Are you a good investment manager?

Investors usually go down the stock picking route because they think they can outperform both the ‘market’ (typically the FTSE 100) as well as professional fund managers.  Of course there is an element of interest and even excitement in stock picking, but at the end of they day if you’re investing thousands of pounds in your own stock picks you’re doing it to make more money than you could elsewhere.

Since that’s the case, tracking your returns over the long term is important just to make sure your efforts are worth it and if they’re not, then perhaps you should either buy the footsie and find another hobby, or get someone else to make your stock picks.

In my case I started value investing in the middle of 2008 and so I now have a three year track record.  In that time I have learnt an enormous amount about both the technical and behavioural side of investing and I hope to put that knowledge to good use in the future.  You can see my results so far on the about page and you can see them in the table below too.

FTSE 100 total return
UK Value Investor
2008 (from 31/07/08)
2011 YTD (May)
Total from start
Annualised from start

If you turn a somewhat blind eye to 2011 (where performance has been hit in the short term due to a number of speculative turnaround situations I bought into that still have a long way to turn) then the results are satisfactory, as Ben Graham used to say.
In his new book The Investor’s Manifesto, William Bernstein has said that investors who manage their own money must have four traits:

1. An interest in the process.
2. More than a bit of math horsepower.
3. A firm grasp of financial history.
4. The emotional discipline to execute their planned strategy faithfully, come hell, high water, or the apparent end of capitalism as we know it.

Although he concludes that “no more than a few percent of the population is qualified to manage their own money”, for those that are lucky enough to possess those four traits, the extra rewards may well be worth the effort.

For the vast majority that don’t possess all of those traits the answer may be to either find someone who does, or just track the indices and forget about stock picking altogether.

10 Beefy stocks to chew over

The companies in this month’s shortlist are sorted and selected based on their growth, both past and estimated future, as well as their current dividend and earnings yields. They all have steady histories over the past decade and I’d go so far as to describe them as good companies at good prices.
Rolling PE

Generally I start at the top of this list and if I find something that fits my criteria I’ll buy it, assuming I have any cash to deploy.  Otherwise it’s still worth reviewing a company or two in greater depth just in case some cash magically appears (I wish!), since most of the leg work will have already been done.

I’m pretty sure that out of this list of companies there’s something that I’d be happy to put into my pension fund, in fact I already own four of them.  I’m looking for something where I’d be happy to go to sleep for five years and trust that the investment has one hell of a good change of returning a fair profit in that time.  Or in the words of a rather clever chap,
“Only buy something that you’d be perfectly happy to hold if the market shut down for ten years” – Warren Buffett
That might be a bit of a stretch for most people, but it should get you in the right mindset for picking great companies.  Picking great companies is important because by buying any company’s shares you are putting your money at risk and just as importantly, you are tying your economic future to their economic future.
How you live when you retire is going to be affected in a massive way by the value of your pension fund.  Pick the wrong companies and the consequences can be huge.  Pick the right companies at the right prices and your retirement might look a whole lot different.

Vodafone – From growth to value in 10 years

Paying too much for a company is never a good idea. 10 years ago Vodafone was a cool tech company that was going to grow to the moon and was worth, at least to investors of the time, about 60 times its adjusted earnings which gave an earnings yield of 1.7%. Ouch, is all I can say.

Behind the whacky share price is a real business which operates year in year out, doing its thing to the best of management’s ability.

For example, since 2002 Vodafone has doubled revenue, almost doubled operating profit, tripled adjusted earnings per share and increased the dividend six-fold. Compound growth of adjusted earnings and revenue has been about 10% while returns on equity hovers around 9%. I estimate return on the last 10 years retained earnings at around 15%.

And the share price? After falling below 150 pence in 2001 it’s been more or less stuck there ever since.

Back in the real world Vodafone continued as a market leader in an ever growing market and became the owner of the world’s fifth most valuable brand.

Somebody much smarter than I once said “If the business does well, the stock eventually follows”, it’s just that in Vodafone’s case that ‘eventually’ has taken 10 long years. But with the current earnings yield over 10% and the dividend yield over 5% it’s highly likely that future growth will cause the share price to follow since a dividend yield of 5, 6 or 7% on a company like Vodafone is going to suck in investors like a black hole (not the most positive metaphor, I know).

The question then is can Vodafone be expected to keep growing over the next few years through whatever outrageous fortune the future may throw at it?

I think that is can. The market for mobile telecommunications is still growing, mostly in emerging markets. In mature markets growth is likely to come from data revenue rather than voice as people switch to smart devices like smartphones and iPads. I see no reason why Vodafone cannot grow as the market grows.

As for outrageous fortune, telecommunications is a defensive industry and generally isn’t too heavily impacted by economic downturns. In the same vein Vodafone is a global company which may protect it from issues in any one country. If things get ugly (should that be more ugly?) in the next few years it should provide a relatively safe harbour for any cash I invest.

Other levers to increase the share price are the progressive dividend policy and the £7 billion of cash allocated to share buybacks.

In the wise words of Warren Buffett:

Your goal as an investor should be simply to purchase, at a rational price, a part interest in an easily understandable business whose earnings are virtually certain to be materially higher, five, ten, and twenty years from now

Vodafone may just fit that bill.

As at today I would consider buying more shares under 185 pence (disclosure – I already have), whereas if the price shot up due to some good news then I would consider selling at anything over 250 pence.

May 2011 Update

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 23rd).  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.

Rolling PE

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:

I would consider:
Buying under 630 pence
Selling over 840 pence

Robert Wiseman Dairies

Robert Wiseman Dairies (RWD) produces around 30% of the fresh liquid milk inBritain.  They have grown rapidly in the last decade and now share the market lead with Arla Foods and Dairy Crest.  They have established a reputation as the supplier with the most modern dairy network inBritainand for having an obsession with efficiency; both of which are critical factors in what is effectively a logistics business supplying a commodity product.

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%.

I would consider:
Buying under 350 pence
Selling over 460 pence

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.

Overall result
4.7% gain in 169 days

New holding – Braemar Shipping Services

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.

I would consider:
Not buying at any price
Selling over 45 pence

Annual report – Yell Group

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.

I would consider:
Not buying at any price
Selling over 14 pence

Chemring Group – Leveraging global leadership

Chemring is primarily a defence group that currently focuses on countermeasures, counter IED, pyrotechnics and munitions.

These four areas take advantage of the company’s three core competencies of energetic material expertise, high product safety and reliability and high volume manufacture of explosive products.

They’ve managed to grow earnings and dividends in 9 out of the last 10 years and just as importantly, that growth has been consistent.  The compound rate of earnings growth in the last decade is around 27% and nearer 40% in the last 5 years.  Return on equity has averaged over 19% and return on capital employed is typically over 30%.  Free cash flow has been generated in all of the last 8 years and capital expenditure has been just over half of total cash flow, leaving plenty of extra cash for dividends and more growth.

In a nutshell the company has been growing like crazy and is expected (by the company and analysts alike) to keep growing at a somewhat lesser pace for at least the next few years.  Of course, we all like a bit of growth, but what about the price?

At 693 pence the price to earnings ratio is around 14 and the current earnings yield is 7%, which is just above the level of a basket of investment grade corporate bonds.  That’s not great, but it’s not terrible either.  The dividend yield is low at less than 2%, so that’s not fantastic, but with a historic growth rate of 27% it starts to look more acceptable.  The PE is well below the price/earnings/growth ratio using historic growth, and it is also well below the level suggested by a proxy of a 15% discounted cash flow calculation (6.5 + ½ of growth).  The current PE sits at its historic average which isn’t helpful, although that hasn’t stopped past investors earning fantastic returns.

In order for me to expect a decent return, Chemring is more reliant on future growth than any of my other holdings.  If earnings stay close to where they are now for the next few years there seems little reason for the share price to increase and with a 2% dividend, that’s not much to look forward to.

