On Investment vs Speculation

I have mused in the past on the differences between investment and speculation. Some refer to the contrast as follows: an investment has the overriding attribute that growth in the underlying cashflows will generate a return for the investor; whilst a speculation has the overriding attribute that a change in asset price, mostly from other people’s appraisals of the value of the asset, will generate a return for the speculator. This is a nice summary, but there are grey areas in between, and it may over-simplify the (never entirely clear) differences.

In this post, Jason Zweig cites the following excellent quote from Fred Schwed to illustrate his view of the difference, “Speculation is an effort, probably unsuccessful, to turn a little money into a lot. Investing is an effort, which should be successful, to prevent a lot of money from becoming a little.” He goes on to make very valid points that the same asset can be an investment for one person and a speculation for another; the reasoning behind an investment decision is what differentiates an investment from a speculation.

I have been pondering the above as this year has been a very good one indeed. The portfolio grew by 89.3% over the year - from a still concentrated portfolio of 6-8 stocks. The nature of the investments could be accurately termed ‘unconservative’, but I do not believe that they were entirely ‘speculative’, even though the underlying future cashflows are subject to a high degree of uncertainty.

The reason that I do not deem either the individual investments to be entirely speculative, and more particularly the portfolio as a whole, is that - in my mind at least – for a reasonable range of future scenarios, the weighted expectations of fair values were all far above the share prices when the shares were acquired. Some factors left investors focused more on the downside risks, than the upside potential, to the point where, in my estimations, the probability-weighted fair values made the investments compelling.

And the next part is where I wonder if I may have an edge over the majority of other investors. It barely occurred to me, as far as I can recall, that concentrating my bets in investments with uncertain future cashflows and therefore uncertain future share prices was a particularly risky strategy. Quite the opposite, in fact. By owning shares in businesses that I deemed to be worth a lot more than I was paying, I felt that I was reducing the risks of losing money in the event that my analysis would be proved wrong; the essence of Graham’s ‘Margin of Safety’.

The other dilemma that this poses, is that having generated a return in a single year of close to 100%, it seems that I have truly entered the realm that Keynes termed ‘unconventional’, as part of the phrase that, “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.”

In any case, and for whatever reasons, 2017 worked well. The risky stock mentioned in my last post tripled over the year. A reasonably large spread-betting business with a 24% FCF yield growing at over 20% a year almost tripled, including dividends (a bit less after withholding taxes) and other investments added to the overall return also.

And as to whether this may constitute the last year of writing on the topic of investment gains, the jury is out as ever. It would certainly be no bad thing to apply skills learned from my personal account investing to much larger pools of capital, helping institutions to achieve returns that compensate them for equity market risks. In fact it would be doing more for society than simply compounding the assets of my own family. However, it is hard to escape the idea that making outsized gains (20%+) over a long period of time would generate gains (even after appropriate fees) that should be highly attractive to those able to tolerate the vicissitudes of Mr Market’s fluctuations.

Using the Buffett fee model (no fees on the first 6% gain, 25% of gains above this paid as performance fees), a 20% underlying asset growth would translate to 16.5% gains after fees. Over 20 years of compounding this would generate profits on a £1m investment of £20m; an enormous sum vs expected returns on most equity funds. Perhaps this could be the plan, with 20% gross gains targeted over 20 years, starting in 2020. As at 28 January 2018, the portfolio has grown at an annualised rate of 29% over three years and 33% over five years, so even with less concentration, the idea of a 20% annualised gains doesn’t seem so far fetched.

On When To Sell

[Note to Readers: no companies mentioned by name in the below blog post are current holdings and there is no intention of advocating any purchases or sales based on the below commentary.]

In my last blog post, on 30 April 2016, I mused over how to tread in the event of a bear market in stocks, noting a 49% cash holding in portfolio-land. This was rather handy in a sense as certain domestic UK stocks fell markedly eight weeks later following the UK electorate’s vote to leave the EU. The currency markets voted that this would hurt the island nation’s future growth prospects, and sterling fell by over 15% from the end of April to the end of the year.

