UK Value Investor

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.

At the end of January my fund was down over 1% taking the rolling one year figure to 13%, slightly lagging the FTSE 100. 13% is down a long way in relation to the December one year figure (22%) but that’s due to what happened last January rather than in this one (last year’s was much better). 

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.

On January 6th I put 4% of the UKVI ‘aggressive’ fund (aggressive being a new term outlined here) into Armour Group at 7.46 pence.  The 4% came from existing cash from the sale of Victoria.  At the time Armour came top of the UKVI valuation table, with a ‘returns yield’ of about 40% and according to their web site “Armour Group is the UK’s leading consumer electronics group within the home and in-car communication and entertainment markets”.

The company trades on the AIM index, which I’m not so keen on as they have live outside of the tax haven of an ISA wrapper, so it’s not for those investors who only have money in an ISA, but I have a little bit outside the wrapper so that’s okay.

The key data are as follows:

ROE10 = 9.2%, ROE5 = 7.5%, ROE3 = 5%, P/B = 0.18, market cap = 5.3M

As is typical of many value investments, the trend in earnings is downward, but that’s fine as earnings mean reversion is one of the main causes of share mispricing.  Typically companies rebound faster and better than expected.

This leaves my cash position at about 14% which is spot on the current cash target.  The cash target for the ‘aggressive’ portfolio being half that used in the ‘defensive’ portfolio described in detail here.

As ever, please check out the trades, portfolio and performance pages. 

I’ve also added a new page for the new soon to be up and running Trade Alert membership service, which will allow interested parties to ‘mirror’ my trades.

697 days after first buying into Victoria PLC, I've let the old girl go.  During that time I gained 18% in total, which works out at about 9% annualised.  

Part 1 - The Benefits of Not Buying a Ferrari

I'm still here, I'm still investing, and I didn't buy a Ferrari.  This years take-away lesson for me was that sticking with the plan and not spending your savings are both Good Things To Do.

It's easy to talk about valuations, rebalancing, asset allocation, analyst projections and all the other stuff that private and professional investors love to bang on about.  But for me the most important thing is to just stay in the game and not get blown off track by the things that life throws at you.

Since selling my house in 2004 and 'lucking' into a sizeable chunk of capital, there have been an enormous number of things in the outside world that have wanted a slice of that money.  The two big chunks that escaped out of the ISA before I got serious about investing went into a Jaguar XK8 (which I had for two years and it lost about 20% a year - not a good investment even including the fun factor) and a franchise business for my wife (which has returned about 30% a year so far in a tough recession, so a somewhat better investment than the Jag).

Other than that I've fought off countless urges to spend the money on various enjoyable but ultimately goal-defeating items.  That is my main achievement for the year and hopefully that'll be a pattern that lasts into the distant future.

Part 2 - Cut the Crap, How Did The Portfolio Do?

Things were going okay until December which was crazy.  It produced a 12% gain which took the results for the year to over 22%, which is 10% clear of the iShares FTSE 100 ETF total return benchmark.  2010 is safely in the bag with results that were well worth the effort.

Relative to other small cap funds the results are not quite so impressive.  For example the Standard Life UK Smaller Companies fund managed 47% and on www.trustnet.com the smaller companies sector was up 30%.  In blog-land Mr Beddard over at Interactive Investor was up 27% and the amazing Running Capital managed 58%, although with a much higher work rate than my good lazy self.  Overall it seems to have been good times galore in the small cap camp.

Part 3 - 2011

2011 starts off with my recently changed strategy, although I hope the changes are evolutionary and not revolutionary as they like to say in F1.

There was a problem in mid to late 2010 where I think my fund under performed relative to some of my peers.  This was likely due to a feature of my old investing style where those companies that performed well (reached a price/book ratio of 1) were sold, while those that did poorly were kept on.  Eventually this led to a portfolio with an increasing proportion of weak businesses who were perhaps really not worth book value  (their average ROE10 was 5.7%).  A portfolio to deservedly cheap companies is not a good place to be.

To fix that I have changed my approach somewhat as detailed in recent posts.  A further tweak to those changes is that I will force myself at gunpoint to make one trade per month.  Each month I'll sell the least undervalued company (or use existing cash) and buy the most undervalued company in the market, by my measures.  If I hold twenty companies this should give an average holding period of twenty months, which is slap bang in the middle of the range where value shares outperform the wider market (citations needed but I don't have them to hand now - just take it as given that value shares don't out perform over 3 months and they don't outperform over 10 years, the sweet spot is somewere in between).