On the assumption that the growth does continue in some form, if I project book value into the future growing at the rate of retained returns on equity (14%), add in dividends at the historic payout ratio (26% of earnings) and finally calculate the share price using average returns on equity (19%) and the average price to earnings ratio (14), I get a 5 year total return of 49%, while I’m typically looking for 100% as a ballpark.  This low figure comes from the low growth rate of 14%, given by removing the dividend from the average return on equity of 19%.  In Chemring’s case, they actually grew earnings by around 27%, so this projection comes out somewhat ‘pessimistic’.  It also comes from calculating earnings at the 10 year average return on equity, which is 19%.  More recently ROE has averaged 26%, so by assuming it will be 19% in the future I’m saying in this case that current earnings are abnormal and that for the next couple of years they will go down (and therefore in this projection I ‘expect’ the share price to be down for the first couple of years).

Projecting earnings growth using the actual historic growth rate (27%) and paying out the dividend at the historic rate and pricing the company at the historic PE, I get projected 5 year total return of  237%.  Much better of course, but remember to take a quick cold shower as these are projections and nothing more.

So now that I have my projections, one of which is not good enough and one of which is very good indeed, what should I do?  Perhaps take the middle road and say that total returns might be in the middle of 49 and 237, which is 143%.  That’s a pretty good return and if I close my eyes and make a wish it might come true.

Now that I think Chemring might be able to give me the returns I’m after, what kind of events might happen to make things turn out less rosy then I expect?

The first thing is the current level of debt.  With net debt at some £300 million, the company has a net gearing ratio of 95%, which is pretty high.  It also means that interest is covered only 7 times, which is okay but not fantastic.  More positive is debt to earnings, which is about 3 times, and my general guideline is no more than 5.  So debt is a bit on the high side but not catastrophic.

What about risks to their markets?  Looking at the last 3 years it’s obvious that the recession had no impact whatsoever, but that’s not so surprising when you consider that their major clients are governments.  So what about US and UK spending cuts?  That’s where it gets a bit more interesting.  In simplified terms, it’s pretty easy for a government to make capital spending cuts in the military, you just don’t build any new aircraft carriers, or you make the army keep using the tanks they’ve already got rather than upgrading to some shiny new ones.  On that basis it would hurt the tank manufacturer.  But Chemring makes disposable products, things that get fired out of something to either blow something else up or to stop something else blowing you up.  It’s easy to not buy new tanks but it’s not so easy to not buy new ammunition for those tanks.  It’s probably even less easy to not buy the defensive countermeasures that stop the enemy killing your chaps inside those old tanks or the counter IED technologies that the company develops.Using that logic it seems that Chemring’s earnings may be relatively well insulated from any spending cuts.

Okay, what else?  In the 2002 annual report earnings fell from 5p to 2p, which was the last time earnings didn’t grow.  Why?  Sadly, a worker was killed in Kilgore, Tennessee, in an incident in April 2001.  This seems to have led to the rebuilding of the whole plant at significant cost, although by 2004 much of those costs had been recouped through insurance.  The negative growth in this case was an infrequent, one off survivable catastrophe.

I’ll try not to get too excited though as Chemring does not have a low cost durable competitive advantage.  They probably do have some advantages in expertise and management and organisation, but these are grist for the mill of capitalism.  The nearest thing they have to a low cost durable competitive advantage is their position of global leadership in the countermeasures market.  Being the market leader at anything typically means you have many advantages including economies of scale and being ‘known’ as a leader when tendering for contracts, even in markets outside the one where you are the leader.  They are looking for most of their growth to come from further expansion into larger markets outside countermeasures and it’s likely that this will be aided greatly by being the global market leader and largest supplier of countermeasures to the US and UK air forces.

I think Chemring has earned a place in my portfolio and so I’ve put in 1/20th of my pension at around 680-690p.  I expect to hold for as long as the projections suggest that the future returns will be good, or when peace breaks out across the face of the Earth; whichever comes first.

Predictability, growth and price

One of the interesting things about investing is the almost infinite number of ways that you can tackle it.  From indexing to stock picking, bottom-up and top-down, technical and fundamental analysis, skuttlebutt and quantitative formulas, you’ve got enough options to keep you happy for a thousand years.  That’s why I’m going to try out a new approach to value investing for a while.  The eagle eyed among you may spot its origins.

Note – Although I did say I would cover my recent flurry of purchases I just haven’t had the time, especially given that I’m trying out this new way of looking at stocks.  Apologies for those who really wanted to know why I invested in Yellow Pages.

Mears Group

Mears Group is my first purchase of a company which is currently doing pretty well in addition to having a very solid history.  In the past I’ve focussed on companies that are ‘cheap’ first, with only a fleeting glance as to their quality.  Going forwards it’s likely to be the other way around.

Mears currently operates in two main markets; support services to local authorities and domiciliary care.  They began life as a small, private building contractor in 1988 and by 1992 they had moved partly into maintenance and repair work for local authorities.  In 1996 they floated on the AIM market with a turnover of £12 million and 83 employees.  Through organic growth and acquisitions they grew to a £200 million turnover in 2005, winning the ‘Decade of Excellence’ and ‘Best Performing Share Over 5 Years’ AIM awards.  By 2010 they had listed on the main market, won the PLC Award for ‘New Company of the Year’, joined the FTSE4Good index and grown to a £500 million turnover and 12,000 employees.

By any stretch of the imagination that’s a pretty impressive track record.

Just as impressive is the level of consistency in these results.  Revenue, profit, dividends, they’ve all grown in every year for a decade.  The only blip, if you can call it that, has been the current year in which profit before tax and basic earnings per share were down slightly from last year.  Consistency is important as it may correlate with predictability of future earnings, which is useful since I’ll be doing some forecasts in a minute. 

All this growth and consistency translates into a compound growth in earnings around 21%, an average return on equity of 23% (although for the last few years it’s been nearer 15%) and a high return on capital. 

Since 2001 management have retained almost 90 pence of basic earnings per share.  In that time earnings have grown by about 13 pence, which you could say gives a return on retained earnings of just under 15%.  Using adjusted earnings, they have retained over 98 pence and the growth in earnings is almost 17 pence, giving a return on retained adjusted earnings of over 17%.  Either one of those numbers is a pretty good rate of return on retained earnings. 

The return on retained earnings is important because the earnings generated by a company can go in two directions.  Some portion of it can be paid out to shareholders as a dividend, which they are then free to spend or invest as they see fit.  What isn’t paid out is retained within the company and is therefore at the mercy of management.  If management decide to put the money in a bank account, or invest it into equipment which is needed just to maintain the current level of earnings then you’re unlikely to get a good rate of return, if any, from that portion of the earnings.

It’s all well and good buying a lot of earnings for your money through a low price to earnings ratio, but if management have to reinvest those earnings just to stand still, the earnings are effectively worthless.  Imagine a company earning a million pounds a year and you buy that company lock, stock and barrel for ten million pounds.  You’ve paid ten times earnings which is a pretty good price.  If the company then spends a hundred thousand on upgrading equipment and then pays nine hundred thousand out to you the owner, you’re getting a 9% return on your investment.  If the company doesn’t grow over time then you’re getting 9% a year, which you can look at as if it’s a bond with a variable yield since the company earnings are likely to fluctuate somewhat each year.

However, if the same company then has to spend eight hundred thousand pounds a year on new equipment, just to keep up with some new competitor and just to keep the earnings at the one million mark; those earnings are effectively lost to you.  They disappear into the pockets of the equipment suppliers.  In this case from the one million earnings you only see two hundred thousand as a dividend, a 2% return.  Even though the company is retaining much more earnings they still cannot grow the company, so the 2% return is more or less static.  This, of course, is a much less happy situation than the 9% return, but in both cases you are getting a 10% earnings yield.

The key point is what happens to those earnings?  Are they reinvested, either by you or by the management, at a decent rate of return or are they burned up in a desperate effort just to stand still?

