Tuesday, 19 February 2013

A leisurely update

Now I'm not expecting to do frequent portfolio updates as I don't trade very often and most short-term market movements are just noise anyway but quite a lot has happened to my portfolio in the past month and a half so I thought I'd better get my thoughts together. Yesterday, my largest position - All Leisure Group (LON:ALLG) - announced their 2012 results. It's risen quite a lot this year, ~57% even after the pull back after the results, but I'm getting increasingly bullish on this share and don't see any need to trim it yet. It's actually my pick this year (and last year!) for the Motley Fool's share competition and I did a write up here as well as follow up comments so I recommend reading that first before reading this blog post.

The results at first seem very subdued. Revenue takes a large jump up but full year profits were tiny at £0.8m. What's there to be excited about? Well, 2012 is pretty much a transitional year for ALLG. Due to a weak cruising market (partly due to the Costa Concordia tragedy) and a fleet in need of a revamp the directors took the decision to pull three (out of four) of their ships out of service for a good part of the year for upgrades. Also, for one of their ships a third party charter pulled out and left the vessel out of service (during which they decided to do the upgrades). As a result, their cruising division showed a stonking loss for the year of -£6.9m - they say the loss of the charter 'contributed significantly' to this loss. However, this is in the past and we now have a fleet that's been recently upgraded and ready to operate at full capacity again. This appears to be paying dividends already:
"At the start of the winter 2012, mv Voyager was in the exceptional position of being 82% sold for that season prior to her inaugural sailing. Currently revenues per diem for mv Voyager are forecast to be 20% higher than achieved 2011/12 on mv Discovery. This is driven by the increased number of outside and balcony cabins and less capacity."
"Over the winter 2011/12, mv Minerva was out of service for just over three months, whilst a substantial technical upgrade was carried out. During this time the ship also underwent an extensive upgrade to both public areas and the 197 cabins. 73% of the cabins are outside cabins and clever use of space increased the number of balcony cabins from 12 to 44. A new observation lounge added to Promenade Deck increases the on board facilities. Passenger response to the upgraded vessel has been extremely positive."
So if cruising caused such a big loss, what made up the difference? Here we get on to what I see as being a very exciting development for ALLG - the acquisition of Page and Moy Travel group. They first announced the acquisition here where the headline figures got my attention. They paid £4.2m for a group doing £107.6m in revenues! How did they get it so cheap? The catch - it made an operating loss of £5.6m in 2011. Not great. The previous owners were two banks - HSBC & Credit Agricole - who ended up with it after the previous private equity owners, HgCapital, went bust with it in the 2008 downturn. It's probably worth noting at this point that HgCapital paid £180m for it. Whoa. Clearly they were far too optimistic but it's clear this business has done pretty well before in the past to have warranted such a price. Naturally the banks here just wanted this loss making business off their books so weren't price sensitive allowing ALLG to swoop in and nab it for a relative song.

At the time of the acquisition I was a bit worried as it seemed a big risk to be taking on such a loss making business given the current one wasn't firing on all cylinders either. However the heavy degree of insider ownership re-assured me that if anyone was going to lose big here through hubris it was going to be the directors so I trusted they'd thought this through (I very, very strongly prefer owner-operator shares. Never forget the power of incentives!). The annual results give more detail on the acquisition so we can learn more about what's going on here. Let's take a look at some figures for Page & Moy in 2012:

Full year results:
Revenue: £93.9m, Profit: £4.6m

Contribution to results:
Revenue: £60.9m, Profit: £8.9m

Balance Sheet Pre-Acquisition:
Tangible Assets: -£14.7m

So this tells us another reason why they got the business so cheap - it has negative tangible assets. This has pros and cons: pro, it means the business probably operates on negative working capital (like the cruising business) so expansion is an extra source of cash which can be used in the business. con, it means if things turn south the business is in trouble. That being said, the directors also state the business is a "low-risk model and has no forward financial commitment for hotel costs, transportation costs, or aviation capacity", which it probably needs to be to make negative working capital operation safe and viable.

