Category: Investment strategy

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.

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.

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.

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.