Wednesday, 19 June 2013

Research for the Individual Investor

And Aberdeen Asset Management

"Research holding the torch of knowledge" by Olin Warner, Library of Congress, courtesy Wikipedia

Research material has never been more abundant for the individual investor. As far as information is concerned, the diligent individual investor is now on an equal footing with the institutional investor. This may seem unlikely but consider:
1. Publicly listed companies in the UK make available a wide range of information on their websites. The individual investor has the same access to raw company data as the institutional investor.
2. Company specific news is available from online brokers, financial websites, and from publications such as the Financial Times or the Investors Chronicle.
3. Online broker websites provide information on broker forecasts and recommendations. Many provide free advice.
4. Credit rating agencies offer credit ratings on the debt of bond issuers. Pay a small price and you can get the full report.
5. Newspaper business sections, the financial press and bloggers offer tips on a wide range of companies and asset classes.  
All this is available from the internet without moving from one's desk.
 Institutional investors are reckoned to hold two significant advantages over the individual. They have access to company management and they have financial models that can churn through large amounts of data. But are these really advantageous?
Meetings with company managers are fraught with problems. Naturally, management see an investor meeting as an opportunity to promote their company. As managers are invariably enthusiastic and optimistic exponents of their company's activities, the fund manager or researcher may well leave a meeting with a good narrative to tell about the company. It looks good, but a narrative obscures the rational approach required of a good investor. Benjamin Graham avoided such meetings, as they might have clouded his judgement.
Company analysis is a cottage industry. It does not require the processing of large quantities of data. Indeed, the danger of processing large amounts of information is that the investor will lose sight of what is important and will ignore what cannot be quantified.
It is useful to know the opinions of other investors. The weekly magazine and website, Investors Chronicle (IC), is the best source of new, interesting investment opportunities I know of. And it covers a very wide range of companies, provides basic data and a summary to support its Buy, Hold or Sell recommendations.
If the individual investor feels that he is labouring at a disadvantage to professional fund managers, he should think again. Robert Schiller, in Finance and the Good Society (2012), writes:
"Professional investment managers do not seem to do particularly well in selecting their own portfolios either. A 2011 study by Andriy Bodnaruk and Andrei Simonov obtained data on the personal portfolios of mutual fund managers in Sweden. (It is possible to get these data in Sweden because the country levied a wealth tax until 2007, and so wealthy people had to report their entire personal portfolios to the government.) They found that the investment managers did no better on their investments than the average investor, nor were they more diversified."

Aberdeen Asset Management

Where are the yachts of Aberdeen's clients? (Cover of Aberdeen's 2012 Annual Report)
Aberdeen Asset Management (Aberdeen) was selected by the Investors Chronicle (18 January 2013) as the best of the ten pure asset managers that are large enough to be included in the FTSE 350.
Aberdeen has grown, via a series of acquisitions, to be the 67th largest asset manager in the world. Pooled funds, from retail investors, account for 45% of Aberdeen's business. The remaining 55% come from institutional investors such as pension funds, insurers, sovereign wealth funds and governments. 54% of assets under management are in equities, with the remainder in fixed interest, hedge funds, property and money markets. Aberdeen does not offer any Exchange Traded Funds (ETF).
The UK, with 41% of Aberdeen's revenues (fees and commissions), is its prime market, though Singapore (25%), Europe ex-UK (16%) and the Middle East (12%) are also important sources of business. It has a small US operation, which accounts for 7% of its annual revenues of 869 million pounds.
 In its 29 April 2013 edition, the Investors Chronicle rated Aberdeen a Buy at 456p a share. "Risk-hungry punters have sunk so much cash into equities recently that first-half profits at Aberdeen Asset Management (ADN) smashed City forecasts and propelled shares in the fund manager to an all-time high. Underlying pre-tax profit rocketed over a third to £222.8m and analysts at JPMorgan have upgraded their full-year underlying EPS estimate by 9 per cent to 30.9p (from 22.6p in 2012). Even that, they say, may be too cautious."
And, "Earnings upgrades have helped drive Aberdeen's share price recently. But a forward PE ratio of under 15 still looks attractive given the likelihood of a cash return and estimates of double-digit profit growth for at least three years. Buy."
Aberdeen's share price (in blue) has fluctuated wildly when compared to the FTSE All Share Index (in green):

