How to generate income and what is an asset

Kids, one of the books that you should read very early on in preparing for investing is the 'Rich Dad Poor Dad'-series by Robert T. Kiyosaki. There are a number of books written by him and they are all fairly easy to read. As always, with anything you read or hear, you need to be critical and have your own thinking and opinions about the material. But you should always also open your mind to new and interesting ideas and not shut them out before thinking about them critically.

For me there have been two key take-aways from reading these books; a) one about how to think about different structural options to generate income and b) one about what is an asset and what is not.

A) Regarding the structural options to generate income, Kiyosaki introduces a concept of a 'CASHFLOW Quadrant', which basically lists four type of ways to generate income.

Most people in today's society live their lives mainly on the left-hand side of the quadrant, i.e. as employees or as self-employed (e.g. small-practice lawyer, doctor or similar). Even though it is possible to reach financial independence on the left-hand side, most people who have reached it have done it on the right-hand side (as business owner and/or as investor). Please however remember that there are also many failures on the right-hand side, not everyone who tries that side will succeed.

I strongly believe that you should try to find your the passion in your life from which you can also generate a healthy income to live off and to invest. This can be in any of the four quadrants. However, I also strongly believe that you should as early on as possible develop your skills as Investor to have your excess money work for you. This will give you financial independence at some point in time and give you many additional degrees of freedom in your life. Even if you do not think investing is fun, you should at least try to acquire knowledge of the basic concepts within investing, so that you at least can challenge and potentially judge the advisors that you want to have to help you with the investor quadrant.

Personally, I have spent most of my time after university in the E square, but for the last 15 years also allocated capital in the B quadrant. After reading 'Rich Dad Poor Dad' I have for the most of my career sought after job positions where I can combine E with B in order to get some of the financial upside of the B quadrant and also to get as much understanding of how successful people in the B quadrant think and operate and to learn things that I can also use in the I quadrant. I have, however, never been the majority shareholder and/or founder of a business, so in essence I have not really given that quadrant a proper go. In parallel, also for nearly 15 years, I have started to build my skills in the I quadrant. Most of the posts in this blog relate to the learnings and ideas I have about being an investor and those I want to pass onto you, no matter what you choose to do in life for a living.

B) The other key take-away is regarding what is an asset and what is not. Until my early 30's I was so 'brain-washed' from school and university with the concept of assets being such things as the apartment or the house where we live or even the car we own, i.e. things that have a market value. It was not until I read 'Rich Dad Poor Dad' that it struck me that an asset is 'anything that produces a positive cash flow'. Our house will only produce a negative cash flow as long as we use it to live in and the same goes for our car. Hence they are not assets, they are only 'liabilities' and have a huge alternative cost... The most practical example of this is that we today could sell our existing house and move to a much cheaper house somewhere on the countryside or a smaller town, become debt-free and have all the cash-flow from real assets that we need to live a comfortable life without needing to work. But with the current 'assets' (mainly our house) I still need to work as it consumes cash (rent payments, running costs and maintenance costs) and hence is NOT a true asset (that generates a positive cash-flow). A share in a company is however most often generating cash to the owner through dividends or share redemption programs and this is in my world a true asset.

As a final remark, I think one should focus most of the attention on how one can generate the most income rather than spending as little as possible. The reason is that it (at least for me in relative terms) is so much easier to spend little money, whereas the effort to increase income (through getting a higher-paying job, starting and driving a business or learning how to invest successfully over time) is much, much tougher. Naturally one should keep costs low, but it is only a (smaller) part of the key to achieve financial independence.

Kvaerner - additional investment

On Friday I did a small add-on investment in Kvaerner of 5000 shares at 10,70 NOK. This company will most likely not be part of a long-term portfolio as I have very hard to judge its short-, medium- and long-term business prospects. The operating cash-flow recently has been wildly negative with 274 MNOK in the first half-year of 2014. The management claims that the cash flow is fluctating in this business and that is even illustrated separately on p13 in the latest Q2 2014 presentation.

