Saturday, 29 December 2012

My investment non-mistakes in 2012: Part 3

Right, let's wrap this up:

7) Halfords - HFD

I first bought Halfords in 2011 at ~295p on a very simple thesis. The share price had fallen significantly after 2011 profits were a bit disappointing (and it too has the 'retail' stigma attached to it), however HFD offered a) a business with high long term ROEs, b) a large yield of over 7% at the time and c) a low historic P/E. I thought that the decline in profit was likely to be relatively short term and the company would carry on growing in the future as it also had an auto garage business that was expanding to offset the retail slowdown.

I didn't really expect what happened next, when profits looked to have another year of -20% falls. I'm still not entirely sure what caused it, but the share price reaction was to knock a further ~35% off the price down to ~190p. I topped up again, at 210p, but was still kind of unsure as to why profits were falling so fast. Halfords then decided on a CEO swap, and together with a big boost in cycling sales from the British Tour de France success the share price swung back up as high as 355p. I got pretty lucky as I sold out completely at 351p basically because the shares looked much worse value given profits were still expected to fall significantly and, importantly, I don't really get why the decline is so drastic nor why it should reverse. I'd be interested to hear if anyone has any further light to shed on this situation.

8) Staffline - STAF

I don't have a great deal to add beyond Paulypilot's summary of his meeting with management here and MaxCashflow's share competition write up here. It ticks the boxes of a) good long term growth b) decent level of management ownership and c) an attractive valuation. It's gone up ~30% since I bought it so I've trimmed a bit at ~300p but I still hold a good chunk for the longer term.

9) 21st Century - C21

C21 is an interesting one. I got in to this quite late, making my first purchases at 17.8p (including the 3.5p return of capital) as it has quite a nice growth story but without a sky-high P/E. Carmensfella has a good write up here which is well worth a read. The really interesting thing for me is the number of very good investors who own large chunks of this share. The historical numbers probably aren't a good guide for the future here as so much has changed in the past few years after activist investor Peter Gyllenhammar effectively revamped the management and focused the company on its products which had achieved product/market fit and were beginning to grow rapidly.

Naturally, the next thing that happened after making my purchase was the shares tanked on no news. Actually, I consider this to be one of the great strengths of small caps. Share price volatility without fundamental volatility allows bargains to be had from time to time, and I took advantage here and added a lot more at 10p. As they declined even further to 8.5p I wanted to make a big top up but I knew Carmensfella had scheduled a meeting with management in December so I told myself I'd wait till then, learn more about the company, then add if I was still very confident. Sadly I never got this chance, as the share price recovered and the meeting never happened because senior management were busy with meetings in France (They have next to no sales in France at the moment, so this is kind of a good sign!) and they released this trading statement that really sent the share price up - which probably wins the record for most apologetic 20% rise in profits I've ever seen :)

Even at the current price of 14p, the shares are only trading on ~10x 2012 profits which seems far too harsh for a company that considers 20% growth disappointing. I'm planning to hang on in here and benefit from the growth and/or the re-rating it deserves.

10) Robinsons - RBN

Robinsons I bought pretty much entirely as an asset play. It seems clear they have a lot of land on the balance sheet which isn't reflected at its true value. Aimzine has a good write up here (you may need to register to read it, if you even can anymore, as they have now merged with investors champion). I also liked the side-story of them rationalising their business to focus on the profitable, higher margin "secondary packaging". In the end though, I sold out after a decent rise to ~120p (I first bought at ~90p) as I realised that, while the asset backing was nice, I probably wouldn't see any of it for a long, long time. To quote the Aimzine article:

"We see our substantial non-core land and property holdings as part of a long-term disposal process.  We will be looking to sell at the most opportune moment in the property cycle and in our opinion this may not arrive for at least five, perhaps even fifteen years from where we are today."

I don't really fancy management trying to time the property market, especially since they bottled their timing in 2005-2007 and it's not as though someone rings a bell at the top to let then know when to sell! After the rise, I decided that I didn't really fancy being around here for the long term as the ROEs the company earns aren't great (they are largely in a capital intensive commodity business after all) so at a forward P/E of 12 and a ~3% dividend yield I reckoned I could find better value elsewhere.

Right, that's all the shares that have contributed to my positive performance this year. I still hold a number of shares from 2012 that haven't really gone anywhere or I've bought recently and haven't moved (ALLG, JD., MGNS, KENZ, LCG, SIV) which I'll get round to discussing in 2013.

Disclosure: I own shares in STAF, C21, ALLG, JD., MGNS, KENZ, LCG, SIV

Friday, 28 December 2012

My investment non-mistakes in 2012: Part 2

Continued from Part 1:

4) Lo-Q - LOQ

Lo-Q is a company I liked from the first time I heard what their product was. As a big fan of theme parks and rollercoasters I'm aware of how terrible the whole queuing system is, no one wants to wait an hour or more for a one minute ride (One of my favourite memories is going to Universal Studios in the American off season and being able to ride this crazy thing over and over and over with almost no queue... bliss!). Lo-Q offer a product that theme park fans like me love and the theme parks love. You use their devices and virtually queue for a ride rather than physically, allowing you to go off and do something else (and importantly for the parks, potentially spend more money whilst you're not queuing) and when the time comes you just turn up to the ride and walk straight on. Theme parks love it too, as it brings not only an extra revenue stream from customers purchasing the devices but they also have more time in the park where they're not queuing when they can be buying other rides, food, toys etc. The model also has high barriers to entry as there will be switching costs and inertia for any new supplier who'd want to break in to the market.

