For fixed rate investors the difference is clear.  They save money into an account and the value of each pound saved never changes.  The account then provides an income which is known in advance and drops into the account several times a year.  The chance of an adequate return is high and the chance of a permanent loss is effectively zero.  None of this sounds remotely like gambling.

A fine distinction

Ben Graham said that an investment should provide safety of principle and an adequate return.  Of course, adequate return is subjective, but if you’re happy with the lower and more certain returns of fixed rate investing then it certainly fits Ben’s definition.

Gambling on the other hand offers the chance of an adequate return and perhaps a life changing return in the case of the National Lottery, but it also offers a meaningful chance of a permanent loss and even a total loss; that is the key distinction.

Both investing and gambling can provide adequate returns and better, but only investing can do this with little or no chance of a permanent loss.  Strangely enough, the stock market can be a place for both investing and gambling.

Short-term gamble, long-term investment

If you had some money to invest for a year while you travelled the world, putting the money into the stock market would be a gamble.  This is true because returns from the stock market in a single year can range from perhaps 30% up to 50% down.  With a possible 50% loss in a year the stock market over such a short time-span is a gamble.

If instead you were investing a lump sum for 20 years then the FTSE 100 becomes an investment.  That’s because over 20 years the returns from the stock market are almost always positive, even in inflation adjusted terms, so the chance of a permanent loss is virtually zero and the similarity to gambling fades away.   The same thought process can be applied to individual stocks so that they become investments rather than gambles.

Stock picking for investors, not gamblers

In most cases investors don’t look for a 20 year holding period in an individual stock, so let’s take something a little more typical.  Say my investment horizon for each stock is 5 years.  It might be more, it might be less, but that’s the general ballpark.  If I was to invest in Balfour Beatty today at 290p I’d get a stock that pays a dividend of around 4.5%, which is well covered by earnings and is expected to grow at least in line with inflation.

If I owned this stock for 5 years I might receive dividend payments totalling around 25% of the purchase price.  For this to be a gamble rather than an investment I’d have to say that there was a meaningful chance of a negative return over the expected holding period.  To have a negative return the share price would have to drop by more than 25% (i.e. the capital loss would negate the dividend income).

If the share price fell 25% to 220p then the dividend today (at 12.7p) would be 5.7%.  That’s high, but far from impossible.  In 5 years however the dividend could easily be nearer 15.5p (growing at an unspectacular 5% a year) and in that case a 220p share price would give a dividend yield of 7%; again, that’s not impossible but it is unlikely.

With almost no chance of a total loss, only a small chance of any loss at all and a good chance of ‘adequate’ returns (perhaps 10% a year), Balfour Beatty looks to me like a sound 5 year investment as part of a diversified portfolio of similar stocks (in fact I do already own it).

When you’re stock picking it’s critically important to differentiate between investing and gambling.  Knowing one from the other can mean the difference between achieving long-term investment goals and missing them by a country mile.

Further reading

• An understanding of uncertainty of at the cornerstone of every sound investment strategy
• To buy or sell Tesco?
• The long-term drivers of equity returns

Those are interesting numbers, but far from exceptional; so what is it that drew this outfit to my attention?

Lots of intangible assets

Yes, I said intangibles.  I’m guessing that traditional asset based deep value net-net style investors (who typically assign a value of zero to intangibles) have now left the room so please allow me to explain myself.

Centaur has £126m of intangible assets on the balance sheet.  This gives the company a book value of £124m (because tangible book value is negative).  This in turn means that they have a lot of ‘assets’ relative to their earnings so they are more likely to turn up on low book value based screens like the one I use for small caps.

Traditional deep value investors wouldn’t touch a negative tangible book company with a barge pole.  One of the margins of safety they often use is that if the company fails and is sold off, the sale of physical assets (factories, equipment and inventory for example) may still be enough to give the investor a profitable return.

For me there are a couple of problems with that approach.

The first is that if you look at low debt companies then very few of them go bust, perhaps less than you’ll see in the rest of the market.  This means that the liquidation value is often irrelevant.  In my case I only pick net-cash businesses which typically (like Centaur) have little or no debts.

The second problem with a focus on tangible assets is that by ignoring intangibles you exclude a wide variety of companies that don’t have many physical assets, such as media companies.