However, at the current price it is yielding very close to 12,0%. This company I value mainly on the valuation metric of EV / EBIT of 3,24 (at the purchase price of 10,7 NOK). The company has a negative NIB (Net Interest-Bearing debt) of about 489 MNOK (cash of 972 MNOK and interest-bearing debt of 483 MNOK). TTM EBIT I have calculated to 738 MNOK. With the negative NIB, it gives me some comfort to invest in this company, more with the approach of a 'cigar-butt' investment that gives me some cash back short-term.

Hence it gives me a decent return without having to risk too much money while building the dividend portfolio. The company itself states its dividend policy as follows: "The ambition is to pay semi-annual dividends with increases, in order to give a stable and predictable dividend growth, balancing out the underlying volatility of earnings". The next declared semi-annual dividend of 0,64 NOK will be paid out on October 24th. 

With this investment I expect some 270 kSEK in dividends (after tax) during 2015.

Betsson - my largest holding

My largest holding (measured as current value) is currently Betsson. I have owned the company during the more than three years (measured as weighted average) and the first investment was done about 4,5 years ago. On a few occasions the last 1,5 years I have sold smaller parts of my investment, but also added positions. Net divestment during the last 1,5 years is 850 shares.

During the time that I have now owned the company my CAGR (pretax, but incl. received dividends after-tax) is above 25%, which is far above my long-term investment return target of 10% p.a.

In the chart below I have plotted the EPS TTM (last twelve months) for Betsson as red bars and then the closing price as the blue line and the corresponding P/E TTM in the green line. The flat red line is the average P/E TTM (14,0) during the period (since Oct 8th 2007). The black arrows indicate when I have bought (upward-pointing arrow) and when I have sold (downward-pointing arrow). The length of the arrow correspond to the size of the transaction in number of shares. In the chart it is a hard to see that the EPS TTM is now close to 14 (13,88 to be exact, based on the recently released Q2 report).

As you can see from the chart above the first investment was made at a fairly high P/E (of about 15,5) in early 2010. One of the good things about following a company for a longer time, is that you start to get a better understanding for when it is cheap and when it is expensive. In mid 2011 I was even more confident that the company was attractively priced and added a fair position. Over the last 18 months I have started to take some money 'off the table' through a number of divestments. The main reason for this is that due to fairly high valuation at several points in time (P/E well above 14), I have judged it a good time to take some money 'off the table'.

What I like about this company is
- strong (although diminishing) ownership by physical persons
- consistent management; Pontus Lindwall (former CEO) now holds the Chairman position in the Board and works actively with strategic tasks
- fantastic ability to generate and distribute cash (through redemption of shares) to shareholders while growing the business
- market leading position (no 1 or no 2) in key markets
- seem to be able to acquire other smaller companies at interestingly low multiples to EBIT
- seem to (here I would, however, still not draw too far-reaching conclusions) learn how to integrate those acquired companies into existing operations to extract synergies
- seem to build in-house capabilities in many key areas (IT platform, payment solutions, data mining, proprietary games, marketing etc) to be successful in this business, while continuously pouring money into marketing
- 'pricing power' in the sense that this business should always - all else equal (i.e. mainly given a stable competitive situation) - be able to offset impact from inflation
- the option of successfully entering the Chinese market, which could potentially allow for massive growth over many years

There are also a number of key issues with the business, the main being that I do not see any clear moat (competitors popping up left and right as limited capital is needed to start up a business). If I had seen a clear moat, I would probably have poured all my money into this single company as it otherwise have nearly all characteristics that I like for a company that I want to own.

Today, I would most likely not add to the position unless P/E comes down to 14 or below before year-end this year. However, I do not believe I will sell either (at current price levels) as I think the company will be able to continue to grow its earnings in a pace that will give me some 8-9% total investment return over the next 10-20 years (given that they can hold an RoE at 32% or more and continue to reinvest the same share of their earnings into the business as they have done the last couple of years)

Ross Stores - additional investment made

Yesterday I did a smaller add-on investment to one of my existing investments. I bought 165 Ross Stores shares (ROST).

