Hubris - The Great Enemy of the Experienced Investor
And Unilever PLC
Cover of Ray Perman's book Hubris, published in 2012
Excessively self-confident bank managers wrecked half of the UK's banking sector in the financial crisis and left the remainder nursing huge losses. The Chancellor of the Exchequer of the day declared he had ended the business cycle. An unusually long period of economic growth and low inflation lured rational, experienced people into being blind about their own limitations. Though the vastly expensive consequences of their hubris are there to see, few of those responsible recognise their responsibility.
Anthony Bolton was one of Britain's most successful investors. For 28 years he managed Fidelity Special Situations (FSS), which achieved an annual return of 6 percentage points more than the FTSE All Share Index. An investor who bought 1,000 pounds of FSS units in 1970 would have seen their value increase to 147,000 pounds by 2007. In December 2007, at the peak of the bull market, Mr. Bolton retired as manager of the fund.
In April 2010 Mr. Bolton moved to Hong Kong and launched the Fidelity Chinese Special Situations Investment Trust (FCSS). This was sold to UK investors, who put up an astonishing 580 million pounds. They were lured by Mr. Bolton's reputation and prodded on by financial intermediaries who were promised trail commissions (not practiced by other investment trusts) by FCSS. With nearly 9 million pounds in annual fees, FCSS is a nice little earner for Fidelity.
FCSS has underperformed the MSCI China Index by 10%, but, from a UK investor's viewpoint, what is far worse is its poor absolute performance (minus 13%) in a period when the FTSE 100 has increased by 21%, including dividends. FCSS offers a dividend yield of 0.9% compared to the FTSE's 3.5%. (Graph courtesy of Yahoo, FCSS in blue, FTSE 100 excluding dividends in green, click to enlarge).
In an interview with the Financial Times (14 December 2012), Mr. Bolton said, “I was quite unusual in transferring from one region to another. It’s not something we normally do.”
But Mr. Bolton did make the transfer. He was suffering from hubris. Consider the following:
1. As the Lead Investment Manager of the new Chinese investment trust, Mr. Bolton had never lived in China, nor did he read, speak or understand Mandarin. He had no experience of investing in Chinese companies or of Chinese business practices.
2 The Prospectus stated, "Although there is no proven relationship between GDP growth and investment performance, the Directors, as advised by the Investment Manager, believe that the growth in China could be rewarding for investors." In fact the MSCI China Index is down by 3% over the last 3 years, while the Chinese economy, in dollars, has grown by 64%.
3. FSCC borrowed up to the maximum permitted 25% of assets, thereby amplifying the poor results from the portfolio.
4. FSCC lost money on companies run by fraudulent directors. This lack of due diligence was the result of inexperience when dealing with Chinese businessmen.
5. FSCC charged higher commissions than other, similar investment trusts. J P Morgan Chinese Investment Trust charges a flat 1%, and has performed better than FCSS. FCSS started by charging 1.5% (reduced to 1.2% this April) plus a further 15% of any performance that was at least 2% better than the index, up to a total of 1.5% of the fund. Potentially triple the industry standard.
6. In the December 2012 FT interview, the reporter wrote, Bolton seems to have few regrets about returning to front-line fund management, or moving to Hong Kong. “It’s very vibrant. In fact, it’s all been good apart from the stock market.”
A long, successful career as a UK investor blinded Mr Bolton to his own limitations.
Experienced investors will recognise the symptoms of hubris. They would be wise to:
1. Think twice before branching into something new. And always ask the opinion of a peer.
2. Stick to a proven methodology. This is not infallible, but it will help to save the investor from losing money.
3. Be humble. There are a lot of things we do not know.
4. Learn from Sherlock Holmes - see the post on this blog at http://thejoyfulinvestor.blogspot.co.uk/2013_03_31_archive.html
Photo courtesy of Wikipedia
In the middle of the 19th century, 8,000 Chinese came to Arrowtown, New Zealand to mine gold. The only Chinaman to become wealthy and establish his family in the country was Choi Se Hoy. He was not a miner. He sold provisions and mining equipment to the miners, and the sixth generation of his family (he married a European) lives on in Dunedin. Sometimes the best business is to sell to new markets rather than invest in them.
Similarily, British companies selling into growing, emerging markets (EM) are often a better investment than those EM stock markets. Although the UK has its fair share of crooks, they rarely make it to the boards of British domiciled PLCs listed on the main market. And the London Stock Exchange is transparent, unlike many EMs where cronyism and plain dishonesty can be common.
Unilever, thanks to its brands and its experience of global marketing, is one of the LSE-listed companies that fit the bill. In the last 10 years, sales to EMs (ex Latin America) have surged from 25% to 40% of the total. Including Latin America, EMs now account for 55% of sales. The following graph, from the 2012 Annual Report, plots the change: Europe is in green, the Americas is in mauve and Asia/Africa/ Middle East/ Turkey/Russia/Ukraine/Belarus is in blue (click to enlarge).
Almost half of Unilever's sales come from 14 super brands each selling more than €1 billion. Since 2005, management has concentrated the business on fewer brands in four main sectors, in the process divesting marginal businesses, reducing staff, outsourcing admin functions, unifying the twin-company structure, reducing the number of suppliers and driving into the markets where growth – and profits – promise most. The financial results are astounding: Net debt is down from €26bn in 2000 to €7.4bn in 2012; working capital as a % of turnover is down from 10% to negative; spending on capital expenditure is down, and has now stabilized around €1.5bn; net margin is up from less than 5% to 13%. Asia now accounts for a larger volume of sales than
Financial results are strong.
1. Earnings per share have increased by 11% pa from 2001-3 to 2010-12
2. Dividend per share has increased by 18% pa from 2001-2012.
3. Return on equity averages 31% on an historical basis, but this has fallen to 15% on retained earnings.
4. Free cash flow of €27 billion in the past 5 years has paid for capital expenditure and the dividend with €6 billion to spare.
5. Equity per share has increased by 7% pa since 2001.
6. Unilever has a long term credit rating of A+.
Between the defined benefit pension schemes and future health benefits Unilever has booked a net deficit of €4.2 billion, which is likely to increase with the changes to IAS19. This compares to a market value of €93 billion and a post-tax profit of €4.9 billion.
At the current price of 2833p, Unilever shares are on a PE of 22 (19 prospective) and a dividend yield of 2.9% (3.1% prospective). 2 Directors made large share purchases in February, when the share price was 2564p.
The average valuation based on earnings (2605p), return on equity (2486 p) and equity per share (2745p) for the 5 years 2013-2017 is 2612p. The shares are currently priced at 2833p and have seen a high of 2853p on 3 April 2013 and a low of 2001p 18 May 2012. The discount rate used is 10.8%, which includes a margin for error.
Cautious investors will note that:
1. Although sales volumes continue to grow, Unilever's growth in earnings has slowed down these past 2 years. Against this, the consensus forecast for 2013 is for 15% earnings growth.
2. The gains from working capital management have mainly been booked, and there is little room for further improvement.
3. The management have a large number of 'soft' objectives on social and environmental issues that might distract them from profit making and cash generation.
4. Although the company has changed the basis for its pension scheme from final to average salary, pension and retiree health insurance costs are likely to increase at a faster rate than net income. They could well become a significant drag on profitability.