Richfield International Services

On Monday I finally managed to purchase some shares in the highly illiquid Richfield International Limited (17,538 units for $0.115 each). The way in which I eventually got hold of those shares was rather serendipitous. A number of months ago I put out a buy order for RIS shares - determined to pay no more than 11 cents - but the sellers were always out of reach, usually asking for 12 or 13 cents. Eventually tiring of this stalemate, I thought to myself that if someone offers 11.5 cents I'd just take it. One day I remarked to my friend Kelvin about RIS, 'That damn seller on the other side won't budge either', which is when he laughed with amazement and told me he had just placed an order to sell at 11.5 cents. Incidentally he was thinking the same thing about the highest bidder (me), hoping that I would yield. We quickly agreed to place orders at 11.5 cents on Monday, which were executed first thing in the morning. Initially I was rather concerned to find out that he was selling while I was buying but having made a decent profit he simply wanted to reduce his weighting in RIS. At least that's what he tells me...

I suspect most readers have never heard of the $7.2 million business called Richfield International, which is probably why diligent value investors can come across these opportunities. Having suspended its loss making container ship operation, RIS provides port, shipping and chartering services for foreign-vessels. Although listed on the Australian Securities Exchange, RIS primarily operates in countries such as Singapore, Vietnam, Bangladesh, Indonesia and Thailand. The company's main subsidiary was founded in 1984 by Chak Chew Tan, who has been managing the business ever since. If he's stuck around for that long, Tan probably views RIS as his baby and is more likely to put the long-term interests of the company ahead of any short-term focus. It's also great to see that he holds 23.4 million shares, making him the largest shareholder and therefore has his interests aligned with mine. 

Recent years have been tough for the shipping industry with sustained depression in shipping freight rates while operating costs have been increasing due to higher bunker fuel costs. This has had a flow-on effect for RIS since it provides services to these shipping companies, but its financial results have been improving over the past few years. This is rather interesting as I can't identify any competitive advantages that RIS can provide in its highly competitive sector other than the long-term relationships it has established with customers over the decades its been around. Anyhow, should the shipping industry recover sometime in the future, RIS is very likely to further increase its profitability. For what its worth, in its 2013 annual report management needed to perform a goodwill impairment test and used a forecast revenue growth rate of 3% p.a which they considered 'ultra-conservative as there is an expectation of a rebound in the global shipping sector over the next four years'.

Fortunately, my investment thesis doesn't rely on conditions improving as RIS already produces earnings that can easily justify its current market price. In the financial year ended December 2013, RIS reported a net profit of $964,725 but adjusting for foreign currency gains and the discontinued container ship subsidiary, I estimate its normalised earnings were around $850,000. This puts RIS on a P/E ratio of around 8.5x, far from expensive. Margins were very high, with a gross margin in 2013 of 87.4% and a normalised NPAT margin of around 23% so any sudden increase in costs shouldn't cause RIS to start making losses. It's also a very capital light business which is generally a good thing but with negligible capital expenditure I'm slightly concerned that RIS is underinvesting in itself. However, as a service business it relies more on its people than property, plant and equipment which may excuse the low investing cash flows. As a result, the great operating cash flow of $1.7 million goes almost straight to its bank account.

This brings me to the final, and most significant reason why I invested in RIS - its cash pile. This is one of those rare instances in the share market where you find a profitable company trading below its net cash: $11.4 million vs a market capitalisation of $7.2 million. Even if RIS decided to pay off all its liabilities (primarily payables), it would have $8.4 million in cash. If you include receivables of $700,078 RIS could have up to $9.1 million in excess cash. In other words, the market is offering a situation in which a sole owner of the business could buy it for $7.2 million, pay himself at least $8.4 million in cash and be left with a business earning around $800,000 a year (adjusting for the loss of interest revenue). And with every quarterly report RIS is building up more cash: in the first quarter of 2014 operating cash flows were an excellent $461,547, bringing the cash balance to $11.9 million. Although that operating cash flow could be distorted by a reduction in working capital or other one-off factors, it's a very encouraging start to the year.

This is primarily a statistical bet for me - it is unlikely to shoot the lights out in terms of returns and may take quite some time to play out but with the large amount of cash on the balance sheet, it seems hard to envision this investment being a terrible one either. Nevertheless, there are of course a few risks to keep an eye on. The shipping industry is obviously one, blowing the cash on an overpriced acquisition or diluting shareholders unnecessarily for a large acquisition are others (Chak Chew Tan got approval from shareholders for the ability to issue an additional 10% of the shares on issue and has mentioned he's on the lookout for mergers/acquisitions). Regrettably, as good as this investment appears now I passed on it when it was around 7 or 8 cents. Ah well, better late than never.

P.S You might want to take a look at their very retro website. Rather concerning how 1990s it is, but if it's a reflection of the tight cost control at RIS, I'm all for it. After all, the $300+ billion Berkshire Hathaway isn't too different.

Random Thoughts About Randomness and Black Swans

Nassim Nicholas Taleb reminds me of the venerable Charlie Munger in many respects: they are both experienced (and successful) in finance, multidisciplinary, iconoclastic, unwilling to mince words and voracious readers. After hearing his name crop up many times with regards to investing, I knew that I had to get around to seeing what all the fuss is about, and I'm glad I eventually did. 

In Fooled By Randomness: The Hidden Role of Chance in Life and in the Markets and The Black Swan: The Impact of the Highly Improbable, Taleb argues that the world we live in is subject to considerably more randomness and extreme events (Black Swans) than we usually realise. I think they're both great reads, not just for investors but anyone who needs to make decisions under uncertainty (i.e. everyone). 

One of my favourite examples from The Black Swan is his idea of the turkey problem. Imagine a turkey that is fed every day for 1000 days. From its point of view, with each passing day and each meal, it gains increasing confidence that humans are acting in its best interests. That is until day 1001 which turns out to be the Wednesday before Thanksgiving... This event is a Black Swan for the turkey, but not for the butcher who knew it would eventually happen. Extend this problem to any patterns that humans interpret - even with 1000 years of evidence to suggest something will continue, it is impossible to predict a Black Swan type event that has never occurred before and we could find ourselves helpless as a turkey in the face of the unforeseen event. 

