Half year review - Part 2

Continuing on from my last post here. Technically since last time I have one to add to the 'Closed positions' list as I've sold out of MGNS, so I'll start with that.

Closed Positions

MGNS - Morgan Sindall

Whilst I still think Morgan Sindall is not near fair value, this has been an odd case of a) the investment case deteriorating yet b) the share price increasing leading me to sell out in search of better ideas. I originally bought in to Morgan Sindall on a thesis that a) the company has a good, decade plus record of well managed, value-creating growth b) it's an owner-operator share c) It was trading on a low P/E of around 7 whilst earnings and margins were far towards cyclical lows d) it paid a ~7% dividend. Since then, margins have deteriorated even further to a record low (at least as far back as I can see, to 1999) and the dividend has been cut for the first time (at least not since 1999). Whilst I still think this is a function of the cycle which will eventually turn the other way, the market has run up recently such that I was sitting on a ~15% share price appreciation despite the fact that broker forecasts for future earnings have been trending downwards:

Whilst I'd still bet on a medium term regression-to-the-mean here and the long term success of MGNS, it no longer appears as dirt cheap given recent fundamental & share price performance, sitting on a forward P/E of 11. I decided to sell on the basis of opportunity cost given the ideas I have elsewhere.

Open Positions - Contributors

ALLG - All Leisure Group

All Leisure has had a volatile 6 months, rising from 23.5p at the beginning of the year to a high of 52.5p, before falling back to the current price of 31p. I already did a big update fairly recently on ALLG here so I'll just add my thoughts on recent developments. I still think ALLG is one of the cheapest stocks I own, although it does just love stumbling between one-off disasters. This RNS basically sums up the recent troubles - with ship technical problems causing cancellation of a few cruises and the political troubles in Egypt cancelling some more. Both of these will lead to one-off costs of ~£3.1m, not insignificant. Together with the extra synergy costs planned for this year I actually expect ALLG to return a full year loss.

However, this is not necessarily the year I thought earnings would especially shine as ALLG flagged up before that they would already have a number of one-off costs due to integrating the acquisition of Page and Moy (which I still think was an utterly fantastic purchase). The light at the end of the tunnel though is that trading appears to be improving. The medium term bull points appear to be coming to fruition:

"The integration between the cruise division and tour operating division in Market Harborough has gone well and the Burgess Hill office was closed on the 31 May 2013.  The cost to the company and the synergies outlined previously remain in line with expectations.  Where previously the company had experienced later bookings, trading at this early stage of the financial year 2013/14 has started very well across all brands, with the exception of Discover Egypt, which has limited forward capacity.  Sales for Voyages of Discovery are up 30%, Swan Hellenic 21%, Hebridean 19%, Travelsphere 23% and Just You 29%."

Hopefully this should lead to margins returning to pre-2008 levels for the cruising division. Together with the post-synergy contributions from Page and Moy I can see the real normalised earnings power of ALLG being revealed which should lead to a well deserved re-rating by the market.

ARGO - Argo Group

I invested in ARGO after reading Wexboy's excellent extended thesis and agreeing with how very cheap it is. Given the move in share price from 12.5p to 14.8p, together with a 1.4p dividend, ARGO has given decent returns so far yet still trades at a huge discount to intrinsic value and even the cash and investments held on the balance sheet. I still harbour hopes that Wexboy's persistent activism will lead to some of the value-generating moves he suggests being taken up by management. Their funds have been performing really well recently as was highlighted to me by @FlorisOliemans, with the The Argo Fund up ~15% YTD but especially the Argo Distressed Credit Fund which is up a staggering 33.6% this year. These developments should bode well for AUM as well as Argo's ability to attract new business based on this excellent performance (and don't forget earnings! 33% returns do quite nicely under a hedge fund cost structure...). I continue to hold in anticipation of greater gains.

