Anodyne Inc. Quarterly Report to Shareholders

TSE 300 index, 25 October 2006 - 24 July 2007: 13.99% gain

Anodyne Inc. 25 October 2006 - 24 July 2007: 27.28% gain

Relative result: 11.06%

Anodyne Inc. and the TSE 300 index have both been on a tear since my first attempt at public portfolio management toddled out into the world in late October 2006. For this first nine month period, Anodyne Inc.'s gain has significantly exceeded the TSE's.

The TSE figure is important because it shows what you could earn by passively investing your money in an index fund, thereby missing out on annual report reading, financial statement deciphering, and ceaselessly worrying when the CFO of one of your largest positions is dismissed just a week or two before the annual report's release. The index also serves as an objective benchmark of my investment decision-making. If Anodyne Inc. reports a 5% gain while the index gains 15%, Anodyne's gain sounds OK on its own, but actually represents poor relative performance. Similarly, if Anodyne loses 12% while the index loses 18%, the relative result indicates better-than-average performance, despite the objective loss.

I judge my performance as you should, over the mid- to long- term. I hope to consistantly beat the TSE 300 index over a rolling three year period, a benchmark that many professional Canadian fund managers find hard to meet. Over shorter time periods the portfolio may fluctuate in value, sometimes impressively. These fluctuations don't bother me, and they shouldn't bother you, either.

That said, I have certain advantages that most real fund managers don't. I'm running money for myself, as a purely didactic enterprise. Real managers have clients, and need to maintain a cash position to satisfy the needs of clients who, for whatever reason, need to cash out in a hurry. I am not constrained by investment "themes" or "styles" -- I don't have to buy "mid-cap growth," or "large cap value," or maintain a certain percentage of the portfolio in a number of different sectors of the economy in the name of "diversification." I don't have to buy the stock of companies I don't personally like or understand. And I don't have to trade like mad, with all the frictional costs that implies, in order to hit a quarterly performance target that benefits the marketing department more than the fund's investors.

Few readers seem to care about the portfolio, but those that do ask very focused questions. Each quarter, I briefly discuss some of the portfolio's holdings, and try to give some insight, however brief, into my decision making process. I've learned a lot from master investors like Benjamin Graham, Warren Buffett, Martin J. Whitman, and Canada's own Irwin Michael, who have generously discussed their own decison-making in public, thereby enabling amateurs like me to learn from their example. Investing -- as opposed to day- or momentum trading -- is a craft, and, as with any craft, one learns best by watching, listening, and reading.

Today, I thought I might discuss some ideas that guide my security-selection process. Most of the portfolio's holdings carry lower P/E (price-to-earnings) ratios than that of the TSE 300 index. The P/E ratio represents the price you have to pay to get your hands on $1 of the business' current earnings. Eg., if Company X sells at a P/E of 15, you're paying $15 for every dollar earned by Company X. And in my world (as opposed to the impenetrable and foolish worlds of momentum trading, "technical analysis," etc.) dollars earned by companies -- their operating results -- are the only way that you as an investor make any money, either because the company pays out earnings as dividends, or retains the money as "retained earnings," which will presumably either be paid out to you later on, or reinvested in the business to help it grow. (I am simplifying somewhat; change-of control and going-private transactions can also make you money, but the timing of these events is a lot harder to anticipate, and consequently riskier, than simply focusing your attention on basic business results).

[For detailed discussions of change-of-control, going-private, & etc., see Martin J. Whitman, The Aggressive Conservative Investor, and Joel Greenblatt's excellent, if goofily-titled, You Can Be A Stock Market Genius.]

A few other thoughts. I like companies that pay dividends. (Portfolio examples: Norbord (NBD), Loblaw (L), Amerigo (ARG), and the income trusts). Dividends are hard to fake; if the company is borrowing at the bank to pay the dividend, this information is easily divined from the financial statements. Steadily increasing dividends or cash distributions? (Hart Stores (HIS), Parkland (PKI.UN)) Even better.

I like companies whose basic business models are describable in plain English. I tend to get bored by or have very little patience with companies whose business models rely on industry-specific jargon. I'm sure that there are biotech companies and technology companies that are bonanzas for their shareholders, but with a few exceptions (ie., Microsoft (MSFT), in the Anodyne Inc. US$ portfolio) I lack the specialized skills required to evaluate them. I like industries I can relate to jobs I've previously held. I purchased Amerigo Resources (ARG) for the portfolio after realizing -- on the bus, on the way to work -- that Amerigo was, at heart, performing exactly the same job that my brother dru and I did as kids, hiking down to Thunderbird Marina every Sunday, sorting through the marina dumpsters, and retrieving cans, bottles, lead batteries, etc. from them. (Amerigo is recovering copper and molybdinum from a big pile of mine tailings in Chile, but the business model is identical in every respect).

I like companies that don't shower their executives with stock options. The old song and dance that goes, "We have to compensate our executives competitively, or they'll walk," is bullshit, if amusing bullshit. My favorite employee -- me! -- is motivated by a deep personal identification with his work that transcends financial renumeration. Sure, but you're an owner, says the counter-argument. Yes, and Pulpfiction's staff are workers, who were first paid minimum wage, then better-than minimum wage. Then came cash bonuses, and the health and dental plan. Would I -- and the staff -- have been better off if we were all showered with goodies on day one? Clearly not: better-than-average business productivity means better-than-average profits, which dictates better-than-average staff renumeration and benefits. But the business results dictate the compensation-and-benefits package; good things don't just materialize out of thin air.

More soon. I'm off to enjoy a celebratory g'n't next door.
- posted by cjb @ 6:24 PM