What does this mean for us then? It means that we need to be very wary of relying on past data to predict the future and individuals should try to make themselves robust to Black Swans. In financial terms, that might mean reducing debt or eliminating leverage from your life altogether, taking out more insurance protection, or it might mean that you need to diversify your investments more. It makes me wonder whether it is reasonable to assume that share markets will continue to outperform all other asset classes over the long term. Despite over a century of information indicating share markets return around 10% per annum, the next century could severely disappoint - Taleb reminds us that Black Swans aren't just completely unexpected events, events that are widely expected but do not materialise are also Black Swans. It is impossible to determine with precision the likelihood of this Black Swan. 

Perhaps we need to look deeper and try to determine the cause/s of the pattern we see in order to establish whether it is truly sustainable and to find out what could disrupt its continuation. For instance, one could argue that because share markets are more volatile in the short term, they deserve to be priced at a discount to less volatile asset classes (in finance speak, shares require an equity risk premium). A 5% p.a. return from the share market that could vary wildly year to year is not as desirable as a smooth 5% p.a. return from your bank account, so shares should be priced to give a higher return. Therefore, one would need to figure out what if and what could disrupt this driver of returns. Is it possible that shares become less volatile in the future? Is it possible that corporate earnings (another driver of the excess returns from share markets) could grow at a much slower rate in the future or be hit negatively by a Black Swan? Is it possible that interest rates will be permanently lower (and therefore all investors receive a lower return)? The answer is yes, they are all possible, but I would guess improbable. Therefore, with an awareness that 10% returns are not set in stone, I come to the conclusion that investing in the share market over the long term is still the best course of action - others may disagree and they would be perfectly justified in doing so as the answers are too unclear. 

Speaking of the best course of action, I recently wrote about my loss on Antares Energy: "I think that the initial reason for purchasing was still valid, as it appeared more likely than not that the deal would go ahead, in which case the net cash per share would have been almost double my buy price. Unfortunately, chance has an annoying habit of making rational decisions look silly from time to time, but that's just a part of investing you have to deal with." I was trying to communicate the rather counterintuitive idea that even though I made a loss, it was the right decision to invest in Antares. 

Fortunately, I'm not the only who thinks this way and Taleb is more eloquent in explaining it than I am: "I will repeat this point until I get hoarse: A mistake is not something to be determined after the fact, but in the light of the information until that point." If that still doesn't make sense, consider a situation where if you roll a six-sided die and land a three, you have to pay me $5 but if you roll anything else, I'll pay you $5. Clearly, the odds are skewed in your favour - the rational thing to do would be to grab the die and roll it as many times as you can before I realise my idiocy. But what happens if I only gave you one roll and you happened to roll a three? Sure, you lost money but your decision to roll the die was not a mistake. In light of the information that you were provided, you made the rational choice but the outcome was obscured by randomness. The exact opposite occurs in a casino. 

Taleb expands on this concept a little more, stating that, "One cannot judge a performance in any given field (war, politics, medicine, investments) by the results, but by the costs of the alternative (i.e., if history played out in a different way). Such substitute courses of events are called alternative histories. Clearly, the quality of a decision cannot be solely judged based on its outcome, but such a point seems to be voiced only by people who fail (those who succeed attribute their success to the quality of their decision)." He applies this alternative history idea to the choice of a career. For example, if you decide to become a dentist, your future financial position is far easier to predict than one in which you become a writer (where only a very small minority claim the majority of money to be made in the writing industry). Therefore, even if you made it big time as a writer and became a billionaire like J.K Rowling, you made the irrational decision financially. If you lived your life as a writer another thousand times, in the majority of those lives you would be pretty poor. Although it is very unlikely you'll ever become a billionaire in your thousand dentist lives, it is also unlikely you'll be struggling financially. Performance should be evaluated using this logic - despite a favourable or unfavourable outcome having occurred, what were the alternatives that could have happened? Unfortunately, it seems humans are wired to take outcomes at face value and ignore these alternative histories. 

A corollary of this alternative history idea is that the financial success of many billionaires or the fame of many celebrities is simply due to luck. There will always be a few lucky fools that were simply in the right place at the right time, but they are usually admired all the same as those who succeeded due to inordinate skill or effort. Equally, it is an unfortunate truth that there are many extraordinary individuals deserving of success that the world will never know of because they were unlucky in some way or another. I suppose the lesson to learn here is not to simply judge people on where they ended up, but rather to look at the alternative histories that would have occurred if they lived their lives many times over. Or in Taleb's more profound words, "Heroes are heroes because they are heroic in behavior, not because they won or lost."

Although I have doubts about some of Taleb's other ideas such as his 'barbell strategy' and found him to criticise a little too much for my liking, I wholeheartedly recommend you read Fooled by Randomness and The Black Swan. In this blog post I've only scraped the surface of what he writes about in those two books, as it is difficult to compress his ideas - a compliment to Taleb. I haven't got around to reading his most recent book, Antifragile, but I'm expecting it to be similarly thought-provoking. 

Finally, I thought I'd pass on a great piece written by Tony Hansen, who runs Eternal Growth Partners. More interesting thoughts abound here. 

Vision Eye Institute and a Portfolio Shakeup

I'm happy to report that on Monday I went on a bit of a shopping spree (on stocks of course), adding some Vision Eye Institute (ASX:VEI) and topping up on my existing holdings, which I'll talk about later. Many Australians in New South Wales, Queensland or Victoria will have either heard about Vision Eye Institute or have utilised their ophthalmic services. These eye related services are broken down into three categories: consultations, refractive surgery (better known as laser eye surgery), and other surgical procedures performed in a day surgery. In the last decade, the company experienced rapid growth as it bought more clinics and attracted ophthalmologists on the east coast, but poorly structured deals eventually led to an exodus of ophthalmologists. In combination with a high debt load, the company was brought to the brink of bankruptcy but has fortunately managed to stage a recovery recently. 

Instead of rambling on for many paragraphs about why I believe VEI is an attractive investment, I thought I'd try to keep my reasoning as concise as possible this time. Many of the most successful investors such as Peter Lynch and Warren Buffett suggest that investors be must able explain why they are purchasing a stock in a succinct manner, which makes perfect sense to me. It focuses your attention on the most important factors, encourages you to be rational, and ensures that you clearly understand the rationale. Alright, here we go!

