This article from the FT, and the research that it refers to to, nicely illustrates what I think is one of the biggest myths of investing:
http://www.ft.com/cms/s/0/21c20d22-effe-11de-833d-00144feab49a.html?nclick_check=1
The article refers to a study by academics claiming that analysts' forecasts have no effect on share prices. The authors analyse a load of share price moves following analyst forecast changes and could find no evidence that such changes had any effect on prices. Therefore, the authors conclude, star analysts and stock pickers add no value to investors.
Unfortunately the authors are completely missing the point. The conclusion that forecasts do not move share prices is not particularly surprising. Indeed value investors have long since largely considered accurate forecasting as not a very relevant input to valuation analysis (sometimes it can be interesting to know which way forecasts are going, but they tell you nothing about the underlying value drivers). It implies a degree of knowledge and accuracy that is simply not there. Furthermore, study after study has shown how pathetic analyst attempts at forecasting earnings actually are (e.g. James Montier's many studies). They are almost as bad as economists' attempts at forecasting GDP. Therefore why should we be surprised that the market takes no notice of forecasts?
The value added part of fundamental stock analysis comes by identifying genuinely undervalued securities, not by forecasting what next year's eps is going to be. To do this requires accurately valuing the company's assets, the earnings power and, where appropriate, any long term growth prospects. Once this process is completed the investor looks to buy at a discount to this value, providing margin of safety. Value investors rarely make any attempt to forecast earnings, expect perhaps for the purpose of scenario analysis.
That said, for all the misconceptions surrounding the forecast obsession, from a value investors perspective I hope the fetish prevails. The more analysts spend their time desperately trying to produce more accurate forecasts to base their valuations off, the more likely they are to miss more obvious value opportunities.
Friday, December 25, 2009
Sunday, November 15, 2009
Henry Boot
This is a property construction and land development group that operates mainly in the north of England. Being quite small (£140m mc) and family controlled, it tends to fall under the radar of most stock brokers and investment analysts (in fact there is only one house that covers the shares, and the are the house brokers).
The land development business is main reason why the shares are interesting (http://www.hallamland.co.uk/). The business model is to buy land cheaply, usually from from farmers under option or agency agreements, invest in getting the land through the planning system (can take 10-15 years), and then eventually selling it on, usually to one of the major UK housebuilders. The business has a long and good track record of doing this successfully. Current trading is depressed, both because of the economy, and also because the housebuilders themselves are not in a position to buy any new land.
However, the market does not appear to be properly valuing the land business. On the balance sheet, the only value assigned to the land development business is the inventory entry, which consists of the amount originally paid for the land (tiny in comparison to what is sold for) plus any capitalised planning costs that have gone into specific acreage that the company expects to gain planning permission on. As at the last balance sheet reporting date, this amounted to £54m. Over the three year period 2006-8, total land profits were over £70m. It also possible to verify that the £54m entry is extremely conservative by conducting a simple discounted cash flow model on the current land bank. I have used the following information and assumptions provided by the company: 1666 acres owned outright, 6500 acres under option (where the company has 15% ownership interest), 50% success rate, 50% usable land per acre (the rest is car parks, communual areas etc.), 10 units per acre, £40,000 site value per unit on sale. With a 30% tax rate this suggests a normalised profit to the company of £12.3m per annum. Spread this out over 15 years and discount at 10% to get a valuation of £94m. Alternatively, if I assume that all land sold is replaced with new inventory, and then value the cash flow on a perpuity basis (10% discount rate), the valuation rises to £112.
It is possible to verify that the market undervaluing the land business by deducting the value of all the compnay's other assets from the enterprise value and seeing what is left. Fortunately, the company's other assets are fairly straightforward and easy to value.
The other major asset is the property portfolio, which consists of a series of retail parks, warehouses etc mostly in the north of England. At the last reported balance sheet date, this was valued at £117.2m, following a year and a half of hefty rightdowns (-£20m in 2008 and -£24m in H1 2009). Additional to this, the company had just over £70m of property under construction which, when complete, would move to the propety investment portfolio. This is valued at cost, which means it might be reasomable to expect some writedown on completion, although I have been advised by the company that this is unlikely to be the case as they already have a large provision in the balance sheet (£11m). The other way of verifying that the propety portfolio is not overvalued is to look at the rent it generates. At the last reported valuation date, the gross rental yield was 9.3%, which is a lot higher than the major UK real estate majors. Although this would partly be expected given that these are lower grade properties in the north of England, it still suggests that the portfolio valuation is pretty reasonable.
The company has three other small assets. Firstly, there is a PFI contract to run the A69 for another 17 years. This is highly defensive, generating just over £2m in profit for the company per annum. Valuing this on a no-growth basis (i.e. 17 years discounted) suggests a value of £17m. In reality there is likely to be some growth suggesting a higher valuation may be fairer. Secondly, the company operates a plant hire business, mainly to the construction and housebuilding sectors. Unsurprisingly this business is on its knees right now. Profit will be negative this year, although cash flow will be positive as they are letting the fleet age by not investing. I value this business by taking a 25% haircut on the net assets, which gives a value of £9m. (note: historically the business has done £1-2m of profit). Finally there is a general construction business, which is also struggling right now. It has made money historically, but clearly the outlook is poor and there are very few assets associated with it (in fact net assets are probabyly negative due to the customer advances that are usually associated with this sort of contracting business). Therefore I give it a zero value.
On the liability side, I am taking the debt at face value at the last reporting date. I am adding £20m to the pension deficit, partly to be conservative, but also because there is a triennal review approaching.
Putting all this together we have:
Investment property and development = £190m
PFI asset = £19m
Banner plant = £9m
Net debt = -54m
Pension = -45m
Net to equity ex Hallam Land = 119m
Market capitalisation = 143m
Implied value of Hallam Land = 24m
From the above it is therefore possible to infer that the market is valuing the land business at merely £25m. As the above analysis has suggested, a conservative going-concern valuation for the land business is more like £95m. Adding this to the valuation suggests a fair value of £214m, or 166p per share or 50% upside.
Conclusion: I think this is enough to justify buying a position in the shares. However, although there is margin of safety here, it must also be conceded that there are factors that could cause loss of capital, in particul a double dip recession combined with a further leg down in the housing market. This would further depress the housebuilding industry and either impair or delay the realisation of value within the land business.
The land development business is main reason why the shares are interesting (http://www.hallamland.co.uk/). The business model is to buy land cheaply, usually from from farmers under option or agency agreements, invest in getting the land through the planning system (can take 10-15 years), and then eventually selling it on, usually to one of the major UK housebuilders. The business has a long and good track record of doing this successfully. Current trading is depressed, both because of the economy, and also because the housebuilders themselves are not in a position to buy any new land.
However, the market does not appear to be properly valuing the land business. On the balance sheet, the only value assigned to the land development business is the inventory entry, which consists of the amount originally paid for the land (tiny in comparison to what is sold for) plus any capitalised planning costs that have gone into specific acreage that the company expects to gain planning permission on. As at the last balance sheet reporting date, this amounted to £54m. Over the three year period 2006-8, total land profits were over £70m. It also possible to verify that the £54m entry is extremely conservative by conducting a simple discounted cash flow model on the current land bank. I have used the following information and assumptions provided by the company: 1666 acres owned outright, 6500 acres under option (where the company has 15% ownership interest), 50% success rate, 50% usable land per acre (the rest is car parks, communual areas etc.), 10 units per acre, £40,000 site value per unit on sale. With a 30% tax rate this suggests a normalised profit to the company of £12.3m per annum. Spread this out over 15 years and discount at 10% to get a valuation of £94m. Alternatively, if I assume that all land sold is replaced with new inventory, and then value the cash flow on a perpuity basis (10% discount rate), the valuation rises to £112.
It is possible to verify that the market undervaluing the land business by deducting the value of all the compnay's other assets from the enterprise value and seeing what is left. Fortunately, the company's other assets are fairly straightforward and easy to value.
The other major asset is the property portfolio, which consists of a series of retail parks, warehouses etc mostly in the north of England. At the last reported balance sheet date, this was valued at £117.2m, following a year and a half of hefty rightdowns (-£20m in 2008 and -£24m in H1 2009). Additional to this, the company had just over £70m of property under construction which, when complete, would move to the propety investment portfolio. This is valued at cost, which means it might be reasomable to expect some writedown on completion, although I have been advised by the company that this is unlikely to be the case as they already have a large provision in the balance sheet (£11m). The other way of verifying that the propety portfolio is not overvalued is to look at the rent it generates. At the last reported valuation date, the gross rental yield was 9.3%, which is a lot higher than the major UK real estate majors. Although this would partly be expected given that these are lower grade properties in the north of England, it still suggests that the portfolio valuation is pretty reasonable.
The company has three other small assets. Firstly, there is a PFI contract to run the A69 for another 17 years. This is highly defensive, generating just over £2m in profit for the company per annum. Valuing this on a no-growth basis (i.e. 17 years discounted) suggests a value of £17m. In reality there is likely to be some growth suggesting a higher valuation may be fairer. Secondly, the company operates a plant hire business, mainly to the construction and housebuilding sectors. Unsurprisingly this business is on its knees right now. Profit will be negative this year, although cash flow will be positive as they are letting the fleet age by not investing. I value this business by taking a 25% haircut on the net assets, which gives a value of £9m. (note: historically the business has done £1-2m of profit). Finally there is a general construction business, which is also struggling right now. It has made money historically, but clearly the outlook is poor and there are very few assets associated with it (in fact net assets are probabyly negative due to the customer advances that are usually associated with this sort of contracting business). Therefore I give it a zero value.
