Friday, 25 January 2013

London Capital Group - Worth a (spread) bet

OK, so the title isn't winning any awards for the terrible pun but hopefully the rest of the post will compensate. I'm a fan of London Capital Group (LON:LCG) as I believe it's a business that is fundamentally very attractive and is suffering from a number of headaches in the short term which don't really impair the long term value anywhere near as significantly as the market is pricing it to.

So, what's the story? LCG are a spread betting firm, a mix of their own brands and white label to other big names such as TD Waterhouse, Betfair, Bwin.Party and Saxo bank. They offer a number of products but by far the most significant is their UK Financial spread betting service (£26.6m revenues in 2011) followed by their Institutional FX business (£8m revenues in 2011). Whilst you might think this business is something similar to a stock exchange in characteristics I see it far differently; the economics share far more similarities to the gambling sector, an area I used to work in and know fairly well. The vast, vast majority of clients do not use spread betting like true 'investors' but instead they speculate heavily on margin - and they don't speculate very well. Nearly all the clients end up as net losers. A few people have asked me how such a model is sustainable, how does the business survive if the customers keep going bust? It's simple really - the same way William Hill & co survive, through a combination of recruiting new accounts and having old accounts redeposit. You'd be amazed at the gamblers who deposit year in, year out and somehow convince themselves that they are actually 'winners' and 'the sharp money'. Spread betting is, as the name suggests, gambling. The average revenue per user is much higher than traditional gambling too, at ~£1.4k per annum compared to more like £300 for a bookie.

At the end of 2008 LCG were riding high with their share price touching 400p. Now they are hanging just over 33p. What happened? The classic case of high profit multiple (20x in 2007) meets profit collapse in the 2009 recession. Since then the company has lurched from disaster to disaster; first the FSA forced them to pay a significant fine on grounds that seem very harsh, then the company had to write off millions of pounds worth of software assets after they proved unsatisfactory. To top if off, the most recent trading statement shows that profits for this year have collapsed to a loss after revenues took a big dive. How can this happen? Well, spread betting revenues are inherently more volatile than that of traditional betting as they depend on volatility in the markets. Big swings in the markets encourage clients to trade more and generates high revenues. Having a quiet year in the markets is the equivalent of William Hill having half the football matches they'd normally get in a season.  To get an idea of this volatility, here's a graph I lifted from the last annual report:

Looking at the graph, it's almost pure fluke that revenue growth has been so smooth for the past few years - good half years can be almost double bad ones. IG Group, LCG's much larger listed competitor (LCG are number 2) also reported significant drops in revenue for the past six months so this is clearly an industry issue rather than just an LCG issue. This is a big crux of my argument for this share - I believe this is not a structural decline but rather a cyclical one. It's folly to value a cyclical business on one year's results and a far better method is to look at average earnings over a decent period. Joel Greenblatt calls this kind of investing 'time-arbitrage', I'm able to 'arb' the difference between the price now, caused by investor's short time horizons, and the price sometime in the distant future due to my long time horizon.

Given everything is so terrible with LCG, why do I like it the share today? Essentially it all comes down to valuation. The market has looked at the most recent result and decided the company will never make a profit again, as the company now trades at a discount to the net cash on the balance sheet (£20.3m of cash against a £17.7m market cap) and about half of book value (which contains intangibles - it trades at 0.84 of tangible book). This is for a company which has, historically, earned an average of 20.7% ROE for the past five years even including all the disasters.

The business also has a number of qualities that are very attractive. For one, it's number 2 in it's main market (although the number 1 is 10x larger in revenues) which is still growing overall. LCG has achieved a huge CAGR of 35% in sales for the past five years and IGG has also done 27%. Whilst I don't think this level of growth can be achieved in the future I don't see why double digit revenue growth, on average, shouldn't be achieved. This is a growth company in a growth industry. Secondly, the company has a number of competitive advantages. Whilst regulation is a burden for this company it does massively increase the barriers to entry - if you want to be another FSA regulated spread better you'd have to comply. Whilst it's possible to relocate offshore (and a number of their competitors do) the FSA badge of approval is valuable in it's own right. It'd be especially tough to come in and try and win the white label contracts that LCG already have. Also the product is not a commodity - it has to be good to attract and win clients and a new competitor would need to reach their standard to compete. The competitive advantages LCG and IGG enjoy are reflected in the very good economics of their businesses: Both are non-capital intensive and generate high average ROEs despite the large cash regulation requirement and both have huge margins. So we have a growth company with good competitive advantages earning a huge return on capital and enjoying high margins (key phrase here - on average) - what's not to like? :)