Mr Market’s reaction to the referendum result was one of those rare events where certain stocks trade briefly at very silly prices; this time at bargain valuations rather than what seems a more common silly-on-the-expensive-side prices that have been more prevalent since the Financial Crisis. The constraints of my workplace and a broker whose website was failing and call-centre flooded with incoming orders, meant the first few hours of trading were blocked for me, but decent valuations persisted for a number of weeks, leaving time to pick up bargains.

Thus it should have been a return-to-form year for yours truly, but a few errors were made afterwards (namely selling too soon), and what now seems like a stroke of bad luck hit the portfolio’s returns in December to produce another flat year – the second in a row. This time the result felt extremely poor, with the S+P up 11% for the year (close to 30% in sterling) and the FTSE 100 up by 18%, the portfolio’s meagre 1% gains looked feeble in the extreme and ended a run of six calendar years of market-beating performance.

The bad luck in December was that three of a total of seven holdings racked up double-digit losses in the same month. Fortunately all three have since rebounded; less fortunately one was sold before the return to form; more fortunately one was added to before an over 50% rebound; and happily the largest holding is now up by almost 100% for 2017 so far. The effect of all this is that, somewhat related to the calendar year coinciding with temporary dips in Mr Market’s appraisals for portfolio holdings, the YTD return for 2017 is a rather pleasing +44%.

Now I have been here before, halfway through the year, in a self-congratulatory mood with over 40% gains, and yet I am still to complete a calendar year with over 50% gains, which is the benchmark Buffett has pointed to being a return he ‘knows’ he could generate with $1m or so.  So what will come of the full 2017 is a rather interesting question.

One choice is to lock in gains, riding out the year to meet that arbitrary hurdle for the first time. Given one of the stocks is what may politely be termed ‘speculative’ this is of course the prudent course to take. However, Munger’s concept to constantly search for ‘lollapalooza effects’ and then maximize the gains after loading up on opportunities exposed to them is front and centre of why this may be, in fact, a decision that could lead to regret. On the other hand, the words of Joseph de La Vega that, “Profits on the exchange are the treasures of goblins. At one time they are carbuncle stones, then coals, then diamonds, then flint stones then morning dew, then tears,” spring to mind. Only the passage of time will tell which will be the more apt given the outcomes for this largest holding in particular are particularly uncertain.

In any case, the concept that ‘nobody ever went broke taking a profit’, i.e. lock in your gains, fits very poorly with my personal experiences of selling Lo-Q at an average of £2 per share (having bought in at an average of £1) to now see it quoted at over £16 per share. I even remember saying how £6-8 was possible in certain scenarios, and yet the short-term profits seemed so high relative to my original investment that further gains didn’t seem likely or even possible, so in the end a conservative valuation for the business and other factors led me to sell too soon (my last sale was at £2.40 and there really was no solid reason to sell at the time apart from a 20x trailing earnings multiple).

More recently I sold my holdings in a UK sports-focused retailer despite a valuation for the business of almost twice the levels at which I sold them. I reasoned that they could go lower through earnings. This worked out poorly as they are up over 20% in the past week (post-earnings), but as they say – win some, lose some. Another sale that seemed prudent (and even lucky) at the time was Ferrexpo – sold for an average of 56p/share (despite a valuation multiples of this higher) and recently changing hands for over £2/share. Holding stocks of a lower quality, it seems, requires something of a stomach for short-term declines in quoted market prices. The gut truly is a more important organ than the brain at such times, and sticking to a process and maintaining a logical appraisal of a firm’s prospects and fair values for the potential outcomes matters more than the instinctive response to either gather more information to understand the odds of future outcomes better (hint: it rarely helps) or to cut the position to stem the feelings of pain that losses can induce.

Conversely, it certainly seems wise to sell when a stock has done well on the back of limited new information, i.e. merely a change in the mood of Mr Market vs a clear change in the underlying fundamentals, and yet this could mean walking away from large future potential profits should the business have future outcomes not fully discounted at the time the decision is made. Note, however, it is the prospects of the business that require appraisal, not that of the share price. The former is important and elements will be knowable, whilst the latter is a blend of a scoreboard for the business and the mood swings of an ever manic-depressive business partner, known as Mr Market.

