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

Why you're undervaluing good capital allocation

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

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

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

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

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

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

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

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

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

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

I disagree with this verdict. Whilst you're highly unlikely to identify the next Buffett you can identify managements who excel at capital allocation by examining their actions and modus operandi because they follow patterns. I recently read a fascinating book that lead to me making the conclusions I've outlined in this post: Outsiders. In it, William Thorndike identifies eight CEOs who most outperformed the market over their reign of operation. Obviously Buffett is one of them, but have you heard of Henry Singleton? Tom Murphy? I highly recommend reading the book itself as I can't do it full justice in only a blog post but the lessons are clear; here's a good extract from the book description:

"Humble, unassuming, and often frugal, these "outsiders" shunned "Wall Street" and the press and shied away from hot management trends. Instead, they honed specific (and less sexy) characteristics including: a laser-sharp focus on per share value rather than sales or earnings; an exceptional talent for allocating capital and human resources; the belief that cash flow, not reported earnings, determines a company's long-term value; and, a penchant for giving local managers autonomy to release entrepreneurial energy."

Reading through it certain attributes come out time and time again. Only making acquisitions at incredibly attractive prices. Buying back stock when it trades at a discount to intrinsic value (and the corollary, using stock to make acquisitions when it's over-priced). A tough focus on the rate of return from capital expenditure. Avoiding hot trends and the 'de jour' market hypes.

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

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


Disclosure: Long JDG

Tracsis - Late to the party

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

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

High quality of earnings

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

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

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

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

Niche markets as a source of competitive advantage

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

Good capital allocation ability is under-rated

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

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

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

Disclosure: I own shares in TRCS

2012 results and my current portfolio

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

2012

Total portfolio gain: 59.4%

Internal Rate of Return: 97.07%

Lifetime

Total portfolio gain: 36.59%

Internal Rate of Return: 39.50%

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

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

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

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

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

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

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

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


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

My investment non-mistakes in 2012: Part 3

Right, let's wrap this up:

7) Halfords - HFD

I first bought Halfords in 2011 at ~295p on a very simple thesis. The share price had fallen significantly after 2011 profits were a bit disappointing (and it too has the 'retail' stigma attached to it), however HFD offered a) a business with high long term ROEs, b) a large yield of over 7% at the time and c) a low historic P/E. I thought that the decline in profit was likely to be relatively short term and the company would carry on growing in the future as it also had an auto garage business that was expanding to offset the retail slowdown.

I didn't really expect what happened next, when profits looked to have another year of -20% falls. I'm still not entirely sure what caused it, but the share price reaction was to knock a further ~35% off the price down to ~190p. I topped up again, at 210p, but was still kind of unsure as to why profits were falling so fast. Halfords then decided on a CEO swap, and together with a big boost in cycling sales from the British Tour de France success the share price swung back up as high as 355p. I got pretty lucky as I sold out completely at 351p basically because the shares looked much worse value given profits were still expected to fall significantly and, importantly, I don't really get why the decline is so drastic nor why it should reverse. I'd be interested to hear if anyone has any further light to shed on this situation.

8) Staffline - STAF

I don't have a great deal to add beyond Paulypilot's summary of his meeting with management here and MaxCashflow's share competition write up here. It ticks the boxes of a) good long term growth b) decent level of management ownership and c) an attractive valuation. It's gone up ~30% since I bought it so I've trimmed a bit at ~300p but I still hold a good chunk for the longer term.

9) 21st Century - C21

C21 is an interesting one. I got in to this quite late, making my first purchases at 17.8p (including the 3.5p return of capital) as it has quite a nice growth story but without a sky-high P/E. Carmensfella has a good write up here which is well worth a read. The really interesting thing for me is the number of very good investors who own large chunks of this share. The historical numbers probably aren't a good guide for the future here as so much has changed in the past few years after activist investor Peter Gyllenhammar effectively revamped the management and focused the company on its products which had achieved product/market fit and were beginning to grow rapidly.

Naturally, the next thing that happened after making my purchase was the shares tanked on no news. Actually, I consider this to be one of the great strengths of small caps. Share price volatility without fundamental volatility allows bargains to be had from time to time, and I took advantage here and added a lot more at 10p. As they declined even further to 8.5p I wanted to make a big top up but I knew Carmensfella had scheduled a meeting with management in December so I told myself I'd wait till then, learn more about the company, then add if I was still very confident. Sadly I never got this chance, as the share price recovered and the meeting never happened because senior management were busy with meetings in France (They have next to no sales in France at the moment, so this is kind of a good sign!) and they released this trading statement that really sent the share price up - which probably wins the record for most apologetic 20% rise in profits I've ever seen :)

Even at the current price of 14p, the shares are only trading on ~10x 2012 profits which seems far too harsh for a company that considers 20% growth disappointing. I'm planning to hang on in here and benefit from the growth and/or the re-rating it deserves.