Because it is hard enough to find low debt and low price to book companies in sufficient number to create a widely diversified portfolio, it may be reasonable to value intangibles at face value and include media, pharmaceutical and other such companies when they appear on the list.

Investing by numbers

Following my pre-defined system, I’ve assigned 1/60^th of my small-cap value fund to Centaur.  You can see the current holdings below and their performance so far:

Further reading

• 21st century net-nets
• 3 signs that AGA may be a bargain
• How a takeover can create value

One small complication in this process is the fact that the intrinsic value of every company changes over time.  It’s hard enough coming to a sensible estimate of value and it may be even harder to estimate value once you actually own a company’s shares because behavioural economists tell us that we are more likely to value things more highly once we own them.

Many investors feel the need to re-think their investment’s value almost constantly by following every piece of news and factoring it all  into their latest estimate.  However, if a company needs that sort of close attention, or has an intrinsic value which is so sensitive to the day-to-day events that happen to all companies, then perhaps it wouldn’t make such a good investment after all.

Alternatively, a large, mature and stable company is more likely to have an intrinsic value which is better insulated against the ups and downs that all companies face.

The intrinsic value of a good business typically takes time to change, which is why the annual report may be the best time to do a re-valuation.

Looking at BAE (a company which I’ve owned since early 2011) as an example, I can compare the key numbers which make up my valuation in order to see how they’ve changed in the last year.

• For 2010 the average earnings for the previous 10 years was 26.6p.  For 2011 it was 28.4p, an increase of 6.7%.
• For 2010 the 10 year earnings growth rate was just under 8%.  For 2011 it’s just over 8% after a negligible change.
• For 2010 the dividend was 17.5p.  For 2011 it’s 18.8p, an increase of 7.4%.

Using these simple long-term fundamentals I think it’s reasonable to increase my estimate of BAE’s intrinsic value by something around 7%.  Alternatively I can combine value with price and look at the long-term earnings yield and the dividend yield to see if BAE is good value for money at the moment.

Of course there are thousands of other factors that can be considered and after I’ve read through the annual report I might think about some of them in more detail.  However, the truth of it is that even if I learned more about BAE than the company’s CFO, it’s unlikely that that knowledge would give me much more of an investing edge than just a handful of key long-term metrics.

Company/Business risk

This is the risk that the company either doesn’t pan out the way you thought, or it goes bust or gets taken over or does something stupid that permanently damages the intrinsic value of the business.

You have some control over this and basically this is what all the analysis effort goes into.  How will it do, what will the profits be more or less, will it keep trading through your holding period, will that catalyst appear; those sorts of issues.  For bottom-up value investors this is what it’s all about.

Market risk

This is Mr Market’s speciality.  It’s basically the risk of making a loss due to a change (downward) in the share price or of the portfolio as a whole.  To most value investors this is utterly irrelevant, or at least it should be.  Mr Market is there to serve you and not to guide you and the basic premise of value investing is that Mr Market makes a lot of mistakes and that basically he’s either a bit stupid or mad or both.  He’s definitely not the sort of person whose opinion you want to listen to.

Value investors come to their own independent conclusions about the likely value of a business by doing fundamental research.  If Mr Market offers them an opportunity to buy it at a significant discount from that value then they’ll take him up on his offer.

If he subsequently decides that the company is worth only half what it was before and drops the share price by 50% the value investor is supposed to be even happier because there’s an opportunity to buy this asset at an even lower price.  Of course, that’s assuming company risk hasn’t appeared and the company is actually worth less than it was before.

On its own though a falling share price means nothing and the market is efficient enough so that you really do have absolutely no way of knowing which way the share price is going in the next few days, weeks or months.

The real risk of market risk is that it can cause you to buy and sell at the wrong time which is known as…

Behavioural risk

This is where you come in.  Probably the biggest risk of them all and certainly the most important is the risk that you’ll do something stupid, or at least bad for your future wealth.  On the assumption that you’re a human then you’re likely to have a slew of behavioural quirks that might be good in social situations and for wrestling tigers, but they’re a big hindrance when it comes to investing.

One risk is that you’ll stop saving so much during bull markets.

Another risk is that you’ll buy whatever has had the biggest price appreciation (note that I didn’t say value appreciation) in the last year (shame on you if you’re a value investor).

Or on the flip side you might sell when the market drops out of fear, thereby changing the irrelevant market risk into realised and highly relevant behavioural risk.

