Monday, 22 May 2017

A Tale of Two Companies

“In the short run, the market is a voting machine but in the long run, it is a weighing machine.” Benjamin Graham
You may think that you are immune to the story that management tell you about their companies. However as charities & marketing professionals know, the reality is we are hard-wired to respond to stories far more than facts & figures. The market votes for the stories it likes with capital flows and it can take a long time for those stories to be weighed by actual future results.

Take for example the tale of two companies that I know well. Both are in the business of designing & manufacturing technology products (although in different fields.) Both have recently gone through a difficult period due to increasing commoditisation of their markets. Consequently both companies have undergone restructuring including outsourcing of manufacturing to China to reduce their production costs. However they have taken very different approaches to their accounting treatment of this period. Company A has presented all of their restructuring costs as exceptional costs to be removed from reporting. Company B has presented only a small bad debt as exceptional. Company A has also been regularly capitalising development costs whereas Company A has expensed theirs’. If you took the adjusted figures at face value you would likely conclude that Company A has been the most successful in their turnaround:

And looking at both the company fundamentals & chart the market appears to have voted this way:

(Blue is company A, Grey is company B, compared from the start of 2014)
However let's do a bit of weighing.

When we adjust for the capitalised development & exceptionals we get a different story:

Although the net margins for both companies clearly indicate companies undergoing challenges it is Company B that appears to have better navigated those challenges.

Net margins are of course not the only factor to consider. The story that the management of company A are telling is one of strong operational gearing. However when we compare gross margins we see that although company A has done well to increase theirs’ over the last few years they are still 10% below those of company B:

It would seem that company B is likely to have better operational gearing and a greater competitive advantage.

Free Cash Flow margins also seem to be the same or better for Company B:

What company A has been successful in doing is driving higher revenue higher, particularly in 2016H2:

(For ease of comparison revenue of company B has been normalised to company A 2014 H1.)
Although looking at the previous charts we see it has been at the expense of Net Margins & Free Cash Flow.

In these times of low economic growth in developed markets & record low interest rates the market has been paying a high price for revenue growth. Could this be the source of the difference in rating? I don’t think so since it is company B that has double the broker forecast revenue growth of company A:

All in all it would appear that company A is overvalued or company B is undervalued. Maybe both. It really does matter what story you tell investors and certainly at the moment investors are willing to ignore the adjustments made to tell the story. I think it is telling that company B is run by highly paid turnaround specialists with large stock option grants whereas company B is run by a long term managers. I look forward to the market weighing. 

Saturday, 22 April 2017

Know Your Competitive Advantage

It’s a feature of a competitive market that over the long term a company without competitive advantage will not earn a return above its economic cost of capital. Even if a company has a competitive advantage those supra-normal profit margins will attract competitors who will try to erode that competitive advantage over time.

It is for this reason that so much of successful investing is about identifying companies that possess a sustainable competitive advantage. That is a competitive advantage that cannot be attacked by competitors or it’s difficult to do so due to network effects or legal monopolies like patent protection. A lot of literature is written on the subject. Warren Buffet has become a multi-billionaire mainly due to his ability to identify companies with a wide competitive moat. Even more quantative investors like Joel Greenblatt try to use metrics like ROCE to identify those companies that possess a sustainable competitive advantage, with varying degrees of success.

While understanding the competitive advantage of companies can be a vital part of success as a stock-picker many people forget to apply the same principle to their own investment practice. Simply put if you are a good analyst but don’t have any competitive advantage in investing then you will earn the market return minus costs. If you are an active investor these costs are likely to be large enough for you to underperform the market. If you are a bad analyst you will significantly underperform the market.

As an individual investor (and for most professionals too) the following are NOT sustainable competitive advantages:

I am more intelligent

You may be clever. Most investors I know are. However you are unlikely to be the cleverest person to trade stocks. If your strategy requires you to know a large cap company (even the one you work for) better than a full time analyst with a PhD and access to the management you will lose.

I am quicker

However quick a decision-maker you are, you will never compete with a high-frequency trader. In this realm microseconds are becoming the norm for news reaction and machine readable news aggregation is becoming the way that economic news like interest rates or non-farm payrolls are integrated into pricing. Very few hedge funds even can afford to compete in this space and the incremental returns to speed have probably already reached a plateau. If you are not already one of these few you are unlikely to become one of them. They possess the moat not you.

I work harder

If investment returns were proportional to the man-hours put into it then you are always onto a loser. No matter how many hours a week you personally put in another investment firm can simply hire more analysts to out-work you.

I have a good gut feel

The problem with basing an investment strategy on your feel for the markets is that it is very hard to get effective feedback on how good you actually are. We all suffer form a form of attribution bias where we remember the successful investments we make and forget the losing ones. Even if you keep detailed performance records of your investments it takes a lot of data to be able to show that your gut feel adds any value. And since the market is a complex adaptive system your gut feel may stop working. You can lose a lot of money until you realise that things have changed.