10) Robinsons - RBN

Robinsons I bought pretty much entirely as an asset play. It seems clear they have a lot of land on the balance sheet which isn't reflected at its true value. Aimzine has a good write up here (you may need to register to read it, if you even can anymore, as they have now merged with investors champion). I also liked the side-story of them rationalising their business to focus on the profitable, higher margin "secondary packaging". In the end though, I sold out after a decent rise to ~120p (I first bought at ~90p) as I realised that, while the asset backing was nice, I probably wouldn't see any of it for a long, long time. To quote the Aimzine article:

"We see our substantial non-core land and property holdings as part of a long-term disposal process.  We will be looking to sell at the most opportune moment in the property cycle and in our opinion this may not arrive for at least five, perhaps even fifteen years from where we are today."

I don't really fancy management trying to time the property market, especially since they bottled their timing in 2005-2007 and it's not as though someone rings a bell at the top to let then know when to sell! After the rise, I decided that I didn't really fancy being around here for the long term as the ROEs the company earns aren't great (they are largely in a capital intensive commodity business after all) so at a forward P/E of 12 and a ~3% dividend yield I reckoned I could find better value elsewhere.



Right, that's all the shares that have contributed to my positive performance this year. I still hold a number of shares from 2012 that haven't really gone anywhere or I've bought recently and haven't moved (ALLG, JD., MGNS, KENZ, LCG, SIV) which I'll get round to discussing in 2013.

Disclosure: I own shares in STAF, C21, ALLG, JD., MGNS, KENZ, LCG, SIV

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 non-mistakes in 2012: Part 1

If that last post was really tough to write at least this one should be much more fun - I get to focus on what went right! So here goes: a list of all my positions this year that contributed positively towards my returns, roughly in order of contribution to overall returns:


1) Trinity Mirror - TNI

If you were looking for a rollercoaster ride this year, Trinity Mirror was probably it. It started the year at 48p where I thought it was insanely cheap having bought in 2011 at prices of 54.8p and 43.9p respectively. I did a post on TMF where I tried to value TNI but long story short I thought that a) The business was still highly cash generative and not declining that quickly and b) The balance sheet was much stronger than it first appears due to the large amounts of freehold property that hasn't been revalued in over a decade, a pension deficit inflated by artificially low gilt yields and a deferred tax liability that's largely a figment of some daft accountant's imagination. I pegged my target value somewhere in the 100's and felt pretty happy with my purchases.

Naturally, the next thing the share did was a steady decline from March to May down to a low of 25.5p. Why? I wish I knew, I'm still a bit baffled by it. No significant news came out really to warrant a 50% decline in share price. Perhaps there was a distressed seller? Who knows. I'd love to say I was cool as a cucumber and accumulated a gigantic position to take full advantage but really I was questioning my analysis. What does someone else know that I don't? Maybe I'm underestimating the danger of the pension liability? What if the phone hacking situation is set to take down TNI? I researched and researched and still felt pretty confident the equity was worth far more than the market price so I topped up significantly at 30.7p and 26.9p in April and May. It was one of my biggest positions but no where near the "all-in" bet I'd have made if I'd been ultra-confident - ah well, hindsight investing is so easy isn't it?

Since then my thesis has played out fairly well - the company announced profits ahead of market expectations (an unexpected bonus) and the old CEO got the boot which the market quite liked. The Happli investment got killed which I never really liked (Groupon has shown that the economics of daily deals isn't quite there yet). There was a bit of a hiccup when the phone hacking scandal flared up but I still think it's a largely insignificant event in valuation terms - big news, perhaps, but not big financially. Having said that, I don't think the news was almost 4-bagger worthy, which is what has basically happened since the lows of ~25p given the share is pushing for 100p now. The award for making a mockery of the efficient market hypothesis this year surely has to go to TNI.