Or perhaps you’ll have a good run for a year or two and start getting big headed and lazy with your analysis, load up with crummy stocks and take a huge fall from grace.  Trust me, it happens.

The best way to control these risks is to do good, methodical analyses, ignore Mr Market when you need to and have a well thought out battle plan for every step of your investment process so that you’re not making decisions on the hoof.

Further reading

1. 5 ways to measure debt
2. Why a falling share price is often a good thing
3. Scottish and Southern Energy – A wolf in sheep’s clothing?

One of the most useful definitions of risk is that it’s the probability of something bad happening, and if you want to get fancy you can include the severity of the bad thing as well.

Uncertainty and risk are often interrelated

You’ll find a lot of risk and uncertainty in the stock market, although it’s not always obvious which is which or how much of either you’re currently facing.

One of the risks that you may not have thought about is the effect that stock market investing can have on your saving rate.

An uncertain pot of gold at the end of the rainbow

Most people are investing so that they can buy something big in the future.  This might be a pension annuity or university fees or a McLaren MP4-12C, or perhaps even something frivolous but expensive.  If there are 10, 20 or 30 years between now and the purchase date, it’s likely that some money is going to go into the stock market; perhaps all of it, especially given that you’re reading a blog about value investing.

The problem is, even though every pound you put into the stock market is very likely to grow above inflation over 10 – 30 years, you have absolutely no idea exactly how much it will be worth.  If the next pound you invest today grows at a nominal rate of 5% then you’ll have about £4.30 in 30 years’ time.  Change that rate of growth to 10% and you’ll have almost £17.50, more than four times as much.

If the end results are so uncertain, how on Earth do you decide how much to save each month?

Bull markets give the illusion that you only need to save a bit and the market will do the rest

Another problem is bull markets.  During the incredible speculative run up to the year 2000, many investors sat and watched their pension pots explode upward in value.  There are a few different problems with this, but in the context of savings rates the main one is that some investors reduce their savings rate precisely because the stock market is doing all the work.

They’ll look at the stock market and the value of their portfolio and think about how they’ll be able to retire early and afford two cruises a year instead of one, so why bother to save when the market’s going up 20% a year anyway?  In 10 years’ time they’ll be millionaires.

As many found out, only the lucky few can really take advantage of bull markets.  Most people saw their portfolios crushed by the subsequent bear market and the grinding sideways market we’ve had since then.  Illusions of a happy retirement are shattered and years of missed savings opportunities have gone.

Fixed income: High certainty, lower returns but happier investors

A simple alternative is to set up your savings plan on the basis that you want as little uncertainty as possible.  That usually means some sort of cash or bond with a fixed interest rate, or something that tracks the inflation rate.

If you forget about what you may or may not get on the market and instead think in terms of a fixed and low real return on your investments then you can start to see how much, in a worst case scenario, you should be saving to hit any specific goal.

One approach is to assume your real returns will be something like 2% (less than half the market’s actual long term return), from which you can work backwards from how much you want to accumulate and how long you have to do it to find out how much you need to save each month.

Stocks are not for everyone

The stock market is a very crazy place and it makes a lot of people who are normally smart, do a lot of stupid things.  It’s not just that most professional fund managers can’t even beat a simple index, and it’s not just that most retail investors don’t even get the returns of the average fund manager (because they buy last year’s hot fund at a high and sell out low when it inevitably falls); it’s worse than that.

The stock market makes people think they’re going to get rich quick, whether that be from an index tracker or some nano-cap oil company in Mongolia, and that erodes what is for most people the true driver of long-term performance – the amount they save each month.

So if you’re the sort of person who gets carried away with excitement when things are going well, or plummets into the depths of despair when things go badly, you might want to re-think the size of your equity allocation and adjust it to the point where you are indifferent to the market’s performance.

Further reading

1. Bogle on valuing the market
2. Why stock tickers are bad for your wealth
3. The long-term drivers of equity returns

Overview

Flybe is Europe’s largest regional airline.  In 2002 it had a name change from British European to Flybe and moved to a super-low cost business model which it had to do to stay alive.  Later in 2007 it took over the BA subsidiary BA Connect and finally went public in 2010.

Share price history

The share price since the IPO hasn’t been pretty.  It started off somewhere over 340p and has basically gone down all the way to 63p, which is a loss of something like 80%.