In Mears’ case, they have not had massive capital outlays and have managed to deploy the retained earnings into various profitable ventures.  This makes me happy since, as the owner, I want my earnings to be invested at the highest rate possible.

So on the face of it Mears is a good company earning profit, paying a dividend, growing steadily and strongly over a long period of time.  It is perhaps the sort of company I’d like to add to my portfolio, but only if the price makes sense.

There are various ways of deciding if the price is right.  The current earnings yield (the inverse of the PE ratio) is around 9%.  Given that management are growing their retained portion of earnings at something over 15%, I can sensibly count their earnings as part of the earnings yield.  The current yield on a basket of corporate bonds is around 5%.  So in one way Mears could be viewed as a variable rate bond, yielding 9% now and growing that yield at around 15-20%, which looks better than a static 5%.

Another way to look at the current price is to look at the price/earnings/growth or PEG ratio.  The historic earnings growth has been around 20% and the current PE is around 11, so the PEG ratio using historic average growth is around 0.5-0.6.  Anything below 1 is considered by many as worthy of further investigation.

Yet another way of thinking about the current price is to compare the current PE to its historic average.  In Mears’ case, the current PE of 11 is below the average of 17, which means that investors are unlikely to be as positive about Mears’ future as they have in the past.  Interestingly, 17 would put the PEG ratio quite close to 1, and therefore perhaps quite close to fairly or normally valued.

If the current price looks interesting, how will that translate into future returns for me as a shareholder?  That’s the big question isn’t it?  Of course there is absolutely no way to know.  But to avoid giving up and going back to indexing, we can try to make some reasonable forecasts for the company’s future.  These forecasts will never be anything other than wrong, but they may be able to give a rough guide to what we can expect.

But, before putting on our forecaster’s hat, let’s think about the kind of things that might make any forecasts meaningless. 

For example, what happens if there is a big recession?  Typically sales and profits might vanish and so any interest bearing debt the company carries can suddenly become a real problem.  Fortunately Mears has only 8% net gearing and interest payments are covered thirteen times over by current earnings.  On top of this, their revenues come from long term contracts, around 5 years in length, which are largely from non-discretionary, legally required services which the company’s clients have to provide to their tenants.   During the recent great recession revenue did nothing but grow.  They even view the Comprehensive Spending Review as possible positive, as local authorities are forced to look for savings; savings which they may get by outsourcing services to Mears.

In the longer term it’s unlikely that any of the services that Mears provides will become obsolete as local authorities and social housing landlords will always need to provide repair and maintenance services to tenants.  People will always need some sort of care in their homes so the domiciliary care business seems to have a future too.

Despite this seeming robustness, Mears does not have a low-cost durable competitive advantage, so why should their future look like their past?  Well, that’s a tough one.  I don’t know.  However, they must be doing a lot of things right to have the history that they have.  These things don’t vanish overnight, nor does the goodwill built up over time between them and their clients.  According to the company they are the leader in both their main fields and that’s a big plus for any company.  More importantly there is research which says that the performance of outperforming companies does gradually revert toward the industry mean, but only over many years and even then is typically still above the industry mean.  So even if Mears doesn’t have the fabled durable competitive advantage, I think it’s likely to continue its winning ways for a while yet.

Now back to those projections.  The average return on equity has been around 23%.  Of that, typically 18% was retained and 5% was paid out as a dividend.  If we assume that the 18% is added onto book value each year then we can project book value forward into the future growing at 18% a year.  To find the earnings in each year multiply the book value by the average return on equity.  To find the share price for each year multiply the earnings by the average price to earnings ratio of 17.  This gives a share price in 5 years of 1575 pence and 3600 pence in 10 years, compared to the current price around 250 pence.  To calculate the dividend use the average payout ratio over the last decade applied to the earnings of each year.  To get a total return estimate, sum up the dividends to the year in question and add that on to any estimated capital gains.

That gives a forecast where earnings next year are 47p compared to the current 23p and in five years time the earnings are 90p.  Since the PE ratio is also estimated to return to 17 rather than the current 11, the compound returns are 210% to year one, 44% to year five and 31% to year ten.  What that means is that if the ROE and PE return to their historic averages in year one, which is highly unlikely, the share price would be 813p and the annualised returns would be 210%.  If we held for ten years and sold at the average PE the annualised return would be 31%.

Since these seem somewhat optimistic (but who knows, only time will tell), let’s run the same forecast using the average ROE of the last four years which is 15%.  In that case the earnings next year are 28p, in year five they are 44p and year ten 77p, giving annualised returns of 88%, 25% and 18% respectively.  This seems much more realistic, but again who knows?

Another way to forecast the future is to use the historic earnings per share growth rate.  In this case it’s about 21.8%, of which 5.1% is paid as a dividend and around 16.7% is retained.  By projecting forward the current earnings by 16.7% a year, calculating the dividend using the historic dividend cover average and getting the share price from the historic PE of 17, it’s possible to forecast the total returns for each of the next ten years.

In this case the one year annualised return would be 87%, five years is 34% and ten years is 28%.  These are all healthy figures.  If you want to be pessimistic you can assume that the PE stays at its current low level forever.  If you do that then your forecast returns will equal the earnings growth rate, which in this case is about 22%.

All of the above projections give annualised returns in excess of 15%, which is my goal, so the estimated returns are more than good enough.

A word of warning is required here though.  Just because you’ve done a forecast doesn’t mean that it will come true, in fact the odds of any forecast coming true are close to zero.  The forecasts are a guide, nothing more.  However, the more predictable the earnings of the company, the more likely it is that your forecasts will be robust.

The final question is, why the low price?  What is there in the company or the environment that makes investors so wary of this company? 

I think there are several factors.  The first is the recession; the shares have yet to beat their 2007 high.  The second is the basic earnings which have been hovering around 17p for the last four years, even though adjusted earnings have continued to grow strongly; the difference being growing amounts of amortisation of intangibles from recent acquisitions.  The third is the recent failures of Connaught and Rok, two major competitors who went bust partly by bidding too low for contracts (something Mears says it will never do).  Another factor is the looming government cuts since local authorities are the main clients.  This is a risk but Mears are confident their outsourcing services will be in demand as a way for authorities to cut costs. 

So Mears in itself hasn’t done anything wrong, it’s the market it works in which is facing hard times.  How these hard times will affect Mears is just one more unknown in the vast sea of unknowns which make up the future, which brings me back to the idea of predictability.  The more consistent a company’s growth over the long term, the more likely it is that the growth will continue into the future.  That’s not to say that it will continue, it’s just more likely. 

For now I’ll keep looking for these predictable, growing and reasonably priced companies.  It’s a very different way of looking for returns than the kind of turnaround situations I’ve typically invested in before, but it sure is a lot more upbeat and that’s got to be worth something.

A quantitative model

The model that makes up about 80% of my stock picking process has undergone several minor adjustments, one following quickly after the other. Since I have referred to it quite a bit recently I thought it might be useful to thrash out the details as well as its history.

The model detailed here replaced a previous effort which I used through 2008-2010. The old model focused almost exclusively on the balance sheet rather than on earnings, but eventually I had to admit that earnings might be important so I started this new one from scratch, basing it on the strongest research I could find.

Version 0.1 – Fair value and the Piotroski F-score
First I calculate an approximate fair value for the company and hence its shares. I do this by taking the average of ROE10, ROE5 and ROE3 (which in turn are the 10, 5 and 3 year ROE averages) and using that as an estimate of the average future ROE under normal conditions. By blending those historic averages I weight recent results more heavily than results many years ago.

There are various issues with this approach that need to be manually looked at when selecting a company.  For example, companies with extreme ROE figures in some years due to their book value being unusually small at some point. This might skew otherwise weak ROE results upwards and makes them look attractive.

I then assume that fair value is ten times my normal return estimate, which produces a target price from which I can calculate the upside from the current share price. This upside is the first factor in the model as it measures the capital gains you might reasonably expect in the long term.

