When TP ICAP joined the UK Value Investor model portfolio in 2011 it was called Tullett Prebon and was the second largest interdealer broker in the world behind ICAP PLC.
I invested in Tullett Prebon for the usual reasons: it appeared to be a good company whose share price was depressed by what I hoped were some hopefully short-term problems.
Although the company had an excellent track record of growth, in my original analysis I mentioned that its rapid growth may have been driven by the pre-2009 boom in financial markets rather than by any enduring traits of the company itself.
In the end, and after a five-year holding period, I think that somewhat pessimistic viewpoint was largely correct; Tullett Prebon was a good company, but its pre-2009 growth rate of more than 20% per year was not sustainable in the post-financial crisis world.
After 2009 the company’s fortunes began a decline which continued beyond its entry into the model portfolio in 2011 and has only recently shown signs of slowing down.
Tullett Prebon did not perform as well as I had hoped, but it wasn’t a bad investment.
However, at today’s share price, I see no compelling reason to continue to hold and so at the start of January, I sold the entire position. The overall results are below and, as I said, they are not quite as I hoped for but are nonetheless not too bad:
- Purchase price: 359p on 05/09/11
- Sale price: 469p on 06/01/2017
- Holding period: 5 Years 4 months
- Capital gain: 29.2%
- Dividend income: 27.8%
- Total return: 57%
- Annualised total return: 9.3%
Those simple statistics do not quite do the investment justice as it was a bumpy ride from the very beginning. The share price chart below should give you a better idea of how the investment actually went:
Note: The sell price in the chart is 433p as that was the price when I did the sell analysis. By the time I sold a few days later, the price had jumped up to 469p.
Buying: The financial crisis and regulatory change create a buying opportunity
In the years before Tullett Prebon joined the model portfolio it had exactly the kind of track record I look for. It had a long history of revenue, earnings and dividend growth, and that growth was relatively consistent as well.
Consistent and rapid growth usually produces a premium share price and that was the case here, with Tullett Prebon trading as high as 525p per share back in 2008.
But then the financial crisis arrived, the shares fell below 150p, and the interdealer market changed forever.
Unfortunately, I wasn’t looking for defensive value stocks back in 2009, otherwise, I might have invested in Tullett Prebon during the crisis at that 150p price point. Instead, I was investing in “net net” stocks, companies selling for less than the value of their fixed assets minus all liabilities (a crude approximation of their liquidation value, and a favourite metric of Ben Graham).
By 2011 that had changed and I was in the early days of becoming a defensive value investor, but my approach was very different to the one I use today. I didn’t look at profitability, dividend growth, capex ratios, or any number of other factors that I now take into account. In fact, my approach was much closer to the one detailed in Mary Buffett’s book, The New Buffettology.
I focused on calculating a company’s rate of return on retained earnings and then using that to project future earnings and dividend growth over the next few years. Armed with future growth rates, I could then calculate an “expected” future share price based on the company’s historically average PE ratio.
Somewhat embarrassingly, my projection in 2011 for Tullett Prebon’s 2016 share price was 1,484p; not exactly close to my eventual exit price of 469p.
That was the somewhat optimistic basis for the investment, but I wasn’t completely optimistic and did know about some of the major headwinds the company was likely to face in the years ahead.
These were primarily the financial sector’s reduced appetite for speculative trading and impending tighter regulations on the all-important OTC (over-the-counter) financial markets (in my opinion both welcome side effects of the financial crisis). So it wasn’t all sunshine and rainbows, but the outlook was rosy enough for me to invest.
The table below compares the 2011 versions of Tullett Prebon and the FTSE 100 using my current metrics (which you can calculate yourself for any suitable company using these investment spreadsheets). Even though I didn’t use these metrics at the time, the company still comes out looking attractive relative to the market.
Holding: Known headwinds prove to be stronger than I had expected
The investment in Tullett Prebon did not exactly get off to a flying start. Within a few short months, the share price had fallen by more than 25% and the Chief Operating Officer had resigned. However, more important than share price movements or musical chairs in the boardroom were the company’s unfolding results, which were consistently negative.
This initial period of weak results is entirely normal in the world of value investing; after all, companies usually only become attractively valued when they are facing obvious problems of one sort or another. Generally, a best-case scenario is that both the problems and the depressed share price are short-lived.
In this case, the initial period of weak results continued into 2012, 2013, 2014 and, to a lesser extent, 2015.