As an investment, the company fell very much in to the GARP category for me - it was trading at only 15x earnings when I first bought at ~180p (it later fell to 150p in October 2011 and I bought some more) and the potential for further roll out of an already proven, profitable business seemed pretty obvious. I'd never heard of the product before and I like to think I've been to a fair few theme parks in my time so there was obviously huge scope for adding incremental parks. Also the company had been trialing a wrist-band for water park queuing, opening up a whole extra adjacent market. The company had a new CEO with a good track record and £6m of net cash on the balance sheet to comfortably support further expansion.

So, what did 2012 bring? Results in February showed revenue up ~20% although EPS was actually slightly down, largely due to the way they've accounted for the dilution for the new CEO's options (I believe the whole amount have effectively been issued up front) although going forward that should be the end of the dilution. Since then the company have been announcing contract wins left, right and centre and it's hard to see anything other than a really bright future here. Most recently, they've announced an acquisition of accesso plc to expand their overall ticketing empire.

The share price has responded by shooting up to as high as 389p (as of today) however I must admit I got out this year at an average of 333p. Whilst I still love this company and think it's got a bright future ahead of it the price was getting too racy for someone like me who likes owning companies at a hefty discount to easily identifiable value. At 15x earnings, I felt the company was hugely underpriced for the growth that seemed highly likely over the next five years or so and could have seen myself holding here for a very long period but given the huge run up in price I started feeling uncomfortable as we slowly entered the high 20's. Even now, the share trades at 35x 2011 EPS, although this will look better soon as 2012 figures are expected to put the current price on ~28x earnings.

Does this mean I think the shares are expensive? Actually, no, they may actually still be very cheap on a long time horizon as I think the growth here could be very rapid and erode those high multiples in a few years time. It's also a matter of opportunity costs - I think I can find other shares that also have similarly good growth prospects but trade on much lower multiples. Lower multiples reduce the downside risk from either short term (or indeed, long term) disappointing changes in the future and increase the potential upside from a re-rating, LOQ style. To carry on holding at high multiples I need a higher degree of certainty of the growth that LOQ can generate not just next year but over many years, something I'm not confident enough I can do.

Having said that, if I were more growth-orientated as an investor I'd definitely consider holding LOQ for the long term - I reckon investors who stick this away for years and years could well end up making me look foolish for selling so soon.

5) Indigovision - IND

Another rollercoaster of a share. I bought after a profit warning with impeccable timing at a bit under 300p back in 2011 - just before the full results came out and the price tanked even further to a low of 165p. Ouch. So, why did I buy? Well, my thesis was that a) this was probably a short term problem and the real earnings power of the company wasn't that affected in the long run and b) the strength of the balance sheet wasn't being factored in by the market, which had not only had £5m in cash (of which a lot appeared to be largely excess to working capital requirements) as well as £4m in deferred tax assets which get converted in to pure cash as the firm makes profits. These are obviously very significant in a market cap of about £23m (when I first bought).

I didn't add any further in 2011 as the price really tanked as a real drama erupted in the company no one saw coming. Besides the results being way worse than expected (even after the profit warning) the CEO tried to make a low-ball bid for the whole company backed by private equity which the board rejected. This then turned in to a bit of a spat between the CEO and the board, and full credit to the board, they held firm against the CEO and protected smaller shareholders from being taken out for a song. There was even some suggestion (bulletin boards love their rumours) that the CEO deliberately mis-managed the company to harm short term results in order to panic the market (which it did) in order to engineer his low-ball buy out. Even if this isn't true at all, the manner in which he cynically attempted to exploit the low share price for his own riches is very poor and it takes a lot of guts from the board to do the right thing here and say no to him.

After the old CEO got evicted, his second in command stepped up to the CEO role and got to work. Given I now felt the company had a good reason for the short term poor performance which had been removed (the old CEO's bad management) and the balance sheet strength still hadn't been factored in by the market I topped up at 337p and also at 368p. The company then put out an exceptionally bullish announcement which was way out of form compared to the previously reserved tones - talking of "matching market growth" which they also mentioned happened to be 20%+, as well as a special dividend of 70p to return a lot of that excess cash. Wow! The price rocketed up and I got a bit uncomfortable that too much of the valuation seemed to be based on this one statement. Given the company's past of rollercoasting between "It's all great!" and "Ahhhhhh profits are down!" I wasn't entirely convinced I could bank on suddenly getting high growth now so I sold half my stake at 530p. Naturally, the next statement seemed far more subdued and then the price shot down again.

