The Valor Blog.
Investment News and Views, Direct from Our Team.

“Simplicity is the ultimate sophistication” (Da Vinci)

We live in interesting times.

It is very easy to get caught up in the hullabaloo of markets and forget the basics.

The genius of Warren Buffett is his method is so simple. He has a four filter model and sticks to it.

  1. Understand the business
  2. Moat around the business
  3. Exceptional management
  4. Reasonable price

As much as Trump’s antics are theatre redefined, they have very little to do with investing.

Over a 100 year chart, with no dates, it would be difficult to pinpoint the exact periods of most US presidents. Major market crashes may make certain periods more obvious, but the effect that presidents have on markets over the long-term is usually negligible.

The geniuses at Alphabet are not sitting at their desks thinking, “Donald Trump is president, let’s not invent driverless cars”.

I had a client who recently planted a mushroom crop. His expected return on invested capital is approximately 100% per annum. I can assure you that he is not thinking “If labor gets elected, I won’t plant my mushrooms”.

The decision to invest in an asset should solely rely on the expected return of cash over the life of that investment discounted at a reasonable rate. Short-term factors such as politics, a recession or a failed product of a well diversified company should be factored into the price, but over a 20 year period will likely have little influence on whether to buy that asset.

“Time is the friend of a wonderful company and the enemy of a poor one”. (Warren Buffett)

Source: Eikon

The last piece of Buffetts four filters is price. It is the least important of the four filters when purchasing an asset, however it still matters.

A business that earns $1 trading for $35 requires a perfect future. Businesses rarely have perfect futures.

The market seems to be ignoring price for a number of companies. Paying multiples of the value of a business can lead to a number of years of anaemic returns. There is much of this folly in todays markets:

“Fools rush in where angels fear to tread” (Alexander Pope)

Despite the lofty levels of markets, we recently added to our position in Ambev. Ambev is a wonderful company at a reasonable price.

Ambev is easily understood, has a wide moat, is run by outstanding management and is below our estimate of intrinsic value.

Source: Eikon

Disruption Fad

Disruption is the word of the day.

There are numerous funds that only invest in disruptive companies.

I think it is a fad.

The issue with most of the disruptive companies that I analyse is that they are selling their services or items at below cost. This is not disruption, it is destruction (of capital).

If potatoes cost $1 kilo to grow, selling them for 50c is not disruption, it is destruction.

A company selling potatoes at 50c will be a very fast growing company. The demand for their services will certainly be there as they steal market share.

Investing in loss making “growth” companies is fraught with danger when they are selling their items or services at below what it costs to produce.

Many of these companies are playing the “Adjusted EBITDA” game. I can make almost any company look profitable if I adjust the earnings for just about anything that actually costs the company money.

Caveat emptor.

Why Rolls-Royce should call Berkshire

Rolls-Royce is about to embark on an enormously dilutive capital raise. I think it may be a mistake.

They probably should be calling Berkshire Hathaway to discuss a preference share.

Berkshire is highly unlikely to have been considered due to the very unusual position Berkshire Hathaway is in to do large deals, very quickly. Most companies cannot provide $10 billion dollars within 24 hours from a simple phone call. Berkshire Hathaway can. They may be the only company in the world that can do deals of this magnitude and many still do not think of them during situations like this.

Berkshire Hathaway owns Precision CastParts, Flight Safety and NetJets. They have in-depth knowledge of the aviation industry. As a long-term shareholder in Berkshire Hathaway and an expert on the company, I am confident I am able to suggest this alternative avenue to source capital. I have confirmed with other experts on Berkshire Hathaway that Warren may be amenable to a potential deal such as this. Berkshire Hathaway currently has approximately $147 billion USD in cash. They certainly have the ability to do a large deal.

I am also very aware of commitment bias. It is human nature to want to follow a path that you have committed to, despite evidence that there may be a better path. It is very difficult to be able to change course, regardless of whether changing course may potentially be the most rational decision. The Rolls-Royce team has likely put in long hours organising the capital raise and deals with investment banks. No one likes to be told that their work is to be discarded for a different decision. 

So, what is the potential cost to Rolls-Royce shareholders with the proposed capital raise? A 10 for 3 capital raise roughly destroys 2/3 of shareholders ownership in Rolls-Royce. Giving away two thirds of the pie is a decision that wipes away decades worth of equity creation. It is not unreasonable to assume a conservative £1 billion of free cash flow in 2025, and a modest free cash flow multiple of around 12 times, Rolls-Royce could be worth approximately £12 billion. Shaving two thirds off this could be an £8 billion decision. 

