UK Value Investor

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:

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.

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 performance 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.

The UKVI fund was down 6.48% this month compared to our iShares FTSE 100 benchmark. This was due to a large 7.04% gain in the benchmark which completely trounced my holdings over this short period.  What upside we had was mostly thanks to French Connection and their sale of Nicole Farhi, which prompted a raft of activity from institutional owners perhaps helping the share to its 23% gain from last month. On the downside, Luminar continued to slide another 16% but now it is such a small part of the fund that any further losses will be barely noticeable overall.

The six monthly figures are not much better (down 3.4% relative to benchmark), but six months is too short a time to make any meaningful judgments on performance. The goal for the fund is to outperform the benchmark in any given five year period so I am not sweating the small stuff just yet.

Other events of note

M J Gleeson sold off their property maintenance and emergency respose unit, Powerminster. I have no idea how this sale to Morgan Sindall for £6.6M cash will affect things other than to give Gleeson a boost to their already huge £20M cash balance.

In addition to French Connection’s share price increase, the fund received its first FCUK dividend which puts their total realised returns at 1.1% which is 0.8% annualised. Not exactly Earth shattering but at least it is a start.

Victoria’s latest interim management statement said of their three geographic regions that Australia was good, the UK was bad and Ireland was ugly. In summary they said that;

Overall, the trading environment will continue to be challenging. However, the Group remains confident that it has a financially strong position, a solid and geographically diverse business model which is well positioned to support future growth when the markets in which it operates start to strengthen.

Notice the all important word, "when". The "when" may be sooner than with some other holdings as Victoria has a lot of exposure to Australia which may well return to boom long before the UK can even dream of such things.

Titon Holdings also produced an interim management statement but a much happier one than Victoria’s with revenues are up by 19%.  However, uncertainty and caution continue to loom large on the horizon and so the champagne remains on ice.

600 Group have just released their preliminary results for the year but I’ll leave any comment on that for next month, except to say that they are still making a loss overall, book value is down slightly but they at least made an operating profit in the second half.

How goes it for the market?

Currently the FTSE 100 has a real PE10 of about 12.7 which is slightly below my long term average estimate of 13.8. This is pretty close to a sensible value and if I were rebalancing an index tracker account between stocks and bonds today I’d put 72% into stocks.

And housing?

Some signs of weakness have started to appear, but as ever with the market that acts like a super tanker it may take a long time to find out which direction we’re headed. Currently the PE is still about 5.5 according to Nationwide, which is over 30% above my estimated sensible ceiling of 4.

A reader (link) recently asked me for a list of books that I’d recommend for other investors. Flattered that anyone would care what I though, I’ve decided to do a post on that very subject, and here it is. This is a list of the books and studies that have most influenced my thinking so far, both positively and negatively.

Secrets for Profit in Bull and Bear Markets (Stan Weinstein)

This is a book about technical analysis. I spent a short while trying to apply technical techniques and failed miserably. Of course this means I now think this approach is of no value.

How to Make Money in Stocks (William O’Neil)

Covers both technical and fundamental analysis, including things like earnings, new products, management, growth, that sort of thing. It also covers technical strategies to help time your purchase, like "buy on a new high from a properly formed base". I tried this approach for a while but found the chart aspects too ambiguous and too much work.

Various books by Jim Rogers of the Quantum Fund

I got into macro economic predictions for a while, playing the game that almost everybody else plays (which is why it’s such a bad game to get into). It didn’t take me long to see that this was either a game for short term traders or for people who wanted to bet on decade long themes... neither of which was me.

The Intelligent Asset Allocator (William Bernstein)

This book is awesome (dude). Just about everything I know now is down to this book. It very clearly lays out the ideas behind Modern Portfolio Theory and easily sold me on it since it requires almost no effort to apply. After reading this I adjusted my portfolio to a split between US, UK, European and Japanese index trackers and I think a bond tracker too. I’m still on the side of the efficient market to a large extent, certainly for people who don’t have an interest in stock picking. However, this book also covers bubbles in history and how markets may be predictable. It also talks about how value investing has the best long term results, how good companies are usually bad investments and bad companies are usually good investments.

The Intelligent Investor (Benjamin Graham)

I was moved to by this book because it is mentioned in The Intelligent Asset Allocator. This is my favorite investing book so far. It clearly demonstrates how the market swings from one extreme to another, extrapolating the last year’s earnings off into the distant future instead of taking them as part and parcel of any normal business cycle. I have the 1946 version and will at some point get the newest version to see what the differences are.

