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.
Sunday, February 22, 2009
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.
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