Editor’s Blog – Page 21 – UKValueInvestor

Bogle on valuing the market

Morningstar recently put out an interesting video from the master of Common Sense Investing, Jack Bogle. The video was called Speculation Dwarfing Investment and in it, Bogle basically says that there is about 200 times more trading and speculation than there is an investment.

The Best of Last Week – Stagecoach

Stagecoach released its interim report last week and was the highest-ranked stock on my shortlist to do so. The question is, at a price of around 250p, what do the shares of this company have to offer the average investor?

Why Stock Tickers Are Bad For Your Wealth

Having share prices in your face 24/7 is like having a giant red sign on top of your house constantly flashing the price that everyone else (on average) thinks your house is worth.

HomeServe – A Big Price Equals Big Losses

The stock market can be an unpleasant place. Let’s say, for example, that you own shares in HomeServe, the international home emergency insurance and repair business.

Happy hour or hangover for SABMiller investors?

It’s not easy being picky. I’ve just spent the morning looking at Mothercare and still can’t decide whether I like it or not. It’s either a speculative screaming bargain or a value trap with a UK business that could suck cash out of the good part of the business (the high growth international bit).

Tips for Overcoming Overconfidence

I’ve made my fair share of investing mistakes and I’m sure that, despite my best efforts, I’ll continue to make them. The trick is to be honest with yourself and learn from them and learn to recognise them before you make the same ones again. For me, the biggest offender is overconfidence.

Scottish and Southern Energy – A Wolf In Sheep’s Clothing?

Utilities are often seen as boring investments. They’re never going to be sexy, they’re never going to cure cancer or have their products at the top of a teenager’s Christmas wish list. That may well be true, but value investors have a history of liking boring companies and Scottish and Southern Energy (SSE) has a lot to like.

The Four Drivers of Long Term Equity Returns

As a stock picker, I’m investing to beat the market over the long term. Of course by ‘beat’ the market I mean that the value of my portfolio goes up more than the value of the market, including re-invested dividends.

UK Mail – Can A 9% Yield Ever Be Sustainable?

I know I’ve written a lot lately about big cap, solid growth companies like Vodafone, BHP Billiton and MITIE, and I guess some people who read this stuff might think, “What sort of value investing is this? Where are the obscure, the unloved and the unfashionable?”.

The FTSE at 5000 – Good Value?

I’m sure you don’t need me to tell you what mood the market’s in. Borderline panic is probably as good a description as any. I may not like the panic, but as a value investor I do like the bargains it throws up and one such bargain may well be the FTSE 100 itself.

MITIE – A Very Impressive Company For a Fair Price

Warren Buffett has a name for companies that are virtually certain to grow consistently for decades into the future. He calls them The Inevitables. Now, I certainly don’t think I have the skills to spot these uber-rare companies, nor do I think I need to. But occasionally I bump into a company whose financial results do a fantastic impression of one.

5 Ways to Measure Debt

To most value investors, debt is one of the first things they look at when analysing a company. Since value investing, almost by definition, involves buying unpopular stocks, there is often some kind of bad news surrounding the company which will only be made worse by high levels of debt.

Why A Falling Share Price Is Often A Good Thing

One of my favourite value investing sites is The Value Perspective which is the web outlet for some of the (value) fund managers over at Schroders. In their latest piece, Andrew Lyddon talks about how the telecoms sector is not exactly a hot favourite. Despite the sector’s deserved reputation as a defensive play, share prices often fell and lagged far behind the wider market and even other defensive sectors.

More Mega-Cap Value with BHP Billiton

A lot of value investors talk about how you have to look for the unloved, the obscure, the boring and the small. That’s fine if you want to invest in those sorts of companies but personally, I sleep better when I’m invested in big, well-known, highly profitable businesses and fortunately, these can be value investments too.

Tullett Prebon – Terry Smith joins the portfolio

Tullett Prebon is an inter-dealer broker, which basically means they act as a middleman between commercial and investment banks and other parties. If somebody wants to trade in treasury products, interest rate derivatives and fixed income, they go to Tullett Prebon.