IND seems inherently a bit unpredictable to me. There's a number of good private investors I pay a lot of attention to (particularly Paulypilot, who's been in the share for a long time and knows it well) who are still very bullish on the future and may well be right but the problem for me is I can't value the earnings too highly as I don't feel I can predict them very well. It's fine when my investment thesis only partly relied on earnings and was predominately about the balance sheet, but with the cash now paid out and the price still being higher ex-dividend any thesis now has to be based on earnings. The shares still look fairly cheap, at 11x 2013 forecasts, but I've sold out completely now as I don't know the company & the industry well enough to have a strong opinion about the company's future. Hopefully they'll nail it and I'll look a fool for having missed a great growth opportunity - if they can get anywhere near 20% consistently they're a huge bargain right now.

6) Debenhams - DEB

Debenhams is probably the fastest time I've gone from investigating a share to buying it. It's a well known company in the UK but because it had the stigma of being both a) retail and b) straddled with lots of debt from being private equity owned the price was insanely cheap for a company which is much bigger than I'd normally buy. At a P/E of 6 and paying a 6% dividend yield the price (54p when I bought) incorporated a lot of pessimism which felt really unfounded. Firstly, many years of earnings as well as a rights issue had paid off a large amount of the debt which had, for the past good few years, heavily burdened the company. Secondly, the company's earnings weren't forecast to fall off a cliff like the price implied and the company was expected to grow both revenues and profits. Unlike FCCN, DEB is a more diversified retailer and the specific fashion risk was low as they sell a range of brands rather than a specific one (like FCCN) - this is reflected in the earnings history, which is far more stable and predictable than you'd expect given the low PER at the time.

Long story short, the shares started rising and, well, didn't really stop. If there's a lesson here, it's that I sold too early - half at 81p and the rest at 100p - the shares went over 120p this year. Again, another baffling inefficient markets example as, whilst the results they announced this year were better than expected, they weren't exactly miles ahead. Why did they double? Well... I don't really know. Then again I don't really know why they were so cheap in the first place. I sold early mainly because I felt I had "better ideas" after the price rise. One of those "better ideas" being FCCN. D'oh.

OK, only four more winning shares to discuss for 2012 then I'm done! The gripping (!?) finale to come in the next few days and I'll post my full 2012 results on 1st January, then a look at my current portfolio and my favourites going in to 2013.

Disclosure: I own shares in FCCN

Wednesday, 26 December 2012

My investment non-mistakes in 2012: Part 1

If that last post was really tough to write at least this one should be much more fun - I get to focus on what went right! So here goes: a list of all my positions this year that contributed positively towards my returns, roughly in order of contribution to overall returns:

1) Trinity Mirror - TNI

If you were looking for a rollercoaster ride this year, Trinity Mirror was probably it. It started the year at 48p where I thought it was insanely cheap having bought in 2011 at prices of 54.8p and 43.9p respectively. I did a post on TMF where I tried to value TNI but long story short I thought that a) The business was still highly cash generative and not declining that quickly and b) The balance sheet was much stronger than it first appears due to the large amounts of freehold property that hasn't been revalued in over a decade, a pension deficit inflated by artificially low gilt yields and a deferred tax liability that's largely a figment of some daft accountant's imagination. I pegged my target value somewhere in the 100's and felt pretty happy with my purchases.

Naturally, the next thing the share did was a steady decline from March to May down to a low of 25.5p. Why? I wish I knew, I'm still a bit baffled by it. No significant news came out really to warrant a 50% decline in share price. Perhaps there was a distressed seller? Who knows. I'd love to say I was cool as a cucumber and accumulated a gigantic position to take full advantage but really I was questioning my analysis. What does someone else know that I don't? Maybe I'm underestimating the danger of the pension liability? What if the phone hacking situation is set to take down TNI? I researched and researched and still felt pretty confident the equity was worth far more than the market price so I topped up significantly at 30.7p and 26.9p in April and May. It was one of my biggest positions but no where near the "all-in" bet I'd have made if I'd been ultra-confident - ah well, hindsight investing is so easy isn't it?

Since then my thesis has played out fairly well - the company announced profits ahead of market expectations (an unexpected bonus) and the old CEO got the boot which the market quite liked. The Happli investment got killed which I never really liked (Groupon has shown that the economics of daily deals isn't quite there yet). There was a bit of a hiccup when the phone hacking scandal flared up but I still think it's a largely insignificant event in valuation terms - big news, perhaps, but not big financially. Having said that, I don't think the news was almost 4-bagger worthy, which is what has basically happened since the lows of ~25p given the share is pushing for 100p now. The award for making a mockery of the efficient market hypothesis this year surely has to go to TNI.

Actually, I have a hypothesis as to why things are so crazy here: the accounting is totally nuts. I don't know how it's happened, but there's a few things that are bizarre going on in the balance sheet. 1) Check out page 53 of the 2011 annual report, they report negative equity of £675.4m when it's actually positive. Eh?! 2) How on earth did they decide to capitalise the future cash flows of the business and make it a huge intangible asset?! This is what gives rise to the vast majority of the deferred tax liability - it's the discounted value of the tax they'd pay in the future if they make the profits they expect... I've never seen any other business do this precisely for the reason that it's completely daft. Having said that, it is kind of interesting in the sense that, if management expectations are 'correct', the equity should be worth about book value as it includes not just the current assets but also the present value of the future profits. We're currently at 0.34 of book value...

