I enjoyed the process of writing Value.able immensely and its best seller status suggests there’s a growing band of individuals in Australia who’d like to be successful value investors. If you want to become a successful investor or simply invest successfully, I believe it’s best to learn from those that have a demonstrated track record. As Buffett once observed, “Wall Street is the only place that people ride to in a Rolls Royce to get advice from those who take the subway.” One bloke who I count as a mate, a successful investor and who doesn’t need to take the subway, has written a book on investing that I think will prove to be a classic. Matthew Kidman and I were on CNBC together recently and knowing we were going to be on air together we happened to bring in our respective books, which of course we swapped. I have finished reading Matthew’s Bulls Bears & a Croupier, enjoyed it immensley and I commend it to you. If you were wondering what you were going to read over Easter, well now you have a very profitable suggestion. I am sure Matthew would love to hear what you think so be sure to return here and post your thoughts and questions.
Before I go, here’s an extract from Bulls Bears & a Croupier (pp173-176). It’s one of the many real life stories in the book and this one ties in nicely with our value investing and ROE methodology…
“ABC Learning Centres
I first met Eddy Groves in 2001. I was sitting at an outdoor cafe with Geoff Wilson when he came strolling down Macquarie Street with a stockbroker, planning to pitch the float of his childcare company, ABC Learning Centres. If memory serves me correctly, he was wearing a light grey suit with an open neck shirt. He didn’t quite fit the textbook profile of a CEO, with his shoulder-length blond hair and Cuban-heeled boots. When I said to Geoff, ‘Here they come’, he leaned over and said, ‘How are we going to invest with this guy? He looks like Johnny Farnham’.
Over the next hour Eddy, still only in his thirties, was subjected to a range of tough questions, but to his credit, he wowed us with his knowledge of the childcare business. At that stage the company only had 31 centres in its portfolio but Eddy knew every employee in every centre, every rental charge per square metre, the occupancy level of each centre, the waiting lists and so on. He was also disarmingly honest, telling Geoff and me straight up,‘The key to our business for the shareholders is the occupancy levels at our centres. If occupancy is above 90 per cent then we start to make a lot of money.’ He repeated that comment several times during that session and in many subsequent meetings. I have not met a CEO before or since that day who demystified a business so rapidly for incoming investors.
At first we weren’t convinced. Still sceptical of this young Queenslander, and never having come across a childcare operator that relied heavily on government spending, we decided to give the float a miss. Before the company listed on the sharemarket a couple of months later, I met Eddy at least twice more and said to Geoff that we needed to look at this company more carefully, because this guy really knew his stuff. Not many people were prepared to look at the company because it was so small, but I thought it fitted into our sweet spot — undiscovered and fast growing.
The stock listed and Eddy got busy buying more centres and spreading the gospel of his company to investors. He had enough energy to run a power station. It wasn’t long before the broader market discovered the company and its colourful chief executive. In those early days he worked exceedingly hard with only a handful of stockbrokers hovering around sniffing for fees as the company needed to raise capital to fund its endless list of childcare centre acquisitions.
Whatever Eddy Groves was doing, it was working, and the share price increased threefold in a short space of time. It was only then that we wilted and decided to help buy a parcel of shares in ABC held by Hunter Hall, who had profited nicely. Luckily for us, though, Eddy was only just getting started. His empire around Australia was expanding exponentially and over the course of the next year or so we watched our investment triple before our eyes. Things got so hot and steamy the company thought it necessary to split its stock to create more liquidity and give the impression it was not so expensive. The pièce de résistance was the merger with Australia’s other largest childcare centre manager — Peppercorn.
The brokers were now lining up to support the company, which was like a fee-generating machine on the back of so many capital raisings and mergers. ABC now stood at the top of the mountain.
Then the 20 per cent plus growth that investors had become accustomed to started to become harder to achieve. Eddy turned his attention offshore and before you knew it he had bought businesses in the United States, followed by operations in the United Kingdom. Following a series of capital raisings, the market capitalisation of the company had soared into the billions, while the PE kept travelling north to well above 20 times forecast earnings as investor interest started to emerge from all over the globe.
There had been some public detractors of the stock, including well-known analyst, market commentator and fund manager Roger Montgomery, who made the prescient observation that returns in the business had gradually declined over time as more and more acquisitions were made. He was, like Winston Churchill, a voice in the wilderness, with the share price rising each day as investors, including me, ignoring the financial fundamentals.
In 2006 I went to a presentation by ABC at a big brokerage firm where there was standing room only. I was lucky to grab a seat near the door but due to the size of the crowd I couldn’t see Eddy — but I could hear him. I had decided to come along just to get an update on the latest acquisition and find out how the business was travelling. There were a lot of new investors in the room asking questions that long-term investors had asked many times before, so I was guilty of not concentrating and reading something else. And then one person piped up and asked the question: ‘What are the occupancy levels of the centres in the US?’ Eddy replied that it wasn’t important to concentrate on occupancy levels. I nearly fell off my chair. Another person asked why that was the case and Eddie launched into a long-winded answer that didn’t really make much sense.
I didn’t stick around to hear the rest of the presentation, sneaking out the door that I was sitting near. I raced back to the office and as I walked in I said to Geoff,‘ We need to seriously think about selling our ABC Learning shares’. He said, ‘It’s fine with me’. We spent the next few days re-examining the accounts and we had a lot of questions, including what had happened to $400 million of cash that had seemingly disappeared. Fortunately for us the stock was still trading in tremendous volumes and we were able to sell our shareholding at slightly more than $7 a share.
As is well documented, ABC Learning hit the wall in 2008 when the GFC hit. The company, which had enjoyed investor support to the tune of more than $1 billion through a series of equity raisings, had somehow found a way to fall prey to a multi-billion dollar debt burden.
There were many lessons to learn from the ABC Learning experience, but the point here is that stocks can be in the limelight for days, months or even years, only to become a disastrous investment down the track. Invariably as a story spreads across the market and more and more people get interested, more exotic reasons are created to buy the stock. Stockbrokers will place price targets for the stock near the current share price level, and when the PE ratio goes from say 10 to a head spinning 20, the analysts will generally follow with their valuations of the business. Things like sagging returns and higher debt levels are conveniently pushed to the side by investors and brokers as they all get sucked into the vortex of a rising stock price. At some unknown time in the future the share price will reflect the financial fundamentals and start to fall. For the investor the hardest aspect is timing when this will happen rather than if it will happen.
Our croupier Peter Proksa learned this the hard way. In his bid to avoid paying too much for a stock he has limited his investments to shares or options that trade at 1 cent of less. This method also removes the possibility of his becoming enchanted by the story rather than concentrating on the facts presented in the accounts.
The reality was, however, that if you were onto the ABC Learning story early, like the Hunter Hall investment team, then you could have made many times your money. The key was seeing that things were changing and working out when to sell. Roger Montgomery picked it and was happy to tell the rest of the market, which should have listened more carefully. Things had changed at ABC Learning over the years and Eddy admitted it in that meeting, but most people holding the stock just weren’t listening to the message he gave everyone.
There are snakes and ladders everywhere
Many people will argue these two examples do not apply to the big end of town, where a special breed of stocks called blue chip resides. And there is a grain of truth in this. There is very little chance of a big company going broke in Australia due to an unwritten contract between investors and company management who know they are too big to fail. That does not make them immune from being shocking investments.”
Extracted From Bulls Bears & a croupier, John Wiley & Sons, 2012