A short background to the investment is that I have owned HM since the market crash 2008 but due to the recent very high valuation of HM I have sold out part of the investment to buy some other companies. However, I like the simplicity and stability of HM and have therefore for some years been following another company that I think is somewhat similar to HM and that maybe could do the same trip as HM without necessarily competing too much with HM.

Some 'soft' investment highlights that I like about ROST (you can read up briefly on the company for instance here or on their homepage):
- The company has proven itself over quite many years (about since mid 80's when it was IPOd), with a concept that now encompass over 1300 stores (Ross Dress for Less and dd's Discount) over large, but not all, parts of US. They seems to have a very well-defined concept that has been consistently expanding for more than 20 years
- What I personally like very much from an outside perspective (without knowing the persons) is that the recent succession is an internal manager. New CEO Barbara Renter has been with the company for 28 years and her most recent position has been Chief Merchandising Officer. Also some other promotions are for internal managers, and notably former CEO Michael Balmuth has become Chairman of the Board. I like consistency in management, and internal promotions of management. For me that is one of the strongest signs in a 'simple business-idea' company that the concept works, that the management believe in it and that they will not change the winning concept. Kids, you can read about this in the book 'Built to last' by Jim Collins and Jerry I. Porras.
- One weak point is that there is (to my understanding) not one single strong 'flesh-and-blood' owner. However, this is partly compensated with the fact that several key managers own about 10-30 MUSD of stock in the company, which I think is a large enough sum to really care about what you are doing as a manager. Please however also note that most managers seem to sell of a smaller sum consistently over time
- 20 years of consecutive dividend increase (although at only about 1,3% yield yesterday, dividend ratio (to EPS) has been below 20% historically)
- Number of outstanding shares is decreasing continuously. The management has driven a share buy-back strategy consistently over a long time period as a way to distribute the free cash flow back to shareholders.
- My outside view of the key issue and opportunity for this company is that it will have to prove that its concept will work outside the US within about five years (as growth opportunities in the US is starting to diminish). As their largest peer (TJX) has done this (although with some problems if I understand) in both Canada and parts of Europe, I believe ROST can also do it.

'Hard-facts' investment highlights:
I have looked back at key figures of EPS, equity per share, RoE, dividend per share, share of earnings as dividend, year-end share price, P/E ratio, number of shares and interest-bearing debt. In the table below you can see the key figures, for most of the metrics since 1997. I have calculated the seven and 14 year CAGR averages in growth for EPS, equity per share and dividend using three-year averages (i.e. comparing the period 2011-2013 with 2004-2006). RoE, dividend share of earning and P/E averages are normal averages, whereas share price is normal CAGR for the latest seven and 14 years respectively. In the row above ('Assumptions going forward') you can see my key assumptions on RoE (38% this year and declining to 30% in 2020), dividend share of earnings (at 20% this year and increasing up to 75% in 2023) and 'normalized' P/E ratio of 15 (as compared to 15,3 for the last seven years and 17,0 for the last 14 years). The share price of 62,23 USD correspond to the price of my latest purchase.

Interest-bearing debt is low at 150 MUSD and cash was 435 MUSD at year-end, giving a negative net interest-bearing debt, which is something I really prefer in my investments.

I will go into more details about my thinking on how this 'hard-facts analysis' works in a separate post. However, with the above assumptions (which I deem fairly realistic on the side of conservative),  I expect a investment CAGR (share price increase before tax and received dividends after-tax) of
a) 13,8% in a 3-year perspective
b) 11,9% in a 10-year perspective
c) 10,4% in a 20-year perspective
This is above my target return of 10% p.a.

The CAGR figures are calculated using the expected share price and dividend that you can see for the upcoming years, given that the assumptions about RoE, dividend share and P/E ratio hold.