Sorting companies by upside alone gives a top scoring decile (50 companies out of a universe of 500 with positive 5 year ROE) with these attributes: Normal ROE 15.8%; price/book ratio 0.64; Piotroski F-score 5.6; net gearing 45%; upside 234%.

I use the Piotroski F-score in an attempt to measure where the company is in the business cycle and therefore how far it may be from recovering and being re-priced back to normal levels. It’s better to have a company with 50% upside that may return that amount in 6 months rather than one that may take several years. The F-score may be useful here as it measures changes in returns, cash flow, leverage, liquidity, margins, and asset turnover among other things, all of which help define a positive or negative trend.

To factor in the Piotroski F-score I simply multiply it by the upside so that the higher the F-score the better the company scores in my model.

Sorting on this score gives a top decile with these attributes: Normal ROE 16.6%; price/book ratio 0.7; Piotroski F-score 6.0; net gearing 52%; upside 231%. This gives a higher F-score than before but somewhat higher gearing too. High gearing may or may not be an issue for companies that are well into the turnaround phase.

Version 0.2 – Adds net gearing
The previous version gives an average top decile net gearing of 45%, but this is the product of some companies with almost no gearing and many with over 100% or even 200% gearing. In the name of caution I decided to control this risk by adding net gearing as a factor. This is done by multiplying the version 0.1 score by POWER(2, -(net gearing/100)), in excel speak. This means a net gearing of 0% doesn’t change the score, 100% becomes ½ and so halves the score, 200% becomes ¼ and so on. Net cash produces a number greater than one and so increases the score. This helps bring down the average gearing of the top scoring companies.

Sorting on this score gives a top decile with these attributes: Normal ROE 16.1%; price/book ratio 0.7; Piotroski F-score 5.9; net gearing 23%; upside 223%. This group has slightly lower upside than before but half the average net gearing.

Version 0.3 – Adds absolute ROE
With the previous models, two companies with the same upside and gearing would score the same even if one had a normal ROE of 20% while the other could only manage 10%. After reading the Magic Formula book I was swayed by the argument that a higher ROA or even ROE is better regardless of price as earnings can be reinvested more efficiently. To factor in ROE as an absolute number rather than just in relation to the current price/book ratio version 0.3 multiplies the version 0.2 score by the expected normal ROE, so the higher the ROE the better the score.

Sorting on this score gives a top decile with these attributes: Normal ROE 19.2%; price/book ratio 0.9; Piotroski F-score 5.8; net gearing 24%; upside 218%. Once again the upside has dropped slightly but gearing and the F-score remain steady while average ROE has gone up by 3%.

In comparison, the universe of 500 companies has normal ROE 14.9%; price/book 2.3; F-score 5.9; net gearing 43%; upside -3%. So the top decile has better ROE, lower gearing, about the same amount of fundamental momentum and is lower than half the price (relative to book) of the universal average.
The upside of -3% across the whole universe shows that perhaps there is some sense to my estimate of fair value, given that on average the 500 stocks are about fair value.

One other telling metric is the current ROE in comparison to the expected normal ROE. The top decile has a current ROE some 28% below their expected normal level, which suggests that investors are pricing the companies on an excessively short timescale. The universe as a whole is down 16%, which makes sense as we are in the great recession. The bottom decile, containing the most overvalued companies, has current returns almost 9% above their normal average. This suggests that investors are perhaps overpaying for short term good results, something which value investors have been saying for almost a century.

Unfortunately the only way to know if the differences between these models makes any difference is to test them all together in real time going forwards, which isn’t going to happen. I think it’s likely that they would all perform reasonably well, but each adjustment makes me slightly happier with the selection of companies it produces, which is important if the strategy it to be stuck with over the long term.

Does value screening still work?

Over the years there have been many studies into how different investment strategies affect your potential returns over the long term.  Often these studies involve the selection of companies based on almost childishly simple criteria which ultimately turn out to uncover some hidden truth about market efficiency and the value premium.  Since I use these simple screens to make the bulk of my investment decisions, it seems prudent to check that these simple formula still work when applied to the market as a whole.

Below is a graph of the returns of all companies* in the main and AIM markets in the UK over the last year, where the company had returns for the last 10 years (as I will be sorting by ROE10 shortly).  Sorted by the size of the returns the returns for over five hundred companies looks like this:

1 year returns by returns

As you can see some did well and some did badly.  The average return was 23.7% so this subset of companies strongly outperformed the FTSE 100 and similar indices, but that’s not the point of this exercise.

According to much research (not cited here), sorting by P/B (price/book ratio) is likely to show some sort of trend where low P/B stocks outperform the average and definitely outperform high P/B stocks.  Sorting (descending) by the estimated P/B from one year ago** produces this:

1 year returns by pb

The trend line does seem to indicate what the literature would have us believe – that on average lower P/B stocks have had better returns in the last year.  Breaking the results into five equal groups, the average returns of each group were:

Group 1 2 3 4 5
Returns % 18.9 22.4 25.9 24.0 27.2

Before getting too excited though, remember that low P/B companies tend to be smaller and less liquid, i.e. with a wider spread.  I think that the extra returns will be enough to outweigh the spread costs, but spread size is an important factor in low P/B and small cap investing.  Something to cover at length another day perhaps along with dividends.

Another point is the spread of returns.  In each group some companies did fantastically while others did terribly.  Unless you can spot the difference beforehand you need to be sufficiently diversified, otherwise you could end up with a massively under performing portfolio no matter which group you pick from.

The next well known and highly tested metric is market cap.  When sorted by market cap (descending) from one year ago*** the returns look like this:

1 yr returns by cap

And the quintiles again:

Group 1 2 3 4 5
Returns % 20.4 20.1 26.8 23.8 27.5

So market cap is still a very useful tool in the selection of outperforming companies.  However, the large spread issues are even greater here as by definition the smaller outperforming companies in group five are small and likely to have greater spreads, especially on the AIM index where most of these shares live.

Just from looking at the plot it seems that the variation of returns from each company is much less for big companies (on the left) than for small.  An efficient market proponent would probably say that’s part of the reason for the small cap premium, the variability of returns is that much greater.

The final metric is ROE10 (ROE averaged of the last 10 years), which on its own is most definitely not a value metric as it says nothing about price.  I’ve included it here though as it’s a GARP metric which is closely related to value investing, but more importantly I’ve started using it recently to sift for winners.  It can be combined with the size and P/B metrics to aid and perhaps enhance them.  Sorting by ROE10 (ascending) gives the following results:

1 yr returns by ROE10


Group 1 2 3 4 5
Returns % 15.0 22.4 26.7 28.2 26.2

From this it seems that investing in high return companies turns out to have been more than worthwhile, regardless of the price paid for the shares, which is what growth investors have been saying all along.  Note also that the spread of returns in the top performers (right of the plot) seems to be far less than that of top performing small cap or low P/B stocks.  Interesting.

Now onto some combinations.  If I multiply size and P/B it gives:



Group 1 2 3 4 5
Returns % 21.8 14.9 26.3 24.3 31.2

Which if we look at group five, the smallest lowest P/B stocks, we get the highest returns so far, 31.2%.  Of course this is just a spreadsheet based on data with things like survivorship bias and other reliability issues, but it’s still nice to see that combining size and P/B gives the expected outcome of higher returns.  Note though that group one is a bit of an anomaly (large cap high P/B stocks) with very few losses; perhaps this is the UK large company premium which has been found in a couple of studies.

Finally if I combine P/B and ROE10 I get this:



Group 1 2 3 4 5
Returns % 15.0 18.7 25.9 27.4 31.6

In this case you have to ignore the first 115 or so companies (the first group pretty much) as they are all negative ROE10 companies where the results are messed up by the negative value.  However, I wouldn’t recommend investing in them anyway as a negative ROE10 is not a good thing.  The remaining four groups show a nice progression of returns up to a high of 31.6%.  What’s also nice about this group is that you get the high returns without always being in micro cap stocks.  The estimated average market cap of group five a year ago was 2.5 billion and less than half the companies are on the AIM index, which helps keep trading costs down via a smaller bid/ask spread.