On the liability side, I am taking the debt at face value at the last reporting date. I am adding £20m to the pension deficit, partly to be conservative, but also because there is a triennal review approaching.
Putting all this together we have:
Investment property and development = £190m
PFI asset = £19m
Banner plant = £9m
Net debt = -54m
Pension = -45m
Net to equity ex Hallam Land = 119m
Market capitalisation = 143m
Implied value of Hallam Land = 24m
From the above it is therefore possible to infer that the market is valuing the land business at merely £25m. As the above analysis has suggested, a conservative going-concern valuation for the land business is more like £95m. Adding this to the valuation suggests a fair value of £214m, or 166p per share or 50% upside.
Conclusion: I think this is enough to justify buying a position in the shares. However, although there is margin of safety here, it must also be conceded that there are factors that could cause loss of capital, in particul a double dip recession combined with a further leg down in the housing market. This would further depress the housebuilding industry and either impair or delay the realisation of value within the land business.
Monday, October 12, 2009
UkrProduct Group
I recently bought shares in this company at 17p. I think it could be a very lucrative investment.
What is it?
The company claims to be the leading branded dairy producer in the Ukraine with over 20% market share. Most of the revenue and profit comes from branded sales. They also have a skimmed milk business, which appears to be considerably lower margin and much more commoditised. The company’s stated strategy is to focus on the branded part of the business. They have historically recorded very respectable EBIT margins and ROCEs and CRFOIs in the 10-15% region. The company is AIM listed, with a current market cap of just under £8m. The balance sheet is strong with a net cash position as at the half year end in June.
Why I am buying it?
Valuation. The shares cropped up on both my deep value screen (shares trading below book value) and my more general Greenblatt screen (shares with high CFROIs on low valuations). This is a fairly unusual occurrence, as deep value ideas tend to be deep value for a reason – i.e. they are loss making or the margins/returns are heavily depressed.
This company trades on 2.6X historic EV/EBIT. However profits will be down this year due to the Ukrainian economy. In the first half, they generated £1.1m of EBIT, which was 11% lower than the same period last year. If I assume a similar level of EBIT in the second half then the valuation multiple would rise to a whopping 3.6X EV/EBIT. Cash flow has been even stronger due to a working capital inflow. Management actually expect an improvement in trading in the second half as the Ukrainian economy appears to have bottomed and they have launched a series of marketing initiatives for their major products.
In the UK the closest comparative company I can think of is Dairy Crest, which is valued at nearer to 9X EV/EBIT. If I put UkrProduct on even half that valuation I get over 40% upside. Interestingly the company has in the past traded on multiples considerably higher than this, suggesting that a valuation closer to Dairy Crest it is not unreasonable for the company’s assets.
Worth noting that a pure balance sheet valuation also suggests considerable upside. At the year end for 2008, the company was carrying £13.3m in inventories, receivables and cash. They also had property, plant and equipment valued at £10.5m. Of this, the depreciated Land and Buildings amounted to £5.3m (last re-valued in 2005), whilst the depreciated vehicle fleet was valued at £1.9m (they appear to own their own vehicles according to the conference call). Excluding all other assets, and subtracting total liabilities of £6.5m leaves an NAV of £14m, versus a current market cap of just under £8m. Therefore, assuming the reported numbers are correct, this investment has considerable margin of safety.
What are the risks?
Two main issues::
1) There are a number of company-specific issues affecting the company this year. Firstly, the depreciation of Hryvnia as the Ukrainian economy crashed has adversely affected the reported GBP numbers this year. Secondly, local producers of hard cheeses cut prices in order to stimulate demand. This has been negative for the company’s sales of processed cheese as consumers have switched from one to the other. Thirdly, Russia implemented a ban on diary imports from Belarus, which has had the effect of directing Belarusian dairy exports to Ukraine instead (particularly butter). To my mind, most of these are temporary issues which, at the very least, should not be expected to negatively impact profits further. The Hryvnia has stabilised, while the Ukrainian economy appears to have bottomed out. I have been unable to find much information on the Belarusian situation, although I cannot imagine that the Belarusian dairy export market is sufficiently large to destroy UkrProduct’s business.
2) The company is AIM listed and does not operate in the UK. Therefore, there is always a chance that it is one big scam. Against this I am encouraged by the company’s disclosure (numerous investor presentations, a results conference call etc.). The management team also own a lot of stock and appear to have a reputable business track record.
All in all, valuation (potential 3-4X upside) appears to more than offset the risk.
What is it?
The company claims to be the leading branded dairy producer in the Ukraine with over 20% market share. Most of the revenue and profit comes from branded sales. They also have a skimmed milk business, which appears to be considerably lower margin and much more commoditised. The company’s stated strategy is to focus on the branded part of the business. They have historically recorded very respectable EBIT margins and ROCEs and CRFOIs in the 10-15% region. The company is AIM listed, with a current market cap of just under £8m. The balance sheet is strong with a net cash position as at the half year end in June.
Why I am buying it?
Valuation. The shares cropped up on both my deep value screen (shares trading below book value) and my more general Greenblatt screen (shares with high CFROIs on low valuations). This is a fairly unusual occurrence, as deep value ideas tend to be deep value for a reason – i.e. they are loss making or the margins/returns are heavily depressed.
This company trades on 2.6X historic EV/EBIT. However profits will be down this year due to the Ukrainian economy. In the first half, they generated £1.1m of EBIT, which was 11% lower than the same period last year. If I assume a similar level of EBIT in the second half then the valuation multiple would rise to a whopping 3.6X EV/EBIT. Cash flow has been even stronger due to a working capital inflow. Management actually expect an improvement in trading in the second half as the Ukrainian economy appears to have bottomed and they have launched a series of marketing initiatives for their major products.
In the UK the closest comparative company I can think of is Dairy Crest, which is valued at nearer to 9X EV/EBIT. If I put UkrProduct on even half that valuation I get over 40% upside. Interestingly the company has in the past traded on multiples considerably higher than this, suggesting that a valuation closer to Dairy Crest it is not unreasonable for the company’s assets.
Worth noting that a pure balance sheet valuation also suggests considerable upside. At the year end for 2008, the company was carrying £13.3m in inventories, receivables and cash. They also had property, plant and equipment valued at £10.5m. Of this, the depreciated Land and Buildings amounted to £5.3m (last re-valued in 2005), whilst the depreciated vehicle fleet was valued at £1.9m (they appear to own their own vehicles according to the conference call). Excluding all other assets, and subtracting total liabilities of £6.5m leaves an NAV of £14m, versus a current market cap of just under £8m. Therefore, assuming the reported numbers are correct, this investment has considerable margin of safety.
What are the risks?
Two main issues::
1) There are a number of company-specific issues affecting the company this year. Firstly, the depreciation of Hryvnia as the Ukrainian economy crashed has adversely affected the reported GBP numbers this year. Secondly, local producers of hard cheeses cut prices in order to stimulate demand. This has been negative for the company’s sales of processed cheese as consumers have switched from one to the other. Thirdly, Russia implemented a ban on diary imports from Belarus, which has had the effect of directing Belarusian dairy exports to Ukraine instead (particularly butter). To my mind, most of these are temporary issues which, at the very least, should not be expected to negatively impact profits further. The Hryvnia has stabilised, while the Ukrainian economy appears to have bottomed out. I have been unable to find much information on the Belarusian situation, although I cannot imagine that the Belarusian dairy export market is sufficiently large to destroy UkrProduct’s business.
2) The company is AIM listed and does not operate in the UK. Therefore, there is always a chance that it is one big scam. Against this I am encouraged by the company’s disclosure (numerous investor presentations, a results conference call etc.). The management team also own a lot of stock and appear to have a reputable business track record.
All in all, valuation (potential 3-4X upside) appears to more than offset the risk.
Friday, October 9, 2009
Topical question
What is this a chart of?
Two clues:
1) It is a chart of one asset or asset class relative to another
2) The start date is not random
Two clues:
1) It is a chart of one asset or asset class relative to another
2) The start date is not random
Answer: Global equities total return, versus gold. The start date is the month that Nixon took US off the gold peg, August 1971. Interesting that at the market bottom in March, gold had actually matched the total return of equities over the entire period. Gold provides no income and has no real utility value. It is purely a store of value.
I still cannot figure out what this is telling me, and in particular why gold should suddenly start performing so well only recently. If it were inflation/monetary debasement fears then bond yields should have gone up by now, but they have not. If it were concerns over general financial stability then equities should have performed a lot worse. Yet the most recent rally has seen both gold and equities go up. I cannot explain gold; it remains a mystery to me.
Saturday, September 26, 2009
Wednesday, September 23, 2009
Dividend yields versus bond yields
Following the recent “once in lifetime” move in credit spreads, an interesting situation now presents itself in some sectors of the market: dividend yields that are greater than bond yields. This now appears to be the case in the Telco, Pharma and Utilities sectors. Of these, the first two arguably present the greatest possible valuation anomaly because the free cash flow generation and corresponding dividend cover are that much greater. The table below shows the dividend yields for the European telco majors versus the yield on a representative 10 year bond. In each case I have selected a bond denominated in the same currency that the share is quoted in. The chart underneath shows the evolution of the relationship over the past 3 years, demonstrating the current situation is quite unusual.