Actually, I have a hypothesis as to why things are so crazy here: the accounting is totally nuts. I don't know how it's happened, but there's a few things that are bizarre going on in the balance sheet. 1) Check out page 53 of the 2011 annual report, they report negative equity of £675.4m when it's actually positive. Eh?! 2) How on earth did they decide to capitalise the future cash flows of the business and make it a huge intangible asset?! This is what gives rise to the vast majority of the deferred tax liability - it's the discounted value of the tax they'd pay in the future if they make the profits they expect... I've never seen any other business do this precisely for the reason that it's completely daft. Having said that, it is kind of interesting in the sense that, if management expectations are 'correct', the equity should be worth about book value as it includes not just the current assets but also the present value of the future profits. We're currently at 0.34 of book value...

I trimmed a little at 78p but only for portfolio balancing reasons - I still hold the majority of my stake as I think the upside here is still big. Come on 2013!


2) Judges Scientific - JDG

Oh Judges, how I love thee so! I initially discarded Judges for probably the same reason probably many people did, it's another company plagued by horrible accounting which hurts their profits (but not their cash flow, importantly) which put them on a huge P/E. I took a deeper look in January and liked what I saw. The Judges model is pretty simple but really powerful. Basically the company buys very small, niche scientific instrument manufacturers who earn fantastic returns on invested capital because they happen to be the only providers of these highly specialised instruments and components. It does so at ridiculously low valuations (sometimes P/Es as low as 4) because these companies are so tiny that there's no natural buyer for them. Judges also uses a reasonable amount of debt to leverage the returns but not so much as to pose significant risk to the overall company. If you can borrow money at ~5% and invest it in earnings yields of 20%+, you have a very good business.

It also helps that Judge's CEO, David Cicurel, is a pretty charismatic guy (he's presented at the Mello events in London a few times) and admits that a large part of his edge is that he finds these companies whose owners are at retirement age and want to cash out but want a buyer who will run the company 'the right way' which Judges can offer. Judges itself is still a very tiny company and will probably earn only a bit over £5m PBT this year and so this model still has a long way to run in my opinion, although David reckons that there's a lot more buying competition from the likes of Oxford Instruments (OXIG) for purchases with over £1m PBT.

I made my first purchases in January at 436p more as a value share (it was trading on a P/FCF of about 7 at the time) as I was learning about the company and after more research finally felt I really understood the potential of Judge's business model and decided to make it a my largest position by some way (~15-20% of my portfolio, that's how much I liked it). Sadly, before I could buy even more Judges announced an acquisition and the price shot up to ~650p. I have never been so sad to see one of my holdings shoot up in value! Despite this I bought anyway as I think the long term value is significantly higher than the price then and even the current market price. In fact, I intend to do a blog post at some point on how I think very good capital allocation is systematically undervalued by the market, but that's for another day.

Judge's CAGR of all metrics - revenue, profits, book value etc over the past five years has been astronomical and I still think there's plenty of years of 20%+ growth in the tank. Most companies able to do this kind of compounding get awarded, quite rightly, large P/E multiples but even after the rise to ~970p the share is only on a multiple of ~14x 2012 profits. If another year of 20% growth is achieved for 2013 then the share is still only on ~11.5x - even large multiples get eroded pretty quickly (N.B. All these multiples are before the convertible debt dilution which is ~12%. Even the adjusted P/E values are too low though EDIT: @marben100 has pointed out that ~95% of the debt has now been converted so these P/Es are all after dilution - bonus!).

A not-so-quick note on the accounting issues. Read on if you fancy falling asleep; if you're not in to detail then I suggest you skip to the next share. First, Judge's issued convertible debt a few years ago. For some reason, under current accounting rules this lead to them having to record losses to the equity because the share price rose significantly above the conversion price. Sort of makes sense, but really, really confusing and counter-intuitive unless you're an accounting geek. Company does well, share price goes up, so the company 'loses' money? Bizarre. The appropriate way to do it is to just value the company in a fully diluted equity sense, which is what I do. Thankfully the company are aware of how confusing this is and are looking to convert all the debt shortly.

Secondly, the latest IFRS rules seem to require acquirers to put a whole load of intangibles on the balance sheet like customer relationships, brand value etc etc and then amortise them. This is again, completely daft, as these intangibles are really just pseudo-goodwill. Goodwill hasn't been amortised under accounting rules for years and years, because it makes no sense to charge it off against profits as it doesn't reflect on-going capital expenditure. If you buy a good business it tends to be worth more than the accounting book value because it earns a high return on that book value - this is what 'goodwill' reflects. If the business carries on being 'good' and grows then, if anything, 'real' goodwill should increase, not amortise. I really hope this rule gets changed soon because it's only confusing to the non-accounting-astute investors.


