Carpetright Look 2

In July I took a look at Carpetright. It was - and is - an interesting company if only due to its enormous RoE. Since July its share price has declined from 640p to 345p, and it has just issued a fairly grim set of interims. So I took another look.

First the consistent features:
- Margin of about 60%.
- High fixed costs.
- Negative working capital.
- Return on Equity of 50-130% (until the latest set of interims).

At the moment their sales are being squeezed by:
- The low level of house-buying.
- The impending recession and general lack of consumer confidence.

The lower sales have two insidious effects:
- Sharply lower profits. Their high fixed costs cause a strong multiplier effect.
- A rapidly worsening cash position. Their negative working capital is unwinding, leading to substantially increased debt.

Their bank facilities are up for renewal in September 2009. They're positive, but of course they would be. They have limited headroom in the meantime.

Carpetright's very high Return on Equity needs to be paired with a "moat" if it is to be maintained in the long run. For a carpet company, that comes primarily from its size. It can achieve economies of scale and take market share from smaller independent operators. It is exploiting this advantage, and widening its moat, with its new warehouse and cutting facilities. This gives it reduced costs and the ability to achieve keener pricing than its competitors.

About 25% of Carpetright's sales appear to be directly linked to house sales. That's based on the way their like-for-like sales fluctuate based on mortgage approvals. The drop in mortgage approvals from a long-term average of about 60k per month to 22k per month has translated to a 15% decline in Carpetright's like-for-like.

Although house prices will almost certainly continue to decline, I imagine we'll see a recovery in purchase volume in advance of a price rally. So that's one point in Carpetright's favour - although shaky consumer confidence and rising unemployment might well cancel out any gains.

Once we are out of the recessionary woods, Carpetright looks like a good company to invest in. It has excellent growth potential. In the meantime, I am concerned over their cash position. Paying any dividend at all is frankly barmy in my opinion, even a much-reduced one. 2009 is not going to be a good year - and while I expect they will eke out a profit, there are going to be heavy outflows of cash.

Post-recession I think reasonable earnings would be 70p per share. A reasonable P/E ratio is difficult to come by. On the one hand are a low tangible asset value, but on the other are its high growth prospects and strong cash generation. A P/E ratio of 10 doesn't sound totally unreasonable, and in a buoyant market 20 might be achievable (it can pay out 80% of its earnings in dividends, still reinvest enough to grow the business, and a yield of 4% doesn't sound mad).

The share price was 345p when I started this latest look, but has recently rallied to 385p. I think this is quite tempting at 350p, and certainly at around 250p I don't think I could resist. In the meantime I'll continue to keep an eye on its cash position for any sign of improvement.

Greene King, Tesco updates

Two updates out this morning. Initial reactions:

Greene King - Pretty much as expected. Things have definitely declined since last year, but they're still profitable, still well within debt covenants, and still very good value at their current price.

Tesco - Very positive, doing well despite poor conditions. Continuing strong growth internationally, although as you'd expect, less substantial growth in the UK.

Let's see what the market's reaction is:
- Greene King down 8.28%. Slightly surprised by that, I know the results aren't great, but they still met earnings expectations.
- Tesco up 6.22%. I think these results were better than analysts expected.

Consolidation done

I've completed the consolidation I wrote about yesterday. IFFF, IEER and LTAM are no more. IEEM is welcomed to the portfolio. I've also substantially added to my BDI holding to bring it up to a similar level to MXM and QDG.

My portfolio now looks like this:
GNK: 14.5%
IAPD: 13.6%
IDVY: 12.8%
TSCO: 9.0%
RBS: 8.4%
BDI: 7.8%
IEEM: 7.7%
NXT: 7.5%
ZRX: 7.3%
MXM: 5.4%
QDG: 5.0%
TW: 0.9%

Consolidation

Due to the vagaries of the market, some of my investments are looking very paltry indeed. In particular, BDI, IFFF, IEER, LTAM and TW are looking very anaemic. I'm going to take a few different approaches:

• Sell IFFF, IEER, LTAM, and instead buy IEEM, a general emerging markets tracker fund. IFFF, IEER, LTAM broadly track IEEM, and I see little point holding three different shares where one will do. Of course the transaction costs are annoying, but better to consolidate earlier rather than later. At least I won't pay stamp duty (since ishares are listed in Ireland). I'll probably top up to the holding to be slightly larger at the same time.
• Invest further in BDI, taking it up to a similar level as QDG, MXM.
• Leave TW alone for now. If they agree more relaxed covenants then it might recover to a more reasonable holding size in short order. If they doesn't, it will be worthless.

