UK Value Investor

When it’s raining, buy sun cream

John Kingham — Thu, 17 May 2012 06:40:28 +0000

And boy is it raining in Europe. Being a contrarian investor is a no-brainer for many of the top investors in the world. It’s just the nature of the business. But being contrarian isn’t always a good idea, nor is it always necessary to be successful.

Value for money

When I go shopping (a rare event) I want value for money. Value investing and value for money share the word value for a good reason. Value investing is value for money investing.

If there are two shops selling the same shoe, I buy the cheaper one. If there are two stocks offering the same dividend and the same growth rate, I buy the cheaper one (the one with the higher yield in other words).

But you don’t have to be a contrarian to buy tomatoes on the cheap, nor do you have to be a contrarian to buy the cheaper pair of shoes. You just have to watch out for bargains and to know the difference between value and price.

Cheap and value are not the same thing

A pair of shoes may be cheaper because they are lower quality or damaged goods. The same is true in investing. Some companies are cheap simply because they are low quality and may be fragile (likely to go bust). Cheap is a starting point, but it’s really value for money that we’re after.

This is a lesson I’ve had to learn over and over through life. As a tightwad, at least most of the time, I tend to buy cheap things. Then they break and I end up buying a much higher quality item which lasts for years and ends up being far cheaper on a total cost of ownership basis. Everything that is cheap is not value for money.

Fashion and value rarely go together

And then there’s fashion. Fashion and contrarianism do work together outside of investing, and inside it too. I don’t remember the last time I bought a fashionable item of clothing, and I know that my clothing is cheaper because of it. No £100 trainers for me. Fashion in the investment world is Apple and Facebook and LinkedIn. Although I haven’t looked at these companies in detail, I’m pretty sure their valuations are high and their value for money low.

That’s because in the investment world, prices are driven by short-term demand, either for buying or selling. When something’s fashionable, everybody buys it and the price goes up which, assuming nothing in the company changes, pushes down the amount of value that each investor gets.

Going against the crowd is not always a good idea

A lot of people in the value investing crowd talk about going against the crowd and the madness of the crowd. I am one of those people and I must admit that bashing the crowd can give you a nice feeling of superiority and, in the world of investing, going against the crowd is often the best course of action. Often, but not always.

If you were in Pompeii in AD 79 and everybody started running like crazy away from Mount Vesuvius, you would be a good contrarian but a bad insurance risk if you decided to stand still, purely on the grounds that you were doing the opposite of what the crowd were doing.

In a similar way, just because everybody had ganged up on RBS back in 2008, were selling like crazy and the shares had fallen from 600p to 200p, it didn’t mean that all free thinking, independent contrarians should stampede in and hoover up the shares. At around 20p today, it should be clear that no matter how far a share has fallen, zero is always a long way down.

Economists = Weathermen

It’s all about cycles. The weather is probably my favourite analogy for the stock market. If I ask you what the weather’s going to be like, in detail, on Wednesday two weeks from now, I’m pretty sure you won’t have a clue. You might be able to say something vaguely reasonable based on the time of year, like “it’s May so it’ll probably be wet and cold”, but any trace of specifics are missing.

However, if I ask you what the weather’s going to be like in summer, or winter, you’re probably going to come up with a half decent description, because every year we get more or less the same sort of thing in each season. The weather goes in roughly predictable cycles and there are stock market cycles too.

The history of finance is to some extent a history of cycles. When it’s the end of the world and all news is bad (much like these past few years) then the markets get cheaper, just like sun cream in the rain.

Since we’re all here, the end of the world hasn’t happened yet, and history shows that it hasn’t happened in the past either. All previous crises have ended, following the famous words, “This too shall pass”, and so far it always has.

One day the sun will start shining and it will be time to sell the sun cream at a profit and to start buying umbrellas because, with cycles being cycles, another storm is never too far off.

Certainty is not complacency

Although I’m virtually certain that this recession/depression/Euro crisis will end at some point, that does not mean I’m complacent about it. In fact I’d say the opposite.

Knowing (or as near as you can know anything) that there will be crises in the future is exactly why it’s a good idea for active investors to own a diverse group of financially strong, global companies that are at the front of their industries, and at the same time to stay away from over-indebted, weak and small companies that have no competitive strengths.

Knowing that there will be good times at some point in the future also means that it’s easier not to panic, not to sell into cash at the worst possible moment, and instead to stick to a sensible investment plan through thick and thin.

Related posts

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Rolls Royce–Are the shares as attractive as the company?

John Kingham — Fri, 11 May 2012 11:42:47 +0000

It’s hard to argue with Rolls Royce if you want a company which can produce steady income growth over the long-term with limited risks, but how does it stack up as a value investment at almost 830p a share?

