Wednesday, 24 April 2013

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


Unilever PLC

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 Europe.
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.






Wednesday, 17 April 2013

Predicting the Stock Market: Contrarianism and the AA II Investor Sentiment Survey

And an Income Orientated US Exchange Traded Fund

Quartz crystal ball image courtesy of Wikipedia
Stock market pundits are in as much demand as astrologers and soothsayers were before the Enlightenment. Last week's post on this blog included a comment from Howard Marks that "There's only one way to describe most investors: trend followers. Superior investors are the exact opposite." Marks is a contrarian. To be contrarian, we need to know what other investors are thinking.

The American Association of Individual Investors (AA II) surveys its members every week to ask them if they are bullish, neutral or bearish on the US stock markets. The results of the AA II Survey are as close as we can get to a consensus opinion of other investors on the future movement of the US stock market. Over the long term, AA II Bulls exceed Bears by 8.5 percentage points. What makes the survey interesting is that AA II members nearly always get it wrong.

Last week's survey revealed a very high bearish sentiment. Bears exceeded Bulls by 35.2%. This is the most negative sentiment since July 2010, when Bears outnumbered Bulls by 36%. Then the S&P 500 recorded a weekly low of 1062 points, which was followed by an uninterrupted bull market. In March 2009, Bears outnumbered Bulls by 51%. March 2009 also coincided with the lowest point in the S&P 500, at 696 points, since October 1996.

As the UK stock market closely follows the US stock market (see the graph below), an American sentiment survey is almost as valid for a contrarian here as there.

(Graph courtesy of Yahoo, click to enlarge)
Can we use the AA II indicator to predict future trends in the stock market, provided that we do exactly the opposite? In January 2013, the CXO Advisory Group, a consultancy, published a study comparing the AA II investor sentiment survey to movements on the S&P 500.  By comparing the net investor sentiment (Bulls less Bears) to prior and subsequent movements in the stock market, they found the following correlations.

In a layman's terms, the above correlations show:
1. AA II sentiment is largely driven by what has happened in the past, especially what happened 4 weeks ago.
2. As anticipated, the stock market has tended to move, looking forward, in the opposite direction of AA II investor sentiment. Bearish sentiment tends to be followed by bullish markets and vice-versa, but the relationship is very, very weak, negligible one week ahead and still tiny 6 months ahead.
3. The study also finds that, since the beginning of the survey in 1987, AA II members have 'learnt' from their errors. They are less prone to error in their sentiment. And the value of their opinion, for a contrarian, is not worth as much as it used to be.
4. However, the study found that very bearish sentiment, when the net sentiment is 16% more bears than bull, is followed, especially after 6 months, by a more bullish market. But even the most extreme Bullish decile does not indicate shorting.
 See the table below (click to enlarge).

The study found that the 6-month return after the 1% most bearish net sentiment readings (14 observations < -35% in 25 years) is about 16%. The study concludes: “evidence indicates that investors may be able to exploit extreme values of AAII net investor sentiment [Bears outnumber Bulls by more than 35%] as contrarian signals, but reliable (extremely bearish sentiment) signals are rare.”
It happens that the latest AA II survey has thrown up exactly one of these rare moments, with a Bear minus Bull reading of 35.2%. Should we jump into equities?
Skeptical investors will note that:
1. The S&P 500 is only 3% off its 90-year high of 1597. This is not a repeat of March 2009, when the S&P 500 was 44% off its all-time high.
2. Statistically, the number of readings when this contrarian indicator (most extreme Bearish sentiment) has worked is very small (only 14 instances to date).
3. The AA II survey, as a contrarian indicator, is useless for predicting bear markets.
4. AA II members are merely reacting to recent past information.
5. No one can or has ever been able to consistently predict future events. Why should they be able to predict stock market movements?

