Interview with Peter Kennan
Investor Vantage Newsletter
Peter Kennan — Black Crane Capital Peter Kennan explains his philosophy to deep value investing with a corporate finance twist, how he uses travel efficiently, how he analyzes a company quickly and efficiently on Bloomberg, and why he sees opportunity in Emeco Holdings, MMA Offshore, and Halcyon Agri. Peter Kennan founded Black Crane Capital in 2009. At Black Crane, Peter and his team have been able to generate superior returns using a unique, corporate finance driven investment philosophy. He takes a deep value approach with an interesting corporate finance strategy to create value maximizing catalysts for his investors. Prior to founding Black Crane, Peter received his engineering degree and worked at BP before working in the corporate finance world at UBS. He and his company have won numerous awards over the years including Best Asian Event Driven Fund in 2014 and Best Long-Term Performance of an Event Driven Fund in 2014. Currently, Peter is finding opportunity in three interesting deep value investment ideas in Emeco Holdings, MMA Offshore, and Halcyon Agri. All three of the companies featured meet his stringent factors for deep value with future catalysts. Great to have you here Peter. Before we get into the nuts and bolts, could you give us a little bit of your background and how your view of investing has evolved, if at all? Peter Kennan: I was trained as a chemical engineer, so that’s partly where my analytical bent comes from. I had seven years with British Petroleum; then I joined a predecessor firm of UBS in Sydney in ’94. UBS was my first foray into corporate finance. At BP, I enjoyed the commercial side of the oil business --- the trading and supply and logistics and the refinery economics. I was exposed to some quite complex microeconomic issues around how to set refineries up and optimal supply logistics. That was a lot of fun. The puzzle-solving aspect was not dissimilar to investing. Following that, I moved into corporate finance, working with UBS for 15 years --- 10 of those in Sydney and five in Hong Kong. When I left Australia, I was head of the Telecoms Media Sector team. In Hong Kong, I formed the Asian Industrials group for UBS. The industrial sectors at that stage were tiny in Asia. The Asia banking and equity capital markets were focused on banks, large Telcos, and the oil companies. But we knew there was huge growth potential; between 2004, when I arrived in Hong Kong, and late 2008 when I left, the industrial sectors became 50% of the street. At that point, I had 32 bankers reporting to me and I was probably the second-most senior banker at UBS. Through that period, I worked a lot with corporates both in Australia and Asia. At the time, there was a big contrast between the two markets, the Australian was a relatively mature market compared to the relatively immature, emerging Asian corporate finance markets. I could see that there was a huge pipeline of corporate finance activity that was going to unfold through Asia in the coming decades. That’s part of the genesis of the Black Crane strategy --- (1) the immature corporate finance settings, approaches, set-ups of companies; and the crystallization/realization of opportunities and knowing they would be evolving over a multi-decade-period; and (2) The recognition of deep value. My boss at UBS was a Buffett fan from way back and went to the annual meetings. He was always talking about him, so I read quite a lot about Buffett and value investing in the late 90s (and continue to this day). I am naturally very analytical. I like understanding things to the core, so concentration was always going to be my approach. As an investor, this approach allows me to understand a small number of positions in a deep and fundamental way. Joel Greenblatt’s book, “You Can Be a Stock Market Genius”, was great. He discussed how eight stocks is enough to properly diversify a portfolio. How he thought about portfolio concentration rang true with me. I’ve always admired entrepreneurs - a lot of clients I had as a banker at UBS were entrepreneurs. I enjoyed working with them, and the family offices and private equity funds related to them. When I left UBS, I had an objective --- I wanted to leverage my analytical and intellectual skills and ultimately get rewarded for that by doing something entrepreneurial. Black Crane came to fruition from that seed. The problem with being a full-time employee in a high-powered role with a bank like UBS is that it’s so exclusive, it dominates your mind. You don’t have time to explore other pursuits and do a whole lot of investing outside. My sector was half the market and I had to get the global head of corporate finance’s approval just to trade a stock in my sector. These days, I understand that UBS prohibits personal investing full stop by investment bankers. That exclusive relationship meant I couldn’t really explore my evolution as an investor until I left UBS. And now, when I think about the amount of work I do in one situation and how much time is spent thinking about it, I know that I could never have done any meaningful investing while working 60/70 hours a week. I value family life as well, and there was little enough time for that. After leaving UBS, I started investing in equity special situations involving companies I knew in Australia with my own capital. What became apparent to me is that in Asia there’s a lot of value around, but you need a corporate finance process or an event to realize value. There are value traps everywhere. That’s the original thinking behind the strategy. It’s evolved to incorporate activism