2019 41,927 3,753 973
Q2 2019 42,151 4,078 845

*Expected annual figures

From the very beginning we said that the goal of My Little Conglomerate is to maximized the the firm's overall earnings, calculated by aggregating the earnings of its underlying firms as we treat each investment like a subsidiary. By that metrics, we performed very well with 5 consecutive quarters of earnings increase since inception.

We believe by running the portfolio like a business, we will achieve market beating returns in the long run. Below are our results compared to our chosen benchmark the S&P 500 Total Return Index:

Date Market Value Capital Activity ROR Cum. ROR SPXT SPXT ROR SPXT Cum. ROR
Q2 2018 29,554 30,000 5350.83
Q3 2018 32,712 - 10.7% 10.7% 5763.42 7.7% 7.7%
Q4 2018 29,944 - -8.5% 1.3% 4984.22 -13.5% -6.9%
Q1 2019 41,927 10,000 6.6% 8.0% 5664.46 13.6% 5.9%
Q2 2019 42151 - 0.5% 8.6% 5908.25 4.3% 10.4%

We had a lackluster Q2 in terms of market value of our businesses, causing our total return to underperform the S&P for the first time since inception. We are confident that this is a temporary phenomenon.

We've indicated above in this article that we are waiting for the right price levels to dispose of China Mobile, to acquire Microsoft, and to potentially add to SCIF. There were no significant updates to our other portfolio companies this quarter.

We are constantly in the look out for other great businesses being offered at attractive valuations - as new opportunity arises, we may enter into other investments not mentioned here. We intend to fund future acquisitions via a combination of fresh equity injection (I've promised to invest 10k into the firm on an annual basis), leverage, and dispositions. Follow me to keep up with the latest updates on My Little Conglomerate.

Disclosure: I am/we are long CAI, SCIF, CHL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.