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.

On Turning Pro

Um, it’s all gone slightly insane in portfolio-land. I’m up 26.5% this year and it’s only the end of March. The total cumulative performance is 129.9% since inception (17.9% annualised), and 80.8% since the end of March 2009. For comparison, the FTSE 100 with dividends reinvested is up 39.6% (6.8% annualised) since the same start date (10 March 2005) and is up 50.7% since the end of March 2009.

Well, maybe I’m due a ‘correction’, or maybe value investing with a concentrated portfolio of undervalued securities is a smart way to compound capital. The great thing about blogging for the past 16 months is that it records some of the thoughts going through my head during the period, thus avoiding the perrenial problems of hindsight bias.

A few further statistics worth noting are that of the 16 securities I owned over the period, just 9 were sold for, or are currently showing, a profit. Of the total monetary gains, 91% have come from 3 securities (32% Berkshire, 17% Hallin Marine and 42% Lo-Q). The maximum percentage loss was a 49% loss in RBS, but this only comprised 2% of the total P/L over the period. When I really liked something I bet big and when I wasn’t sure I bet small.

In a world of mixed fortunes I’m now working as a professional again, 7 years after first starting out as an Equity Analyst but with over a 5 year gap during the period. I feel pretty much self-taught, although working at a small fund a while ago certainly taught me a lot about investing in general and investing in the stock market in particular. I wonder how much use the leveraged global-macro betting was in coming to terms with my fallibility, a lot I suspect. It also taught me a great deal about how markets react to news and the various capital flows that ebb and flow over the credit cycle.

Whilst it’s great to be working again, I can’t just buy and sell for my own account as I might like to any more. I also have a lot less time to look at small-cap shares as I’m spending it looking at larger stocks at work. I’m learning a great deal from some guys with loads more experience than I have, and the game has changed somewhat as the size of shares to look at has grown.

Whilst I can simply read a set of financial statements and feel I have an edge on other market participants with the smaller £10m or so companies, it’s going to take an awful lot more work to feel like I have an edge (most of the time) while looking at £500m and upwards companies. Suddenly the market is far more efficient and effectively smarter. This is not all bad, as reasons for a re-rating should be uncovered faster, but the ultimate goal of maximising post-tax returns is simply a lot harder when investing tens of millions over tens of thousands of pounds.

By way of completion, I did say I’d post my portfolio up here with prices and so on. It’s moved around a bit since I said that but the current situation is as follows:

Stock........Price Paid......Current Price........% Value in Portfolio
LOQ.............£0.80.................£1.21..............................59%
MTEC..........£2.03................£2.22..............................17%
EMG............£2.05................£2.42................................7%
WMH...........£1.62.................£2.11................................4%
GMG.............£1.57................£0.98...............................2%
(Cash)...........................................................................11%

If I were starting from scratch I may have similar holdings, but weighted something along the lines of 50/20/10/10/10 (%-weight in the order of stocks listed above). In fact, Lo-Q isn’t looking quite so attractive any more as the price has risen, although it’s still reasonably cheap and my other ideas for inclusion aren’t so great or developed at the moment, so there’s no need to sell just yet.

As a final note, I’m happy to think that you can still pick up the odd bargain in the mid-cap pool of stocks. Game Group is a great business; the market leader in its niche in almost all its territories. The earnings are strongly cyclical, and Myopic Mr Market has some trouble looking more than 12 months ahead, so it’s selling at around a 60% discount to its fair value. I could well be wrong on this, as the world of tomorrow won’t look like the world of yesterday, but at least I feel I have a Variant Perception. Hopefully they’ll be dishing out some more profit warnings soon and the market will become even more depressed and the bargain even more attractively priced for all the long-term value investors out there.

Tomorrow, And Tomorrow, And Tomorrow

One of my favourite stock market quotes comes from the great American Financier (or robber barron, depending on your view) - J.P. Morgan. When asked what the stockmarket will do next, he responded that, "It will fluctuate." And that is about the most prescient answer anyone could ever give on the subject.

Anyway, investing isn't about peering into a crystal ball and seeing what will be. It's a search for opportunities where, on balance, the likely reward of an investment outweighs the potential risks. You can concentrate your risk in a few high-potential investments, or spread it over more ideas that collectively should give you less volatile returns. All this balancing of risks and rewards is a tricky business. This past week or two being a case in point.

One of my favourite stocks at the moment is a little minnow that I now have a reasonable amount of shares in called Lo-Q (ticker LOQ). From looking at the annual report, reading information on the internet, reading the available broker note, talking about the business with friends, thinking about the business lots and finally speaking to the founder on the phone recently, I have formed a strong view on the likely fair value of the business. And my valuation (around £40m) was just a little bit higher than the market cap of the company as quoted on AIM last week. Just a little bit being £30m higher (or a potential 300% rise from the current £10m market cap)!