and engagement. It’s “friendly” for the most part, but we use hostile activism as a fallback. We take significant shareholdings in companies and then basically determine the corporate finance settings that we think are optimum in consultation with the board and management. So you’ve done it all, oil and gas to deep-value special situations and activism. What does your day kind of look like from beginning to end? Do you have any daily rituals or habits that you do that you think help keep your edge? PK: The fund is based in Hong Kong, and my family lives in Singapore. Generally, I will spend a week in Singapore and a week in Hong Kong. Buffett said that Omaha is a safe distance from New York. I certainly like that change in routine. Hong Kong is the New York of Asia, so it’s more externally focused and where I conduct the majority of my meetings with investors and companies. I have an office at home in Singapore that is set apart from the house, and there I do a lot of research and thinking. Having that distance from the market is important. Both Hong Kong and Singapore are great hubs, which reduces the need for me to travel frequently – sometimes travelling can be an inefficient use of my time. The concentration in the portfolio means that my routine always starts around the portfolio, the existing positions and keeping myself up-to-date with those. I always try to look at a couple of new situations each day, just to keep a fresh idea flow coming through on a consistent basis. The Bloomberg FA function is great for this. It used to take analysts three days to come back and report. Now it takes fifteen or twenty minutes for me to do the same work. That’s allowed me to develop the ability to understand a company’s financials very quickly. One of the things I’m cautious about is being too reliant on management engagement. When you have a close relationship with management, it’s a positive from an investment point of view, but you can also inherit their biases. You’ve got to be careful. That’s why when I start looking at a company, I begin with the numbers. What do the numbers tell me? What’s the track record? I speak to a range of people external to the company to get independent views. I have an extensive personal network thanks to years in banking, but given we’re opportunistic, we could be in any sector or any country. We therefore use an “expert network” to put us in contact with other sources where needed. Having that diversity of information in conjunction with management engagement enables us to get to the bottom of a situation and understand what’s going on in the company. If we don’t understand it, then we don’t invest. One thing that I constantly indulge in is reading. I always have a book about investing on the go and generally get a chapter or two read every day to keep the habit of continuous learning from other investors. I share the best of these with my subscribers via the Black-Crane website. What do the first 60 minutes of your days look like normally? PK: I’m an early riser. By 07.30, I’ve usually cleared my emails and done a half hour of reading on investment or investment-related matters. Then I exercise. I have a small gym at home and a membership to a city gym in Hong Kong where I do my high intensity workouts six days a week. These are great to keep in shape, clear the head and get focused for the day ahead. What would you say is a little-known secret about you or Black Crane that no one knows but should? PK: There are a lot of fund managers out there who begin their journey because they want to manage money freely but they don’t feel passionately about being an entrepreneur or about building a business. And they typically don’t stay on when the going gets tough. My business began in 2009, just after the global financial crisis. Being a start up, doing something from nothing during that time was grueling. Trying to get investors to put money into a start up was almost impossible. Many said I couldn’t do it. Exit strategies were everywhere. Different paths were available. And they were tempting. But I thought about Hernán Cortés – I thought, ‘what if I just decide to burn those boats and keep going?’ And I did. I had such confidence in the fundamental integrity and value of my strategy, I decided to ignore the exit strategies for as long as was feasible, and just hone my craft, learn and build, slowly and steadily, without getting spooked. I knew the strategy was sound but that it would take intense focus, the ability to shake off the skeptics and a hell of a lot of hard work. This is what got the fund up, but it’s also what underpins the success of the fund today – the recognition of deep value and the ability to see the journey through. Also critical, is my ability to identify the events that are likely to crystallize that value. It’s unemotional, accountable, common sense investing. Starting a hedge fund hasn’t been an easy path. But it’s been 100% worth it. Black Crane Capital now has a niche position in the hedge fund market and a solid history of successful investing. But of course it’s a daily journey. Who are the people that have inspired you the most whether it’s an entrepreneur or investor? PK: From a more general philosophical standpoint on how to approach and live life, it’s certainly Charlie Munger. I’ve read a lot of his stuff. He has such a common sense, down-to-earth approach. I love some of his sayings and phrases. Nicholas Taleb is another writer I respect - his thinking about life and how the world works resonates with me. Fooled By Randomness and Antifragile really bring it all together. He’s made me thoughtful about risk and what