JD. - JD Sports Fashion

My thesis on JD Sports is fairly simple. We have a business which a) has shown good long term growth and returns on investment b) has depressed earnings from taking over a loss-making business, Blacks, from administration which should contribute, not detract, from performance further down the road and c) trades on a low multiple of such earnings. The share price has rallied from ~700p to around 900p yet the business still looks fairly cheap. It's quite interesting comparing it with Sports Direct (SPD), its major competitor, which trades at a price to sales ratio of 3.6 yet JD. can manage only a lowly 0.35! Whilst SPD looks expensively priced to me (and, to be fair, is a better business, although not much better), the comparison is still staggering. The main detraction to me is the reputation of the chairman, Peter Cowgill, who has a number of vocal detractors on message boards due to his behaviour at MBL group. Despite this, I continue to hold (although a smaller position than usual)

JDG - Judges Scientific

I try hard to keep myself rational when considering Judges but it's hard not to love a management team who can deliver such exceptional compound growth. The Judges' story still hasn't changed in my mind although the best share price performance is behind it due to the re-rating that has occurred since my first purchases - on a historic P/E of around 7 - to the current P/E of 20. That being said, the compounding effect of Judge's business model means that a re-rating isn't required for exceptional share price performance in the future - that P/E keeps getting eroded with a rating of ~14.5 on forecasted 2014 earnings (which I think look far too conservative given the potential earnings impact of the last acquisition, Scientifica, as well as the fact that pro-forma organic growth is now up to 13% because of how strongly GDS and Scientifica are growing). I trimmed my holding based on the re-rating having occurred but I intend on holding a significant portfolio allocation for the long-term. If I had to put all my money in a single share and go and live on an island for the next decade Judges is exactly where I'd put it.

KENZ - Kentz

The KENZ price is a funny one that seems to swing repeatedly between about 370p and 430p. The fundamental performance however has been fairly positive, with repeated trading updates about how everything is going swimmingly and new contract wins. KENZ has the headwinds of its major customers being squeezed on capex as miners and oil companies cut back on investment however despite this Kentz has been able to grow earnings. KENZ ticks all my boxes of being a) a high quality company that earns high returns on investment b) having excess balance sheet strength that's being ignored by the market (although I've read recent reports that Kentz intend on using their excess cash to make acquisitions - seems like a good time whilst the whole sector is quite cheap) and c) is available to buy at a single digit P/E, and is even more attractively priced on EV-based metrics. The biggest detraction is the high accruals rate in the past year, although Kentz have given explanations for this that seem reasonable to me. I did a more detailed post about this on Stockopedia here. I added recently at the ~370p trough and made a small trim recently at ~420p (just in case the previous price behaviour decides to continue frequent re-balancing seemed sensible) and am a happy holder.

I've still got LCG, PVCS, SPRP, TNI and TRCS to update on but I'll save these for another post. SPRP certainly warrants a longer mention as it's a new position I haven't written about before and I hold in some conviction as it's ~10% of my portfolio at the moment - lots more share price appreciation to look forward to I hope!

Half year review - Part 1

As it's now (a bit over, I'm slightly late!) 6 months into the year it's time for a portfolio update. Whilst I think 6 months is an insanely short period to measure portfolio performance it's at least interesting to reflect on decisions made in the time period and try and look for areas of improvement.

For reference, here's what my portfolio looked like going in to 2012:

And here's what my portfolio looks like now:

Summary

As of this weekend, this corresponded to a total return of 20.4% after costs (An IRR of 44.1%). Whilst good, this is only marginally ahead of the returns I'd have made in the main benchmark, the FTSE Small-Cap Index (ex-investment trusts) of 18.4% although decently ahead of the FTSE All share, which would have grown my capital 12.2%.

I've gone from a total of 16 investments down to 13, so I've gone more concentrated overall. Partly this is down to a conscious choice to limit the number of holes on my investment 'punch card' in order to force me to really think about my investments although I'd quite like to go back up to around ~15 investments as this feels like a good balance between concentration and diversification.

The big positive drivers of my overall return have been from ALLG, JDG and SPRP. ALLG & JDG I felt were my best ideas and hence had big allocations going in to 2012. Both performed well, with JDG reaching new highs recently although ALLG has given a lot of performance back since peaking at over 50p in April. SPRP is a more recent addition I made with the proceeds from halving my stake in JDG (made because it was making up an uncomfortably high % of my portfolio)

The biggest detractors of my performance have been from CLIG and C21. I continue to hold both, and have added more to CLIG recently as the price has fallen.

Closed Positions

FCCN - French Connection

Closed out around 26.5p. To quote a previous post:

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.

CHG - Chemring

Sold out at 273.3p. It was a small position for me (I covered CHG in my 'Investment Mistakes' post - it didn't go very well!). A combination of feeling that I couldn't determine intrinsic value anymore due to the rapid earnings collapse as well as a desire to focus on high conviction positions led me to sell out.