The cost of the preference share would also have a higher interest rate than the debt Rolls plans to raise. Let’s assume another £300 million off the free cash flow amount, bringing the number down to £700 million per annum in 2025. At 12 times £700 million Rolls could be worth £9 billion. 

Obviously, Berkshire would require an element of equity stake in Rolls for a preference share. Let’s assume that this is around £3 billion in the form of a warrant.

This still leaves a disconnect of around £3 billion of potential market capitalisation that will effectively be wiped away with this enormously dilutive capital raise. 

A secondary, yet potentially important consideration is the increased market confidence that an investment by Berkshire would attract. A seal of approval by Berkshire Hathaway would likely garner market support around Rolls-Royce and make any further dealings with bankers a less arduous task. 

I have deliberately left these calculations very rough. An in-depth analysis would be less than helpful as the accuracy of the free cash flow forecast for 2025 is itself liable to be within a wide range of outcomes.

I am well aware that there may be factors behind the scenes that may preclude a deal of this magnitude being done with Berkshire Hathaway. A phone call to Warren may only take 5 to 10 minutes of their time as Warren is extremely direct. He will say yes or no relatively quickly.   I am unable to know whether a deal with Berkshire is possible or not, however, if possible, I am confident that a preference share could save Rolls-Royce shareholders somewhere in the vicinity of £3 billion over the coming years. This is not a decision Warren East should take lightly.

What “Can” Happen vs What “Will” happen

There are lots of market commentators who promote absolute certainty. Many of them have reasons to pretend that they are absolutely certain about a subject, because their lively hood depends on a specific outcome.

            Never ask your barber if you need a haircut

A far more rational way to view the world is to be less certain, but position your views toward risk weighted outcomes. When you realise you don’t know what is going to happen, you can start to attempt to correctly price risk.  

This is where we find ourselves today in the middle of the corona virus.

Be very careful of those that promote absolute certainty and listen more to those that allocate capital with skin in the game in a probabilistic manner.

The beautiful position of being asset agnostic means that we can allocate to where we believe we know much of the range of what “can” happen and we are getting paid to take the risk.

Tail risk outcomes are becoming more likely in this environment. We have a strong view on Australian property and the Australian banking system. Our view is that property is multiples of its fair value in Australia and if it reverts closer to its fair value, the banking system requires large recapitalisations. We have had this view for a number of years, although we have never known when the risk might materialise. We are now seeing that risk increase. We know what “can” happen to the Australian property market, but we certainly don’t know what “will” happen. We are very confident you aren’t being paid a premium to take the risk to find out.

By using what “can” happen to avoid risk, we believe we are protecting capital better than many.

Conversely, when we see opportunities that have significant upside versus potential downside, we take a very assertive position. We certainly don’t know exactly what will happen, however we generally know what “can” happen which means that we will likely be far more right than we are wrong over time.

“Delighting Moats” vs “Parasitic Moats”

I have recently reorganised my thoughts around moats.

One of the least discussed elements of a moat is its permanence. It is a quite subjective matter when evaluating the permanence of a moat. One way to attempt to bring some observations to the argument to reduce subjectivity is to look at the type of moat that a company has.

Is the company delighting its customers or is it a parasitic company that has a captive audience that can’t go anywhere else for its products or services.

The latter type of company can look impenetrable, however as soon as a customer has a better alternative they could leave.

A company such as a drug company might have a very wide moat on a certain drug, however they often raise the price to the point of extreme pain for the consumer (be that the end consumer of the government who subsidises it).

A bank might have a switching cost due to the difficulty of changing loans or accounts, however if they create too much pain for the consumer, or another new “easier” product is created by a fin-tech, the consumer could leave.

The local convenience store might have significantly higher prices than the supermarket 15 minutes away. If a supermarket starts up close to the convenience store, its business is crippled.

A company that delights its consumer is likely to have far more permanent customers.

People are “fans” of Apple. People are “obsessed” with Instagram. People are “addicted” to their double shot, half cream, caramel Frappuccino from Starbucks (or maybe thats just me).

Our portfolio is filled with “delighting moat” companies. A considerable percentage of the mistakes we have made over the years have included a number of “parasitic moat” businesses. Some “parasitic moat” businesses have their place and are acceptable businesses (at the correct price), however they are lower down the pecking order of companies we prefer to invest in.

We are loathed to sell a company that is widening its moat by delighting its consumers. We are quick to sell a company where a manager doesn’t understand what their competitive advantage is and is slowly eroding their moat.

What happens when Warren Dies?

Berkshire has been all about Warren since he took control of the struggling coat lining business.

One day Berkshire will be without its Warren. Whether this is in 10 years, 20 years or tomorrow is unknowable.

