Thursday, 24 December 2015

My Investment Mistakes of 2015

One of the reasons I love investing is that it is not just a battle against other intelligent, knowledgeable and committed people but a battle against yourself. Each of us have biases that prevent us from acting optimally and it is by knowing ourselves better and designing strategies to overcome these biases that we become better investors. It is in this spirit I offer, not a celebration of the 2015 successes or tips for 2016, but some of the mistakes I made this year:

Not being bold enough when the downside was negligible

On 12th August a company called Pure Wafer announced that they would return 140-145p to shareholders from an insurance payout related to a fire in the UK part of their business. The shares opened that day at 145p to buy, presumably due to generally poor market sentiment in August 2015. Given that the company still retained a profitable US trading business then it was highly unlikely the shares would be worth less than 145p. I used all of the spare cash in my dealing account to purchase shares and then turned to my spread betting account. However at this point I was not bold enough. Given that the downside was negligible I should have used all available margin to open a position however I was too cautious and only added a small amount. The shares rapidly rose to 165p that day as others realised the opportunity and following the sale of the trading business should return 188p in total to investors. The market rarely offers a free lunch but when it does you need to absolutely stuff yourself.

Thinking that buying the best companies in an industry with bad economics would protect the downside

One of the biggest investment themes of 2015 has been the rout of commodity prices and the impact on commodity producers. Although I’ve never liked commodity exposure as investment theme in itself there are certain attractions to owing oil companies. Their assets are easily analysed and assets that will be drilled or developed far in the future are often neglected in valuations giving opportunity to those with longer term investment horizons. As a contrarian investor I wanted exposure to the sector but to limit the downside should there be no medium term oil price recovery. Therefore I added shares like Ophir & Bowleven that had strategic assets and large cash holdings. Despite paying historically low prices and below cash in the case of Bowleven that didn’t stop prices falling as the oil price fell further. When a sector is seriously out of favour then everything gets sold. This maybe illogical and may be a good contrarian buy going forwards but the strategy of buying the cash rich oil companies didn’t in reality protect the downside in 2015.

Being too worried about the spread

The commodities rout has had a knock on impact into the oil services sector leaving a number of companies looking very cheap, at least on historic metrics. I’m always interested in extremely sold off shares and unlike oil exploration and production companies the service companies often have other subsidiaries unaffected by the oil price collapse. Two such companies that are on my watch list are Northbridge Industrial and Pressure Technologies. In both cases I was very close to buying, Northbridge quoted at 66p and Pressure Technologies quoted at 147p. In both cases I rejected the quote because I didn’t want to pay the full ask. Prices now are 89p for Northbridge and 192p for Pressure following trading statements or results that were not great but simply not as bad as the market feared. Sometimes it pays to pay up, especially when prices are already significantly depressed.

Failing to exit an investment going wrong quickly

On 17th March defence training specialist Pennant International reported their FY results. Although on the surface they seemed to be fairly positive a detailed reading of the figures suggested that they were struggling in a number of areas and were overly reliant on a few contracts. Since I was slow to do the full analysis the price had dropped from 98p to c.80p by the time that I had realised that things were not as rosy as they initially appeared and due (presumably to loss aversion) I didn’t sell. Today Pennant trades at 40p.

Exiting promotional shorts too soon

Nothing goes up 4-5x in a couple of months without significant amounts of ‘hot money’ being involved. Therefore when you see these sort of rises in story stocks they can make very good shorts. Particularly where there is some kind of share overhang on its way (e.g. a lockup period for a major holder ending) which will apply pressure to reverse the flow of hot money. The area that I have found most lucrative is companies that have entered into an equity swap financing deal like Amur Minerals or AFC Energy. These deals see the company raising funds by issuing shares to a company like Lanstead Capital but using that cash to enter into a swap agreement with Lanstead whereby the cash payment they receive each month depends on the share price. This leads to a strange mix of incentives. The management want the share price as high as possible but once it has risen the swap provider wants to sell as many shares as possible to fund their payments to the company and reduce the amount that they pay. Hence the spike up and the slow decline:

Amur Minerals

 AFC Energy

So what’s the mistake? In both cases having got good entry points (40p for Amur Minerals & 54p for AFC Energy) I closed the shorts far too soon (27p for Amur & 33p for AFC.) What went wrong was I started to fear the promote would push the shares higher and failed to believe my own analysis that said that the share overhang of the equity swap provider exiting would push the shares much lower and reverse the flow of hot money. Amur currently trades at 8p and AFC at 24p. It’s annoying to get the analysis right but not fully capture the resulting move.

Underestimating how foolish takeover buyers can be

In March 2015 the Australian law firm Slater & Gordon paid £640m for the legal services part of Quindell a company of which I was short. My analysis had shown that there were significant issues with the quality of Quindell's business and that without Slater & Gordon's intervention the group was likely to run out of cash. It seemed completely illogical that S&G would pay a significant premium of £640m for a business that was close to bankruptcy particularly since it would require significant debt and equity raise by S&G to fund it. As it turns out that my analysis was probably correct and Slater & Gordon have subsequent lost almost 90% of their value since the deal. What I got wrong was probably not the analysis but dismissing quite well sourced rumours that a deal had been done and then closing the short when the deal was announced. The rest of the Quindell business was of such poor quality that if I'd simply rode out the intitial deal spike I still would have made money on the short.