What Has Worked in Investing (Tweedy Browne)

This booklet is largely responsible for my current approach to value investing. The studies go over and over the idea that portfolios made up of low PE or low PB small companies are the best performers. It talks about debt levels (lower is often better) and past earnings growth (the more past earnings growth the less there is likely to be in the future and vice versa). It is a very compelling read if you like academic studies that are tested in the real world.

Time and The Payoff to Value Investing (Rousseau, Rensburg)

This study looks at high and low PE portfolios held over various time periods. "The conclusion is that on an annualised basis the returns to value portfolios become noticeably higher at time horizons extended beyond 12 months". In other words, value investors can take advantage of the short time horizon of the average investor by taking a longer view.

Corporate Turnaround (Stuart Slatter)

I guess by this point I’d invested in Ennstone and watched it crash into the ground like a dart. So understandably I became interested in what killed companies, what sort of thing you’d do to turn a company around and what sort of thing a turnaround specialist would be looking for in a company before he decided if it was doable or not. From my point of view this is important as I’m looking to invest in struggling companies which can quite often be classed as borderline turnarounds.

Financial Control (David Irwin)

This is a book for someone running a small business or doing the books for a small business (which I had recently become). I found it useful for learning about some accounting ratios, specifically balance sheet ratios like quick, current, credit and debt turnover rates, how long a company can survive without sales etc.

Testing Benjamin Graham’s Net Current Asset Value Strategy in London (Xiao, Arnold)

This is another study of low PB stocks, but in this case specifically the classic net-net Graham stocks. The results are compelling and motivating and possibly astounding. If you have the guts to invest all of your capital in perhaps less than 5 companies (see 1997), all of which are basket cases, then you are welcome to the excess returns and you’re a more brave than I.

Saying that, I still would like to set up a portfolio based on net-net stocks, but I’d mitigate the extreme risk by holding a portion in cash depending on the value of the overall market. That way when the market is cheap and there are more net-nets around you are more diversified and need less cash, but when the market is expensive and net-nets can be counted on one hand, you hold a lot of cash so even if they all blow up you aren’t burned too badly.

The Superinvestors of Graham-and-Doddsville (Warren Buffett)

A well written set of arguments against the efficient market and in favour of value investors (of course).

Wall Street Revalued (Andrew Smithers)

This book, along with The Intelligent Asset Allocator, is where I really formed my current ideas on the timing and valuation of markets. Smithers shows, as others have done, that sensible measures of value do exist for markets. It is therefore possible to say something about whether a market is over or under priced and by how much, at least relative to historic norms. This allows you to estimate expected future returns based on history and produce some nice bell curves. In the future you can compare these with the return distribution predicted by the standard model (a distribution that does not change over time as far as I’m aware, or at least does not change with market value) and see who was right.

The Snowball (Alice Schroeder)

Not really an investing book but it’s still a great read if you’re interested in Buffett and has a lot of ideas about investing and perhaps most importantly to me, the idea of building your snowball as early and as fast as you can. The most important factor in personal investing, orders of magnitude more important than investing style, is to start saving more money earlier, the more and the earlier the better.

Value Investing : The Use of Historical Financial Statement Information to Separate Winners From Losers (Piotroski)

Richard Beddard is a big user of the F-score (the subject of this paper) and it does seem to have some merit. I have started to integrate this into my screens and am also going to watch my current holdings to see if there is any evidence that high F-score companies turn around quicker than low F-score companies.

Determining Value (Richard Barker)

Finally, my chosen approach doesn’t really pay too much attention to things like discounted cash flows or dividend growth models etc. So I’m working through this book to gain a better perspective of how more mainstream value investors do their work and come up with their values. That way I’ll be able to have a more meaningful conversation with them and perhaps it will add to my understanding of value.

Well that’s one man’s journey from indexer to deep value, feel free to outline some other books that you’ve found useful in shaping your investing worldview.

Investing can be a bit like religion in that it requires a good dose of faith.  When you buy into a company it could be years before you get any feedback on whether it was a good idea or not.  In the mean time you just have to kneel before a picture of Ben Graham and say "I believe" before you go to bed each night.  The same goes for the portfolio as a whole where you might under perform a simple stock/bond split for what seems like an eternity. 

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.