One strange thing about this company is the following note in the latest 10-K on p11:
"There were 822 stockholders of record as of March 12, 2014 and the closing stock price on that date was $72.38 per share.".
A company of this size only having about 800 stockholders, can that really be true? Is there any reader with good knowledge about US stocks out there that could clarify this to me; could this really be the case for such a large company as ROST (a little bit less than 1/4 of HM as measured by market cap)?

How to think about performance vs. index

I know most investors (incl. Warren Buffett) compare themselves vs. index. This is of course fair and relevant in many ways, especially in deciding if you should spend time in allocating capital yourself or handing it over to someone else. However, I am more inclined to set an absolute long-term target for my total return, and preferably after adjusting for inflation. I believe e.g. Seth Klarman calls this an 'Absolute-Performance Orientation'. Kids, when you become old enough to have amassed some experience (i.e. having made a few mistakes on your own...) from investing (my guess would be somewhere in your early 30's) and can judge how interested you are to spend time on investing, then you should set your own absolute long-term return target.

Right now I am operating with a minimum target level of 7% total return (in nominal terms, i.e. without taking inflation into account) over the long-term (20+ years). In real terms I expect that to be about 5,5% total real return (i.e. after inflation), assuming inflation continues to be at the same low rates as last 21 years (about 1,4% CAGR measured as CPI (KPI) by SCB in Sweden). If the return I generate is less than that, I believe I should just hand over my money to the cheapest index fund there is and spend my time on something else.

The reason for this is that absolute return on my capital is of much higher importance than beating an index. I will not be able to retire by beating an index. I will be able to retire because the businesses I own on average will increase my equity base by at least 7% p.a. I believe this way of thinking is more    close to how an owner of a business thinks, and I like my investments to be closer to that thinking than to beating some index that I anyway do not understand.

Now, 7% is not my target level. Currently it is rather 10% p.a. in nominal terms. So far, since end of 2000 which is as far back I can track my figures, I have had a CAGR return of some 12%+ in nominal terms. Now, as I still have a very large share of my financial assets invested in stocks, and I believe them to be somewhat overvalued currently, I would say that the 'true' intrinsic value CAGR is somewhere between 9-10%.

Given that I would be able to spend 100% of my time allocating capital, I would probably raise the target level to 12%. The figures may not seem very impressive, but having these levels over long periods of time is much harder than one thinks when you are young. Mistakes (losing all or a large part of your money) also takes a very large bite out of your total return.

HNWI status - 2014 Q2

Below is a summary of my best understanding of the investable assets (in SEK) for some bloggers as of end of Q2 2014.  For bloggers marked in red, the data is a few months old. A few bloggers have been added since last update.

NB: HNWIs are defined as those having investable assets of US$1 million or more, excluding primary residence, collectibles, consumables, and consumer durables.

Exchange rate as of June 30th, 2014: 6,74 SEK/USD

I was still able to make it above the 1 MUSD mark by having investable assets of about 6 950 000 SEK as per end of Q2 2014.

Quarterly update - some historical notes

This post will contain a number of historical reflections on the post 'Quarterly update 2014 Q2'. Please refer to it to easier understand my comments.

The current level of debt vs. property value is the lowest that we have ever had since starting to pour cash into our living premises, but in absolute terms it is still higher than at most times, however it is down from the top levels two to six years ago. We have switched property several times and the first two quarters in the summary show the actual price appreciation between a purchase (which was a couple of years before Q2 2004) and sale in Q3 2004. At that time we did something very uncommon in the market in the city we lived in, we sold our property BEFORE we bought a new one (this practice became much more common after the crisis in 2008). We were also very diligent when looking for new property and probably looked at about 100 different properties before we finally were able to acquire one where I actually thought there was an inaccurate price (in relation to value) in the market; we were at that time in a strongly rising market able to buy the property at a seven percent lower price than the seller had paid several years before (the broker clearly told me a couple of days before closing that he did not think the seller would accept our offer). Three years later we were able to sell the property at a price well above 40% more than we had paid. In the summary I have spread out the appreciation equally per quarter over the holding period. Furthermore, the last few years we have chosen to drive down debt in two larger one-off 'amortisations'. I did this in order to take down the risk to a level that I am more comfortable with, and to counter the effect from increasing interest rates (boy have I been wrong there so far...). At a debt level below well below 50% and interest rate at all-time low we are currently not doing any regular monthly amortisation.