On Dealing With Bear Markets

My last post noted that there were limited obvious bargains available back in March 2015, and yet sensible investing requires the identification of superior businesses (which, by definition, will significantly grow earnings over time). In the absence of bargain-priced securities there are two broad options available. (1) Stay fully invested and stomach the inevitable downturn when it comes (note, given that markets are clearly cyclical over time it should not be controversial to say 'when' rather than 'if' with respect to a future downturn). Or (2) Sell investments in order to build a cash balance which will mean available firepower to make the most of potential bargains in the months or years ahead.

There is a beauty in simplicity and for those with the temperament, just staying fully invested through thick and thin, i.e. not trying to time markets, seems to be the best option. Those who felt great by avoiding the enormous downdraft of the declines of 2008-9 often found themselves holding cash or hedges and avoided some or all of the massive upswing back to record stock market levels. Those who stalwartly held good businesses from 2007 to 2016 may have seen the quoted prices of these businesses halve (or worse), but the intrinsic values have steadily risen and in many cases risen quite markedly in this 9 year period.

Since March 2015 (the last blog post), I had the concept to hold cash in anticipation of better prices to come. However temptation took a hold and I bought shares in two businesses that were, in short, mistakes. The early signs were reasonably positive on these investments, and the portfolio's value reached new highs with returns of over 1,000% since inception. As has happened before (more than once!), the feeling that I was smart was quickly treated to a good slap around the face by Mr Market's gyrations.

Somewhere around May 2015, it almost felt like a switch was flicked and the broad stock markets started to inflict their first real bout of pain for the decade. By the end of the year, despite broad indices being down slightly (up slightly with dividends reinvested), many value investors had horrific results for the year. Some prominent investors had the worst results they had ever experienced. Whatever the reasons, I found myself thinking how sensible I had been to think that cash was a good investment in March, and yet how dumb I had been to then buy shares in two seeming bargains soon afterwards.

My unfortunate capital allocations decisions for the year were Ferrexpo and Delta Lloyd. The former, being a Ukrainian Iron Ore mine, had plenty that could go wrong with it, and although I was looking at 40% paper profits in May, by August I had lost my appetite for the risks associated with the business and I sold out for a small gain. As it turns out this was enormously lucky as the firm announced in mid-September that its cash balances were in an insolvent bank owned by the CEO. Any calculations made for testing the solvency of the business - already a marginal affair - were suddenly in jeopardy and the stock quickly halved in price. This somewhat heart-stopping behaviour was a reasonably good lesson in reaching for yield/gains. I knew there were risks, but having cash reserves effectively vaporised was not something I saw coming. A part of me knew that commodity producers (for a start) are poor places to see capital treated well. Another part of me knew that leverage in a capital structure can lead to problems (great businesses have no need to juice returns with debt in the first place, so its existence - if material - on a balance sheet is often a poor sign). But the allure of keeping up my 40%+ returns led me to take on excessive risk. I was lucky to escape without any losses on this one.

Delta Lloyd was a mistake in listening to (and believing) management. I had followed the firm for a while, and been to see them present at their Investor Day in Amsterdam twice, meeting the CEO, CFO and so on. Management were quite insistent that the business was producing around €450m of cash a year, which was remarkably high vs a €3.5bn market cap at the time. As the quarters rolled by their story became less coherent with various odd reasons provided for why book value fluctuated wildly with slight variations in interest rates. By August, investors had had enough when the firm posted a €1bn move in book value in a single quarter on a book of just €4bn (the goal of any bank or insurer should be to protect book value as one would an investment portfolio). Their reasoning was mostly centred around how they mark their liabilities to market, but effectively investors lost confidence in management's ability to manage. It was only after this that I purchased shares (having sold my holdings prior to the August shock). My reasoning was that the price had fallen so far that the market cap was implying a €1bn capital raise. Reasoning that no rational management team with any interest in preserving shareholder value would look to raise capital after the price had fallen so far, and also looking at their capital base and seeing it was still a solvent entity - with adequate capital for all regulatory requirements - I was busy buying the shares. As events transpired, the new CEO showed he had no interest in preserving shareholder value, only in over-capitalising the business and diluting the interests of shareholders who had been aboard for a very unhappy ride in the past. In the end I suffered a 25% loss in this position, or about 5% of the portfolio's value - a wound, but not as bad as it could have been.