3) PV Crystallox Solar - PVCS

A very recent purchase by me but it's still had a large impact on my returns this year - I only wish I'd spotted it at the start of the year! PVCS has long been tipped as a value share favourite since I started investing but it never really appealed to me when I looked at it when it was ~50p - fine, it had a low P/E, but it's in a commodity industry (they make solar energy components) and I felt that these profits looked set to collapse. And collapse they did - in 2011 they recorded a loss of ~£60m. Ouch. The share price dived down to as low as 3.7p as a once FTSE250-sized company dived in to obscurity. I imagine the decline won't have been helped by a number of institutions being forced sellers here because of the newly low market cap, creating a feedback loop which pushes the price lower.

The price doubled to ~8p on the back of news that they'd won a court case against one of their long term contract holders and been awarded €90m in cash for it. Against a market cap of sub £20m, this is obviously very significant news! The price then did very little for many months, but attracted the attention of such famous investors as George Soros and myself who bought in at a little under 8p (just kidding... no one has heard of Soros :)).

So given the situation is so horrible, why do I like it? Well, the company's balance sheet is actually very strong. They have no debt and the bulk of the liabilities are provisions for the losses they'd make if they have to execute their current long term contracts at the current market prices so the future losses are already priced in. What isn't priced in is the potential upside for the termination of the contracts with their buyers (apart from the one that's already been claimed). PVCS have been very sensible in agreeing long term contracts with both their suppliers and their customers so in the case of a large market decline, like now, they are protected to an extent. So while the downside occurs by overpaying their suppliers there is upside from their customers who have to pay way above market rate (or exit these contracts and pay the hefty cost associated with this). To quote their interim results:

"As previously disclosed, the Group had been negotiating compensation from a former customer for the termination of a long-term wafer supply contract.  A satisfactory agreement was reached in May 2012 and this resulted in a cash settlement of approximately €90 million.  This payment together with the successful implementation of our cash conservation strategy has considerably strengthened the Group's net cash position which was €122.4 million at the end of H1 2012 (31 December 2011: €22.6 million).

We have been unable to reach a satisfactory agreement with two long-term contract customers who have been amongst the industry leaders in recent years and we are seeking resolution under the jurisdiction of the International Court of Arbitration.  While successful judgements in the Group's favour are anticipated there is increasing uncertainty as to whether one of these companies will have the financial resources to fully settle its claim."

Such cash works out to be 23p per share in total of which the deal was ~17p of that! Now, the company expects that this will be "by far the biggest" settlement and one of the remaining two may be unable to pay but the one settlement that is still expected should still be pretty significant. Even if it was 4p, that would be 50% of the price I paid for the shares and 36% of the current price. It's worth noting that JP Morgan expect there to be cash of 17p per share at the end of the year due to operating these loss making contracts but the company has recently announced that they intend to be broadly cash neutral in 2013 so it looks like the cash burn has largely been halted by the cost cutting they've done. Even assigning no value to the potential contract termination, you're still looking at net cash much bigger than the market cap.

It's worth mentioning that the CEO owns 44 million shares, so has a huge incentive to maximise his own wealth here. I think that, on balance, the company has done well given the hand they've been dealt. They've sensibly cut costs and rationalised the business and the long term contracts have protected them against this downturn to an extent. The low degree of operational leverage is what I feel protects me here.

There's also now a catalyst as the company have announced they intend to make a cash distribution in 2013. I've no idea how big this will be, but even under a conservative estimate I reckon they could pay out 30-40% of the market cap in cash and still be comfortable. Being bullish there's even the possibility they could pay out my whole purchase price in cash. This is the nice thing about this situation - the plant and equipment could even be completely worthless and I'd still come out ahead. If the market ever recovers and the plant and equipment becomes useful again then there's huge upside available. I see it as buying cash with my cash and getting a free option on a business.

This is still one of my largely contributors to this year's performance for me as the price has risen almost 40% since my purchase (and I gave a large portfolio allocation to it) but I still think there's a lot of upside still here and I intend to hold on in to 2013.



Wow, those three alone were much longer than I expected! I'm going to have to break this write up in to parts to keep it to a sensible length, so expect more in the coming days. Hope everyone's having a great boxing day!

Disclosure: I own shares in TNI, JDG and PVCS