Some more tasty facts and figures: Including the broker's expected profit for 2012 (-0.4p), the 4 year average profit of the business is 4.53p. Given the current share price, that's an average P/E of only 7.36. An average of 2.18p was paid in dividends over the period too (assuming no final dividend this year) giving an average yield of 6.53%. Now, I've chosen the 4 year time period to be as harsh as possible as it excludes the good 2008 & 2007 results. The same figures for a 6 year period are 8.94p of average earnings for an average P/E of 3.7 and an average dividend of 4.36p for an average yield of 13.11%. Even going on just the horrible 4 year numbers though, which includes two years where essentially no profit has been made, the share price still looks excessively cheap. It's worth pointing out that I don't include the net cash at all in my valuation. This is because almost all of it the company is required to hold under FSA regulations and so it's more like working capital than free capital - don't expect any IND style large special dividends any time soon.

The way I see it, even if things carry on being terrible the company is still going to earn a decent return, on average, for shareholders at the current price. The other thing to remember is that margins have come down from a high of an average of 44.7% for the four years 2005-2008 to an average of 18.1% (on adjusted profit figures) for the past three years. Profit growth hasn't come close to matching the revenue growth because of this margin contraction. IG Group have managed to hold their margins in the 40%s over this period so clearly LCG have under-performed in this regard. This is due to a number of factors: First, management have launched a number of smaller products that have more or less all made losses so far and so dilute the margin. Secondly, costs in the core business have also shot up without a corresponding rise in revenue. This is something management are now taking action about and are looking to trim back the cost base & try and get the smaller divisions to focus on achieving profitability. They believe they've found some 15% of the cost base that could be taken out and Simon Denham mentioned at the Mello meeting that IT costs should be dropping after a period of investment anyway. This is a source of further upside - if the company can execute on their cost cutting promises profits should recover.

Another factor to consider is the current interest rate environment. LCG benefit hugely from higher interest rates because they carry so much gross cash they can't do anything with (cash from customers and regulatory capital) other than invest at close to base-rate levels. At June 2012 they had £67.3m of this gross cash so each 1% rise in interest directly adds an extra £0.67m of profit to the bottom line - it's that simple. Not only that, but LCG also charge their customers financing charges to hold bets open based on LIBOR. Again, an interest rise plays nicely in to generating extra revenue here. This is yet another potential source of significant upside should interest rates begin to rise.

One last thing that stood out to me in the presentation Simon did. I knew from my time in the gaming industry that the customers tend to follow an extreme pareto distribution - 50% of your revenues come from the top few % of your customers. The big 'whales' as they are known are very important. However, when I asked Simon about his customer concentration he replied that his top ten customers account for no more than a handful of % of his revenues. This was pretty surprising to me, so I asked how this was the case. It turns out it's a deliberate risk management strategy, which makes sense, but it does mean LCG are turning away their biggest and most profitable customers! Again, I see further potential upside here should they decide to change this policy.

In the dream scenario here, revenues recover, margins go back to historical highs & interest rates rise. Any combination of these three would see PBT shoot back up and trigger significant multi-bagging from the current price. The downside is fairly well protected due to the very strong net asset position, of which a large chunk is held in cash. In my mind, this creates a really attractive risk/reward proposition. Simon mentioned at the Mello talk that a number of potential acquisition suitors had come knocking after the share price decline which I take as a good sign - people who know the industry well are coming around making opportunistic bids. I doubt a bid will take place around the current price any time soon though, LCG has big insider ownership from the three co-founders who will demand fair value for any purchase (which they believe, as I do, is significantly above the current market price). Personally, I'd much prefer a slow but big recovery than a quick 30% gain from a bid and am happy that my incentives are closely aligned with management.