However, now that the shares are so much lower they’re starting to look interesting from a low debt and low price to book point of view.

Valuation

The shares are now less than half book value and tangible book value.  Both of those are classic signs of potential value, on the assumption that the company is at least a going concern.

The price to sales ratio is almost a joke.  With a market cap of less than £50m and a sales figure from last year of over £500m, the company is priced at less than one tenth of sales which is insanely low.

Of course if it can’t produce any significant earnings from those sales then the current price is fair, but I’m really not in the prognostication business.  When I’m investing in small-caps I just buy a ton of relatively debt-free assets as cheaply as possible and let management get on and try to generate some economic value from them.

Risk management

Talking of being relatively debt free, after the IPO handily raised over £60m, the company has £80m in the bank which is just about enough to give it a net cash balance.  Hopefully this means that banking covenants and other debt related woes won’t be high on the agenda any time soon.

The second step to reducing risk with these out-of-favour small-cap stocks is to be widely diversified, which in my case means having 60 holdings in the portfolio so it can take advantage of underpriced stocks while remaining robust in the face of poor judgement and bad luck.

Always be testing

Investment commentary is worth nothing if it isn’t testable, which is why all of the ideas I like end up in one of several model portfolios.  In this case Flybe is taking a 1.7% part in the 21st century net-net portfolio of small cap value stocks.  The buy price is 64p and you can see the current holdings below.

Further reading

1. Home Retail Group
2. AGA
3. Psion

Some things are just very complicated

There’s an upcoming book called “The Ant and the Ferrari”, the title of which neatly captures what I’m getting at.  Imagine you’re an ant, standing on the bonnet of a shiny red Ferrari.  As far as your beady little eyes can see the whole world is flat, smooth and red.  What lies outside your immediate ability to see, as well as your cognitive ability to understand, is the rest of the Ferrari.

Underneath that shiny red bonnet lie tens, if not hundreds of thousands of parts, each of which has behind it centuries of  technical evolution.  The materials, the manufacturing techniques, the highly advanced electronics and adaptive technologies in the dampers and the differential; they are all many many orders of magnitude beyond the ant’s ability to comprehend.

That’s an analogy of the relationship between humans and the universe, but it also applies to investing.

Some things are fundamentally unknowable

After a brief period where we thought the universe might be relatively simple and mechanistic, it now seems far more complex and strange.  For all we know, quantum theory and string theory might just be scraping at the first layers of an onion which has thousands of layers.  But beyond complexity, some things just cannot be know (as far as we can tell).  The Uncertainty Principle implies that:

“it is impossible to simultaneously measure the present position while also determining the future motion of a particle”

Replace the word particle with ‘company’ and you have investing in a nutshell.  There is no possible way to know how any of the factors which affect a share price will pan out in the future.  Not the economy, not the company itself or its market, and definitely not its share price.

So what to do about it?

The mainstream academic answer to all this complexity and fundamental uncertainty is to avoid looking at the things that you can know nothing useful about.  This means that they generally ignore the economy and the businesses within it.  They ignore the business cycle and social and technological developments.

Instead, they focus on what can be measured.   This means they focus on the long-term averages of risk (volatility) and returns from various asset classes where they have enough data to be statistically ‘confident’.  You then invest in something like 5 or 10 different asset classes which are uncorrelated (i.e. when one goes up the other goes down), with a slight leaning towards those assets with the best long-term returns, which is equities.

Overall this has been a pretty successful strategy with the current peak exponent being Yale University and the Yale Model.

So the take-away point of looking at the academics and what their universities are doing is:

It’s probably better to ignore what you cannot know and then diversify because you cannot know what will happen to any one company, country or asset class

Uncertainty for stock pickers

As stock pickers we can’t just run to the nearest index, invest and go to sleep because it’s the index that we’re trying to beat.  So how does a firm realisation of the sheer, incomprehensible bulk of uncertainty affect a stock picker’s strategy?

For me, it means that I build my investment process around several key pillars from which all the details follow.