So while fairly diligent on the property side already early on, I today with hindsight would really like to give you kids some advice on cars. Today we own a really basic car, bought used while still not being too old or having too much mileage to (hopefully) incur too much issues (and costs) with repairs. More than ten years ago I went 'all-in' buying a brand new car (in cash). Don't do that when you are young (unless you already have made all the money you will ever need)! The alternative cost for that cash has proven to be fairly high, so I would today have been able to drive a used Porsche Panamera instead ;-) or better, already laid the first part of the equity fund to pay off the remaining debt.

Kids, it is also always very important to remember that these assets (property and cars) are cash-consuming, so I do not view them as keys to building wealth, rather the opposite. They just cost you. You can (or if you run into trouble have to...), however, dispose of them to improve your debt situation. The less of these type of assets (cash-consuming) you acquire (especially early on in your lives) the more you can invest in the cash-generating assets.

So, now to the really funny part, the financial assets. They GENERATE cash. Every year we get a CASH amount as dividend or interest (on cash). This year alone, the cash amount generated by the financial assets will be higher than total financial savings were ten years ago. It is quite amazing when I think about that now.

In general I have put nearly all surplus cash (except the two larger amortizations mentioned above) into financial assets over the last twelve to thirteen years plus reinvested dividends. The CAGR value growth since late 2000 is currently somewhere above 12%, probably close to 13%. This will probably fall down to 9-10% when the next major correction will come. Still, this is a number I am OK with, even though my ambition would be to increase it somewhat when retiring fully and being able to spend more time following potential investments.

As you see from the asset figures, (easiest seen in figure 2), I was lucky to hold a fair share of my financial assets in cash by end of Q32008, and then going 'all-in' in the beginning of Q42008 when the world was in turmoil. Since then it has basically been a soon six-year very positive development in the stock markets. As you can also see I have nearly all the time since more than three years operated with a fairly high amount of cash, having the 'gun' ready for shooting. As you can also see, the last quarters I have shifted over even more of the financial assets to cash, basically just loading the gun with more bullets as I cannot find any big elephants to shoot. My cash amount is today higher than my total financial assets were less than six years ago, so there is now some firepower if/when needed.

Quarterly update - additional comments and reflections

This post will contain a number of comments and reflections on the previous post 'Quarterly update 2014 Q2'. Please refer to it to easier understand my comments.

First I would like to go through some important events and give some additional key information on how certain asset values are estimated. Starting with the asset side, ease of valuation is inversely proportional to the the liquidity of the asset. For instance, the property we hold is traded very infrequently (e.g. once every ten years or so) and there is no exact copy of it. Valuation of it is therefore quite tricky. I will revert to it in a moment. The car we have is easier to value, as there are fairly many cars with similar specification and mileage as ours sold (it is one of the ten most common models in our country) and price intervals are stated in various public sources. An estimate with a ca. +/-10% margin is reasonable to make at all times. Shares (which make up the absolute majority of our financial assets) traded on stock exchanges are again very much easier to get a 'price quote' on (normally during some eight hours every working day), and during that time the 'price quote' often changes many times during a minute. The value of the share I do not however think changes that rapidly and as volatile as the 'price quote' mechanism ("Mr. Market") seem to imply. Hence, valuation of the shares is also not so easy... However, in the quarterly summary update I use the 'price quotes' given by the market for 'valuing' the shares that I have acquired in a number of businesses. Cash on a bank account is 'traded' extremely frequently in the financial system, so it is easy to value in the short term. What you have to consider if you plan to hold cash for some longer time is the effect of inflation (which normally diminishes the value of your cash unless you get an interest on your cash of at least the inflation rate).