Back in October I sold out of two business I thought it wasn't worth being in - Umeco and Severfield Rowen. They both seemed undervalued still but my other ideas just seemed better. Plus I was starting to really understand the concept that it's hard to think about more than, say, 6 ideas at once as I was having trouble thinking very deeply about the 11 ideas I had in my portfolio at the time. So I sold out of those two stocks in favour of Lo-Q and Staffline (ticker STAF).

Of course Umeco promptly rallied from 290p to 350p, which just reminds me (again) that my short-term market timing skills are rubbish to say the least. In consolation Staffline managed a 42% rally in November, which was nice.

So this LOQ then. At the end of the analysis I just saw a great, growth business with relatively few issues to derail growth over the next couple of years at least. And at 75% undervalued, a fairly compelling prospect. What to do. Hmm. I thought about selling out of the larger issues I have that are less undervalued (BRK.B at 20% and EMG now at 40%). Probably a good idea, but that's not how a balanced portfolio would look. And there's the rub.

If I'm managing this mini-portfolio with a view to showing others how I would manage their money one day that's one thing (and being somewhat diversified to reduce volatility and avoid potential value traps makes good sense). However, it is a little different to what I should be doing if I were just managing this tiny amount of capital with the very pure goal of maximising post-tax returns in mind.

Recently, it's begun to sink in that I'm going to struggle to get any sort of investment business underway without some fairly huge levels of confidence in me from a set of very well capitalised supporters. And the types of people who would back me would basically ask themselves, "If he's so good, why is he so poor?" Which ends up with the slightly tortuous conclusion that, to be in a position to manage money away from the crowds, I first have to have enough behind me so that I basically don't need to work. Well, if that's what it takes, then so be it.

There's some freedom in the above, though. I was fixated on making my portfolio work in a way that would be operationally viable with a much larger sum than I am currently managing. And the case in point, LOQ, is not something that anyone with decent sums of money could invest much in. If you're managing £100m or so and want to get a decent return, you've got to start looking at companies with market caps broadly in excess of £100m to avoid owning more of the company than you can get in and out of easily. Any smaller and you're going to end up owning such a large chunk that you'll move the price significantly on your way in and out, thus eliminating the potential profits that a smaller fund could benefit from.

Happily, mini-investors with the time and skills can look in this sub-£100m market cap universe and find a wealth (literally) of undervalued gems to put their money to work in. Frankly, it seems like a decent investor with small sums of money should be able to totally destroy the market averages by investing a concentrated portfolio in this universe of stocks, so that's where their attention (and mine while not working for anyone else and managing miniscule sums) should be focussed.

It's been a year since I started this blog now, so I may post less frequently from now on. Here's the current portfolio and performance since inception, as at 30 November 2009. Hopefully I'll be able to update the portfolio and performance and check back on how the likes of LOQ are progressing in the future. It's good to get ideas down before the event, and check back later to see how things are panning out. As Buffett says, "In the business world, the rearview mirror is always clearer than the windshield."

Portfolio

BRK.B - 19%

HMS - 18%

MTEC - 18%

LOQ - 12%

EMG - 11%

ISG - 9%

WMH - 6%

STAF - 6%

GMG - 5%

Returns

(Compound)

Since Inception 3 years 1 year

Portfolio 59.2% 38.4% 7.1%

FTSE 100 26.0% -2.4% 26.8%

S&P500 -0.3% -16.4% 26.7%

(Annualised)

Since Inception 3 years 1 year

Portfolio 10.3% 11.2% 7.1%

FTSE 100 5.0% -0.8% 26.8%

S&P500 -0.1% -5.8% 26.7%

Inception was on 10 March 2005. Portfolio returns are calculated after all costs (paying the spread, stamp duty and dealing costs) but uses the mid-price for current valuation purposes. Index returns assume dividends are reinvested and do not take any costs into account (meaning the actual returns from investing in such indexes would be lower).

A New Dawn

The sun gradually pushed out a soft light across the dewy hills. As the shadows appeared, our protagonist stirred and shifted, awaking from a deep and restful slumber. To the east a ball of light hinted at its imminent arrival, haloed over the jagged peaks, spreading it's rays over the upper sky. Slowly, but steadily, the ball arose and the rays fell, in perfect harmony. Light shone on the investor who had been roused by the appearance of daybreak. A new day had arrived, and he intended to live it to the full.

Whatever has happened is in the past, and all you can do is look to making your future as bright as possible. I've always known that my future is as an investor and not a trader, so it's with some disappointment that I reflect on the past few years of excessive trading activity, where capital has been created and destroyed. But underneath the gross volatility of my trading activities I have been developing a knowledge and skill base that I am increasingly certain is one that will significantly outperform over time.

It's all about Value, it always has been and it always will be. But my investing hasn't always been intelligent. To have almost proved the maxim that with a bit of capital and a high IQ you can lose a great deal very fast isn't perhaps an achievement I need to reflect on too deeply (or indeed share too often), but I have to admit to my mistakes and learn from them. Perhaps slowly, but I have to learn.

So, out with the currency trading, out with bond futures, out with options, commodities trades and the like and out with equity index punts. In with VALUE INVESTING. The way it should be and the way it needs to be.

