Artful Investing

The last portfolio review concluded:

Make no mistake however, this month's [7%] gains are exceptional, don't expect a repeat performance in every other month this year.

I stand by that and don't let this month's even more exceptional (can one thing be more exceptional than another?) 9% increase fool you into thinking monthly gains of this size are sustainable.

But hooray! February has made my performance after two months of 2005 greater than my gain for the whole of 2004.

That's slightly misleading. 2004 was a year's harvest more dissappointing than Hiroshima's 1945 sake vintage. All stocks in my portfolio started the year with plenty of headroom to grow into. Now that huge advances have been achieved, returns can be expected to calm in later months.

More encouraging still, nearly all four shares have appreciated a similar amount since New Year, each up between ten and twenty percent. The gains have been broad and consistent and here is where they have come from since my last update:

Porfolio at 29/01/05:

Ben Bailey, 20/02/03 at 178p (423p)
Ben Bailey, 21/06/04 at 390p (423p)
Chaucer Holdings, 06/10/03 at 42.88p (52p)
Chaucer Holdings, 06/04/2004 at 54.75p (52p)
Dana Petroleum, 20/11/03 at 223.75p (491p)
Mayborn Group, 15/03/04 at 282p (260p)
+ cash holdings

Today's total as of 28/02/2005

Ben Bailey, 20/02/03 at 178p (485p)
Ben Bailey, 21/06/04 at 390p (485p)
Chaucer Holdings, 06/10/03 at 42.88p (55p)
Chaucer Holdings, 06/04/2004 at 54.75p (55p)
Dana Petroleum, 20/11/03 at 223.75p (515p)
Mayborn Group, 15/03/04 at 282p (290p)
+ cash holdings

But this performance could be dramatically reversed in March as Chaucer, Mayborn and Ben Bailey will all deliver final results. Ben Bailey is my largest holding, representing 35% of portfolio value. Bailey is expected to report at 7a.m. tomorrow. And this time, I will be getting up on time to act if necessary.

Thanks to February and here's to March - make or break.

The Artful Dodger

On Friday at 3 p.m. Coral Products, a U.K. listed company manufacturing compact disc and DVD cases, kicked investors in the wallet with news that trading has gone from weak to worse.

we advise that profit for the current year ending 30th April 2005 will be significantly lower than the market's current expectation. The influences of unexpected raw material price increases and slower than expected demand in the DVD market are having an adverse impact on operating margins. Although our market remains increasingly competitive, we are taking steps to mitigate our raw materials exposure

Shares were hammered immediately following this announcement, down at 25p after opening at 35. This sort of announcement is what the market calls a profit warning. The news a company is failing to operate at the level of profitability everyone expects forces a swift re-rating as it's reputation is torn apart faster than a kosher cookbook at a Hitler Youth reunion.

But the consensus appraisal might not be accurate and profit warnings often present golden opportunities to buy stock at a beaten-up price as negative sentiment can reaches a never to be exceeded crescendo.

So, in light of this news, what is Coral worth paying for? In December 2004's interim results, the company reported a ten percent decrease in turnover but a fifty percent fall in profits. The board tried to spell it out for any remaining investors of a Panglossian persuasion:

Profits for the full year will not reach those of last year and, as we enter the second half, trading conditions remain difficult within our industry.

The dividend was cut from 1.05p to 0.7p. Friday's announcement raises the prospect of the dividend hangman bidding investors a good morning and shaking their hands at 7a.m. on the announcement of final results in July.

The recent announcements are unnerving on many fronts. As a UK based manufacturer of commodity goods, Coral Products' longevity thus far is a surprise in itself. In recent years manufacturers have only managed to increase shareholder returns by offshoring labour-intensive manufacture, as Mayborn have done so successfully in China or pursue high-margin services work a la WPP.

With raw materials prices and currency movements crushing the company's profits it's difficult to see Coral returning to the level of profitability it reported in 2003, when shareholders enjoyed 6.89p of earnings per share. Before this news Coral looked reasonably attractive. Total net assets measured £11.5m versus a market capitalisation of £7.5m. The market price is now approximately £5m but visibility of earnings has been severely clouded by Friday's announcement and I'm left wondering if a company like Coral has any future in the current economic climate of high wages and expensive raw materials.

Everything has a price that makes it attractive but I'll suspend judgement until I've digested Friday's exocet.

The Artul Dodger

Every quoted company is given a shorthand moniker by financial news providers allowing investors to access quotes and announcements quickly.

Chaucer goes by the acronym CHU. Most companies have a three letter acronym to index, usually made up of letters from that company name. Dana Petroleum, Ben Bailey and Mayborn are known as DNX, BBC and MBY respectively. Recent news from other insurers and Chaucer have powered the CHU price higher.

Chaucer is a Lloyd's insurer and is part of a sector that is entering results season. Nearly all their peers will be announcing full-year results over the next month, Chaucer is due March 18th.