I’m sure I’ll make many more mistakes next year and despite these this year I made enough good decisions to generate an ok return. My aim however is not to repeat these particular ones.

Wishing you all a Happy Christmas! And may you only make new mistakes in 2016 too.

Saturday, 5 December 2015

Is Avanti Communications' equity worthless?

I originally wrote a version of this post on but thought worth re-jigging it on here to incorporate some further research and thoughts into one place.

Avanti (AVN.L) is a communications company operating satellites providing internet capacity to users who don’t have access to regular high speed internet capacity via broadband. Currently they have 4 operational satellites (ARTEMIS, HYLAS 1, HYLAS 2, HYLAS 2-B) with plans to launch 2 more in 2017 (HYLAS 3 & HYLAS 4).

Launching satellites is a capital intensive business. You spend hundreds of millions of dollars getting them into space with the expectation that they pay for themselves many times over in their c.15 year useful lifetime. The capital intensity combined with the long payback period makes Avanti a high risk investment. If the geographic areas they covered were to receive broadband access of high speed mobile internet then the demand for their services would decline rapidly or face severe pricing pressures. The investment case for Avanti very much depends on how rapidly they can sell their satellite capacity while retaining premium pricing. Any analysis of the company should focus on these factors.

They have been heavily loss making so far but promise rapid growth that will deliver profitability to the company in the future:

…management expects cash generation to grow swiftly as revenues exceed Avanti's largely fixed cost base.’ Q1 2016 Trading Statement

In order to judge their success we need to look at what are their sources of revenue. These are my understanding of the main categories of Avanti’s sales in order of declining quality:

  1. Data sales – these are really what Avanti is about selling internet data - they should be high margin and cash received under normal payment terms.
  2. Equipment sales – Avanti also provide the equipment for users to access their data services. Usually these will be paid in cash, again good quality but variable in nature.
  3. Project sales - where they are paid to do work for a client, good quality but usually non-recurring.
  4. Equipment sales where they are paid over a number of years - presumably they are intended to allow cash strapped customers to generate data sales they couldn't otherwise however these are particularly poor quality earnings since the revenue is booked in year 1 with the cash coming in much later and the risk of bad debt (of which they have had some.) Also since they are lending the money to the customers at about half of their cost of debt capital the longer the terms the worse the deal as Matthew Earl points out here:
  5. Spectrum sales - as far as I can tell these seem to be completely non-cash since there is no up-front payment to them and no accrual in the balance sheet. As Tom Winnifrith points out rather than generating cash for Avanti this ‘sale’ is costing them $13m cash over the next few years: . These sales are of such poor quality that it seems Winnifrith has written to the FRC to question it.

It would be great to be able to separate out the revenue and costs associated with data sales and equipment sales and analyse these separately but as far as I can tell Avanti have not provided these consistently. In the 2014 Annual Report they do break revenue out into $16.6m of equipment sales out of $65.6m total. They did the same in 2013 but in the 2015 Annual Report they only break out the $25.1m Spectrum ‘sales’. Also you have to read the notes to the Annual Reports to see these. They don’t seem to be broken out in the half year results or in the results RNS’s. Hence the analysis that follows excludes the non-cash sales of Spectrum Rights but assumes all other revenue is recurring.

Things were going well for Avanti until H1 2015 when revenue started to drop. (H1 2016 is estimated by doubling Q1 2016 revenue.)

This sort of drop off in revenue can mean one of two things. Either customers are using less of £AVN ’s services, or they are paying less for them. 

Not that you’d be able to see this revenue drop if you read Avanti’s management commentary. By careful choice of comparatives, last quarter vs same quarter in the previous year, and including exceptionals in the reporting period and excluding them in the comparative period they have managed to give the appearance of rapid revenue growth in a period when revenue has been dropping half on half:

Let’s look at some of the comments relating to utilization and pricing:

‘Average Fleet Utilisation was at the upper end of the 20% to 25% range during the period’ Q1 2016 Trading Statement

‘Avanti's average pricing remained stable.’ Q1 2016 Trading Statement

‘This was lower than Avanti's prevailing run rate of growth, due to a larger amount of equipment and government revenue in the previous year, which, although recurring, tends to be recognised on a non-linear basis.’ Q1 2016 Trading Statement

‘Avanti's Fleet Utilisation was within the 20% to 25% band at the end of 2015, having increased from the 10% to 15% range in the prior year.’ 2015 FY Results

Based on these comments I’ve added estimate of the utilisation to the revenue graph:
So it seems that data rates are stable but customers are paying less for £AVN’s equipment or value added services meaning that rapidly increasing utilisation is not turning into increasing revenue.

So if we are conservative and assume that Q1 2016 had very little equipment sales and was mostly data revenue what is interesting is to scale up the Q1 2016 revenue to get the maximum theoretical revenue at full utilisation as Avanti suggest we do in their 2015 annual report:

If we take 23% as ‘the upper end of the 20% to 25% range’ then based on the Q1 2016 revenue of $13.6m at the current pricing the maximum theoretical revenue of the existing satellites is $238m a year.
So how fixed are those costs? The accounts split costs into 3 categories:
1.   ‘Satellite Depreciation’ we will ignore for now as a non-cash cost.