Due to our quite concentrated investment in Berkshire, I have received many questions by clients as to what will happen to Berkshire when Warren dies. Many are fearful that the stock will drop.

Whilst in the short term the stock may fall, we are not at all worried about Berkshire after Warren.

Funnily enough, Warrens death may actually be a catalyst for higher earnings per share over the next decade.

Berkshire has enormous spare cash resources. Any reasonable fall in Berkshire’s share price (greater that 15%) will very likely spur a huge buyback for Berkshire. A fall in the price of Berkshire will lead to a rise in the value per share thanks to the buyback.

As Warren often touts, if you own a truly wonderful company and they have the ability to buy back shares, you want the share price to go down not up so that the company can buy back shares at a lower value which will result in higher long-term returns.

Warren, I will shed a tear when you die. You have been a great teacher and role model. When you do, Berkshire will power on thanks to the powerhouse masterpiece that you have built.

Smart things and dumb things to do August 2017

Our latest edition of Smart things and dumb things to do has an increased list of dumb things to do as most markets around the world trade at higher prices and offer lower future returns. Investors who are expecting to live off assets and need a mid single digit after fee, after tax after inflation return are likely to be quite disappointed over the coming decade. Most markets are trading at gross future returns of around the low single digits, suggesting net returns after tax, inflation and costs of 0% or below.


Dumb things to do:

1. Aussie Property

2. Aussie Banks

3. China debt dependent industries

4. The vast majority of bonds, particularly the high yield space and long term government bonds.

5. Buying index’s that are at all time highs

6. Im going to mention Aussie Property again because it is such a dumb investment from here.

7. Leveraged infrastructure/ Leveraged Private Equity/ Leveraged “alternative investments”

Smart things to do:

1. Wonderful companies with high owners earnings yields, despite the general over priced nature of most markets.

2. Some cash

3. Some inflation linked and floating rate corporate bonds


Deeper explanations:

Dumb things to do:

1. Aussie Property. With the latest rises in Sydney and Melbourne, the time to invest in Aussie property has never been worse. The total property recently hit $7.1 Trillion for a $1.7 trillion economy. This ratio is around 4.17 times the economy. This is only the major cities. Add in the rest of Australia and we are approaching 4.5 times the economy in just property. This is insanity on a whole new level. Lets put this stupidity in perspective:

Country Property to GDP Ratio Real Price Falls Years to recover
USA (2006) 1.9 35% 12 (After inflation yet to recover)
Ireland (2007) 3.5 58% Still negative return
Hong Kong 1998 3.6 65% 10
Spain 2007 3.6 60% Still negative return
Japan 1989 3.8 75% Still negative return 28 years later
Australia 2017 4.4 ? ?

Australia is now the most likely contender of the biggest property bubble in global history. This is not a mantle we want to hold when the only other four bubbles that reached a level of around 20% below this point fell an average of 65%. Watch out below!

(Please note that the above figures are obtained from numerous sources and are averaged out. We have used  a number of investment banks, research institutions, country statistics bureaus and university papers to obtain these statistics . There is no single accurate source for property to GDP. They are all estimates. There are numerous property data companies in Australia who are often out by 10% or so from each other. We simply attempt to show an approximate amount. Whether Australia has 4 times the economy or 4.5 times the size of the economy in property is a mute point when the long term average is closer to 1.5 times. Anything over around 3 times the size of the economy is sheer stupidity)

Once again, we have no idea when the tide will turn. We do not short markets or predict timing. We simple look to avoid folly. The Australian Property market looks to be about the dumbest investment we have ever seen right now (tied with European Junk Bonds). With gross rental yields below 3% in the two largest cities and net rental yields in the 1% range, using the term “investor” for this asset is similar to calling someone in the 13f’s football team a talented player.

Just because an investment offers you no prospective future return above inflation, does not mean that speculative hype cannot drive the prices higher. We offer no short term view on the market, simply to say that there that history will view a net rental yield in the 1% range as an inappropriate return for the risk.

The falls in other property markets around Australia such as Perth, Darwin and Brisbane apartments, has made these investments less dumb, however we still see downside in these areas as they continue to trade well above long term averages.

2. Aussie Banks

Aussie banks continue to follow the property market. Whilst the banks are now counting around 25% of their loans as risk weighted assets, this still leaves 75% of their mortgage book with no capital. With some house prices in the western suburbs of Sydney hitting the mid $1million mark and people still borrowing 10 times gross wages, we are worried that this capital position will not be sufficient when the tide goes out. An example of a $1.35 million dollar loan against a $1.5 million house in the Western Suburbs is certainly not worth 100 cents in the dollar when long term prices are closer to 3.5 to 4.5 times wages which puts average house prices around the $450,000 mark. Whilst it is impossible to know the extent of the stupidity of the banks lending, we see a number of clients come to us with loan to income ratios that would be impossible to apply for in the vast majority of other countries. There is much subprime lending in Australia. It is simply called interest only loans to people at greater than 6 times gross wages.