The obvious question then is why this should be so. I think there are two potential explanations:
1) The market expects the dividends to be cut. In the short term this is clearly unlikely, as the cash flow cover for the dividends is substantial. In the longer term there is perhaps a greater likelihood of a cut, particularly if we enter a prolonged deflationary cycle. However, the recent rally would suggest that the markets at least are no longer expecting this outcome (implied inflation from the index linked market has risen this year). Therefore if dividends did end up being cut, the rest of the stock market would presumably get hit much harder.
2) The bonds are mispriced. I am not a bond expert, but I am reliably informed that current investment grade spreads are still pricing a recession, albeit, not the depression that they were implying late last year. Telco bond yields also do not appear to be out of line with other investment grade sectors, so unless the whole market is wrong, I find this explanation unlikely.
Conclusion? Sell Telco bonds and buy Telco equities.
The obvious question then is why this should be so. I think there are two potential explanations:
1) The market expects the dividends to be cut. In the short term this is clearly unlikely, as the cash flow cover for the dividends is substantial. In the longer term there is perhaps a greater likelihood of a cut, particularly if we enter a prolonged deflationary cycle. However, the recent rally would suggest that the markets at least are no longer expecting this outcome (implied inflation from the index linked market has risen this year). Therefore if dividends did end up being cut, the rest of the stock market would presumably get hit much harder.
2) The bonds are mispriced. I am not a bond expert, but I am reliably informed that current investment grade spreads are still pricing a recession, albeit, not the depression that they were implying late last year. Telco bond yields also do not appear to be out of line with other investment grade sectors, so unless the whole market is wrong, I find this explanation unlikely.
Conclusion? Sell Telco bonds and buy Telco equities.
Wednesday, August 19, 2009
CPL Resources, decent margin of safety
Most people would run a mile from this company: AIM-listed recruitment company (highly cylical) that operates entirely in Ireland (basketcase economy). Looking at the valuation and the financials tells a different story however.
At year end 2008 the company had EURO 36m in cash, and 35m in trade receivables (limited impairment risk). The only liabilities were 24m trade payables. No debt to speak of. So the net asset value for the company (not including any long term assets) was EURO 45m, or 1.21 EURO's per share. The current share price is 1.61 EUROs, although I bought in back in July on the London listing around £1.2. At the lows it got down to below 1.oo EURO, a 20% discount to the net current assets.
It seems to me that buying a business such as this at around book value (or ideally at a discount) is an extremely attractive proposition. Why? Three reasons.
Firstly, despite the highly cylical nature of the gross profit, the business model faces little risk of actually going under. There is no debt. It is also fairly easy to downsize the business by reducing the workforce, although admittedly there comes a point where the fixed costs associated with branches become too high.
Secondly, even if operating profit is negative, it is unlikely that the business will burn through its cash. Trade receivables are 40% higher than trade payables, which means the business releases working capital as it shrinks. Therefore, it is not unreasonable to assume that current cash levels will at least stay where they are (even if net current assets fall slightly as the business downsizes).
Finally, the potential upside is really quite high. In the good times recruitment companies can trade up to 4-5X book value. Earnings can recover quickly once the decline stops. Even if this is a 2-3 years away, it still makes the investment attractive. Given that the downside appears to be rather limited, this investment offers an attractive asymmetric risk-reward profile. For sure, CPL is not at the quality end of the recruiters. For choice I would much rather own Hays or Michael Page, but both of these shares already trade at big premiums to their tangible net asset values (despite also being essentially breakeven).
At year end 2008 the company had EURO 36m in cash, and 35m in trade receivables (limited impairment risk). The only liabilities were 24m trade payables. No debt to speak of. So the net asset value for the company (not including any long term assets) was EURO 45m, or 1.21 EURO's per share. The current share price is 1.61 EUROs, although I bought in back in July on the London listing around £1.2. At the lows it got down to below 1.oo EURO, a 20% discount to the net current assets.
It seems to me that buying a business such as this at around book value (or ideally at a discount) is an extremely attractive proposition. Why? Three reasons.
Firstly, despite the highly cylical nature of the gross profit, the business model faces little risk of actually going under. There is no debt. It is also fairly easy to downsize the business by reducing the workforce, although admittedly there comes a point where the fixed costs associated with branches become too high.
Secondly, even if operating profit is negative, it is unlikely that the business will burn through its cash. Trade receivables are 40% higher than trade payables, which means the business releases working capital as it shrinks. Therefore, it is not unreasonable to assume that current cash levels will at least stay where they are (even if net current assets fall slightly as the business downsizes).
Finally, the potential upside is really quite high. In the good times recruitment companies can trade up to 4-5X book value. Earnings can recover quickly once the decline stops. Even if this is a 2-3 years away, it still makes the investment attractive. Given that the downside appears to be rather limited, this investment offers an attractive asymmetric risk-reward profile. For sure, CPL is not at the quality end of the recruiters. For choice I would much rather own Hays or Michael Page, but both of these shares already trade at big premiums to their tangible net asset values (despite also being essentially breakeven).
Friday, June 26, 2009
UK Banks again: 2 bull cases and a bout of hedonic editing
This sector is fascinating. Every time I read a note, speak to an analyst or look at a model there seems to be a different view or emphasis. The variances in estimates and price targets are huge. There must be an opportunity here.
Because banks are so opaque and difficult to analyse my current focus has merely been to try and establish where the key points of contention are. Once this is done it should be a lot easier to establish whether or not there is genuine value here. As far as I can make out there are basically three areas of disagreement: pre-provision profits; total impairments; and the starting capital base.
1) Pre-provision profits: In a bull note on RBS published yesterday, a well known UK broker appears to be constructing a bull case for RBS on the basis of higher pre-provision profits than what the bears are assuming. For the 2008-11 period they have a total of £48bn of cumulative impairment, versus the uber bears who are assuming £49.6bn, slightly higher but not much difference. They key difference is the level of cumulative pre-provision profits - £35bn versus only £26bn for the uber bears. This constitues an extra £10bn of capital. Interestingly, this bull case does not rely at all on the other bull argument in the market - the assumption of lower impairments on the non-APS book versus the APS book (see 2 below). As stated explicitly in the note today: “With so few details on the composition of the assets that will be covered from APS, we do not assume any reduction in the impairment charge, once RBS has utilised the £19.5bn first loss”.
2) Impairments on the non-APS book: The other source of bullishness for the sector is the argument that the non-APS book will experience much lower provisions. Most analysts (bulls and bears) don’t assume anything for this, instead using a normalised number, although some of the bulls recognise that this could become a source of upside once more information is available. It is interesting that some analysts’ do believe that they already have sufficient information to make the assumption of lower non-APS impairments versus APS impairments. This is clearly a really important issue, and potentially one that the company's themselves may be able to provide some colour on.
3) Deductions to capital: The uber bears on the sector depress their starting capital by subtracting up front the non-amortised portion of the APS fee and the EV deduction for the life business. Others don't do this. Having considered this issue, I have concluded that the bearish view is illogical, at least as far as the APS fee is concerned. The bear arguement is that the APS fee is an intangible asset and should therefore be deducted from equity as you would goodwill. The problem with this analysis is when inferences are then made as to what the ROE should be, on the basis of the written down capital base. The APS fee represents payment for a long term insurance contract on the banks’ assets. If BP were to purchase a 7 year fire insurance contract on their head office, I would not deduct the entire cost immediately from the shareholders equity. And even if I did, I certainly wouldn’t make inferences about whether or not the resulting ROE was sustainable (the ROE would be higher because equity would be lower, but this would clearly be an accounting illusion). The APS fee should be considered as a cost of running the business and should therefore be spread over the life of the contract, ideally reflecting the timing of the losses.
That said, even if I do adjust the bear's numbers by adding back the APS fee to capital, the resulting NAVs are still some way lower than where the bulls are (especially when you get out to 2011 and 2012 when most of the fee has already been amortised). This suggests to me that a bull case on these stocks probably rests more on points 1) and 2) rather than 3). This means taking a view on how bad you think the UK economy is going to be over the next 2-3 years relative to what is already being assumed and, crucially, the extent to which LBG and RBS have managed to dump all their toxic assets into the APS. I suspect the investment case would need to rest more on the latter point rather than the former.
Because banks are so opaque and difficult to analyse my current focus has merely been to try and establish where the key points of contention are. Once this is done it should be a lot easier to establish whether or not there is genuine value here. As far as I can make out there are basically three areas of disagreement: pre-provision profits; total impairments; and the starting capital base.
1) Pre-provision profits: In a bull note on RBS published yesterday, a well known UK broker appears to be constructing a bull case for RBS on the basis of higher pre-provision profits than what the bears are assuming. For the 2008-11 period they have a total of £48bn of cumulative impairment, versus the uber bears who are assuming £49.6bn, slightly higher but not much difference. They key difference is the level of cumulative pre-provision profits - £35bn versus only £26bn for the uber bears. This constitues an extra £10bn of capital. Interestingly, this bull case does not rely at all on the other bull argument in the market - the assumption of lower impairments on the non-APS book versus the APS book (see 2 below). As stated explicitly in the note today: “With so few details on the composition of the assets that will be covered from APS, we do not assume any reduction in the impairment charge, once RBS has utilised the £19.5bn first loss”.