It also says that the timing of the acquisition flatters the profits by £4.3m, so the combined entities made a loss in this FY. However, the major plus is that management have already turned the £5.6m loss in to a £4.6m profit. It hence means they acquired the business for less than last year's profits! What a wonderfully shrewd move by management. Revenue is down from 2011, yes, but this is due to cutting unprofitable lines of business. To quote the results again:
Following a detailed strategic review of the Page and Moy Travel Group brands and product portfolio prior to its acquisition, a number of underperforming products and business lines have been discontinued for 2013. Ceasing to operate the ex UK coaching holidays and components of the Christmas programme was part of this strategy, along with the decision to phase out the Page & Moy brand and incorporate the profitable components of the business into Travelsphere's portfolio of tours. The Group then re-launched the Travelsphere brand as a value for money, yet quality product. The end of year results show this has been very successful and going forwards the flexible business model of our Tour Operating Division allows us to align our capacity to fluctuating demand.
This means the 'pro forma' results of the business in 2012 were:

Revenue: £160.4m
Operating profit: -£3.5m

However we now have all ships upgraded and back in action. Given the non-acquired business did £66.5m this year but did £80.4m in 2011 implies at least a boost of £14m in revenues just from ships coming back in. Stockopedia reckons that the brokers are putting them on £202m of revenue for 2013 (although these same brokers reckoned they'd do £192m of revenue this year and make a 5.2p profit - no idea how they thought that was possible!!) which seems high but potentially achievable given the ship upgrades in capacity and quality. For fun, let's imagine a set of  'pro forma' results that take the 2011 ALLG numbers (with no ships out of capacity) and the 2012 Page & Moy numbers and combine them:

Revenue: £174.3m
Operating profit: £8.0m

So this puts this hypothetical year (which is probably closer to an average year) on a P/E of 3 at the current share price! Now in this hypothetical year the directors are still complaining about how poor the results are due to the economic climate (they were in 2011 and in 2012's results,) so clearly they still see the margins here as being poor at ~4.6%. ALLG was doing solid >11% margins pre-2009 so clearly there's scope for improvement there (although I've no idea what P&M's average margins are). So, we have a business on a pro-forma P/E of 3 despite the E being disappointing. This is why I'm so very bullish on these shares and think there's still plenty more upside available when the true earnings power is revealed here in the next few years of results and the business gets re-rated to a more sensible valuation.

What are the risks here? Well, besides all the ones I've mentioned before in my other posts I think the big new one is balance sheet risk. The weak balance sheet of P&M means that the combined business only has £9.3m of net tangible assets and the previous tangibles are now intangibles. I think the benefit of increased earnings power here outweights this though.

That's my updated thesis on ALLG. Since my last update I've also added CLIG & SIGG to my portfolio. I got the idea for CLIG through a Motley Fool write up here (and there's more here) and I especially liked their shareholder-orientated incentive structure (as well as the dirt cheap price and wonderful business economics). This quote from the annual report really got my attention:
As shareholders are aware, we run a business with a very simple business model. We collect fees from our clients for our services, we pay our bills which are both forecastable and to a great extent fixed. We don't use leverage, nor off-balance sheet instruments, nor do we trade derivatives as principal (other than occasional low level hedging). There are no associated companies or minority interests within the Group. We do not use tax havens. We do not handle client monies. We have a significant amount of cash in the bank relative to our size and we basically stick to what we know.
With regard to remuneration we continue to distribute 30% of our profits as profit-share. Our staff, clients and shareholders understand this formulaic approach. It's a pity that this approach has not been embraced by the financial service industry generally. As it is, in many parts of the financial services industry it seems as if losses are not the responsibility of mangers rather it's the shareholders who take the rap. Whilst our formulaic approach seems out of keeping with many in our industry, at least our shareholders have an idea that our returns go up and down together with theirs.
We have continued to manage our business very conservatively. We have continued to attempt to keep costs down. We do not spend shareholders' funds entertaining and we generally attempt to manage our business as if shareholders were present in our offices every day of the week. One reason I would suggest that expenses are kept down is because staff are either shareholders themselves or own shares via the CLIG ESOP. At present staff own (including ESOP ownership) 27.9% of CLIG shares, and 75 out of 82 of us are incentivised in this way (a handful of more recent recruits do not yet hold options).
As for SIGG I got the idea from @marben100 on Twitter and read some notes @BrianGeee1 kindly sent me. Essentially it's a wind-up play for 96.4p of assets compared to a market price of 57p. There's a lot of worry on ADVFN about the quality of the assets and how illiquid they appear to be. The new management however take a low management fee of 0.5% but are largely compensated as to how quickly and effectively they can realise the assets for shareholders so I'm glad our incentives are aligned here. Even at a big hair-cut and a relative slow asset realisation process my IRR should be decent here. I currently also have one other share on buy list but I'm waiting for cash to build up before I buy it - I'll reveal more when I actually pick it up!