Although it is unlikely that you will be a successful investor unless you are clever, work hard and are able to make quick decisions based on your accumulated experience, these are only necessary conditions not sufficient.

In his latest book ‘David & Goliath’ [1] Malcom Gladwell points out the underdog doesn’t always lose. When the David’s of this world choose to fight unconventionally rather than face a much stronger opponent head on they win a surprising number of battles.

So what are the unconventional sustainable competitive advantages that an individual investor can possess?

I am able to invest with a longer term horizon

This is an area where a private investor can have a real advantage. Most professional investors bear significant ‘career-risk’. That is they are likely to be fired or lose mandates if they have a period of long underperformance. Outperforming the market by definition requires doing something different to everyone else and hoping that you are both right and that the market comes round to your viewpoint. This takes time and the more different you look to everyone else e.g. by refusing to buy tech stocks in 1998/9 the more likely you are to be fired for a period of underperformance. As Lord Keynes said worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.' For this reason most professionals prefer to chase small relative short term outperformance than true long term outperformance. When you manage your own money you don’t report to anyone but yourself. You can focus on mis-pricings that may take years to correct without the fear that short term under-performance will hamper your ability to retain capital or your job.

Find areas where the market is excessively myopic. For example a company may warn on profits dues to delayed contracts and be marked down significantly. However the reporting period of a company is essentially arbitrary. If you can be confident that the contracts are delayed not cancelled and the delay won’t cause financial issues for the company you may be able to buy at an undervalued price from investors who are overly focused on the next set of financial results only.

I am willing to bear risk that others aren’t

Bearing risk alone doesn’t guarantee return since if it did then everyone would bear more risk to get that return and the excess return would be arbitraged away. What we are looking for is situations where other investors won’t take a given risk at any price. One example is that historically if you bought non-Investment grade bonds after they have been downgraded from an investment grade they outperform. The reason is that a lot of bond funds have rules that say they can only own investment grade bonds so after the downgrade you have forced sellers. An individual bond is still risky (hence the downgrade) but on average across all recently downgraded bonds the forced selling has taken the price below the level that balances risk & reward.

It is price insensitive sellers in spin-offs that Joel Greenblatt describes taking advantage of in ‘You can be a stock market genius.’ You have shareholders who end up with a small spun-off holding that is insignificant compared to their other holdings and in an industry they maybe didn’t want to own. The spin off company will also have limited financial history so few new investors want to bear the risk of buying the spin-off immediately creating a price anomaly.

Find areas where price insensitive sellers and a lack of buyers willing to bear risk creates opportunities.

I can invest in smaller and less liquid stocks.

This is an area where hard work can pay off. When you get to the small and micro cap part of the market then professional investors would struggle to get enough stock to make any meaningful impact to their performance no matter how compelling the investment case. Hence it is simply not worth them researching these smaller stocks and equally it is not worth brokers producing research since no one will pay for it. Although the previously held belief that smaller stocks outperform simply due to being small is probably weak [2] it is that lack of competition that means being willing to work hard in this area can pay off.

Academic studies suggest that the average individual investor makes very bad investment decisions [3] . So if these are your only competitors you stand a good chance of success. Assuming of course that you don’t fall for the same poor behaviours and biases that lead this set of investors to underperform on average. e.g. [4]

Find good companies that are not well understood by the average small cap investor and are priced cheaply. Work hard to understand those companies better than the market.

So you see that the individual investor ‘David’ can win against the professional ‘Goliath’, but if you want to be successful you have to learn to fight unconventionally - where you have the competitive advantage.

Monday, 30 January 2017

My Investment Mistakes 2016

I’m a bit late to the party but have finally had the time to do a review of 2016. Although 2016 was a better year than 2015 in absolute returns (+18% vs +10%,) the relative out-performance vs FTSE all share has been much lower. So again rather than celebrating too much on the high performers I focus on my mistakes with the aim of continuously improving my investment process. These mistakes broadly fall into 3 categories, buys or sells that shouldn’t have occurred, missed opportunities and incorrect position sizing.

Wrong Buys or Sells

Selling Lavendon for £1.33. I sold because I was worried about the increasing debtors from its Saudi Arabian business. Although the company appeared to be cheap even if they did have to write off significant portions of the Saudi debtor book I feared the negative market reaction if this happened. Letting the fear of price action rather than valuation lead my decision making process turned out to be a mistake as Lavendon received competing takeover offers from a number of larger hire groups. Currently it looks like they will be sold for about £2.70.

Another sale mistake was selling Somero (SOM.L) after the surprising Brexit vote. Being in the construction industry Somero’s markets are highly cyclical so I thought that any economic weakness would disproportionately affect them. In reality there has been little sign of any significant economic weakness and Somero’s dollar earnings combined with continuous shift into eCommerce (whose warehouses require the flat concrete floors that Somero’s equipment provides) means that their business continues to thrive and it was a mistake to sell.