So what are the big risks? Well, cash has fallen significantly over the past 6 months - down from £25.5m to £20.3m, far more than the actual profit loss. I remember Simon Denham saying something like only £4m of that £25.5m was 'excess cash' so it must mean they are close to eating in to regulatory capital (although in the 2011 annual report they say that, of the £25m of net cash, they had £10.7m of surplus regulatory cash requirements so maybe I'm misinterpreting him?). I'd expect that the company have anticipated such liquidity needs and are prepared accordingly. Another big red flag is the COO, who is also a major shareholder, has quit to 'pursue other interests'. This is a big worrying although the optimist could interpret it the other way, that after a number of years of poor margin performance we are seeing a replacement in a very significant senior position. There's also regulatory risk present, as we saw when LCG had to pay a large fine to the FSA. I see this kind of risk as an unpredictable cost of doing business, which decreases my valuation of the business but not in a significant way. A more serious regulatory risk would be if the government changed the rules to remove the tax advantages of spread betting, which would be very harmful to the industry.

The other really big risk is that I've completely mis-read the revenue decline and it's the start of a serious structural collapse. If that's the case, the assets could become significantly impaired by losses and the downside protection would be eroded. However, I personally believe the odds of this are pretty low given the obvious cyclical history of the company. There's also a bit of a stigma for these companies recently after the MF Global and Worldspreads frauds with the companies both dipping in to client funds. I think this risk is in reality very, very tiny due to the insiders owning such a large proportion of the company. Why ruin a great long-term business by engaging in short term fraud? I don't see the incentive here and as Charlie Munger says "Never, ever, think about something else when you should be thinking about the power of incentives".

With all that in mind, I've made LCG a 4.8% portfolio allocation (down from last time due to the price fall and appreciation of the rest of the portfolio) and I'm tempted to top up after even more recent falls. As for the rest of my portfolio, since my last post I've sold out completely of FCCN and redirected the proceeds in to KENZ and MGNS (which have both gone up since, nice to have a bit of good luck!). The losses at FCCN were worse than expected and due to the high operational gearing of the company the risk here is too high for me. Against weak comparables from last year the company still reported a revenue fall. The company has net cash of ~£25m, granted, but they burned £10m of cash last year. Even if things don't get worse, which there's no reason why they couldn't, they'd burn through that pile pretty quickly. Operational gearing could make the situation either very, very good or very, very bad here - it's kind of an all or nothing punt. Since I'm an investor who likes to be fairly concentrated and I can't protect the downside here it's one I'm going to pass on.

This could well turn out to mistake and a number of investors are still bullish here, including Paulypilot who knows the sector far, far better than I ever could given he's worked in it but I don't feel like I'm able to calculate the upside/downside scenario probabilities here. If the upside scenario materialises I won't kick myself, there's always plenty of other opportunities out there. I will, however, be paying close attention to this graph on Google trends as it's probably a useful indicator of any turnaround success. The current graph direction isn't all that pretty though...

For the record, here's my portfolio as it currently stands now:

Disclosure: I am long LCG, KENZ & MGNS

Saturday, 12 January 2013

Why you're undervaluing good capital allocation

"All I can do is remind them of the truth of Albert Einstein’s alleged response when he was asked, “What do you, Mr. Einstein, consider to be man’s greatest invention?” He didn't reply the wheel or the lever. He is reported to have said, “Compound interest.”"

There's nothing so much fun as playing with a compound interest calculator and seeing the crazy numbers that get spit out for one's investment lifetime. Money invested at 15% for 50 years multiplies a thousand fold. The difficultly, of course, is achieving 15% - no mean feat at all. I like to think of there being two general 'routes' to compounding: Closing discounts and intrinsic value growth.

Value investing disciples love to trot out the lines about buying £1 for 50p. Obviously, that's kind of a good deal. The problem with it comes down to what is that £1 made up of? How do you know it's worth £1? Sometimes you can find stocks which have liquid assets that have market values of X and the security is selling at less than X. This is a case where the return is largely going to be driven by the closure of discount - you don't expect X to grow necessarily over time but you reckon that the gain possible justifies the time you'd have to wait in the investment to realise your return. This approach works very well and is essentially the true 'Graham and Dodd' approach to investment and one that worked nicely for Buffett during the early years of his partnership.

The downside to this approach is that it requires the constant finding of good reinvestment opportunities - once the discount is closed, where do you go from here? You have to sell and find another discount to close. This is why this style of investing is commonly known as the 'cigar butt' approach; you're getting one last puff but that's it. Whilst you're buying £1 for 50p that £1 isn't going to grow in to £2, or £10, or £100.

