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

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