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

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

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:

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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:

http://www.investegate.co.uk/elektron-technology-(ekt)/rns/directorpdmr-shareholding/201201180700227333V/

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.

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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