Market Mayhem or Golden Opportunity?

The FTSE 100 closed last Friday at 5,129, about 13% down from when the carnage began in early August. At that level, it has a PE10 of about 12 (PE10 is the 10-year average real price-to-earnings ratio) while the PE10 average is around 17.6. PE10 has been a pretty good indicator of future returns over the last century and it’s a favourite of mine for checking what sort of returns might be possible in the next few years.

Balfour Beatty – The Construction Industry Is Only Sleeping

The model portfolio is filling up nicely (12 out of 20 slots taken) and now it’s time to buy another company.

BAE Systems – It’s Time to Get Defensive

BAE Systems, the giant defence contractor, is another high-quality company with a sustainable income that’s very likely to keep growing through the coming years. The company is financially robust, has a long history, a growing dividend and is internationally diverse. In fact, as I write this it’s currently yielding an incredible 7%.

Better than the FTSE 100

So, what makes this such an attractive proposition? Apart from the fact that there’s a 7% cash payout, it’s a reliable payout. There is no significant risk of it being cut or stopped. Many professional analysts seem to think that the dividend is going to keep growing at 6-7% a year. A 7% yield, growing at 7%, what’s not to like?

Let’s take a look in more detail, using my un-famous technique of comparing any potential investment to an investment in the FTSE 100. That’s a useful thing to do since you can invest in ‘the market’ for low cost and very low effort. Just sit back, re-invest the dividend and get rich slowly.

How does BAE stack up? Here’s a table to go over it all, step by step:

Factor	FTSE 100	BAE Systems
Earnings yield	12%	16%
Dividend yield	4%	7%
Historic earnings growth rate	7%	12%
Return on retained earnings	10%	15%
Possible future growth rate	5%	8%

The numbers in this table are from various sources and are guideline figures. They are also rounded to the nearest whole % point since more accuracy might indicate a degree of knowledge about the future that is not realistic.

In each case, BAE has the upper hand. At the current price, it’s yielding more dividends and earnings. It has historically grown faster (although the fall in the pound in the last few years may have skewed this figure upwards, but currency speculation is just that, speculation). It has been able to generate a higher rate of return on that part of your earnings which are retained within. Finally, using a simple estimate of future growth (simple because more complex models aren’t necessarily more accurate), it looks like BAE may be able to grow faster than the FTSE 100.

The wooly factors

I have Monevator to thank for the term ‘woolly’, which he used to describe the soft factors like: what business are they in? How will their market do in the future? How will they cope with government cuts and the collapse of the west?

Historically, this area of investing does not have an impressive track record. There have been many studies which show that people who are subject ‘experts’ often have no better forecasting ability than the man in the street. Ask a weather forecaster what the weather will be like in 2 weeks’ time and your guess is as good as theirs.

That’s why 80%, at the least, of my effort goes into using hard numbers and actual past results to determine if an investment is attractive. It pays to take heed of history.

However, there is some work that can be done to sanity-check an investment.

The past

Generally, you want a company where its business history has been consistent over the long term. This is useful because you are investing in the company’s future and if its past has been unpredictable and varied then the future might be the same. If the company has a history of changing its core business or remodelling itself then what has produced the good results of the past may be restructured or jettisoned in the future, leaving you with a less attractive investment.

In BAE’s case, their history seems fairly steady, with their defence contracting history stretching back many decades. They’ve changed a lot in that time, as have the products and services they supply, but basically, they’re doing much the same job they were half a century ago.

The present

Shares are usually attractive for a reason and that reason is typically that no one else wants to own them. This can happen either because of a general market panic about something (sound familiar?), or a real or perceived problem with the economy, the industry or the individual company. The question is, is the factor causing the low price likely to affect the long-run returns of the company?

If the answer is yes then perhaps you should look elsewhere for a more trustworthy source of returns.