In summary, value screening still seems to work; or at least it did last year.  Adding ROE or perhaps any measure of earnings into the mix probably does have some benefits.  Of course there are many more screens, as many as investors can dream up; but whether you use this approach, the Magic Formula, low p/e or some other system, screening definitely still has something to offer the rational investor.

* Data from Sharelockholmes.  5 companies from over 550 were removed as outliers returning over 400% in the last year.  Although keeping them in would have favoured the P/B ratio’s predictive ability, by the other measures they were random and skewed the data so I took them out.  Of course in the real world you can’t do that, so perhaps that’s a good reason to pick low P/B stocks, to increase the chances of picking up a mega-mover.

** P/B 1 year ago is calculated from the current P/B and the last years returns, i.e. assumes that book value and the number of shares was unchanged.  This is a naive assumption but I don’t think it is too unreasonable and hopefully it hasn’t skewed the results.

*** Market cap 1 year ago just relies on the number of shares on average being the same, which is a reasonable assumption I think.

Adding ROE into the mix

Basing my company valuations on book value is nice and everything, and has a lot of historical and empirical support, but I’ve always had a nagging doubt about my core assumption in relation to earnings:

“”Any reasonably competent management should be able to produce returns at some point such that the company is worth its net asset value.””

This is the basis on which I expect to exit the companies I own.  Most companies that are priced well below book value do eventually end up back above it and usually via a higher share price rather than a lower book value.

Reading through some of the obligatory writings of a certain Mr Buffett however, highlights a consequence of ignoring earnings:

“When Buffett Partnership, Ltd., an investment partnership of which I was general partner, bought control of Berkshire Hathaway, it had an accounting net worth of $22 million, all devoted to the textile business.  The company’s intrinsic business value, however, was considerably less because the textile assets were unable to earn returns commensurate with their accounting value.  Indeed, during the previous nine years (the period in which Berkshire and Hathaway operated as a merged company) aggregate sales of $530 million had produced an aggregate loss of $10 million.  Profits had been reported from time to time but the net effect was always one step forward, two steps back.”

The risk to an investor like me is that a company will never sell at book value because it is just not worth that much even with the best management.  Looking at my own holdings, Northamber had produced average returns on equity of 3.8% over the past decade, 600 Group had managed 2% and MJ Gleeson 2.3% (according to Sharelockholmes).  Not exactly electrifying and not a return you’d want to leave the safety of a savings account for.

But does this matter?  Well, perhaps.  Looking back at my ex-holdings and plotting the annualised returns I got from buying and selling them against their 10 year ROE I get the following:

ROE chart

Unfortunately that’s not a lot of data,  but it’s a start for sure and does seem to imply what I’d intuitively expect – that those companies with higher average return on equity find it easier to return to book value more quickly and profitably.  I think it’ll be another year or two before I have enough data to draw a more solid conclusion though (unless there’s some research out there already).

But if ROE is useful then how should I integrate it into my system? 

As a starting point, I have decided that a company must have a minimum average ROE of 5%.  The goal with this is to skew my holdings toward the right side of the above chart.  It might also increase my dividends, but I haven’t check that yet.

In addition to that hurdle, I have adjusted my buying and selling price points.  Previously I’d sell if the price/book was 1.  Now I think I’ll sell when the price/book ratio is ten times the average ROE, or when it’s 1, whichever is lower.  The point here is that in my imaginary world most investors will settle at some point for 10% returns (after all that’s what the stock market historically makes), so a company with an average ROE of 8% should at some point sell for 80% of book value giving the shareholder a 10% return (assuming all earnings are paid out as dividends, but that’s another story).  But, if the company has produced returns above 10% then I take the pessimistic view that they may not match such lofty heights in future and that even if ROE has historically been say 15% then I will sell at price/book of 1 rather than 1.5.

The same logic applies to buying, where I will now only buy if I have at least a 50% margin of safety against ROE10 times 10.  So with the 8% ROE example above I’d have a maximum buy price/book of 0.528 (66% of 0.8) and a sell price/book of 0.8, instead of my previous 0.66 and 1.0 targets.  Of course if I can buy a company more cheaply than this then all the better.

Using this approach I have decided to jettison Northamber, 600 Group and MJ Gleeson from the portfolio, as they were all priced above their ROE10 times 10 valuation.  I’ve replaced them with AGA Rangemaster (average ROE of 8.7%), Barratt Developments (average ROE of 18.5%) and Vislink (average ROE of 9.5%).  A bit drastic perhaps, but at least none of the jettinsonees were sold at a loss (annualised returns of about 14.8%, 2.2% and 22.6% respectively) and both AGA and Barratt bring some well known names into the fold, which makes a change.

Last but not least, I sank some more money into Luminar just to thank them for not going bust yet.  Good work chaps, keep it up and perhaps I’ll get that 462% gain my spreadsheet says I’m due.

Are you really smarter than a chimpanzee?

My current investing goal is to outperform an ETF tracking the FTSE 100 total return over any given five year period.  However, after reading some more about expected returns and the various sources of those returns I think that goal needs some adjustment.

Whilst I don’t believe the market is completely efficient, I do think that the market is efficient enough so that for most people the odds of adding value via stock picking are virtually zero.  This doesn’t mean that you have to settle for the returns of the FTSE 100 or All Share indices though, or even an international mix of indices.

The CAPM Three Factor Model says that the returns from a diversified portfolio come almost exclusively from Market Risk, Size Risk and Value Risk.  What constitutes a diversified portfolio is somewhat subjective, but according to Elton and Gruber’s paper “Risk Reduction and Portfolio Size: An Analytic Solution” a portfolio of 10 holdings will have about half the volatility of annual returns of a single holding.  More holdings reduce volatility by an ever reducing amount.  If you hold fewer companies then you are exposed to Concentration Risk, which according to the theory doesn’t have any associated return.

Instead the returns come from the market return multiplied by the percentage of stocks in your portfolio (the stock/bond split) and the weighted average beta of those stocks, the weighted average market cap and the weighted average price/book ratio (and a few extra bits about the risk free rate which I won’t go into here).  The lower the average size and price/book, the higher the expected returns. Given that my benchmark is a tracker of the FTSE 100 which is full of large companies and many growth companies and that my portfolio consists exclusively of small value companies, it doesn’t seem fair to just beat that benchmark and claim myself victorious since the model says a dart throwing chimp could do the same.

As yet I don’t have figures for the UK, but there are a number of sources that have figures for the expected return from holding small value companies in the US.  For example, in Mark T. Hebner’s active investor bludgeoning “Index Funds, The 12 Step Program for Active Investors” (available for free at his rather excellent site), he cites the return in the US from 1927 to 2006 from holding the smallest 30% of companies relative to the largest 30% of companies as 3.13% per year, and the return from holding the 30% of companies with the lowest price/book relative to the 30% with the highest price/book as 5.11% per year.

My holdings have a weighted average market cap of about 25 million pounds, which puts them in the bottom 20% of the All Share index in terms of size, so I should expect the full size premium over the FTSE 100 (which by definition is full of the largest companies).  The weighted average price/book of my holdings is 49%, which puts them in the bottom 10% in terms of ‘value’ (ignoring negative book value companies).  The FTSE 100 actually has a fair spread of price/book ratios, so on that basis I think I can reasonably expect to see half the value premium which would be about 2.5%.

Putting that lot together I think a more appropriate target is to produce returns equal to the FTSE 100  total return multiplied by the UKVI fund’s weighted average beta, plus an annual 3% size premium and 2.5% value premium over the long term.  That’s a bit of a mouthful, and given that the UKVI beta is currently very close to 1 and I’m virtually 100% in stocks, I could simplify it and say:

I expect to beat the FTSE 100 total return by about 5% annually over the long term. 