STAF - Staffline

Sold out at 339p. I still really like the company and sold far too early (the shares are now 440p) but at a P/E of 12 (when I sold) I felt I had cheaper ideas to invest in to. Also, I was concerned about the need to build up working capital from the Welfare to Work scheme and I disliked the fact it that part of the business relies on government spending for a policy-du-jour. That being said the company has a great long term track record and management have been executing well, so I can understand further price rises.

SIV - St Ives

Sold at 132p. Again, too early, the value investor's curse. Here quality of earnings concerned me, as investors seemed happy to focus on adjusted earnings and dividend yield ahead of true cash flow generation. When I met with management I was told that the restructuring was over and to expect no more exceptional charges - but now the exceptionals no longer live up to their name. I was also a bit weary of the prices being paid for some acquisitions, which are the main source of cash-flow reinvestment. On balance, despite seeming cheapish, I felt that after the price appreciation and my revised expectations for 'real' earnings I had better ideas elsewhere.

SRT - Software Radio Technology

Sold at 23p (D'oh!) as part of a deliberate focus of strategy to move away from hot growth stocks with no cash flow (regardless of the convincing nature of the story!). I felt the growth in sales being made over the last 2 years didn't justify the valuation and given the mandated nature of the sales I felt the story was undermined somewhat. The shares are now 34p, so I'm living up to my own incredibly low expectations of myself when it comes to market timing!

GFIR/SIGG

A wind up play I exited after participating in a tender offer at NAV. Overall I made a small ~5% return here, so not bad although I exited early after I changed my mind on the investment due to recent events. First, the new managers published a more detailed look at the assets of the portfolio which were worse than I was expecting. Second, the activist investor on the board resigned and has begun selling down their position. Third, after the tender the share price dropped much less than I expected it should have done given a constant discount to the non-cash assets. The combination of these three lead me to consider ideas elsewhere.

Open Positions - Detractors

C21 - 21st Century

My largest faller in my investment list, down 30% since the start of January (excluding dividends). Sadly this is a case of a GARP share losing the G part. EPS was forecast to grow to 2p (which also seemed reasonable to me given the recent success in winning contracts) but instead is now forecast to come in around 1p instead, quite a difference! The company put this down to delays in receiving orders, teasingly hinting that this is because the 'large value' of the contracts means they have to go out to tender first:

For the five months to 27 May 2013, our trading results are ahead of the Board's expectations but, as in prior years, the Group's sales targets are weighted toward the second half of the year. Generally the market does remain subdued and consequently we are encountering delays in progressing a number of potential sales. Given the value of these, the Board currently expects revenues for the full year to be similar to those achieved in the year to 31 December 2012 at around £14m.

These previously anticipated new sales have been impacted by a number of significant overseas customers needing to obtain funding from local transport authorities before committing to new projects whilst others, who are trialling EcoManager, potentially now being obligated to go through tender processes because of the large value of these contracts.

They also claim additional investment in marketing and sales is hurting short term profits for long-term benefit. If true, this is the kind of long-term thinking I applaud from public companies so I'm willing to give the management the benefit of the doubt here.

Thankfully because I was able to buy C21 with a large margin of safety in the first place even a drastic cut in expected profit doesn't make the shares seem overpriced (and the 30% decline has helped too!) - in fact they seem very cheap even under fairly pessimistic scenarios of growth. They have around £2m of net cash on the balance sheet (against a market cap of ~£10m) and are on a P/E of 10.5, 8.4 ex-cash and yield 6.67%. Should any of these large contracts ever actually appear then the company is insanely cheap although even under a no-growth scenario on sub-peak profits the investment is hardly expensive. I continue to hold.

CLIG

Currently down 16% on the year and over 20% from my initial purchases. However in this case I've decided to add more and build my position. Why? The shares have been under pressure from two sources. First, they are an emerging markets asset manager and EM indexes have been performing badly. I believe this to be a good buying opportunity rather than any long term problem with EMs and investors are overly focusing on the negatives when there's so many positives - see Wexboy's detailed thesis here - and EMs have historically performed well at similar valuations to today.

The much more worrying second reason is the recent board room shakeup. The founder, Barry Olliff, had to come back to lead the firm once more after the CEO and Finance director both resigned. Both these two were long-timers at the firm which makes this increasingly concerning, although the counter to this is that Barry and other insiders still own large amounts of the company and so still have their incentives well aligned with shareholders. As asset managers are largely 'people' businesses it's ultra-important to have the incentives between staff and shareholders aligned compared to other businesses.