The alternative approach is to find opportunities where intrinsic value can be compounded internally by the management of the company over a very long time period. These kind of situations are exceptionally rare but incredibly lucrative if they can be identified ahead of time. Some companies are just 'born with it' - the nature and characteristics of their business mean they only need to deploy a small amount of capital to grow significantly. This was Buffett & Munger's insight in to Coca Cola; the presence of a large, sustainable competitive advantage in an industry where the economic conditions are fairly stable meant that the business could earn incredibly attractive returns on the capital it kept inside the business and give the excess back to the shareholders.

I was very interested to read this article in the FT recently where they cite Jeremy Siegal's work indicating that the 'fair value' of Coca Cola in 1972 was a staggering 92x earnings. Can you imagine paying that much for any business? Coca Cola was hardly growing at Facebook style rates then, yet the combination of highly predictable business dynamics and fantastic compounding returns on invested capital produced these outstanding results when given a long time frame.

This leads me on to the main message of this post: Good capital allocation is systematically undervalued. It almost has to be due to the difficulty of comprehending the power of compound interest. Financial students are taught to discount future cash flows to compute present values, but what happens when the compounding rate is higher than discount rate? The maths says as the growth rate tends to the discount rate, the multiple one should pay rises asymptotically to infinity. Our valuation methods just cannot deal well with excellent long term compounding. Of course, trees don't grow to the sky, but sometimes even small textile mills do grow in to giants.

As another demonstration of what I mean, let's consider Berkshire Hathaway. The year is 1966, and you've just noticed that a talented young investor has taken control of this textile mill. You've seen his results under his partnership and can't help but believe that he's going to do a great job of capital allocation when he's there. Fortunately, a wormhole from the future opens next to you and out drops two things: a piece of paper with Berkshire's share price at the start of 2011 (~$120,000) and the average annualised returns of the market since 1966 till then (9.38%). You eagerly do a quick bit of maths and work out the fair value you should pay to get the same return as the market - $2123 (120,000 / 1.0938^45)

What is Berkshire's current share price? $20. Book value? $28.3 The fair value of Berkshire Hathaway, a textile mill with terrible economics, is 75x book value. Anyone buying now isn't buying $1 for 50c. They are buying $1 for 1c. The compounding effect of a manager highly talented in capital allocation is worth a premium so large it's completely unfathomable. Man's failure to conceptually grasp the power of compound interest creates this gigantic valuation discrepancy.

Now, there's an obvious criticism to my conclusion here. I've deliberately picked examples of two companies that have been utterly exceptional. You can't identify winners like this ahead of time, you cry! Hindsight investing does no one's wealth any favours.

I disagree with this verdict. Whilst you're highly unlikely to identify the next Buffett you can identify managements who excel at capital allocation by examining their actions and modus operandi because they follow patterns. I recently read a fascinating book that lead to me making the conclusions I've outlined in this post: Outsiders. In it, William Thorndike identifies eight CEOs who most outperformed the market over their reign of operation. Obviously Buffett is one of them, but have you heard of Henry Singleton? Tom Murphy? I highly recommend reading the book itself as I can't do it full justice in only a blog post but the lessons are clear; here's a good extract from the book description:
"Humble, unassuming, and often frugal, these "outsiders" shunned "Wall Street" and the press and shied away from hot management trends. Instead, they honed specific (and less sexy) characteristics including: a laser-sharp focus on per share value rather than sales or earnings; an exceptional talent for allocating capital and human resources; the belief that cash flow, not reported earnings, determines a company's long-term value; and, a penchant for giving local managers autonomy to release entrepreneurial energy."
Reading through it certain attributes come out time and time again. Only making acquisitions at incredibly attractive prices. Buying back stock when it trades at a discount to intrinsic value (and the corollary, using stock to make acquisitions when it's over-priced). A tough focus on the rate of return from capital expenditure. Avoiding hot trends and the 'de jour' market hypes.

Whilst identifying the next Buffett may be close to impossible, checking whether management display the signs of skillful capital allocation is not. The results of their endeavours should be obvious - good capital allocation has to lead to excellent growth in intrinsic value per share.

