A review of five years with the three concepts any investor must know – 2003

Kurm has been a stable and safe investment. The consistent and patient application of certain key investment principles has ensured this. Indeed, only for a very brief period did Kurm’s investors experience a decline in value below their initial capital, and this was during the peak of the bubble which burst in 2000. This situation was swiftly corrected, while many who had benefited during the boom saw tremendous losses.

It is clear that anyone who invested in Nasdaq and managed to cash in at the peak would have fared very well. Unfortunately, very few did so and, indeed, many actually began to invest at or near the peak. It is hard to imagine many of these investors seeing their capital returned to them, let alone the high returns promised or imagined.

Of course, with hindsight, there are some areas in which Kurm’s investment decisions could have been better managed. Firstly, while we did take advantage of the temporary fall in Berkshire Hathaway’s share price to almost half of what it is now, we could have been much more aggressive, given our conviction in its value. Secondly, we could have exited the investment in Household International in the second quarter of 2000, when the price hit an all-time high. However, we remained convinced of its potential as a long term hold and so held our position, eventually to sell at a lower price with HSBC’s take-over offer, at which the company management did not act as honourably as we had hoped or trusted them to. These were the two major mistakes in the course of the last five and a half years. We will continue to look for exciting opportunities in public markets, with fund managers with good histories and, to an extent, with illiquid, private, transactions both in the USA and further afield.

During the period since Kurm’s inception, investors have witnessed a bubble and a subsequent crash, and they have experienced the connected sentiments of greed and fear. We have all seen almost incredible failures of ethics, each such act of greed resulting in the further erosion of the public’s savings.

Whether we call the most recent boom the Internet boom, the TMT boom, or the technology boom, it has the same characteristics as that of many other such phenomena in history, and each was followed by its own bust.  Such phenomena are usually always based on an element of truth, such as the rising value of Tulip Bulbs in 17^th Century Holland, or the possibilities created by new technologies such as the Internet.

Gradually, as prices for the asset in question, or share prices of companies in that particular industry, rise, they take on a momentum of their own, driven by the psychology of investors, the opportunism of entrepreneurs and promoters, and the sometimes-questionable ethics of various agents such as auditors, actuaries, brokers and bankers.

Investors begin sharing with their friends, and anyone who will hear them, news of the great gains they have made in a particular issue, although it is surprising how we seldom hear of their losses. As this positive anecdotal evidence and newspaper and TV reports begin to accumulate, most individuals begin to feel they are losing out and they begin to need to get a “piece of the action.” Investors follow the crowd, time and time again, in each and every boom.

The fear of losing out begins to set in. Sooner or later, a great tip comes along, one which is “sure” to lead to a multiplication of capital, and so greed takes over from rational analysis. Companies with little or no history, an unproven business plan, zero to negative earnings, begin to be valued for billions of dollars. Those who do not invest in such situations have their wisdom and intelligence challenged. Eventually, for some reason or another, perhaps a scandal, or even a small change in the economic environment, or when reality simply begins to set in, the boom, which has become a bubble, comes to an end.

At the beginning of the boom, entrepreneurs might begin to take advantage of an emerging technology or market, and profit handsomely. Sometimes they float a company which attracts wonderful valuations on the stock market. As this phenomenon attracts investors and the “crowd,” many opportunistic promoters and financiers enter the market to take advantage of rising valuations by creating and listing companies in the relevant industry. The fees from facilitating such transactions are so attractive to bankers and brokers that they are tempted to give advice, even if the investment is not necessarily one which would be prudent for the investor, generating huge potential conflicts of interest. Indeed, auditors and actuaries face conflicts of interest too, as their fees are paid by the companies whose practices they are supposed to monitor for investors. Such auditors and actuaries allow some managers to show accounting-generated earnings growth so that they can cash in their options and boost their wealth to the long-term detriment of shareholders.