With one of the highest proportion of interest only loans and mortgages of any banking system in the world, Australia has over cooked its banks and economy to a level that will only be revealed when the tide goes out. With a large dependence on overseas capital to sustain this bloated balance sheet, we have put ourselves in a precarious situation. Our reliance on the kindness of strangers makes us closer to a developing nation than a developed nation when looking at our financing.


3. China debt dependent industries

China borrowed around $5 trillion last year according to Jim Chanos. The reported figures and estimates from numerous sources vary, however one constant reigns true, they are borrowing at multiples of their economic growth. This is mathematically unsustainable. To quote Herbert Stein “If something cannot go on forever, it will stop”.

China’s debt growth has led to numerous “experts” and journalists claiming that China is now “stable”. I had to re-look up stable in the dictionary after these countless references to make sure I truly understood the meaning. Borrowing at 3 times the rate of your economic growth is anything but stable. It is enormously destabilising and the problems in China are continuing to worsen.


When China is not borrowing at 3 times their economic growth, we are very comfortable that the exceptional period of commodity price strength since 2002 will likely appear an anomaly. At this point in time, prices will likely revert closer to their long term averages which is still a material fall from current prices.

Owning commodity based companies dependent on this debt growth will likely remain painful as it has since 2011.

4. Bonds

European junk bonds hit a low of 2.79% a few months ago. If you can’t work out how monumentally dumb this is, then you should never investing money. There are very scarce opportunities to create wealth in the bond market right now and the king of credit, Howard Marks has sounded his cautionary stance.

5.  Indexing

Indexing has become wildly popular of late, however we are at market levels where the future returns from stocks are likely to be less exciting than most are prepared for. Whilst Hussman funds invests in a way we do not think is rational, their market analysis on the general level of the market has some credibility. The latest report from Hussman suggests we are certainly near the upper levels of where the market will average over the long-term. Caution is warranted.

6. Aussie Property

How many warnings is enough?

7. Leveraged illiquid assets

There is a very large proportion of the pension and superannuation market that is trending into “alternative assets”. With these assets providing less volatility due to not being quoted daily on a market, it is understandable that it attracts large amounts of capital. Unfortunately the popularity can also lead to higher prices for assets due to higher competition. Interest rates around the world look like they might have bottomed. Margin contraction from having high leverage for a relatively low yielding asset in a rising interest rate environment may prove far less attractive than it has been in the falling interest rate environment from the last few decades. Be very careful of infrastructure, private equity and alternative investments that have shown high returns from leveraged bets on illiquid assets.

Smart things to do:

1. Wonderful companies with high owners earning yields

Despite the general loftiness of the market, there are still attractive investments that offer solid returns. These investments are as rare as hens teeth, however they are still available. In a 2% to 4% owners earning yielding world, we continue to find investments in the high single digits and even double digit owners earning yields. For this reason, we are not recommending that investors go to 100% cash as may be assumed from our general cautious tone from this blog. We are actually quite excited about the prospective returns from the collection of great companies that we own. Yes there will be volatility in the share prices, however if you are getting paid 9% a year in owners earnings and the share price drops 20%, then we are excited to buy more of that business at an 11.25% owners earning yield. If you were only getting 3% owners earning yield and the share price drops 20% then a 3.75% return remains similarly unexciting.

2. Cash

We continue to hold cash as an option to buy assets at more attractive prices at some point in the future. For Australians, having some cash outside of Australia is still a rational allocation.

3. Inflation linked and floating rate notes

In Australia, we have some insurmountable household debt problems. Due to this high debt, households have little left over to spend on other areas of the economy leading to lower inflation and wage growth. If history repeats, rhymes or comes half way to where every other housing bubble eventually settled, then we are in for some very difficult times. There is no need to despair. We will hopefully avoid being the next Argentina or South Africa as the Aussie dollar will likely take some of the pain. A large fall in our currency will likely cause an increase in tradable goods inflation. The bank bill swap rate may also rise due to difficulty in funding our problematic banking asset excesses. In this environment, inflation linked and floating rate notes may provide some protection. Sadly this is a very small part of the market.

Final Note:

I truly believe that we are in one of the more difficult environments to be an investor. The prospective low returns in almost every asset class leads to most investors stretching themselves and taking risks they are unaware of. The calm that is upon markets may be hoodwinking investors into a false sense of confidence.