Given that the FTSE All Share has returned about 7% capital gains plus about 3% from dividends and the FTSE 100 is likely to be similar, I would expect a total annual return in the region of 15% with somewhat more volatility than the benchmark due to the additional risk I’ve taken on in order to get the extra returns.

Remember that even if I match this performance it does not show any proof of skill since the assumption is that by throwing darts at a board of small value companies (or hiring a chimpanzee to do it) I could achieve the same results.  Only by beating that target can I claim some semblance of an apparently ‘socially useless’ skill.

Finally, to aid in the general excitement I’ve added a discrete period performance table, showing monthly performances for me and the benchmark, as well as year to date figures to the about page.  Discrete yearly figures will appear when I’ve been around long enough to gather them.

As you will see, despite underperforming the benchmark by about 5% this past 6 months I’m still in the lead for the year by over 6%, but there’s plenty of time to fall behind yet.

Building Asset Value

I thought I’d say a little something about how I decide to buy and sell companies, and what my rationale is behind each trade. There is some discretion involved, but not much, and this is certainly a fair summary of what I do.

Let’s say I start with £1000 in cash.  I look for a company where I can pay £1000 for something worth at least £1,500. ‘Worth’ is a slippery term, but to me it means shareholder equity or book value, and I prefer tangible real assets to intangible assets. I realise that book value isn’t always the actual net value of the company assets, what with ‘cooking the books’ and all. However, I don’t have the time or interest in digging out all the details so I imagine that the good and bad net each other out. To be on the safe side I use a wide margin of safety.

So I head out into the market and find some companies where I can buy a pound fifty of book value for a pound. These companies are typically quite sick, often making losses, often unloved by almost everybody. Because they are often losing money they need to be able to weather their current problems. They need a bomb-proof balance sheet, or as near as can be. Typically this means they don’t have a lot of debt and have at least fair liquidity.Debt is often what gets a company killed. If the banks refuse to lend to a company which is dependent on debt it’s game over and the companies I buy are not top of many banks lend-to lists.  Debt can be measured in many ways, but I tend to use net gearing, which is gearing based on net debt, which is interest bearing debt minus cash and equivalents. What exactly is low debt is debatable and I don’t have a hard rule, but certainly less than 100% of tangible equity.

Once I have added a nice cheap strong company to my portfolio I only check on it’s market value once a week. Each week I take a quick look to see if the market value has reached the book value. The answer is usually no. It’s usually no for many months if not longer. Sometimes there will be a dividend, for which I am truly grateful, but these aren’t that common since many of my holdings are loss making. Something has to happen to move the market price, so I sit and wait for something to happen. Alba was a good example of this. They sold the Alba name to Argos and de-listed down to the AIM. They completely restructured the business getting rid of all sorts of non-core bits and that was enough to make Mr Market happy. The share price shot up and I got out.

And talking of getting out, if I can sell a company and turn its book value into cold hard cash then I will. Once the market price equals the book price I see no sense in hanging on. During my holding period the original £1,000 has turned into £1,500, perhaps with some small dividend paid out in the year or three I had to wait. Now I have £1,500 cash in my hands, so I go right back to the market looking for that pound fifty on sale for a pound, or in this case £2,250, at which point it all begins again.

As you can see, the focus is always very much on building up the total book value of my holdings.  Of course, it isn’t always a happy ending. Sometimes the managers manage to burn a big chunk of my book value up. Sometimes I wake up and the new annual report says my company is worth 30% less than it was yesterday and suddenly the market price is above book value. It might even be worth less than I paid for it. From here there are two courses of action. I can ignore the paper loss, turn a blind eye and say “I will only sell if I have a gain”. But this is not logically consistent. It smacks of making up the rules as you go along and one of the keys to investing I think is to make up the rules and then stick to them! So what I should do – and have done so far on the one occasion it’s happened – is to sell at a loss, try to work out where it all went wrong, swear at the management and start looking for the next unloved but robust company to back.

A value based asset allocation strategy – A minor update

This is just a minor update to my previous post about allocating assets to stocks depending on the current value of CAPE compared to its long term average.  In the graph using Shiller data I plotted a straight line at 16.35, the current long term average of CAPE.  However, it would perhaps have been better to show the CAPE average as it would have looked at the time, therefore removing the benefit of hindsight and showing what information investors would have had at the time.  And here it is, with the long term CAPE average shown in black:

Although the average plot now wiggles to some extent, it doesn’t take long for it to settle in close to 15, from where it never really deviates very far.  In fact, continuing my obsession with averages, the average of the long term averages of CAPE is 15.4.  Putting this into the allocation function gives the results below, which is little different from the previous version since the function is fairly insensitive:

A CAPE-based asset allocation strategy

I’ve mentioned my tactical asset allocation efforts in a couple of previous posts.  Both of those have been somewhat vague about how I actually decide on the stock/bond split, although not deliberately so.  If Ben Graham can shout out the Net Net method to the world over 50 years ago and not have its effectiveness affected, then surely my tiny whispers on the web can do my approach no harm.  In fact, it may to some miniscule degree make the markets more efficient.  Like the proverbial fly stopping an oncoming supertanker.  Perhaps I may even win a Nobel Prize, but I doubt it.

Both Shiller and Smithers and others have shown that it is possible to value markets and that market valuations are bound by an invisible elastic thread to both earnings and assets.  More importantly, these valuations allow you to say something about the expected future returns.  Higher valuations mean lower expected returns and lower valuations mean higher expected returns.  Also, average valuations mean average expected returns.

Shiller’s CAPE (Cyclically Adjusted Price Earnings) is my starting point when looking at earnings related valuations.  This is the ratio of current market price to the market’s average real earnings over the past decade.  For the S&P500 the long-term average CAPE is currently 16.35 and is shown below as the horizontal line.  The data for this can be found here.

The chart shows that 1920 was a good time to invest in the US, as was 1932, but 1929 was not so good, nor was 2000.  If you had calculated CAPE at the time and compared it with the long-term average then you would have been able to see that this was true.  Perhaps you could have even adjusted your portfolio to take advantage of this insight.  This was entirely possible since the long-term average CAPE was about 15.5 in 1920, 14.8 in 1929 and 1932, and 15.5 in 2000.  None of these values are much different than today’s average of 16.35.  In fact, it does look like 16.35 is skewed by the recent liquidity bubble since the 1980’s, so nearer 15 may be nearer the true average.  I’ll check again in 20 years.

A nice mental image is to see the current CAPE as being attached to its long-term average by a piece of elastic.  The further it gets from the average the more force there is pulling it back to the average.  It becomes more likely that price will move CAPE back toward the average rather than continue away from it.  Eventually probability and mean reversion win the battle against fear and greed.

For the FTSE 100 I have data going back to 1993 (if someone has better then please let me know).  This gives me CAPE values from 2002 to 2010, the average of which is 16.47.  If I include the earlier years, averaging for what years I have (i.e. in 2001 I only have 9 years of earnings to average and 1993 only 1 year) then I get a somewhat fudged long term CAPE average from 1993 to 2010 of 18.7.  The higher value isn’t a surprise as this period covers the dot com bubble.  Overall, I don’t think these values are too different from the US long term average, so my working assumption in the absence of better data is that the FTSE 100 long term average CAPE is the same as the S&P500’s.  Of course, this isn’t true but fiddling with the numbers doesn’t in the end produce meaningful differences; saying the average was 15 or 20 produces similar results.

The next thing to do is dream up some sort of function to decide on the stock/bond split.  By looking at the chart above you can see that the CAPE value never really gets below about 5, and only twice goes above 30.  My assumption is that it would probably be a good idea to be 100% in stocks near the low points and 100% out of stocks at the high point, and to have an average amount of stocks, say 30 or 40%, when CAPE is at an average value.  Again, whether the limit values are 100% or 90% doesn’t make much difference.  5 is pretty close to 8, which is half the long-term average.  30 is pretty close to 32, which is twice the long-term average.  This gave me the nice simple and dare I say it elegant idea of adjusting my allocation to stocks as CAPE moves between half and double its long-term average.  A simple transform function can take the current CAPE and adjust it to give a percentage between 0 and 100.