I trimmed a little at 78p but only for portfolio balancing reasons - I still hold the majority of my stake as I think the upside here is still big. Come on 2013!

2) Judges Scientific - JDG

Oh Judges, how I love thee so! I initially discarded Judges for probably the same reason probably many people did, it's another company plagued by horrible accounting which hurts their profits (but not their cash flow, importantly) which put them on a huge P/E. I took a deeper look in January and liked what I saw. The Judges model is pretty simple but really powerful. Basically the company buys very small, niche scientific instrument manufacturers who earn fantastic returns on invested capital because they happen to be the only providers of these highly specialised instruments and components. It does so at ridiculously low valuations (sometimes P/Es as low as 4) because these companies are so tiny that there's no natural buyer for them. Judges also uses a reasonable amount of debt to leverage the returns but not so much as to pose significant risk to the overall company. If you can borrow money at ~5% and invest it in earnings yields of 20%+, you have a very good business.

It also helps that Judge's CEO, David Cicurel, is a pretty charismatic guy (he's presented at the Mello events in London a few times) and admits that a large part of his edge is that he finds these companies whose owners are at retirement age and want to cash out but want a buyer who will run the company 'the right way' which Judges can offer. Judges itself is still a very tiny company and will probably earn only a bit over £5m PBT this year and so this model still has a long way to run in my opinion, although David reckons that there's a lot more buying competition from the likes of Oxford Instruments (OXIG) for purchases with over £1m PBT.

I made my first purchases in January at 436p more as a value share (it was trading on a P/FCF of about 7 at the time) as I was learning about the company and after more research finally felt I really understood the potential of Judge's business model and decided to make it a my largest position by some way (~15-20% of my portfolio, that's how much I liked it). Sadly, before I could buy even more Judges announced an acquisition and the price shot up to ~650p. I have never been so sad to see one of my holdings shoot up in value! Despite this I bought anyway as I think the long term value is significantly higher than the price then and even the current market price. In fact, I intend to do a blog post at some point on how I think very good capital allocation is systematically undervalued by the market, but that's for another day.

Judge's CAGR of all metrics - revenue, profits, book value etc over the past five years has been astronomical and I still think there's plenty of years of 20%+ growth in the tank. Most companies able to do this kind of compounding get awarded, quite rightly, large P/E multiples but even after the rise to ~970p the share is only on a multiple of ~14x 2012 profits. If another year of 20% growth is achieved for 2013 then the share is still only on ~11.5x - even large multiples get eroded pretty quickly (N.B. All these multiples are before the convertible debt dilution which is ~12%. Even the adjusted P/E values are too low though EDIT: @marben100 has pointed out that ~95% of the debt has now been converted so these P/Es are all after dilution - bonus!).

A not-so-quick note on the accounting issues. Read on if you fancy falling asleep; if you're not in to detail then I suggest you skip to the next share. First, Judge's issued convertible debt a few years ago. For some reason, under current accounting rules this lead to them having to record losses to the equity because the share price rose significantly above the conversion price. Sort of makes sense, but really, really confusing and counter-intuitive unless you're an accounting geek. Company does well, share price goes up, so the company 'loses' money? Bizarre. The appropriate way to do it is to just value the company in a fully diluted equity sense, which is what I do. Thankfully the company are aware of how confusing this is and are looking to convert all the debt shortly.

Secondly, the latest IFRS rules seem to require acquirers to put a whole load of intangibles on the balance sheet like customer relationships, brand value etc etc and then amortise them. This is again, completely daft, as these intangibles are really just pseudo-goodwill. Goodwill hasn't been amortised under accounting rules for years and years, because it makes no sense to charge it off against profits as it doesn't reflect on-going capital expenditure. If you buy a good business it tends to be worth more than the accounting book value because it earns a high return on that book value - this is what 'goodwill' reflects. If the business carries on being 'good' and grows then, if anything, 'real' goodwill should increase, not amortise. I really hope this rule gets changed soon because it's only confusing to the non-accounting-astute investors.

3) PV Crystallox Solar - PVCS

A very recent purchase by me but it's still had a large impact on my returns this year - I only wish I'd spotted it at the start of the year! PVCS has long been tipped as a value share favourite since I started investing but it never really appealed to me when I looked at it when it was ~50p - fine, it had a low P/E, but it's in a commodity industry (they make solar energy components) and I felt that these profits looked set to collapse. And collapse they did - in 2011 they recorded a loss of ~£60m. Ouch. The share price dived down to as low as 3.7p as a once FTSE250-sized company dived in to obscurity. I imagine the decline won't have been helped by a number of institutions being forced sellers here because of the newly low market cap, creating a feedback loop which pushes the price lower.