With sales and profits measured in billions, as well as staff measured in tens of thousands across the globe, there are few companies that are safer. In fact the company’s past results are so impressive that I’d be more than happy to join existing shareholders as a part owner of this iconic company… but only at the right price.

Between 2002 and 2012 sales have gone from about 360p to almost 600p; adjusted earnings have gone from 11p to almost 48p and the dividend has moved up from 8p to over 17p today. By every meaningful measure the company has more than doubled its return to shareholders and that is exactly what most investors want to see.

Even better than that, the share price has gone from around 150p in 2002 (or if you timed it right, an incredible 70p in March 2003) to the 830p we see today. Even if you just got in at 150p rather than 70p, you would have seen the share price increase by over 450p. If those returns are not spectacular for a blue-chip stock then I don’t know what is.

Break the returns down into their component parts

Returns flow to shareholders from various sources, so let’s have a look at where they came from for our Rolls Royce investor between 2002 and now.

Dividends – The easiest thing to work out is the dividend. Between 2002 and 2012 (inclusive) the total pay-out has been just over 118p.

Earnings growth – With earnings at 11p then and 48p now, earnings have grown by 336%. Assuming the PE ratio had remained the same (at 13.6) until today then the shareholder would have gained about 504p from the growth of the company.

PE ratio changes – As Mr Market’s mood changes, the valuation given to any one company change change by a surprising amount. You only have to look at a chart of Rolls Royce – a huge global company with a relatively steady business – to see that its market value halved in about a year in the initial stages of the credit crunch. For those investors that hung on, they were rewarded as the stock has tripled since the low point. As of today the PE ratio is about 17.3, which is an increase of some 27% since 2002. This has added another 177p to our shareholder’s return.

Implications for the future

So how might our investor fair over the next 10 years? Of course neither I nor anybody else knows what the future will bring, but let’s have a go at working it out anyway. Remember, we’re starting this journey at 830p a share.

Dividends – Assuming a 10% growth rate, which is approximately what the company managed in the previous decade, the dividend will go from 17.5p today all the way up to 41p in 2020, with the total pay-out being 279p.

Earnings growth – With a 10% growth rate, adjusted earnings would go from 48p to 113p in 2020, which would give a share price of 1,958p if the PE ratio stayed at 17.3. That’s a gain of 1,128p from today’s price.

PE ratio changes – This is the big unknown. It is quite literally impossible to know what a company’s PE will be one day to the next, let alone 10 years down the line. However, we can look at some scenarios:

If the PE were to drop back to the 13.6 that the 2002 investor saw, then the share price would be 1,539p in 2020, which is 418p less than if they PE stayed where it is now.
If the PE dropped to 9 as it did in 2009, then the share price would be 1,019p in 2020, some 939p less than if the PE stayed where it is now, and
if the PE dropped to 6.5 as it did in 2003 when the share were available for 70p (!) then the share price would be 736p in 2020, which is less than it is today and some 1,222p less than if the PE stayed where it is today at 17.3.

So what does it all mean?

I hope by this brief review that I’ve highlighted some of the most important thinking behind a long-term investment. In the above example I’ve assumed a 10% growth rate for Rolls Royce over the next decade, which many people would probably say is optimistic.

This leads to a reasonable dividend income of 279p, which would be a 34% return on the original investment.

The return from earnings growth would be 1,128p which is a 136% return in 10 years, which is a reasonably good result, but it will only be seen IF the PE ratio stays above the 17 it’s at today.

The big question, and the big risk, is the current valuation multiple. With the PE at 17 there is a long way down to some of the recent low valuations, where investors have seen the PE as low as 9 and even lower at 6.5 in the last two bear markets.

If the shares fell back to a PE of 6.5 because of a future bear market or a run of bad results for the company, then even if Rolls Royce doubled in size again in the next decade like it has in the past, investors could see almost no return from 10 years of ownership.

On that basis, even though I really like the company, Rolls Royce is only rated as a 2-star investment.

Related Posts:

3 Tips for your investment strategy

John Kingham — Fri, 04 May 2012 06:43:02 +0000

I came across a new book the other day called Repeatability, by Chris Zook and James Allen of Bain & Company. Although the book is about building enduring businesses that can cope with constant change, what struck me was how applicable some of the ideas on building a great business were to investing.

Three ideas are particularly relevant as key pillars of a sound investment strategy:

Be different

It’s important for a business to differentiate itself from the competition, but this idea also applies to many of the most successful investors. It’s hard to beat the market if you’re doing exactly the same as everyone else.

With value investing, being different is a core part of the philosophy. Simply by buying those stocks that are relatively cheap, you are almost guaranteeing that what you’re doing is different from everybody else. Of course there are lots of value investors out there, but compared to the total population of investors, we’re a tiny minority.