2) Impairments on the non-APS book: The other source of bullishness for the sector is the argument that the non-APS book will experience much lower provisions. Most analysts (bulls and bears) don’t assume anything for this, instead using a normalised number, although some of the bulls recognise that this could become a source of upside once more information is available. It is interesting that some analysts’ do believe that they already have sufficient information to make the assumption of lower non-APS impairments versus APS impairments. This is clearly a really important issue, and potentially one that the company's themselves may be able to provide some colour on.
3) Deductions to capital: The uber bears on the sector depress their starting capital by subtracting up front the non-amortised portion of the APS fee and the EV deduction for the life business. Others don't do this. Having considered this issue, I have concluded that the bearish view is illogical, at least as far as the APS fee is concerned. The bear arguement is that the APS fee is an intangible asset and should therefore be deducted from equity as you would goodwill. The problem with this analysis is when inferences are then made as to what the ROE should be, on the basis of the written down capital base. The APS fee represents payment for a long term insurance contract on the banks’ assets. If BP were to purchase a 7 year fire insurance contract on their head office, I would not deduct the entire cost immediately from the shareholders equity. And even if I did, I certainly wouldn’t make inferences about whether or not the resulting ROE was sustainable (the ROE would be higher because equity would be lower, but this would clearly be an accounting illusion). The APS fee should be considered as a cost of running the business and should therefore be spread over the life of the contract, ideally reflecting the timing of the losses.
That said, even if I do adjust the bear's numbers by adding back the APS fee to capital, the resulting NAVs are still some way lower than where the bulls are (especially when you get out to 2011 and 2012 when most of the fee has already been amortised). This suggests to me that a bull case on these stocks probably rests more on points 1) and 2) rather than 3). This means taking a view on how bad you think the UK economy is going to be over the next 2-3 years relative to what is already being assumed and, crucially, the extent to which LBG and RBS have managed to dump all their toxic assets into the APS. I suspect the investment case would need to rest more on the latter point rather than the former.
Wednesday, June 24, 2009
UK Banks: no longer a mug's game?
I am convinced that UK domestic banks are least understood sector in the market, despite all the media and analyst coverage. The basic reason for this is the huge divergence in forecasts for impairments, NAVs and normalised earnings. As an example, the list below shows the forecasted NAV/share for Lloyds Banking Group (LBG) from various sources.
HSBC: LBG NAV (2011) = 112p
RBS: LBG NAV (2011) = 92p
Redburn: LBG NAV (2011) = 99p
Panmure Gordon: LBG NAV (2011) = 74p
JP Morgan: LBG NAV (2011) = 20-25p
Now this is a most unusual situation. Normally analysts huddle together, unwilling to take a stand too far in one direction. Situations such as this, where this is a huge variance of forecasts make for potentially very attractive investments, assuming you can get your analysis correct. I don’t have the answers yet, but I am finding myself becoming more positive on both the UK domestic banks. There are two main reasons for this:
1) A misunderstanding of the asset protection scheme (APS). The way the APS works is that both LBG and RBS have to take the “first loss” on their asset impairments (£25bn pre tax in the case of LBG), after which the Government takes 90% of any further losses. However not all of the banks’ assets are in the APS. The idea was that only the bad stuff would be put there, in effect creating a pseudo good bank/bad bank structure. A really important question from a valuation perspective is what will happen to the non-APS assets – roughly £460bn in the case of LBG (£260bn are covered by the APS). Many of the bears appear to be assuming continued high level of impairments on the non-APS assets into 2010 and 2011 once the first loss is hit (it is consensus that LBG will hit the first loss in early 2010). However, a contrarian on the sector recently made an excellent point to me: the losses on the non-APS assets are actually likely to be substantially lower than on the APS assets, much lower indeed than most people appear to be assuming. Many of the bears appear to be assuming similar or marginally lower level of losses on the non-APS assets. He reckons the non-APS assets are likely to experience around 25% of the losses experienced by the APS assets. If you run these numbers then the trough valuation looks much more appealing.
2) Economic versus accounting adjustments - NAV / RoE circularities. The other issue with banks, one that becomes much more prevalent during recessions and bear markets, is capital and reserves. During a boom no one cares about book value, but once asset impairments enter the picture suddenly all anyone can think about is whether the bank has enough capital. While this is important from a regulatory perspective, there comes a point where the economic reality becomes obfuscated by accounting gimmicks. For example, some of the bearish analysts are now deducting from capital the APS fee, and doing it up front. Since this is £15.6bn it seriously reduces the capital base. Then they say, “look how high the ROE is! that cannot be sustainable, the bank must need more capital”. The ROE is of course much higher because the capital base has been reduced by 30-40%, but does this actually matter? Is it economic? Imagine if a normal company were to announce that they were paying all their staff 7 years salary up front. Would it make sense to deduct this from their capital? Of course not, it should be amortised over the whole 7 years. Once you realise this you can see that conclusions based on implied ROEs have to be treated with much scepticism.
This idea is still very much work in progress. Clearly there are still huge problems with the UK economy, so impairments on the non APS book could in fact be higher than the bulls are assuming. It is also still not entirely clear how risky the assets outside the APS book actually are. Nevertheless, preliminary work suggest an NAV per share for LBG of 100-120p could be achievable by 2011. And when you consider that this is likely to mark the bottom of the impairments cycle and the bank will have a quasi monopolistic position with the domestic mortgage market, it is not hard to imagine a 1.5-2X multiple of this NAV, implying 175-250p potential value.
HSBC: LBG NAV (2011) = 112p
RBS: LBG NAV (2011) = 92p
Redburn: LBG NAV (2011) = 99p
Panmure Gordon: LBG NAV (2011) = 74p
JP Morgan: LBG NAV (2011) = 20-25p
Now this is a most unusual situation. Normally analysts huddle together, unwilling to take a stand too far in one direction. Situations such as this, where this is a huge variance of forecasts make for potentially very attractive investments, assuming you can get your analysis correct. I don’t have the answers yet, but I am finding myself becoming more positive on both the UK domestic banks. There are two main reasons for this:
1) A misunderstanding of the asset protection scheme (APS). The way the APS works is that both LBG and RBS have to take the “first loss” on their asset impairments (£25bn pre tax in the case of LBG), after which the Government takes 90% of any further losses. However not all of the banks’ assets are in the APS. The idea was that only the bad stuff would be put there, in effect creating a pseudo good bank/bad bank structure. A really important question from a valuation perspective is what will happen to the non-APS assets – roughly £460bn in the case of LBG (£260bn are covered by the APS). Many of the bears appear to be assuming continued high level of impairments on the non-APS assets into 2010 and 2011 once the first loss is hit (it is consensus that LBG will hit the first loss in early 2010). However, a contrarian on the sector recently made an excellent point to me: the losses on the non-APS assets are actually likely to be substantially lower than on the APS assets, much lower indeed than most people appear to be assuming. Many of the bears appear to be assuming similar or marginally lower level of losses on the non-APS assets. He reckons the non-APS assets are likely to experience around 25% of the losses experienced by the APS assets. If you run these numbers then the trough valuation looks much more appealing.
2) Economic versus accounting adjustments - NAV / RoE circularities. The other issue with banks, one that becomes much more prevalent during recessions and bear markets, is capital and reserves. During a boom no one cares about book value, but once asset impairments enter the picture suddenly all anyone can think about is whether the bank has enough capital. While this is important from a regulatory perspective, there comes a point where the economic reality becomes obfuscated by accounting gimmicks. For example, some of the bearish analysts are now deducting from capital the APS fee, and doing it up front. Since this is £15.6bn it seriously reduces the capital base. Then they say, “look how high the ROE is! that cannot be sustainable, the bank must need more capital”. The ROE is of course much higher because the capital base has been reduced by 30-40%, but does this actually matter? Is it economic? Imagine if a normal company were to announce that they were paying all their staff 7 years salary up front. Would it make sense to deduct this from their capital? Of course not, it should be amortised over the whole 7 years. Once you realise this you can see that conclusions based on implied ROEs have to be treated with much scepticism.
This idea is still very much work in progress. Clearly there are still huge problems with the UK economy, so impairments on the non APS book could in fact be higher than the bulls are assuming. It is also still not entirely clear how risky the assets outside the APS book actually are. Nevertheless, preliminary work suggest an NAV per share for LBG of 100-120p could be achievable by 2011. And when you consider that this is likely to mark the bottom of the impairments cycle and the bank will have a quasi monopolistic position with the domestic mortgage market, it is not hard to imagine a 1.5-2X multiple of this NAV, implying 175-250p potential value.
Thursday, April 30, 2009
BP, boring but cheap
What I find particularly interesting about this share is the extent to which the market does not seem to believe the earnings/cash flow/dividend targets of the company. The dividend yield is 8%. The 10-year Graham-Dodd p/e is under 12X, one of the lowest in the market (at least among large cap names). Admittedly the current earnings based valuation is flattered somewhat by the fact that capex is likely to run ahead of depreciation for while. Nevertheless, from an absolute return perspecive, I don’t think this valuation is sustainable if the dividend is not cut.
What will cause a cut in the dividend? Two possibilities: 1) Management cannot cut costs suffiently to bring the business in line with a lower oil price world; 2) Oil price goes down and stays down. I think the results this week showed that we can worry less about point 1) as they have already reduced costs by 1.2bn versus 2bn target for the full year.
The second point is clearly a risk. However I think one needs to question much of a risk it really is given where the valuation currently lies. Assuming they cut the dividend in half the share will still yield 4%. If oil goes to $30 and stays there for 3 years the share will probably underperform, but I am not sure it will underperform by that much given the implications of $30 oil for the rest of the global economy. And this must be the only scenario in which an investment would lose money in an absolute sense.