Be diversified

The key defence against the unknown is diversification.  This comes in several flavours which are:

• General – Don’t put all of your eggs in one basket is the ancient advice.  For me this means upwards of 30 separate holdings in any portfolio.  This is because the fortunes of any one company are uncertain.
• Industry – Across those 30 or more companies I try to have as many different industries as possible.  This is because the fortunes of any industry are uncertain.
• Geography – I try to focus on international companies because the fortunes of any one country or geographic region are uncertain.
• Operational – I want companies that are operationally diverse.  This can mean they operate in a range of industries, or perhaps a range of areas within an industry, or they have a range of diverse products, customers, suppliers and aren’t depended on the powers of any one (or few) ‘super employees’ (i.e. Berkshire Hathaway and Warren Buffett).

Prefer Size

Given that the future is uncertain and that many unpleasant things are bound to lurk out there, I prefer large companies because they may be more capable of surviving down-turns and depressions.

Look for a proven history of profitability and growth

I want companies where they have earned profits through thick and thin for many years with no losses to tarnish the record.  An unbroken history of dividend payments for a decade or more is also high on my wish list.  It’s even better if the profits and dividends have grown consistently across business cycles too.

Avoid excessive levels of debt

This is the lesson that we are all learning now.  Debt is pro-cyclical, toxic and very bad in many ways.  It’s precisely because I don’t know what’s going to happen that I only want to invest in low debt companies.  That way when there is a recession or depression or credit crunch, the companies I own won’t hit the wall immediately, or have to raise additional equity.  Instead they can sit back and take market share from those who do.

Pay a low price relative to past earnings and current dividends

I have no idea where share prices are going this year, next year or ever.  What I do know though is that they more or less track the earnings of companies over the long-term.  Sometimes they’re 20 or 30 times the earnings and sometimes they’re 5 or 10 times the earnings, but in the long run it is earnings that drive share prices.

Since I know that share prices swing from high to low and back again, but the precise timing and extent of these swings is unknown and unknowable, it makes sense to ignore any predictions of future prices and just buy when prices are low and, of course, sell when they’re high.

If only it were that simple.  But with a robust and long-term measure of what’s high and what’s low it’s possible to do precisely that.

Uncertainty, uncertainty, uncertainty

For property investors the mantra is location, location, location.  For equity investors it should be uncertainty, uncertainty, uncertainty.  Always be thinking about how much you don’t know and how it can hurt you and how to protect against it.

Remember, for every factor that you understand about an investment there are probably ten more that you know about but don’t understand, and another ten thousand that you haven’t even thought of.

Further reading

1. Why a falling share price is often a good thing
2. Is Marks and Spencer good value?
3. Four drivers of long term equity returns

That’s why I also insist on net cash and a price to sales ratio of less than one to help rule out overly indebted companies that aren’t selling anything.

In the case of Molins, it’s an international business designing and making machinery for high-volume consumer goods like food and tobacco.  It also supplies related services as well.

It’s a small-cap with a market value of just over £20m.

The company has borrowings of about £6m and cash of about £12m.

Sales are over £80m which is almost four times the market cap.

There’s also a reasonable history of dividend payments and the yield is currently almost 5%.

But, I’m a system-addict so I can’t get ahead of myself with excitement.  Let’s fill in those simple numbers first:

The numbers, step-by-step:

Price to book = 0.43

price to tangible book = 0.6

Price to Sales = 0.25

Net cash = £6m

Are they about to go bust?

Not that I can see.  The latest news and annual report just seem to confirm that the company is bumping their way through the economic landscape, just as they have since 1912.

A toe in the water

I’m not much of a stock picker.  One of the things that differentiates me from most value investors is that I have little faith in the benefits of extremely deep analysis.

Other than in rare cases, I think it’s almost impossible to beat the market by working harder and analysing deeper than everyone else.  There are just too many smart people working long hours across the globe for me and my little 3lb brain to have any chance of success by being BETTER or SMARTER than everyone else.

However, I think it is possible to beat the market if you are DIFFERENT from everyone else (or at least from the vast majority of market participants).

In my case that primarily means buying out of favour stocks (the central theme of value investing) and holding them longer than most other investors, a process known as time-arbitrage.

For these small-cap stocks I have a fixed holding period of 5 years because that seems to be the time horizon over which the most outperformance can be had for the smallest amount of effort.

And on that note Molins has joined the 21st century net-net portfolio with a 1.7% weighting (1/60th).  You can see the existing holdings below and how some of them have already jumped up in value.