The value that I use for the current property we hold is based on two independent valuations made late last year. I have taken the lower end of each respective valuation and taken the average of that.
From that amount I have deducted the broker fee that we would have to pay when selling the property and after that I have deducted the capital gains tax. I believe that that is a conservative estimate of the price that we would be able to get today. As a note I can also mention that I would be very reluctant today to sell the property at the price used in the summary (but I want to have a margin of safety).

For the liabilities side there is a loan where the security is the property we hold. Without going into details, the debt is well below 50% of the latest valuation accepted by the lender. Deferred tax liabilities are related to unrealised gains on shares that have appreciated in value since purchase.

Some key ratios that are important in judging the risk we are exposed to:
Net debt (loans less cash and short-term interest bearing bond funds): About 1,4 MSEK (my definition of net debt can be discussed if correct, but I find it to be the practical one)
Equity ratio (equity as share of total liabilities): About 74%
Interest coverage should also be measured, but for various reasons I do not want to disclose it. However, dividends and interest on cash alone today give an interest coverage ratio well over 600%.

In general I think the debt situation in relative terms is very manageable (we can e.g. pay off our debt about two and a half times only with our financial assets). I sleep well at night. However, I would still like to improve the situation further. In case of an extremely severe crisis, we are still 'swimming with our pants down' and that is always making our manoeuvre room in such situation more or very limited. Currently, my overall thinking to mitigate that risk is that from early next year starting to build a specific equity portfolio with the purpose to
a) specifically generate dividend to pay interest on the loans we have (interest rates today are extremely low, so having debt is extremely cheap. E.g. I today risk-free have a positive spread of 0,46%-points between the interest I get on my cash deposits and the loans we have on our property)
b) build the size of the portfolio (in value terms) to match the loans, thereby creating a 'virtual' zero net debt position
c) over the long-term use additional capital appreciation of the equity portfolio over the current loan amount to pay down the loan

So, in total kids, I deem it necessary to further improve the balance sheet with the ultimate goal to become debt-free. Then no one (in our current legal and political system) can take our assets and it is much easier to remain cool-headed in times of severe crisis.

I also realise that there needs to be at least one more follow-up post on the quarterly update to cover some history.

Quarterly update - 2014 Q2

As investor, I think it is very important to understand your own (or your family's if/when applicable) personal balance sheet, thereby laying the ground to understand your risk exposure and consequently how that might affect your investment strategy. I therefore regularly track our balance sheet position (in the more traditional 'accounting' style of setting up a balance sheet).

Below in three figures is a summary per quarter during the last ten years of the assets and liabilities in our household (the currency is SEK in all figures). It is showing the overall picture of our balance sheet position, and it is the one I use to regularly track our position and judge our risk exposure. The summary is not 100% accurate as it does not include all assets and deferred tax liabilities in our household. For several reasons (mainly simplicity, confidentiality and difficulty of valuing correctly) I have not included them. The net equity effect today, however, is in my most conservative estimate 0 SEK, i.e. these assets and deferred tax liabilities have a zero or positive effect on our equity. Assets not included are e.g. 6-month 'cash emergency fund', all other inventory (such as computers, TV-sets, gaming consoles, furniture etc which is popular to sell in the TV-show 'Lyxfällan'), shares in non-listed companies and savings designated to our children.

I am starting by showing the asset side of the balance sheet. It is compromised by four main elements, starting with the most illiquid asset type first
A) property
B) inventory
C) financial assets
D) cash and short-term interest bearing funds

Figure 1. Shows asset side with most illiquid assets below and most liquid assets on top.

Figure 2. Shows asset side again, now with most liquid assets at the bottom. I only include the cash and financial assets when calculating HNWI status.

Figure 3. Shows liabilities side, with debt at the bottom, deferred tax in the middle and equity at the top. The line shows the equity ratio.

I will add comments and reflections in the next post.