If the oil price stays flat at $50 or goes up to, say, $75, then the share will certainly go up in absolute terms, and probably relative also (although clearly it will underperfom the oil beta names).
Personally, I would be buyer of this share whether on an absolute or relative basis simply because the valuation currently looks so appealing.
What will cause a cut in the dividend? Two possibilities: 1) Management cannot cut costs suffiently to bring the business in line with a lower oil price world; 2) Oil price goes down and stays down. I think the results this week showed that we can worry less about point 1) as they have already reduced costs by 1.2bn versus 2bn target for the full year.
The second point is clearly a risk. However I think one needs to question much of a risk it really is given where the valuation currently lies. Assuming they cut the dividend in half the share will still yield 4%. If oil goes to $30 and stays there for 3 years the share will probably underperform, but I am not sure it will underperform by that much given the implications of $30 oil for the rest of the global economy. And this must be the only scenario in which an investment would lose money in an absolute sense.
If the oil price stays flat at $50 or goes up to, say, $75, then the share will certainly go up in absolute terms, and probably relative also (although clearly it will underperfom the oil beta names).
Personally, I would be buyer of this share whether on an absolute or relative basis simply because the valuation currently looks so appealing.
Monday, April 27, 2009
Safety in semis?
Safety is perhaps not the right word, as you can probably never have safety in the semi-conductor space. The speed of product innovations and the severity of the cycle can potentially blow you out of the water at any time.
Nevertheless, two UK small caps that might be worth a closer look are CSR and Wolfson Microelectronics. Both companies operate in the semi-conductor industry. They are “fabless”, which means they do not manufacture their own semi-conductor wafers (a highly technologically intensive and expensive process). Rather they buy the wafers, and then use them in their own products that are sold onto end customers, mostly in the consumer electronics industry. CSR specialises in wireless connectivity, particularly Bluetooth. According to their annual report, last year they shipped 40% of the world’s Bluetooth chips. Wolfson’s specialises in audio chips, targeting newly released consumer electronics products where quality is paramount. They have a reasonably diverse end market customer base including handset OEMs, personal media players, games consoles, TVs etc.
Both companies have a number of issues. In the near term, the global recession is hammering, and will continue to hammer their revenues. Estimates for Wolfson’s 2009 revenues have fallen by nearly 50% in the past 9 months. Longer term, there are also some concerns about loss of market share to larger competitors. For CSR, the concern is that handset OEMs and other customers will move toward multi-purpose chips that do more than just Bluetooth. Indeed this is one the reasons the company has recently bought out a struggling GPS chip computer with a view to combining their products together. Wolfson faces similar issues, having recently lost a the I-pod contract to a US competitor.
All doom and gloom them? Not entirely. The potential attraction of these companies is the valuation. Both shares have fallen around 80% from their peaks in 2006. Back in the bull market the market looked to price the shares off expected earnings. Margins and returns were high on the back of the worldwide consumer boom. What is interesting is that the shares have now traded down to a level that is not far off the liquidation asset value.
Using Ben Graham’s approach of ignoring all the intangible assets and netting off the total liabilities against the tangible assets, we come out with share prices not a million miles away from current prices. Marking the 2008 year-end property and inventory at 50%, the receivables and cash at 100%, and netting off all the liabilities gives a net asset value of $109m for Wolfson and $276m for CSR (both companies are dollar reporters). Converting into sterling this gives per share values of 65p for Wolfson and 148p for CSR.
Granted, after the recent risk rally, both shares currently trade higher than these levels – Wolfson is at 108p and CSR is at 240p. However, one would have to be very negative indeed about future prospects for either company to argue that they should trade in inline with the tangible net assets on an ongoing basis. Under any scenario which does not involve permantly collapsing end markets, both companies continue to generate cash and deliver high returns on equity and capital employed. And presumably at some point the consumer electronics market will at least start to stabilise. Even for 2009, both companies expect to deliver at worst flat cash flow (although this may tougher for CSR now following their acquisition). Also worth noting is that both shares did actually trade more or less in-line with the net-tangible assets back at the lows in February and November 2008 (they have both risen c.55% since). If we do see a pull back in markets, I would definitely look to start buying these stocks if they start to trade back down toward the tangible asset value.
Wolfson report Q1 on Wednesday. It will be interesting to see what they say about the full year outlook and what their cash flow situation looks like for Q1 which will surely be one of their worst quarters ever.
Nevertheless, two UK small caps that might be worth a closer look are CSR and Wolfson Microelectronics. Both companies operate in the semi-conductor industry. They are “fabless”, which means they do not manufacture their own semi-conductor wafers (a highly technologically intensive and expensive process). Rather they buy the wafers, and then use them in their own products that are sold onto end customers, mostly in the consumer electronics industry. CSR specialises in wireless connectivity, particularly Bluetooth. According to their annual report, last year they shipped 40% of the world’s Bluetooth chips. Wolfson’s specialises in audio chips, targeting newly released consumer electronics products where quality is paramount. They have a reasonably diverse end market customer base including handset OEMs, personal media players, games consoles, TVs etc.
Both companies have a number of issues. In the near term, the global recession is hammering, and will continue to hammer their revenues. Estimates for Wolfson’s 2009 revenues have fallen by nearly 50% in the past 9 months. Longer term, there are also some concerns about loss of market share to larger competitors. For CSR, the concern is that handset OEMs and other customers will move toward multi-purpose chips that do more than just Bluetooth. Indeed this is one the reasons the company has recently bought out a struggling GPS chip computer with a view to combining their products together. Wolfson faces similar issues, having recently lost a the I-pod contract to a US competitor.
All doom and gloom them? Not entirely. The potential attraction of these companies is the valuation. Both shares have fallen around 80% from their peaks in 2006. Back in the bull market the market looked to price the shares off expected earnings. Margins and returns were high on the back of the worldwide consumer boom. What is interesting is that the shares have now traded down to a level that is not far off the liquidation asset value.
Using Ben Graham’s approach of ignoring all the intangible assets and netting off the total liabilities against the tangible assets, we come out with share prices not a million miles away from current prices. Marking the 2008 year-end property and inventory at 50%, the receivables and cash at 100%, and netting off all the liabilities gives a net asset value of $109m for Wolfson and $276m for CSR (both companies are dollar reporters). Converting into sterling this gives per share values of 65p for Wolfson and 148p for CSR.
Granted, after the recent risk rally, both shares currently trade higher than these levels – Wolfson is at 108p and CSR is at 240p. However, one would have to be very negative indeed about future prospects for either company to argue that they should trade in inline with the tangible net assets on an ongoing basis. Under any scenario which does not involve permantly collapsing end markets, both companies continue to generate cash and deliver high returns on equity and capital employed. And presumably at some point the consumer electronics market will at least start to stabilise. Even for 2009, both companies expect to deliver at worst flat cash flow (although this may tougher for CSR now following their acquisition). Also worth noting is that both shares did actually trade more or less in-line with the net-tangible assets back at the lows in February and November 2008 (they have both risen c.55% since). If we do see a pull back in markets, I would definitely look to start buying these stocks if they start to trade back down toward the tangible asset value.
Wolfson report Q1 on Wednesday. It will be interesting to see what they say about the full year outlook and what their cash flow situation looks like for Q1 which will surely be one of their worst quarters ever.
Saturday, April 11, 2009
Margin of Safety
I recently ran into a copy of Seth Klarman's classic, "Margin of Saftey Risk Averse Value Investing Strategies for the Thoughtful Investor". Out of print, they sell for $700 second hand, but copies appear to be going around electronically (Sorry Mr Klarman , but I am sure you would rather people were reading it than not).
This book was written in 1991 and has not been updated since. Nevertheless, I am struck by the timliness of the arguments and insights, especially considering all the extraordinary events that have taken place in the financial markets since then. E.g:
Investment Fads:
"There are countless examples of investor greed in recent fianancial history. Few, however, were as relentless as teh decade-long "reach for yiled" of the 1980s... Known among Wall Streeters as "yield pigs", such indivudual and institutional investors were susceptible to any invstment product that promised a high rate of return. Wall Street responded with gusto, as Wall Street tends to do when there are fees to ear, creating a variety of instruments that promised high current yields."
Short terminism of Wall Street:
"The utter hypocrisy of Wall Street is exemplified by the "equitization" wave of early 1991, whereby overleveraged comanies issued equity and used the proceeds to repay debt. Wall Street collected investment banking and underwriting fees when those companies were acquired in highly leveraged junk-bond financed takeovers and collected large feees again when the debt was replaced with newly underwritten equity."
"The utter hypocrisy of Wall Street is exemplified by the "equitization" wave of early 1991, whereby overleveraged comanies issued equity and used the proceeds to repay debt. Wall Street collected investment banking and underwriting fees when those companies were acquired in highly leveraged junk-bond financed takeovers and collected large feees again when the debt was replaced with newly underwritten equity."
"Investment bankers in Wall Street firms are constantly creating new types of securities to offer to customers. Occasionally such offerings both solve the financial problems of issuers and meet the needs of investors. In most cases, however, they address only the needs of Wall Street, that is, the generation of fees and commissions."
"Investors must recognize that the early succss of an innocation is not a relaible indicator of its ultimate merit. Both buyers and sellers must believe that they will beneft in the short run, or the innovation will not get off the drawing board; the longer-term consequences of such innovations, however, may not have been considered carefully... Neither cash-hungry issuers nor greedy investors necessarly analyze the performance of each financial-market innovaation under every conceivable economic scenario. What appears to be new and improved today may prove to be flawed or even fallacious tomorrow."
