This week, Jamie Ward returns to talk about how passive investing is logical but isn’t really investing. He also posits that passive investment cannot exist without active investment but the reverse is not true. Companies covered: DCC, OCN.
US inflation data set the tone for markets last week. The previous readings for US core and raw inflation were 4.1% and 3.7% respectively. Core inflation, which exclude certain seasonal factors, was expected to stay the same this month whilst the raw figure was expected to decline to 3.3%. Both versions of US inflation came in 0.1% lower than expected. That might not sound a lot but consider that in a monthly-released data point of an annual measure, eleven of the twelve data points are already known. The effect was profound on the day with small and mid-caps around the world seeing a particularly strong bump. Overall, for the week, both US and UK broad indices saw gains of around 2.5%. Unsurprisingly, the moves were felt in the fixed income market also with the yield on the UK ten-year Gilt declining >20bps for example – at its most extreme during the week, the cost of borrowing for the UK Government had declined by 35bps.
If you take the Ben Graham definition of investment, the phrase ‘passive investing’ is oxymoronic. He stated that:
‘An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.’
But to do so passively explicitly removes the analysis element since it involves buying indiscriminately. Nevertheless, the trend toward passive investing seems unstoppable. There is an obvious logic to it, that is all investors as an aggregate will generate market levels of returns minus the fees. In the UK for example, the returns generated by all and sundry are equivalent to the FTSE All Share less the cost of investing. Thus, obtaining the average as cheaply as possible sort of makes sense, if you squint a little bit.
Passive investment is cheapest when it is simplest. It becomes more expensive the further it moves away from simplicity; add in a style factor like ‘value’ and the rule set makes it harder to replicate and thus, more expensive; use an asset class for which there are a considerable number of underlying securities and the complexity adds cost; move from a liquid class like the S&P500 to something more niche like French corporate bonds and the lack of underlying liquidity makes replication complex, and the end product more expensive.
Passive investing makes a forlorn acquiescence that average is as good as it gets for the whole and therefore, we may as well try for average and do so as cheaply as possible. It goes further though as it states that the only value that can be added to an investment operation comes from asset allocation and that individual security selection is a waste of time. There are even dubious academic papers that suggest this (cui bono? Probably the providers of passive products).
Were all investments to go this way then we would all get the same thing – low-cost mediocrity. I suspect that the readers of an investment article aimed at private investors want more from their portfolios. Of course, all markets can’t go passive, in reality, there needs to be investors making judgment calls on the relative worth of securities for prices to reflect the fundamentals. For me, this is an important point, for markets to function correctly, there needs to be price discovery, which is provided by active participants. In that sense, passive investment represents a parasite on active markets.
That’s not really meant to be pejorative, but rather to say that, I don’t believe passive investing can exist without active investing doing the hard work of ensuring price discovery – the reverse however is not true; active very much can exist without passive. If you spend enough time immersed in capital markets you can detect the influence of passive investment where, simplistically, stuff that is cheap seems to stay cheap and vice-versa. It wasn’t always thus. I have a feeling that the reason for this is that the marginal buyer of securities has been valuation insensitive for a long time now. David Einhorn mentioned it earlier this year when he said value investing was dead. He didn’t mean you shouldn’t do it, but rather when you buy something undervalued, there aren’t enough people out there making active decisions to correct the price to better reflect the value. Sad really.
For me, the purpose of making specific investment decisions is more than just about returns. When I make an investment, there is a belief that what I’m buying is going to become more valuable, but why I buy what I buy is as important as than the raw performance. This is very hard to formulate and so much of it is qualitative insofar that the reasons are based on mercurial criteria. For me, formulaic investment of the kind that can be defined down to a systematic approach is akin to paint by numbers whereas true investment, like true art, is closer to attempting to render the look and feeling of mist on a landscape painting. However technically challenging and realistic the final result, paint by numbers is never art, but the latter, when done well, can be.
Paint by numbers. Clever though it may be, it isn’t art
Maybe I’m just a romantic but there are certain attributes that I like to see when investing in individual businesses and even I struggle to define them. I certainly can’t quantify them and I’m absolutely sure that even were a passive investment provider minded to do so, they couldn’t replicate my own investment criteria.
Warren Buffett is right when he says that for a lot of people, the best thing to do is buy the cheapest index trackers. However, without active participants creating price discovery, I’m not sure I’d trust what these investment vehicles actually track. I feel I’m amongst friends on here with that viewpoint.
This week, I looked at DCC, which I thought about buying as recently as a few weeks ago and am now kicking myself that I didn’t. I provide an overview of Ocean Wilsons, a fascinating business-cum-fund of hedge funds that I have owned personally for a number of years and which also released last week, and which included an update on a strategic review.
