5 Investment lessons for 2015 and beyond

2014 has been a bit of a damp squib for most UK investors. The FTSE 100 fell from 6,750 to around 6,600, aggregate large-cap earnings declined while dividends in total remained more or less unchanged.

About the only thing that increased dramatically was volatility, with near-vertical declines and recoveries in October and December.

While 2014 failed to provide most investors with decent returns (myself included) it did provide me with a number of lessons which, if carved into stone and applied diligently through 2015 and beyond, should turn out to be far more valuable than the few extra percentage points I might have gained in a more positive year.

I’ve written about most of these lessons in recent months, so as an end-of-year round-up, I thought it would be useful to summarise them all here. Hopefully, this might in some small way popularise the idea that an end-of-year investment strategy review is just as important as an end-of-year investment performance review.

Investment lesson 1: Focus on defensive sectors to lower risk

I call my strategy “defensive value investing” after Ben Graham’s description of someone who would look to invest in “a diversified list of leading common stocks”. It is still value investing, but at the more defensive end of that wide spectrum, focusing as much on high yields and low risk as on beating the market.

Part of my strategy for achieving that is to invest mostly in companies with long records of profitable dividend payments and progressive dividend growth.

However, sometimes a company has grown its revenues, profits and dividends over many years because of a cyclical market upswing which is unlikely to last much longer.

This is a very different situation to a company where growth has been driven by long secular trends which are likely to play out over many decades, rather than cyclical trends which reverse every few years.

While I’m not totally against investing in cyclical companies I do want to limit the number of them that find their way into my portfolio, and at some points in 2014 it looked like I might end up with a defensive portfolio built primarily from cyclical companies, which isn’t what I wanted.

So a few months ago I decided to add a new rule to my investment strategy, which is that cyclical companies should make up no more than 50% of the stocks in the portfolio by weight.

Original article: How I’m increasing my focus on defensive sectors

Investment lesson 2: Take account of profitability

As I mentioned above, I mostly focus on companies with long histories of revenue, profit and dividend growth, which generally means I’m looking at “good” companies. I also use valuation multiples such as PE10 (price to 10-year average earnings) to decide if a company’s shares are potentially good value or not.

PE ratios imply that the more earnings you can get for each pound invested the better, but the earnings of some companies are worth more than the earnings of other companies. This becomes clearer when you think about where those earnings go.

Some earnings are paid out as dividends, which have equal value no matter which company they’re paid from as they’re paid in cash.

Earnings that are not paid to shareholders as dividends are effectively reinvested within the company, possibly to buy back shares or pay down debts, but more typically to maintain the company’s current earnings power and to improve its future earnings power. This can be achieved by investing in new equipment, factories, intellectual property and so on.

Some companies can produce very high rates of return on retained earnings, perhaps 20% or more. Other companies struggle to generate returns that match the “cost of capital”, usually measured as the market rate of return, which is about 7% a year in the UK.

Profitability is important because a company with a 20% ROCE (return on capital employed) may be better value than a company with a 5% ROCE, even if the more profitable company has a higher valuation ratio. That’s because it may be able to grow faster while paying out a higher percentage of its earnings as a dividend.

For example, £100 of earnings retained by the 20% ROCE company produces £20 of additional earnings, while £100 retained by the 5% ROCE company only produces £5 of additional earnings.

It’s also important because a high ROCE value is a good indicator of some kind of defendable competitive advantage, which often makes for a more reliable and defensive company.

Original article: Taking account of return on capital employed

Investment lesson 3: Be more wary of leverage

I have always been relatively cautious about debt because one of the first companies I invested in had too much of the stuff and it went bust.

A year or two ago I devised a cunning and convoluted way of estimating future earnings upon which I based my Debt Ratio metric (total borrowings divided by estimated average earnings over the next 10 years).

However, problems in some of the companies that I own and which are held in the UKVI model portfolio, such as Balfour Beatty, Tesco and Serco, have shown that my old Debt Ratio was too optimistic about future earnings, especially when applied to cyclical companies.

As a consequence, I decided to remove the complexity and reduce the allowable level of debt by comparing borrowings to actual past earnings rather than estimated future earnings.

On top of that, I spent some time researching banks and insurance companies in order to find some rules for those companies which would allow me to invest only in the most prudently run examples of those financial institutions.

Original article: Measuring leverage in banks, insurance companies and non-financial companies

Investment lesson 4: Use absolute limits as a sanity check

For a long time, my approach to valuing companies has been entirely relative; in other words, my investment strategy didn’t have any rules such as “only invest in shares where the yield is above 4% and the PE ratio below 10”.

Instead, the strategy is built around the idea of investing in shares with the best combination of factors like the speed and consistency of growth, and the price relative to cyclically adjusted earnings and dividends.

So if a company had grown at 20% a year with 100% consistency and where ROCE was 25%, I might well have ended up paying a high valuation multiple (perhaps a PE10 ratio of 40 or more), as long as that valuation was low relative to other, equally successful companies.

The problem here is that for the most part companies cannot sustain growth at 20% a year or more, and are therefore rarely worth valuation multiples based on such high rates of growth. As such, paying a multiple of earnings which is way above the market average in order to buy fast-growing companies is a dangerous game to play.

One way to avoid overpaying for outstandingly successful companies is to draw an absolute line in the sand, beyond which you won’t go.

This is an approach I’ve always used for my Debt Ratio because I learned many years ago that allowing any amount of debt as long as the company is cheap enough (i.e. a relative approach) is a really bad idea because cheap companies with lots of debt tend to go bust.

I haven’t written an article about this change as it’s a pretty simple topic, so I’ll just summarise my new absolute limits here:

• Maximum PE10 of 30
• Maximum PD10 (price to 10-year dividend average) of 60
• Minimum 10-year Growth Rate (see my spreadsheet for how this is calculated) of 2%
• Minimum 10-year Growth Quality (again, see the spreadsheet) of 50%
• Minimum median 10-year ROCE (or ROE for financial institutions) of 7%
• Minimum 10-year unbroken record of dividend payments

Investment lesson 5: Be wary of value traps

Value traps are an occupational hazard for value investors, even relatively defensive value investors like me. They cannot always be avoided, but there are some things that can be done that will hopefully reduce the odds of them getting into our portfolios.

First and foremost is a cautious approach to debt and other forms of leverage, which I’ve already mentioned above. After that, it’s a good idea to think about the ways in which a company’s future could turn out to be considerably less rosy than you would prefer.

Perhaps the company operates in a cyclical industry where demand is about to collapse for a few years, or it depends on patents that are about to expire or high commodity prices that are about to collapse.

Thinking about these issues won’t give you a crystal ball into the future, but it might help you decide whether a company’s shares are cheap or not, whether a company has too much debt or not, or whether it should be avoided at all costs.

Original article: Value traps – 18 questions to help you avoid them

Learning lessons in order to beat the market

Learning lessons and tweaking an investment strategy are all well and good, but only if they improve the odds that the UKVI model portfolio (and my personal portfolio and any other portfolio that follows this investment strategy) achieves its stated goals, which are:

1) To have a higher yield than the FTSE All-Share

2) To produce higher total returns over a 5-year period than the FTSE All-Share

3) To be less volatile than the FTSE All-Share

Once 2014 is over I’ll do a detailed review of that portfolio to see how things are progressing on all three fronts.

Until then, have a very happy new year!