In the past few years, we have witnessed brokers and investment bankers peddling companies at sky-high valuation to increasingly irrational investors, while sometimes privately disagreeing with the recommendations that are being made. The accounting irregularities at Enron, led to its demise as a business, and the end of the venerable practice of Arthur Andersen, whose name had only recently been valued at a seven-digit dollar sum. Huge bankruptcies have followed excessive debt-funded asset generation or acquisition sprees, sometimes advised by bankers and facilitated by auditors’ allowance of aggressive accounting practices. Currently, we are witnessing many companies declaring their pension funds to be hugely underfunded, another result of imprudent management, and actuaries with a conflict of interest.

In this kind of situation, many of us would have left our investments in the hands of professional investors. Some would have trusted mutual fund managers. Unfortunately, many of these people made the very mistakes discussed above. The last few months have presented news of a still daunting phenomenon, termed “market timing,” where hedge fund managers take advantage of their close relationships with fund managers to buy or sell units of the funds in question using information which the funds’ small investors cannot use. Again, the small investor has suffered.

On top of this, with all this uncertainty, many investors turned to the so-called guaranteed products offered by insurance companies. Investors often believed that profits and principal were guaranteed by the insurance company. Of course, in many cases, when the markets began to fall, “market value adjustments” became a phrase familiar to all such investors, whereby they learnt the hard way that profits, and sometimes even principal, were not guaranteed, or that they would have to hold on to the investment for much longer to see their original investment. Worse, in many cases, people were urged to “gear up” these investments, leading to even worse losses.

However, given these experiences, it is very important not to shy away from investing in stock markets altogether. Investments in shares are still a very attractive asset class, and have outperformed most investments over long periods of time. It is possible to approach stock market investment in a way which can avoid many of the problems discussed above.

Indeed, as we speak there are emerging some very interesting opportunities in the very sectors which experienced most of the excesses of the boom, and in which so there is so much pessimism now, such as energy or telecoms. At the same time, there are also signs that there may be the reappearance of overvaluation in certain shares.

Over the last few years, Kurm Investments has cautiously invested the capital of its shareholders using a conservative approach, based on buying at a discount to intrinsic business values. We have always thought of shares as pieces of a business, whose underlying value derives from the business itself, and not as pieces of paper to be traded as though they were commodities. There has been success in preserving capital, while the returns have been modest. However, Kurm has managed to avoid the major mistakes of the last few years, and also managed to avoid suffering from a great deal of volatility.

Apart from investing in conservatively managed companies, Kurm has always looked at companies with a sustainable competitive advantage and high returns on capital. More importantly, it is important to be with an honest management, which thinks like owners, and has the majority of its own wealth in the shares of the company, so that they benefit as we benefit, and lose as we lose. Also, investing with price discipline, with a “Margin of Safety,” helps with the goal of capital preservation, and to avoid speculation.

The concept of “margin of safety” comes from the insights of Graham and Dodd, in their classic book “The Intelligent Investor.” In the book, they also share the concept of “Mr. Market,” in which they give the market a personality, that of a business partner who is schizophrenic and who will each day come in with either great optimism or great pessimism. On an optimistic day, he will offer you an extremely great price for your share of the business, and on a pessimistic day, he will offer to sell his share to you for a bargain. In any event, you can chose to ignore him, and he will still keep coming back. If we learn to take advantage of such volatile emotional behaviour, without letting it affect our own outlook, we will be able to profit handsomely.

These three concepts have been of tremendous value in directing Kurm’s approach. In addition, we have always thought to invest in simple businesses which are thus relatively simple to value. The company currently has a large proportion of its investments in the insurance and reinsurance industries, as well as in investment companies. All of these companies are well capitalised and conservatively financed, so that they can take advantage of the relative weakness of competitors and also make opportunistic investments. In addition, we now have an indirect exposure to the telecoms sector, which represents good value with a large potential upside.

While Kurm’s structure has now changed, its basic investment philosophy will remain the same. It has been a pleasure to be involved with the company, its shareholders and its supporters since its inception, and I look forward to many years of continued success for Kurm Investments.

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