2.   Operating Expenses do appear to be largely fixed costs running at $35m pa for the last couple of years. If anything these will increase slightly as Avanti state ‘There will be a modest increase in costs in 2016 as further investments are made in sales and marketing and ground operations ahead of the launches of HYLAS 3 and HYLAS 4.’ Annual Report 2015

3.     Cost of Sales however do not appear to be fixed as an absolute value but as a percentage of revenue of c.60%. I had expected the gross margin to increase as data sales made up a greater proportion of revenue however there is little sign of this in the numbers. Given that COS as a % of revenue are around 60% when revenue is $7m or $40m then it would seem a reasonable figure to take for COS as a percentage of $238m revenue = $143m.
So at full utilisation the current satellites will generate OCF of $238m – $143m – $35m = $60m.
However Avanti has c.$640m of debt accruing interest at 10%pa = $64m/year interest which means even at full utilisation the current satellites would generate a cash loss of $4m/year. Given these sums it is somewhat surprising that the Avanti share price reacted positively to the Q1 2016 results, although it has since fallen back to below previous levels.

Avanti have $219m of cash on hand so can manage an extended period of high negative cash flow however the majority of that cash is committed to the development and launch costs of HYLAS 3 & 4. This means that although I don’t think the committed cash should be included in a valuation it is also wrong to exclude the future potential revenue from HYLAS 3 & 4 when they are launched in 2017.
In order to work out what the impact of the valuation implied by the $13.7m Q1 revenue and 'upper end of the 20% to 25% range’ for utilisation we need an NPV. To do this we always need to make some assumptions, here are mine:

1.      As previously stated Avanti don’t consistently break out data revenue and equipment revenue so I have to assume that these move roughly in step.

2.     Maximum Revenue is assumed to be proportional to capacity in GHz with ARTEMIS, HYLAS 1 & HYLAS 2 adding up to the $238m current max revenue at full utilisation. The revenue capacity of HYLAS 2-B, HYLAS 3 & HYLAS 4 are proportional to their capacity.

3.     Avanti depreciate satellites over 15 years which is meant to be there useful life. Therefore I assume they generate no revenue 16 years after launch. This looks like:

4.       Cost of Sales remain at 60% of revenue. Admin Expenses at $35m pa and debt interest at $64m pa.

5.       Utilisation increases 10% each year to reach full utilisation at 100%.

An NPV is only as good as its assumptions of course but with these (that could be considered aggressive in some areas e.g. 10% discount factor when the debt is yielding 10%, they are funding with debt & equity and equity holders are taking more risk) yields an NPV10 of only $480m – considerably less than the outstanding debt:

With the current 182p share price you have a market cap of c.$400m and an EV post capex of c$1.0b vs a $480m valuation.
Of course this analysis ignores revenue from any future satellites Avanti may develop & launch. The reason is that these would have to be funded via further debt and/or equity. In lieu of this I have excluded satellite depreciation. With these assumptions Avanti would be FCF positive in 2019 however not earnings positive until 2021 or later with depreciation charged to the income statement. Note that the senior secured notes are due in 2019. Since Avanti will not be able to repay these from cash flow they will be reliant on credit markets at the time to refinance this debt.

Assuming they can increase the utilisation more rapidly at 20% pa to reach full capacity then the NPV10 increases to c$840m. More than the debt but still makes the equity significantly overvalued. Add in an extended life of each the satellites for 5 years at full capacity in addition to the rapid utilisation and you still get an NPV10 at a discount to current EV.
In conclusion, unless Avanti can rapidly increase capacity utilisation much faster than they have done in the past or if they can generate significantly higher pricing & margins then the equity could well be worthless. That Avanti’s management seems to prefer finding creative ways of giving the appearance of growth in their commentary rather than actually driving the business to create this growth, gives me little confidence that they will deliver improved growth or margins in the future.

Disclosure: Since the current equity valuation seems to be pricing highly optimistic scenarios for both pricing and utilisation that I believe to be unrealistic based on the performance of the company over the past 2 years I am currently short the equity.

Saturday, 7 November 2015

Using Short Interest Data to Make Better Investment Decisions

Shorting individual stocks is a hard game. Investors who do so face high costs to borrow the stock, bear the risk of unlimited losses, and are rarely popular amongst the mainly long-only investment community. To be a successful shorter you generally have to be an excellent analyst, a good trader and most importantly be right.

In the UK since 1st November 2012 there have been disclosure requirements in place that require anyone short more than 0.5% of the outstanding share capital of a company to declare this.

The Financial Conduct Authority provides a daily spreadsheet with these details. Originally I used to download and manipulate the data in Excel but very helpfully Castellain Capital has provided a website that does it for you:

Given that short funds tend to be ‘smart money’ how much notice should you take of a large short interest in a stock?

Firstly it is important to check for corporate actions – there are many funds that are involved with takeover arbitrage. This strategy involves assessing the likelihood of a takeover going ahead and judging if the market has mispriced this. A typical position to take account of a mispricing is to go long the acquired company and short the acquirer. So if the company you are interested in has announced a takeover of another and this hasn’t been fully priced into the market expect short positions to increase.

The second thing to look for is the presence of convertible bonds issued by the company. These are often used for a volatility arbitrage strategy called delta hedging. This strategy requires the trader to be short the equity of the convertible. Hence if a stock has a large convertible bond you can expect a large short position to be declared.

