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.

On Market Inefficiencies

Where could be better to dig for an overlooked gem of a business than in the small-cap space? Nowhere as far as I'm concerned. This does not mean that there aren't bargains to be found in other areas of the markets, but the glaring inefficiencies in the form of undervalued assets are far more likely to be found where nobody is looking.

An efficient market is likely to have a relative balance of potential buyers and sellers and relatively little emotion from those participants. Thus the larger anomalies of market peaks and troughs coincide with maximum optimism and pessimism in market participants. Where more eyes are fixed on a given security, ultimately its price is going to be closer to its intrinsic value. In general, markets may not be precisely right all the time, but they are approximately right most of the time.

So, where a stock has very few followers, and relatively little understanding of its products out there in the investment community, you're more likely to find something significantly mis-priced than in the over-analysed world of large-cap investing.

Take Lo-Q. I first came across this stock when a friend told me about her family's outing to Legoland Windsor. The family had used a 'Q-bot' device to avoid having to physically queue for popular rides for the day. The device sounded a bit clunky, but the basic service of cutting down physical queuing times struck me immediately as something that society at large would happily pay a decent price for. The other great thing was that remote queuing remained 'fair' to everyone as you had to pay for the service and you joined the queue with the same waiting time as if you had joined the physical queue.

The next morning a technology sector stock screen at work showed the business trading at a very, very low price versus its prior year's earnings and cash on the balance sheet. For some reason the market thought that a business growing at 20%+ a year with £2m of cash and £2m of pre-tax profits (for the prior year) was worth around £10m. Fair enough if that profit level is illusory, but I felt it was certainly worth a little investigation.

Well, 6 months on and there is now over £4m in cash, still no debt, pre-tax profits are at £2.4m and the market cap still reflects a high degree of scepticism in the business model at £13.5m. To be fair the clearing price may actually be higher than the market cap as the brokers won't sell me as many shares as I want to buy - my first taste of the annoyance of illiquidity issues in small-cap investing.

Anyway, it probably helps that I learned the business has survived the attempts of over 20 competitors (all of whom have failed) over the years, but I found this out from a simple phone call. I honestly quite often wonder if many investors go to the trouble of reading an annual report (or even the balance sheet and income statement) before they invest in businesses sometimes. I certainly don't know many private investors who take even 5 minutes to do just that. Peter Lynch once lamented when asked what investors should look for in a stock, "Well, they could start by looking for some profits!”

So, as institutions can’t operate with much less than £20m, say, in assets (1% of which is hardly going to do much more than turn the lights on in The City), any business trading for much less than £50m or so is just going to have fewer people following it. And brokers see no value in producing research on a stock if institutional investors aren’t churning their portfolios through them. So you get some tiny companies growing at astonishing rates, valued as if they about to slide into an imminent decline.

Of course it may just be that you have missed something, but if you’ve done your homework and still think you’ve found a bargain, chances are that you are correct. As Mr Buffett says, “You’re neither right nor wrong because other people agree with you. You’re right because your facts are right and your reasoning is right – and that’s the only thing that makes you right. And if your facts and reasoning are right, you don’t have to worry about anybody else.”

On Myopic Mr Market

Well, the market is fluctuating, which isn't much of a surprise. Every day events cause the prices of thousands of securities to gyrate with dizzying velocity. Perhaps the 'fundamentals' are moving at the same breakneck speed, and the value of all future cash flows is being efficiently priced in from minute to minute, and day to day. Or perhaps not.

With so many people excessively concerned with the next quarter's numbers for the company they have their eyes on that day, it's no wonder that stocks move in such manic-depressive swings. Frankly, it's unlikely that a company such as Man Group was correctly priced at £3bn in March 2009, £6bn in November 2009 and now at £4bn again in January 2010. This is, of course, quite good news if you are able to stay focussed on the long-term in your outlook.

Taking the view that companies are very rarely correctly priced by the markets seems the only rational explanation to me of why share prices move so wildly over a one year period or so. The fact that they can fall 3-5% in a day if they narrowly miss forecasted quarterly numbers, seems rather short-term biased to me. And it creates a nice opportunity for people to effectively profit from the short-termism of the market and it's gyrating prices.

