Building and managing a portfolio of investments inevitably includes shares that will prove to be winners but also those that will fail to deliver on their investment case - the losers. Successful portfolio management essentially involves picking more winners than losers. Following the recently announced buyout offer for the whole of Dimension Data, this investment has turned out to be one of the portfolio's winners. The Dimension Data investment clearly demonstrates the application of our investment philosophy.
A portfolio of investment ideas
While we describe ourselves as bottom-up stock pickers, these individual share ideas are delivered in practice to our clients through a portfolio of several stocks. At the point of investment we are naturally optimistic that each stock we decide to invest in will outperform the greater investable universe we can select from. However, in reality there will also be those investments that will disappoint for a variety of reasons. In all investment portfolios over time there will therefore be both winners and losers. Successful portfolio management essentially involves picking more winners than losers. There are clearly added dimensions to this in that it is not simply enough to numerically choose more winners than losers. To be a consistently successful investor one also has to ensure that:
- One's winners outperform by more than one's losers underperform
- One has allocated more capital to one's winners than one's losers
A recent winner
In Quarterly Commentary 3, 2008, I explained the detailed investment case for Dimension Data (Didata), one of the top 20 holdings in our portfolios at the time. That article summarised the main reasons why we considered Didata an attractive investment, especially given that it had been noticeably absent from our portfolios when it was very popular at the height of the IT bubble in late 1990s.
At the time the 2008 article was written, Didata's share price was 705c or 50p (Didata has a primary listing on the London Stock Exchange). On 15 July 2010, Nippon Telegraph and Telephone Corporation (NTT) - Japan's largest telecommunications company - announced an offer of 120p (approximately 1400c at the prevailing exchange rate, representing an 18% premium to the previous day's share price) for the whole of Dimension Data. Relative to the South African All Share Index (ALSI), Didata outperformed by close to 100% from the end of September 2008 to 15 July 2010. Once all the necessary buyout conditions are met, we expect the transaction to be imminently concluded and Didata (now one of the top 10 overall holdings) would be monetised in our portfolios.
Apart from the specifics of the company itself, the investment in Didata was and is an interesting example of two important aspects of our investment approach:
1. It illustrates our contrarian, value-based philosophy in application
2. It displays the manner in which we are able to accumulate and then sell a large stake in a single company
1. Philosophy in application
Graph 1 reflects the share price of Didata from 1997 to the present time (shaded area) and superimposed on this is a stylised graphical representation of the Allan Gray investment philosophy.
From the point of maximum optimism reflected in the share price at Point (a) to extreme pessimism at Point (c), Didata share price lost over 97% of its value. As contrarian value- based investors, who prefer to be, in the words of founding father of value investing, Benjamin Graham, 'greedy when others are fearful', Didata first started appearing in Allan Gray portfolios at around Point (c) ' when panicked investors aggressively sold the share. Shortly thereafter however, a short-lived but sharp rally in positive sentiment caused the share to re-rate, quickly reaching close to fair value (see Point (d)) without a corresponding improvement in the underlying fundamentals of the business. This caused us to exit the relatively small stake we had begun to accumulate sooner than we would have expected as the share price was not justifiable.
However, by late 2005/early 2006 (Point (e)), the Didata share price once again started entering attractive territory when the counter traded at a wide margin of safety discount to our estimate of its intrinsic value. From this point we recommenced accumulating a stake in Didata for our clients as we believed the long-term business fundamentals of the company were not being reflected in the share price. With an investment philosophy that accommodates both patience and a long-term approach, we felt convicted in the view that over time the improving financial performance of the company in a more normalised operating environment would justify a higher share price than the market was attributing at the time.
Some market participants might argue that the purchase price offered by NTT for Didata (effectively Point (f) on the graph) might not be high enough to reflect the value of the business, as if NTT is prepared to pay close to 1400c for the entire business, then Didata must be worth more.
The way to address this is to consider our overriding investment objective. As value-based contrarian managers we invested in Didata when the profitability of the business was well below normal and the share price depressed due to inter alia the poor financial performance of the company. Our investment case essentially hinged on a turnaround in the business and we were able to invest at a price that reflected a deep discount to the value of the business. From NTT's perspective, it is investing in a Didata that today is largely firing on most cylinders - the business has successfully turned around and is now achieving what we believed would be normalised operating profit returns.
NTT is specifically optimistic about the unique strategic fit that Didata has with NTT's existing operations (in terms of geography and product offering); the benefits that putting the two groups together can unlock; and the opportunity for greater growth that the combined entities can achieve which might not necessarily be possible if they were separate.
Indeed we expect the value of Didata as a company to continue to grow in NTT's hands. As an investment, however, we think the quantum of return we have achieved through the considerable re-rating in the share price culminating in the buyout offer has been material, and we are content we have extracted sufficient value for our clients.
2. Selling a large holding
Our clients collectively owned in excess of 25% of the issued share capital in Didata by late 2008, with our holdings reaching a peak level of over 27% by the end of 2009. In our history as investment managers it is not uncommon for us to accumulate large stakes in investments in which we have high conviction.
These large stakes have at times drawn criticism by external parties in that they are perceived as being risky both in terms of concentration risk (too much money invested in a single share) and liquidity risk (the difficulty of selling a large stake in the market).
We do not believe that owning a large stake in a very attractive share is risky. We feel we mitigate the above-mentioned risks by:
- Adhering to strict controls that govern the percentage of our total portfolio that can be invested in a single share
- Limiting the overall percentage of the issued share capital we purchase in any single company to 25% (and in exceptional circumstances up to 30%)
In our opinion the market tends to misunderstand the issue of historic liquidity/tradeability. In the Didata example, at Point (a) on Graph 1, at the height of optimism over IT shares, Didata was a highly tradeable and liquid share as there was both great demand for and supply of the share. When the IT bubble burst and Didata's share price collapsed (Point (b)), the high liquidity and tradeability of the counter in 2000 did not provide any protection against loss in capital that subsequently ensued.
During the period between (e) and about a year before (f) is probably when Didata's liquidity was lower than its historic average, as value-based shareholders such as ourselves were accumulating and holding a position when we believed the share price was not yet reflecting the intrinsic value of the company. As the earnings performance and prospects of the company began to improve over this same period, so too the investor interest and sentiment in the company began to recover, and then also the corresponding liquidity of the share. This culminated in the NTT offer. With the opportunity to exit our clients' entire holding in Didata in a single transaction at what we believe is a price reflective of the business value of the share, the issue of liquidity risk is in effect a non-issue.
SUCCESSFUL PORTFOLIO MANAGEMENT ESSENTIALLY INVOLVES PICKING MORE WINNERS THAN LOSERS
The risk we are most concerned about in investing is losing our clients' money. We accumulate significant stakes in companies when we have a particularly strong investment case and can invest with a reasonable margin of safety. Buying or holding a share with low liquidity at a discount to its intrinsic value will always be far more preferable to us than buying a highly liquid but overvalued share.
We lose some too
As investment managers, we are always mindful of the reality that not all investments will end in the positive way Didata has ended. While we never intend to invest in shares that ultimately underperform, we know there will unfortunately be losing investments in our portfolios, just as there will be winning ones. What we can control, however, is our commitment to our investment philosophy that, over the past 36 years, has enabled us consistently to uncover more winners than losers for our clients.