It will be a gradual shift, but the portfolio is formed now and I've finally made the analysis of my performance that I had meant to do for a long while. In short I've made 55.4% since March 2005 versus the FTSE being flat and the S+P down 12%. Not too shabby. The annualised return is 10.0% since March 2005, which I can live with. And here are the current stars of the portfolio...

1) Berkshire Hathaway (BRK.B) - 20%

The one and only. After the analysis is done I have this as a 25% discount to fair value, so a potential 33% upside if it achieves that fair value in the near future. But the return on equity from this fantastically well capitalised business is a not stellar 6.6%, although probably over 10% on a normalised basis (excluding 2008 losses on stocks and derivatives). 10% on $109bn - not bad, sir! Once the only stock in here, now maybe on its way out, think it will have to go if the discount narrows to 10% or so.

Everything from Insurance to t-shirts and prefabricated houses. A holding company for a fantastic collection of 100% owned businesses and shares in fantastic publicly traded companies, bought either at fair prices or a discount to fair prices. Over time this business will grow and grow and continue to produce prodigious amounts of cash. Succession risk prevents the stock from shooting upwards, but it has an excellent returns to sleep ratio to it!

2) Hallin Marine Subsea International (HMS) - 14%

My best idea currently. According to my estimates, this company is trading at a 51% discount to its fair value. It returned 65% on equity last year and is on a P/E of 2.65x last year's earnings despite a 30% run up in the stock prior to tomorrow's earnings announcements.

The more I think about the business, the more I like it. A great management team providing excellent service to a sector with lots of cash available doing things that are difficult to do and winning new business at a steady pace.

HMS provides subsea intervention equipment and teams to the oil and gas and telecommunications industries. A lot of their revenue is earned out of their Singaporean hub, where the economy is on a much sounder footing than here in Europe. Growth at the profits line has been 120% annualised over the past 4 years... yes, annualised! They have managed this by starting out small, but they are still pretty miniscule at a market cap of £56m - although I expect that will change markedly over the next few months.

3) Man Group (EMG) - 12%

An association with the Head of Research of AHL (the futures trading arm of the hedge fund group) first introduced me to this company. In an industry in turmoil and in need of consolidation, I believe these guys have what it takes to come out not only in one piece, but shining.

I have them at a not-quite-enough-to-be-buying-here 22% discount to fair value. But they are yielding 9% on a well covered dividend. That's 9% from what I regard as a solid business when I can get around 1% in a bank. Returns on Equity are over 10% still based on last year's earnings, which look unlikely to be repeated for a good while yet, but even with normalised earnings of a little under $1bn per year the stock's market cap of $8.4bn isn't what I would regard as expensive for what I do regard as a business with a good future.

When to sell will be a dilemma, but I think with such tiny sums of capital to invest at the moment it will be a case of finding new ideas to invest in before selling ideas that still show up as value investments in my mind.

For completeness, here are the other protagonists in my motley crew of investments. In order of the value within the portfolio...

4) Interior Services Group (ISG) - 12%

5) Matchtech (MTEC) - 12%

6) William Hill (WMH) - 7%

7) Game Group (GMG) - 7%

8) Lo-Q (LOQ) - 6%

9) Umeco (UMC) - 5%

10) Severfield Rowen (SFR) - 4%

11) Staffline (STAF) - 2%

The one idea that I am least happy with is Umeco, and may sell out of this stock soon enough. They provide supply chain outsourcing to the aerospace and defense markets (unexciting) and also manufacture composite materials for airlines, wind turbine blades and Formula 1 teams (exciting). But margins aren't all that wonderful and the return on equity is around 8.5% versus 20%+ in most of my other holdings with the exception of Man Group and Berkshire Hathaway.

At least it is up 20% on where I bought it less than a month ago (the market has been strong this Autumn), so the discount has narrowed and the reasons for buying the stock have diminished somewhat. That leaves a question of what to do with the funds once the stock has been sold. There's not much bad news knocking about in my favourite stocks, so I'll probably add to the holdings in Lo-Q, which could be a fantastic investment, but it's hard to see if the business model is truly sustainable.

So, a new dawn has arisen in this investors outlook. I'm going back to London for work, but my heart will stay in the mountains. And my dreams of running a fund are still in tact, as you can probably see from the above. The counter on this blog has been ticking upwards recently, and I'm not sure exactly who is reading this, so if you have anything to add, please comment below and be as open as possible. Feel free to spread the word if you find anything useful here also - anyone buying my investments will only push the prices up and I'm pretty much fully invested now, so that's ok with me!

The true test starts now though, as my portfolio did not fully exemplify my value philosophy before the recent additions in August. I'm very pleased to have made such good returns in the past, but really it's 20% a year in good years and to not lose too much in bad years that I'm shooting for. Then again, with 2008 such a disaster for most investors, I think I have the right to feel pretty good about a 50% plus gain over a period when the FTSE has ended up where it started.