If you have either of these cases a declared short position is nothing to be concerned about since they are related to strategies that don’t require the equity to fall in value to profit.

Also seeing ‘Quant funds’ declaring a short is not usually that concerning since they are not doing research into specific companies but buying and selling a very wide portfolio of stocks based on certain factors (value, momentum) that have historically delivered over/under-performance. By buying a stock with a quant-based short you are of course buying something that is either in a medium term downtrend or looks expensive on typical value metrics like P/E. This should act as a warning sign but if you are a value investor buying a bombed out stock and can explain why it may appear expensive on typical value metrics but is indeed undervalued this shouldn’t deter you. A good example here would be an oil explorer that has fallen in response to the drop in oil price. It may have no earnings and a high price-to-book but still hold a very valuable oil asset. Of course you have to be sure that there is a clear route to monetisation of that asset through sale or development that remains viable in a low oil price environment. If you have done a solid valuation based on conservative assumptions then a quant fund declared short shouldn’t put you off since it is unlikely that they have done a similar analysis.

After you’ve ruled out corporate actions and convertible bonds then the presence of discretionary stock picking funds that are short should be a big red flag. Given the inherent risks of short-selling those funds also tend to share research and be activist – through publishing reports or going on financial TV to explain their negative views. Therefore if you see a large increase in a declared short position it should act as a very strong signal to be wary – negative news is likely to be on the way.

Given the breadth of companies available to an investor to allocate their capital to, one may simply want to avoid these companies. However, although I take increasing discretionary short interest very seriously, short sellers still suffer from the same biases as the rest of us. It is my experience (although I cannot prove this with objective data) that short sellers sometimes get it wrong on individual companies when they engage in sector or ‘story’ shorts. This is where they take a sector view like ‘oil is going down’ or ‘The UK High Street is Dead.’ These investment theories may be well founded but their implementation will never be perfect when expressed through individual stocks. Therefore where you see high short interest around a particular sector like UK Supermarkets but your analysis shows that one of the companies in that sector is significantly undervalued due to the unique nature of the business then that can be an opportunity. If your investment thesis proves to be correct then you will get very handsome returns since you have short funds who will become large buyers of the stock as the company releases positive trading results and the price rises.

An example of this at the moment I believe is Home Retail the owner of Argos & Homebase which (as of 6th November 2015) has an 8.9% declared short interest according to:

Why do I think the short funds are wrong?

Firstly they have got it wrong in the past. Looking at the history of Home Retail’s short interest, it peaked at 15% in Jan 13 when the share price was c£1.20 and dropped to its lowest point around mid 2014 when the share price was £2+. The nature of these businesses has not changed significantly since this period and the progress to an increasing digital store portfolio is significantly more advanced today than it was in 2014.

Why might they be short?

This is where the story comes in. The UK high street has serious structural problems. Retail is increasingly moving online. The historic high cost rents of the high street are a drag on profits compared to an internet retailer like Amazon.

What might they have the missed?

  •  Argos is the UK’s second biggest internet retailer behind Amazon ( I doubt many hedge fund managers shop at Argos but plenty of people do.
  •  Like most retailers they are highly cash generative and run negative working capital so funding growth is easy. They are currently investing in digital stores and same-day delivery infrastructure. Very few companies will have the range and infrastructure to be able to offer same day service. Amazon are just starting this to so if this is a unique value proposition for people then this may end up like a duopoly with only Amazon & Argos with the scale, range and delivery infrastructure to offer this. They have cash on their balance sheet t
  • They own their own credit book – that is money they have lent to customers to buy from them. This isn’t the highest quality of credit, they have taken provisions against bad debt of 10.1% of the loan book, however net of provisions this is still worth £550m. This is an asset that could be sold off or securitised. This may not be the best thing for the business as a whole since they use this for promotional activity (interest free credit etc.) however it remains an asset that could be sold to fund investment or simply return cash to shareholders.
This of course is not an exhaustive analysis, there are some negatives like a pension deficit and some onerous rent provisions and given the level of short interest one would want to do a thorough analysis. However given the £0.9b market cap and netting off the £550m financial services loan book you are not paying much for the underlying business – and that in my opinion makes it worthy of further investigation.

Tuesday, 3 November 2015

Should you average down or up?

One of the most contentious topics in investing seems to be the issue of whether you should average up or average down. That is whether you should consistently add to a winning position or add to a losing position. Great investors hold strong and often contradictory stances on this topic and their views are widely quoted. E.g.

We like to buy stocks which we feel are undervalued and then we have to have the guts to buy more when they go down. Walter Schloss

‘Always sell what shows you a loss and keep what shows you a profit’. Livermore

...a price drop [is] as an opportunity to load up on bargains from amongst your worst performers…a price drop in a good stock is only a tragedy if you sell at that price and never buy more. Peter Lynch

Don’t garden by digging up the flowers and watering the weeds. Warren Buffet

One of the mistakes investors can make when reading these quotes is to read these as strict rules. They often miss the caveats contained within them. For Schloss averaging down has to be in something still ‘undervalued.’ Lynch says a price drop in ‘a good stock’ is an opportunity not a price drop per se. Knowing Buffett’s strong focus on the performance of a business not the market price I’m sure his ‘flowers’ are well performing businesses with good economics and his ‘weeds’ are badly performing businesses. I doubt any of these investors are recommending taking action purely on price action alone yet often we interpret them as such.