it means for me to have an entrepreneurial mindset. This has been particularly beneficial because there’s no one else doing what I do (especially in Asia). It can be difficult at times, as there are plenty of people telling me that you can’t do it this way, or it doesn’t work. Does that make you want to do it more or does it disenfranchise you sometimes? PK: It varies. It depends on how tired you are at the time when you hear it. Now I’m used to hearing it, and that’s good because it means I’m sticking true to what I believe in. That differentiation is the advantage— the added value. I think a lot of people get caught halfway between trading and investing. Taking a very pure approach is hard to do. I don’t know if it’s just human psychology, but everyone loves to think they can market time. And that can be a slippery slope. I’ve taken a position that says we just don’t try to do it. We’ll average down in our top ideas if cheap gets cheaper to take advantage of market volatility but we don’t actively trade in and out of our positions based on a market view. Nor do we attempt to hedge overall market movements. What I’ve decided to do is to keep the strategy pure, so there’s no noise from seeking to hedge or trying to time the market or those sorts of things. If people want to hedge our strategy from the outside, they can do that. We try to keep it as simple as possible, so clients get our alpha only. It’s an intellectual high ground. It means that everything I do is defendable and has a credibility to it. As soon as I start deviating from that or letting people influence me, then I’m on thin ice. Because if it goes wrong, where’s my defense, where’s my credibility, how do I justify what I’ve done? Every time I make a decision, I think about that and say to myself, “Okay, if this went wrong, how do I justify making that decision?” Because we all know that if it goes right, you don’t have to justify it. No one questions something that’s a winner, right? Well, how do you know the winner wasn’t luck and vice versa? How do you know the loser wasn’t a good decision? Another person who has influenced me is Mohnish Pabrai. I liked his book, Dhando Investor, and his asymmetric approach to investing. Guy Spier’s book, Education of a Value Investor, is excellent too. His writing was so honest. I have a potential investor in New York, and the whole meeting was targeted around some of the emotional issues and psychological pressures you face running a strategy as I do. That’s the interesting thing about Guy’s book; he’s focused just as much on the emotional aspect of investing as he is on the analytical side. So speaking of some books, what would you say are the top three books that you would recommend that people don’t necessarily talk about enough? PK: I like Joel Greenblatt’s first book a lot, You Can Be A Stock Market Genius which I mentioned earlier. Mohnish Pabrai’s Dhando Investor is great, though I’m sure you don’t see that at the top of lists anywhere. And another book, someone you’ve talked to already, is Tobias Carlisle. His book, Deep Value, was very quantitative. Lots of things sound good in theory, and you can understand them qualitatively. But quantitatively, what do the numbers tell you? His book completes that circle and I think he’s clearly a deep thinker about investing and very experienced. Can you describe your philosophy and process to investing, how you go about searching for investment opportunities and your criteria for investment? PK: The process has changed a little bit over the years. I start with fairly simple scanning, because I find if you make the scan too tight, you end up with too few potential opportunities in your basket. I scan religiously for any stock that’s fallen more than 50% in the last 12 months within our universe --- Hong Kong, Taiwan, Southeast Asia and Australia. We’re looking for all the accidents and the fallen angels. Then we try to figure out what’s gone wrong with them. We like to look at the description of the company and its sector. Then I apply a broad filter, asking myself, “Can I imagine myself owning that business?” And if the answer is no, I don’t go any further. I can rule out a lot simply on that basis. Do you keep a watch list of these names? PK: Yes. The size varies, but at the moment, it’s probably 40 companies or so. The good thing about companies who we’ve already done quite a lot of work on is, if something changes in those companies, we can act quickly. If we’ve never met the company, and we’ve never thought about the sector or never done any work on it, then it’s going to take me a month to analyze the situation. Occasionally, we get referrals, or I’ll bump into people, and very occasionally this leads somewhere. For example, a guy who used to work for me pointed out the rubber company that we’ll talk about later as an investment prospect. It ended up being a great idea, but I had to back up a little and say, “Okay, well let’s get some independent views because I like that guy a lot. I respect him, and I think he’s smart.” So the risk is you just take what he tells you 100%? That’s very risky. If you start with management or you start with an insider, it can be risky if you’re not careful. You can be influenced too heavily. It’s critical that you have independent thought. If I get an idea, I’ll start on Bloomberg using the ‘FA’ function and look at the latest set of results. Sometimes, I’ll read a brokerage report, just to make sure I’ve got the numbers right. Then I’ll try and construct a general thesis with valuation. I’ll look at the upside, what’s the risk, what are the potential events, etc. Depending upon the