Man Group (EMG) is a good example. I first took a good look at the business in the summer of 2008. Back then the company was valued at £8-10bn by the market, and there were some serious problems brewing with respect to redemptions and the future for the hedge fund industry in general. My view was that if any hedge funds survive, Man should be one of them as it's very well run by nice and dull looking accountants and lawyers (this is meant as a compliment!).

That view hasn't changed, but redemptions appeared to stabilise with the markets in general during 2009. Next came some unfortunately poor performance over the year within their flagship AHL fund. But that's one bad year in a string of performance that is quite astonishing over a far longer period of 18 years or so.

So, now you're faced with some relatively bad results for the quarter, the year and maybe even a year or two in the future. But the business hasn't fundamentally altered in any way that I can see. They just had a bad year, and that happens to even the best fund managers who aren't composed of computer algorithms.

Anyway, I could of course be wrong in my assessment, but it does seem to me that a business worth between 3 and 10 billion pounds (as assessed by the market) is selling on the cheap side as it's had a bad year. Which is really quite nice for me, as I think it will do fine over the next decade or so, and currently looks cheap on that basis.

The point here, is that short-term myopia is the norm in investment circles and those chasing strong monthly performance for their funds. It just seems way easier to me to be picking up these things that are punished by the markets for having a bad quarter or year, but have not really changed their businesses recently and are still well managed, than to try and predict the unpredictable.

Focussing on what's important and knowable, rather than what is unimportant and unknowable is the way to make money, and yet so few people do it! Maybe it's a worthwhile process to try and predict the next gyration, but it seems better to me to try and think for oneself and remain rational. Better, but perhaps not particularly easy, and therefore quite a rare virtue to keep working towards.

On Having A Variant Perception

What a great term, ‘variant perception’. It sounds both straightforward and intelligent. The meaning is also both simple and profound. How does what I think differ from what everyone else is thinking?

Well, if you take a moment to consider it, you’re really not going to do particularly differently to the average if you lack a variant perception. Equally, it’s worth considering that the ‘crowd’ could very well be correct in their thinking, and by seeking to be contrarian too often, you may end up fighting against the tide.

What this whole Value Investing business boils down to is the attempt to find better-than average businesses at lower-than-average prices. Ideally you’ll find a superstar business at a price usually reserved for basket cases, but that may be a wish too far for most of your lifetime (incidentally these wishes were coming true for brave investors back in March 2009).

Well, having tried both the global macro approach to investing, and the value investing approach, it just seems to me far, far easier to have a useful insight and a ‘variant perception’ in the field of relatively simple-to-understand businesses (micro-economics) than in the field of enormously complex and difficult-to-understand global economies (macro-economics). Not to say that the latter is impossible, I just personally find it much, much harder most of the time.

Being a fairly simple soul, and thinking that results gained from less effort are superior to those gained via more effort, the value approach seems preferable to me over the alternatives. This is especially true with small sums of money to invest, however I can see how things would change as the pool of capital under management gets large enough to limit your investable options in the equity space.

Back to ideas and performance, as it’s the end of the year. Some mixed luck came my way on the 11th of December. HMS, spiked up in price on news of an all-cash bid taking place. The price went from 125p to 215p in the course of the morning, and has been gradually ticking up towards the 233p takeover price ever since. This sort of luck is something that I’m very happy to receive every once in a while, although it is somewhat mixed as the company would be worth far more if it could secure reasonable funding from the banks. In the absence of available credit, it makes sense for them to sell out to a well-financed entity, but the deal was struck at a lower price to the acquirer than I think the enterprise was worth.

Anyway, that provided a nice boost to the portfolio to end the year up 24.1% versus 27.6% for the FTSE 100 index with dividends reinvested. Since inception the portfolio is now up 80.3% versus 31.8% for the FTSE and 1.9% for the S+P. Over the past 3 years the portfolio is now up 52.7% against returns of -1.0% for the FTSE and -16.0% for the S+P, also with dividends reinvested. Long may the outperformance continue!