DCC, Results for the six months to end of September
I wrote about DCC briefly and in passing in a piece I wrote last year about roll-up stories. DCC is one of the oldest and largest businesses listed in the UK that is involved in the practice of roll-up. In recent years, investors have become rather bored by the business and the shares have materially derated as a result. This most recent update suggests there is plenty of life in there still.
The history of DCC goes back to the late 1970s. It was founded as effectively a venture capital, which you can see from the origins of its name since DCC stands for Development Capital Company. Later on, it pivoted to a more buy-and-build type operation whereby instead of providing capital to bright young things with clever ideas, it became involved in rolling up smaller companies into a larger whole. The management adopted an opportunistic attitude towards the types of businesses it was willing to buy.
Early on it was focused on the energy sector, which remains by far the largest area. What it does here has evolved over time with the kernel remaining; that being the distribution of energy products and services to customers. Historically, this meant delivering LNG to customers not attached to a grid and the operation of petrol stations. These remain, but increasingly this is taking the form of providing installation services for renewable energy like solar.
The other, small divisions are Healthcare, which is involved in the sale and distribution of medical products and devices. As with energy business, the company sells across multiple geographies and is diverse in its customer base. Finally, the technology division acts as a fulfilment business for small technology businesses.
Today, the business remains a buy-and-build operation. What it does is unsexy, but it has always executed well and unsexy means simple. Whilst the sectors addressed are different, a reasonable couple of analogues would be businesses like Diploma and Bunzl.
In theory, the figures are in line with expectations, but the double-digit rise in the shares suggests a degree of relief and reappraisal from the market. For a good few years, DCC was a bit of a darling to those who knew it. Management executed well and generated a very nice outcome for shareholders with operating profits typically rising 14%(ish) every year on average. A few years ago, management decided it wanted to enter the US natural gas distribution market. This made a lot of sense for two reasons; one, DCC contains considerable expertise across different markets doing exactly this sort of business; and two, the US gas distribution market is large and fragmented owing to its vastness and relative sparsity of large parts of the country where few properties receive grid-based gas.
To do so, management raised considerable equity capital via a rights issue. Initially, investors remained happy with the strategy but every time they looked like closing a US acquisition, the price became too high and DCC walked away. Over time, investors soured on DCC since it had raised all this cash and they expected growth. For me, this was admirable and was largely because the cost of capital was so low that private transactions had become prohibitively expensive. To walk away when valuations stop making sense is the right thing to do. It reminded me of Bunzl in c. 2006 and 2007 when there was an effective moratorium on acquisitions owing to similar factors. In the aftermath of 2008, Bunzl made some of its best acquisitions and were able to do so because of the balance sheet strength created through discipline when deals were too expensive.
As with Bunzl back then, DCC went through a protracted period of balance sheet strength but now that the cost of capital has risen once again, it is able to make very astute acquisitions. In the last six months, the company committed £310m to new acquisitions at seemingly very attractive valuations. I don’t know the exact source of the rise on the day of the figures, but at a guess, the implied growth from the acquisitions and the assumption that DCC is back making acquisitions of size was a part of it.
For the eight years from 2022 to 2030, management believes that the company can double its profit in the energy business by applying the same disciplined approach to capital allocation it has always displayed. As by far the biggest division, this represents the majority of the growth for the group. It actually represents a bit of a slowdown on the previous 30 years however, given it is a much bigger business than at the time of list; this seems fair.
DCC is one of those businesses however that regularly underpromises (a la Next etc) so I would feel fairly comfortable that this is more than achievable. Despite the increase in acquisition spend, compared to its history, there remains plenty of balance sheet capacity were opportunities to deploy capital to present.
On an EV/EBIT basis, the shares have rarely been cheaper and you can see the derating very clearly that occurred when shareholders got bored., it was really only cheaper during the depths of the great financial crisis. This doesn’t seem fair even if the growth rate has tempered from the old 14% per annum to 9% per annum. Additionally, a dividend yield of 3.5% looks quite attractive.
The following isn’t a forecast as such but merely a musing. Were the company to grow at 9% per annum for the next seven years, and the dividend to be c. 3.5% and the shares to rise to c. 13x EV/EBIT, then the total return over that period of time would be c. 200% – I can cope with that.
Imagine becoming bored by a well-managed company that demonstrates its quality by withdrawing from making acquisitions when they become expensive. That is what has happened to DCC. The shares hit a high of >7500p in early 2018 shortly after the capital raise. Since then, a fairly extraordinary set of circumstances has led to a mere 10% increase in earnings whilst the shares are down by nearly one-third.