When analysing companies, I always look to see if I can find that elusively rare find - management which display all the calling cards of excellent capital allocators. In my portfolio today, I think Judges Scientific (LON:JDG) best display these properties and it's the reason it's my number one position despite not being dirt cheap on any valuation multiples. Management repeatedly make acquisitions of wonderful companies at ridiculously low multiples. The inevitable result of this is CAGRs of sales and earnings at rates of 32% and 49.7% respectively over the past five years. The company currently trades on a multiple of expected 2012 earnings of only 14x. I'm not saying the company is a Coca Cola or a Berkshire and worth gigantic multiples of current earnings but I'm willing to bet it's significantly above the current market price. I'm happy to sit back, wait, and let intrinsic value grow for me. The market can do what it likes in the mean time.

Disclosure: Long JDG

Friday, 4 January 2013

Tracsis - Late to the party

In the past few days I've been researching a company which I've just added to my portfolio called Tracsis. This is one I've heard mentioned before on the zulu thread on ADVFN, amongst other places, but never got round to investigating it properly - sadly one of the constraints of only investing part time means I don't get a chance to do the amount of research for new investments as I'd like.

Now, I'm pretty late to the Tracsis party. The shares went from ~55p to ~160p last year - wow! Shareholders of 2012 are dancing hard but I still reckon the party has a way to run yet and I'm getting involved. Now I'm not going to do a full write up of TRCS as thankfully, as part of the NFSC on TMF, TheKingsGambit has done a brilliant, comprehensive write up here. What I will do is highlight a few aspects and themes of the investment I think are important.

High quality of earnings

I'm a strong believer in the power of the accrual anomaly. I'm going to steal Stockopedia's description of it for their screen because it's so good:

"This screen is loosely based on the influential work of Richard Sloan from the University of Michigan, published in 1996 documenting what is referred to as the “accrual anomaly”. A pound of earnings can be comprised of assumed non-cash earnings called “accruals.” His landmark 1996 paper revealed that shares of companies with small or negative accruals vastly outperform (+10%) those of companies with large ones His paper found that investors focus too heavily on earnings and not on cash generation. They value the earnings of a high accrual company just as highly as the same earnings of a low accrual company, even though the high accrual company’s earnings are more likely to reverse in future years. When future earnings reverse, investors are “surprised” and sell off the stock causing the stock price to decline. Similarly, when a low accrual company’s earnings accelerate in future years, they are surprised in a good way."

Tracsis have very high cash generation from their profits and hence very low accruals. In fact, if you ignore the one-off acquisition earn-out payment, they generated £3.57m of cash last year compared to a reported profit of £2.42m. Now part of this is due to improved working capital management which can't be a long term source of cash but even before working capital movements they generated £2.78m of free cash flow (excluding the acquisition payment, because I'm trying to work out the current 'steady state' cash flow production going forward).

This is very different to a number of software companies who love using capitalisation of software development costs to boost profits. Too many investors ignore the cash flow statement and treat all profits as being equal. I can tell you right now, I'd take hard cash over an intangible asset any day. You can't spend intangibles. This keeps me away from investing in companies like Globo (GBO), a software company that makes lots of accounting profits and so many investors go "Low P/E, good profit growth, must be cheap!" but this logic is flawed. Free cash flow has been negative for many years, so for GBO to be cheap it must demonstrate that the present value of the FCF it can generate in the future is greater than the market cap. It may well be that Globo's investment in it's software will generate these cash profits in the future and the intangibles are justified, but it hasn't proved it can go FCF positive in it's results - yet. This is the kind of situation I find hard to appraise and so I avoid.

Niche markets as a source of competitive advantage

I like companies that address small, niche markets. That sounds a bit counter intuitive, as surely investors want to find the next Facebook which have the potential to grow in to giants? Possibly, but I think it's far easier to identify companies that operate in markets in which only a very small number of companies can operate in. This specialisation allows for high returns as it generates pricing power - if you're the only guy with the best rolling stock planning software for railways then you can capture a lot of the value you create. Also, niche markets aren't necessarily low growth - they are just small in absolute terms relative to wider economy. It's also a highly defensive proposition if you're a niche, non-commodity product business. It'd be hard for someone to come along and win Tracsis's current contracts unless their software is of at least a vaguely comparable standard (which is hard to achieve given how specialised the knowledge base is) and a decent cost saving to the existing deal TRCS have.