Keep it simple

If knowing the ins and outs of a business, its industry and the wider economy were the most important aspects of investing, then CEOs and managers would be the best investors in the world; but they’re not.

One reason for this is that no matter how much you know about a company, its competitors, industry and the economy, there will always be far more that you don’t know – most of which you don’t know that you don’t know.

This is sometimes called the illusion of knowledge, the idea that if we know more about something then we can make better decisions. Sadly, this isn’t always true. In many situations there are perhaps only 10 or 20 pieces of information which dominate the subsequent outcomes, and the other few hundred pieces of information that you thought might be important turn out to have little or no impact.

Even on the occasions when some obscure bit of data does matter, the timing and magnitude of the effects are usually unpredictable which renders the additional information useless anyway.

The trick here is to know which pieces of information have the most impact most of the time, both in terms of the company’s prospects and more importantly, on the investor’s total returns.

Make it repeatable

It’s not enough to be a contrarian (implicitly or explicitly) with a simple core process which focuses on the most important drivers of equity returns. If the process is applied in an ad hoc manner by an investor who makes it up as they go along (perhaps using different financial ratios depending on how they feel that week) then there may be trouble ahead.

Companies which succeed are often those which have systems which they’ve really nailed down over the years and which can be applied to new stores or factories, or new markets and countries quickly and accurately with maximum impact.

The same applies to investing strategies.

Those strategies which are successful are often the ones that have been written down and refined over time, perhaps into an investment checklist with all the critical go/no go decisions in place so that nothing is missed and every lesson learned is built back into the system.

So whether you’re building your own investment strategy or judging the approach of someone else, remember to think about how its differentiated, whether it’s relatively simple and whether it can be repeated accurately, over and over, year after year.

Further reading

British American Tobacco–More than just an income investment?

John Kingham — Fri, 27 Apr 2012 11:26:29 +0000

If you’re not worried about the ethical implications of investing in tobacco companies, then being a shareholder of British American Tobacco over the last decade would have been a very profitable experience.

The shares have risen from around 700p in 2002 to more than 3,000p today. Along the way it’s paid out another 700p in dividends which gives a total gain of approximately 3,000p on an initial 700p investment. That’s more than 400% in 10 years compared to the FTSE 100’s total gain of nearer 50%.

But just because a stock has had a great past, it doesn’t automatically follow that it has a great future. The company could run into problems, or we could just be overpaying at today’s prices, so let’s dig in and see how British American Tobacco shapes up for the next 10 years.

Start with safety in mind

As a defensive value investor I like to start off by looking at how robust the company is, in order to get an idea of how well it can cope with the harsh capitalist environment in which most companies exist.

Diversity – Whether it be products, suppliers, customers or locations, diverse operations can help a company to survive problems in any one area. The most obvious sign of diversity for British American Tobacco is that it is incredibly international, selling tobacco products to over 180 countries with revenues spread fairly evenly between all the continents of the world. If one region becomes less friendly towards tobacco, the company has other regions to sell in to.

Consistency – Estimating the intrinsic value of a company is not an easy thing to do, but it’s child’s play compared to predicting the future. However, both of these tasks can be made somewhat easier if the company you’re looking at has a consistent history. By consistent I mean consistent results in terms of sales, profits and dividends, as well as a consistent operating history, i.e. they’ve done the same thing for a long period of time.

British American Tobacco ticks both these boxes. They have been in the tobacco business for more than 100 years and more recently they’ve turned out consistent results and returns to shareholders. Both earnings and dividends per share have increased in every one of the last 10 years, from 66p and 35p respectively a decade ago to 194p and 126p today.

Success – Another trait of defensive value investors is that they tend to only invest in very successful, market leading companies. Once again, British American Tobacco ticks this box as it’s the second largest (by market share) listed tobacco group, with a market cap of more than £62 billion. Of course the consistent profitability I’ve already mentioned is another sign of a successful company.

A survivable present and future – It’s no good buying a company with a great track record if it’s about to go bust, or if it’s main product or service is likely to become obsolete within a few years (as happened recently to Game Group). In this case, there are no obvious immediate threats to the company’s existence, but there is at least some level of uncertainty about the future.

Although it’s unlikely that mankind is going to kick the cigarette habit any time soon, it is, at least in the west, obvious that cigarettes are becoming marginalised and pushed out from mainstream society. Just think back to the days when guests (or even hosts) on talk shows could sit there puffing on a cigarette live on TV. So there is an issue, but I don’t think it’s likely to materially impact the big tobacco firms in the near future.