In other news, my big write up on LCG came good when not one but three potential bidders appeared! I made some comments in my stockopedia post here as to what I think could happen. I'm still very bullish on the shares. MGNS also announced their results today and they were pretty disappointing - especially the big dividend cut. The outlook is still grim but the price is so low for a business that is clearly only suffering from a cyclical downturn that I'm happy to still sit tight and wait it out. It's another owner-operator share and John Morgan has stepped back in as CEO to take charge so our incentives are aligned here - I trust him to focus on long term shareholder value.

We're clearly in a full on bull market in UK small caps at the moment, with the FTSE Small cap index (ex. investment companies) up 8.25% YTD and the AIM index up 6.64%. I'm a bit torn between the worrying signs of increasing optimism from other investors however I still think I can find companies on cheap valuations so I'm not taking money off the table yet. I've had a good start to the year so far - I made only one short-term performance prediction in my 2012 performance review and that was that there was no chance I'd better my IRR of 97% (which I made entirely through lucky timing). Currently I'm being proved very wrong and my IRR for 2013 YTD is 166% as my portfolio is up 13.8%! As much as I'd love to put this down to skill I have to hold my hand up and admit I'm just the lucky beneficiary of a bull market - a lot of my out-performance has been driven by a handful of concentrated positions (especially ALLG) so it's statistically meaningless unless I can repeat this over many, many years.

Right, that's the end of this update. My current portfolio allocation can be seen below (Disclosure: I own all the shares shown):

Monday, 4 February 2013

What's your investing edge?

