What investors can learn from Sherlock Holmes

And Cranswick PLC

 

(Illustration courtesy of Wikipedia)

It is well known that a series of psychological traits impede our performance as investors. These include:

ü  A propensity to buy when we feel good and, conversely, to sell when we are unhappy.

ü  Overconfidence from familiarity with the industry or company in question.

ü  Blaming external factors when things go wrong, while claiming credit when an investment turns out well.

ü  Foregoing our own time-consuming analysis for the opinions of others.

ü  Allowing intuition to influence our judgement.

ü  Giving preference to information that is easily available, while failing to notice what is missing.

ü  Focusing on one element at the cost of ignoring other equally important elements.

ü  If one element seems positive, other elements will seems so too, and those that don't will be subconsciously reasoned away (the 'halo effect').

ü  Reacting with haste to an event that at the time seems important, but in the long run is insignificant.

The psychologist Maria Konnikova (Mastermind: How to Think like Sherlock Holmes) has written a book about how we can avoid these psychological traps by studying the behaviour of Sherlock Holmes. Her insights are applicable to investors.

1. As he tackles a new mystery, Sherlock Holmes exclaims "The game's afoot"! "That mindset is incredibly important, because that's the way he sees it, and that's why it's exciting and engaging to him," says Konnikova. A sense of play is vital to have "a presence of mind that not only allows us to extract more from whatever it is we are doing but make us feel better and happier." One has to enjoy investing - and why not? - see it as a game with serious consequences, to maintain the diligence, concentration and openness of mind that are the prerequisites for success. Warren Buffett's letters to his shareholders exude the pleasure he gets from his business. That keeps him enthusiastically and successfully at the helm of Berkshire Hathaway at the age of 82.

2. Holmes notes that "the improbable is not impossible". Or, to put it in investing terms, when everyone is convinced that X is the right strategy, the thoughtful investor will wonder if it might not be Y or Z. To do so he develops his own theories. This requires method, discipline and patience. Holmes's method is to make lists of all the relevant facts; he bounces ideas off Watson; he steps back and plays the violin, or he has "a three pipe problem". "Distance . . . forces quiet reflection and has been shown to improve cognitive performance and self-control," notes Konnikova. Only when Holmes is sure of his ground does he act. This slow, deliberate procedure goes against our nature, which Konnikova calls the System Watson, that jumps to conclusions. Buffett has his own methodology. He accumulates information. He bounces ideas off his partner Charlie Munger. He lives in Omaha, distant from Wall Street, and ignores the crowd. He is renowned for following investment targets for long periods.

3. Holmes is capable of completely ignoring the opinion of others, but he listens to what they, especially Watson, have to say. The investor keeps abreast of the financial news, but he is bombarded with opinions he would be wise to ignore.

4. Holmes relies on deduction. "You lay out your chain of reasoning and test possibilities until whatever remains is the truth." Conan Doyle has Holmes say: "It may be that several explanations remain, in which case one tries test after test until one or other of them has convincing support." This is not so distant from trying to value a company. One must place a value on its future and its future is uncertain and requires testing. What might happen to its market, its management, and its financial results? One method is discussed in the 20 February post on this blog on Warren Buffett and Berkshire Hathaway http://thejoyfulinvestor.blogspot.co.uk/2013_02_17_archive.html. The essence is to make a stab at what the company might be worth in, say, 5 years time, and then discount it back, allowing for a margin of safety.  Only by working the numbers can one get a feel for their validity. And, by valuing the company using different parameters (for example earnings per share, return on equity and equity per share) one can pick up inconsistencies in valuations, forcing further analyses.

All this can fall into place if you enjoy investing.

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Cranswick PLC

Who would have thought that Warren Buffett's biggest acquisition would be a boring old American railway company, the Burlington Northern and Santa Fe Railroad? Boring businesses can offer the investor the best of returns. Cranswick started as a business in pig feed, left that business and went into pork sausages. Now it specialises in all pork products and supplies the supermarkets in the UK. The company's share price has multiplied by 80 times . . . The blue line represents Cranswick's share price versus the FTSE 100 in green.

(Graph courtesy of Yahoo, click to enlarge)

Cranswick's success is based on a high degree of specialisation, product innovation, quality production, brand marketing and maintaining a close relationship with the all-important supermarket chains. Just two of them account for over half Cranswick's business. The company is capitalised at 490 million pounds and, in 2012, made an after tax profit of 37 million on a turnover of 821 million. Exports, 90% to Europe, accounted for only 3% of sales. The management note in the latest Annual Report the "increased popularity of pork products", which is largely attributable to "the competitive price of pork compared to other proteins".

The company is self-financing. Net equity has increased from 52 million to 296 million pounds since 2002, yet net borrowings have increased by only 25 million. In the last 5 years, cash from operations have paid for all its capital expenditure and dividends with 40 million to spare. Cranswick's growth is both organic, from its existing products, and from a cluster of small acquisitions.

Some key data:

Item	Period	Value
Return on equity	Historical	12%
Return on equity	On 2001-2011 retained earnings	13%
Earnings per share growth p.a.	2001-3 avge to 2010-12 avge	12%
Equity per share growth p.a.	2002 to 2012	19%
Dividend yield	Current	2.8%
Price Earnings ratio	Current	14

 

Cranswick's balance sheet holds no surprises. Net borrowings are 8% of equity. And the deficit on the defined pension scheme, closed in 2004, at 5.3 million pounds is but 2% of equity. By far the largest single investor is Invesco Perpetual, with 29.4% of the outstanding shares.

Cranswick borrows at a weighted cost of 2.3%, and I have added 5% for operational risk (more below) and 5% as a required profit and margin of safety when calculating the following:

Valuation based on:	Value per share in pence
Discount rate of 12.3%
5-year earnings per share growth to 2017	914p
5-year equity per share growth to 2017	1,348p
5-year return on equity to 2017	879p
Average	1,047p
Current share price	1,014p

 

While the current share price is reasonably in line with the valuation model, the cautious investor will note:

1. Earnings growth has slowed markedly in the past two years, because of shrinking margins, and the company's share price is quite volatile. It hit a 12 month low of 714p in October last year and reached a high of 1040p on 22 March.

2. Cranswick is heavily dependent on its sales to the large UK supermarkets, and margins would be severely depressed if one or more replaced the company's branded products with their own and/or by the products of other suppliers.