Prudent finances – Debt can kill even the healthiest company if it’s used to excess, so prudent levels of borrowing is another indicator of a good defensive stock. Once again British American Tobacco sails through with interest payments covered more than 10 times over by earnings, and although total debts of £10 billion sounds like a lot, it’s less than three times the adjusted earnings which are over £3 billion. Both of those are relatively conservative debt ratios.

And so it looks like British American Tobacco may be the sort of company that a cautious or defensive value investor could invest in, at the right price.

Look for returns from all sources

Returns in the long run typically come from three places: dividends, earnings growth and increases in the price to earnings ratio. It is the combination of returns from these three sources which produces the total return that the investor sees over time.

Look for a low price relative to long-term earnings

I’ll start with the PE ratio, which is one of the main drivers of returns from the stock market. Earnings can bounce around all over the place from year to year, rendering the usual PE ratio almost meaningless, so I prefer to use the average earnings of the last 10 years rather than simply the earnings of the last 12 months. This is especially appropriate for the sort of large, stable companies that defensive value investors are mostly interested in.

For British American Tobacco the price is currently around 3,160p and the adjusted earnings have averaged about 116p in the last 10 years, so the price is over 27 times the long-term average earnings, while I prefer companies to be below 20 times.

Ben Graham suggested various limits at different times, but one that may be useful was the suggestion to be wary of paying more than 25 times the 7 year earnings average. Using 7 year average earnings the company is currently priced at over 23 times that amount, so by both Graham’s measure and mine the company looks to be expensive.

To give you some context, the FTSE 100 is currently priced around 14 times its 10 year average earnings and the median of FTSE 350 companies is about 17.

So relative to past earnings the shares do not look immediately attractive, unless of course there is a reason to believe that the company has an outstanding future, far better than that for the average company in the FTSE 100.

Look for long-term growth

Typically I would expect a stock which is expensive relative to past earnings to either be a ‘hot favourite’ of the market or a stock with a high past growth rate which is expected to continue into the future.

In this case it looks like British American Tobacco has indeed managed to produce an above market growth rate over a long period of time. In 2002 the adjusted earnings were 66p while the dividend was 35p. In 2011 they were 194p and 126p respectively. That’s a pretty healthy growth rate of around 10% a year and one that has also been remarkably consistent, with earnings and dividends per share growing in every single one of those years.

Most companies would love to have a track record like that and it shows the real power of tobacco economics.

That 10% growth rate compares well to the FTSE 100 as a whole, which has generated earnings growth nearer 5% over the same period.

Look for a high and sustainable dividend yield

The dividend for this stock has a very solid history and tobacco stocks are well known and liked by many investors who are primarily looking for income. The stock has yielded around 4% historically and that’s about where it is today. Also important for income investors is the consistent above inflation growth rates that the dividend has seen over the years.

The dividend is not well covered relative to most other companies, with earnings only 1.5 times the dividend. However, that’s not such a problem as it may at first appear as tobacco companies don’t generally have to retain much of their earnings to generate new growth. It’s not like a pharmaceutical company that has to pump millions into R&D to develop new products.

Two out of three isn’t bad at all

Of the three sources of total stock market returns, British American Tobacco has the market beat in two of them. Both its growth rate and its dividend yield are higher than the market can manage, and that may potentially point to better returns going forward.

The only downside from the valuation point of view is the high price relative to past earnings, but to some extent that’s to be expected of a company which can generate very high rates of return on retained earnings and that is also quite likely to continue to perform well relative to the market.

Defensive Value Rating

Subscribers to the Defensive Value Report will know that each month it produces a ranking for about 200 FTSE 350 stocks which is used as an indicator of a potentially interesting defensive value stock. This rank is a combination of the stocks relative performance for dividends, earnings growth and PE valuation (10 year of course).

The rank for British American Tobacco in the April issue was 589, while the FTSE 100 at 5,800 points had a rank of 590, so there is but the thinnest of cigarette papers between them.

In reality it may be that BATS is overly hurt by its high price relative to past earnings, which may be justified to some extent by the high growth rate and the low level of earnings required to sustain that growth as well as the dividend.

To make the defensive value rating system a little clearer I will be changing it to a 5-star rating system which most people are familiar with from sites like Amazon (although the underlying ranking process remains the same).

Currently the FTSE 100 just about makes it into the 4-star category, which suggests that it may be an attractive investment at current levels (which is something I agree with). BATS currently also has a 4-star rating as you can see below.

If you’d like to know which stocks get the top 5-star rating, just visit the UK Value Investor homepage and sign up to the free email newsletter for one 5-star stock idea each week, or click here to try the Defensive Value Report for free and see all the 5-star stocks every month.

Related posts

How to set and use investment goals

John Kingham — Mon, 23 Apr 2012 13:18:20 +0000

Like most complex and long-term projects, it’s important to have investment goals so that you have a destination in mind at all times.