So the bear market was wiping out years of capital growth from various stocks, and it has continued to do so in 2016. Three seemingly good businesses that I follow in retail have fallen quite a way since last summer. Hugo Boss is down nearly 50% in the past year after attempts to address the brand's drift downmarket have come unstuck (the CEO having fallen on his sword may have marked a turning point for the strategy). Next has fallen 30% this year after saying sales in their online channels are under increasing pressure from new market entrants. And Sports Direct shares are almost 50% lower than their 2015 highs after a series of what could politely be termed poor public relations events transformed the business from a solid growth story to an embattled corporate governance debacle. In all three businesses the outlook for profits growth has certainly slowed, perhaps turning negative for a period, but the businesses have hardly changed in the past year, and it seems to me that their intrinsic values are not 30-50% lower than they were a year ago, but the market's perception has shifted, and with it the quoted price for each share in the equity of the business.

In portfolio-land 2015 ended with a lucky escape as GVC (then my largest holding) rose 23% in the month (I no longer hold shares in the enterprise as I can no longer see a bargain valuation and I can still see a variety of risks). The overall return for the year was a rather meak 0.2% - at least a positive result in a year that saw a variety of proverbial bombs exploding across equity markets. 2016 to date is showing a return of a healthier 7.2% and the portfolio currently consists of 49% cash. The high proportion of cash has looked like a missed opportunity as markets have rallied since February lows when fears (again) of a serious credit contraction in China or due to oil and gas related loan losses in the banking system took hold. The adage to invest when others are fearful should have flagged putting money to work in those areas given I did not share the view that either risk was as prominent as commentators seemed to think, but a lack of focus (for positive reasons such as focusing on my day job) held me back from taking advantage of this mood swing.

The above inaction at an opportune moment (in the short-term at least) is a good example of the difficulties created by not being willing or able to adopt a long-term investment horizon (an affliction that prevents many professional fund managers from making the most of their opportunity set). In addition, it takes a good deal of time and energy to grow a pool of assets in a concentrated portfolio. Finding bargains takes time. Understanding potential risks if searching for bargains in lower quality assets takes time. But most of all, being able to take a long-term view and being prepared to stomach volatility in the interim depends very much on your own character, as well as the support of your client base. The 'excess' returns earned from 2011-14 in the below chart were very much linked to not having any clients to worry about and also having the energy to stay focused on what was important and knowable, rather than be distracted by the unimportant and unknowable noise bounded around in market-chat all day long. For now a lack of time and an inability to write on stocks as bound by the rules of a new employer will likely cause this to be the last of these blog posts. The record is pretty good at 22% over 11 years, or 814% overall. Perhaps there will be a chance to reproduce at least some decent returns on a larger pool of money one day in the future.

On 10 Years of Investing

Today marks 10 years from inception in the portfolio and I thought I'd use it to record some thoughts on, broadly, what works and what doesn't. First off is performance - the output - and the record shows a 725% gain in 10 years, or 23.5% annualised against 6.5% annualised for the FTSE 100 and 7.6% for the S+P 500 (with dividends). Of 28 investments made, 15 have been profitable with 2 making over 100% gains and two making between 50 and 100% gains. 95% of cash profits came from just two investments - LOQ and GVC Holdings. In essence, the excess returns came from taking large positions on illiquid holdings that were under-researched and misunderstood.

Warren Buffett summarises investing (which I contrasted with speculation in the last post) rather eloquently. This direct quote sums up the best way to compound money at a decent rate over a long period of time: "Your goal as an investor should be simply to purchase, at a rational price, a part interest in an easily understood business whose earning’s are virtually certain to be materially higher, five, ten and twenty years from now. Overtime, you will find only a few companies that meet those standards – so when you see one that qualifies, you should buy a meaningful amount of stock."

The above is really something that you can remind yourself of time and again. The amount of patience needed to just sit there holding on to shares in wonderful businesses is a vanishingly rare skill (and one that is hard to recognise in others, and even harder to practice in a professional investing role). I wish I could say that I find it easy, but the truth is that in an environment filled with daily news, second-by-second price quotations and populated by well spoken men (they are almost always men) with convincing stories about which way a price will move next (therefore providing easy-wins), it is harder still to stay true to the above goals.