Around 90% of VEI's revenues are non-discretionary due to the essential nature of its services to its customers. This stability in revenue was demonstrated throughout the global financial crisis and the years afterward which were spent addressing the decline in ophthalmologist numbers. Better still, with the ageing population, demand for VEI's services should continue to grow at a nice 5%+ p.a over the foreseeable future. The past issues of ophthalmologists leaving appear to be largely resolved, with the number of doctors increasing from 68 in October 2013 to 77 doctors currently. With management indicating that they will recommence the search for organic growth by expanding the number of clinics/ophthalmologists, economies of scale should help boost margins and build its competitive position. The cost of interest payments has also been dramatically cut in the most recent half, which will boost profits and reduce risk. Regarding the all important price, I estimate that VEI is trading on 7x to 8x its FY14 earnings and a DCF calculation confirms that it seems cheap enough for me. Finally, with a 20% stake in VEI, Primary Healthcare (ASX:PRY) may look to acquire the whole business, perhaps providing a nice catalyst for a re-rating in VEI's share price. 

On the flip-side, I think it's also a good idea to balance out that optimism by writing down the main risks which could result in a poor investment. To my mind, the main two are the bargaining power of ophthalmologists which is putting pressure on gross margins, and the gearing level. As the most important assets of VEI's business, the ophthalmologists have been able to push for an increasingly higher share of profits. Although gross margins have fallen from more than 50% to 43% in the first half of 2014, management have warned that this margin compression will continue. Although I believe that this trend will come to a stop in the next couple of years to balance with the benefits of VEI's business model to the ophthalmologists, I could be completely wrong, in which case the earning power of VEI may not be able to justify its current valuation. Despite reductions in net debt from $105 million in 2008 to $30 million today, this is still a relatively high 40% net debt/equity ratio. Furthermore, there are very few tangible assets to back its borrowings, so shareholders and creditors are solely reliant on the continued cash flow generation of VEI to sustain that $30 million of debt. Given the banks require $3 million to be repaid this year, management need to be careful with balancing their growth and dividend intentions in order to avoid another debt debacle. 

Although I don't think VEI is going to shoot the lights out in terms of share price performance from its current level and the risks outlined above are concerning, the case for investment was still tempting enough for me to purchase 2,786 shares at $0.61 on Monday. Speaking of temptations, it was difficult to resist making one of the endless lame puns on 'vision' that I was thinking of, but if that's your thing, take a look at the VEI attempts in their older annual reports (how about the 2005 line: 'focused on the future'). 

On a less positive note, I decided to finally exit my position in Antares Energy (ASX:AZZ) at a loss of around 23% on Monday after the proposed takeover offer of US$300 million fell through. Even though a number of investors I highly respect either recommend or hold Antares, holding onto this kind of business for the medium to long term is simply outside my circle of competence and I don't feel comfortable relying on the opinions of others. I think that the initial reason for purchasing was still valid, as it appeared more likely than not that the deal would go ahead, in which case the net cash per share would have been almost double my buy price. Unfortunately, chance has an annoying habit of making rational decisions look silly from time to time, but that's just a part of investing you have to deal with. 

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In addition to the above transactions, I added $6,600 to my portfolio and used most of it to purchase existing shares so their weighting in the portfolio stayed in line with what I think is reasonable. These purchases were 331 TGA at $2.11, 482 IMF at $1.86, 7,096 BOL at $0.155, and 12,000 ACG at $0.125. Consequently, my portfolio value currently stands at just over $16,000 with around $2,000 in cash that will hopefully be invested in a new stock if my buy order gets executed soon. This means that I've more than doubled the size of my portfolio in less than a month, and to account for my additional contributions, I'll be calculating a time-weighted return (the measure used by professional fund managers to adjust for inflows and outflows). Although portfolio performance over the past few months has been disappointing, I feel much more comfortable going forward with AZZ gone and the additions of ACG, BOL, NOD and VEI. It is probably for the best that my investing ego isn't inflated so early on by excellent portfolio performance, and it's also a good reminder that the index (All Ordinaries Total Return) is a tougher benchmark to beat than most people expect. To the right are the full gory details of my portfolio. 

For those of you seeking more detailed analysis of VEI, I can once again highly recommend The 8th Wonder - who incidentally posted just after I bought shares - and Intelligent Investor Share Advisor. After completing a six week internship at Intelligent Investor Funds Management (who are the second largest shareholders of VEI according to the 2013 annual report) and the guys at Share Advisor, I can definitely vouch for their ability and integrity. And no, unfortunately I was not paid to say all that. 

Nomad Building Solutions

Today I purchased 33,333 shares in Nomad Building Solutions (ASX:NOD) at a price of $0.051 each. Like Boom Logistics, this is another stock that was brought to my attention by Alex over on The 8th Wonder. Their main business now is a subsidiary called McGrath Homes that builds and sells modular homes in Western Australia. Unfortunately, because I'm very snowed under with university work at the moment, once again I'm going to refer readers to Alex's summary of why NOD looks cheap, which I substantially agree with. Besides, after that long post on Atcor Medical, I think both you and I could do with a shorter post.

I'll just point out one important piece of the puzzle that Alex didn't mention in his post, and the one that concerns me the most - while NOD has wound down the Nomad Eastern States segment, they had a non-cancellable lease over a premises in Wacol, Queensland. If you look at the annual report under note 29, you'll find that Nomad is required to pay more than $3 million in FY14 for non-cancellable leases, almost $10.6 million in the four years afterward (an average $2.6 per year), and $2.3 million thereafter. I'm assuming that the entirety of these amounts refer to the Wacol lease, as the $3 million figure roughly lines up with the $1.4 million loss from operating activities in Nomad Eastern States for the first half of FY14. This is very significant in relation to the group's profits and will continue to drain cash until management is able to sub lease this property, which is understandably one of their highest priorities at the moment. When and on what terms this sub lease is established is an important risk, and one investors should watch closely.