Graph courtesy of Yahoo, click to enlarge.
Is Aberdeen a good long-term investment, and if so, at what price?
Aberdeen is financially in good health and it has a good trading record in recent years:
1. Gross debt declined from 256 million pounds in 2009 to 82 million in 2012. At March 2013, net cash stood at 638 million pounds after a fund-raising of 322 million pounds.
2. Operating cash flow, once share purchases to compensate for employee share awards and capital expenditure are deducted, covered the dividend by 1.8 times these past 5 years. This left 337 million pounds for debt reduction and acquisitions.
3. Earnings per share have increased by a compound 12% since 2005-6, equity per share by 4.5% and the dividend payout by a compound 18%.
4. Return on equity has averaged 9% since 2005.
Using these figures and projecting them for the period 2013-17, with a discount rate of 11.3%, values Aberdeen's shares at 232p. This compares to the current price of 405p, which is on an historical P/E ratio of 23 and a yield of 2.8%.
Aberdeen's business is highly leveraged to the stock market. Costs are fixed while income from fees and commissions are highly variable. A 13% increase in the FTSE All Share between September 2012 and March 2013 translates to an increase of 22% in Aberdeen's earnings per share (H1 2013 compared to H2 2012). Funds flow in and the increase in the value of the funds managed generates higher income. As a result, the present estimate for 2013 earnings is 37% up on 2012. So, at the current price of 405p, the shares are on a prospective P/E ratio of 13 and yield 3.7%. Aberdeen might well be a trading opportunity at 405p.
However, unless we are in for a sustained period of growth in the stock markets, for the long term the present share price is well ahead of fundamentals. Consider:
1. The CEO notes in the 2012 Annual Report, "a battle between active and passive managers is taking place in developed markets". Passive funds (in grey), such as ETFs, are taking market share from managed funds (in orange). And Aberdeen has no passive funds:

Courtesy of Thomas Powers, click to enlarge
2. Asset Managers rely on their performance to gain new customers, and Aberdeen is not currently in the top ten UK asset managers by performance, according to City Wire Global (JP Morgan leads the pack).
3. The UK's recommendations from the Retail Distribution Review, which requires greater transparency of fund charges, are likely to put pressure on the commissions earned by asset managers.
4. Between September 2010 and March 2013 Aberdeen's funds under management have increased by 18%. The FTSE All Share has increased by 13% over the same period and Aberdeen has steadily acquired new businesses. What might be called organic growth is tiny.
5. Two directors have sold 15 million pounds of shares between February and June 2013 at prices between 402p and 466p a share.
6. Aberdeen's shares are trading at 69% above their 12-month low of 241p (in July 2012).
[NOTE: The next article will be published on 3 July]



Wednesday, 12 June 2013

The Use and Misuse of the Price Earnings Ratio

And Interserve PLC

Courtesy Wikipedia

We like to keep things simple. A long time ago, investors settled on the price-earnings ratio (P/E ratio)* as an indicator of how a share was valued by the market. Naturally, the flaws in the denominator of the P/E ratio, earnings per share (EPS), drove investors to look for indicators that are more meaningful. *The P/E ratio = the market price per share X number of shares outstanding/ post-tax profits.
Yet the P/E ratio is not a silly number. As the numerator of EPS is profit after tax, it cannot be ignored. Profit after tax determines, via the balance sheet account of retained earnings, the funds available for distribution to shareholders as dividends. And management often decides the company's dividend based on a fixed percentage of EPS.
The P/E ratio is just one of many measures used to value a company. It is often misused either as a substitute for further analysis or by quoting a figure based on management's 'adjusted' earnings. Management often adjust earnings to exclude amortization, depreciation and impairments to intangible assets and/or non-recurring or exceptional items. This usually inflates EPS and consequently understates the true P/E ratio for the company's shares.
 But the P/E ratio is very useful for measuring aggregates - entire stock markets.
Robert Shiller, a glutton for statistics, showed in 2005 (Irrational Exuberance 2nd Edition)what every investor already took for granted ". . . investors who commit their money to an investment for ten full years did do well when prices were low relative to earnings at the beginning of the ten years." Shiller favours the Cyclically Adjusted Price Earnings (CAPE) ratio as a measure for an entire index, which is a ten-year rolling average P/E ratio.
The following table illustrates the Shiller CAPE for the S & P 500 going back to 1880 (S & P 500 to 1926 and extrapolated backwards) plotted against long-term interest rates. From this graph, one concludes that there is no constant relationship between interest rates and the stock market, except that since the 1980s interest rates have a positive correlation to CAPE but with a lead-time of between 10 and 20 years. According to this measure, the S & P 500 is not far from its long-term mean. (I am not aware of any similar long-term study for the London Stock Market.) 