situation, the next step might be a call to management or, more likely, contact independent experts and other external sources. How would you describe the “uniqueness” of your investing strategy? PK: It’s the corporate finance aspect that is unique. In Asia, just buying and waiting does not work. You could be waiting for ten years or more, and your investors will lose patience. Many of the investors I speak with are very skeptical of the “buy and wait” strategy in Asia. The central component of the strategy, the part that pulls it all together is the event aspect. It’s not your typical investment catalyst or event. It’s a corporate finance process, and you have to have a high level of confidence that it’s going to happen. I like a situation where I am going to be right, or wrong. The ones that are trickier are the ones where the timing of the events is less clear. I like the situation to break one way or another. I like to see a potential end to a situation. I also like to have the size of the company such that we can become one of the biggest shareholders. I can then have better control over the outcomes. Do you think there are sectors or industries right now in the market that offer outsized returns over the long term? PK: Our horizon is two to three years, so we’re looking to get involved in a company at a particular turning point in its life as opposed to through the cycle. Having said that, I think it’s far safer if we are involved in industries that have reasonable returns through the cycle. For instance, offshore vessels do have (and have had) attractive returns on capital compared to commodity shipping, which never has. Personally, I feel commodity shipping is difficult just because you’re still in an industry that has poor supply control and has historically not had attractive returns. That’s a bad starting point unless you’re buying below steel value and you’re going to liquidate the company, scrap the vessels and collect the cash. We often invest in out of favor sectors. At the moment, we have mining equipment, and we have offshore vessels. So we do have a commodity element, but not straight commodity plays. The good thing about mining equipment is, the miners just have to keep mining. The equipment eventually wears out, and there’s only one material supplier which is Caterpillar. Similarly, with offshore vessels, there’s a correlation with oil and gas prices. However, you don’t have full exposure to oil and gas. We have a company that’s in the rubber industry, and the cyclicality has caused that to become a great opportunity. They are building a business, and they’ll end up the largest rubber company in the world where they’ll supply 30% of the rubber to the major tire companies. They will become a professional supply chain business. The rubber industry has never had that. The rubber industry has always been full of various layers to the supply chain owned by different people and everybody punting the rubber price. They are driving industry change, so it’s an interesting situation around that particular industry. The cyclicality has created an attractive entry point opportunity. How would you describe your value discipline once you find a company worthy of investment? PK: The primary thesis is to limit the downside. If I’m wrong I don’t lose much --- it’s a “heads I win, tails I don’t lose too much” philosophy. On the upside, we’re looking typically to invest at half of fundamental value. At the moment, we’ve got a bunch of things in our portfolio that are much cheaper than that with around 3-4x upside. However, 1x upside is sufficient. Even a little less if it’s very safe. We expect to realize value over a two to three-year timeframe. And if it happens to be three years, that’s 33% gross IRR. That’s our target return. So anything with a 20-30% valuation discrepancy, I’m not interested. It’s just not enough. Regarding position size, I try not to differentiate too much at the get-go. A 10% position is a standard position for us. If it’s very compelling, meaning there are some short-term events, I might go to 15% on day one. I much prefer to have eight A-Class positions than have thirteen positions where I’ve got three or four B-Class positions in there. And then what happens is interesting because typically one company will go through an event by itself and nothing else will happen in the portfolio. When an event happens all of a sudden a 10% position can be 20% of the portfolio. And the effect can be magnified if I have a 4% or 5% position due to a price decline, and I buy more to go back to a 10% position. If the price just goes back to its original investment price, we’re quickly at 20%. At the moment, we have three positions at ~20% of the portfolio and some that are 8-10%. As far as your position sizing goes, with the 10% position you mentioned earlier, do you buy the whole lot at the initial point or do you scale it over time? PK: Typically we establish at least a 5% position, and then we wait and see. Then it just depends on the timing of events, and the position of the overall portfolio. One big question for us is, “Once you’ve invested and the stock falls, how much does it need to fall by before you aggressively reload?” So we have some rules around that, e.g, it needs to fall 30%-35% before we start to reweight. If you re-weight too often, you compound your mark-to-market entry losses. With that said, what would you say is one of the top mistakes that investors make as it relates to investing? PK: It’s interesting what you said before. I like to describe two classes of people as Howard Marks has: First Level Thinkers and Second Level Thinkers. I think