AtCor Medical

Since its invention in 1881, doctors, specialists, researchers, hospitals and pharmaceutical companies have been utilising the sphygmomanometer. Sph-what? Don't worry it's just the inflatable cuff that your doctor may have placed around your arm that is used to measure blood pressure. It's proven to be a very useful device for predicting and preventing cardiovascular disease, strokes, diabetes, kidney failure, eye disease etc. However, while it measures the blood pressure in your arm, known as brachial blood pressure in medical parlance, what we really want to know is the blood pressure around your heart, or your aortic central blood pressure. Until recently, the only way to find that out was to use an invasive catheter - basically a tube they stick into your body to reach the heart - and as such, this was typically done in a hospital. 

The SphygmoCor XCEL

However, in 1992, a company was co-founded by two clever guys and in 1994 they developed a device called SphygmoCor. It was able to take your brachial blood pressure (blood pressure in your arm) and mathematically derive your central blood pressure with a good degree of accuracy compared to the invasive catheter, in addition to a host of other useful measurements. The newest iteration of that technology called the SphygmoCor XCEL is in the cuff based form that GPs and patients are used to. The operator simply presses start, waits 60 seconds and all the data is fed to a computer.

As you might have guessed, I'm writing about all this because the device and its 8 patents are owned by AtCor Medical (ASX:ACG), which designs, manufactures and sells the SphygmoCor products all over the world with the help of distributors. Although I typically stay away from emerging biotech companies because they are often too speculative and too hard to understand, the risk/reward appeared compelling enough for me to buy 14,530 shares at $0.12 yesterday. I've actually been following this company since June or July last year, when shares traded at around $0.07 and I was very tempted to dip my toes in and buy some shares. My more intelligent friend purchased shares but regrettably I didn't, and I watched as the shares rocketed up to a high of $0.21 in October, before gradually dropping back to its current level. At a market capitalisation of $18.9 million, or $21.3 million assuming all options are exercised, I believe that this business could be significantly undervalued and will try to explain why. 

In the last decade, study after study has come out showing that central blood pressure provides more useful information than brachial blood pressure. Even though two people could have the same brachial blood pressure, their cardiovascular risk as measured by central blood pressure can differ significantly. Using central blood pressure helps doctors to diagnose people better, and a study has shown that it improves treatment too, since the better diagnosis allows them to prescribe fewer drugs to patients. In addition, pharmaceutical companies are able to develop more effective drugs with fewer side effects, cardiologists are able to better treat complex cases of hypertension (high blood pressure), renal physicians can improve treatment of kidney problems, and researchers are able to draw better conclusions in their studies. The list goes on. 

The body of evidence in support of using central blood pressure is growing every year, with over 100 new peer reviewed journals being published each year. At the forefront of this trend is ACG with its SphygmoCor technology, having been mentioned in over 700 per reviewed journals to date. As the first device to measure central blood pressure through a noninvasive method, it's been subject to a lot of scrutiny, and has held up quite well. So much so, that new devices are regularly compared to the SphygmoCor in academic papers to determine accuracy, and the management of Atcor labels its device the 'gold standard'. I am quite confident that this technology will eventually replace the old sphygmomanometers that only measure brachial blood pressure, but what I'm much less sure of is how long it will take. Some other important measures a SphygmoCor device can take include pulse wave velocity, heart rate variability and arterial stiffness, but I won't get into these (mainly because I don't understand myself). 

Reflecting their usefulness, these machines do not come cheap, and although I am not sure about the latest figures, I believe they were being sold for $15,000 to $20,000 before. This is obviously why ACG has stunningly high gross margins of over 80%. Assuming they sell for $15,000, that means it only costs ACG $3000 to manufacture it. However, as a small company, administrative expenses, marketing and sales expenses, and research and development each away at a large portion of that gross profit. With a substantial amount of relatively fixed costs, ACG has a lot of operating leverage, which will supercharge profits when revenue increases, and vice versa. Only last year AtCor managed to report its first profit after many years of losses, and has had positive cash flow from operating activities for the last 6 quarters. Bear in mind however, that ACG has been receiving financial support from the government through grants and R&D tax concessions, and this will not continue indefinitely. Recent performance has meant the balance sheet is in much better shape than it has been in the past, with cash of $4.1 million and no debt. 

ACG's head office is based in Sydney, but it is in their American office that the CEO Duncan Ross resides. Why? Because for many years ACG has been focusing on driving penetration in the US market. Rich, developed nations that seek out the best technology are the perfect target for ACG, and America falls into that category. In addition, the majority of big pharmaceutical companies are based in America, and around 60-70% of ACG's sales come from selling devices to these companies for their trials. Astonishingly, as of late 2012, SphygmoCor had a 95% share of the market in this pharmaceutical trials sector and speaking with management on the phone, it seems Atcor's position may have even turned into true monopoly. Aside from providing higher quality data, one of the reasons for this is because ACG adds further value by offering data management services to pharmaceutical companies, which can be quite a hassle for these companies if they are running big trials. AtCor's exceptional service has led to a 100% retention rate in this market. Apparently one pharmaceutical company tried a competing product, in the end coming to ACG and saying that they regretted it. Management reckons that the market for selling these devices to pharmaceutical companies is US$110 million annually. With only single digit penetration so far, ACG would be hugely successful if it could continue to maintain that monopoly whilst take up within the industry heads higher, given its total sales were just $9.1 million last year. 

Unfortunately, the pharmaceutical trials market is quite lumpy, and delays in contracts has led to ACG's sales dropping 51% in their most recent half (56% on a constant currency basis), knocking the share price down a fair bit. Nevertheless, I believe that this is only a temporary hiccup that the market is too impatient to look past. Encouragingly, sales to US clinicians grew 77% in spite of uncertain market conditions. One major short term risk is that in FY13, $5.3 million out of AtCor's $9.1 million in sales were from just two customers (which I presume are pharmaceutical customers). This helps to illustrate how ACG's revenue could easily fall dramatically, as it did in the first half of FY14. Fortunately, results are expected to improve in the second half, and the pipeline of potential new pharmaceutical business is quite strong at more than US$16 million. 

The other three markets that ACG is targeting are the clinical specialists (such as cardiologists, nephrologists and endocrinologists), researchers (universities and affiliated hospitals), and the clinical - primary care market (GPs, internists, executive health, wellness centres). The research market has the smallest potential at US$22 million annually, followed by clinical specialists at US$100 million, pharmaceutical trials at US$110 million, and finally the clinical - primary care market at US$268 million. In total, the global market potential is around US$500 million annually. Penetration in the research market is 11%, while the other three categories are in the low single digits. As you can imagine, with its current margins, even if ACG manages to capture even 10% of that $500 million total, shareholders at the current price will do very well. Driving adoption in the specialists is particularly important, because general practitioners want to see that the specialists are using a procedure before they adopt it themselves. 