Stock allocation = 1 – (CAPE – AvgCAPE/2)/(AvgCAPE*2 – AvgCAPE/2)

As the market gets gradually more expensive the stock allocation reduces.  This is in line with the reducing expected future returns of stocks, and the increasing risk.  Here I’m measuring risk as the increased likelihood of the market falling from current levels, rather than as volatility.  Hidden in that sentence is, I think, the key to value investing.

So now I have a function which tells me how much to hold in stocks depending on the value of CAPE.  If cape is 8.18 then I’ll have 100% in stocks (and we saw about that level in March 2009).  If CAPE is 32.7 then I’ll have 0% in stocks.  If CAPE equals the long-term average of 16.35 then I’ll have 66% in stocks, which is pretty close to the 60/40 split recommended in many places.

The results of this function can be seen below, using my slightly fudged CAPE values for pre-2002 years.

In this chart the split is between stocks and high interest cash accounts as defined in swanlopark.  The FTSE 100 plot is with dividends reinvested; 60/40 is 60% FTSE 100 and 40% cash; and the cash plot is the high interest cash.  TAA is the asset allocation portfolio.  It is rebalanced annually to bring the allocations back into line according to CAPE.  Trading costs should be negligible.

And there we have it.  An approach which gives roughly the same results as the market with much less risk.  More importantly it does it without the terrifying drawdowns that the FTSE 100 has.  It’s much easier on the mind, which makes it easier to stay invested for the long term.  I know this first hand having seen relatives selling out last March after 50% declines.  Now they are still in cash and regretting ever getting out.

Valuing the FTSE 100

As mentioned previously, my wife’s pension is invested using a ‘tactical asset allocation’ function dreamed up by my good self.  It basically uses the long term average of the FTSE’s real CAPE (real as in adjusted by RPIX).  More specifically it uses the long term average of what I call CAPE10, which is the average of the last 10 years CAPE values.

I’m not sure if this is any better than just using a longer earnings average for CAPE (i.e. CAPE is also known as PE10, the current price of the market divided by the average of the last 10 years real earnings, so you could use PE20 or PE30 as has been done in some studies to good effect).  However I haven’t seen anyone else use it so it’s nice to be in virgin territory, even if the difference is likely miniscule and possibly negative.

Anyway… the current CAPE10 value is 15.8.  I have estimated the long term average CAPE10 to be 17.59.  That’s pretty approximate as it’s derived via various adjustments from the long term average CAPE of the S&P 500, i.e. the US market.

So my market prognostication is that:

  • The FTSE 100 is current ‘undervalued’ by 16%
  • The current ‘fair value’ is about 6,170

Therefore I think that future returns are likely to be slightly above average.

Holding Periods

After reading a post on The Div-Net, I started to think about how I differ from dividend investors and why.  The first point to make is that I’m not a dividend investor, in fact I consider myself a trader rather than an investor.  An investor to me is someone who buys something with no explicit intention to sell it.  This typically means they are either buying it for the income (dividend investors, landlords, Warren Buffett etc) or perhaps they are buying it to let the capital appreciate for decades or to let the kids inherit.

So why would I trade rather than invest?  Well, there is some evidence that the returns are better if it’s done properly (which I’ll try to cover at some point), and more importantly it’s a better fit with my personality.

Since I’m buying with the intention to sell, how long do I expect to hold my stock?
It usually doesn’t take long for someone reading up on value investing to realise that it’s usually a long term game.  As Ben Graham said in The Intelligent Investor:

The fact that both the favorable and unfavorable situations are part of any normal long-term picture (and as a consequence both should be accepted without undue excitement) is evidently not part of the stock market’s philosophy.  The latter seems to be grounded on the feeling that, since nothing is really permanemt, it is logical enough to treat the temporary as if it were going to be parmanent – even though we know it is not.

So the stock market’s view is short-term, the next few quarters or perhaps a year.  Current earnings are bad, a new competitor has arrived, the CEO has quit, etc etc.  Mr Market is depressed about the company and wants to get shot of it now since it is unlikely to produce a good return, and may even go down further, in the next six to twelve months.  The intelligent investor steps in, happy to buy such a ‘poor’ investment.  How long will it be before things start looking up and Mr Market is knocking on our door offering a fair price for the company?

One study that does much to show how value shares outperform over a longer time horizon, but perhaps even more importantly, that they do not usually outperform over short time horizons and may even underperform in the months after your purchase, is Time and the Payoff to Value Investing.  This study of South African value stocks splits the market by current P/E (a poor but easy to use measure of value) and holds the various portfolios for periods from six to thirty months.

The graphs clearly show how there is no meaningful difference in performance between the high and low P/E stocks within a six month timeframe.  But by eighteen months the expected returns of low P/E stocks are clearly better.  Their Figure 2 shows how the lowest 10% of stocks by P/E, over a 30 month period, outperform the average of their sample on an annualised basis by about 20%.  That’s 20% annualised outperformance.  Of course the standard deviation is higher but I (like many Grahamites) don’t use that as a measure of risk; perhaps the subject of another post.

Looking at my own Trade History, my average holding period has been 199 days.  Somewhat shorter than a year, but that’s probably largely to do with the huge bounce in FTSE shares since March 2009.  On top of that I’m still holding several companies which I bought in late 2008, where the holding period is now approaching eighteen months.

So next time I buy into a company, only to see if fall, and fall, for months on end, and then for it to flounder somewhere slightly below where I bought it for a year or more, I can look back at this article to assure myself that the odds are on my side and to quit worrying.  That’s the theory at least.

Backtesting of tactical asset allocation strategies

I’ve long been fiddling around with various mechanical methods of adjusting an almost passive index investing stragety to improve the risk/reward ratio.  This is sometimes known as Tactical Asset Allocation (TAA).  I thought I’d put up some charts of my efforts.

The lines in the charts are for four portfolios:  Cash, with the returns calculated using the average instant access interest rates borrowed from the rather excellent Swanlopark;  The FTSE 100 with dividends reinvested;  A 60/40 FTSE 100/cash split rebalanced each year; Another FTSE 100/cash split which is rebalanced annually using my asset allocation function which is fed with the FTSE 100 real earnings over the period in question.

The first chart shows the portfolios with a single lump sum invested in 1993:

As I’d expect, the cash is safe and predictable but has the weakest returns; FTSE 100 is the most volatile with the greatest returns most of the time; the fixed 60/40 split is somewhere in the middle.  The interesting thing is that by taking note of the value of the stock market the red line has better returns that the fixed split, but with broadly similar volatility.

I think this is very suitable for a ‘conservative’ portfolio and it’s exactly how my wife’s pension is invested.  The most important thing is the small drawdowns, which is how most retail investors measure risk, i.e. how much has it fallen from some previous value.  In the above chart the FTSE loses almost 40% in its biggest drawdown, the 60/40 split loses 18% (2000-2003) and the TAA portfolio loses 15% (2008-2009).

The next chart shows the returns when the investment was added in 2000, i.e. a bad time to invest in stocks:

As you can see, cash was a much better place to be than stocks if you were putting away a lump sum in 2000, however theh TAA portfolio has recently taken the lead and looks much healthier than the other stock holding portfolios. 

The next chart shows the benifits of dollar cost averaging, where you invest new money over time.  This means you buy more when stocks are cheap and less when they are expensive:

Although the returns across all portfolios are broadly similar, the volatility is much reduced and given that stocks are now fair to cheap, the portfolios holding stocks are more likely to begin to outperform cash once again. 

Next up is a chart where I’m drawing a pension starting at a somewhat arbirary 5% of the initial investment, increasing the drawings by the RPI each year:

Here it looks like everyone is happy except the cash holder.  At a real 5% the cash pension might last 20 years or so.  All the other portfolios are fine… but what if the drawings started in 2000?