Setting investment goals

People invest for a wide variety of reasons, but it generally breaks down into either:

a future lump sum or
a future income stream.

Then you can get into more detail with the SMART system. Let’s say mine looks like this:

Specific – I’m investing to build a dividend income to retire on

Measurable – I want a real retirement income of £50,000 within 20 years.

Achievable – A £50k income at 5% drawdown will require a lump sum of £1 million. I would then have to work out how much I must save given various starting funds and growth rates. One detail here is that I wouldn’t personally assume a growth rate faster than the historic average of the stock market; to do so would be overly optimistic in my opinion.

Realistic – Assuming that I found the goal to be achievable, I can then check to see if it’s realistic. Is the savings rate realistic? Will I really want to save that much for that long? Can the stock market really return the results that I used in the calculation? Do I have the stomach for the levels of equity investment required to reach the goal?

Time-bound – The goal should have a time limit, which in this case is the 20 years mentioned above.

Using investment goals

Once you’ve nailed down an investment goal or goals, whether it be for a lump sum or an income, you should try to make sure that you actually use the goal.

Sometimes my investment goals are my PC’s wallpaper and sometimes I have then printed out and stuck to the wall above my desk. Either way, I make sure that the long-term goals of my investing activities are front and centre in my mind when I’m thinking about investments.

Think long-term

An important secondary use for an investment goal is that it can help keep you focused on the long-term. If my goal was to have £1 million in real terms in 20 years then that time horizon can help me to cope with the ups and down of the market today.

If I’m invested in a diverse group of high quality market leading companies (either via the FTSE 100 or in a portfolio of stocks that I’ve hand picked myself) then what’s happening today should, in 99% of cases, not be important.

It might be interesting or worrying, but that doesn’t mean it’s important.

Let’s say the FTSE 100 is going to be at some level in 20 years time (which it will be). Let’s assume it’s going to be at 15,000 in the year 2032.

If the FTSE 100 was at 6,000 yesterday and fell to 3,000 today, what would that mean?

It would mean that almost everybody would be panicking like crazy because the market had tanked by 50% in one day.

But to somebody who had their eye fixed firmly 20 years into the future? It would mean that the market is now 50% cheaper than it was the day before, so the market will gain 400% between today and 2032 (a 12,000 point gain from starting at 3,000), rather than the 150% it was going to gain from yesterday to 2032 (a 9,000 point gain from a starting point of 6,000).

In other words, the long-term investor looking to the future would see that the market was far more attractive today than yesterday and might well start selling the family silver to invest in stocks, although it’s likely that friends and family would be screaming for them to sell the stocks instead!

The sign post, the weather vane and the siren calls of the market

Investing is very hard on the mind; that’s why most people are really bad at it once they move from being passive investors to active investors. The more attention they pay, the worse their results get because they tend to only have a short-term outlook and get bounced around by market noise.

As an investor it is far better to be a sign post than a weather vane. Sign post investors have a long-term goal and a consistent long-term plan to get there, and they stick to it no matter what. Weather vane investors don’t have a consistent plan, and instead get blown around and end up getting nowhere.

SMART long-term goals are a useful tool that investors can use to help them become sign post investors – pointed in the right direction, no matter what the market does, or what the media says.

They are the mast that sensible investors can tie themselves to when the market sirens start calling.

Further reading

Investors outperform when they ignore siren calls (efinancialnews.com)
How to become an even better investor
Using an investment checklist to value Shell

GlaxoSmithKline

John Kingham — Wed, 18 Apr 2012 07:01:00 +0000

Glaxo is a popular stock. It’s often among the most traded stocks in any given day and it’s a favourite of Neil Woodford, the current Master of the Fund Management Universe. Not only is it one of Woodford’s top holdings, but according to the Citywire web site, it’s a top five holding for four out of their five ‘top fund managers’.

This level of popularity is interesting; not because I like popular stocks but quite the opposite – as a value investor I’m more used to backing companies which are having a hard time of it in the press, or at least in the minds of other investors. With Glaxo I find instead a company that is both popular and which also seems to be attractively valued.

Dividends are king… for now

The stock’s popularity probably has more to do with the current investment environment than anything else. Dividends are king at the moment precisely because this sideways market means there is little capital gains to cheer about.

And yet despite this current popularity for dividend stocks there just isn’t enough interest in equities in general to push the market up, so quality companies remain both popular and cheap.

What’s to like?

Quite a lot I think. In terms of safety, the company is a huge international firm operating in the defensive industry of healthcare. It is one of the world’s largest pharmaceutical companies and has been consistently profitable for a very long time.