For years ACG has been trying to get the CPT code I, which means that Medicare in the US will reimburse clinicians every time they take someone's central blood pressure. Private payers, such as insurance companies, generally follow Medicare's lead on what they will reimburse for and how much. While AtCor managed to obtain a CPT code III for their technology a couple of years ago, this is a temporary code reserved for emerging technology/processes and is generally not reimbursed. I was told that the reimbursement rate for ECG, which is around $50 per test, would be quite a reasonable amount in the event that ACG gets the CPT I code (keep in mind there are variations based on geographical regions). At this level, the payback for doctors would be around 6-9 months, while the device can be expected to last around 4-5 years. I agree with management that these are very compelling economics, and one could expect sales to increase quite rapidly if this does eventuate. Although I am no expert on the approval criteria, it seems to me that success is more likely than not as almost all of the boxes have been ticked, and for what it's worth, management has a 'good degree of confidence'. ACG is expecting to file for a CPT I code later this calendar year with the backing of the Renal Physicians Association (who also played the same role for the CPT III) but even if it is approved, the earliest it could come into effect is 1 January 2016, so patience is required on this front. The existing CPT III code and the CPT I code will only apply to FDA approved products, of which there are only four, and only products that utilise the central waveform. Most competing devices that spit out numbers don't actually use the central waveform and therefore won't be covered by the CPT code. 

At the moment, there is very little competition in the US for ACG as most of its competitors are based in Europe and focus on selling their products into European countries, potentially allowing ACG to build up a decent first mover advantage in the US. This is partly due to the regulatory environment in Europe, which has a simpler regulatory regime than the US and therefore has lower barriers to entry. However, the European market for these devices is more reliant on the government than private payers, and as we all know, the government budgets for European countries are generally not too great at the moment. In addition, most of the European sales are made to researchers, which is the smallest market for central blood pressure devices. These factors help explain why AtCor hasn't been very profitable in Europe. Asia doesn't yet have a culture of funding healthcare and new technology, although this is gradually changing as the middle class grows. Recent regulatory approvals in China, Canada, Mexico and Korea should help boost sales, although are unlikely to be very significant in the short term. Excluding pharmaceutical sales (which are grouped in the Americas segment even though they are increasingly globalised), sales between Americas, Europe and Asia Pacific are fairly even, with America a little bigger than the other two. Over time, I believe governments will recognise that it is in their economic and social interests to adopt this technology. As Benjamin Franklin said, 'An ounce of prevention is worth a pound of cure', and this is very true of central blood pressure measuring devices. It is cheaper for governments and insurance companies to prevent people from developing serious complications by funding these devices than to spend years trying to treat people.

My main concern with ACG is its competition - if AtCor is unable to differentiate its product, it is quite likely that its gross margins will get crunched, or sales will simply stall. Regardless of competition, management expects gross margins to contract as clinical sales become more important as clinicians don't require all the extra features that researchers and pharmaceutical companies purchase. The bigger problem is that even though ACG markets itself as the gold standard, and has had its technology validated through many studies, the competition is catching up and may even be better than the SphygmoCor technology. Indeed, another listed competitor, Uscom (ASX:UCM) has recently started calling its central blood pressure measuring device the gold standard. This was in response to a study that rated UCM's Cardioscope II product as having more 'clinical applicability' than SphygmoCor. Bearing in mind that this study was only conducted by one researcher, who acknowledged the ratings were entirely subjective, and who did not refer to the product comparison at all in the rest of the paper, I was quite sceptical as to how much reliance should be put on this piece of information. Nevertheless, I quizzed management about it, who aside from pointing out the above, said that the main reason why the Cardioscope II and the Centron cBP301 were rated higher was because unlike the SphygmoCor they do not require a computer for data to be fed into. The requirement for a PC enables clinicians to keep a patient history and connect to AtCor's proprietary data management system, which is why AtCor believes it is actually an advantage rather than a disadvantage. 

Although that study may not be the best source of information to draw conclusions about the relative merits of each product, after reading dozens of other academic comparisons, I get the impression that while AtCor still provides more metrics than its competitors and has the overall technological edge, the accuracy of the data that its competitors do measure is quite close to the SphygmoCor. Another issue is the expiry of patents, some of which AtCor has had for a long time (patents generally last to a maximum of 20 years). Encouragingly, even though an important patent - the generalised transfer function (the mathematical model used to derive central blood pressure) - had expired three years ago, management says that the competition has so far been unable to fully replicate it. They also interestingly mentioned that one patent that ACG holds is unlawfully being used by a Japanese competitor called Omron Corporation, but since Omron is quite large, ACG has decided not to pursue a costly legal battle with them at the moment. Fortunately, most of AtCor's competitors are very small and are in a weak financial state (take a look at Uscom, which had sales of only $387,119 in their most recent half and will be out of cash in the next 6 months if they continue their performance). I was told by management that 'AtCor is well and truly the largest player', which is a little surprising given ACG is still a very small company itself. 

As you would expect, ACG isn't resting on its laurels and is developing new versions of its SphygmoCor technology that is tailored to each market (eg. one for researchers, another for clinicians etc). In addition, it has formed alliances with three other companies to either develop new products (one of which is due to be launched in July this year) or to help market the SphygmoCor XCEL to new segments such as urologists. AtCor is investigating complementary technologies, such as optimising pacemakers using central blood pressure and are also working on applications in cerebral vascular and intensive care medicine. I view all of these additional opportunities as an extra bonus if they do turn out to be successful, but in the short to medium term, all eyes will be on how well SphygmoCor goes. 

In terms of the people running the business, I don't have strong views one way or another. Duncan Ross has been CEO since 2006, when he replaced co-founder Ross Harricks, while the other co-founder, Dr Michael O'Rourke remains as a non executive director. Directors and executives hold a modest number of shares, and their compensation seems sensible to me. While progress since the IPO in 2005 has been slow, I think management have largely done as good a job as they could have, and am comfortable with them continuing to manage the business. Peter Manley, the CFO, was very generous with his time in answering the numerous questions I had by phone and email, so one might infer that the company's attitude towards shareholders is quite positive. Either that, or they've got too much time on their hands. 

