2019 update

“For most people, the first $100k is a long slog” – Charlie Munger

  • Portfolio
  • Saving

Portfolio

The portfolio YTD has returned 20.5% vs 21% achieved by the S&P 500 (GBP). The portfolio saw quite a bit of activities in q2 and 3 as I firm up my conviction on several companies.

Private equity

I bought Brookfield Asset Management (BAM) and Blackstone (BX). The two amount to 4% of the portfolio.

Let me explain the wonderful economics of the Private Equity house by quoting Mr Stephen Schwarzman – CEO of Blackstone:

“The appeal of the private equity business model to a couple of entrepreneurs was that you could get to significant scale with far fewer people than you would need if you were running a purely service business. In service business you need to keep adding people to grow, to take calls and do the work. In the private equity business, the same small group of people could raise larger funds and manage ever bigger investments. You did not need hundreds of extra people to do it. Compared to most other businesses on Wall Street, private equity firms were simpler in structure, and the financial rewards were concentrated in fewer hands” – What It Takes (Page 99)

Over the past 40 years, this economics has worked its wonders for the majority of the PE houses, for lots of asset managers, and most interestingly, it has worked for both investors and investor-disguised self-promoters.

Mr Schwarzman and Mr Bruce Flatt – CEO of BAM, being both great promoters themselves, chose to become great investors as they build wonderful track record of consistently beating the S&P. Their high standards, great ethics and shrewdness motivate my purchase of BAM and BX, 2 outstanding businesses operating in an industry badly made famous for being the “Barbarians at the gate”.

Both companies, at the current price, are selling for prices that only reflect their current management fees earnings. That leaves the future management fees earnings and the performance fees, conventionally thought of as being fickle, for free. My expectation is that as Mr Flatt and Mr Schwarzman convert more capital into “permanent capital”, the performance fees will be viewed in a more favourable light relative to the management fees. Of course this is subjected to them continuing institutionalising their investment process while preserving the long-term outperformance track record as they raise larger amount of money.

Larger amount of money makes a lot of sense when being deployed in infrastructure and real assets. As Mr Buffett explained to his shareholders“We are attracted to regulated infrastructure because you can deploy big capital in it”. I’m motivated that as BAM and BX continue to gather and invest bigger and bigger capital, their competency, which has always been in infrastructure and real assets will serve them well for years ahead.

Banks

I bought Bank of America (BAC) and Wells Fargo (WFC). They are trading at 7-8x pre-tax earnings and both are spending everything they earn on share buy back and dividend. That works out to an awesome 12-14% pre-tax “cash” yield. I’m sitting here hoping for even more favourable upside from future rerating which may or may not come with interest rate eventually trending upward. But of course the question in the mind of many observants is when, not whether.

Put options

I also sold a put option on BAC and about to sell another put option on WFC. The “float”, ie the difference between what I receive in up front premium and the amount that I need to lay out to cover the 2 positions should the share price fall down to the strike price, amounts to 7% of the current portfolio or predictably, 5% of the portfolio in 2 year time. The 2 put options will expire in 2.5 year time. Within this time period, should the share price decline to the strike price I’m happy to lay out 7% of my current net worth at any time to buy the stocks. The enthusiasm for this action stems from the fact that at the strike price, I would be able to buy 2 well-capitalised deposit-gathering machines at 5x pre-tax earnings. The premium is roughly 10% of the strike price, which also looks quite compelling. This combination of sufficient “premium” and long-dated life appeals to me. However as Mr Buffett has advised “if you like the stock so much to write put options on it, you will be better off just buying the stocks” when he explained the 1993 put options he wrote on Coca Cola. Hence selling put options is by no means a change to what I have done so far, ie, find great businesses and don’t overpay for them. I’m also not comfortable to push the float beyond 10% of my net worth. Hence, that leaves some room for another put option to be sold in 2 year time.

Amazon

I also bought Amazon – the house that Jeff Bezos built. I wrote to a group of friends outlining my thoughts behind the purchase as follow:

“I’m gonna pitch a super boring idea but exciting company. Won’t score me any originality point here.

I think Amazon is cheap….or an elephant hiding in plain sight. The headline PE is in its own league, at 60x-70x thereabouts.

However it’s cheap because the future earning power is huge, and it makes the market cap of $900bn of Amazon worth it.

Two ways to think about Amazon cheapness, both of them I didn’t come up with but I “stole” from reading others opinions (Sequoia Fund and Bill Miller):

1/ The segments in amazon that are the easiest to discern earning power is AWS and its advertising business. One has a reported ebit margin of 25% and one has a characteristic of being able to earn 25%. Assuming AWS and advertising to grow 25%-30% top line next 5 years, and a multiple of 20-25x pre tax earnings, then Amazon current market cap only reflects the valuation of AWS and advertising in 5 year time. Leaving the e-commerce biz for free here. So then the problem is to determine the earning power of the e-commerce biz which is up for interpretation.

There are two ways of thinking about the valuation of Amazon e-commerce biz. One is to view it from the “Costco” business model and the second is to look at it from the “margin destroying” angle (“your margin is my opportunity” – Bezos).

Amazon reinvested the majority or all of its First party and ThirdParty sales into 1/ lowering prices further and further (free shipping, one day delivery, mark up by just 15%, cheap prices on unlimited selection etc) and 2/ satisfying customer unknown needs (do you want a talking black box in your kitchen (Alexa), no? We gonna give it to you anw). And as a result, they killed all of their margin (eBay margin on third party is a whopping 22%, but eBay doesn’t spend a dime on any of these margin destroying initiatives).

All of these results in Prime membership fees flowing directly through to profit, which at 130m members and a price of $130 per annum, that is $15bn or so flowing directly through to profit (I assume here that profit on third party and first party sales are used to offer the benefits of Prime – so prime videos, free shipping, etc. I would argue that it can flow directly through to profit if you look at the first party, third party and prime as a group). And hence this is pretty much like Costco biz model.

2/ the second way is to think about Amazon steady state, ie do I get the growth option for free? If we assume Amazon to stop all of their margin destroying initiatives, then First party sales should earn 3-4% pre tax margin (Amzn and Costco and Walmart have similar mark up policy- only mark it up by 15%), physical stores which is Whole Food earning 5%, Third party should earn 20% (similar to eBay), AWS should be eventually able to earn 35% (akin to Azure reported margin), advertising biz should do 25% (akin to google and fb). Then I estimated the normalised earning power assuming Bezos stopping all of his margin destroying initiative is $40-$50bn pre tax ie 20x or so pre tax multiple on current market cap which seems fine. As such all the growth option is for free”

Now it is important to realise that there are quite a lot of subjective assumptions used here. And as such I demand more margin of safety both in the way of appropriate position sizing (4%) and the value-price gap. I first read Jeff Bezos shareholder letters in 2017 and I think it is an extraordinary business priced quite fairly.

Saving

The saving journey is tracking well. The average saving rate is currently 40-60%. 5-10 months from now, at the age of 25, I should be able to cross the first $100k in net worth, the majority of it being tied up in pieces of wonderful businesses ran by business leaders I admire immensely.

I owe nothing in credit card debts nor student debts or mortgages. This is a blessing as I have a great family who took good care of my education and has been taking good care of my life for the past 24 years. I shall not treat this advantage lightly, and in fact I will take full advantage of it to accumulate more net worth.

“I crave the independence” as Mr Munger put it.

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