Following on from the last post where I quickly covered the sale of the old guard and their mighty balance sheets and weak earnings, below are the new entries that will carry me forward into 2011, along with the main metrics I currently use to generate a 'reasonable' valuation:

Company        ROE10  ROE5  ROE3  Avg   p/b
Barratt        14.3   7.3   1.8   7.8   0.25
AGA            9.2    7.8   5.4   7.5   0.42
Vislink        9.5    13.5  12.0  11.7  0.61
Airea          6.7    2.6   0.7   3.3   0.33
Belgravium     20.9   10.1  8.1   13.0  0.34
Tribal         7.3    7.5   7.8   7.5   0.25
Interserve     21.5   26.3  27.0  24.9  1.22
Flying Brands  25.7   22.2  21.5  23.1  1.33
Creston        7.5    11.2  11.2  10.0  0.55

As I'd expect, the companies that have produced the highest returns on equity generally have the highest market price for that equity, but the price/book ratios are still low and the combination of low price/book and relatively high ROE figures are where I hope to make my gains in 2011.

Part 4 - The Blog

I'd like to say thanks to all readers who comment in such measured and thoughtful ways, the blogging game would be a boring one without your input.  And to those that just read,  I doff my cap in your general direction repeatedly each day.

I hope 2011 serves you well.

As has become clear, my portfolio has undergone a major change from a collection of low price/tangible book, low earning companies to a growing collection of low price/book companies with far better earnings histories.

Using my new approach to valuation (which as ever is mostly stolen from the giants whose shoulders I am trying to stand upon), I found that most of what I owned was already 'overvalued'.

The list of the departed and their annual gains is as follows, some of which I've mentioned before:

Company              profit/loss    Holding days
J Smart Contractors  5.2%           403
M J Gleeson          34.2%          541
French Connection    15.7%          639
600 Group            4.2%           682
Northamber           31.2%          757
Mallett              -8.9%          785
Titon                47.7%          812
Averages             18.5%          660

Even though I've ended up selling these companies outside of my original system (which was to sell when the price/book ratio reached one, or after five years) I am happy, or perhaps lucky, with the average returns.

Currently my valuation method is in a bit of a flux, and there may be some movement beyond what I mentioned before.  The basics remain the use of historic ROE and price/book, but the ROE factor it is likely to be some combination of ROE10, 5, 3 and 1, all handily provided by sharelockholmes.

The companies above were re-valued either with ROE10 alone or the averages of the above averages (making averages of averages seems to be a compulsion of mine).  Taking the average of the averages gives around a 40% weighting to the current ROE, with gradually less for the prior years.  It makes some sense to me and in combination with less strict price/book entry criteria (I will now buy companies above book value and with negative tangible book values (!)) it certainly throws up a different sort of company to those I've held before.  I'll nail down the exact approach in the coming weeks or months.

I realise this move (from buying assets on the cheap with little or no thought for anything else, to paying much more attention to the earning power of the assets) represents a sizeable amount of style creep, which can be a very bad thing; but as long as you're creeping in the right direction I think it's justifiable.  I can only point my finger in Buffett's direction and say that if he did it, so can I.

As I said in the last post, the fact that earnings can impact company valuations has finally entered my brain and caused a cascade of activity in my once quite and peaceful fund.  The turmoil began with the the 600 Group.

I first bought 600 Group back in December 2008 when it was trading at a sizeable discount to tangible assets.  Gearing was low and liquidity was good and that was enough for me.

However, things move on and now I look at returns on equity as well as book value, gearing, liquidity, etc.  Over the longer term the ROE for this company are frankly appalling and the economic value of the company's assets is much less than their book value.  For example, ROE10 is -0.5%, ROE5 is -2.4% and the current ROE is -14.5%, none of which screams of success.

I realise of course that this is massively oversimplifying things, but unless you have a brain the size of a planet then pretty much any analysis you do is a massive simplification of reality.

So 600 Group departed with a total gain of 4.2% in almost 2 years, to be replaced with Barratt Developments.

Barratts is a very different company to what I've invested in before.  Yes it is trading below book and tangible book, it has reasonable debt and liquidity, but what makes it different is its size.  The market cap is £723 million and the net asset value is over £2 billion.  That puts it well outside of my usual small cap zone.  But in terms of what I'm buying I am much happier.  Price to book and tangible book are lower than with 600, but also ROE10 and ROE5 are better at 14.3% and 7.3% respectively, including the negative values of the last two years.

It is cheap for various reasons: the housing market, the economy, the recent rights issue, the level of debt they took on at the peak of the market, etc etc.  But as of now I think it has a good chance of outperforming over the next year or three.

And because everybody else seems to, I'm going to include a target price.  As of now my target price for Barratt Developments is 208p which, although it sounds a lot compared to the current price of 75p, is way below the previous zone of 250-800p in which it traded for much of the last decade.

Of course none of my feeble analysis means I will be better off with Barratts than I was with 600, but in terms of the kind of companies they represent (high earners versus low earners), I think I will be.