Friday, 25 April 2014

Revisiting Jacko the Stock Exchange Gorilla and the question of benchmarks

And Stanley Gibbons Group PLC

My first article at this blog discussed the extraordinary stock picking exploits of Jacko the gorilla. Jacko lives in Amsterdam's zoo. In January 2000 he was presented with seventy-five bananas, each of which represented one of the largest 75 stocks traded on the Amsterdam Stock Exchange. He chose ten and this was his starting portfolio. Every month since then Jacko picks out one of ten bananas corresponding to his portfolio and that stock is sold. Then he chooses one banana from another pile of 65 bananas, corresponding to shares he does not hold, and that is his buy.
Jacko's banana portfolio has beaten the AEX index of large Dutch companies every year except for 2011. Cumulatively, Jacko's portfolio has increased in value by 108% compared to a loss of 41% of his benchmark, the AEX (both exclude dividend income). This represents an average outperformance of 9.4% every year for 14 years. By comparison, star fund manager Anthony Bolton's Fidelity Special Situations outperformed his benchmark by 6% a year over a period of 28 years.
In 2013, Jacko's portfolio beat the AEX by 22%. As Jacko's investments are reported daily, neither Jacko nor his human interface have had the opportunity of cheating. But Jacko's portfolio exposes the limitations of index benchmarking, which are often ignored.
Ø  Jacko's portfolio is chosen from the 75 largest stocks traded in Amsterdam compared to the 25 largest which makes up the AEX index. The other stocks are quoted on the AMX - mid-cap, representing the 26 to 50 largest stocks, and the AScX - small cap shares, representing the 51 to 75 largest stocks traded in Amsterdam.  
Ø  Even if these indices were included, they would misrepresent Jacko's choice of stocks, because the indices themselves have changed radically over the 14 years that Jacko has been trading.
   Number of constituent companies in the index in both January 2000 and March 2014:
                Amsterdam large cap    AEX                       13 of 25 constituents
                Amsterdam mid-cap      AMX                        3 of 25 constituents
                Amsterdam small-cap   AScX                        0 of 25 constituents
Ø  The indices are weighted annually by free float market capitalization for each company. Jacko gives equal weight to each stock (banana) in his portfolio.
Jacko can beat his benchmark because his portfolio has little to do with the index used as his benchmark.
Our own indices are also in flux. The FTSE 100 has gained 160 constituents and lost 160 over the last 14 years and it is rebased every quarter for market capitalization.
Individual investors face trading expenses and income and capital gains tax that are excluded from the indices.  Benchmarking a portfolio is good practice: without a benchmark we are like a rudderless dinghy bobbing along at sea, with no idea and no control over where we will eventually land. Fund managers require a generally accepted yardstick in the public domain, usually an index, but that doesn't mean this is the right yardstick for an individual.
Financially speaking, individual investors have messy lives. We spend large sums on weddings, houses, divorces, our children's education and our own businesses. We save as best we can, if we're fortunate we receive bonuses and inheritances, and by downsizing our homes we release capital to invest. We invest when we can and disinvest when we have to; at bottom our financial objectives have nothing to do with the vagaries of any market index.
Benchmarking should reflect our goals. For a young professional, who wants to buy a first home, the most appropriate benchmark might be to accumulate X thousand pounds within Y years as a deposit.  This he or she must achieve through savings and capital gains. For the self-employed homeowner, who wants to secure his retirement, the benchmark might be a Self Invested Pension Plan that, with current annuity rates, will provide an income of at least X pounds a year from the age of 65. And for someone nearing retirement, who wants an income to keep pace with inflation, the most relevant benchmark will be based on the income generated by his or her investments and not the asset value of his portfolio. Our benchmarks change as our lives and circumstances change. And by being specifically related to our financial objectives our personal benchmarks point us to the financial assets that best suit our needs.