An Income Orientated US Exchange Traded Fund: SPDR S&P US Dividend Aristocrats ETF

The easiest and cheapest way for a UK investor to invest in the US stock market is by way of an Exchange Traded Fund (ETF). The Investors Chronicle (1 November 2012) recommends HSBC S&P 500 ETF (HSPX), which has the lowest cost (TER) of all such funds at 0.09% p.a.
An alternative ETF, the SPDR S&P US Dividend Aristocrats ETF (USDV), offers the investor a narrower selection of stocks based on the S&P High Yield Dividend Aristocrats Index. This is comprised of the 84 stocks of the S&P Composite 1500 Index that have increased dividends every year for at least 20 consecutive years. According to State Street, the USDV fund manager, "these stocks have both capital growth and dividend income characteristics, as opposed to stocks that are pure yield, or pure capital oriented." USDV yields 2.95% and stands on a collective PE ratio of 16. This compares to HSPX's yield of 1.75% and a collective PE ratio of 18.
As USDV was launched in October 2011, its track record is rather short. To date, the ETF has outperformed the S&P 500. (Graph courtesy of Yahoo, click to enlarge)


USDV is domiciled in Ireland, which does not impose any withholding taxes, and the fund has distributor status, ensuring that all gains are taxed at the rate for UK Capital Gains and not as UK Income Tax. The ETF is physically backed by securities and, capitalised at over $1 billion, it is both liquid and large enough to reap the benefits of scale. It has an annual cost (TER) of 0.35%.

The wise investor will note that:
1. As USDV is only invested in companies that have a 20-year dividend record, this excludes a very large number of newer technology stocks. Only 3.7% of the funds are in the IT sector compared to 18.2% of the S&P 500. Consumer staples, industrials and utilities are all disproportionally represented in the USDV portfolio.
2. USDV digs deeper than the S&P 500 into smaller cap stocks that are included in the S&P 1500. The minimum market cap for the S&P 500 is $4.5 billion, whereas USDV's cut-off is at $2 billion.
3. USDV is weighted by the dividend yield of each component (instead of the customary market capitalization) up to a maximum of 4% of the total fund. Hence the largest fund component is Pitney Bowes, famous for its postal franking machines, with a market capitalization of only $2.9 billion. Its number one spot is due to its enormous dividend payout of 9.9%.


Wednesday, 10 April 2013

Where are we in the Stock Market Cycle?

And a high-yield stock on AIM

The best advice for the private investor often comes from America. Howard Marks, one of the founders of Oaktree Capital Management, a fund manager based in Los Angeles, summarises what he has learnt from his working life in an economical 180 pages (The Most Important Thing: Uncommon Sense for the Thoughtful Investor). While he writes that "Successful investment requires thoughtful attention to many separate aspects, all at the same time", understanding market cycles are key to four of his nineteen aspects. Oaktree Capital Management applies Marks's principles to the $71 billion debt, property and equity investments the company manages. Mr Marks has a personal fortune of $1.5 billion. 
Investors who base their decisions on the price of a company's stock by estimating its intrinsic value are, in theory, immune to the stock market cycle. Nevertheless, a feel for where we are in the stock market cycle is, in practice, most useful.  Returns are accelerated and risk reduced by buying at a time when conditions are favourable and the cycle is somewhere near a low, or at least not near a high.
To understand where we are in a market cycle, Marks sets out a simple checklist that he calls "The poor man's guide to market assessment". For each consideration he has set up a pair of answers. Check one of the two for each consideration. "And", he writes, "If you find that most of your checkmarks are in the left-hand column, hold on to your wallet."
Capital Markets
Interest rates
Eager to buy
Uninterested in buying
Asset Owners
Happy to hold
Rushing for the exits
Starved for attention
Hard to gain entry
Open to anyone
New ones daily
Only the best can raise money
General partners hold all the cards
Limited partners have bargaining power
Recent performance
Asset prices
Prospective returns
Popular qualities
Caution and discipline
Popular qualities
Broad reach

Note: not all the conditions are applicable to all four markets (equity, bond, property, and housing). The technique can be applied to any segment of these markets.
This list is of no use to day traders, but it is an aid for long-term investors. And checklists are useful. They impose a degree of objectivity and discipline that are necessary for successful investing (see How We Can Learn from Sherlock Holmes at
Marks's checklist seeks to be contrarian. But then he opens his chapter Contrarianism with, "There's only one way to describe most investors: trend followers. Superior investors are the exact opposite."
Any investor would be wise to run through Marks's guide regularly. It should give him or her a feel for where we are in the market cycles for bonds, equities, property and housing.