Short-terminism of institutional fund managers:
Failure to understand leverage:
"The relaxation of investment standards by junk-bond investors was accompanied by the dangerous misconception that the amount of debt and equity in a company's capital structure junior to one's own investment provided a degree of protection. It was as if the value of a business existed on the liability side rather than on the asset side of its balance sheet. Although it may be superficially reassuring to know that there are investors in a company whose claims are subordinated to your own, this information is of little, if any, value in asessing the merits of your investment."
Failure to understand risk:
"The view that risk is dependent on both the nature of investments and on their market price is very different from that described by beta... [R]isk is a perception in each investor's mind that results from analysis of the probability and amount of potential loss from an investment. If an exploratory well proves to be a dry hole, it is called risky. If a bond defaults or a stock plunges in price, they are called risky. But if the well is a gusher, the bond matures on schedule, and the stock rallies strongly, can we say they weren't risky when the investment was made? Not at all. The point is, in most cases no more is known about the risk of an investment after it is concluded than was known when it was made."
Banks and financial companies:
"Most businesses can exist indefinitely without concern for the prices of their securities as long as they have adequate capital. When additional capital is needed, however, the level of security prices can mean the difference between prosperity, mere viability, and bankruptcy. If, for example, an undercapitalized bank has a high stock price, it can issue more shares and become adequately capitalized, a form of self-fulfilling prophecy. The stock market says there is no problem, so there is no problem. Ine early 1991, for example, Citicorp stock traded in the teens and the company was able to find buyers for newly issued securities. If its stock price had been in the low single digits, however, it would have been unable to raise additional equity capital, which could have resulted in its eventual failure. This is another, albeit negative form of self-fulfilling prophecy, whereby the financial markets' perception of the viability of a business influences the outcome."
Forecasting
"Some sources of earnings growth are more predictable than others. Growth tied to population increases is considerably more certain than growth stemming from changes in consumer behaviour... On the whole, it is far easier to identify the possible sources of growth for a business than to forecast how much growth will actually materialise and how it will affect profits."
Saturday, April 4, 2009
Time to take on the debt recovery trade?
“While a speculative capitalization structure throws all the company's securities outside the pale of investment, it may give the common stock a definite speculative advantage... Because of this fact there is a tendency for speculatively capitalized enterprises to sell at relatively high values in the aggregate during good times or good markets. Conversely, of course, they may be subject to a greater degree of undervaluation in depression. There is, however, a real advantage in the fact that such issues, when selling on a deflated basis can advance much further than they can decline.” [Security Analysis, B.Graham and D.Dodd, 1934 ed, p466]
Consider two companies, A and B. Operationally both are identical in all respects. Both have £1bn in revenue, £150m in EBITDA, and an annual £20m maintenance capex requirement (2% of sales). Over the next three years revenues, margins and capex at both businesses will be flat. So these are reasonable businesses - defensive, but with little growth prospects.
The only difference between the two companies is how they are financed. Company A is entirely equity financed, while company B is levered to 3.5X net debt/EBITDA. Mr Market has decided that the enterprise value for these businesses is £800m - i.e 0.8X EV/sales, a low valuation in normal times for businesses such as these but not inconceivable in current markets. So company A has £800m market capitalisation, while company B has only £35om because it is carrying £450m in debt. Because company A has no debt issues the Board has decided that it should pay out 100% of its free cash flow as dividend. Company B has decided that it will pay out only 50% of its free cash flow, so that the other 50% can go into paying down the debt burden (which the market does not like).
Lets consider what a simplistic p&l and cashflow will look like for these two companies.
Under these (admittedly very simplistic) assumptions, it is clear that the "overlevered" company generates a superior total return. Why is this the case? The reason is that the company is still highly cash generative. Each year the debt is paid down by the cash flow, which means the equity portion of the EV rises as the debt portion falls. Meanwhile shareholders are also picking up a sizeable dividend yield on the smaller equity base.
So, does this mean we should be buying companies with debt? Not necessarily. Clearly the above example is only valid if a number of factors are in place.
1) The market must be valuing the EV and equity of the company in this way - i.e. the equity must be at a suitably depressed price versus unlevered peers.
2) There must be a high level of confidence in the EBITDA and cash flow forecast for the levered company. If this is not the case then the financial leverage could quickly see the cash flow dissapear and hence there will be no capital appreciation. This will tend to mean companies that have reasonably defensive revenue streams.
3) There must be no big refinancing looming. Or, if there is, one must be sure that it is not going to have adverse consequences for the company.
In the UK market there are a number of companies (mostly mid-cap) that potentially satisfy these criteria such as: Informa, Premier Foods, Meggitt, FirstGroup, Melrose.
Consider two companies, A and B. Operationally both are identical in all respects. Both have £1bn in revenue, £150m in EBITDA, and an annual £20m maintenance capex requirement (2% of sales). Over the next three years revenues, margins and capex at both businesses will be flat. So these are reasonable businesses - defensive, but with little growth prospects.
The only difference between the two companies is how they are financed. Company A is entirely equity financed, while company B is levered to 3.5X net debt/EBITDA. Mr Market has decided that the enterprise value for these businesses is £800m - i.e 0.8X EV/sales, a low valuation in normal times for businesses such as these but not inconceivable in current markets. So company A has £800m market capitalisation, while company B has only £35om because it is carrying £450m in debt. Because company A has no debt issues the Board has decided that it should pay out 100% of its free cash flow as dividend. Company B has decided that it will pay out only 50% of its free cash flow, so that the other 50% can go into paying down the debt burden (which the market does not like).
Lets consider what a simplistic p&l and cashflow will look like for these two companies.
Under these (admittedly very simplistic) assumptions, it is clear that the "overlevered" company generates a superior total return. Why is this the case? The reason is that the company is still highly cash generative. Each year the debt is paid down by the cash flow, which means the equity portion of the EV rises as the debt portion falls. Meanwhile shareholders are also picking up a sizeable dividend yield on the smaller equity base.
So, does this mean we should be buying companies with debt? Not necessarily. Clearly the above example is only valid if a number of factors are in place.
1) The market must be valuing the EV and equity of the company in this way - i.e. the equity must be at a suitably depressed price versus unlevered peers.
2) There must be a high level of confidence in the EBITDA and cash flow forecast for the levered company. If this is not the case then the financial leverage could quickly see the cash flow dissapear and hence there will be no capital appreciation. This will tend to mean companies that have reasonably defensive revenue streams.
3) There must be no big refinancing looming. Or, if there is, one must be sure that it is not going to have adverse consequences for the company.
In the UK market there are a number of companies (mostly mid-cap) that potentially satisfy these criteria such as: Informa, Premier Foods, Meggitt, FirstGroup, Melrose.
Sunday, March 29, 2009
Three behavioural biases
Around this time last year I remember starting to think that investors in general, especially those in the equity market, were becoming overly bearish. Markets had already fallen a fair amount from their peak. Equity valuations did not look hugely stretched, at least not on some measures (see below). Meanwhile, the press and all the talk seemed to be very negative. For sure, some of the bears made valid points, such as analyst estimates being way too high, and the still highly inflated prices in other risk assets such as commodities and real estate. But, for equities in particular, I couldn't help thinking that a lot of this was now priced into the markets. Of course, subsequent events, which saw equity markets in developed economies fall at least another 30%, suggested that my view was clearly wrong, or at best far too early.
Of course at the time it was not clear that the financial markets were about to almost completely collapse. Even the uber-bears were not predicting this. So I think it would be unfair to say that the subsequent path of equity markets proves that my belief this time last year was wrong. That said, I am somewhat disappointed with myself for not being able to truly see the wood from the trees. That equity markets have fallen way further than I thought they would when I initially turned positive suggests that I had at least not aqequately assessed the risks involved.
So why did I fail to assess the risks properly? Having put considerable thought to this question, I have come to the conclusion that it can mostly be explained by behavioural finance biases, rather than a specific informational or interpretative deficiency. Indeed, I think the only information gap was my lack of understanding of the banks' and non-bank financial institutions' balance sheets. However, virtually all investors were in this camp given the poor levels of disclosure. Behaviourally speaking, I woulld highlight three biases that I think adversely affected my assessment of the situation:
1) Familiarity bias. This is the tendency to draw heavily on facts that one is familiar is. Being an equity investor and not a credit investor, I tended to look closely at equity market valuations, and especially those in the sector that I was a research analyst for at the time. I did not think these valuations were hugely stretched given how far many of the stocks I was interested in had already fallen. Therefore I conlcuded that it would be very unlikely for these stocks to fall a great deal more given what the market had already priced in. The mistake I made was to apply this to the whole equity market, failing to appreciate fully that a lot of other sectors such as mining (well at least I knew that was overvalued!), industrials and other financials were not yet pricing in the same sort of outcomes. I also rather naively assumed that the outcome being implied by the credit markets should not be taken too seriously given the huge liquidity dislocation within those markets.
2) Extrapolation bias (I think this one may actually have another name, but it is obvious what it means). Here I think the mistake I made was relying too much on one indicator - the earnings yield versus the bond yield - to draw a bullish conclusion. This measure which has worked reasonable well for the last 20-25 years or so suggested equities were very cheap compared with bonds, even after adjusting the earnings down 15-20%. I knew that other measures such as cyclically adjusted p/e ratios and tobin's q still suggested the market was slightly expensive on an absolute basis, but I also knew that historically these measures have not been great buy and sell indicators in the near/medium term (i.e. 1-2 years). Perhaps I should follow Jeremy Grantham and rely more on mean reversion for my investment decisions in the future.