The difficult part is to fight the urge to do something, to be clever and make a quick 25% in a month.  Short-term trading is so alluring and that’s why so many stock pickers do it because the gains can look fantastic.  However, in the longer-term it almost never works out and many short-term investors find themselves on the road to day-trading hell.

Further reading

1. 21st century net-nets
2. PV Crystalox Solar
3. Home Retail Group

Suitably impressed, Mr Market responded with a four percent plus rise in the share price.

AstraZeneca on the other hand (a FTSE 100 drug maker and a stock I have reviewed before) met with a much harsher fate by merely matching expectations, which are generally pretty glum anyway.

Overall, the market expects one company to do well in the next few years and the other to have a very tough time.

Massive Valuation Differences

These differences of opinion have caused a massive difference between the valuations of the two companies.  Whether these differences are justified or not will only become clear in the years ahead, but at the moment they are striking.

Let’s start with the Smith & Nephew chart:

That’s a pretty good looking chart which will probably please long-term shareholders.  It’s up by something like 60% in 10 years, which gives a compound growth rate of about 5% and of course there would be dividend income too.

So if you jumped on board yesterday or today, what exactly are you getting for your money?

Good, solid and consistent long-term growth

Smith & Nephew is a world class company, there’s little doubt about that.  It has produced good results for many years, with long-term earnings per share growth of around 11%.  You can see the per share results in the table below:

Companies don’t produce results like that unless they have a solid competitive advantage in a growing industry.  So the underlying company is good and perhaps excellent, which is always a nice place to start.

But what about the price?  It may be a good company, but buying good companies is only half the story in our efforts to beat the market.

A high price relative to historic earnings

The price today is about 21 times the 10 year average earnings.  This isn’t horrendously high (Ben Graham suggested a maximum of 20 times) and some companies can carry off this premium price if earnings can continue to grow for long periods of time.

In fact this stock was more expensive (relative to earnings) back in 2002, and look at the share price since then.  But still, a high valuation is a risk because any drop off in growth can result in the shares falling a long way, leaving investors with a capital loss for many years.

A weak dividend yield

How much you care about dividends may depend on what kind of investor you are.  But regardless of personal opinions, dividends are a very handy source of additional reliable returns.

In this case, the company has paid a dividend very consistently and has increased it in just about every year of the last decade.  Both of these are very good signs and what I’d expect of an excellent company.

The problem though, is size.

The current yield is less than 2% which does not stand up very well to many other companies of similar quality, and it also fails to match the yield of the FTSE 100.  It provides little downside protection if growth falters.

If the yield was closer to 6%, as it is for AstraZeneca, then it’s doubtful that the share price would fall much further, assuming the dividend was maintained.  Even if the share price did fall, you’d have a yield of over 6% as compensation in the short and medium term.

No stock is an island

There is no point in analysing a stock in isolation.  Each stock has value only in relation to what else is available, whether that’s bonds, other stocks, index tracking funds or perhaps even actively managed funds.

Compared to the FTSE 100 and AstraZeneca, Smith & Nephew stacks up like this:

Taking the simpleton’s route to total return estimates by just adding long term growth to current dividend yields (which is of course naïve, simplistic and probably just as good as anything else) then we get estimated total returns of 12.4% for Smith & Nephew, 19.9% for AstraZeneca and 8.5% for the FTSE 100.

If you want to get clever with it then you can double count dividends as there is a general rule of thumb which says that cash in the hand (the dividend) is worth twice as much as the promise of future cash (earnings growth).  However that still doesn’t help Smith & Nephew as dividends are the weakest part of its investment case.

Only spend time on obvious bargains

Life is short enough as it is without wasting time analysing investments that are not obviously cheap.

In this case, although there is much more to do in a full analysis of Smith & Nephew, from the numbers above I don’t think it would be worth it.

With a ballpark total return figure only 3.9% better than the FTSE 100, and yet with all the additional risk that comes with owning a single stock rather than a basket of 100 large-caps, I don’t think the recent good results are anything to shout about for new investors.

For owners the recent good news is indeed good news as it increases their net worth and provides a possible selling opportunity.

Prospective buyers on the other hand may be better off waiting for the company to miss estimates and fall in value before considering a purchase.

Further reading

1. Large-Cap Value 101
2. Is it Time to Sell Tesco… or Buy?
3. AstraZeneca and the FTSE 100

Despite these dangers, value investors do love their small-caps and so it’s worth spending some time drawing up a repeatable and systematic plan for uncovering value.