The price doubled to ~8p on the back of news that they'd won a court case against one of their long term contract holders and been awarded €90m in cash for it. Against a market cap of sub £20m, this is obviously very significant news! The price then did very little for many months, but attracted the attention of such famous investors as George Soros and myself who bought in at a little under 8p (just kidding... no one has heard of Soros :)).

So given the situation is so horrible, why do I like it? Well, the company's balance sheet is actually very strong. They have no debt and the bulk of the liabilities are provisions for the losses they'd make if they have to execute their current long term contracts at the current market prices so the future losses are already priced in. What isn't priced in is the potential upside for the termination of the contracts with their buyers (apart from the one that's already been claimed). PVCS have been very sensible in agreeing long term contracts with both their suppliers and their customers so in the case of a large market decline, like now, they are protected to an extent. So while the downside occurs by overpaying their suppliers there is upside from their customers who have to pay way above market rate (or exit these contracts and pay the hefty cost associated with this). To quote their interim results:

"As previously disclosed, the Group had been negotiating compensation from a former customer for the termination of a long-term wafer supply contract.  A satisfactory agreement was reached in May 2012 and this resulted in a cash settlement of approximately €90 million.  This payment together with the successful implementation of our cash conservation strategy has considerably strengthened the Group's net cash position which was €122.4 million at the end of H1 2012 (31 December 2011: €22.6 million).

We have been unable to reach a satisfactory agreement with two long-term contract customers who have been amongst the industry leaders in recent years and we are seeking resolution under the jurisdiction of the International Court of Arbitration.  While successful judgements in the Group's favour are anticipated there is increasing uncertainty as to whether one of these companies will have the financial resources to fully settle its claim."

Such cash works out to be 23p per share in total of which the deal was ~17p of that! Now, the company expects that this will be "by far the biggest" settlement and one of the remaining two may be unable to pay but the one settlement that is still expected should still be pretty significant. Even if it was 4p, that would be 50% of the price I paid for the shares and 36% of the current price. It's worth noting that JP Morgan expect there to be cash of 17p per share at the end of the year due to operating these loss making contracts but the company has recently announced that they intend to be broadly cash neutral in 2013 so it looks like the cash burn has largely been halted by the cost cutting they've done. Even assigning no value to the potential contract termination, you're still looking at net cash much bigger than the market cap.

It's worth mentioning that the CEO owns 44 million shares, so has a huge incentive to maximise his own wealth here. I think that, on balance, the company has done well given the hand they've been dealt. They've sensibly cut costs and rationalised the business and the long term contracts have protected them against this downturn to an extent. The low degree of operational leverage is what I feel protects me here.

There's also now a catalyst as the company have announced they intend to make a cash distribution in 2013. I've no idea how big this will be, but even under a conservative estimate I reckon they could pay out 30-40% of the market cap in cash and still be comfortable. Being bullish there's even the possibility they could pay out my whole purchase price in cash. This is the nice thing about this situation - the plant and equipment could even be completely worthless and I'd still come out ahead. If the market ever recovers and the plant and equipment becomes useful again then there's huge upside available. I see it as buying cash with my cash and getting a free option on a business.

This is still one of my largely contributors to this year's performance for me as the price has risen almost 40% since my purchase (and I gave a large portfolio allocation to it) but I still think there's a lot of upside still here and I intend to hold on in to 2013.

Wow, those three alone were much longer than I expected! I'm going to have to break this write up in to parts to keep it to a sensible length, so expect more in the coming days. Hope everyone's having a great boxing day!

Disclosure: I own shares in TNI, JDG and PVCS

Monday, 24 December 2012

My investment mistakes of 2012

Investing mistakes - I've had my share this year. I'm a relatively novice investor (I bought my first individual share in September last year) so I expect to have my fair share of errors as I go along, the key thing as I see it is to learn from my mistakes to prevent their repetition as far as possible. So, without further ado, here's a tally of my investing cock ups:


1) Elektron Technology - EKT

Technically this is a mistake of 2011, my only action in 2012 was to sell my remaining shares in January at 23.3p. Given the market price is now 17.3p this was arguably a successful decision! However it's worth a look at because I think the mistake I made here is an easy one to do and one I anticipate I'll inevitably make again - trusting in management who aren't operating in shareholder's best interests.

The Chairman, Keith Daley, currently owns 13% of the company, which is normally a very good sign. Management who are owners overcome the principal-agent problem and tend to act in the better interests of shareholders. Key word - tend to. The incident in question that led me to selling out here was this statement:

Wow - management awarding themselves bundles of shares - giving away almost 10% of the company in one fell stroke! Now I'm all for management being well incentivised, but this was beyond ridiculous. Such an action is effectively a big middle finger to all non-management shareholders. The business may be selling well below the intrinsic value right now but with management having shown they are in this to maximise wealth for themselves at the expense of other shareholders, who'll be the end recipient in the long run of this value? Given there's cheap companies out there which have shareholder-friendly management why take the chance?

