UK Value Investor

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.

Following on from my thoughts in the last post I've added Luminar to the portfolio.  Luminar run popular venues where people can meet, eat, drink and dance.  This is the first new holding in almost five months and it feels good to have a change at last.  Instead of funding this purchase with the dividend from Waterman as originally intended, I sold my holdings of Electronic Data Processing (EDP) and used the proceeds plus some cash.  The affect on the portfolio is to add about £20k to its book value since Luminar is so much cheaper, although as I said before I'd be surprised if that didn't come down again.

Sale review of EDP 
Electronic Data Processing is the largest IT solution provider to the UK independent builders and timber merchants market place.  I bought shares in EDP on the 28th of August 2009.  At that time I thought the book value was about £14 million, which put the price/book ratio at under 0.5 and well within my target range.  The rest of the structure of the balance sheet was good, current and quick ratios were fine and the company had net cash.  However, I failed to spot that a recent share buy-back had been used to return some £6 million of excess cash back to shareholders.  So in fact the price/book ratio was about 0.8, far above what I'm after and only with a 25% expected upside.

The sale of EDP had been on my mind for a while and really I was just waiting for something better to come along.  Recently the share price had climbed back in to profit so that was enough to make me back Luminar instead.  In terms of results, I made 6.6% after fees for an annual rate of about 12%.

Purchase review of Luminar

Luminar is very different to EDP.  The price to book is worryingly less than 0.2, although the price to tangible book is still cheap but more reasonable 0.4.  These will change soon though as one of Luminar's holdings has gone bust which is expected to wipe about £17 million from the book value.  Even with that factored in the valuations are good.  Less good is the tangible gearing which is right around my limit of 100%, but given that the margin of safety is so wide I think I can accept somewhat more gearing than I'd like.

I've limited the amount invested in Luminar so that the target sale value isn't too large.  In other words, if I put 10% (~£6,000) into Luminar and the price went up to give a price/book of 1, then the holding would be valued at about £35,000, which would be about 40% of the total portfolio.  Far more than I'd like in a single company... especially one as highly geared as Luminar.

Mallett Final Results

Mallett, one of the largest and most exclusive antique dealers in the world and one of my holdings since 2008, have produced their final results for the year.  While they still made a loss the general mood is more upbeat as the cash position has improved, turnover is up and the loss is smaller than last year.  As the chairman says, "we are only part of the way through the task of re-engineering Mallett's business model and cost base in order to align them with the demands of a rapidly evolving marketplace", which is becoming a familiar phrase around here. 

With the impending dividend payout from MJ Gleeson, I've been thinking about what to do with it. I mentioned at some point in the past that I wanted to hold more cash and bonds, using the CAPE10 based function I've posted about before. That function calculates my cash or bond holdings using the value of the FTSE 100 and is therefore suitable for portfolios where the stock holding is an index tracker following the FTSE 100. In fact that's exactly what I've used it for so far when annually re-balancing my wife's pension and currently the bond allocation is about 30%.

With a report titled "Restructuring to return French Connection to Profitability", the team at French Connection have start the real work of turning their fortunes around.  I'm not really a details sort of person, so the main points are that they are selling the Nicole Farhi brand and loss making stores internationally.  I hate to speculate about the future, but generally I'd say this is a good thing and the markets seem to agree as it's been up by over 10% today.


More importantly for me, the report comes attached to the preliminary results for the year ended 31 Jan 2010.  The sole point of interest here is that the book value of the company has changed from £83.2 million at the interim report to £72.3 million now.  The market cap is currently £43 million so it's still cheap by my simple metrics.  All in all I've lost a little book value but gained some market value, neither of which should make me jump for joy nor cry into my tea.  I wonder if they'll give me a discount on a new shirt?