As for my future as an investor, I have to admit that even with limited trading activity in my portfolio, I find thinking about it a distraction from my work, which at the moment is paying the bills and providing the foundations for potentially starting a family (a position fairly far removed from the first blog post in December 2008 when I moved to Chamonix on my own). My job at the moment is to provide investors with plausible stories on why they should act. What they should do is listen to Buffett and sit on part-ownership stakes in wonderful businesses. But what a person should do and what they actually do are not always the same thing. As a stockbroker my job is to feed their hunger for ideas/action with investment analysis packaged into a neat stories for bite-sized consumption.

Perhaps I'll switch to an investment role soon, and try my best to apply the skills I've learned and create an environment where my patience can be tested on the coalface of a professional investment mandate. I realise 20% a year is vanishingly difficult in an institutional world, but I do hope that if I'm given the chance, I'll be able to generate returns that are at least in excess of those of a passive index tracker over a long period of time. The power of compounding is still somewhat compelling with 7% annualised returns, whilst it becomes absolutely startling with 23.5% annualised returns (7% doubles your money in 10 years, 23.5% takes it up 8-fold over the same period).

To drill in the above point of Buffett's, and to point out the chief mistake of most investors is the same thing. To have startling returns you don't buy something at 10% or 20% less than it's worth, you buy it for 50% less than it's worth. It's just that simple. Holding cash at the moment is probably the best strategy as there's little obvious value out there and confidence is relatively high versus the past few years. And this is where the patience comes in. The confidence that something will come along eventually that is materially mispriced is what you need in order to hold cash and forgo the last few percentage points of the bull-market's gains.

Nobody can time markets, but everyone who is worth their salt can tell if a stock is compellingly cheap or not. If there's nothing to do, do nothing. Only professional investors are required to remain fully invested at all times. For the private holders of wealth, who can act in a contrarian manner, cash can be a wonderful investment as it offers the holder the option to pay what may be compellingly lower prices in the future for a given stock. And when dealing with a manic depressive business partner (an apt description of Graham's 'Mr Market'), it will often pay to wait for a bout of depressive behaviour before parting with cash for a part-share in the many wonderful businesses for which he quotes prices daily.

It may be that this is the last post here, given I really should focus more on paid sources of income, and less on compounding returns on just my own capital (as fun as the outcomes of the latter when it works may be). I hope that anyone reading this will have a sense that it is not impossible to beat markets over time, but also that an investor's chief enemy in doing so will, in fact, be themselves. Human beings have brains so well adapted to running and hunting in the savannah that they have trouble with the complexities of investment analysis and staying rational where money and risk (and therefore emotions) come to the fore.

The one certainty an investor (even one who is doing it right) can have is that they will make mistakes. But for those who persevere with it anyway (probably because they love the process and the constant sources of opportunities to learn and improve) the rewards - both material and psychic - come highly recommended.

On Investing Being Simple But Not Easy

Another year and another slightly surprising 40%+ gain; apparently I'm doing something right here. The cumulative total return is now 751% over almost 10 years (from 10 March 2005), or 24.3% annualised. The last 3 years have been impressive: 202%, or 44.6% annualised; apparently markets aren't totally efficient all of the time!

The advantages of having a small amount of capital and no outside investors that could pull their funds from you are huge versus the constraints within the professionally managed funds universe, but I still don't think all that many people could manage over 20% for 10 years - which will be the outcome if there are no shocks in the next 10 weeks. But enough bragging (except for maybe a cheeky chart at the end), on to stocks...

One source of frustration in 2014 was a mistake of omission. After 5 years of waiting for AHL (the quantitative funds within Man Group) to perform, I eventually gave up in 2013 on the basis that it was something that could not be analysed or known. Whilst this was true, there was nothing in the share price to account for the option value of AHL generating a return. Then, finally, the fund was up 34% in 2014 and the stock up 103% (including dividends) as a result. So, solid analysis, an outcome that eventually matched my expectations, and an overall loss of 7% over a 5 year period. One more episode to deposit in the bank of experience.

With the above in mind, one purpose of having a record of choices made is that it can serve as a reminder as to why a stock was selected in the first place. If you don't remember why you bought something, it's very hard to work out when to sell it. So, on to three new ideas added during 2014 which may also take patience to play out as expected.