To summarise this post before it drags on any longer, although there are most certainly substantial risks to investing in ACG, and it is definitely not a stock for everyone, I believe that the potential upside more than compensates for the risk. I won't present any singular valuation because the probabilities of various scenarios are too difficult to estimate with any reasonable degree of accuracy, but I'm confident that with even modest success in growing sales, AtCor will be rewarding shareholders quite handsomely. 

Influence: The Psychology of Persuasion

As I've previously mentioned, in his speech titled The Psychology of Human Misjudgement, Charlie Munger discusses 25 tendencies that lead to irrational behaviour. He acknowledges that many of these ideas and examples in the speech came from a book called Influence: The Psychology of Persuasion, written by Robert Cialdini. After reading that Munger immediately sent copies of this book to all his children, and gave Cialdini a share of Berkshare Hathaway Class A stock as thanks, I knew that it must be something special.

Indeed, although this is a blog primarily about investing, I was so impressed by the book that I'm persuaded to recommend it here (pun intended). It is not entirely unrelated however, as some of the lessons it contains such as the consistency and scarcity principles are quite applicable to investment decisions, and it is curiously part of the Collins Business Essentials. Originally published in 1984, the 2006 revised edition is updated to reflect new findings about the process of influence, and at the end of each chapter, Cialdini discloses letters that readers have written to him about their personal experiences. 

Like many people, Cialdini admits that 'All my life I've been a patsy', so as an experimental social psychologist, he spent 35 years conducting experiments into how people think and what makes them likely to be persuaded. In addition, he spent three years going undercover by applying for jobs in fields such as real estate, user car dealerships, advertising, public-relations, fund-raising, telemarketing and restaurants. These insights into how the professionals get us to say 'yes' provide a nice demonstration that what works in experiments applies equally well to the real world. Cialdini's writing style is easily understandable and humorous, but fortunately doesn't patronise readers by oversimplifying. My only criticism is that he tends to be a little repetitive in drilling home the results of an example or the message he's trying to convey, but overall the book is a pleasure to go through. 

Influence: The Psychology of Persuasion details six very powerful principles, one per chapter:

1. Reciprocation

2. Commitment and Consistency

3. Social Proof

4. Liking

5. Authority

6. Scarcity

These principles usually work to our great benefit, but our regular reliance on them may cause lapses in judgement, especially when someone is intentionally exploiting them. Although some may seem obvious, I think you'll be surprised how powerful they are once you read example after example of their applications. By understanding how these principles work, you can use them yourself to help persuade others (hopefully with good intentions), or you can avoid being led into unwanted situations (Cialdini explains 'How to say no' at the end of each chapter). Interestingly enough, even though I'm planning on pursuing a major in psychology - as well as finance and accounting - my first few weeks of social psychology have made no mention of any of these principles. 

Using these principles, Cialdini explains why a woman in New York was chased and stabbed to death while 38 of her neighbours watched on without calling the police or intervening, why the number of airplane crashes and automobile fatalities shoots up after a highly publicised suicide story, and how a cult leader got more than 900 people to kill themselves in an orderly fashion by passing around a vat of poison. To find out the tragic and disturbing reasons for these extreme examples, you'll have to read the book! 

In summary, if this was a broker report, my recommendation would be BUY. 

Finally Sold Delta SBD

Delta SBD, an underground coal mining services business I bought shares in almost a year ago, has been by far my worst investment mistake of commission. Just as my cat learned very quickly not to pee on the carpet after my dad rubbed his nose in it, I believe that rubbing my nose in my mistakes is a good practice. Thus, today's rather unpleasant post.

Less than six months ago I mentioned the discomfort that this stock had given me in the context of psychological biases, but justified my decision to hold onto DSB as I thought it was still cheap. Well, it now seems that Mr Market (an allegory for the general share market) was right in his pessimistic appraisal of this business, and after the most recent half yearly results of DSB came out on Friday, I have come to agree with him. In fact, it took me all of around five minutes of reading the report before I knew that my valuation was wrong and that I should get out quick. 

I sold out in two parcels, one at $0.29 and another at $0.28, before the share price dropped further to close at $0.25 - an almost 22% drop in one day. After accounting for fully franked dividends and brokerage costs, my personal losses have been 61% and 44% for the two respective parcels, or a total of $845 in dollar terms. These are unpleasant numbers, but if it's any consolation to myself, they're not as bad as Delta SBD's results.

Revenue for the half fell 52% to $35.4 million, while the underlying profit of $5.2 million became an underlying loss of $1.0 million. All $29.2 million of DSB's goodwill was written off, and a couple of other minor items meant that the statutory loss totalled $30.7 million. Poor results were widely anticipated due to the severe downturn in the Australian coal sector, but evidently they were worse than what I, and the market had expected. The announcement was enough to send DSB's closest listed peer, Mastermyne Group (ASX:MYE) down almost 15%, even though Mastermyne's share price had already been punished from its similarly disappointing half yearly report three days earlier. 

Although the market capitalisation of DSB is $11.6 million and it has net tangible assets of $28.2 million, the bulk of its assets are in the form of plant and equipment, which in the current industry climate would almost certainly be worth less than the $37.6 million stated on the balance sheet (this amount reflects historical cost minus depreciation rather than what you could sell it for on market). Indeed, DSB sold some of its assets to provide cash, and recorded a loss as part of its statutory results from it. Therefore, it doesn't appear to me that there is sufficient protection if DSB were to go into administration, and although I am not predicting this will eventuate, there are some eerie similarities to the rapid demise of Forge Group that make me uneasy. 

For one, cashflow from operating activities has deteriorated dramatically, going from inflows of $2.9 million, to an outflow of $1.9 million in the current half, and as previously mentioned, the business has moved from an underlying profit to an underlying loss. Once you get into the world of negative compounding, it can be very difficult to dig yourself back out, and it seems to me that DSB won't be able to withstand the pain for much longer. This business has a worryingly high net debt to equity ratio of 51%, and a current ratio of just below 1.0, indicating that it will be having some funding issues over the next few months. To their credit, management have been working at reducing debt levels as fast as they can, but with the company now bleeding cash, it seems the only avenue for further deleveraging will be more asset sales. 

