Ann: Trading Update, page-31

@MarsC

Regarding the discussion about REH's warts, up to now, from what I can see, there is no reason to be concerned about the strength of REH's competitive moats. In fact, in my opinion, the moat has continued to grow wider every year.

I believe the concerns about the effects of slowing building activity is misplaced in this case. A slowing market will negatively affect everyone, including REH. However, relatively speaking, REH should be able to weather the storm much better than its competitors, such that after the downturn, its competitive position should be stronger than before.

Everyone is different, but with me, too much worrying about the little things can sometimes make me forget about the big picture and do the wrong thing, i.e. selling an excellent company because of a temporary macro condition.

Nevertheless, I think there may be a not-so-small flaw in your argument about "expensive stocks". Whilst I completely agree that strong moat businesses, especially those that can reinvest large portions of their earnings at high rates, but even if they pay out most of their earnings, will over the long haul generate the greatest wealth. And it is the long-haul, and the long-haul only, that ultimately matters in this game.

My earlier post didn't include the other part of my investment process, i.e. the need to keep cash and wait for opportunities to come. Every now and then, the market will mark down the valuation of good companies for no good apparent reasons. When this happens, we as investors should be ready to pull the trigger.

Sometimes the window of opportunity lasts a little while, while in other times it only lasts for a few hours or a few days at most.

If we combine the approach of concentrated portfolio of excellent companies with the patience of waiting for opportunity to present itself, I believe the investment result will be quite satisfactory.

If my earlier post gives the impression of suggesting to buy "expensive" companies blindly at any price, then please accept my apology for being not clear enough.


(a) In the last 10 years, how much of the gain from those high quality businesses, has come from PE expansion, versus earnings growth?

Looking at my personal record, most of the gains have come from a combination of both PE expansion and earnings growth. Without a record of stable earnings growth, the company is unlikely to be fortunate enough to experience PE expansion.

(b) How much of that PE expansion has been driven by market and interest rate factors outside of your or my control?

I can't answer your question definitively. As per the above paragraph, although I admit that market and external interest rate factors did play a part, the company itself must have performed solidly for its PE to be expanded by the market.

And if inflation ever gets out of control and interest rates becomes high again, I prefer to have my investments in these high-quality companies who are able to exert control over the price of its products/services.

The alternative, mediocre businesses, on average, will struggle in a more challenging macro environment.

(c) How likely is it that such PE expansion will continue in the next 10 years?

Again, I don't know what will happen. But, stranger things have happened in the market. For example, there are companies out there whose PE is currently above 50!

I am however confident that the companies in my portfolio will be able to grow their earnings consistently in the next 10 years. And when this happens, the high PE will be slowly eroded by the earnings gain.

So for my money, if it's a choice between buying mediocre businesses at bargain prices, or paying nose-bleed prices for quality, I will choose the former.

Please note that I don't like to pay nose-bleed valuation too.

I am however willing to pay high-ish valuation that is still quite reasonable for the kind of quality that I'm buying. Why? Because time is on my side. As long as I stick with companies which display the characters that I look for and that I patiently wait for opportunities, even if I don't purchase at bargain level valuation, I am confident that my investment will do fine.

For example:

These are the PE ratio that I paid for the first tranche of the various investments that I made:
- REH: above 20
- BRG: approx 16
- ARB: approx 16
- ONT: approx 15
- NCK: approx 16
- RWC: approx 26

For the following tranches, I usually pay higher PE than the original tranche.


These companies managed to grow their earnings consistently and as a result, the relatively high PE that was paid initially are no longer that high relative to current earnings.

---

The next thing that we need to consider is the position sizing. At the end of the day, dollar return is more valuable than percentage return. In other words, there is no point in scoring a ten bagger, if we only put 1% in it. Yes, the gain is nice but it's not going to be life changing.

A better outcome is to score a 2-3 bagger on a 20-30% position.

Anyway, this is just my personal preference.