The timeless lesson of being greedy when others are fearful and fearful when others are greedy has been acutely felt by investors over the past decade. Nobody could argue - especially given the benefit of hindsight - that the mood was anything but complacent back in 2007 and early 2008, then despair and panic took over for the following year before investors were willing to tip-toe back into the water. A few years on and it's pretty much party-time again in the markets with new all-time highs for the major US indices.
Back in portfolio-land it was a relatively inactive year - partly due to a sense of foreboding at the potential for further gains in the general market given the artificial nature of demand-led growth from unsustainably low rates (unsustainable, that is, in the absence of many years of flat to falling prices), and partly due to a new job taking up time and the related lack of time available to review opportunities in the often lucrative sub-£100m market cap world of micro-cap investing.
Most interestingly for me, in micro-cap land a few years back there were a veritable smorgasbord of stocks selling at single-digit P/Es, with earnings at what now seem to be depressed levels. These same stocks sell for 20-30x earnings now, and earnings are up significantly (50-100% is not uncommon). It has been heaven for small-cap value in the UK as far as I can tell. Predictably, share prices rises have lead to inflows of further capital and now probably excessive valuations. Lo-Q, for instance, (now called Accesso) trades at 777p/share - up 100% from what I thought was a high price a year ago - and somewhat frustratingly up over 200% from the point at which I sold my last shares!
The portfolio's performance in 2013 was mostly attributable to just two stocks. Man Group started the year at 83p, ended it at 85p and paid 10p in dividends along the way. It was actually up 70% for the year to mid-May, as the optionality I had invested for started to look like it would become rather more in-the-money than previously priced in. But the trends it was set to profit from all broke down, and along with it the stock price. At 80p, the margin of safety allowed the 2013 performance to remain positive, and management also continued to clean up shop. But I have now exited, thinking of Munger's advice to own wonderful businesses at a fair price over fair businesses at a wonderful price - more of which later.
The second stock - GVC Holdings - has risen to my prior estimate of fair value. However the transaction with Sportingbet was far better than I previously realised - paying 1x EBITDA for an admittedly risky business, but this is in the context of 8x EBITDA as standard fare for the same business in less risky jurisdictions. Overall, the business is certainly cheap on any sensible metric, and with small-caps pricing in nothing less than wonderful execution in general, this one appears still to be pricing in the swing of an executioner's axe over half the revenues in the near future. Back to Munger, though, and it's simply not a wonderful business, so the potential for error is high, but I suspect Graham would agree that there's an element of a Margin of Safety built in to the valuation. I do find it a conundrum that investors choose to shy away from the shares due to the high risk nature of the business, and yet this well flagged risk makes the investment a high yielder with good growth prospects in a world where growth is more than priced in on the whole.
A certain style shift is taking place at the moment, with a few 5% positions in lower upside potential stocks, but significantly none are particularly tied to prospects of economic growth. The three new additions are: (i) Delta Lloyd - a Dutch insurer that is opaque and difficult to understand, but clearly worth at least 50-100% more barring sovereign defaults and/or mass deflation - neither of which I see as high probability outcomes in the next few years (but they remain possibilities), (ii) Lancashire Holdings - a UK/Bermuda based insurer and re-insurer with an extremely impressive underwriting record and a management team laser-focussed on returns on equity (partly through significant and frequent dividend payments of any excess capital) and (iii) DaVita Healthcare - a US based provider of health services looking to tap an exceptionally large growth area (US healthcare) by partnering with existing service providers to give the US population what it really needs - efficient and effective healthcare.
The latter is somewhat of a departure from the goal of finding mis-priced securities as it is not, in fact, cheap on any short-term metrics. I would expect the business to compound earnings at a rate of 7-10% for an awfully long time, though, so paying 20x current earnings doesn't seem unreasonable. Graham would balk, but I suspect Munger would approve. The idea was straight from the new Berkshire PMs, and is coat-tailing, but demand is independent of economic activity and I have learnt that 20x need not be expensive when a business has wonderful growth opportunities ahead. Back to Accesso, though, and once you get into 45x earnings, there is less room for error and I don't think that's a pool I intend to go fishing for ideas in anytime soon.
Performance has been positive again, with a gain of 47% for the year, versus 18% for the FTSE 100 and 32% for the S+P 500. 2014 could well mark the end of an awfully good run for both the stock market in general and for my portfolio. Since inception the FTSE 100 and S+P 500 have annualised 7%. My portfolio is up an average of 23%, or 536% overall, which I would love to think of as a long-term average but with less time to find mispriced micro-caps and capital being put to work in 10% compounders at reasonable multiples those returns are likely to fall. Barring any shocks (and the portfolio remains exposed to shocks!), I would still expect to outperform the broad indices by a decent margin over time, but 40% annualised over 3 years is likely to be the exception rather than the rule.
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