3) Overconfidence. Here I think my mistake was not to fully appreciate how serious the "known unknowns" could be, in particular the scale of the exposure on bank balance sheets and the knock-on effects this could have. For sure, I was aware of the problem, I knew it was one of solvency and not liquidity, and I also suspected that more capital might need to be injected at some point. But I was overconfident (naive?) to think that this was already reflected in the general level of equity prices. One of the tests that behavioural finance researches routinely run is to ask people to estimate on the spot with 90% probability (90% confidence interval) a range of answers for a specific question, such as the 150 year total return of US equities. The results usually show that respondents vastly overestimate their ability (i.e. way more that 10% of respondents' range estimates are outside of the answer). I guess if you had asked me to estimate a 90% range for the market this time last year, where we ended up would have been outside of my range.
Of course at the time it was not clear that the financial markets were about to almost completely collapse. Even the uber-bears were not predicting this. So I think it would be unfair to say that the subsequent path of equity markets proves that my belief this time last year was wrong. That said, I am somewhat disappointed with myself for not being able to truly see the wood from the trees. That equity markets have fallen way further than I thought they would when I initially turned positive suggests that I had at least not aqequately assessed the risks involved.
So why did I fail to assess the risks properly? Having put considerable thought to this question, I have come to the conclusion that it can mostly be explained by behavioural finance biases, rather than a specific informational or interpretative deficiency. Indeed, I think the only information gap was my lack of understanding of the banks' and non-bank financial institutions' balance sheets. However, virtually all investors were in this camp given the poor levels of disclosure. Behaviourally speaking, I woulld highlight three biases that I think adversely affected my assessment of the situation:
1) Familiarity bias. This is the tendency to draw heavily on facts that one is familiar is. Being an equity investor and not a credit investor, I tended to look closely at equity market valuations, and especially those in the sector that I was a research analyst for at the time. I did not think these valuations were hugely stretched given how far many of the stocks I was interested in had already fallen. Therefore I conlcuded that it would be very unlikely for these stocks to fall a great deal more given what the market had already priced in. The mistake I made was to apply this to the whole equity market, failing to appreciate fully that a lot of other sectors such as mining (well at least I knew that was overvalued!), industrials and other financials were not yet pricing in the same sort of outcomes. I also rather naively assumed that the outcome being implied by the credit markets should not be taken too seriously given the huge liquidity dislocation within those markets.
2) Extrapolation bias (I think this one may actually have another name, but it is obvious what it means). Here I think the mistake I made was relying too much on one indicator - the earnings yield versus the bond yield - to draw a bullish conclusion. This measure which has worked reasonable well for the last 20-25 years or so suggested equities were very cheap compared with bonds, even after adjusting the earnings down 15-20%. I knew that other measures such as cyclically adjusted p/e ratios and tobin's q still suggested the market was slightly expensive on an absolute basis, but I also knew that historically these measures have not been great buy and sell indicators in the near/medium term (i.e. 1-2 years). Perhaps I should follow Jeremy Grantham and rely more on mean reversion for my investment decisions in the future.
3) Overconfidence. Here I think my mistake was not to fully appreciate how serious the "known unknowns" could be, in particular the scale of the exposure on bank balance sheets and the knock-on effects this could have. For sure, I was aware of the problem, I knew it was one of solvency and not liquidity, and I also suspected that more capital might need to be injected at some point. But I was overconfident (naive?) to think that this was already reflected in the general level of equity prices. One of the tests that behavioural finance researches routinely run is to ask people to estimate on the spot with 90% probability (90% confidence interval) a range of answers for a specific question, such as the 150 year total return of US equities. The results usually show that respondents vastly overestimate their ability (i.e. way more that 10% of respondents' range estimates are outside of the answer). I guess if you had asked me to estimate a 90% range for the market this time last year, where we ended up would have been outside of my range.
Thursday, March 12, 2009
Laird looking promising
Encouraging results from Laird yesterday. It sounds like they have not seen any further deterioration in their end markets since the profit warning back in November. The handset business (55% of sales) is tracking down slightly more than 10% in volume terms, roughly in line with the OEM handset market. The CFO produced an interesting slide, showing just how far away they actually are from their debt covenants. Adjusting for the currency mismatch between the balance sheet reporting date and the average rate used for the EBITDA suggests they can see a £60m fall in their EBITDA before hitting their covenant. So the current £100m of EBITDA is 250% above the floor. The main risk is pricing, especially in handsets. Their key customers are Nokia, Samsung, Mororola etc., all of whom are facing double digit declines in their end markets. If the overcapacity in the handset market is not corrected quickly enough, Laird’s gross margin (currently, c20-25% in handsets) could get hit. A lot of costs have already been taken out, so the hit to profit if there is another big leg down in trading could be severe. Against this, Nokia has no interest in busting one of their major suppliers, and it also sounds like a lot of Laird’s (unlisted) competitors are in even more trouble that they are.
These shares have fallen over 85% now from their peak. Even after yesterday’s move in the share price, they are trading on just over 4X 7-year average trailing p/e (4.3X on next year’s consensus estimates), and around 30% of reported 2008 book value. If you are prepared to accept that trading is not going to be so bad that the covenants are hit, then the market is basically saying Laird is an ex-growth, low return on capital business. The historical 7 year median CFROI has been over 15%, and the return on capital is over 10%. For sure returns are unlikely to return to their historic level, but it certainly seems like there is a decent margin of safety to the Laird shares. If I put all the intangible assets (mostly acquisitions) and the PPE and inventory at 50% of reported value, then the adjusted book value per share is 100p, 20% up from today’s 80p.
These shares have fallen over 85% now from their peak. Even after yesterday’s move in the share price, they are trading on just over 4X 7-year average trailing p/e (4.3X on next year’s consensus estimates), and around 30% of reported 2008 book value. If you are prepared to accept that trading is not going to be so bad that the covenants are hit, then the market is basically saying Laird is an ex-growth, low return on capital business. The historical 7 year median CFROI has been over 15%, and the return on capital is over 10%. For sure returns are unlikely to return to their historic level, but it certainly seems like there is a decent margin of safety to the Laird shares. If I put all the intangible assets (mostly acquisitions) and the PPE and inventory at 50% of reported value, then the adjusted book value per share is 100p, 20% up from today’s 80p.
Sunday, February 22, 2009
Travis Perkis: into the abyss?
We saw Travis Perkins management last week. The company is a supplier to the building and construction industry and since the acquisition of Wickes is also a player in the DIY market. Clearly not a great place to be in right now.
It was a very odd meeting, perhaps the strangest of all management meetings I have attended. In the week or so running up to the meeting there had been a raft of rumours about an iminent rights issue (the company has debt issues) in both the press and the stockbroking community. A number of broker notes had even been put out running the numbers on a rights issue.
On Thursday the company released their results - tough end markets, revenues down etc. But no rights issue announcement. Clearly some investors were rather irritated by this as the investment case in the company had become rather predicated on management sorting out the balance sheet.
Well, according to management, they had no idea that investors were expecting a rights issue. Rather they thought that their advisors and corporate brokers were merely trying to generate commissions and fees by encouraging them to come to the market (which is probably true, but beside the point here).
What made the meeting so odd was that the CFO then went on to explain why he thinks they don't need a rights issue. According to his model, they will be tracking down -25% on volumes this year, and that will keep them within their covenants. When we asked him about the sensitivites, it was stated that should they be at -30% they would be in trouble.
Now, to my mind this is more than enough evidence to support the case for a rights issue. His model was clearly based off past experience (i.e. the 1990s recession). This time around, housing valuations were more extreme at the peak and now are tracking down at a much faster rate. Therefore, the difference between -30% and -25% is, quite frankly, just noise. Management reckon they will still be able to come to the market if and when their lead indicators turn down. I think they underestimate the speed with which the share price will fall, thereby eliminating this option. Perhaps they will be OK, but its not a risk I would take right now.
It was a very odd meeting, perhaps the strangest of all management meetings I have attended. In the week or so running up to the meeting there had been a raft of rumours about an iminent rights issue (the company has debt issues) in both the press and the stockbroking community. A number of broker notes had even been put out running the numbers on a rights issue.
On Thursday the company released their results - tough end markets, revenues down etc. But no rights issue announcement. Clearly some investors were rather irritated by this as the investment case in the company had become rather predicated on management sorting out the balance sheet.
Well, according to management, they had no idea that investors were expecting a rights issue. Rather they thought that their advisors and corporate brokers were merely trying to generate commissions and fees by encouraging them to come to the market (which is probably true, but beside the point here).
What made the meeting so odd was that the CFO then went on to explain why he thinks they don't need a rights issue. According to his model, they will be tracking down -25% on volumes this year, and that will keep them within their covenants. When we asked him about the sensitivites, it was stated that should they be at -30% they would be in trouble.
Now, to my mind this is more than enough evidence to support the case for a rights issue. His model was clearly based off past experience (i.e. the 1990s recession). This time around, housing valuations were more extreme at the peak and now are tracking down at a much faster rate. Therefore, the difference between -30% and -25% is, quite frankly, just noise. Management reckon they will still be able to come to the market if and when their lead indicators turn down. I think they underestimate the speed with which the share price will fall, thereby eliminating this option. Perhaps they will be OK, but its not a risk I would take right now.
