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.