The other issue with saying one is ‘averaging down’ or ‘averaging up’ is it suggests that your current average buy price matters. It does not. To the fully rational investor a historic trade price is completely irrelevant. A rational investors asks themselves ‘given all current information do I have the right position size in relation to the risks and potential return?’ not ‘should I average up or average down?’ (See my blog post on portfolio optimisation)

Rules like ‘never average down on a losing position’ can be used to try to overcome behavioural biases like loss aversion but they should be recognised for what they are – an attempt to overcome one’s personal bias – not a general investing rule that everyone should follow. Rules can be very useful way of addressing behavioural biases (see: my blog post on portfolio rules) But for a rule to be relevant then it must address a bias that has led to past under-performance. If you have a tendency not to recognise when the fundamental investment case has significantly deteriorated and have a history of adding to positions that never bounce back then set a ‘don’t average down’ rule. If you have a habit of being overconfident and over-sizing your winning positions then set a ‘no averaging up’ rule.

For everyone else simply optimise your portfolio regularly based on the latest information available and forget what the average buy prices of your portfolio constituents are.

Monday, 31 August 2015

Are financial discussion sites dangerous for our wealth?

There are many investment websites where private investors and market professionals discuss potential investment ideas. Seeking Alpha, The Motley Fool, Stockopedia and ADVFN are just a few of the ones I regularly read. They can often be a fantastic source of knowledge, wisdom and experience as contributors from all walks of life freely discuss their investment ideas and strategies. When you add in Blogs & Twitter there are a myriad of ways to read or share investment ideas. While there are undoubtedly some misleading contributions from people who manipulate information for their own ends, in my experience most people who post do so out of a genuine desire to gain and share knowledge. And experience teaches you to spot those whose opinion could be questionable.

So why do I think discussion boards have the power to lead us to poor investment decisions? Primarily because contributors to these sites make very public statements about their opinions and psychology teaches us that once we’ve done that we find it very hard to change our minds on a subject even when the facts change.

The desire to appear consistent is a very powerful psychological effect. Robert Cialdini explains this in his excellent book, Influence: The hidden power of persuasion. He describes how getting people to agree to and write down statements was used to great affect by the Chinese Army on American POW’s in the Korean War. The Chinese would start by asking a POW to agree to a simple statement such as ‘America is not perfect.’ Since this was undoubtedly a true statement as far as the majority of POW’s were concerned then complying with this request wouldn’t have seemed a big deal. However once they had written the statement the POW’s would be asked to write a list of ways in which America is not perfect. Once they had agreed in writing that ‘America is not perfect’ it became very hard not to comply with the second request and add some details. This list would then maybe read out on the camp radio with their name making the public commitment complete. Compared to the harsh conditions of the Korean POW camps the Chinese camps were far more effective at getting prisoner compliance. Breakouts were very rare and given their public statements of compliance POW’s often turned in fellow countrymen for minor rewards such as a small bag of rice.

Psychology researchers replicated this effect in a kinder setting in an experiment conducted in California. They approached households and asked if they would mind displaying a small sign on their lawn asking passing drivers to ‘drive carefully’. Since careful driving in their neighbourhood was a public good that all householders were interested in and the signs were not particularly disruptive it’s not surprising most of those approached agreed to display the small sign. The power of the desire to be consistent with one’s former actions was shown two weeks later when the researchers returned to ask if the householders would mind displaying a much larger and uglier ‘Drive Carefully’ sign that they’d mocked up in a brochure. Here over 50% of householders who’d displayed the smaller sign agreed to display the larger sign compared to less than 20%  in the ‘control group’ of householders who were not first approached to display the smaller sign. That’s a big change in average behaviour from a small public commitment.

The power of public commitment can be a useful aide when trying to do more exercise or give up smoking. However when it comes to the complex and rapidly changing environment of investing being fixed in one’s opinion is rarely good. Once we publically take a position, like a positive write-up of a company on a website, it becomes much harder not to commit further by buying shares or increasing a position. And much harder to sell a position for which we’d previously made positive public statements.

I sometimes I find this effect even manifests itself in the amount of research I do. The more I research a company the more I want to appear consistent to myself that the hours of work are worth it, the more likely I am to find justifications why this is a good buy (or sell) and more likely to take a position. Then given the amount of research done I’m more likely to share this publically and compound the effect.

And the most worrying thing about the ‘consistency’ effect is that we may be completely unaware of its influence on us. The same researchers who did the initial experiment with the 'drive carefully' sign repeated it but rather than using the small sign as the initial influencing factor they asked residents to sign a petition agreeing with ‘keeping California beautiful.’ Surprisingly this, effectively nonsense petition, had the same effect as the small sign in activating the residents’ sense of civic duty and led them to accept the large ‘drive carefully’ sign in almost a similar proportion. But more assiduously, whereas maybe some of the participants in the initial study may have thought ‘hang on a minute, I’m only accepting this large sign because I accepted the small one two weeks ago’ in this case I would imagine very few people made the link between accepting the large sign and the petition they signed a few weeks ago. Yet the evidence is that it was a significant influencing factor for many of them.

