Valuing the market – A first step beyond passive investing

“Investments may be soundly made with either of two alternative intentions: (a) to carry them determinedly through the fluctuations that are reasonably to be expected in the future; or (b) to take advantage of such fluctuations by buying when confidence and prices are low and by selling when both are high” – Ben Graham

For the investor who wishes to receive reasonable returns and is willing to see some fluctuation in the value of their funds but does not wish to put out too much effort, a simple portfolio which tracks both the FTSE100 and government or corporate bond indices is perhaps a good place to start.  One question which will then arise is how much to allocate to each asset class when annually rebalancing the portfolio?

There is no definite answer but the usual suggestion is 40% to bonds or your age as a percentage in bonds.  Another way is compare the current level of the market to its past level in order to determine whether the future may be brighter than normal, or not.

Currently the FTSE100 is around the 6,000 mark which is about 14 times its inflation adjusted earnings over the last decade.  This number is sometimes known as the PE10 and the ratio of the current PE10 to its long run average has been shown to be helpful when determining whether an equity index’s price is high or low and therefore whether future returns will be higher or lower than average¹.

The current level is lower than the long run average and historically the lower the level the higher the future returns, at least in the long term.  In a passive index tracking stock/bond fund the target allocation for shares should perhaps be higher than normal to take advantage of this situation.

Using a formula to set target allocations based on the ratio between the current PE10 and its long run average is one way to remove emotion, and possibly poor judgement, from this process.  My own asset allocation formula currently gives the following allocations:

This approach to asset allocation would have held only 20% in shares at the peak of the dot com boom and 90% at the bottom of the bear market in 2009.  In a model portfolio the returns have beaten a typical 60/40 stock/bond strategy² by about ¾% a year.  An equally important improvement is the reduction of risk of loss.  The biggest loss since 1993 for the model portfolio was 17% compared to over 40% for the FTSE100 and 24% for the 60/40 split portfolio.

This approach appears to give the passive investor, with only a small output of energy, a way to generate slightly better returns with noticeably lower risk of loss than the typical 60/40 split.

Investment grade companies – For both the defensive and enterprising investor

“Each company selected should be large, prominent and conservatively financed.  Indefinite as these adjectives must be, their general sense is clear” – Ben Graham

For those investors who wish to pick individual companies, the table below lists 10 with a high dividend yield and a low price to earnings ratio (as at May 23^rd).  All of these companies have a track record of consistent revenue, earnings and dividend growth going back over the last decade.  They are, on first glance at least, solid, stable and growing and may therefore have a fair chance of growing in the future.

When a company with a high dividend yield continues to increase the dividend then there is a limit to how low the share price will go.  Over time the increasing dividend will become so attractive that new investors are likely to buy the shares and push up the price to a point where the yield is less attractive.  The dividend effectively sets a ‘floor’ under the share price.

Compare that to the situation where a company grows its earnings and dividends but because the initial price paid was too high the investor still manages to lose out.  Vodafone is a good example of this.  The company’s earnings have gone from around 5p to 15p per share in the last decade, with the dividend going from around 1p to 9p.  Unfortunately for the investor buying around the turn of the millennium, even with these gains in the underlying company the share price has gone from over 200p to around 170p now.

In this case paying 40 times earnings, or an earnings yield of 2.5%, with a dividend yield of less than 1% left a lot of room for the share price to drop, no matter how well the company did.

High yield shares are not for the faint hearted though.  As with any type of value investment there is likely to be some kind of problem – either in the short term or perhaps the longer term – which means that investors require a higher yield before they’re willing to invest in the company.  When looking at high yielders it may be best to look for strong, stable, growing companies where the risks are short term and survivable, or non-existent.

Further analysis leading to price targets

Braemar Shipping Services

Braemar is the second largest shipbroker listed on the London Stock Exchange.  They provide broking and consulting services to the global shipping industry across four divisions: Shipbroking, Logistics, Technical and Environmental Services.  According to the company these segments “offer a unique set of skills and related services for clients”.

Shipbroking accounts for around 75% of total revenues with the rest split fairly evenly between Logistics, Technical and Environment Services.  The shipbroking business benefits from a globally diverse client base, activity in all the major bulk shipping markets and good order book visibility; all of which has helped generate stable earnings in the past.

In the last 10 years adjusted earnings per share have tripled, revenue is up fivefold and the dividend has more than doubled.  The average return on equity is over 18% and the return on retained earnings has been around 20%.  These results have been consistent with growth in revenues, earnings and dividends in almost every year.  2009 saw a reduction in profits due to the global recession, but most of this has been recovered in 2010.

The company’s excellent results have been driven primarily by growth in global trade and increased demand for natural resources around the world.   Although the company has performed well over the last 10 years there does not seem to be any particular competitive advantage beyond being a market leader and a well run company.  Their chief rival Clarkson has in many ways had a better run of it over the years, so there is the chance that Braemar has had good results solely because of the industry they are in.