A high-yield stock on AIM

Personal Group Holdings (PGH) is a small company that provides insurance services to company employees via direct selling. The company floated on AIM in 2001 and its share price (in blue) has comfortably outperformed the FTSE 100 (in green):

(Courtesy of Yahoo, click on the graph to enlarge)
PGH has a successful, though not unique, business model. PGH offers payroll services and employee benefit schemes to major companies and organizations. Then it cross-sells insurance policies, for health, accident and pensions, to these same customers. Thanks to its purchasing power, it can source such policies at a discount to the general market. Underwriting casualty insurance is risky, while underwriting life insurance is low margin. PGH does neither. It underwrites sickness, accident and private medical insurance for its own, captive market. The capital requirement of 4 million pounds for this underwriting is more than twice covered by qualifying reserves.
In 2005 PGH purchased Berkeley Morgan Group, which offered financial services, at a cost of 13 million pounds. This has proved to be a mistake, and its activities have been sharply scaled back and much of its goodwill written off the balance sheet.
The founder and major shareholder retired from the company in December 2012. PGH appointed a new CEO, CFO and Commercial Director in 2011 and 2012. The new team has been charged with modernising company processes and seeking growth. Initial results are promising: final quarter 2012 revenues are 15% ahead of 2011; the company has stopped taking new business into its financial services company Berkeley Morgan (no doubt as a result of the new, unfavourable, fee and commission structures required of IFAs); management report improving response times to claims etc. from days to minutes; they have introduced iPod direct selling to replace paper and improve productivity; staff have been retrained; and more is to come with much new business 'in the pipeline'. As sign of confidence in the future, the Board has declared an increased dividend to be paid in 2013.
PGH offers a dividend yield of 5.1% on an historic PE of 16. The company has net liquid assets of 15 million pounds, about 15% of its market valuation of 106 million pounds. It has no defined benefit pension scheme to provision for, nor any other worrying balance sheet entry.
Using a discount rate of 10.8% gives a valuation of 339p for the shares, an average of the Earnings per share (growth 7.5% p.a.), Return on Equity (the company generates a high, 26% ROE) and equity per share growth models. The offer price for the shares is 373p. The company's shares have traded at a 12 month low of 286p (in May 2012) and a high of 394p (on 30 March 2013).
PGH shares qualify for business relief for Inheritance Tax purposes (see an explanation of the special considerations and benefits from investing in AIM stocks at
Assessing the special conditions of companies quoted on AIM:
1. The 'free float' is 53% of outstanding shares, much larger than the 25.1% required to block unilateral inside shareholder decisions. The remaining shares are held by the founder, C W Johnston, with 43.1% and senior management with a further 3.9%.
2. PGH is a long-established company that has high governance standards.
3. The offer to bid spread for its sharers is 5%, which is typical for this size of company on AIM. It is not suitable for short-term investors.
4. The company is cash generating and holds no debt.
The prospective investor will note that, although the new management team offers the possibility of a significant improvement in PGH's performance, the current share price of 373p is substantially ahead of its valuation of 339p.
 However, the valuation does not take into account the IHT concession, and if this is important for the investor, PGH's value would rise considerably. For example, if the 40% IHT relief were to kick in one year beyond the required 2-year holding period, the current valuation for the shares would be 448p.

Thursday, 4 April 2013

  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 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.


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:

          Return on equity
          Return on equity
   On 2001-2011 retained earnings
Earnings per share growth p.a.
    2001-3 avge to 2010-12 avge
Equity per share growth p.a.
              2002 to 2012
          Dividend yield
Price Earnings ratio


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
5-year equity per share growth to 2017
5-year return on equity to 2017
              Current share price


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.