Amlin announced on Wednesday a record profit for insurance activity in 2002 and announced an improved forecast for the 2003 account. As for 2004...

The 2004 year of account is at an early stage of development and in setting the initial forecast, as usual, a cautious approach has been adopted. Natural catastrophe losses in this year, including the US hurricanes and Japanese typhoon, are currently forecast to be the highest ever.

Kiln followed the next day with syndicate forecasts and a few words on trading:

Kiln continues to perform exceptionally well and is taking the best advantage of the excellent trading conditions.

This is all part of the monitoring an investor in the sector must perform on a daily basis to measure the health of an investment in a similar company. Chaucer's share price has long frustrated me but the company has consistently reported strong, profitable trading since I purchased in October 2003. Chaucer impressed with it's syndicate forecasts on Friday and news that 2005 has started better than the market was anticipating have forced them to a new high:

I am delighted with the results achieved by our Syndicates for the 2002 year of account. Against a market background of high catastrophe events, the 2003 Syndicate forecasts have improved for motor, marine and non marine, and the initial 2004 forecasts are encouraging. I am also pleased to report a promising start to 2005.

Another positive proclamation that's as dry as Tutenkhamun's sherry nightcap. But who cares? The shares are moving higher.

I previously blogged on market overhangs and underhangs - the influence news on insitutional stake clearing or building can have on a company's share price. Last week saw two new announcements of fund managers increasing their exposure to shares in CHU. On Thursday, Aviva announced an increase to 6.18% and Fidelity followed on Friday with the announcement that it too now owns just over six percent of Chaucer.

The newsflow is encouraging and the price movement a wallet and ego-boost. But it's the big one sometime next week. Ben Bailey finals. At nearly 40% of my portfolio this announcement has the potential to make the recent advances of Chaucer look like a schoolboy's with-inflation pocket-money rise.

The Artful Dodger

Mayborn, my fourth largest shareholding, has burst into life this month. As winter starts to lose it's grip, Mayborn is spurting upwards and at 295p to sell has hit a new high since my 2004 purchase at 282p.

I doubt it's the weather that increased interest in the nappy manufacturer, even stockmarket investors are rarely deluded into buying off the back of a few more bees buzzing or daffodils dancing.

On March 10th, 2004, Mayborn announced full year results, a similar announcement can be expected next month. Mayborn is typically a pretty pedestrian share, showing meagre movements and toddling along in no particular direction like one of their own customers. That changed a couple of weeks ago, as sustained buying saw the shares rise from 247p to today's 295p and I'm guessing people are buying in anticipation of March's announcement.

This is common behaviour for smallcap shares. The markets they operate in are tiny and under-reported. It's tough to fathom how the company will be faring without stock exchange declarations. This makes an appraisal impractical at quiet times, resulting in lacklustre price movement. It's a phenomenon akin to Wimbledon fever - for the rest of the year tennis fans are as rare as Tory voting foxes - but in the month before England's premier tennis event, Tiger Tim Henman is back in the news, and an uncharacteristic attitude of unfounded optimism sets into the British mindset. After the competition is decided, apathy and disinterest descend as inevitably as boyband posters from a bedroom wall.

March is set to be a busy month for my portfolio, Chaucer have announced finals will be out on March 18th and Ben Bailey can be expected to report even earlier in the month.

Tim Henman perenially disappoints his followers at Wimbledon. My money is on Mayborn to do different.

The Artful Dodger

Theres a load of ways to value a company's shares. Discounted cash-flow and net enterprise value are two of the more scientific and unwieldy. The most common approach is the price:earnings ratio, the market value of a company divided by the profit generated in a year. PE ratios are normally calculated using broker forecast profits. The lower the PE ratio, the better value being offered, each share being backed by a higher proportion of profit.

Companies across a sector normally trade on similar PE ratios but better or worse prospects are normally reflected in a higher, or lower PE respectively. Shares in different sectors will trade at different ratings as each sector's risks are measured against the other. In the UK, the banking sector trades at a PE ratio around double that of housebuilding where fears of an imminent crippling recession have stymied enthusiasm in the shares.

An investor needs the savvy and awareness that builders will always look much cheaper than banks. The risks faced by each industry are very different. Though a bank may be cheap on a PE ratio of ten or eleven, a builder won't unless its shares are going for four or five times earnings.

In his column in today's Sunday Times, John Waples muses on whether the builders really should trade at such a discount to banks and the rest of the market. If companies like Ben Bailey (my largest shareholding) can maintain profitability in a housing downturn or at least provide evidence that they could, demand for shares in the sector would rocket:

HOUSEBUILDERS are used to being the City’s lepers. Investors have given them a wide berth and have been unable to spot that under the bandages the disease is not as virulent as feared.