For BAE it looks like there are a range of factors, with perhaps the largest being the current market panic. This panic is about US and Euro defaults and other things to do with the global economy, all of which are really not quantifiable. I take the strategic ignorance approach and guess that the defence industry is likely to still be here in 10 years. With that view, the current market panic is an opportunity, not a risk.

Specific to the defence industry are the actual defence cuts that are going through and further possible cuts in the future. Although these cuts are real, BAE seems to think that they can mitigate much, if not all, of the cuts through efficiency and diversification. Another industry factor is the gradual change to fixed-price contracts, which could hurt margins going forward.

Specific to BAE, there are a couple of main risks. First is the repeated allegations of misconduct, which may lead to higher legal costs. Then there is the ever-present risk of competition, in this case from General Dynamics.

However, I don’t see that any of these risks seriously undermine the case that BAE will still exist in 10 years and will very likely be earning significantly more at that point than it does now.

BAE is exactly what a great dividend growth share looks like. It’s big, stable, and pays an amazing dividend which is very likely to keep growing in the years ahead. It is a value investor’s dream, especially one with an addiction to dividends.

– John owns shares in BAE Systems

How to Find the Right Kind of Growth

Microsoft style growth

When I talk to people who ‘dabble’ in the stock market, one of the things that almost always comes up is growth. The general idea seems to be that if you want a reasonable investment then put your money into Tesco, Marks & Spencer or RBS, but if you really want to get rich then the only way is to find some small company that’s about to be the Next Big Thing.

That’s great if you can get in early enough and if you’re right about that small company, but history does suggest that most private investors suck, in a big way, at spotting the Next Big Thing. What tends to happen is that they hear about it several years too late and they hear about it at the same time as everyone else. This means the price of that company or sector or housing market has already been bid up way too high for there to be any chance of making a decent return in the future. What happens then is the carpet gets pulled out from under their feet and fear, emotional trauma and big losses are all the investor has for their trouble.

That’s not the sort of growth I’m talking about.

Next year’s earnings growth

What I’m also not talking about is growth in the next quarter’s earnings, or even next year’s for that matter. I’ve done my fair share of buying and selling companies that have had a hard time this year which has enabled the canny investor to get in at a lower price. If you do this then the assumption of course is that the earnings will rebound into some ‘normal’ range in the next year or two and hey presto, you make a killing.

This is a fairly standard value investing approach and it’s where I started out back in 2007/8. It has a lot of merits but it also involves digging around in companies that often have quite mediocre histories and fairly substantial current problems. Some of these companies do recover as hoped and you can make quite big returns in a short time. But it’s a pretty hairy experience.

When you’re investing in a mediocre company which has hit hard times and is implementing some kind of turnaround strategy (see my investment in YELL for an example of this) you are basically taking an educated guess that the company will be okay in the end and that Mr Market will put on his happy face at some point.

Again, this is all fine and dandy if you’re happy with investing in mediocre businesses that are taking a beating, but I want to keep stress to a minimum so that I can invest and sleep well for the next 10 or 20 years.

This means that companies which are mediocre, a bit wobbly and are having to implement some kind of turnaround strategy, they’re all no-go areas.

In fact, even when looking at nice stable companies that are doing relatively well, I’m not that interested in how the earnings will pan out next year. As I have said before, a reasonable time frame for an investment in shares is 5 years and that goes for each individual holding as well as the portfolio as a whole.

The one thing I can be certain of is that I have no idea whatsoever what the price of any of my shares will be tomorrow, next week or next year. It is simply impossible to know. Even if next year’s earnings are good it often has no obvious impact on the share price. So estimates of next year’s earnings are simply not a factor in deciding what to buy.

The growth I really like – strong, consistent, long term

In the first two articles of this series, I looked at why I like a good dividend yield and why I like a company with a long stable history. Both of these factors are driven by the idea that a share may well be held for a number of years and so predictability in the company’s earnings is important. I want to own companies where profits are virtually certain to keep rolling in and the dividend is virtually certain to keep growing.