Sharing research and investment ideas can be a key part of getting feedback and improving your investment skills as well as being part of an active part of an online community. However next time you make a public statement about the investment merits of a particular share it’s worth thinking in advance of what events would cause you to change your mind and sell (or cover a short.) Even better write them down, so you have made a public commitment to yourself to change your mind if the facts change and you’ll at least want to appear consistent to yourself with that.

Monday, 17 August 2015

The Dividend Fallacy

The dividend fallacy usually goes something like this:

“Reinvested dividends make up the bulk of long-term equity returns. Therefore you should invest in high yield shares.”

For obvious reasons the fallacy is most prevalent amongst those private investors or fund managers who practice high yield or income investing.

Let’s see where this argument goes wrong:

Fallacy 1 - Reinvested dividends make up the bulk of long-term equity returns.

This usually comes from studies comparing the market returns with and without re-invested dividends. E.g.

“One hundred pounds invested in equities at the end of 1899 would be worth just £168 in real terms without the reinvestment of dividend income, but with reinvestment the portfolio would have grown to £24,184.” Barclays Equity Gilt Study 2013

Of course these are not comparing like with like. In the first case you would have had the dividends in your pocket to spend or invest in other assets. In fact if you had another asset class that produced superior long term returns to equities and re-invested your dividends there you would have more money than £24,184. The reason that the comparison is so striking is that equities have been pretty much the best performing asset class to re-invest into (at least in most western countries.)

When you breakdown the Barclays return figures together with their cost of living index into compound annual growth rates they look something like this:

Real Return with Reinvested Dividends                                  5.0%    (A)
Inflation Average                                                                      3 .9%   (B)
Nominal return with Reinvested Dividends                              8.9%    (A) + (B)
Real Capital Return                                                                 0.5%    (C)
Nominal Capital Return without Re-invested Dividends         4.4%    (B) + (C)
From which you deduce the Average Dividend Yield was      4.5%.   (A) – (C)

People then erroneously compare the dividend yield to the real capital return and conclude that re-invested dividends are the major source of return. This comparison artificially separates out the components of compound growth and arbitrarily to applies the compound inflation to the compound capital gains. The re-invested dividends are done so at the nominal price of the index at the time so are subsequently compounded at the nominal rate not the real rate. Simply reversing the logic and applying the inflation to income would show that reinvesting dividends in a market without capital growth would lead to very low real returns and therefore capital gains were the driver of the bulk of returns.

The truth is that both dividends and capital gains are roughly equal in their contribution to equity returns at 4.4% for capital and 4.5% for income. The real return an investor receives is then reduced by inflation that has averaged 3.9% since 1899. This should hardly come as a surprise since the dividend payout ratio has been close to an average of 50% during the last century.

Fallacy 2 - Therefore you should invest in high yield shares.

The second fallacy is assuming that the impact of re-invested dividends on the returns of the whole market says anything about the performance of high vs. low yield shares within that market. To make statements about the relative performance of subsets of the equity markets you need empirical evidence.

In ‘Contrarian Investment Strategies’ David Dremen did these studies for the largest 1500 companies in the US Compustat database from 1970 to 1996 and the results are as follows:

The market total return was 15.1% CAGR over that period. So you can see that sorting by dividend yield does provide out-performance but it is the weakest of the metrics studied. If you want to implement a simple factor based strategy then you are better off using one of the others.

Dividends Redeemed

So you may be thinking that I don’t like dividends. Far from it. Used correctly I think dividends can have an important part to play in one’s investment strategy:

  • Paying a dividend enforces capital discipline on management. Since management know the impact that a dividend cut will have on their share price (and therefore the value of their options) then they really need to make sure the business earns the cash to pay it. They are less incentivised to pursue vanity acquisitions or take unnecessary investment risks.

  • Dividends provide effective signalling of the true opinion of management. A management that provide a cautious outlook but a big dividend increase are usually practicing ‘under-promise & over-deliver’. A management that talk up the company results but hold the dividend could well be ‘travelling hopefully.’ 

Here’s an example of this signalling. In March 2009 a UK company called Interserve (LSE:IRV) issued their 2008 results with the following management commentary:

"2008 was another successful year for Interserve. Whilst the Group is not immune to the current economic challenges, with a solid UK position, continued opportunities in the Middle East, a record order book, strong visibility and a robust balance sheet we believe that the Group's operations are well placed to deliver another year of progress." 

Having traded around the £5 level in March 2008 the shares were trading at around £2 when these results were released and the failure of Lehman Brothers had rocked the financial markets and the Western economies were in a deep recession. Given the uncertainty in the markets and that they were trading at a historic yield of 8.1% no investor would have been disappointed if Interserve had preserved cash and held their final dividend. However they chose to back their cautiously optimistic statement by increasing their dividend by 4.9% giving an 8.5% yield. I took this as a strong signal that things were not as bad as the market feared. This proved to be correct as they continued to increase their dividend and led to substantial gains over the next few years.

  • Focussing on income and not capital value can instil a very long investment timeframe in investors. Having a longer investment horizon is one of the only true competitive advantages that private investors have so this can add significant value to one’s decision-making. Even within fund management, income funds can be a good choice for those who don’t have the time and skills to invest directly. The reason is that these funds are also likely to be long-term focussed, attract long-term investors and avoid high fees or closet index-tracking. I.e. they simply make fewer mistakes than the average fund manager.