Buried in the 'going concern' section in the notes to the financial statements, there are some more worrying signs about cashflow and debt. The directors acknowledge the need for an additional working capital financing facility, which they expect they will have to start drawing down on in March 2014. DSB has been working to secure an invoice finance facility of $4.65 million from an external financier, but should this fail, the group's major shareholders - who I presume are the two founders of the business that own a collective 47% - have committed to provide a facility of $3.5 million. However, there are also strings attached to this shareholder funding, and the report ominously warns that it "will be conditional on achieving predicted revenues levels and appropriately managing the volume and profitability of the business. Should this not be achieved and the Group is unable to restructure existing equipment finance arrangements or raise additional capital, the Group may not be able to continue as a going concern." Further paralleling the signs of desperation that Forge Group displayed before it collapsed, management revealed that "the Group continues to negotiate with finance providers to extend the repayment terms of other existing equipment finance arrangements, and is considering a capital raising via the issue of new shares." 

And finally, whilst I rarely place much emphasis on macroeconomic forecasts (although I probably should have in the case of DSB), the environment for an underground coal mining services business seems pretty bleak to me. The big miners - BHP Billiton and Rio Tinto - have cut capital expenditure in their coal businesses, and in the face of lower prices, capex spend is set to fall further. I'm no expert, but with the rapid increases in the efficiency of solar power that I've been told are trending even faster than Moore's Law in computing power, and the rise of other renewable energy such as wind power, I can't see a bright long-term future for thermal coal. In addition, China, which is the world's biggest consumer of thermal coal, has been making moves to clean up its pollution by reducing its dependancy on thermal coal. As for metallurgical coal, prices are to a large extent dependant on China continuing to grow at a fast rate and build tons of infrastructure, an assumption that appears far from a sure thing to me. 

After all the above, you may be wondering why on earth I ever held shares in this business and why I didn't sell out sooner. I am too. But I think I can list a couple of factors that contributed to this result, many of them psychological. In response to the first question, I repeat what I said six months ago: "I knew going in that this was a fairly mediocre business (current normalised return on equity of 14%, net debt to equity of 32%, and a net profit margin of 5.5%), and anticipated a less than impressive earnings outlook, but the price looked cheap enough to offer a significant margin of safety - less than 5 times FY2013 earnings. In addition, I liked that the founders of SBD and Delta were still managing the company, and held a majority stake." I figured that if DSB could withstand a short term downturn in the coal sector, I would make a fair bit of money. However, in light of the recent results that's a much bigger 'if' than it was almost a year ago when I first purchased shares. 

Last time I also listed confirmation bias as one factor that hindered a true objective analysis of the situation - I remember reading analyst reports that had big 'BUY' recommendations on them, and although my estimates were more conservative than theirs, we were both way off the mark. After recently reading Charlie Munger's brilliant speech, The Psychology of Human Misjudgement, I realise that I most certainly fell victim to what he calls Inconsistency-Avoidance Tendency (the brain naturally being resistant to change in ideas, once you make your thoughts known in public, as I did on this blog, the tendency becomes even stronger), and Overoptimism Tendency (fairly self explanatory). Eventually I recognised that the risks of my investment in DSB had gone up significantly, and deliberated many times on whether to sell out, but never did something about it, until of course this report came out, when my fears were confirmed. 

Another one would be Contrast-Misreaction Tendency, which is perhaps best explained through the boiling frog anecdote. Although the scientific background is shaky, the story goes that if you place a frog in boiling water, it immediately jumps out, but if you place it in cold water and slowly turn up the heat, it will boil to death. Thankfully, the consequences for me were not so serious, but this cognitive bias applies to the brain and the message is the same. I should have reacted to the little pieces of information that built up over time indicating this was a bad decision. Instead, it took a real splash of boiling water in the form of this half yearly report for me to jump out. 

There was simply not enough of the 'invert, always invert' that Munger espouses. Unfortunately, once I have sold out, inverting becomes so much easier to do, as the above paragraphs demonstrate. I should have listened more to the wisdom of Peter Lynch who said, "Rather than being constantly on the defensive, buying stocks and then thinking of new excuses for holding on to them if they weren't doing well (a great deal of energy on Wall Street is still devoted to the art of concocting excuses), I tried to stay on the offensive, searching for better opportunities in companies that were more undervalued than the ones I'd chosen." If someone had asked me a month ago if I would invest in DSB, my answer would definitely be 'no' because the risks were too high, so why did I hold shares in it? Because I made kept making excuses. 

Perhaps I should have also followed the advice of Buffett and Munger, in avoiding the 'cigar butt' style of investing that they had success with but eventually moved on from. But unlike Mark Twain's cat that sat on a hot stove and never sits on another stove, hot or cold, I haven't been burned severely enough by this cigar enough to dismiss cigar butt investing on my first attempt (my apologies for all this burning animal imagery).

Last time I concluded my discussion on DSB and investor psychology by saying, "The verdict is still out on what the future of DSB, the coal sector and China is, but regardless of the outcome, I hope that I will have at least taken away some valuable lessons about investor psychology that will improve my decision making going forward." I just wish it wasn't such an expensive lesson.

P.S. Not all is bad though, Warren Buffett's annual letter to Berkshire Hathaway shareholders was published over the weekend, and as has come to be expected, it is always a good read. To any value investor, his annual letters are required reading. 

Bought Boom

Today I purchased 7428 shares in Boom Logistics (ASX:BOL) at a price of $0.175 each. For those of you who have never heard of this business, it provides crane and lifting solutions to customers in the resources, energy, utilities and infrastructure segments. I had briefly taken a look at this company a few years back and passed, but it was brought to my attention again by a good friend of mine, Alex, who posted about Boom on his excellent blog The 8th Wonder.

After conducting my own research, I reached similar conclusions to Alex about the business, eventually deciding to stop sucking my thumb and to just pay a little extra for some shares. Since I don't think I can put forth the case for investment any better than he already has (and because I'm admittedly a little lazy right now), I recommend you go read his thoughts here and here. Alternatively, he's given me permission to simply copy and paste those posts right here for your convenience. Enjoy!