Give two companies, both of which have long histories with no losses and progressive dividends, which would you prefer: the one that has grown historically at 10% a year or the one that has grown at 2% a year?

It’s not a difficult question. All else being equal, more growth is better than less growth. Of course, you can’t simply look at the past and project it into the future, but it has been found many times over that companies with above-average growth in the past are likely to have above-average growth in the future. Not always to the same degree and not necessarily forever, but as a group they do better than the average company.

If that past growth does continue into the future and if the shares have been bought at a reasonable price (typically based on earnings and/or dividend yield) then as earnings and dividends increase the odds are that the share price will go up too.

I’ve probably used this example before, but just imagine buying a company that’s currently yielding 6%. That’s a pretty healthy yield and if it’s sustainable then there’s a good chance that the share price will go up anyway just because that cash yield is so attractive.

But what if the company manages to grow at 10% a year, increasing the dividend progressively? In 5 years the dividend will have gone up by 50% and not only would you have received over 35% back on your original investment from the dividend, the shares will now be yielding 9%. That’s a fantastic yield although it’s never likely to happen.

If the dividend is sustainable it’s far more likely that the share price will have been bid up by 50% to keep the yield nearer to the already attractive 6%. So you’d end up with a 35% gain from the dividend and another 50% from the share price increase.

Why it’s best to see growth in all the key financials

So much for all the talk about growth. What exactly am I talking about when I say growth; do I mean growth in the CEO’s waistline? No. I mean growth in earnings per share, dividend per share, turnover per share, cash flow per share and net asset value per share (although in some companies like Next this figure is not so useful due to the capital structure of the business). I’m sure there are a few other things you could lump in there.

Basically, I’m looking for growth in everything. It’s no good having lots of revenue growth if it isn’t translating into earnings, and it’s no good having earnings growth if that isn’t translating into dividends, although Warren Buffett at Berkshire Hathaway might have something different to say about that last point. However, for most normal companies not run by the best capital allocator in the world, I would want to see dividends increasing sustainably more or less in line with earnings.

One final point is it’s no good seeing earnings and dividend increases without increases in sales since those earnings increases must be coming from increased gross margin or lower expenses or something else that is only a short-term feature. Without sales growth, you cannot have sustainable earnings and dividend growth over the long term.

And the time period? Typically I like to see this strong consistent growth in all these key metrics over at least the last 10 years. That sort of time frame often indicates that the company has some kind of competitive advantage that allows it to either keep up in a growing industry (where there is often strong competition) or to expand market share in a static or even declining industry. Either way, it’s a useful indicator as to whether a company is above average or not.

There are some tools, free and paid, which give nicely laid out tables of financial data going back over 10 years. I’ll go over these at some later point but off the top of my head, there are Sharelockholmes, Digital Look, Morningstar Premium, ShareScope, Investor Chronicle and probably many others.

Buy only at the best possible price

I was going to say ‘only at a reasonable price’, which is the mantra of GARP (Growth At a Reasonable Price) investors, but that’s not what I mean. GARP is more focused on growth. It’s growth first and then a reasonable price second. As a value investor what I’m after is a fantastic price first and then as much growth as I can get for that price second.

Price, as always, is the key part to success in investing. As I mentioned recently, Vodafone has a great track record of growth, but the shareholders have seen almost nothing but losses from the turn of the century. That’s because they were paying a huge price in the hope that Vodafone would grow quickly and the share price would follow. Vodafone has grown quickly but if you’re paying 50 times earnings and 100 times the dividend, there’s nothing to stop the share price from halving, no matter how good the growth. In Vodafone’s case, it’s taken 10 years for the share price and the company’s earnings and dividends to come together and create an attractive investment.

Building an Income to Retire On

Remember the mantra from last time – income first, capital growth second, invest for the long term. With shares, income means dividends and the higher the yield the better. However, there’s more to it than that.