So used correctly dividends can be an important part of an investor's tool-kit. They provide a measure of management quality, a strong indication of the true performance of the business and a check on our behavioural biases. But only if we leave behind the dogma that reinvested dividends make up the bulk of long-term equity returns and that this makes dividend strategies fundamentally superior to all others.

Tuesday, 11 August 2015

Portfolio Construction - Holding Too Much Cash?

In part two of my series on improving portfolio construction I raised the issue of why would you hold any asset that has a low return. The corollary of this is that why would you hold significant portion of your assets in the low risk but low return cash?

The average private investor holds quite a lot of cash. The AAII asset allocation survey puts the average at 24% over the last 30 years. Given that the average equity fund held just 3.5% in cash and both equities & bonds have outperformed cash over most long periods Cullen Roche makes the argument that this is one of the main reasons that private investors underperform their professional equivalents:

Now a sensible investor will of course have cash holdings for any short and medium-term expenses and will only invest long-term in the stock market. However the AAII survey is looking at investors dealing accounts so this is primarily cash that is looking for an investment home but not found one.

So why do private investors tend to hold so much cash? Cullen Roche suggests that this is short-term thinking with investors (over-) valuing the certainty of large cash holdings. While I’m sure this is true I think there is a subtler effect at play here as well. When you ask investors why they hold cash it is usually to take advantage of market weakness.

We feel clever when the market sells off and we are holding a lot of cash and dumb when we are fully invested!

While the aim is laudable we pay a high price for this feeling. The problem is that the average investor is very bad at calling the short time direction of the market. They spot too many crises and sell up too often. A problem originating from our history as hunter-gatherers. If you spotted an imaginary tiger in the jungle and ran away the consequences were a bit of unnecessary spent energy. However if you failed to spot a real tiger the consequences for you would be very severe. Hence we tend to see tigers in the market far more often than they actually appear.

Then compounding this error we succumb to fear and fail to actually buy on real market weakness. A number of investors spotted the 2008 financial crisis, realised its severity, and sold all their equities. However it's a much smaller number who then spotted that the market was historically cheap in the spring of 2009 and reinvested. There are many who missed out on the early rises and never got back in. Given that the FTSE total return index has returned c.40% since end of 2007 and cash has paid virtually zero in this time even these most prescient of investors may have been better off simply remaining fully invested.

I think the only time that one should hold a significant proportion of cash is when one cannot find any investments that are potentially undervalued with a margin of safety. Given the cyclical nature of the most industries and market sectors it is rare to find a time that the overall market valuation provides no scope for investment opportunities. I'm not saying that the indices are always a buy just that if you are a stock picker you should be deploying your capital into undervalued stocks not holding large amounts of cash hoping for a market crash.

And while having some cash on hand to take advantage of market weakness can be a good strategy it only works if you have the mental strength to deploy it when the market does sell off. So if you are holding a large amount of cash you should ask yourself if you have a good record of identifying when assets are over-priced? And do you have a good track record of actually deploying that capital quickly on market weakness? Unless you can answer both questions positively you may be better off simply remaining fully invested and heeding the old adage that it’s time in the market not timing the market that really pays off.

Saturday, 8 August 2015

Portfolio Construction Part 3 – Rule Your Portfolio

In my first two posts (Part 1 - Diversification, Diworsification?, Part 2 - The Matrix Revolution) I looked at how to determine the correct diversification level for your portfolio and a way to simply but optimally weight those assets. In the last part of this trilogy I will look at some simple rules that can help avoid behavioural biases creeping into our portfolios.

When you get to see the portfolios of most private investors they usually look something like this (based on a real world example from the web):

ABC 19.45%
BCD 12.37%
CDE 9.35%
DEF 6.58%
EFG 6.29%
FGH 5.97%
GHI 3.22%
HIJ 3.01%
IJK 2.90%
JKL 2.83%
KLM 2.74%
LMN 2.47%
NOP 2.45%
OPQ 2.20%
PQR 2.17%
QRS 2.12%
RST 1.95%
STU 1.89%
TUV 1.81%
UVW 1.49%
VWX 1.41%
XWY 1.14%
WYZ 1.12%
YZA 0.86%
ZAB 0.73%
CBA 0.64%
DCB 0.45%
EDC 0.39%

At 28 positions the diversification level is probably about right for an active stock-picker, however note the one or two large positions combined with a tail of very small positions

The Large Positions

Usually the large positions are the investor’s past big winners. I looked at asset weighting in part two and one of the key takeaways was that the largest positions should only be the investment ideas you believe to have the best return potential and the lowest risk. It is always worth re-evaluating your biggest positions to check that they really do match these criteria. Asking yourself the question ‘if I was forced to sell today would I seek to buy back in the same size as soon as possible?’ often helps understand if you have your position-sizing correct. Given the impact on your performance those largest positions will have it is worth setting aside a regular time to do this.

Employer Positions

The other common reason for people having a large holding as a percentage of portfolio is that they are the shares of their employer received through a share-save scheme or similar. I mentioned this briefly in part one. Sharesave or option schemes that allow one to own shares in one’s employer at a discount or without risk at the time of purchase can be a great deal. If you are a director of the company and can assess and influence the competitive strategy of the business it makes sense (and is often expected) to hold onto a significant proportion of these shares. However when you don’t have board level influence the shares should be treated just like any other investment. This means, for example, following the principles of portfolio weighting I discussed in part two. One of the risks I mentioned in that piece was correlation risk, the common exposure stocks have to factors that are out of your control. When it comes to your employer this risk is almost always large not because of the correlation with other stocks but the correlation with your salary. When your employer is performing and growing strongly you are more likely to get pay rises, bonuses or be promoted. Conversely when the business is struggling you are more likely to be made redundant. Your economic exposure to your employer is large whether you own shares or not. It pays to include this factor in your portfolio decision making process.

