UK Value Investor

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.

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.