There's plenty of ire on the ADVFN company board about the management even before the JSOP announcement. My mistake was not investigating this further before I bought at 32.3p - d'oh! One last piece of irony is that one of the board members has written a book entitled Angels, Dragons and Vultures: How to Tame Your Investors... And Not Lose Your Company. The writing really was on the wall... or rather, in the book.

2) RSM Tenon - TNO

Oh dear, oh dear, another 2011 hangover. I bought at 20.6p back in October 2011 and sold in February at 5.8p. The price is essentially the same today but is highly volatile as the equity is now essentially just a stub - the business is bordering on insolvency. There's a good number of mistakes I made here so it's good to go through them all.

a) Read the bloody cash flow statement & be skeptical of accounting profits!

TNO showed operating profits of £30m in 2011, which put the share price on a very attractive "adjusted" P/E of just over 3 at the time of purchase. I say adjusted because actual net profit was only £7.5m due to all the exceptionals, which is another warning sign. The really big warning sign here though was in the cash flow statement. Since 2008, the business was cash flow negative every year despite showing increasing "profits". Accounts receivable were building up, and up, and up...

It all came crashing down in February 2012 after the company reported a loss of £70.5m. Ouch.

b) Balance sheet strength

TNO had significant amounts of net debt, ~£65m, at the time I invested. Whilst a bit of gearing, used wisely, can be a useful way to boost ROEs in this case it meant that the downside here was huge as the equity could easily be wiped out (as I found!) which dramatically changes the risk/reward profit of the shares. I now strongly prefer strong balance sheets when investing as it means that, even if the company has a few rough years, they're able to ride it out and come through the other side if the business is one that's long term viable.

c) Relying on other investors to do the research for me

This was just pure laziness on my behalf. I actually spotted the previous two warning signs before buying the shares and bought them anyway. Why? I saw that Odey Asset Management had taken up a long position in the shares. I assumed they knew better and had done their research - Crispin Odey has a good reputation as an asset manager and is certainly a far better investor than I am. The lesson? Even experienced hedge fund managers get it wrong from time to time - DYOR.

d) Be skeptical of roll ups

I've recently read a book entitled Billion Dollar Lessons - a fantastic read by the way - which analyses corporate failures over the years to look for patterns to learn from. One of these is the high failure rate of roll ups. The story is simple, acquire loads of similar businesses to benefit from synergies. Great idea, right? Sadly, often not. I recommend reading the book to learn why - most of the lessons I think apply to RSM Tenon.

3) Playtech - PTEC

Ah, Playtech. I love the company. It's in an industry that I know well (I used to work in it) and I have a strong admiration for the market position Playtech have in it. The business will do well over time, however I'm not touching the shares. I actually made a profit on this purchase (I bought at 337p in 2011 and sold at 354p in May this year) but I still consider it a mistake, and not because the share price is now much higher at 427p. The company is arguably still very cheap even after the rise at which I sold them at a forward P/E of 10 and a near 4% dividend yield. So why did I sell?

Two words - Teddy Sagi. The founder of Playtech and owner of a large percentage of the shares. This is a man who knows how to play the capital market games in his favour very well - especially at the expense of other shareholders. He has a history of getting Playtech to buy his other companies at, shall we say, fairly generous prices. Of course, the Playtech board say they each purchase is at a fair price and their nominated advisors, Collins Stewart, are happy to put their names to it for an independent assessment but when you get an acquisition at seven times "adjusted EBITDA" you should suspect things to be a bit up. Adjusted EBITDA, as Charlie Munger would call it, translates to "bullshit earnings".

The truth came out in the final results where more details of the acquisition were revealed. The balance sheet was essentially full of nothing but intangibles (tangible book value was negative) and PTTS generated just €3.5m of profits in 2011. Given the acquisition price was €140m with an earn out of another €140m shareholders paid between 40x to 80x 2011 profits for this acquisition! No surprises also that the full earn out was paid in the end.

Let's also not forget the placing that was done at the bottom of the market, underwritten by Teddy Sagi, allowing him to increase his holding at a dirt cheap price.

Playtech will make a lot of money over time - it's very well placed in its market to do that. Sadly, I get the feeling that most of that money will end up in the pockets of Teddy Sagi and not the other shareholders. €280m is 3.6x the total profit that Playtech made in 2011 - that's many year's previous profits that the shareholders won't ever see, because they are now Teddy's profits. Oh well, at least they have a nice new business making €3.5m in annual profit...

4) French Connection - FCCN

I first bought FCCN in 2011 at 86p, then again in April 2012 at 43.4p (Ouch), then once more in August at 20p (Ouch!). So, what went wrong? Simply, FCCN was a turn-around story that didn't turn around. The company has buried within it a very profitable wholesale division but is burdened by the loss-making retail division. When I first bought, profits at the wholesale division were growing nicely and the retail side looked to be under control. Then, things just stopped getting better. The company announced sales weren't going as well as hoped and then they announced double digit sales declines as well as a whole host of 'measures' they were taking to remedy the situation - most of which looked like things they really should have been doing all along. The price crashed down to 20p.