there are a lot of people out there that just don’t do their homework and hence aren’t doing a proper job. When the price falls, they believe the market price is telling them something. The volatility can easily spook them out of their positions. It’s an emotional reaction to share price coupled with first level thinking. It’s all fear and greed and human error that results. I think deep value is hard to market and for people to use as a strategy. As much as people intellectually know a mark to market loss (particularly at year end) is not a real loss, emotionally they feel as if they have lost. Intellectually they know it’s not so, but the emotion just takes control. It takes confidence and perseverance to punch through that. And that’s what I do and what most of my investors do. Still, I’m continually surprised that there are some very experienced and sophisticated people out there who still crack on this point. Speaking of mistakes, what would you say is one of the worst investments you’ve ever made, what happened there and could you give us a little bit of a backdrop? PK: We put on about three or four positions in Hong Kong in 2011. Partly, I was trying to find additional ideas to expand the portfolio and not to be quite so concentrated. This was mainly in response to marketing challenges. There’s a general view that more ideas make investors feel better due to the potential for additional positive things to happen in the portfolio. My fundamental analysis on the downside of these positions was right, so we didn’t lose much money in any of them. However, the upside just didn’t happen. Three of them, in particular, were in China where management was very slow moving. In theory, there was a lot of value. It could be crystallized, but we didn’t have the right events to crystallize it. Other than a direct takeover, the events that works best in Hong Kong are those that effect earnings. It’s a very earnings driven market. So if you’ve got a catalyst that’s more around multiple expansion rather an earnings effect, then it’s a riskier proposition for the upside. We had a toll roads company in China where the government announced a review of tolls. Subsequently, the whole toll road sector sold off. It sold off so much that the implied unleveraged IRRs were 18-19%. Having done all of the analysis, we knew the risk was overblown. The Government needed toll revenue to remain at the current level to meet debt service costs. There was just a complete misunderstanding of the situation. So we invested in a Chinese toll road company. The Government ended up shutting down some illegal tolling and didn’t touch the overall tolls. The market just yawned, and the stock prices did not move. What was one of the best investments you’ve ever made? And give us a backdrop there as well. PK: The best investment we have made so far is Elders Preference shares. It made us about 35% of our NAV in the one transaction. I scanned for preference shares. In Australia, they’re called hybrid securities. (Ben Graham’s book, Security Analysis, talks about them as far back as the 20s and 30s.) Essentially, they’re perpetual debt securities. The only penalty for the company in not paying the coupon is it can’t pay ordinary dividends. This stipulation makes them a terrible instrument to buy at 100 cents on the dollar. But in distress, they often get mispriced because they’re poorly understood and neither debt nor equity. We found this security trading at $0.30 on the dollar. The company, Elders, is in rural services in Australia. It’s a bit like Agrium, but, in Australia, the agricultural market is driven by grazing and livestock as opposed to horticulture. Elders is an iconic Australian company with a 185-year-old brand name. The staff are instantly recognizable in their Akubra hats and bushmen’s shirts. All the major rural towns have an Elders branch. It’s a trophy asset, and they’re connected with the land. They lost a billion dollars in forestry during the global financial crisis. This company has been in work out with the banks from 2008 onwards. As a result, the coupon was not being paid on the hybrids. The company decided to sell all its non-core assets, and then to sell the core business as well. At which point they would return capital to shareholders. We did the work and thought: “The hybrids are worth, maybe not $100, but at least $60.” We’re buying at $30, and we also analyzed the corporate finance activism aspect because if we owned a blocking position of the hybrids, then we could skew the distribution of payout to the hybrids rather than to the ordinary shareholders. Sometimes when preferred securities are held broadly, there’s no single voice. The lack of a unified voice can lead to things like a 50-50 share between common and hybrids, rather than a 90-10 split. That was our strategy --- it was a deep value strategy on the $30 versus $60, then activism to create additional value. In 2013, it was an especially difficult year for the rural sector because there was a drought in Australia. It was one of the worst they had seen in many years. The drought caused the company’s earnings to drop to virtually zero. They sold all the non-core businesses, but they couldn’t sell the core business. The drought ended up being a blessing in disguise as Elders was restored to being a pure Ag business. It was the first time management had headroom to focus on the core business. They didn’t touch the core business before because it was generating all the cash flow to help them to survive. All of a sudden they went from $0 to $25 million of EBIT. With the rains coming back, they are currently now at $45 million of