There's a number of parallels between the twin worlds of investment and gambling. It's no surprise that many hedge fund managers also enjoy playing poker (Like David Einhorn) and both Buffett and Munger have used the analogy of the pari-mutuel system to describe investing. To quote Munger from this talk (italics are my emphasis):
The model I like—to sort of simplify the notion of what goes on in a market for common stocks—is the pari-mutuel system at the racetrack. If you stop to think about it, a pari-mutuel system is a market. Everybody goes there and bets and the odds change based on what's bet. That's what happens in the stock market. 
Any damn fool can see that a horse carrying a light weight with a wonderful win rate and a good post position etc., etc. is way more likely to win than a horse with a terrible record and extra weight and so on and so on. But if you look at the odds, the bad horse pays 100 to 1, whereas the good horse pays 3 to 2. Then it's not clear which is statistically the best bet using the mathematics of Fermat and Pascal. The prices have changed in such a way that it's very hard to beat the system. 
And then the track is taking 17% off the top. So not only do you have to outwit all the other betters, but you've got to outwit them by such a big margin that on average, you can afford to take 17% of your gross bets off the top and give it to the house before the rest of your money can be put to work. 
Given those mathematics, is it possible to beat the horses only using one's intelligence? Intelligence should give some edge, because lots of people who don't know anything go out and bet lucky numbers and so forth. Therefore, somebody who really thinks about nothing but horse performance and is shrewd and mathematical could have a very considerable edge, in the absence of the frictional cost caused by the house take.
Whilst many gamblers consciously try to find their edge through techniques like statistical analysis and informational advantage I find many investors have never really sat down to think about what their edge is. There's a famous saying in poker that if you sit down at the table and can't tell who the fish (the worst player) is, you're the fish. You don't want to be the fish at the investing table! Ray Dalio, the founder of Bridgewater, has similar thoughts on investing:
The bets are zero sum.  In order for you to beat me in the game, it's like poker, it's a zero sum game.  We have 1,500 people that work at Bridgewater, we spend hundreds of millions of dollars on research, and so on.  We've been doing this for 37 years and we don't know that we're going to win.  We have to have diversified bets.  So it's very important for most people to know when not to make a bet.  Because if you're going to come to the poker table, you're going to have to beat me, and you're going to have to beat those who take money.  So the nature of investing is that a very small percentage of the people take money essentially in that poker game away from other people who don't know when prices go up whether that means it's a good investment or if it's a more expensive investment.
There's a number of ways to gain an edge in investing and beat the market. The most obvious is an analytical edge - you have the same information as everyone else, you're just able to process it better than others and see what the market doesn't see. If your valuations are consistently better than everyone else then over time you could beat the market. The problem with this approach is that it's very hard for stocks that have a large analytical following. For stocks in an index like the S&P500 or the FTSE100 you are up against thousands of analysts who pour over every result and are also looking for valuation discrepancies. Especially for the lone private investor, beating the large cap indexes consistently is very tough. The high degree of competition makes out-performance harder and harder. Michael Mauboussin addresses this concept in his book, The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing:
The key is this idea called the paradox of skill. As people become better at an activity, the difference between the best and the average and the best and the worst becomes much narrower. As people become more skillful, luck becomes more important. That’s precisely what happens in the world of investing.
This is the foundation of the 'Efficient Market Hypothesis', that stock prices reflect all information known about them and hence cannot be beaten. Whilst I don't believe that the EMH is perfect (and certainly some of the stricter forms of it seem completely barmy to me!) there is a degree of truth to the idea that having more and more analysts tracking a security will tend to make it more efficiently priced.

Another route to investing edge is an informational one - you know something about the company that no one else does and it's significant in determining a valuation. Again, for stocks that have a large analytical following we run in to the same problem - many people are doing all they can to talk to customers, suppliers and industry experts to glean further insight in to a company or an industry and profit from anomalies. For the private investor it's tough to compete against big research teams with huge budgets. It's also illegal to act on insider information, not that it always stops some hedge funds.

So what can the private investor do to find a source of edge? I think PIs have a number of ways they can gain an edge over the investment professionals - they just need to pick their bets carefully. Private investors aren't managing huge amounts of capital so they can explore smaller opportunities that bigger managers can't. It's worth the time for a PI to spend hours reading up on some small micro cap stock that only has the one house broker because the lack of research competition is likely to throw up big mis-pricings that can be taken advantage of by the good investor. Private investors can get both an analytical and informational edge over the market by focusing on the less-followed securities because the wider investment community is neglecting the opportunities. Howard Marks sums it up best:
People should engage in active investing only if they're convinced that (a) pricing mistakes occur in the market ... (b) they - or the managers they hire - are capable of identifying those mistakes and taking advantage of them.
The other big edge PIs can have is that of patience. Big institutional funds are often forced by redemptions to sell their assets even if they think them to be cheap and equally compelled to buy assets if they have inflows. This creates a buy high, sell low approach that means that investors as a whole under-perform the funds they invest in. The smart private investor can manage his affairs such that he never needs be a forced buyer or seller and can be patient in waiting for attractive opportunities. Institutional investors are compelled to do what their (frequently irrational) clients want them to do. To quote Buffett:
The stock market is a no-called-strike game. You don't have to swing at everything -- you can wait for your pitch. The problem when you're a money manager is that your fans keep yelling, "Swing, you bum!"
Obviously none of these edges come easily. The PI needs appropriate analytical skill, an understanding of the economics of the businesses (the 'circle of competence') and the emotional strength to act against the crowd when they spot big opportunities. None of these abilities come overnight but they can be learned with time, discipline and patience. However, if you want to outperform the market through active investing, having a reliable source of edge is the only way. You don't want to be the fish at the poker table!