I'm actually now only down 25% overall on FCCN ('only'!) as the price has since recovered slightly to 29p. The earnings story has disappeared for the mean time, replaced by losses, but the balance sheet is still very strong and the company is trading at 43% of tangible book value. I think the risk reward balance is in my favour at the current price, and the company sounded cautiously optimistic at the end of the most recent trading update.

So if I'm still long term positive (at least at the current price), what do I consider to be the mistake? My original investment case was built entirely on earnings - specifically, earnings growth. I had no real basis on which to place this - I have next to zero understanding of fashion and for a retailer like this tastes can change on a whim, something I didn't pay enough consideration to in my original investment case. For a company that is operationally geared this leads to disaster. The earnings history alone would have told me that unpredictability was high here and I should have been more cautious. Contrast this with my investment in Debenhams, another retailer, but one that doesn't sell one particular line of clothes for which fashion could swing wildly. The earnings history of DEB is far more stable which can give an investor far more confidence in their valuation on an earnings basis.

However, another good lesson here is to contrast this case with TNO. In TNO, balance sheet weakness lead to my error in guessing future earnings to cause a virtual wipeout of my investment. With FCCN, the investment case has simply changed to an assets-based valuation whereby I have time to wait for the company to try and fix things because of the balance sheet strength. Maybe they will, maybe they won't, but it takes a lot of losses to wipe out the remaining £65m of tangible equity. If they do manage to turn things around there's the potential for significant multi-bagging as the previous expectations of decline in to oblivion get re-assessed. Fingers crossed for next year!

5) Software Radio Technology - SRT

Ah, SRT. This is the classic share I normally avoid like the plague. Few hard assets, no proven earnings and a punchy market cap that expects a lot. The CEO, Simon Tucker, gave a presentation at a Mello event and the story seemed (and still is, kind of) incredibly compelling. Huge market, mandated purchases, little competition etc etc. However a string of missed targets now calls in to question the whole investment case. Orders have always been a bit lumpy, but it feels like every results the next big order is just around the corner. Just not this particular corner.

I allowed myself a little punt on SRT because the story seemed so compelling and so likely to happen (don't they all?) but thankfully I at least had the sense to realise that an investment here was inherently high risk and speculative so limited myself to a small percentage of my portfolio. I topped up at 20p shortly before the shares got tipped by Midas and banked a decent profit before the shares continued their decline. I still hold some shares although it's still a small position for me. I'm a patient person and I'm curious to see how this case turns out so I'll probably hold on to the remainder regardless of what happens. Currently, I think of it as paying a low price for a good lesson - stick to value investing!

P.S. It's interesting to note that, as mcturra points out, the share qualifies for James Montier's Holy Trinity of short selling. D'oh!

6) Chemring - CHG

I outlined my original thesis on CHG at TMF. Presciently, I included the one following line:

"To be honest I don't know the defense sector well at all..."

Which was largely to prove my downfall. Earnings collapsed in a way I didn't expect and the share price fell with it. Thankfully, SaintGermain stepped in and sounded a cautious note in the thread which put me off stepping up my position size. He basically hit the nail on the head with statements like these:

"Industry slowdowns always start with order delays, then cancellations, then earnings downgrades."
"Given the current environment, I think there is downside risk here."

This is a general problem I think I'll encounter a lot - I'm a novice to a great many industries and hence won't have the experience that investors like SG do (He also runs an excellent blog that is well worth following - it's taught me a lot about his investment approach). The lesson here then is to stay within my circle of competence and be fearful when trying to value companies in industries I don't really understand, especially when the valuation is based predominately on earnings.

7) The Real Good Food Company - RGD

Lots of debt. Terrible long term average ROEs. A CEO a patchy corporate history. Low quality of earnings. Why did I buy here? Well, the forecasts for the future look good. If they are achieved the company will probably be cheap. Being completely honest I only bought a small position largely because other private investors I know whose opinions I value a lot like it, so I bought in spite of my reservations from the warning signs. Because that's my main reason, it's a mistake regardless of the eventual outcome. I'm still waiting to see if the forecasts will be achieved - management seem confident they will - but I'll probably be out if the share price reflects any positive results. I don't really know why I'm in this share at all.


Wow, that took a long time to go through, but it's a really useful (if somewhat painful) exercise. It's easy to put mistakes down to bad luck or external factors (I'm a big fan of learning about behavioural psychology - there's a multitude of ways for us to achieve denial) but in reality most will stem from some underlying error of judgement rather than some black swan killing the investment case.

Amazingly, in spite of this catalog of errors I've actually had a pretty good 2012 in investing. I'll do a blog post in the near future on the investments that actually went well, then my overall portfolio results (after the last trading day of 2012) and finally my selections for 2013.

Merry Christmas!

Disclosure: I own shares in FCCN, SRT, CHG & RGD

Sunday, 23 December 2012

Share buybacks - A thought experiment

Hello world,

I'm often taken to thinking a lot about investing but don't often document my thoughts. I've also realised I'm terrible at keeping notes on the shares I own (and why) and so the desire to change these two things has led me to start an investing blog, more for my own records than anything.