On balance, the cheapness and quality of the business still attract me here. At the current prices investors are getting a >10% yield (which management confirm they will pay, despite low cover) and a low P/E on what I believe are cyclically depressed earnings. I don't know when EMs will come back in to favour but I think that they will eventually, helping CLIG to grow AUM again. CLIG's long-term investment results and refreshing approach to asset management also resonate with me, as I identified in a previous post.


That's all of my closed positions and significant performance detractors covered - I'll save the rest for a future post.

Next - The king of share buybacks

Next PLC (LSE: NXT.L) are a company most people in the UK will be familiar with as they are a large clothes retailer with over 500 stores and a FTSE 100 constituent. Perhaps what most people won't be aware of though is the phenomenal success of the shares over the past two decades. Since 1999 (as far back as I can see on Google Finance) the shares have compounded at a rate of 15.3% p.a., and that figure doesn't include dividends. Given other figures I've heard anecdotally from other investors, that figure is even higher if you go back further, rising above 20% p.a.!

Their latest financial report is a brilliant read and it's refreshing to have a company explain what they've done and what they intend to do so clearly without the usual waffle and management speak that's so common. In places they are brutally honest, even to the point where it's slightly comical! Check out this passage:

Planning remains a problem, though often more of a delay than a brick wall. We are actively working with planning officers, councillors and local communities to deliver new shops, investment and jobs. We continue to make a greater investment in the external architecture of our new stores, particularly on Retail Parks. Our aim is to transform the quality of construction associated with out-of-town retail and create the sort of buildings that communities will see as an asset, not an eyesore.

In our dealing with local councils it is noticeable that some are much more pro-growth and pro-jobs than others. Many local councils are enthusiastic and efficient; but a few remain an unhealthy mix of Luddite intransigence and incompetence. Going forward, in areas where councils traditionally have got away with just saying “no”, we will be more active in harnessing the law and the full weight of public opinion to campaign for growth

The part of the report that really surprised me though was the section where they explain their philosophy around share buybacks. Most companies don't really think very hard about share buybacks and when to do them but Next are explicitly clear that they see it as just another re-investment opportunity to be analysed alongside others. It's the kind of thing one expects to read in the Berkshire Hathaway annual letter and reminds me a lot of Outsiders (one of my favourite business books).

It's well worth reading the whole thing yourself, but here's some choice paragraphs:

Despite their increasing popularity, share buybacks are still widely misunderstood. There are still those who wrongly believe that they are some sort of share support scheme. This, of course, would be futile as any attempt to support a share price would evaporate as soon as the money ran out.

The only reason share buybacks can deliver long term value is because they permanently reduce the number of shares in issue and so increase the amount of profit attributable to each share (EPS). An important part of the logic of share buybacks is the implied link between growth in EPS and growth in share price. Whilst, in the short term there might appear to be no link, in the long run share prices tend to reflect the fundamental value of the earnings and dividend stream. If the share price did not rise with EPS, the buyback programme would eventually leave a single share owning all the profits and dividends!

Over the long term, we have been following these rules when considering buybacks:

1. Share buybacks must be earnings enhancing and make a healthy Equivalent Rate of Return (see below).

2. Only use the cash the business does not need. NEXT has always prioritised investment in the business over share buybacks.

3. Use surplus cash flow, not ever-increasing amounts of debt. We have never allowed our share buyback programme to threaten our investment grade credit status and will not do so going forward.

4. Maintain the dividend at a reasonable level through growing dividends in line with EPS. NEXT will continue to increase dividends in line with EPS.

5. Be consistent. NEXT has been buying shares every year for more than 10 years, reducing the shares in issue by more than 50%.

6. For share buybacks to be an effective use of shareholder cash, the core business must have the prospect of long term growth.

I'm not a shareholder myself as I focus exclusively on smaller companies (there's greater share mispricings to exploit) but for the LTBH large cap crowd I'd take a serious look at any company that has such a great record of capital allocation.

Where do I get my investment ideas from?

I've recently been thinking about my sources of investment ideas and how that's changed over time. Given I'm not a full-time investor time is a big constraint when it comes to finding good ideas given a lot of my time goes in to researching existing positions and checking and re-checking my current thesis. When I first started, I got essentially 100% of my ideas from two sources: The Motley Fool UK message boards and anything that came up on my share screener results. I used to use the Sharelockholmes screener but the new Stockopedia one is just brilliant - they have a selection of pre-prepared screens but you can customise and save your own so I've got plenty looking for things like negative enterprise value, low EV/Sales, low P/B & high 5y ROE etc.