As a result, institutions have called the housing cycle about as badly as they could. When the sector was roaring two years ago, housing stocks were as cheap as chips. Now, when every new survey is predicting a further slowdown in prices, building stocks are hitting all-time highs.

It appears that ahead of the sector’s reporting season, investors are realising these companies have real assets, make good profits and their rating has been handicapped by an Armageddon valuation. On top of this, January sales have been strong.

Take Persimmon, the £2.2 billion housebuilder that is on the verge of entering the FTSE 100. It is due to make profits of £469m, yet trades on a prospective p/e of only seven times. Rob Griffiths of Arden Partners said that Wimpey was trading on a p/e of only five times and Barratt on 5.5 times. He said when this occurred in America it was followed by a rerating that pushed average p/e ratios up to eight or nine times....
Buy ahead of the results season, but remember that institutional enthusiasm for this sector is often shortlived.

In March builders will be scrapping for attention like stags in rutting season.The market's reaction will make or break my 2005.

The Artful Dodger

I've posted previously how difficult it is to distinguish whether impressive returns from investment are down to the application of luck or skill in the investment process.

My 2004 result beat the market, as did my performance in 2003. My returns would have been higher still if my portfolio had consisted entirely of either Ben Bailey or Dana Petroleum for the two year period as each more than doubled.

Currently I'm a four stock investor. Someone with a twenty stock portfolio applying similar logic would have a decent case for attributing my outperformance to good luck. Indeed, these returns from a portfolio of that size would be impressive. But do my achievements over the last two years suggest I can win again in 2005?

Burton Malkiel's seminal work A Random Walk Down Wall Street examines the records of investors and fund managers who consistently beat market averages and draws an analogy with a coin-tossing competition between 1,000 competitors.

1,000 contestants flip coins. Just as would be expected by chance, 500 of them flip heads and these winners are allowed to advance to the second stage of the contest and flip again. As might be expected, 250 flip heads. Operating under the laws of chance, there will be 125 winners in the third round, 63 on the fourth, 31 on the fifth, 16 on the sixth and 8 on the seventh.

By this time crowds start to gather to witness the surprising ability of these expert coin- tossers. The winners are overwhelmed with adulation. They are celebrated as geniuses in the art of coin-tossing, their biographies are written and people urgently seek their advice. After all, there were 1,000 contestants, and only 8 could consistently flip heads.

In other words, even if you have beaten the market several times in succession it is no more likely than evens that you will outperform in any given period. Malkiel's swipe at acolytes of Warren Buffett et al. might appear churlish but it raises some crucial questions. Is there anything useful we can learn from the methodology of the superinvestors or are they just super lucky? Is the outcome of an investment decided by luck alone? Is there no way of improving our chance of success?

Malkiel can't hide his envy in this anology. Any curmudgeonly analyst could write off an individual's consistent sucess in a field to luck. Are top surgeons just fortunate craftsmen who have encountered less than their share of fatal complications in the operating theatre? Is the entire golf tour just a travelling circus of jammy sods? Luck plays a part in each of these endeavours. Malkiel says there is no value in the annual letters of Buffett, or Anthony Bolton's frequent interviews in the media: no superior strategy exists and investors should stick to index funds only.

Is there really no-one a keen begineer to investing can learn from? Are Buffett, Bolton and Lynch deluded ultracrepidarians that lack the humility to confess their achievements are down to decades of fluke and nothing more?

I don't believe so and would like to reassert the worth of their opinions, wealth and experience. If the weighting of skill and luck required for an investor to consistently outperform his peers compares better to golf than coin-tossing ask yourself, who would you rather teach you to play the back nine at Augusta, Tiger Woods or Tommy Cooper?

The Artful Dodger

Yesterday's Sunday Times featured an interview with the so-called crown prince of stock-picking, Sanjeev Raja, manager of Fidelity's UK Aggressive fund.

Fidelity is the UK's largest fund manager, custodian of more of the British populace's assets than any rival. The title crown prince might not fit too well on Raja, however, Fidelity's own Anthony Bolton has a produced a formidable return in the last 25 years. This article waxes lyrical on Bolton's excessive successes:

Since 1979 he has returned over 3,000 per cent against an All Share Index that is up only around 1,300 per cent.

Peter Lynch, also of Fidelity, enjoys legendary status amongst stock-pickers after achieving 29.2 percent annualized return for the Magellan fund during his thirteen year tenure.

But let's not do Raja down too much. Though we haven't had to look far to find Bolton and Lynch, apart from each other, the pair are almost peerless in the fund management arena.

In the interview, Raja explains his stock-picking strategy:

What gets me excited is when I discover a stock price that is completely divorced from the company’s prospects, 30% or 40% undervalued. That is what I am looking for, and that is when I will decide to buy.