Anyhow, share buy backs. This is an issue that often comes up on private investor websites and opinion is quite divided. I'm firmly in the camp of pro-share buy backs, at the right price. Anti-buy back investors often point to the futility of many companies who have spent considerable sums buying back their stock but have little to show for it.

Even investors who seem to be pro-buy backs often like them for reasons I think miss the point. At a recent Mello investor event I was sat opposite the presenting company's CEO and another PI and the topic of share buy backs was brought up as a way of correcting the company's undervalued share price. "A share buy back will show confidence - that's what will drive the price back up. Also, you'll take out the seller who is putting downward pressure on the stock." said the PI. "No, the business is trading at a discount to net asset value! Buy backs would be incremental to net asset value per share!" I exclaimed. Sadly, both the CEO and PI stared at me blankly for a moment, before moving the conversation on to how good the vegetables were. I think my message may have been sadly lost...

Since then I've been thinking hard about how best to demonstrate why I think my line of reasoning is correct and I have a simple thought experiment/story to demonstrate what I mean - let's hope this goes better than my dinner attempt.


Undervalued Group Limited is complaining about their languishing share price. No matter how well they seem to do, the market just doesn't appreciate them. For some reason their business of hanging on to £10m in cash and just staring at it doesn't seem to be getting them the kudos they feel they deserve. The stock is trading at £5 per share and there's only 1m of stock outstanding. The balance sheet, being what you'd expect for a company that does nothing but stare at cash, is completely free of liabilities and only has its single asset - £10m in cash. The directors feel, quite rightly, that £1 is worth £1 and so each share should be worth £10.

Here comes along our hero, CantEatValue, who has just been given £5 in pocket money by his parents to invest. "Go along son, do us proud in the capital markets." his dad told him. He promptly finds Undervalued Group Limited and, spotting it is trading at a 50% discount to intrinsic value, makes his purchase of a single share (His broker has kindly offered to waive his first purchase costs and the country both Undervalued Group Limited and our protagonist are based in charge no taxes on anything).

CantEatValue then writes a letter to the directors (who work for free, by the way) urging them to pursue an aggressive share buy back to help close the gap to intrinsic value. The directors, having been too busy staring at the money to have thought of this before, think it's a brilliant idea ("It'll show confidence in our staring-at-cash business!") and begin repurchasing shares. Despite their best efforts, the price doesn't budge from £5 a share. The directors carry on buying and buying stock but it appears that every shareholder, apart from CEV of course, wants to sell at £5 a share! The directors eventually have bought back every single share outstanding other than CEV's lone share and the market price hasn't budged an inch.

"We've failed again! How can the market do this to us?!" the directors say, "It's just not fair!". They tell CEV the bad news, but he rejoices in happiness. "Are you mad?" say the directors, "Nothing has happened! The share price hasn't budged!". CEV pauses more a moment, then smiles.

"It's dividend time."

For CEV knows that he is now the sole owner of Undervalued Group Limited. The directors have spent £4,999,995 buying back the 999,999 other shares and he is the entitled to everything else that is left on the balance sheet - £5,000,005. He collects his £5m dividend and returns to his parents, who are somewhat surprised at their son's 100,000,000% return on his investment. "Not bad, son, how'd you do this then?" his dad asks.

"Share buy backs performed at a price below intrinsic value per share are accretive to intrinsic value per share!" he shouts excitedly.

"Oh. Very nice... anyway, have you tried these vegetables? They really are rather good."


So this example obviously contains a number of highly contrived elements, but I think the lessons are applicable to share buy backs in general. In this example the intrinsic value of the business was easy, it had no assets other than cash, no operating profits to confuse the matter and no taxes to pay. In the case where you have a business trading below intrinsic value that is based on the net present value of the cash flows from future profits I think the lesson still applies - buying £1 for 50p is good business regardless of whether the £1 is in cash available now or discounted future cash.

The other difference is that, in reality, a complete buy back of all the shares is impossible. My example was deliberately structured to show how ridiculously value creative the buy back was if taken to this extreme but it applies to varying degrees depending on how much can be bought back - each purchase by the company increases the intrinsic value per share of the remaining shareholders. The stock failing to go up is actually a good thing for remaining shareholders as it allows the directors to make more and more of a good purchase. This is what Buffett is referring to where he said that he hopes the IBM stock price does nothing or declines - it increases the effectiveness of their share buy back program on increasing long term intrinsic value per share.

More over, I don't believe this exercise is totally academic. Terry Smith did an excellent presentation* on share buy backs here and on page 34 he shows that the bottom quintile of book-to-market companies who did share buy backs handily outperformed the higher book-to-market quintiles who also did buy backs as well as the rest of the bottom quintile who didn't buy back. While a discount to book is no guarantee of a discount to intrinsic value it's probably a good approximation.

In a real life current example, Wexboy is currently petitioning the management of Argo to perform a buyback amongst other things. The company is trading at a huge discount to the cash & investments per share and even more to intrinsic value. I'm a holder and I wouldn't mind them taking a leaf or two out of Undervalued Group Limited's book!

*For another excellent resource on share buy backs, check out this by Michael Mauboussin