In terms of current ideas, I’m looking at a US stock that builds GPS units, called Garmin, Interior Services Group and Lo-q in the UK, as well as Velosi and a fair few others. I’ve also been screening for new ideas via the Company REFS service and via the Bloomberg system, which has produced a cacophony of stocks to research in more detail. I’ve been meeting a few hedge fund managers to hear how they invest and talk about my ideas with, as well as some potential investors.

Well, a new decade is here and it’s time to look ahead. Significant uncertainty is all around, but this is always true no matter what the talking heads or wisdom of crowds tells you. I’m very pleased to have kept a record of the past year as it could well prove to be one of the most instructive (and possibly constructive) 12 month periods in my life. Whatever happens next, I’m guessing my role will be far more in-line with my ideals than in the past, which is a pretty nice thing to be able to say about your outlook, even if it’s not a particularly variant perception.

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 Bright Future

As the investor awoke from his deep slumber, the masks he had been trying on for size during his European sojourn fell away to reveal his true self. The sun was rising in the sky as he stretched his arms high above his head and his now expansive vision of what was to come filled his mind with wonder, excitement and no small degree of trepidation.

There is now a fairly unshakeable belief in me that I can outperform markets in general by a wide margin over time. That belief (and the expected outperformance) is large with small amounts of capital and shrinks with larger amounts. I think that most professional investors would say the same thing, but few probably have personal investment accounts that show they have been able to actually do this. Sadly, only a minority will have professional performances that beat the market averages over time - especially once fees are taken into account.

It may sound egotistical to say you are better than the professionals at an activity, especially one regarded as being so difficult to master, however, for the enlightened at least, the investment game is surprisingly simple and easy to outperform in. That is, before you take behavioural biases into account.

Plato once said, "For a man to conquer himself is the first and noblest of all victories." This couldn't be more prescient in the field of investment management. The only way I know to overcome the inevitable biases is to stick with one strategy and not be swayed by the emotions of the market. Whether or not this will be possible is entirely dependent on temperament. By understanding exactly why you should have an edge in investing, and checking each time you make an investment decision against a list of credentials for making investments, you can alleviate many of the biases that lead to poor performance.

The simple process of finding undervalued stocks may involve a vast amount of hard work, but happily this will neither feel hard or like work if you love what you are doing. You only need to sit and think carefully for half an hour or so on a given company to have an edge on many of the people who will end up buying or selling shares in that company's stock over the next few years. Some will be depressed at it's prospects and offer you very favourable terms to sell you shares in the enterprise at a low price, and some will be highly enthusiastic about the future for the company and willing to pay you a compellingly high price for a share in its expected future profits. It is the induced hope and fear of others that creates such rich opportunities for those with the right temperament, who are also willing to do a bit of work, to profit from their folly.

Sadly, many investors decide to invest for reasons other than a perceived gap between price and value. Exploiting the difference between the two is the lynchpin of the value investing process and has worked over and over again through a variety of markets and with clearly understandable and repeatable results (perhaps more in direction than in magnitude). That few appear drawn to the process seems odd, but when you factor in career risk for professionals and the extreme short-termism of many investors, it is more understandable.

So, opportunities abound for those able to be reasonable at assessing the fair value of businesses, and then exploiting the difference between price and value by buying where a sufficient margin of safety exists.

I look forward to a future where I will be able to help people invest more wisely. I look forward to a future where I can help people by compounding their capital at rates of return that will warm their hearts by helping them to meet their goals and fulfill their dreams. I look forward to a future where I will be able to think about investments all day long and teach others of the plentiful opportunities available in markets; to help them understand the mechanics of valuing businesses and profiting from the market's inevitable bouts of greed, fear and folly.

The road to this point has been rocky at times, and I've had to learn from mistakes that thankfully were never so large as to divert me from the path which I am still on. I will definitely seek out people who I feel I can learn from, but in the final analysis the real rewards of fulfillment and satisfaction will arrive as long as I can immerse myself in an activity I take real pleasure from, and by performing well in an activity that I, personally, attribute value to.