The Small Positions

The small positions usually have only one characteristic - they are the past losers. Once a shareholding is below a certain size it has very little influence on the future returns of your portfolio. A 0.5% holding would have to double to have the same influence as the normal daily noise movements of a 10% holding. So why do we end up with these holdings? I believe this is primarily loss aversion. We prefer the hope of a future gain no matter how unlikely or inconsequential to taking a definite loss today. One of my favourite examples of the loss aversion comes from the book ‘Beyond Fear & Greed’ by Hersh Schefrin summarised below:

Loss Aversion in a Real Estate Deal

Bill & his wife are in their early thirties and have just had their first child. A good friend, Jim, has been successful at investing in real estate deals for a few years suggests that they join him in his next deal. They put in all their $27.5k savings and borrow $75k to fund their half of a parcel of land which will be split into lots for housing and sold off, hopefully for a good return. Given the interest on the loan this investment is cash flow negative for Bill & his wife.

Some time passes and the land sales are not progressing as rapidly as Jim had hoped so he decides to put up a model home on the land. A year later the model home has been built and sold but has not generated more interest in the rest of the land. At this point James, feeling bad that he had got his friends into this, offers to take on their share of the deal. This would mean that Bill & his wife would lose their $27k but avoid any further losses from the loan financed on the land. Despite little experience of real estate investment and the real prospect of further cash outflows on the deal, being loss averse they declined the offer. Over the next few years James offered to buy them out but in each case they preferred the hope of a future gain to taking a definite loss today.

Now in the mean-time Bill became an elected official. At this point his future earning potential is so high that he shouldn’t rally care about $27.5k loss but being loss averse he does and allocates one of his aides to manage the real estate deal. Tragically that aide commits suicide and this leads to scrutiny of exactly what he was doing for Bill. At this point Bill is given a choice. He can accept a censure from Congress, essentially a slap on the wrist, or can agree to a wide ranging investigation into all his affairs. However the censure from Congress is a definite loss today. So being loss averse he prefers to risk the investigation. Unfortunately for him the wide-ranging investigation reveals that Bill is having a sexual relationship with an intern. Now at this point he can be honest, go on TV and beg forgiveness from his wife and constituents. However this would be a definite loss, so being loss averse he rolls the dice and prefers to gamble that they don’t have any evidence to back up the claim. So he goes on TV and says ‘ I did not have sexual relations with that woman.’ Of course we now know that President Clinton did have an affair with Monica Lewinsky, they did find evidence, and Bill was almost impeached as President of the United States. All because of loss aversion.

So the moral of the story is that if a man as successful & charismatic as Bill Clinton suffers from loss aversion so do you and me.

For this reason I have a rule. If a position drops below 1% of my portfolio and I’m not willing to add to the position to make it above 1% then I sell the whole position. If I don’t have the confidence to hold at least 1% this clearly isn’t my best investment idea. The small position size means that its potential impact is very low anyway so if it is still in my portfolio it is a sign that I am suffering from loss aversion. If I don’t clear out that long tail of losers they will take up emotional and mental energy that is best spent on my best ideas. Given the emotions that surround selling losers the 1% rule is surprisingly hard to implement but really worth doing.

The only case that I can see it being worth holding a very small number of shares is when you want to incentivise yourself to better understand a company. For some reason most investors are better at really kicking the tyres when they have some money on the line. This should not be an indefinite position though. You should set yourself a deadline at which point you assess the company and either add to the position or sell it. The downside to this strategy though is that ownership bias will probably make you rate the company more highly than you otherwise would. For this reason this should be used sparingly.


The other most common bias that impacts portfolios is ‘get-even-itis’. You probably have suffered from a case of this too. It starts when you have a position that goes against you. As it appears ‘red’ in your portfolio you start to worry. As it drops further you think ‘I wish I’d sold when I first started to worry.’ The worry stops increasing when it starts to bottoms out and starts to subside as it starts to rise. Then when it gets back to your buy price you are so relieved you immediately sell. This of course is a form of ‘anchoring’ and is illogical. If nothing has changed since you bought then the share price going down and up again has not changed the investment case. Equally if the investment case has deteriorated you should have sold immediately and it is merely chance that means you are back even. Again given the power of this effect it may be worth setting a rule that you never sell a share at your buy price. Particularly when the share price trajectory has been a drop and recovery on no news.

In Summary…

Given that behavioural biases are pervasive, hard to identify in real time and high impact it makes sense to have a strategy to deal with them. I believe the best solution is to create a sensible set of rules in advance, write them down, and apply them rigidly. This doesn’t mean you follow a purely rules based investment strategy but you proactively identify areas of weakness and think how applying a simple rule could overcome that. This frees you to spend your energy where you can have the greatest impact: finding great investments that no one else has spotted.

Wishing you all, correctly diversified, properly weighted portfolios free from behavioural bias.