EBIT. There was such a pricing dislocation at the bottom. Even when we invested the ordinary market cap exceeded the market cap of the preferred shares, which makes no sense because it’s preferred. It was classic mispricing. Graham talks about this in Security Analysis. This type of mispricing can happen in retail hands. Retail investors didn’t know what to make of these hybrid securities. They didn’t know what was going on and didn’t like the coupon not being paid. Post the earnings recovery, the company was doing so well they raised common equity. The company then bought back $30 million worth of the hybrids last August. We are now pushing to have all of the hybrids redeemed or converted by the company. Our average entry price was $22 and the hybrid is now trading at $80. I see you have a position in Emeco Holdings (ASX:EHL). It appears to be trading at 12% of book value right now. Can you describe your investment thesis there? PK: It’s a mining equipment rental company. One of the great things about a business like this in distress is that it does have divisible assets. Its fixed assets are relatively liquid, so you can always sell an individual piece of equipment to make an interest payment. The relatively liquid fixed assets make highly leveraged situations like these much safer than companies who only have one asset or a business where you’ve got an all or nothing sale. So that’s the first point. The second point is you’ve got the asset protection. The thesis was that the equipment depreciates quickly as it only lasts about seven years. As long as miners keep mining, the equipment over-supply corrects pretty quickly. It adjusts quickly because of the high depreciation rate, but also because one of the key suppliers is Caterpillar, which provides supply discipline. The mining industry is in direct contrast to the shipping industry where there’s no discipline on the supply side and the assets depreciate slower. So you have good control on the supply side and depreciating assets in mining equipment. Therefore, a correction should happen relatively quickly. We picked Emeco because they’re #1 in the business, and they’re the largest. They generate revenue from Canada, Chilean copper (good long-term contracts with a big miner down there) and Australia. Our thesis was that we just needed to wait for the natural correction to happen; that utilization will go back up as the equipment wears out. And the other interesting thing about this business is the counter cyclicality of cash flow. Emeco is probably not going to make any profit for a couple of years, but it has strong cash flow because of low CapEx. This year, the free cash flow will be about the same as the market cap. I know you already mentioned book value, but how are you looking at the valuation right now? PK: In these situations, I look at two things: balance sheet (upside potential and leverage risk) and cash flow. A discount to the full balance sheet gives me room for upside, provided the company can get back to earning a decent return on its historical capital. It’s a relatively conservative exit valuation. On the downside, you want to have as big a discount as possible. We’ve a number of these since we started, and an 85% discount is very large. Then cash flow is key. “What is the free cash flow yield today on my equity and what is the free cash flow yield on EV?” Emeco, based on an EV and equity basis, has a very high free cash flow yield. Obviously, with the amount of leverage, you’ve got to look at how safe the leverage is and how you could get stopped out. If you have positive free cash flow and your lenders, for whatever reason, be it the debt structure or lack of covenants, are going to give you time, then your equity value builds from free cash. You’ll ultimately end up with equity value. I missed that point when I looked at a toll road company about four years ago. I didn’t invest because I didn’t like the EV valuation, but that wasn’t the key point. They had very long-term debt and had time on their hands. The Emeco thesis is that they’ve got quite a lot of free cash. Their debt matures in March 2019, and there are no covenants. So they’ve got three and a half years to build equity value. They have a Forex swap on their balance sheet that they can cash out for $65 million plus $25 million of free cash. They can potentially tender for a stack of their bonds at 65¢ on the dollar. This would allow them to deleverage much quicker than is apparent on the surface. Ultimately, there’s also the opportunity to buy back stock and create further value. Your position in Australian based, MMA Offshore (ASX:MRM) appears interesting. I see it’s priced at 11- 12% of book value there as well. Can you give us an understanding of your investment thesis? PK: The investment thesis is pretty similar to Emeco. The oversupply of vessels is in some ways a tougher situation than the mining sector. However, this company has much less leverage, and it has non-core assets that can be sold. It has roughly half its vessels in Australia and the other half in Asia. The original business was just focused on the Australian Northwest Shelf. They have a supply base that services that area; it’s a port and staging yard. That asset’s worth about $110 million and is very saleable. We want them to consider selling that asset to deleverage the company, which then gives them the capacity to buy back stock. They have $900 million of vessels, and $300 million of debt. We like it because it’s heavily discounted but not that leveraged. We are a 5% shareholder. We could become the largest shareholder and have influence if needed. Management is very