Revenues, earnings and dividends tend to increase in most years and in the last decade the earnings per share growth rate has been above inflation, as has the dividend which is currently yielding around 5%.

The shares are priced at just under 15 times the average earnings of the last decade. While this isn’t exactly super-cheap, it’s a fair price and when combined with inflation beating growth and a 5% yield, it’s obvious why many fund managers and private investors love this stock.

Is it a screaming buy?

I would be quite happy to hold Glaxo in my portfolio. However, that’s not quite the same as saying I would rush out and buy it. Of the 200 or so FTSE 350 stocks which I filter and rank each month, GlaxoSmithKline is in 49th place. In comparison, the FTSE 100 (which is ranked as if it were a single super-conglomerate) comes in at position 72. You can see the comparison below:

So it passes the first test, which is that it may be better value than the market index. In my book any equity investment must be compared to the market index because if it doesn’t appear to offer better value than the index why would an investor want to take the additional risk inherent in an individual company?

But it only beats the index by a small margin, mostly thanks to the healthy yield.

In summary then I’d say it’s a great company at an attractive price, but that attraction may be stronger for pure income investors rather than those seeking maximum total returns from a combination of income and growth.

Further reading

3 Ways to find a margin of safety

John Kingham — Thu, 12 Apr 2012 13:05:56 +0000

Ben Graham may not have invented the term ‘margin of safety’, but he did popularise it for investors by making it a core part of his investment philosophy; but what exactly does a margin of safety mean when it’s applied to investing, and how can you go about finding it?

A typical example: The bridge

If you’re going to build a bridge for road traffic then you’d probably want to know what the heaviest vehicle is that’s going to cross it. After that you might want to know how many of these could conceivably cross the bridge all at the same time. So you might say a 50 tonne truck is the biggest and the bridge could have 10 all at the same time, so the maximum load could potentially be 500 tonnes.

Building the bridge to only take 500 tonnes max would then be a terrible idea. What if somebody built a truck that weighed 60 tonnes? What if you had ten 50 tonne trucks on a very windy day, or when there was an earth tremor? What if you’re calculations are wrong and the bridge is slightly weaker than you expected?

The basic principle of a margin for safety is that it in some way protects you from both the unknown and your own errors of judgement and calculation. So how can we apply this thinking to investments?

Diversification – Protection when it all goes wrong

Diversification is primarily the margin of safety for when an investment goes wrong. If you buy a stock that looks attractive but it turns out to be a lemon and, in the worst case, goes bust, how much of a problem is that?

The answer depends on how big a position you took. If you put 30% of your net worth into the company then you’re going to be very unhappy indeed, to put it mildly. 30% down the drain is very bad news because you’ll need the rest of the portfolio to gain 50% just to get back to zero.

However, if you only had 3% to 5% invested in that company then while you might be miffed, it probably wouldn’t be bad enough to make you throw in the towel.

In fact that’s a handy measure of maximum position sizing right there. Just think about your biggest holding going bust. If that would make you want to sell everything and go back to index tracking or even cash, then the position may be too big.

Low debt – protection from the economy and bad management

Nobody needs to be reminded of this these days, but economies can go down the tube. When things turn rough it’s the companies with tons of debt which are in trouble first, and it’s the same companies that tend to go bust or take forever to bounce back.

How much debt a company can handle depends on how stable the company’s cash flows are and how cyclical the industry is, but if you stick to low debt companies then much of that detail can be glossed over. Investors and accountants have developed various ways to measure company debt, the basics of which are relatively simple.

Competitive advantage – protection from capitalism

Capitalism is a tough game. Very few companies survive for prolonged periods of time while the vast majority are born, thrive (or not) and then fall by the wayside as competitors fight them for every penny.

Without a competitive advantage a company’s existence may be more precarious than you think, low debt or not.

The most obvious sign of a competitive advantage is a long history of profitability and growth without the use of excessive leverage. High margins and high returns on equity and capital over the long-term are other popular signs.

Low valuation multiple – protection from Mr Market

The third leg of the margin of safety concept of valuation. You can be holding a well diversified group of high quality, low debt companies that have competitive advantages, but if they are bought when Mr Market is happy then your margin of safety is missing what may be the most important piece.

If the market turns bad, if the company makes a mistake, if another asset class comes into favour, Mr Market can change his mind on a lofty valuation in a minute and crash the stock of even the most sound and successful business.

Tech stocks are the obvious victims here, so I’ll stick to my usual example of Vodafone (which I own). The company has produced very good results since the 1990s, but investors have been rewarded by a massive collapse in the share price between 2000 and 2002, and a relatively slow rate of growth since then. The answer is in the starting valuation.