Graph courtesy of Robert Shiller at his Yale website, click to enlarge.

Goldman Sachs has also produced results, based on CAPE and the forecast P/E ratio for 2013, for 17 major stock markets as of February 2013. The UK stock market was then at a lower valuation than the average for the last 38 years. This is a most useful measure for investors interested in foreign markets, where they plan to invest via a fund.

Table courtesy of Goldman Sachs website, click to enlarge

And this week's Buttonwood column in the Economist uses comparative P/E ratios to show that emerging-market equities are at a 25% discount to developed-world equities. Buttonwood comments, "They [emerging-market equities] have been cheaper in the past, but a further period of underperformance will make them very attractive to long-term investors."
To conclude, the P/E ratio is a useful measure for stock indices, given the few alternatives (dividend yield, price to net assets ratio) available. But given the large amount of financial and non-financial information available for individual companies, the P/E ratio is a really poor measure of that company's value.

Interserve PLC

Courtesy Wikipedia
Interserve is in an unfashionable business (support services to the public sector mainly) and relies for two-thirds of its profit on the stagnant UK economy. The shares stand on a current P/E ratio of 10, half the level of the FTSE 250 (of which Interserve, with a market cap of 610 million, is a component). They yield 4.4% compared to the FTSE 250's average of 2.6%. Interserve's share price has underperformed the FTSE 250 these past 5 years:

Graph courtesy of Yahoo, click to enlarge
Yet Interserve is financially strong and has a good trading record. Consider:
1. After the sale of its interests in PFI (Private Finance Initiative), the company has a net cash position of 27 million pounds at the end of 2012.
2. Interserve's ordinary free cash flow for the past five years, after capital expenditure and paying the dividend to shareholders, left 30 million pounds for acquisitions and reducing debt.
3. Interserve's dividend is twice covered by earnings and has grown by 4% p.a since 2003.
4. Return on equity averages 19% and, on retained earnings these past 10 years, 27%.
5. Ordinary earnings per share have grown by 11% annually and equity per share by 15% annually since the period 2003-5.
6. Business in hand, at 6.3 billion pounds, is the equivalent of 3 years' revenues.
Interserve has a stable management team with the CEO in office since 2003, the Chairman since 2006 and the CFO since 2010. Management has pursued a strategy of:
1. Moving away from construction to support services (over a wide range of activities), where longer contract periods guarantee more stable revenues. However, business in hand at the end of 2012 was no greater than in 2008.
2. Moving into new areas that promise more growth. However, the business sectors served by Interserve are not substantially different from 2004:

                               Sector                                  % Revenues 2012            %Revenues 2004

                               Commerce                                   21%                                     23%
                               Defence                                        20%                                     13%
                               Infrastructure                              16%                                     17%
                               Health                                           13%                                     11%
                               Education                                     10%                                       6%
                               Other                                             20%                                     30% 

3. Increasing the share of international business, dominated by the Middle East, where margins are triple those in the UK. Interserve has increased its international revenues from 8% of the total in 2004 to 33% in 2012. However, operating margins have hovered between 4 and 5% for the past 5 years. 

4. Doubling earnings per share between 2011 and 2015, to about 80p a share. 

To achieve this objective, in 2012 Interserve sold its substantial PFI business and bought a number of companies to extend its business in welfare-to-work (for the UK government), home healthcare and oil and gas services to the Middle East. 

On conservative assumptions*, my valuation model values Interserve at 486p a share, or about the present market price of 470p. *For the years 2013-17: 11% p.a. increase in EPS, 10% p.a. increase in equity per share, 19% return on equity, and an average P/E ratio of 9. Discounted by 12.3% to allow for the execution risk associated with these assumptions. 

Interserve, at its current share price, offers a superior and well-covered dividend that in the past has more than kept pace with inflation. 

The cautious investor will note: 

1. Interserve has made a significant move from its profitable business in PFI to increasing its business elsewhere. This is not guaranteed to succeed. 

2. The company relies on UK public spending/outsourcing for a large share of its business. 

3. The shares have been as low as 292p in the last 12 months (20 June 2012). 

4. Four directors have made large sales of their shares in April at 475p a share. 

5. Although the company closed its defined benefit pension scheme to new entrants in 2009, its liability is growing. In the latest year, the company handed over 55-million pounds of PFI projects to its pension fund to fund a part of the deficit. This is equivalent to 70% of its 'headline' profits for 2012. Future payments have been agreed at an 'indexed' 11 million pounds a year. This will prove to be a drag on profits and dividends.





Wednesday, 5 June 2013

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 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
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

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.