This is the critical first step in becoming a successful investor because study after study shows that investors are generally very bad indeed at stock picking.

Most recently, Professor Greenblatt outlined how individual investors have wiped out the magic formula advantage by making poor stock picks.

So let’s start by picking Psion (makers of the iconic Psion Organiser II back in the 1980s) which is a company that I know scores highly on the 21st century net-net screen, and see how it fares.  Here’s the 5-year chart:

Look for companies with little debt and lots of cash

The reason for wanting little debt and lots of cash is that the future is uncertain.  In fact it’s so uncertain that there are no meaningful ways to work out the probability that any particular economic event will happen.

If the future is uncertain then the earnings of any company are uncertain and so it’s probably better to have the adaptability that being debt-free and cash-rich brings.

Looking for net cash is a simple way to find companies with a good balance of debt and cash.  Psion has net cash with around £27m cash in the bank and only around £2m in debt, compared to £6m operating profit last year.

The current and quick ratios are also favourites of many value investors and for Psion the current ratio is 1.6 and the quick ratio is 1.3.  Both of these are reasonably healthy figures, especially the quick ratio of more than one.

Buy companies that are cheap (this is value investing after all)

This is a ‘deep value’ strategy, based on Ben Graham’s net-net strategy, so value is measured against assets.  Psion’s price to book ratio is 0.35 which is way down in the bottom 10% of companies by price to book.

The price to tangible book ratio is 1.2 because the company has £118m of intangible assets which might scare off some hardcore ‘asset’ value investors, but for this strategy intangibles are not automatically a problem.

The company has enough current assets to pay off all its liabilities so it does have a positive net-net ratio.  However, the net-net value is about £32m while the market cap is £59m, so the net-net ratio is over 1 while Ben Graham required it to be below 0.66.

This isn’t a problem though and actually highlights why the 21st Century Net-Net strategy was created, which was to overcome the overly limiting nature of the original formula.

Buy companies that are cheap relative to their economic activity

It’s all well and good buying companies that are cheap relative to assets, and many academic studies have found it to be a successful – if difficult – strategy to follow.  In practice a pure focus on assets can lead a portfolio to hold many companies that don’t really do very much.

For example, pharmaceutical companies that are still testing their new products and don’t actually sell anything in meaningful amounts, or property companies that have a lot of assets (houses) which don’t generate a great deal of money.

A quick and easy way to check for a reasonable amount of economic activity is the price to sales ratio.  For Psion, price to sales is about 0.33, so last year’s sales were about three times the market cap of the company at £180m.

A final sanity check

Despite the wall of evidence which shows that investors are terrible stock pickers, most people aren’t happy to invest purely on the numbers, no matter how compelling they may be.  So it makes sense to have a final sanity check once all the number boxes have been ticked.

The idea is just to see if the company is facing some immediate threat to its survival or that its key economic engine is about to become obsolete or illegal.

In Psion’s case, after reading through the latest reports and searching recent news articles about the company, I cannot find any obvious evidence that it is about to go broke or be taken over at a price significantly below the current price.

Nor can I find any evidence that the company’s products (robust mobile computing devices) are about to become obsolete or un-sellable for any reason.

Diversity – The final defence against the unknown

The future is uncertain and the capitalist system is brutal for the companies within it (unlike banks for example which don’t really exist in the normal capitalist system).

Since the future is so harsh and non-deterministic it makes sense to be honest with yourself and admit that even with the best will in the world you will likely be wrong about most of the things you think will happen.

In that case it’s probably best to keep your eggs in many baskets and hold as many companies as your funds will allow, without harming returns with excessive trading costs.

For the 21st century net-net model portfolio the number of holdings is 60, so only 1.7% of the fund is allocated to each stock.

I’ve added Psion at 45p today so now the model portfolio looks like this:

Cash is still about 92% of the total and filling the portfolio with stocks will take the rest of the year, but this is a long-term project which I hope will generate a lot of practical insights into many aspects of investing.

P.S. One final point to mention is that Psion pays a dividend which, as far as I can see, is sustainable for the moment.  The current yield is just under 10%.

Further reading:

1. Titon – A Classic Ben Graham Net-Net
2. 21st Century Net-Nets
3. The Four Drivers of Long-Term Equity Returns (for large-caps)