From the vault: A review of the December 2013 issue of UK Value Investor

Each month I like to review what I was thinking and doing two years ago so that I can spot holes in my approach, with the benefit of hindsight.

There won’t always be any dazzling insights to be gleaned from the past, but often there will be so it’s a useful activity.

You can download the December 2013 issue of UK Value Investor here (as a PDF) to get the full picture.

Having reviewed that issue again I would say there are three main lessons, or at least reminders of important points:

• Mean reversion can take a long time
• Temper your enthusiasm, even if your portfolio gains 25% in a year
• Be flexible in your holding period and don’t always expect to hold “forever”

Mean reversion can take a long time

Back in December 2013 things were looking up. The FTSE 100 was up over 12% during the year and was close to its record high at 6,651. The FTSE All-Share tracker which I use as a benchmark had done even better, gaining 17% (with dividends included) year-to-date.

The FTSE 100’s CAPE (Cyclically Adjusted PE) ratio was still some way below average though, suggesting that the “fair value” of the market was higher still.

You can see the range of different market values which relate to various CAPE ratios in the table below (as at Dec ’13):

As we now know, the market essentially went sideways for the next two years, although a near-4% annual dividend has been paid out, so it’s not all bad. But capital gains have certainly been lacking.

However, this does not imply that the CAPE ratio is not a good indicator of future returns, but instead merely that CAPE mean reversion is something that typically happens over seven to ten years or longer, rather than two.

Temper your enthusiasm

In December 2013, my defensive value model portfolio showed a one-year total return of 25.1%. That is, of course, fantastic, especially for a primarily large-cap, high-yield, low-risk portfolio.

Even the FTSE All-Share tracker which I use as a benchmark had gained 19.5% over the same period.

Aah, those were the days! Back then we were still seeing massive gains as the market rebounded from low valuations which were a consequence of the financial crisis.

But such reboundings, or re-ratings, do not last forever. Once the gap between market value and intrinsic value has largely closed, those sorts of spectacular gains are unlikely to continue.

So when your portfolio does well, rejoice, but also remember that it is unlikely to last much longer (and if it does then you should start to worry that the market value of your portfolio might be far above its intrinsic value).

You can see the results of the model portfolio and its benchmark up to December 2013 in the table below.

Be flexible in your holding period

In the December 2013 issue, I decided to buy Royal Dutch Shell when the share price was 2,145p. Having reviewed the company I thought it looked like a good medium to long-term investment, as long as my time horizon didn’t stretch out much past the middle of the century.

Unfortunately, it probably doesn’t, but by that point, carbon emission regulation may be having a serious impact on Shell’s core business.

Over a shorter decade or two timespan, I thought its 5.1% dividend yield and good record of above-inflation dividend growth, along with many other business factors, made it an attractive choice.

However, having bought the shares I ended up being a Shell shareholder for only eight months. In August 2014 the share price hit 2,556p and for a variety of reasons I ended up selling Shell.

There was a nice capital gain of 16.3% which, combined with a dividend income of 2.5%, gave the investment an annualised return of 31%.

However, the company still had a 4.4% dividend yield and still looked like a good investment at that higher price (the oil price collapse was still in the future at that point and almost totally unexpected).

So why did I sell?

When I bought the shares they had a rank of 27 out of 220 stocks on my stock screen, which is actually somewhat low for a new investment.

This put the shares somewhere near the middle of my model portfolio’s existing holdings, based on the combination of a range of defensive and value-based factors (such as growth rate, growth quality, profitability, PE10 ratio and so on).

By August 2014 the company’s fundamentals hadn’t improved (revenues and profits were down, although the dividend had increased by 3%), but the share price had increased by more than 16%.

That isn’t much of a gain in the big scheme of things, but while Shell’s share price had gone up the share price of many other high-quality and relatively defensive companies had gone down.

This made the relative change in attractiveness between Shell and these other companies larger, and so Shell fell down the stock screen ranks to 60th place. That isn’t particularly low, or even expensive, but it did mean there were quite a few more attractively valued stocks on offer.

So even though most investors should go into each investment with the intention of holding for several years at least, they should also realise that circumstances can change and that sometimes it can make sense to lock in a quick capital gain in order to invest in even better companies at lower prices.

Kaizen for investors

If you don’t currently perform a review of your past opinions and decisions, perhaps you might want to slot one into your monthly investment routine.

It can be unsettling to see just how wrong you sometimes are with the benefit of hindsight, but if a culture of continuous improvement can work for Toyota (of which I currently own two!) then perhaps it can work for us small-time investors as well.

You can download the December 2013 issue of UK Value Investor here (in PDF).