Stanley Gibbons Group PLC (AIM stock)


British Guiana 1 cent magenta, 1856, courtesy Wikipedia
Stanley Gibbons (SGI), well known for its philatelic business, has a growing and profitable business in other collectibles as well - First Day covers, rare coins, medals and memorabilia. While sales from the London, Jersey, Singapore and Hong Kong offices, including email campaigns and auctions, contribute the bulk of revenue and earnings, the company is working hard to develop its online business in both the UK and the USA. This is partly in response to the growth of eBay, which enables collectors to buy and sell stamps and coins easily and at a low cost.
At the top end of the market, vendors choose large auctioneers. Sotheby's are auctioning the only example of an 1856 British Guiana 1 cent magenta (pictured above) in June, which is expected to sell for $20 to $30 million. This would be the highest price ever paid for a single stamp.
SGI shares trade on AIM and are eligible for 100% relief from inheritance tax. The company has a market capitalisation of 157 million pounds and nearly 100% of the shares are free float. Institutions own 40% of the company led by BlackRock with 9.2%.
Financial results for SGI from 2003 to 2012 were strong:
Ø  Earnings per share grew at a compound 16% p.a. and the dividend increased in proportion.
Ø  Equity per share grew at a compound 15% p.a. over the same period.
Ø  The historical return on equity is a healthy 17%. However, the return on retained earnings since 2003 has declined to 13%. In 2013 ROE fell to 4%.
Ø  Net margins were 15%.
Ø  Cash flow has been consistently positive with net operating cash flow of 16 million pounds covering the dividend more than twice these last five years.
Ø  At December 2013, SGI had no debt and net cash of 17million pounds, nearly 10% of its market value.
The company is riding a wave of interest in 'alternative' assets, driven in part by the very low cost of money. The price of gold, for instance, has increased by 360% since 2003. And rare British stamp prices have moved ahead of gold:

Graph courtesy Stanley Gibbons, click to enlarge
 SGI's share price (in blue) easily outperformed the FTSE All Share (in red) since 2009:
SGI in blue, FTSE All Share in red, courtesy Google, click to enlarge
The quite sudden fall in SGI's share price since March might seem like a buying opportunity, and a buy tip from the Investors Chronicle (published yesterday) has caused the shares to rebound by 10% in just one day.
SGI's business is changing:
1. Noble Investments:
In November 2013 SGI acquired Noble Investments for 45.3 million pounds. Noble specialises in rare coins and owns two small auctioneers specialising in rare books and manuscripts and jewellery, watches and fine wines. SGI's purchase valued Noble at an historical PE ratio of 15. The company placed shares to the value of 39.8 million pounds to cover the 31.8 million pounds that was the cash consideration for Noble, leaving 8 million pounds for use elsewhere in the business. As a result, SGI shareholders saw their holdings diluted by 37%.
In its 2013 Annual Report, the company explains the rationale behind the Noble acquisition: 
"The  acquisition of  Noble  in  November  last  year  immediately  transforms  The  Stanley  Gibbons  Group  from  being  the predominant name  in  the  stamp  market  to  being  a  major  force  in  both  dealing  and  auctions  in  the  wider  collectibles  market.  The  strategic importance of this acquisition is most relevant in respect of our online strategy to create a global online marketplace for collectibles as a  result  of  the  wider  range  of  collectibles  in  which  we  now  have  authority  and  expertise.  The  primary  objectives  of  our  online marketplace  will  be  to  make  selling  online  faster  and  easier  through  our  bespoke  collectibles  sellers’  tools  at  the  same  time  as providing buyers better protection against authenticity risks and from miss-selling practices."
In the last month of 2013, Noble's rare coin business helped to triple SGI's coin sales to increase trading profit by 0.7 million pounds. This was the result of cross selling its coins to SGI's customer base. The company also anticipates cost savings of close to 1 million pounds this year.
2. The internet
SGI has been straining to develop an online market, both in the UK and the USA, to compete with eBay. This has proved to be difficult and costly. In 2013 the company reported a pre-tax loss of 1.4 million pounds on internet sales, which is large when compared to SGI's total pre-tax profit of 3.5 million pounds in that year.
Internet sales are a mere 8% of the total, and once SGI sorts out its technical problems this should be a source of new business.
However, the costs associated with the acquisition of Noble and developing the internet market are the main reasons why SGI's 2013 earnings per share declined by a third on 2012. Traditional trading in philately and other collectibles improved in 2013, with the Singapore and Jersey offices showing strong growth. 65% of SGI's customers are located in the UK, including the Channel Islands.
At today's share price of 342p, SGI is on an historical PE ratio of 21 (adjusted for exceptional expenses) and a prospective PE ratio of 16. At the present price, the shares yield 2.2%.
My valuation model values SGI at around 300p. This assumes that SGI meets its forecast for next year's earnings and continues to trade at an average PE of 17. Earnings growth after 2014 is assumed to be 5% p.a. through to 2018. This has been discounted at 10.8% (Bond rate - SLXX 3.8%, 2% operating risk, 5% margin of safety).
The cautious investor will note:
·         An eventual return to dear money might prick the bubble in the price of collectibles.
·         Management do not own a significant part of the company. The large share placing in 2013 followed a smaller placing in 2012. The company also buys new businesses with shares, the latest in January 2014, further diluting existing shareholders. While the acquisitions might make commercial sense, the exclusive use of SGI shares as a means of payment dilutes SGI's traditional earnings and existing shareholders. For a cash generating company, with 17 million pounds net cash at year-end, the reliance on equity issues is odd.
·         Return on equity has fallen from an average of 17% between 2003 and 2012 to 4% in 2013. This reflects the large increase in capital in recent years and a decline in earnings.
·         Three directors sold shares worth 1 million pounds at 365p in January 2014. There were no director buys since the placing at 295p in November 2013.
·         SGI is spending large sums to get its online platform up and running. There is no guarantee that SGI will compete successfully in this market with established companies such as eBay.
·         The deficit on the defined benefit pension scheme climbed to 3.3 million pounds. Although the scheme was closed to new entrants in 2002, it is likely to require further financial support.

Wednesday, 16 April 2014

AIM Shares: And Nichols PLC

Introduction to the AIM market at the London Stock Exchange
AIM (formerly the Alternative Investment Market) was founded in 1995 to allow investors access to young companies that could not qualify or would not pay the cost for a listing on the main market of the London Stock Exchange (LSE).
According to the LSE, "AIM is the most successful growth market in the world." At the last count there were 1,094 companies listed on AIM compared to a peak of 1,399 eight years ago. Companies have raised 86 billion pounds since 1995, yet the total value of all AIM shares today is only 78 billion pounds. It has been a wonderful source of fees and commissions for underwriters, brokers, accountants, lawyers and market makers. But what about the humble investor?
The results of the AIM ALL Share Index (blue) compared to the FTSE All Share (red) for the past 10 years, shows just how rotten AIM shares have been, on average, for the investor:

Graph courtesy Google Finance, click to enlarge
Over 3,000 companies have listed on AIM since 1995 and yet only one-third remain. Some have moved to the main market and some have been acquired. But many have gone into administration or delisted, leaving the shareholder with nothing or next to nothing.
Yet there are excellent companies listed on AIM. And AIM shares have one feature that marks them out from the main list: given certain requirements they are exempt from Inheritance Tax. This tax feature has attracted good, UK based family-run businesses that can pass on their shares to the next generation without the 40% tax burden. It is here that one finds the best companies.
As the tax concession is an important incentive to investing in AIM shares, it is important to know what companies will qualify for "business relief" for Inheritance Tax.
Ø  The company may not also be quoted on a "recognized overseas exchange" (HMRC).
Ø  The company may not be engaged "wholly or mainly in dealing in securities, stocks or shares, land or buildings, or in making or holding investments" (HMRC).
Ø  If the company is acquired (or the investor sells his shares) before 2 years are up, provided the funds are reinvested in another AIM company that complies with 1 and 2 above and together they are held for at least 2 years, the investment will be free of Inheritance Tax.
There are other considerations that are peculiar to investing in AIM companies.
As they are usually small cap, the touch - the bid to offer spread - can be very high. Invest in Venn Life Sciences (market capitalization of 6 million pounds), and the stock must appreciate by 14% before you break even before stamp duty and commissions.
A second consideration is that, unlike the main market, AIM’s listing rules do not require companies to have a minimum free float. "Free float" is the proportion of shares that are freely traded in the market compared to the number held by all parties. Free float is important because companies can be taken private by their owners at the price they choose if they control 75% of outstanding shares.
BlueStar Secutech, a Chinese manufacturer of digital video equipment registered in the British Virgin Islands, was listed on AIM in 2007 at 48p a share. Six years later, after reporting a 60% increase in earnings per share and a net cash position, it made a tender offer of 2.5p a share. BlueStar's net asset value per share was reported at 40p at that time. So shareholders were offered just 6% of the net asset value of a profitable, cash rich trading company. As the free float was only 23%, outside shareholders could not contest the price. All AIM companies are obliged to inform the public of their free float on their websites.
A third consideration is that AIM stocks can easily run out of money. Small and high risk companies often find it impossible to get bank financing and they do not have the option of issuing debt instruments. If in need, they must dilute shareholders via a public offering or shut up shop.
The wise investor will approach an AIM-quoted company with the circumspection a bear approaches  a honey trap:
1. Stick to companies with no or little debt, a profitable trading record in a niche market and that are cash generative.
2. Be sure management can be trusted to do the best for the company and not just look after themselves.
3. Check whether the company is quoted on an overseas market and is eligible for business relief for Inheritance Tax.
4. Ensure that the free float is well in excess of 25%; look for well regarded institutional investors who are invested in the company.
5. Take into consideration the share price's bid to offer spread.
6. Have a clear exit strategy. You might need it.