The first is what may be termed a 'growth' stock. The name is Sinclair IS Pharma and the firm manufactures a variety of skin care and aesthetics products that are distributed globally. The products seem to have a bright future, and the firm has both operational and financial gearing, so currently small losses will translate into exceptional earnings growth should the products succeed in the marketplace. My concerns are that various milestone payments mean that actual cash profits will likely be absent for the next few years and the corporate strategy seems to be more about a private sale than generating cash profits. Perhaps it's a multi-bagger, but I do wonder if I shouldn't stick to owning businesses that make decent profits selling at low multiples with profits highly likely to rise over time.

The second is what may be termed a 'value' stock. The firm is Ferrexpo and a simple glance at the past financial statements shows a business with a market cap of $479m with peak profits in 2011 of $568m. Earnings at present are likely to be near zero as their cash costs of production (of iron ore and iron ore pellets) at $70/tonne are around the same as the current realised prices for such products. Iron ore prices have halved in the past year as China switches from a fixed investment economy to one more geared towards consumer-lead growth. I wouldn't say that I have any special insights into future iron ore prices - if anything I expect that they will stay low for a long while - but the firm is likely to stay solvent and earn around $100-200m through the cycle, at a very rough estimate. So I'm paying around 3x earnings for a business that should still be around decades from now. Then again, the political situation in the region (the mines are located in Eastern Ukraine) is not so stable and I do worry about assets being seized one day, and rising taxes on profits, so I don't think I'll be investing too aggressively in this one.

The third stock that I invested in during 2014 is actually the largest company in the world now. I was kicking myself for a while for not buying shares in Apple after seeing David Einhorn speak on the matter in 2012, but eventually bought a few during 2014. Having developed iCancer myself (a disease where new Apple products keep getting purchased somehow), I understood their appeal and the extremely tough job competitors will have to dislodge them for a good few years. Their margins and returns are astonishing, and they still manage to grow sales despite a massive base to build upon. A watch is coming out in 2015, which may or may not be a success, but the phones are the bulk of profits and their latest set are selling well, so no reason to sell the shares just yet. I do feel I should be able to do better, but this investment has been profitable so far at least.

Ultimately, investing is about paying less than you think something is worth, and then sometimes waiting and waiting and waiting. Speculators may look for shifting sentiment towards securities for their sources of return, and investors will look for dividend income and earnings growth to justify the allocation of capital to an idea. Both seek to generate positive returns. Investing seems to really be about finding wonderful businesses that you understand, paying reasonable prices to own a part of the business, and then hanging on to them for a long, long time. I suppose my approach has mixed speculation (looking for changes in sentiment to generate returns), with investment (looking for dividends and earnings growth to generate returns). Both can work, and finding multiple ways to win seems to be working out reasonably well for me so far.

Whilst it is very easy to describe investing wisely, those pesky human foibles exist that prevent cogent decision making. As a result, finding, analysing, investing in and then holding on to good ideas for a long period of time is really not that easy. It's only by delving in and trying that anyone can really learn if they are good at the activity of investing or not. I can attest with 10+ years of experience now that it is definitely not easy, but something tells me I'm gradually getting the hang of it.

Stock.......Price Paid......Current Price.....% Value in Portfolio
GVC............£1.54.................£4.81.......................64%
SPH............£0.30................£0.35.......................17%
FXPO.........£0.50................£0.53.........................6%
LRE............£6.58................£5.60.........................5%
AAPL........£50.36...............£71.46........................5%
DL............£14.39................£14.15........................3%

On A Good Year For Stocks

Onwards and upwards, seems to be the mood of an ebullient market at present. Remarkably (or possibly predictably), all the turmoil of the past few years has ebbed and flowed and the world seems positioned for a period of stability and growth that stock market investors are happy to pay up for. Whether or not this stability and growth is ephemeral is yet to be seen, but the votes are in and the market is up.

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.

On Being Wrong... And Being Right

It was with no small trepidation that I felt I may have some weaker times ahead at the point of my last posting in March 2011. Posting on the strangeness of the investment industry from the inside felt a bit odd (so I stopped doing it), but I think it's well understood, so perhaps I can blog away without refrain.

Of the 3 stocks mentioned last time (Man Group, Game Group and Lo-Q) two were fairly disastrous and one extremely good. The latter, as it turned out, was by far my largest position, so performance has held up pretty well considering my hit rate of winners to losers remains stubbornly around 50% since inception.