For example, the 2012 results were neatly summed up by the Chairman:
“Market conditions remained challenging throughout 2012 as the overall level of activity in the financial markets remained subdued.”
And the CEO had this to say:
“Our customers are operating in a more onerous regulatory environment and there is considerable uncertainty over the impact of new regulations covering the OTC markets. It is therefore prudent to expect that financial market activity will continue to be subdued.”
Subdued activity is not good for a broker, and this was reflected in the company’s declining revenues and earnings.
In 2013 the CEO’s statement was almost identical, as was the decline in the company’s results:
“The overall level of activity in the financial markets that we serve has been subdued for the last eighteen months reflecting persistently low volatility, the more onerous regulatory environment for our customers and the considerable uncertainty over the impact of new regulations covering the OTC derivatives markets, particularly in the United States.”
That statement was then largely repeated in 2014.
Despite the gloom, one helpful aspect in the face of falling revenues was the company’s relative lack of fixed overheads.
Instead of huge factories filled with expensive machinery, “voice” brokerages like TP ICAP generate revenues primarily through a mixture of humans, telephones and technology, with humans being one of the largest and most flexible parts of the cost structure (in 2013 broker compensation was equal to more than 50% of broker revenues and came to an average of £259,000 per broker; nice work if you can get it).
This is helpful in a downturn because costs can be reduced almost in line with revenue declines (i.e. brokers can be laid off), and that reduces operational gearing and helps maintain earnings in the face of lower revenues.
While low operational gearing helped the company avoid a collapse in profits, it was not enough on its own to turn things around. For that, the company looked to major acquisitions.
These acquisitions are intended to be transformative, but I am not the sort of investor who pins their hopes on an unproven future and so they did not sway my decision to remove TP ICAP from the portfolio.
Selling: A weak track record and higher share price provide few grounds for optimism
So why have I decided to sell now? The main reason is, as usual, that TP ICAP is now ranked lower on my stock screen than almost any other holding in the portfolio, with only BAE Systems having a lower rank. This change in the company’s relative attractiveness has come about for two reasons.
The first reason is that its financial track record has completely changed from the high growth record it had in 2011. The company’s results have declined almost every year since 2009 and that has had a massive impact on its growth rate, growth quality and profitability metrics.
The second reason is that while the company’s financial results have been declining, its share price has increased. As a result, its valuation ratios are no longer attractive given the company’s unimpressive track record of recent years.
The table below compares Tullett Prebon at the time of purchase to TP ICAP as it stands today:
Overall, the company’s combination of financial results and valuation ratios is far less attractive than it was five years ago.
However, I don’t just mechanically sell when the stock screen tells me to. I like to think at least a little bit about what the future might hold for a company, and in some cases, if I’m particularly optimistic I might hold on for a while longer, even if the company’s stock screen rank is not that appealing.
In TP ICAP’s case, I might have argued that a weakening financial track record is normal in cyclical companies, especially if they are purchased after a cyclical boom which is then followed by a cyclical bust. I might then have held on in the hope that the cycle would soon turn towards a boom, driving revenues, profits and share prices upwards.
In fact, I do think TP ICAP is caught in a cyclical downturn, but I also think it could be a very long time before we see another financial sector boom.
I could be completely wrong, but my understanding is that credit-driven financial crises can take many many years to recover from, rather than just several years, so TP ICAP’s turnaround could be a very long way off.
In summary, TP ICAP’s track record is not great, its price is not great and there is no obvious reason why things are going to get better anytime soon. That, in a nutshell, is why I’ve sold.
The proceeds will be reinvested into a new holding next month, following my usual portfolio maintenance strategy of buying or selling one holding each month.
Hopefully, the new company will return something better than the reasonable but unspectacular 9% per year that TP ICAP has returned these past five years.
I’ll leave the final word to TP ICAP’s Chairman, taken from the 2015 annual report:
“It is not possible to predict when the structural and cyclical factors currently adversely affecting the interdealer broker industry will ease, or when the level of activity in the wholesale OTC financial markets may increase. Our recent performance has benefited from the buoyant level of activity in the Energy and commodities markets, particularly in oil and oil related financial instruments, and this level of activity may not persist.”
Note: Tullett Prebon joined the model portfolio before I’d started publishing the UK Value Investor newsletter, so the original pre-purchase review appeared in this 2011 blog post instead.