Back in 2000 Mr Market was very happy, and for investors to see good returns Mr Market had to stay happy forever more and in the real world that just doesn’t happen. In 2002 the company was priced at the top end of reasonable with a PE of about 20; the earnings were around 5p and the price was around 100p. However, in 2000 the price was 400p on roughly the same earnings. That’s just crazy and it will probably take another 10 years at least to get back to 400p. That would be 20 years to get back to par (excluding dividends) and all because the price paid in 2000 was way too high.

For every stock that I look at I’m thinking about those four margins of safety:

Does the stock diversify my portfolio and is my position going to be small enough so that I can mentally accept it going bust?
Does the company have a low or easily manageable level of debt?
Is there a competitive advantage? Can I see proof of this in a long history of profit, cash flows and growth?
Am I buying in a a low price so that I have some protection from Mr Market’s wild mood swings? Does Mr Market only have to be moderately cheery for me to make a decent profit?

If a stock can tick all of those boxes then it might be worth a deeper look. If not, then it’s probably time to move on to the next one.

Haynes Publishing–On the road to nowhere?

John Kingham — Tue, 10 Apr 2012 12:19:04 +0000

Just about everybody who has ever owned a car must know what a Haynes Manual is. For many they bring back memories of a misspent youth trying to squeeze another horsepower or two from an aging Vauxhall Chevette or Mini 1000. With the advent of ever more complex cars which are tuned and serviced with little more than a laptop, is Haynes Publishing anything more than a value trap?

I think the answer to that depends on the investor’s time horizon.

The company looks as if it can survive in the short and medium-term. The dividend yield is currently around 7 or 8%, and there are no obvious signs that it’s about to be cut. This is both a handy reward for investors and an enticing lure for new investors which may help prop up the share price, and perhaps even give it a reason to go up.

The balance sheet is relatively strong, with £5m cash on hand and zero borrowings, although there is a pension deficit of some £9m or so. More importantly, relative to some other companies that have struggled with out-dated products like Game Group, Haynes doesn’t have a lot of landlord’s to pay rent to, so any falloff in cash flow is less likely to result in immediate problems.

By various other metrics the company is cheap, whether it be price to book, price to earnings, or price to sales; but cheap is not enough. A company that appears cheap today and which gradually gets cheaper until it reaches zero is not exactly a great investment. There must be some reason for the share price to go back up again.

Although I don’t think Haynes will go to zero anytime soon, it may have a very tough time just standing still in the years ahead. It has already branched out from car repair manuals to all sorts of other hardback books, and more recently it has started to work on web based content, but I still think the core business is on shaky long-term ground.

If I was looking for an investment in a buy-and-hold portfolio I would definitely pass on this company. The yield may be good today but signs of growth are sadly lacking, and with the way car technology is going, as well as print media, it has a whole heap of challenges ahead.

However, in the shorter-term of a year or three, that dividend will act as a strong lever on the share price if anything approaching good news happens for either the company or the economy.

So on the basis that I like it as a shorter-term investment, I’ve added it to my deep value model portfolio, with a weighting of just under 3% (1/36th of the portfolio to be more accurate). You can see the existing holdings below:

Related posts

Defensive Value Portfolio: 2012 Q1 update

John Kingham — Thu, 05 Apr 2012 15:32:19 +0000

It’s been a while since I last mentioned the model portfolio that I run as part of the investment newsletter I launched last year. The constituents of that portfolio match exactly those in my personal pension fund, so this is much more than simply a model that I’m ‘messing about’ with.

The idea of the fund is quite a long way from the deep value investing approach that I started out with five or so years ago. Instead of looking for obscure or despised stocks, the portfolio invests in some of the largest and most well know companies in the world.

There are several reasons for this, but mostly it’s because I know that many investors, including myself, are much more confortable investing in companies that have been profitable and paid a dividend in every one of the last 10 years, and which are often the market leaders in their industries.

I also think that it is just as possible to outperform the wider market with medium, large and mega-cap companies as it is with small companies. For one thing the improved market liquidity makes it very easy to buy and sell shares in a single transaction with a small trading spread.

The basic principles of the portfolio can be summarised as:

Invested 100% long in equities at all times (or as near as possible given dividend income etc.)
invest in FTSE 350 companies
invest for income, growth AND valuation mean reversion
hold 30 companies
don’t hold more than 2 companies in the same industry
only invest in companies that have been profitable in every one of the last 10 years
only invest in companies that have paid a dividend in every one of the last 10 years
only invest in companies that have been relatively stable in the past 10 years
only invest in companies that have grown revenues, earnings and dividends in the last 10 years
only invest where debt levels are low at best, manageable at worst
only invest in companies that are in the market leading group
only invest where either the valuation, the dividend yield or the growth rate (and preferably all three) are significantly better than the market average
sell a holding if neither the valuation, the yield or the growth rate are better than the market

The fund includes such obscure companies as BP, Vodafone, SSE (Scottish and Southern Energy), Reckitt Benckiser and AstraZeneca.