Three weeks ago, I sent a text message to a retired fund manager I know saying DCC looked erroneously cheap at c. 4600p per share and perhaps he may like to have a look. For some reason, I didn’t buy at the time and didn’t own it already. I’m going to rectify that in the next couple of weeks.
Ocean Wilsons, Trading Statement
Ocean Wilsons is weird. It is a holding company that is made up of two main parts. It owns 57% of a Brazilian listed port services business called Wilsons Sons. Wilsons Sons is undoubtedly a curious name for a Brazilian company but remember, not all of South American immigrants came from the Iberian Peninsula, hence why there is a football club in Chile called O’Higgins FC. Wilsons Sons is a decent business on a whole as it operates (regulated) local monopolies in various Brazilian ports. It is subject to the vagaries of the Brazilian economy, itself subject to that of global trade. But, by operating ports and related services, it can generate effectively rentier returns as owing to the fact that it isn’t exactly practical to set up rivals in the sector.
The other chunk of the business is a fund of funds – many of which can’t really be accessed by private investors owing to the minimum investment criteria.
The shares have been a bit lacklustre and frustrating (so naturally, I’ve owned them for a number of years). They have consistently traded at a discount to NAV, which is currently c. 50% and haven’t really had management engaged in closing that discount. This would be fair enough, unfortunately, there hasn’t been a lot of valuation creation to offset this as Wilson Sons, despite becoming more valuable is priced in Brazilian Real and the Real has been poor. The other side of the business, the investment portfolio, seems logically constructed but it too has failed to create much value.
Trading Update (Q3)
Since everything it owns has a price, Ocean Wilsons reports net asset value every quarter, as at the end of September, this was £22.70 per share with the Wilsons Sons holding making up roughly two-thirds of that. For reference, the NAV per share ten years ago was £13.44 – the share price was almost the same. The investment portfolio had a poor time, declining 3.7% whilst Wilson Sons seems to be going rather well. Of more interest, however, is an update on an announcement made on June 12th. Against all odds, management have become engaged regarding the vast difference between the value of its holdings and the value of the shares. It was speculated in the Brazilian press in June that Ocean Wilsons is negotiating the potential sale of 57% stake in Wilson Sons – one assumes the Wilsons moniker will be dropped were that disposal to occur.
Ocean Wilsons confirmed that it is undertaking a strategic review and ’will consider all potential strategic options’. It was also announced that it was early stage however and thus far, no third party had made a ‘formal’ proposal to acquire the holding.
Progress has been made. In the most recent update, the board announced that it has retained the services of a Brazilian investment bank as an advisor and that it had received ‘a number of non-binding offers for its indirect investment’.
I rather like port businesses because of the aforementioned rentier aspect allowing a degree of super normal returns to accrue to shareholders. Nevertheless, Ocean Wilsons hasn’t seemed to be a great vehicle for gaining exposure to the sector (albeit the value investor in me is attracted to the large discount). Rather, simply buying shares in Wilson Sons directly (if possible) would have given a cleaner exposure. It’s still early, but it is beginning to look like there is a potential that some of this value could be realised assuming that the valuations extracted via an eventual sale aren’t heavily discounted.
Management and Shareholders
There is a little oddity in Ocean Wilsons regarding management and shareholders. The investment portfolio is rather expensively managed by The Hanseatic Group (1% AMC plus a 10% performance fee with the usual caveats regarding high watermarks etc). The largest shareholder in Ocean Wilsons is The Hansa Trust, which is operated by The Hanseatic Group. The second largest shareholder is William Saloman, who sits on the board of Ocean Wilsons and is also chairman and senior partner of The Hanseatic Group. I’m comfortable with this arrangement as they are eating their own cooking (so to speak). Nevertheless, I’d like to see those investment management fees come down a little.
Valuation and Opinion
The value is less than the NAV, but the shares are far short of the NAV. This strategic review might well extract some of the value but one ought to exercise caution when ascribing the total NAV to the value of Ocean Wilsons. It is likely that were the indirect holdings in the group be sold to a third party, there will be a fairly sizeable discount applied to the NAV – the advisor will want paying too. Nevertheless, the 50% discount provides plenty of margin of safety on exactly how much discount occurs.
Although I mentioned it further up, for the avoidance of doubt, I do own shares in Ocean Wilsons.
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This article is for educational purposes only. It is not a recommendation to buy or sell shares or other investments. Do your own research before buying or selling any investment or seek professional financial advice.