I find this very interesting.  The TAA portfolio seems to give the best risk/return ratio of the four portfolios during the investing stage, largely regardless of whether you are investing a lump of capital in one go and then waiting a couple of decades before taking an income or whether you are dollar cost averaging;  It also looks like it will produces the safest capital during the income phase.  By safest I mean the capital which is most likely to keep paying a real income for the longest period, regardless of when you start the income phase.  So on this evidence my wife could build up the pension using TAA and continue to use the same strategy once she starts to take an income.

Of course this approach may not produce better results than say a fixed asset split between different geographic regions and bonds, something like US/UK/Japan/Bonds split a quarter each, which is how I used to invest after reading The Intelligent Asset Allocator, but this TAA function is my very own invention and my ego demands that I use it.  In fact, I think if I ever get bored with the additional effort involved in value stock picking I may well just sit back and rebalance my TAA portfolio once a year and find other things to do with my time.

Valuing Markets

I’m a big fan of CAPE (cyclically adjusted price earnings) and Tobin’s Q as tools for understanding expected future risk and returns from a stock market.  After reading Wall Street Revalued: Imperfect Markets and Inept Central Bankers, I’m an even bigger fan. 

The logic is simple.  Market valuations must be tied in some way to earnings (the discounted cash flow that I hear so much about from earnings based investors).  Earnings for an entire market, over the long term, are somewhat predictable using past earnings.  These earnings are generated by assets and so market values are tied in some way to assets.  CAPE seeks to value markets using earnings and Tobin’s Q does it with asssets (or net assets to be more precise).

More important than valuing markets is the idea that higher valuations give lower expected returns for greater downside risk, while lower valuations give greater expected returns for lower downside risk.  Smithers uses a ‘hindsight’ value, the average returns over 1-30 years from any given point in history, to give some indicator as to what the returns were from that time.  This is overlaid with CAPE and Tobin’s Q, both of which would have provided investors with a pretty good guide to their expected future returns.

I invest some of my money passively, using a FTSE 100 ETF and a UK Bond ETF.  These valuation metrics have given me plenty of food for thought with regard to asset allocation.  Typically, using MPT (Modern Portfolio Theory – see The Intelligent Asset Allocator: How to Build Your Portfolio to Maximize Returns and Minimize Risk for a great explanation of this sort of investing) style asset allocation you’d allocate say 40% of you money to bonds and the rest to stocks, the idea being that stock outperform over the long term so you put more money in there.  Then each year you rebalance back to 40/60, e.g. if the stock market went down you might sell bonds to buy stocks which is good now that they’re cheaper.  However, MPT doesn’t really talk much about ‘cheap’ or ‘expensive’.  It’s more interested in risk (standard deviation) and returns and correlation between asset classes.  This is all well and good and very sensible but I like to know the value of what I’m investing in since I believe that markets and assets can be valued.

So without going into too much detail here I use a function to decide my bond allocation for me based on the value of the market using CAPE, or CAPE10 as I call it which instead of using the last 10 years real earnings in the P/E ratio it uses the average of the last 10 years 10 year real average earnings.  I then work out the long term average and see where the market currently is in relation to that long term average.  The lower the CAPE10 value the more I allocate to stocks, the higher the value the more I allocate to bonds.

The same kind of thinking can be applied to individual companies, and that’s basically how I do my value investing.

In a perfectly competitive market a company must be worth its net assets, or at least cannot be worth much more or much less for long.  If a company is earning so much that it is worth more than its assets then competitors would enter the market, replicating the successful company in order to achieve the same high earnings.  This added competition would decrease earnings and the company’s value.  If a company is earning so little that it is worth less than its assets then the owner would either sell the company in order to put his capital to work more effectively; fix the company so that its earnings improved and therefore its value; or if the particular market sector was affected by poor earnings a competitor may sell out thus reducing competition and increasing earnings and therefore the value of the company.

Of course in the real world it doesn’t work out like this given the time and effort and cost involved in both setting up, changing, or closing down a business.  But, on average, over the long haul, perhaps company valuations do mean revert to some typical multiple of their net assets.  Buying low price to book companies allows you to ride the mean reversion wave back to fair value.  On average, over the long term, of course.

Buying Assets and Financial Strength

Over the past 6 months I’ve worked on my approach to finding good investments and I think I’m quite happy for now. I started out just looking at price to book, which often gave me companies with lots of debt, i.e. Ennstone, which then fall over at the first sign of trouble. Then I looked at liquidation value and cash flow, to protect against such a failure. However, I’ve now simplified it so that I pretty much just look at liquidity (current and quick ratios) and debt to equity ratios. Once the companies are filtered by those criteria I just buy whatever is cheapest to book, with half book being the most I’ll pay.  The ratios I use aren’t set in stone, but they are ball parks to get me started and the amounts come from various texts as ‘reasonable’ amounts.

Ennstone teaches me an important lesson

I think it can be difficult to learn anything without actually living it. So handily Ennstone, my first purchase of a value stock using not much more than price to book, has fallen over into the abyss. This is good for a number of reasons, although of course not so good for the staff.

The collapse of Ennstone has helped me re-think my approach to value investing and most importantly helped me to clarify to myself what it means to me to invest at all.

Risk to Returns and Principle. I’m beginning to think that’s what it’s all about. For example, let’s say I have some money to invest, ignoring fees etc I could invest it in:

1. My matress – risk to principle of fire or theft, but no risk to income as there isn’t any.

2. A bank savings account – risk to principle is none as the government guarantees deposits, risk to the about 2-3% income is small and varies with interest rates.

3. Government bonds – no risk to principle and no risk to the about 4% income.

4. Corporate bonds – now here’s the first big risk to principle. If I give my money to a company where the assets don’t cover the debts then if the company goes bust I’ll only get back a fraction of my principle. In a worst case scenario I could get back nothing if assets are mostly intangible. The risk to income is if the company goes bust.

5. Company shares – Of course this can carry the greatest risk to both income and principle. A company can easily cancel income to shareholders, the dividend. You can also easily lose all you’re principle if the company goes bust since any fire sale of assets goes to bond holders first. Shareholders only get what, if anything, is left.

That fear of loosing the principle is where the net net or liquidation value approach to investing comes. If there’s enough assets to probably pay everyone back in the event the company fails then the risk to principle is as controlled as it can be for a shareholder. Unless of course you invest in large ‘moat’ companies that are unlikely to fail in your lifetime.

So my first investment rule, which I had been kind of using from a while back and which would have barred Ennstone from entry to my portfolio, is:

A company must be trading for less than the value of 100% of its current assets plus 0% of its fixed assets minus all debts, or 80% of it’s current assets plus 50% of it’s fixed assets minus all debts.

Both of those are reasonable estimates of the liquidation value of a company. Depending on the ratio of fixed to current assets sometimes one is higher than the other. If a company passes either test then I’m interested. However, a slight caveat is that I’ll also consider companies slightly above this level if the company is generating enough cash.

Once I think my principle is reasonably safe, I’ll look at the cash generated and returned to shareholders over the last 5 years. If the company returned 15% cash returns at the current price to shareholders and had cash flows greater than that (i.e. they weren’t paying out to shareholders more cash than they were making) then I’m interested. The 15% is a number I read that Mr Buffet was happy with, so if it’s good enough for him then it’s good enough for me.

So I end up with a company that has enough assets to privide me with some reasonable downside protection to my principle, and has historically returned 15% to shareholders over the last few years, my assumption being that the next 5 years will look something like the last few years. Without my crystal ball I cannot assume anything else.

At 15% returns most investors would love to own such a stock. The idea is that when confidence returns for this company then investors will pile in. Once Mr Market offers me a price such that I can buy more assets and earnings power elsewhere (perhaps if he offers double my purchase price) then I will sell. If no such offer arises then I’ll sit and hold hopefully getting my 15%. If I don’t even get that then I’ll sell out after 5 years and go panning for gold again.