A few trades
Taking advantage of the weak market last week I decided to make a few purchases with the personal portfolio. They are mostly unloved value ideas, companies which I think will re-rate heavily once the current bout of extreme risk aversion passes.
A good example is Dell. This company faces a number of issues right now. Aside from the obvious macroeconomic senstitivity (sales of PCs go down in a recession), the most pressing issue is the threat posed to the "direct" business model by lower cost asian suppliers and the secular shift away from PCs towards notebooks, the latter being less suited to a direct sales approach.
As a result of all these issues the shares have been hammered - down around 70% from their peak last year. They now cost $8.4, which is a multiple of around 6.4X last year's earnings. Clearly, next year's earnings will be lower, but people are not going to stop buying computers altogether. And the PC market will recover, even if 2009 is a shocker. There is every reason to think that this company will participate in a recovery, even if its future returns on capital are lower than the outsized ones it earned in prior years. What is even more bizarre is the net cash position of the company. At the last reported balance sheet date the company had over $3 per share in net cash, which brings the p/e valuation even lower once it is stripped out. For sure the company will use this cash to buy up other businesses (it wont be returned to shareholders). Perhaps these acquisitions will all prove to be value destructive, but it certainly seems as though these shares have a lot of bad news priced in already.
A good example is Dell. This company faces a number of issues right now. Aside from the obvious macroeconomic senstitivity (sales of PCs go down in a recession), the most pressing issue is the threat posed to the "direct" business model by lower cost asian suppliers and the secular shift away from PCs towards notebooks, the latter being less suited to a direct sales approach.
As a result of all these issues the shares have been hammered - down around 70% from their peak last year. They now cost $8.4, which is a multiple of around 6.4X last year's earnings. Clearly, next year's earnings will be lower, but people are not going to stop buying computers altogether. And the PC market will recover, even if 2009 is a shocker. There is every reason to think that this company will participate in a recovery, even if its future returns on capital are lower than the outsized ones it earned in prior years. What is even more bizarre is the net cash position of the company. At the last reported balance sheet date the company had over $3 per share in net cash, which brings the p/e valuation even lower once it is stripped out. For sure the company will use this cash to buy up other businesses (it wont be returned to shareholders). Perhaps these acquisitions will all prove to be value destructive, but it certainly seems as though these shares have a lot of bad news priced in already.
Wednesday, February 11, 2009
Quality companies at bargain prices
I have just finished reading Joel Greenblatt's, "The Little Book that Beats the Market", and I must admit that I am annoyed I did not read this book earlier. It is certainly one of the best investment books I have read so far.
The central idea of the book is so simple, yet so true when you think about it. Greenblatt reckons that the key to outperforming the market over time is to buy businesses that are both high quality and selling at cheap prices. The methodology is equally as simple: screen the market for earnings yield and return on capital employed, rank every company on each measure and then add the ranks together. Companies with a low score on average outperform companies with a high score. It is so simple, but also so obvious. What I found most surprising (and to be honest I'm not sure I entirely believe it) is the extent to which this approach has actually outpeformed the market. Based on a back-testing exercise, Greenblatt claims that if you bought at the beginning of every year 30 companies in the top 1-2 deciles, held them for a year and then repeated the process again, you would have outperformed by 10-15 percentage points per year over the past 15 year period. What is even more surprising is that it works on the most basic measures - i.e. without any cyclical adjustment.
Importantly, he does admit that the approach does not work all the time. Indeed sometimes it underperforms for 2-3 year periods. Paradoxically, this could be the reason why it works over the long run, as most investors cannot handle such periods of underperformance and will give up.
For my part, I intend to use this approach for idea generation. It will be interesting to screen the market on these measures and see what ranks up the top (and down the bottom). I have just finished doing it for the US market, where I used 7-year average return on capital employed (ROCE) and 7-year median cash flow return on investment (CFROI) for the quality measure, and 7-year average earnings yield and last years EV/EBITDA for the valuation measure. Interestingly, when I compared the results with Greenblatt's own portfolio (as reported on 30/09/08) there was a pretty good correlation between my screen and his portfolio, suggesting that he may be using similar metrics. I found nearly 50% of his holdings in the top 3 deciles of my screen, versus only 25% in the bottom 4 deciles.
The central idea of the book is so simple, yet so true when you think about it. Greenblatt reckons that the key to outperforming the market over time is to buy businesses that are both high quality and selling at cheap prices. The methodology is equally as simple: screen the market for earnings yield and return on capital employed, rank every company on each measure and then add the ranks together. Companies with a low score on average outperform companies with a high score. It is so simple, but also so obvious. What I found most surprising (and to be honest I'm not sure I entirely believe it) is the extent to which this approach has actually outpeformed the market. Based on a back-testing exercise, Greenblatt claims that if you bought at the beginning of every year 30 companies in the top 1-2 deciles, held them for a year and then repeated the process again, you would have outperformed by 10-15 percentage points per year over the past 15 year period. What is even more surprising is that it works on the most basic measures - i.e. without any cyclical adjustment.
Importantly, he does admit that the approach does not work all the time. Indeed sometimes it underperforms for 2-3 year periods. Paradoxically, this could be the reason why it works over the long run, as most investors cannot handle such periods of underperformance and will give up.
For my part, I intend to use this approach for idea generation. It will be interesting to screen the market on these measures and see what ranks up the top (and down the bottom). I have just finished doing it for the US market, where I used 7-year average return on capital employed (ROCE) and 7-year median cash flow return on investment (CFROI) for the quality measure, and 7-year average earnings yield and last years EV/EBITDA for the valuation measure. Interestingly, when I compared the results with Greenblatt's own portfolio (as reported on 30/09/08) there was a pretty good correlation between my screen and his portfolio, suggesting that he may be using similar metrics. I found nearly 50% of his holdings in the top 3 deciles of my screen, versus only 25% in the bottom 4 deciles.
Tuesday, January 20, 2009
HMV Group: Bad assets, good management?
Investors are currently getting very excited about HMV Group, the UK cd, dvd and game retailer. Their two main high street competitors - Woolies and Zavvi - have recently gone bust. In theory this should create a big uplift in demand at HMV stores located near to a Zavvi or Woolies. HMV have also bought a number of new stores from the administrators. We saw management yesterday and they were pretty impressive, very clear about where they want to go with the business and the brand.
It is a nice story and I can see why people are pilling into the shares. However, I cannot help but be reminded of Buffett's famous saying: "I would rather own good assets with bad management, than bad assets with good management". I fear HMV could be a case of the latter. Even with two main high street competitors out of business, they are still operating in a declining industry - cd sales are falling and dvd prices are deflating (even with the Blu-Ray uplift). Management's plan to expand into live music - to the move the HMV brand into the "experiential" realm - is surely the right idea, but there is no guarantee of success. And the valuation is not particularly compelling. Even on the (arguably) inflated 2009 earnings numbers, it trades at a premium to comps.
It is a nice story and I can see why people are pilling into the shares. However, I cannot help but be reminded of Buffett's famous saying: "I would rather own good assets with bad management, than bad assets with good management". I fear HMV could be a case of the latter. Even with two main high street competitors out of business, they are still operating in a declining industry - cd sales are falling and dvd prices are deflating (even with the Blu-Ray uplift). Management's plan to expand into live music - to the move the HMV brand into the "experiential" realm - is surely the right idea, but there is no guarantee of success. And the valuation is not particularly compelling. Even on the (arguably) inflated 2009 earnings numbers, it trades at a premium to comps.
Wednesday, January 14, 2009
UK Banks - still a mug's game?
Some of the brokers seems to be slowly warming up to the idea of investing in the UK banks. Yesterday we saw one analyst who now thinks that the Government may look to help out the equity in banks. His idea is that the Government could take on some of the extreme tail risk that banks have to hold capital against under the Basel II requirements. This would potentially free up around £40-50bn in capital, thereby stimilulating more lending.
Its a nice idea, but I am personally sceptical. The argument that the Government will help out the banks without penalising the equity is, I think, politically naive. If I were Gordon Brown, I would be looking for a way of solving the problem while also screwing over the equity holders, as this would have the best result for Labour's polls. Therefore, the most likely outcome in my view is still further Government equity injection, at the expense of current shareholders. This would then likely be followed by splitting the banks into a good bank and a zombie bank. The latter takes all the bad assets at a discount and is then run down. Remember, in Sweden where this policy was undertaken successfully, it did not happen until 2 years into the recession. In the UK, the loan losses have barely started.
With this in mind, I cannot avoid concluding that investing in banks is still a mug's game. They are not necessarily shorts, just uninvestible.
Its a nice idea, but I am personally sceptical. The argument that the Government will help out the banks without penalising the equity is, I think, politically naive. If I were Gordon Brown, I would be looking for a way of solving the problem while also screwing over the equity holders, as this would have the best result for Labour's polls. Therefore, the most likely outcome in my view is still further Government equity injection, at the expense of current shareholders. This would then likely be followed by splitting the banks into a good bank and a zombie bank. The latter takes all the bad assets at a discount and is then run down. Remember, in Sweden where this policy was undertaken successfully, it did not happen until 2 years into the recession. In the UK, the loan losses have barely started.
With this in mind, I cannot avoid concluding that investing in banks is still a mug's game. They are not necessarily shorts, just uninvestible.
Subscribe to:
Posts (Atom)