As I've learnt more about investing I've slowly added more strings to my bow and now I get ideas from a much wider range of places: Blogs, twitter, bulletin boards, stockopedia, newsletters, company presentations, email contact and more. It's incredible the amount of ideas I have access to from a wide range of investors and a testament to the power the private investor can have in the internet age.

Right now I find I'm using blogs more and more as a great way to find initial ideas. I've got round to adding a 'Blogroll' to the site which contains all the investing blogs I regularly read - I recommend taking a look through them if you're interesting in finding more ideas from other investors (predominately small cap value investors, but there's a few others in there too) who are frequently far better than myself. Even if I don't find myself agreeing with the author's thesis I always find myself learning something so it's a great way to develop as an investor.

You may have noticed a fair few non-UK blogs in my blogroll (especially a number of US investors) and also noticed a distinct lack of any non-UK listed investments in my last portfolio update. This is not because my international counterparts have failed to convince me of the merits of their markets but, I'm embarrassed to say, largely a failure of my own investment process.

In the UK market I subscribe to two services (Stockopedia and Sharelockholmes) which together allow me to quickly investigate a company's financials within minutes and form a general picture of how the business has been run over a long time period. I find this is a great way to cover a lot of ground in a short period and to compare the numbers with the investment thesis I've read elsewhere. (As an aside, I'm a great believer in the ability of financial statements to tell the diligent investor a great deal about the business without even having to know anything about exactly what the business does. I can form an opinion rapidly on management's capital allocation ability, the underlying attractiveness of the historic business characteristics as measured by ROCE, margins, cyclicality etc.) I can also see at a glance all the usual 'core metrics' I'm interested in such as P/E, EV/EBIT, P/TB etc which is handy.

If I'm still interested after this quick check, then I go in to the next 'phase' and dig in to the original reports and detailed financials. The problem I have with international markets is I lack this 'quick investigation' phase which I rely on as a great filter of investment ideas already. Thankfully Stockopedia are looking to expand internationally soon so this should help on this front in time. I'd be interested to hear about what other private investors do when they invest outside the UK markets and what data sources & tools they use? (Or if any international readers have any tips for how best to screen data in their markets) It also doesn't help that my broker, TD Waterhouse, offer horrific FX rates for converting to international currencies!

Anyway, rant over. So what about the other methods I use? Bulletin boards are handy to keep up with news bits you might have missed on specific stocks but the signal-to-noise ratio can be terrible. I use ADVFN and they cover the UK markets (are there any good international BBs worth looking at?) but beware - some of the boards venture in to YouTube comment territory - I'm often worried that the stupidity might be contagious. That being said, often the companies I'm most interested in tend to be off the radar and it's a bullish signal if the only posters on the board of a new company I'm looking at are familiar value investors I recognise and not the ramptastic muppets. Also, I'd wager that the level of posting activity is inversely correlated with future investment returns - busy boards tend to signal that the crowd has arrived.

Twitter's a funny one, because you can't really convey an investment thesis in 140 characters but it does allow me to track specific investors I respect and see what they are buying and selling and why. I've already had one investment idea which I got off twitter (GFIR / SIGG courtesy of @marben100) but probably the other big intangible benefit has been from finding other investors who I end up following (both on twitter and on their blog, if they have one) and often end up communicating with about other investment ideas.

Despite all these modern internet methods of finding investments I've gotten a surprising number of ideas from the old fashioned method of attending company presentations and meeting management. I live in London so it's fairly convenient for me to attend the various private investor events that get organised around here and I only wish I had more time to attend these! My staple diet here consists of recurring dinners known as 'Mello' events. These are organised by @carmensfella who is a well known active UK private investor and I highly recommend going if you live nearby. There's also plenty of other company presentations going on all the time, as well as ShareSoc events, Blackthorn Focus events and more. I only wish I had more time to see more of these!

I am, however, highly cautious of being overly swayed by over-bullish management speak so I tend to try and form an opinion of the business first from the numbers and then use the Q&A time to understand specific aspects better and try and then try and get a feel for how competent management seem at important attributes like capital allocation. Management can talk and talk but it's their actions (which are reflected in the financial statements) that I'm most interested in.

What methods do you use to find good investment ideas? Which do you think work best? Ideas in the comments please!

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):

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!

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