Good capital allocation ability is under-rated

What I really, really like about Tracsis is how much they emphasise how disciplined they are in the acquisition process and make an effort to outline their approach. They also mention in their annual report about how they've looked at many potential acquisitions this year but none met their strict criteria. This makes me even happier that they a) have excess cash on the balance sheet and b) are retaining most of their earnings for growth. I strongly believe that investors under-estimate the power of good capital allocation (which is a skill surprisingly few managements tend to be good at) and the power of compounding - companies that can reinvest their earnings at high rates of return will do very well for shareholders in the long run and are worth a premium. I'm going to do a blog post about this topic at some point as I think it's a very, very important investment lesson many investors under-estimate even if they are aware of it.

I'll end this blog post with an update of my portfolio as it now stands. I trimmed some PVCS as well as adding funds to buy TRCS - still need to get around to adding more MGNS!

EDIT: Just realised I've missed off JD. from my Stockopedia portfolio, here's my updated list:

Disclosure: I own shares in TRCS

Wednesday, 2 January 2013

2012 results and my current portfolio

To conclude my mini-series reviewing my investing winners & losers here's a final tally of my results for 2012 and then lifetime (to include the disastrous half of 2011 I began investing in). Current positions are valued to bid prices and none of this includes taxes although all stamp duty, dealing costs, spread costs etc are included:


Total portfolio gain: 59.4%
Internal Rate of Return: 97.07%


Total portfolio gain: 36.59%
Internal Rate of Return: 39.50%

It's worth clarifying these numbers quite a lot. I added a lot to my portfolio throughout 2012 as cash became available so this skews the IRR a lot - most of my out-performance came at the latter half of 2012, just after I'd added a lot of extra cash to my portfolio. This both flatters the IRR and makes the damage I did in 2011 look less significant (I ended 2011 26.66% down, with a negative IRR of -43.47%! This is significantly under performing both the FTSE All share & Small cap indices IRR of -8.44% and -24.95% respectively).

I'd love to be able to say this was a genius act of market timing but it really wasn't, I've just got exceptionally lucky due to circumstance. I had no idea what direction the stock market would go in 2012 and I have no idea what direction the market will go in 2013; I just try and buy good companies at sensible prices then sit back and wait.

Two other significant factors also make this data next to useless for judging my investment ability. First, a year and a half is far too short a time period to judge investment results (especially when so heavily skewed by the timing of my cash allocation). I'm personally looking to judge myself over 5 year rolling periods, if I can't beat the market over that time period I'm probably not good enough and should just stick to index trackers (even if it is really fun trying all the same!). Secondly, I'm fairly concentrated, and for a large part of this year I had up to 20% of my total portfolio in a single stock (Judges Scientific) and currently have a bit over 50% of my portfolio in my top four positions. This style will naturally bring an extra degree of price volatility, although I disagree with the notion that this necessarily equates to increased risk.

Having said all that though, I'm obviously happy to be ahead of my target indices! I track the IRR of the FTSE Small Cap & All Share indices based on when I added cash in to the market and they have returned 8.54% and 1.00% since I began investing so I'm glad to be ahead (Also, do any readers know if these two indices, ASX and SMXX, are inclusive of dividends? I don't think they are and worry it's not a fair comparison). Anyway, it'd be a shame to ruin the party by going on and on about statistical significance wouldn't it? :)

Thanks to the wonders of Stockopedia's awesome portfolio allocation breakdown, I can give a peak in to what's in my current portfolio:

Now I probably need to do some tweaking here soon - PVCS has shot up to a larger position than I'm probably comfortable with (and the rise has reduced the margin of safety to my valuation, so I should be looking to make it a smaller allocation anyway) and I want to add more to MGNS so I'll probably make that change soon.

There's a number of shares on that list I haven't discussed at all in my 2012 review, largely because they haven't moved much in price to be counted as either a "winner" or a "loser" (ALLG, ARGO, KENTZ, LCG, MGNS, SIV). I'll get round to doing write ups on these shares in good time too, although you can read pretty much everything I think about ALLG in this thread on the TMF and I really have very little to add to Wexboy's ARGO series.

Happy new year everyone, hope it's a good one for investors!

Disclosure: I hold all the shares shown in my portfolio above... obviously.