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.

On Being Right... And Being Wrong

What fun it is to make money - I mean that seriously. You work at it for 8 years (since my I got my first investment job) and I think eventually you develop an edge. Investing really is pretty simple: you analyse the prospects for various companies and buy shares in those businesses when you are getting more quality (or value) than you are paying for. If the company is too difficult to analyse, you move on. You certainly don't need to know about the whole stock market to invest in a few great businesses. Or even to know what the stock market, or general business climate will do next.

It's been an interesting year, and I've learnt a great deal about the inner workings of Myopic Mr Market. The whole game is one played by practitioners that are acting on the incentives in front of them. Essentially a firm can collect in assets with adequate performance, but will probably lose assets fast with poor performance. So asset management firms in general want fund managers to do averagely over the risk of them performing poorly. Average managers get their jobs and do adequately, whilst the firms charge customers a very pleasant 1% on hundreds of millions of pounds. If they just do enough to not be terrible, the manager will probably have a lucrative career and keep their job.

Society seems to not notice the shockingly high fees it pays for this average performance, which is worse than average once fees are taken into account (potentially 14% of the rise in the stock market ends up in the pockets of firms that 'help' society to invest their capital). Outperformance by simply buying a low cost index tracker is a no-brainer for most investors, yet they still give money to large firms that churn through their portfolios and charge a fee for doing so.

Investing may be simple, but it isn't easy. Working in a busy office with Bloomberg screens and constant price updates is an extremely poor environment for performing reasoned analysis with a quiet mind and in a cold emotional state. The market noise is deafening, and small movements in markets can bring about emotional reactions that cloud clear judgement. All it needs to be about is thinking about price and value, and yet predictions fly all over the place and the merry-go-round of the relative performance game keeps portfolios churning and commissions and spreads eating away at returns before even the first investment decision can be assessed as either good or bad.

In my own portfolio I decided that the performance I was trying to show was less important than maximising my post-tax returns (surely the goal of any long-term investor). So from the below 5 stocks I wittled the portfolio down to just 3. Along the way I bought and sold shares in Velosi and GVC Holdings. The former I sold before it was bought for a 54% premium to my initial price (how annoying!) and the latter is still an interesting one with a potential 20% dividend yield selling for around 5-6x earnings, but not a cinch by any means.

The three I held on to were: Lo-Q, Man Group and Game Group. Lo-Q fell soon after I wondered if I was due a 'correction' - turns out I was! But during the year the founder has hired a very pleasant new CEO who promptly dismissed the under-performing sales director and updated investors with what I regard as a very exciting new strategy. The stock is now at 158p and I think it may still be significantly below fair value. The sales director leaving was not regarded as good news by the market, so my 2010 annual performance looks relatively bad as by the end of the year 75% of the portfolio was in this one stock. However the 61% price rise since the end of the year has made up for a poor 2010.

Man Group is up at 274p now and is still cheap on the basis that the flagship AHL fund is unlikely to be 'broken' as far as I'm concerned and the amazing distribution channels remain in tact with hedge fund assets set to rise by 50% over the coming few years, with the bulk of new assets flowing to larger more established firms with strong distribution and experience in structuring, compliance, and so on.

Game Group is in the doldrums at 60p, now yielding 9.4%. The question is, is this the next HMV (a competitor that is about to go bankrupt). Or will HMV's demise lead to higher sales on a relatively fixed cost base. And then is it fair to take recent trough earnings and put them on a P/E of 5.6 when the release of a new generation of gaming consoles could double profits for the group? On the other hand, you can expect to get a few wrong, so maybe this is my dud for the time being. At 3% of my portfolio I can handle it, whereas with Lo-Q now at 80% that idea being wrong would be harder to take.

I'm quite proud of my returns so far. As at today's date (6 years from inception), the portfolio is up 196%, or 19.8% annualised against a rise in the FTSE with dividends of 49% (6.9% annualised) and in the S&P of 23% (3.5% annualised). Since the end of March 2010 (1 year ago) the portfolio is up 29.4% and since the end of March 2008 (3 years ago) it is up 121% (30.2% annualised). The first two years of basically just holding Berkshire and not buying it at much of a discount really hurt the performance over that period, but lessons were learned (and by reading their annual reports each year some hugely important lessons were learned) and the portfolio has started to act a lot better of late.