Managing Financial Risk

And Pearson PLC

Image courtesy of Wikipedia

Seth Klarman (Margin of Safety, 1991) writes, "The primary goal of value investors is to avoid losing money." With this apparently simplistic approach to risk, Klarman disposes of the many useless (for him) academic approaches to financial risk:

1. Risk is not always positively related to return. "Unscrupulous operators will always make overpriced investments available to anyone willing to buy," notes Klarman. "To the contrary," he adds, "risk erodes return by causing losses." Out go the Efficient Market Theory and the Capital Asset Pricing Model.

2. Risk is mistakenly equated with volatility. Klarman writes that people emphasise "the 'risk' of security price fluctuations while ignoring the risk of making overpriced, ill-conceived, or poorly managed investments." In fact, volatility is your friend, as it enables you to buy a security at a better price, while enabling you to exit it later at a profit. Out goes any concern for Beta.

3. Risk has little to do with asset class. It has everything to do with the price you pay for the individual asset. See Risk and the Asset Allocation Dilemma for further analysis at http://thejoyfulinvestor.blogspot.co.uk/2013_05_19_archive.html All the reams of paper dedicated to how best to allocate your assets and at what age can go into the bin.

In conclusion, risk cannot be avoided, but it can be managed. Consider the market price of Pearson PLC over the past 25 years:

Courtesy Yahoo, click to enlarge

Pearson's chairman was driven to write in the 2002 Annual Report:

"I am painfully aware that our share price has dropped dramatically over the past 24 months. It is little consolation that most of our media peers have experienced similar declines. . . Stock markets may have plunged and, as I write this, we may be on the verge of a war, but children are still going to school, governments are still spending on education and bookworms are still feeding their excellent habit. As a result, Pearson Education and Penguin had record performances in 2002."

The falloff in business was caused by the sudden - and temporary - drop in advertising in the Financial Times group. The basic business had barely changed in the three years that saw Pearson's share price first double between May 1999 and April 2000 and then fall to one-quarter by September 2002. Pearson was swept up in the TMT (Tech, Media and Telecom) bubble.

We individual investors are often better situated than the professional to manage risk. Most professional investors believe they have to be fully invested in the investment class of their fund, as this is what their investors expect. And their main concern is to do no worse than the index to which their fund is linked, as to do worse might lose them their jobs. The individual investor is not limited by such considerations.

 Investors can manage risk by:

1. Never being forced to sell against our better judgement. "The trick of the successful investor is to sell when they want to, not when they have to." Klarman notes. The individual investor is in this position when he has sufficient income and/or cash to meet his financial obligations. He is never forced to sell in a stock market trough or feels obliged to buy at the peak. He chooses his moment.

2. Holding cash may seem uneconomic, but it enables the individual investor to take advantage of market fluctuations by buying into stocks when they are cheap. When the share price of a stock like Pearson varies by as much as 50% in a 12-month period, the small cost of holding cash is inconsequential when compared to the opportunities holding cash offers.

3. Select stocks with a 'bottom up' approach. Klarman writes, ". . . Searching for low-risk bargains one at a time through fundamental analysis is the surest way I know to avoid losing money." By paying careful attention to what could go wrong, you reduce the possibility of a loss. This includes building in a margin of safety, by being conservative in your assumptions, into what you are prepared to pay for a share or bond.  

4. Avoid highly indebted businesses with assets that are hard to value or businesses with unknown contingent liabilities. This eliminates entire sectors of the stock market including all banks and most insurance companies.

5. Concentrate on businesses with a good trading history. Newer resource exploration and high technology companies fall by the wayside. And see Warren Buffett at http://thejoyfulinvestor.blogspot.co.uk/2013_02_17_archive.html

6. "An absolute performance orientation is consistent with loss avoidance; a relative-performance orientation is not," adds Klarman. Shielding one's investment decisions from the 'bull and bear' emotions of the market is not easy. But it can be done.

Investors would be wise to review the emotional (or psychological) risks to investing. See the posting What investors can learn from Sherlock Holmes at http://thejoyfulinvestor.blogspot.co.uk/2013_03_31_archive.html

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Pearson PLC

Book collage, courtesy Wikipedia

Pearson is the largest education company in the world. It also owns the Financial Times and 50% of The Economist. It has reached an agreement with Bertelsmann to merge its Penguin book business with Bertelsmann's Random House. Pearson will be left with 47% of the shares in the joint venture, which will be the largest book publisher in the world.

84% of the company's operating profit in 2012, which included Penguin, came from its educational division; Pearson provides learning materials, technologies, assessments and services to teachers and students of all ages. And 74% of operating profits comes from its operations in North America. Pearson depends more on the American market than most large American companies do.

Pearson's traditional educational and publication businesses face competition from the internet and eBooks. The company has a strategy to deal with this unpleasant reality:

1. It aims to extend its business to emerging markets. They currently account for 15% of its sales.

2. A move to digital learning, which now counts for one-third of its sales.

3. It plans to move away from textbook publishing.

In 2012, Pearson acquired three companies in the online and digital fields. Pearson paid $650 million for the largest, EmbanetCompass, at the exalted valuation of 5 times sales. As management measures Pearson's performance by excluding the amortization of Goodwill, this elevated price will not come back to trouble them.

Pearson has a good trading record and strong finances.

1. Earnings per share has increased by 11% p.a. since 2001-3 and the dividend per share by 7% p.a.

2. Return on equity (ROE) averages 15% historically. ROE on retained earnings is 16% these past 10 years.

3. Net debt to equity is a modest 16%, down from 31% in 2008. Moody's gives Pearson a Baa1 credit rating for long-term debt.  

4. Free cash flow, after deducting capital expenditure, of 3.4 billion pounds these past five years, covered the 1.5 billion dividend payout 2.3 times. This left 1.9 billion pounds to spend on acquisitions and to reduce debt.

Pearson's share price has comfortably outperformed the FTSE 100 since 2008:

Courtesy Yahoo, click to enlarge

At the current share price of 1191p, Pearson is on a PE of 18 and yields 3.7%.

My valuation model for the years 2013-17 gives a value of 1336p for Pearson.* But model valuations, based as they are on adjusted historical data, are sensitive to the assumptions used.

*On an historic basis, reasonable 5-year projections are EPS growth of 7% pa, a ROE of 15%, an increase in equity per share of 6% and an average PE of 14. Discount rate of 10.8%.  

The global education market has grown by 75% in the 7 years since 2005 and it is forecast, by Ibis Capital, to grow by a further 43% in the next 5 years. E-learning expenditure is expected to grow by 23% p.a. through to 2017. This bodes well for Pearson.

 

However, Pearson faces more uncertainties than many other businesses:

1. The 16-year reign of Pearson's outstanding CEO, Marjorie Scardino, has come to an end. Her successor has promised to speed up the changes in the organization.

2. The traditional print-based business is declining and while Pearson has moved to digital and online, these are markets where the company encounters new competitors.

3. If the recent acquisition of EmbanetCompass is a sign of things to come, Pearson will be paying a high price to gain expertise in its 'new' markets. It is in this context that it is worrying that management excludes goodwill amortization - effectively the cost of acquisitions - from their performance.

4. The defined benefit pension scheme has a 198 million pound deficit and it is likely to increase with time.

5. Directors have sold a large number of shares in recent months and bought nothing, which is hardly encouraging.