23 Cents on the Dollar

Boom Logistics (ASX:BOL), Australia’s largest crane and lifting solutions provider, caught my eye recently with its price trading at nearly one fifth of tangible book value. After further inspection and a phone call with management, I took a position at $0.12.



Times have certainly been tough of late for anything marred with the mining service brush, and it has been no different for Boom. While this is not a high quality business by any stretch of the imagination, it seems that the market is currently pricing Boom as if death is imminent. When the herd is avoiding a sector like the plague, this has the potential to create opportunities for the contrarians among us.



Boom’s derives the majority of its revenue through maintenance contracts with Australia's major mining companies (as well as energy, infrastructure and civil construction work) which bodes well as Australia shifts from a mining ‘capex’ cycle to one of operation and maintenance. An improvement in residential construction that is underway, along with the increasing trend of crane intensive high density buildings, is also a positive as it may help to soak up crane supply and boost utilisation across sectors. 



While Boom’s profit history has been disappointing due to asset write-downs and restructuring charges, its consistency of operating cash flow is attractive. Over the last 5 years, Boom has averaged $50m of operating cash flow per annum, almost as much as its current market cap. Management have guided they expect capex to be less than depreciation ($20m expected), which coupled with the $11m of asset sales, bodes well for free cash flow (FCF) in the vicinity of $30-40m for FY14. This places Boom on a FCF multiple of less than 2 times!



What is certain is that a stock is unlikely to remain at 2 x FCF or 0.2 of book for long, either free cash flow or book value will reduce or the price will rise. As I expect FCF to be resilient, this gives management optionality in terms of capital management.



Management are aggressively repaying debt (with $12m repaid in the first quarter and a full year target debt balance of $90m) and have stated the intention to buy back stock on market to capitalise on the discount. Boom’ s net debt to equity is currently 33% and is likely to reduce below 30%, which is less than half that of peers such as Ausdrill and Emeco who trade on similar discounts.



The currency sensitivity is also interesting. Boom invested $140m over the last 3 years when the AUD was close to or above parity with the USD. As cranes are sourced from international suppliers, Boom was able to take advantage of the strong currency and replenish its fleet at relatively good prices. However, with the AUD at $0.90 and with expectations that it will continue to fall, cranes are not getting any cheaper in Australia. This bodes well for Boom’s crane values and reduces the probability of future write-downs. However, given the size of the discount at which the price trades at, shareholders have a significant buffer even if write downs do materialise.



There are a number of catalysts which have the potential to provide a rerating: an on market buyback, continued debt reduction announcements, a return to bottom line profitability and a takeover offer from private equity or a trade buyer. Given that sentiment is so bad towards the sector, even a slight normalisation has the ability to provide a rerating.



As Boom trades at such a large discount to NTA, an acquisition creates interesting accounting implications for a potential acquirer. For analysis sake, let’s assume McAleese (ASX:MCS) (who has a large presence in the QLD lifting market and who also has been a substantial shareholder of Boom in the past) is successful at acquiring Boom at $0.20 per share. This represents a ~50% takeover premium for current shareholders. However, as Boom has NTA of $0.51, MCS is likely to record a profit on acquisition of $0.31 per BOL share, as they have acquired $240m of equity for only $94m. No doubt a large profit created by sound capital management would give MCS’s management a tick of approval from their new shareholders. Given its discount, operating cashflow history, relatively lowly geared balance sheet and open register, it seems plausible for Boom to attract some takeover attention.



To me, the epitome of an investment (protection of principal whilst also providing a sound probability of an adequate return) is often found in stocks that have very low expectations incorporated into the share price. If bad news eventuates, the downside is less severe as many were already expecting bad news. However, if good news eventuates, the price is way too low and must quickly rally, thus providing the return. It is these asymmetric opportunities that I love to fill my portfolio with.



Boom is certainly not a buy and hold forever stock idea, nor should one be expecting the price to revert to book value in the near term. My view is that buying at a P/B of 0.20 and waiting for one of the aforementioned catalysts provides a reasonable probability of selling at 0.40 of book (the medium term average) in the next 3 years. If it takes all three, that gives 26% annually. Any sooner is a bonus!

Half Yearly Result Update 

Boom Logistics reported its half year results last week which were on par with my expectations . However, with $319m of equity that is currently generating poor returns, management have some decisions to make.



First, let's revisit the thesis. My attraction was based around the ability to buy lots of tangible assets cheaply, and as the group’s cranes were under employed, disposals and reduced capex were two likely drivers of significant free cash flow. Steve Johnson from Intelligent Investor said it best, 'these businesses have been cash sinks as they grow, they should spew out cash as they shrink'. While it is still early days, it seems management are beginning to gain some traction and the wheels are turning in the right direction. 



Operating cash flow for the half came in at $11m, which was a little below par. It seems clients have been stretching out payments as Booms receivables only decreased 5% while sales fell 23%. Asset sales of $8m were achieved which contributed to $13m of free cash flow, with the majority directed to reduce the debt balance to $102m on a net basis. Importantly, there was no asset impairments and NTA increased to $0.52 per share. To refinance its banking facilities, management were required to conduct a thorough assessment of its assets and to come through without an impairment certainly adds confidence. I will be eagerly watching the full year result for an improvement in operating cash flow and further debt reduction.



I caught up with CEO Brendan Mitchell last week and we discussed an interesting opportunity for further assets sales. There is currently $65m of assets which lay under utilised with the majority idle due to the BMA contract loss. While it seems the preference is to get them re-employed into another contract, management will consider selling the entire fleet if this doesn't occur in the reasonably near term. While conditions remain tough and there is plenty of surplus equipment for sale in the market, prices for cranes haven't plummeted as far as Booms share price would lead you to believe. Indeed, $1.6m of assets were sold for a profit in January. Here lies the opportunity. $65m is nearly 90% of Booms current market cap, however for the sake of conservatism, if we assume a 50% haircut, management could still repay a further $10m of debt and buy back $22m (30%) of stock. This would most certainly reduce balance sheet risk and create immense value for ongoing shareholders.



It seems odd, but I think missing out on further contract wins could work out to be better for shareholders. And if Boom does win work, its not a negative either, creating somewhat of a win-win situation.