sensible. How are you looking at valuation? PK: If they sell the supply base, the price of the vessels is about 15% of book value. The book values, in the large part, are based on depreciated construction cost. EV/EBITDA at the moment is about 6x based on historically very low EBITDA. EBITDA was $250 million a couple of years back, then last year it was about $80 million for the second half of the year. This year, I think it will be $80 million for the whole year. That should be the low point. They’re at 55% utilization, and industry utilization is at 60%. What price would you look to potentially scale out of your position (all else being equal)? PK: It depends on how other things in the portfolio move. There’s an opportunity cost decision here. If it pops and nothing else has moved, then we may re-weight to other opportunities. If everything else is moving with it, then we can hold it longer. I think the book value is a sensible valuation. However, we won’t wait for all of that. Once a position becomes 20-25% of our portfolio, we begin to back it off. It depends on if we’re getting inflows as well. I like Mohnish’s approach to this —-avoid making quick decisions on anything. There’s a rare circumstance where you do have to act quickly, Generally speaking, I like to wait for the dust to settle. I prefer the company to make their announcement, digest the announcement, speak to some people, talk to other experts, talk to management, form a view, and then make a decision. For example, if management started heading in the wrong direction, our response would not be to sell because there’s no controlling shareholder. It would be to launch probably an activist campaign and get other people to come up the register, force their hand and find the right person to get in there and fix the situation. For instance, what happens if you discover a company in China is a fraud? You’ve got to ascertain if there is a permanent impairment. Find out what the value of the business is and if the stock price is at or above that value, then act accordingly. I see you’re also long Halcyon Agri, a Singapore-based company. Can you describe your investment thesis in the company? PK: It’s a rubber distribution and processing business. And it’s a fascinating company. The CEO and controlling shareholder, Robert Meyer, came to Singapore originally when he was an infant. His Father was in the rubber business, so he grew up in the industry. In the last three years, there’s been a generational change amongst the owners of these businesses. Historically, rubber processing has been owned by Southeast Asian Chinese families and the Thais. The big producers are in Indonesia and Thailand. Rubber can only grow around the equator. To process the rubber the trees are tapped, the rubber gets washed in the processing plants and then it gets shipped to customers. Tire producers are about 75% of the market. You need a license to be a processor, but there is surplus capacity. What’s most important is the relationships. The processing market has always been separated from the distribution, which is the trading part of the business. Historically, the industry has been driven by people not worried about margin. They’ve just worried about trading the rubber price. Halcyon first acquired two small plants about three or four years ago. Then just last year acquired Anson Rubber. This move made them #3 in the world in rubber processing. They also acquired two large distribution/trading companies. In the past two years, the rubber price has declined largely on the back of reduced demand in China. Tires drive rubber demand, especially in the replacement market. This recurring demand provides a strong demand outlook. So the outlook is soft in the very short term but strong in the medium term. The industry consolidation will help to reduce costs and stabilize prices. There’s more industry consolidation to come. The stock is very cheaply priced and Halcyon is not yet at full capacity. Where do you see the intrinsic value of the business? PK: I performed a pro-forma earnings analysis and assumed average margins and utilization. Then I applied an 8-10x EBIT multiple. At those multiples, you come up with a $2-$3 stock price. If you look back at your 20-year-old self, knowing what you know today, what advice would you give yourself? PK: That’s a good question. I think about this for my kids. What career advice to give them and I think the key thing is to follow what you’re good at and what you enjoy as opposed as to what may earn you the most short-term income or status. I think that’s what I would advise myself. What would you say are the three things an investor should focus on the most to generate abnormal excess returns over the long term? #1 — I think the first thing is protection on the downside. If you’re wrong, you only lose a little. It’s super important for everything I do. #2 — Then you need to buy things at a discount to fundamental value (margin of safety). Your margin of safety also provides a source of upside return. #3 — You can’t just buy cheaply. I think you need a process or events to realize value over a reasonable timeframe. I think very few companies continue to win over the long run as things always change. You’ve got new competitors, management changes, regulation changes, technology changes, demographic changes, changes in consumer preferences, etc. I agree with Mohnish Pabrai when he talks about how every business is an arbitrage of limited duration. Keeping that in mind is important when making investments; understanding the creation and destruction that capitalism applies to companies and corporate situations.