Sound familiar? In this post I outlined my modus operandi - I seek to buy stocks at a 30% discount to fair value. It's encouraging to learn a manager at the world leading fund houses sees the logic in this approach. The margin of safety makes a lot more sense than Derek Mitchell of ISIS Asset Management's lackadaisical methods.

Raja spent three months "having a think" on an extended holiday in Venezuela, reading Buffett and Ben Graham, echoing my experiences albeit in the huge public parks of Paris in 2002, when I discovered The Intelligent Investor and finalised my strategy in just over a week.

Raja's strategy consists of five tenets, here's my thoughts on each.

1 Find out a company's strategic direction. What is it trying to achieve, what are its three-to-five-year horizons? If it has several divisions, products or geographical territories, discover which have the highest priority in terms of investment and management time.

This boils down to growth. Where is the growth supposed to be coming from? The investor then must ascribe some probability of this being achieved and the magnitude of any increase in earnings. All very sensible but I'd be concerned this can distract the investor from the crucial matter of valuation. And how well qualified are you to judge the company's market anyway?

2 Look at the quality of management... See how in touch the branch or factory managers are with head office, and whether head office really knows what is going on out in the branches. Find out how closely the middle-ranking executives share the optimism of the boardroom.

Again, it makes sense but I'd have thought this level of insight would be difficult to acquire reliably.

3 Check the underlying drivers of the business: sales, the growth rate of the company's market and its market share, what decides price, which products are or are not growing. How free is the company to raise prices? How ruthless is it about cutting out losing lines?

Crucial and a key question. Tick.

4 Industrial context. Is the industry fragmented because barriers to entry are very low, suggesting it will always be competitive because of new entrants, or could a large number of players shrink through mergers or business failures? How easy is it for customers to switch supplier?

This is what Peter Lynch refers to as a 'defensive moat'. An investor must be au fait with the challenges particular to an industry and a company's strategic position against competitors or price squeezes. Vital.

5 buy into a good quality business if it's cheap enough, and a mediocre one if it's way too cheap. He wants to know how good the cashflow is, the underlying profitability and the price/earnings ratio that the shares are on in relation to others in the sector.

I'm in full agreement with Raja again here and have oft-blogged on the need for valuation against sector peers and the imperative requirement of valuation. My only qualm however, is why was valuation ranked fifth in this list of magic secrets?

In February thus far my own funds have continued to progress. I look forward to regaling you all over my next few missives.

The Artful Dodger

It's difficult to distinguish an intelligent investor from a confident investor and a lucky investor from a good one. A lucky investor can easily outperform a better investor over short periods and an investor's confidence may arise from his successes, rather than knowledge and competence.

Ben Graham's investment classic The Intelligent Investor (Amazon, £14.43) is a tour de force of investment experience, theory and reason. I blazed through the book's three hundred pages in less than a week, nodding along in agreement at Mr Graham's insightful and erudite observations and philosophy. This book helped mould my strategy to its current form and in today's blog I'd like to share some of the wise words of The Intelligent Investor. I hope this book will make you and I both intelligent and successful stock-market investors.

The Intelligent Investor begins with some words from Warren Buffett, the world's second richest man and probably the planet's most successful investor, ever. Buffett's preface contains one of his oft-quoted comments on the subject:

To invest successfully over a lifetime does not require a stratopheric IQ, unusual business insights or insider information. What's needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework. This book precisely and clearly describes the proper framework. You must supply the emotional discipline.

I've often blogged on the need to take emotion out of investment decisions, particularly here.

The introduction reads like a giant warning sign posted along a byway in the boondocks: All ye speculators: turn back now...

The extent of the market's shrinkage in 1969-70 should have served to dispel an illusion that had been gaining ground during the past two decades. This was that leading common stocks could be bought at any time and at any price, with the assurance not only of ultimate profit but also that any intervening loss would soon be recouped by a renewed advance of the market.. the market had "returned to normal", .. both speculators and investors must again be prepared to experience significant and perhaps protracted falls as well as rises in the value of their holdings

and continues in a similar vein on the approach to investing and investor psychology:

the investor's chief problem - and even his worst enemy - is likely to be himself. ("The fault, dear investor, is not in out stars - and not in our stocks - but in ourselves...") This has proved the more true over recent decades as it has become more necessary for conservative investors to acquire common stocks and this to expose themselves, will-nilly, to the excitement and the temptations of the stock market... we hope to aid our reader to establish the proper mental and emotional attitudes toward their investment decisions. We have seen much more money made and kept by "ordinary people" who were temperamentally well suited for the investment process than by those who lacked this quality, even though they had an extensive knowledge of finance, accounting, and stock-market lore.

I've added a permanent link to Amazon book store and can assure all readers that the profits I've enjoyed since heeding the advice of The Intelligent Investor have significantly outstripped the cover price. If you'd like help deciding if I qualify for the title intelligent investor, keep on reading.

The Artful Dodger