Looking to the future, their strategy is to build a broadly-based shipping services group around the core shipbroking business.  Growth is expected to be driven by expanding shipbroking geographically, especially into the East.

Estimating future earnings using returns on equity and retained earnings gives an estimated total return in 5 years of almost 160%.  Estimating earnings using the historic earnings growth rate gives an estimated total return of around 175%.  Typically I want to see a minimum estimated return of 100%, although this level is entirely arbitrary.

Questions remain over whether the company will be able to continue to grow as it has in the past, which is really a question about whether growth in global trade will continue at a similar pace.  The answer can only be guessed at, but as long as there is an increase in global GDP is it perhaps likely that global trade will continue to advance.  This level of uncertainty is inevitable when investing in equities.

Given the general performance of the company and a fair estimate of its future:

The past decade has been witness to many ups and downs as the ‘big three’ have fought tooth and nail against each other, and smaller competition, for contracts to supply the major supermarkets.  Generally this is a battle that RWD has won, although at a cost of some £480 million to build the nation’s most efficient dairy network.

Earnings, revenues, dividends, free cash and book value have all more than doubled in the last 10 years.  Revenues have grown in every single year, but adjusted earnings have had negative growth in 3 out of 10 years and are currently expected to fall further next year back to 2006 levels.  However, previous earnings declines have been fully recouped in each of the following years and there have been no losses whatsoever.

Average returns on equity are around 18%, while returns on retained earnings are closer to 10%, which is below the 15% I’d generally prefer, another arbitrary hurdle.  If a company is going to retain any of my earnings I like it to generate a decent return, otherwise it should be paid out to shareholders as a dividend for them to reinvest at their discretion.

Past history then is good, but not great.  The commodity nature of the business, the somewhat volatile earnings and the expected drop in next year’s earnings are of concern.  Of equal concern is the current situation.

The current situation is one of intense price competition.  Tesco and Asda use milk as an almost-but-not-quite “loss leader” where the price of milk has become a key part of their efforts to woo customers away from each other.  Milk producers like RWD have little pricing power against the supermarkets and take prices rather than give them.

This means that margins and profits are declining, but is the situation terminal?  Will it cause a permanent loss of earnings power?  I don’t think so.  Price wars do not last forever and as the current low cost supplier RWD is probably better placed than the competition.  In a year or three the war may well be over and after that, long forgotten with margins and profits back to normal levels.

Estimating future share prices based on earnings growth gives a range of 560 to 630 pence at some point in the next 5 years.  Including dividends, this gives an estimated total return from today’s price of between 110 and 130%.

Portfolio Maintenance – General maintenance on my holdings

Sold – Billington Holdings

Billington Holdings was added to this fund in November 2010 as it was cheap relative to book value.  I now prefer to value zero-growth companies like this by using long term average earnings and price to earnings ratios, a method that values Billington at about 107 pence.  In May the shares moved up to around 100 pence which left only 7% to my target price and so I sold.

As profiled above.  This company gives the fund some diversification outside the UK and into the shipping industry.  The company makes up approximately 5% of the fund as the goal is to own around 20 companies in total.

New holding – Robert Wiseman Dairies

RWD fits nicely into the portfolio as the only other food company it holds is Finsbury Food, a bakery and cake making group.  Again the company is now approximately 5% of the total fund.

Annual report – Luminar

I have already written a brief review of Luminar and my re-valuation of it after the latest annual report, so here I’ll just say that the new target price is 45 pence based on historically average profits from their clubs.  This target is some way north of the current 6.5p share price.  The estimated returns for this holding are very high because there’s a very real risk of the company going bust.  As ever, risk and return are joined at the hip.  This is one of the most speculative holdings in the fund and is the type of investment I am unlikely to try out again.

Yell Group is another turnaround situation that still has a long way to go.  Yell Group is the publisher of the well know Yellow Pages directory, the paper version of which is in terminal decline.  The company has large debts and has waited far too long before investing heavily in digital media, which is their only viable long term future.

The new CEO has said that by 2015 they expect digital revenues to make up approximately 75% of total revenue.  This will involve a reduction in print revenue and hopefully an increase in digital revenue.  Drawing out the trends of the last few years in terms of digital growth, print decline and overall profit margin decline, I have drawn up two scenarios where by 2015 digital revenues are up from the current 24% to 75%.

The first is a pessimistic scenario where print declines at 35% and digital grows at 10%.  This leads to a period of loss to about 2015-16, after which earnings weakly grow up to 3p per share by 2020.  The second has print declining at 25% and digital growing at 25%.  This leads to earnings of around 2p until 2015, after which profits recover back up towards 10p and beyond by 2020.

This is all painfully speculative, but at a typical price to earnings ratio of 10 that gives a price range in 2015 of between zero if the company goes bust and 20p if it doesn’t.  For now I will keep holding for no reason other than I don’t want to realise the paper loss yet.  This level of speculation is not something I intend to revisit.