Lo-Q gradually went from unloved (5x ex-cash earnings) to somewhat liked (12x earnings) to in favour (20x earnings - where I exited) to rabidly adored (32x prior year earnings, where it stands today). I'm not sure if I should be kicking myself for kicking Lo-Q out at 240p (having averaged in at 94p/share), given that it now stands at around 388p. Clearly I would have made more by hanging on longer, but my condolence lies in the concept that your curse as a value investors is selling too early, whilst the alternative curse of the growth investor would be selling too late. Of the two curses, I would rather err on the side of caution and prudence, but it's still annoying seeing a stock go up 50% after you feel the best has passed.

Man Group fell from the 274p that I felt was 'cheap' to stand at 82p at present - a fall of 70%; ouch! I've been adding as it fell, which I could have been more patient with having told myself 80p was where the margin of safety seemed appropriately wide to invest given asset outflows and weak performance from AHL. With 10p/share of 'normal' management fee income and 15p/share of 'normal' performance fee income, I still cling stubbornly to the belief that the shares are cheap, but I freely admit that this is more speculation than investment on the basis that profits are not linked to consumer behaviour, or other predictable phenomena. It seems like a mispriced bet, so it stays in. Amazingly, I'm actually up 4% on a cash basis having originally paid £1.92/share for my first lots, and the business having paid out 86.5p/share in dividends since late 2008 (in addition to a bit of selling and buying along the way).

Game Group proved to be the next HMV and a 'value trap'. Although used extensively, this term really should read simply as 'mistake'. A stock is hardly cheap because the historic dividend yield is high, or P/E ratio low. It is cheap because the future cashflows will be more on a per-share basis than the current price per share. Ratios are a good starting point, but do little more than give a title to the picture - let alone paint it in its entirety. Many so called value investors would be wise to take heed of this credo.

To the above point, I should also add one major point that I had almost entirely missed in reading about value investing from older books, such as those by Ben Graham. A stock need not necessarily be 'expensive' by the same token as above, simply because it has a low dividend yield, or high ratio of price to earnings. It remains a reasonable headline to check the potential relationship of price to value with - but it really is just a starting point. Given that markets are mostly right most of the time, a 'cheap' stock is also likely to be a poor investment versus many 'expensive' stocks. The trick of comparing price to value is a lot more tricky than it first appears, which I suppose is why the game is so much fun!

And to performance and current ideas. I'm really not doing well on the ideas front, but at least performance has come up trumps. 2011 ended with a 32% gain. This was lower than the performance for the year to 11 March, and I was up over 50% in July - which was probably a good signal to cash out on a few ideas! So I actually ended up being rather disappointed with the 32% gain for 2012. The FTSE with dividends fell by 1%, so it was an outperformance that I expected not to repeat again, and I'm certainly proud of it overall.

2013 looks like it will end with similar disappointment and a current 44% gain for the year versus 12% for the index with dividends (an oddly similar 32% outperformance for the year). The performance came in two lumps: Lo-Q in January and a decision to commit capital to GVC Holdings by the middle of the year gave the portfolio quite a boost in September as the stock jumped 71% during the month on news that they were to acquire a portion of Sportingbet. My holding in GVC never matched that of Lo-Q in terms of concentration as the downside was a lot higher, but the percentage returns from the investment look like they will be higher as I am already up 134% and the shares are yet to reach what I figure as their fair value of around 340p each (they are currently suspended due to the transaction with Sportingbet at a price of 233.5p).

Career-wise, not posting since March 2011 has brought about a few changes. My career as an analyst in a hedge fund was brought to an abrupt halt in July of that year as the fund I was working on was downsized from two people to one. I then spent 15 months unsuccessfully looking for a new role before finally ending up on the sell-side with an excellent boutique firm serving up ideas to some of London's top hedge fund and traditional investment managers. Along the way I had extraordinary help from one of London's best fund managers, who seemed to think I might be a fun project to help find a new role for (my current role was found through his friend, so a job well done!). I posted a while back that I looked forward to finding people to mentor me along the way to being a better investor, and the above logic of searching for not only cheap, but also sound, businesses certainly comes from some great chats with my new friend.