At the end of Q1 the yield for the portfolio (assuming a yield of 1% for the cash holdings which make up 10% of the fund) was 4.8%, well above the 3.6% that was quoted for the FTSE 100 at the time.

The median 10 year growth rate is 8% compared to the 5% or so from the index. The median PE10 (price relative to 10 year average earnings) is 13 while the FTSE 100 is currently at 14.

So the portfolio as it stands has a higher yield and a higher historic growth rate, both of which have effectively been bought at a lower valuation relative to past earnings.

I think the prospects of a diversified group of 30 market leading, steadily profitable, dividend paying companies bought at below average valuations should be quite reasonable.

The results so far, compared to the Edinburgh UK Tracker Trust (both including dividends) are in the table below (click to enlarge):

Further reading

How to become an even better investor

John Kingham — Fri, 30 Mar 2012 13:46:46 +0000

A long-time reader recently asked:

Once an investor has a strategy, how can he develop his potential? What should he be reading, or doing? Once you have a screen with certain criteria, then what? Its in our nature to fiddle, to feel like we are doing something, so what should an investor do to develop his potential further?

This is a great question that almost answers itself. It gets to the heart of the problem that many active investors have, and that’s the idea that they always have to be doing something.

It just seems natural that if you want to beat the market then you should be working hard because all the big professional outfits have legions of analysts working long hours to invest money for their clients. If hard work is the route to success for them, and hard work is the route to success in most things in life, then surely even more hard work is the route to success as a private investor?

I think that view is understandable, but wrong.

The lazy way to beat the professionals

As an investor, I can more or less match the market with minimal fees by investing in an index tracking fund or ETF. The effort required for that approach is little more than is required to make and drink a cup of tea. If an investor wanted to hold a portfolio of stocks and bonds and rebalance between them on an annual basis, then the effort might stretch to a cup of tea and a sandwich, once a year.

So at its most basic level, investing is not hard and it does not take great amounts of effort to do it effectively, because as most people know by now an index tracking strategy will beat most professional investment managers after fees.

Act like an owner, not an employee

Index tracking works because it makes use of the fact that you own the businesses in which you invest, rather than work for them. There is a clear distinction between owning a company and working for it. In fact, one of the main reasons for owning a business in my opinion is so that you can hire managers who do the work for you so that you can lie on a beach instead, and perhaps read monthly updates on the company’s progress.

Let’s have a closer look at that index tracking strategy. If you buy the FTSE 100 then you own a collection of 100 very large companies, or at least small pieces of them. Each company probably has many thousands of employees, from frontline workers through various layers of management right up to the board of directors. The whole structure of each business should be geared towards supplying you (the owner) with a good return on your investment. Just think of all those thousands of people, working hours every day just to make you money.

That’s my first point then. The job of the investor is not to work hard, but to find other people to do the hard work instead.

That’s not to say that investing is easy; but the hard work that an investor should do is very different to the hard work done by most people.

Work hard, but not often

There is an extreme example of this in the habits of Warren Buffett. Buffett first bought Coca Cola back in 1988 and he still holds it today. That’s 24 years and a whole lot of returns from a single investment analysis and decision to buy.

And that’s the second point. An investor’s work is done almost entirely before an investment is made, and each investment is almost by definition a reasonably long-term affair. This means that there can be periods of intense work when an investment thesis is being developed, but this is typically interspersed by much longer periods of inactivity when there is nothing to do, and it is this inactivity that gets people into trouble.

Buffett has said this himself many times, whether it be the idea that 20 good decisions in an investment lifetime is probably good going (the 20-slot punch card) or that one good idea in a year is an achievement. Investing is not a daily slog, nor should it be.

Many people struggle with the idea of earning money whilst ‘doing nothing’, but understanding and being at ease with that idea is essential to being a good long-term investor.

There’s a quote from Buffett where he says that he goes to bed thinking about all the facial hair that’s going to grow overnight that will need shaving off the next morning, and how that will lead to many more millions of Gillette razors (a Buffett holding) being sold.

Learn, believe, apply, persist, succeed

Once an investor has a strategy, has honed it and used it and moulded it to fit his or her personality, then the main thing left to do is to apply the strategy. It’s all about the diligent application of a sound strategy, not the continuous tweaking and fiddling of a strategy just to give that processing powerhouse inside our skulls something to do.

Of course we must all keep reading and keep learning, especially from our mistakes, but once an investor is past the beginner stage then the job is no longer about accumulating more knowledge, it’s about more discipline, patience, belief and occasionally, doing nothing.

Further reading