Back to normal this month, with next to nothing going on this month other than volcanoes and general elections campaigns.  If you're interested, please check out the Current Holdings, Trade History and Benchmark pages for the most recent updates.


Current Holdings


Electronic Data Processing made me happy by paying out a small dividend after I'd sold them, bringing the annualised returns for that company to 20% during my brief period of ownership.  


The cash that I had left at the end of March went into Victoria, an existing holding.  I increased this holding because I didn't really want to add another new holding - I like to hold around 10 companies - and it was the cheapest by price to book of those companies where I didn't already have more than 10% of the portfolio invested.  On the downside I don't really rate Victoria's chances of being a big gainer as it hasn't traded much above its current price in the past - i.e. there is technical resistance - and it hasn't traded at book value for years and years, which doesn't bode well for my mean reversion theory.  However, who am I to say what the future holds?  Given that I think most analysts are as good at seeing the future as house bricks I ignored my own fears and upped the holding.


Benchmark


The benchmark figures this month are less ego boosting than last month, but at least they are not depressing.  Once I get some 6 month and 1 year figures I think I'll drop the 1 and 3 month comparisons from the table as I think 1 and 3 month benchmarking is for the short term traders.  Eventually I'll probably just do 1, 3 and 5 year comparisons to the FTSE 100, with 5 years being the important one.


FTSE 100 : 3.7% over my newly adjusted Fair Value


After my idiotic attempts to assign a 'fair value' to the FTSE 100 last month, the far more scrupulous blogger over at Retirement Investing Today pointed out that my assumption that the long run average CAPE is 16.4 (taken straight from Shiller's S&P data) is a bit too simplistic.  It is a fact that the UK markets typically have a lower PE than the US.  Since I have earnings data going back to 1993 I can only produce CAPE going back to 2002, which is only 8 years and a bit crummy.  By looking at how far the S&P's CAPE was over the long term average during the 1993 to 2010 period and extrapolating that onto the FTSE 100, gives an expected long therm average FTSE 100 CAPE of 11.2.  Once again the decimal point is probably going a bit too far.


IMO this is too low as I think the US markets were more over valued in the dot com bubble than in the UK, but of course that's my opinion and probably has no basis in fact.  However, I think it's not unreasonable to move my expected average FTSE 100 CAPE to 13.8, the midpoint of those two values.  On that basis I think the current fair value (i.e. the value that will give a future risk/return profile similar to the long term historic one) is 5,645. Given that it's 5,445 right now then I'd say it's only 3.7% overvalued, which in the big scheme of things is virtually nothing. 


House Prices : Still a crazy 37% over fair value


Grantham thinks the UK housing market is one of only two financial bubbles yet to pop.  Well, I think it popped two years ago, but the government has done an amazing job of patching up the hole.  That doesn't change the fact that the air supply is fading and the rubbing is wearing thin.  High oil prices may yet prove to be the needle once again.

March has been the busiest month at the UK Value Investor head offices (the spare bedroom) for a long time. There's been reports from Mallett and J Smart, a report and strategic review from French Connection (I love their new website) and dividends from Waterman, Gleeson, Northamber and Titon. Then there's the somewhat infamous purchase of Luminar, a company so scary it seems that almost no one will touch it.

Results

I've updated the Benchmark, Holdings and Trades pages so you can see how things have evolved since last month. The total book value is up by over 14% and the market value is up by just over 7%. This compares quite well with the benchmark FTSE 100 ETF, with over 13% out-performance over 3 months. However, I won't get too excited as that could vanish in no time. I'm looking forward to getting some 6 and 12 month comparisons which will be a bit more meaningful, and one thing to remember is that these 3 month figures are helped out somewhat as the portfolio was coming out of a bit of a lull a few months ago.

Annual and Interim Reports

French connection's latest report provided some information on their strategic review of how the management are going to turn things around. I don't really look into these sorts of things too deeply, preferring instead to leave the running of the company to the professionals. Book value was down slightly.

J Smart, the property investment and development company, said (via the Chairman) "There seems to be little prospect of an increase in turnover here over the next twelve months".  Book value was effectively unchanged.

As mentioned in the last post, Mallett's situation is improving somewhat and book value was down only a small amount.

Dividends

First up is the very large dividend from M J Gleeson (over £1,000).  Since they have basically shut the business down into hibernation mode to sleep out the recession, they've built up excess cash which they gave away in this dividend.  For now this is going to stay as cash although I expect to invest it somewhere more exciting during the month.