In terms of purchase mistakes almost all of these took the form of companies that I didn’t research fully enough. For example low end clothes retailer Bonmarche (BON.L) looks very cheap on historic earnings and cash flow metrics. What became clear though is that the free cash flow generated was through cutting all capex to the bone. When it became apparent that the company was going to have to spend significantly on IT systems simply to have a viable business going forward I sold at a loss. Another example of where previous private equity owners managed to generate good earnings and cash  flow for a stock market flotation at the expense of the long term success of the business. I am now very wary of all Private Equity floats.

Missed Opportunities

A couple of times I missed good opportunities because I didn’t react quickly enough. In one example Sirius Minerals announced a placing at the bottom end of their proposed 20-30p range. Good news for me since I had initiated a short position at an average of 35p. The price reacted negatively at first as one would expect – an underwritten placing at the bottom end of the range almost always means that the underwriters have taken some and will sell as soon as they get the shares down the placing level. So when the shares briefly rallied to 31p to sell this essentially was free money – I just wasn’t quick enough to grab it.

One of my core positions is in the airline Flybe (see here for investment thesis: I believe that in the long term their strategy of flying short routes with turboprop planes that jet operators can’t compete economically on is a good one. (For example a friend of mine regretted spending 11 hours on the train to get home to Inverness for Christmas when he could have caught a 1hr Flybe flight. If he had booked a month or so in advance the Flybe flight would also have been cheaper.) In the short term though they face some significant headwinds. Therefore I was pleasantly surprised when their interim results in November were not as bad as I thought they would be. I read the results, thought no drama there and got on with my day. Being the day that Donald Trump was elected I was also distracted by other news. It is only later that I saw that the initial price had dropped as low as 30p (maybe due to the Trump factor) before rallying to close at around 40p. Again there was a brief market inefficiency that I should have taken advantage of and didn’t.

Probably the biggest missed opportunity that I didn’t purchase was Boo Hoo (BOO.L). Paul Scott made a convincing investment case for this up and coming internet fashion retailer when it traded as low as 20p in 2015 after it missed broker forecasts following flotation. I was late to see the attraction and the price had rallied 20% to 24p before I became convinced of the investment thesis. However I became anchored on the 20p low and never bought. The price today is £1.44 having rallied 363% in 2016. Given the current rating I’m sure I would have sold too early but even so price anchoring has cost me significant gains.

Position Sizing

Towards the end of last year I had to reduce some losing short positions because my exposure became too large. Essentially I underestimated the extent that the current market would ignore bad news and in the light of this my initial position size had clearly been too large. There are pockets of the market that currently seem crazy to me. Here are a few examples:

  • A company with a history of aggressive accounting treatment that hasn’t generated any real cash return for shareholders in the last 4 years doubles when based on the company’s own highly adjusted earnings figures it is no longer losing money. The market gives it a rating of 37x forward adjusted earnings.

  • A bank doubles to trade on 3x Book Value when it is revealed that the regulators are unlikely to clamp down anytime soon on its lending practices to criminals, foreign nationals & high risk short term borrowers (payday loans) and that a Trump presidency is likely to be even laxer on regulating banks. The market completely misses the point that the risk here isn’t more regulation but that those type of borrowers are at a much higher risk of not paying the bank back. If that happens in any significant numbers the equity is toast.

  • A company whose product generates almost no consumer benefit reacts positively when it is announced that they are to do a corporate transaction with no economic merit whose sole purpose seems to be to reward Chinese officials for allowing them to keep selling their product in China via a Multi-Level-Marketing scheme.

  • The market thinks that 4.5x Sales & 6x Book Value is the right price for a highly indebted company that aims for 8% revenue growth and consistently misses that aim.

To me it seems that particularly the US market is bid up on expectations of rapid earnings growth across the board and if this fails to materialise there could be a big correction. I expect most of the examples above to trade significantly lower in the next few years but that doesn’t remove the fact that I made a mistake in position-sizing them and had to reduce my position to prevent over-exposure.

None of these mistakes proved to be catastrophic but they did take the shine off an otherwise good year. On a positive note there were also a few key learning points for me during 2016 that didn’t necessarily come from investment mistakes but will help prevent them:

When to average down

This is one of the most difficult decisions for a value investor. I touched on this topic briefly in the past here:

However John Hempton covers this topic better than I ever could in a simple but profound blog post with one of the best explanations of how to do it while effectively managing the risk of doing so:

Also in this space the book The Art of Execution by Lee Freeman-Shor which I read in 2016 gets a very honourable mention.

How to react to a profit warning

Recently published research from Stockopedia suggests that on average you are better off selling as rapidly as possible on a profit warning:

Of course market being complex adaptive systems if it gets to the stage where everyone follows this advice and sells at any price following a profit warning then it will become better advice to buy. It feels like we may be a long way from this at the moment though – particularly in the more inefficient small-cap space. Michael Mauboussin also covered this topic from a slightly different angle here:

I'm sure 2017 will have plenty more learning opportunities to come!