Nichols PLC

Vimto can and pre-war advertisement, courtesy Nichols website 
Nichols is a soft drinks company based on Merseyside. In 2004, the company transferred its listing from the Main market to AIM, explaining that, after selling its foods business, the size of the company did not warrant the costs associated with a Main listing. However, the family held about one-third of the company's shares at that time, so Inheritance Tax considerations may have paid a role in the decision to join AIM. The family now hold about one-fifth of its shares.
The company has a good trading history, a high return on equity and holds net cash of 34 million pounds, 9% of its market value.
Nichols is currently eligible for 100% business relief for inheritance tax, it has a 'free float' of 79%, a market capitalization of 366 million pounds and it trades on a bid to offer spread of just over 2%.
Although Nichols's brands, either owned or under license, cover all main segments of the soft drinks market, except for water, its share of the UK market is only about 1%. And the total market has grown by a compound average of 3% since 2006 (British Soft Drinks Association):
Drink sales UK
Nichols's brands
Total UK Sales in
Pounds Million
% Total growth
2006 to 2012
Vimto, Panda, Sunkist, Levi Roots
30% value
Still & Juice drinks
14% value
Vimto, Weight Watchers
20% value
Fruit Juices & Smoothies
Weight Watchers
2% value
20% value
Sports & Energy drinks
(Included in carbonates and still drinks)
Extreme Energy and Sport
82% volume
From 2013 Refreshing the Nation, British Soft Drinks Association.
While the total drinks market (excluding bottled water) has grown by 20% in value, Nichols's sales have more than doubled in this seven year period. Nichols does not give sales figures by brands, but it is reasonable to assume that this is largely the result of acquisitions and license agreements:
·      2005 - Nichols purchased Panda (including Panda Cola, the 3rd cola drink after Coca-Cola and Pepsi in the UK) for 5.5 million pounds.
·         2010 - it licensed Levi Roots (Caribbean flavoured carbonates) worldwide rights.
·         2011 - it licensed Weight Watchers cordials and fruit juices for the UK and Ireland.
·         2012 - it licensed Extreme Sport and Energy for the UK.
Nichols' core brand in the UK is Vimto, which it launched in 1908. And Vimto exports, mainly to the Middle East and Africa, account for 21% of Nichols's sales, where it relies on third party distributors. The company sees its main growth coming from the convenience and online outlets both in the UK and international markets. Sensitive to the anti-sugar campaign, the company reduced the sugar content of its drinks by 20% in 2013.
Nichols Dispense is the third largest supplier of dispensed soft drinks, to pubs etc., in the UK, after Britvic and Coca-Cola Enterprises.
Shares in Nichols (in red) have outperformed the FTSE All Share (in blue) by a wide margin.
Courtesy Investors Chronicle, click to enlarge
Nichols runs a very lean organization. It bills 640,000 pounds per employee. The company relies on contracting out production, which keeps capital expenditure and inventory low while avoiding any temptation, as its CEO remarks, "to feed the factory."
Financial results are excellent:
Ø  Earnings per share have increased by a compound 16% per annum since 2004, and equity per share has increased by a compound 12% per annum in the same period.
Ø  Net margins are a comfortable 15% of sales.
Ø  Return on equity, both historically and on retained earnings, averages over 30%, and this is without any financial leverage.
Ø  Net operating cash flow, after small amounts of capital expenditure, covers the dividend 2.2 times. The company held 34 million pounds in net cash at the 2013 year end.
At 1,008p, Nichols trades on an historical PE ratio of 22 and yields 2%. The chairman's outlook is positive (2013 Annual Report):
"Although economic indicators suggest signs of optimism, there is evidence that consumer spending in the UK remains cautious and we expect the UK retail market to remain challenging in 2014. Despite this environment we are confident that the Group can maintain its strong performance into 2014. We will continue to invest in our brands and grow distribution in both our UK and international markets. January saw the launch of the “Vimto Squeezy” product which takes the brand into the new ‘water enhancer’ category and in April consumers will see the new Vimto TV campaign."
My valuation model values Nichols' shares at between 1,000p and 1200p, depending on the assumption used for future return on equity.* Nichols' present price of 1,008p is 19% off its recent all-time high, reflecting the recent decline in small cap shares.
 *Assumptions: earnings per share growth 10% p.a.; equity per share growth 10% p.a.; return on equity 25% or 30%; dividend payout 43% of earnings; average PE ratio of 21.5, all discounted at 10.8% (3.8% SLXX + 2% operating risk + 5% margin of safety) for the years 2014-19.
The cautious investor will note that:
1. The soft drinks business is fiercely competitive. Nichols is dwarfed by Coca-Cola, Pepsi, Snapple, Suntory, Britvic and A G Barr (see This makes it very difficult for Nichols to get shelf space in the supermarket chains.
2. The underlying soft drinks business is not growing in volume terms in the UK. Nichols management has proven to be wily. It has improved margins and licensed new products. But, can it match its past performance?
3. The adjusted earnings for 2013, which showed an increase of 10% on 2012, excludes 1.7 million pounds for management restructuring and a 2 million pounds provision for a claim from its former Pakistan distributor. As a result, reported earnings declined slightly on 2012.
4. Cash generation is consistently good, with a year-on-year increase of 10 million pounds in the cash account. Cash conversion exceeded 100% of after tax earnings in 2013. The company has no debt and a cash balance of 34 million.
5. It is reassuring that the Chairman, grandson of the founder, owns 6% of the company and that the Nichols family hold one-fifth of its shares. The company's successful formula is unlikely to be changed by an over enthusiastic CEO.