Berkshire Hathaway

I'm slightly incredulous, but it appears that Berkshire Hathaway shares are moving into value territory. The B shares traded below $2700 for much of Friday, although they closed at $2900. It's slightly tricky to work out a fair value for Berkshire, but worth having a stab. If you can buy $1 for 80 cents and have it managed by the world's most successful investor for free, then you're doing well.

A and B shares
The Berkshire B shares are worth 1/30 of the economic value of the A shares, but hold 1/200 of the voting rights. A shares can be converted into 30 B shares, but not vice versa. Owing to the lower face value, the B shares are far more liquid.

There are 1.08m A shares and 14m B shares, so an equivalent of 1.55m A shares.

Pots of value
Warren Buffett lays out the basis for his own valuation of Berkshire in his annual report. There are two "pots of value". Firstly investments in stocks, bonds and cash, partly funded by "float" from Berkshire's insurance operation. The second pot of value is Berkshire's wholly owned businesses, which appear on the balance sheet at far below fair value.

At 2007 year-end, Berkshire report $141bn of investments, funded by $59bn of float. This works out to $90343 per share. Pre-tax earnings per share for wholly owned businesses were $4093.

Float
How you calculate the float liability is debatable, but since Berkshire has historically made money on its insurance operation, the float has been better than free. An interest-free loan that never needs to be repaid is worth precisely the value of the loan. An interest-free loan that never needs to be repaid and grows over time is worth even more - but let's be cautious and assume float will remain at approximately $59bn, so simply write this off as a liability when considering value.

Balance sheet
It's important to check out the balance sheet to see whether Berkshire are fibbing about their two pots of value. Shareholder equity is $120bn. Writing off goodwill leaves $87bn. That's roughly what you'd expect from the $141bn of investments minus $59bn of float.

Value calculation
Valuing Berkshire's wholly-owned businesses is a bit tricky, but I'm going to put a pre-tax P/E ratio of 10 on them. That equates to about 15 after tax, reflecting the fact that I think they are largely high return-on-equity, strongly cash-generative, stable, successful businesses with a good moat. I don't think Buffett buys any other sort.

I'll value the investments at their face-value (although we'll need to adjust for the current state of the market) and write off the float as a liability, on the basis that it costs nothing and will not need to be repaid in the foreseeable future.

Before adjusting for 2008's changes in value, that leaves us with a value per-share of $90343 + $40930 = $131273. That's $4375 per B share. At the end of 2007, the actual share price was $141000, so pretty close to fair value. Since 2002 Berkshire has traded within about 10% (plus or minus) my idea of fair value.

Book value multiplier
We may be able to approximate the change in value of Berkshire by the change in book value. In order to study this I've pulled data from their annual reports since 2001. My fair value calculation has been fairly consistent at 1.6 times their book value. That makes a handy proxy for current value.

Equities in 2008
Now we come to the interesting bit. Sticking Berkshire's shares into a Yahoo finance portfolio, I reckon their current value is approximate $50bn, vs. $75bn at the start of the year. So barring any changes to the portfolio, Berkshire is down a massive $25bn so far this year. Crucially, rather a lot of that has come since the end of September, so wasn't reported in the last quarterly report. I'd estimate that around $15bn has been wiped off Berkshire's equity portfolio since the end of September. Their quarterly report estimates $9bn by the end of October, and things have got somewhat worse since then, so that tallies.

Current fair value
Based on the latest estimates share prices, book value per A share is about 67750. Applying the same 1.6 multiplier and extrapolating to the B shares, fair value is about $3610.

Alternatively estimating current investments and assuming no earnings change for wholly-owned companies, fair value is about $3910.

The divergence here is because in one valuation method $15bn is wiped off investments, and counts once, and in the other it is wiped off book value and multiplied by 1.6.

Let's call current fair value $3750 as a compromise.

Desirability of investing in the US market
Despite my calculations suggesting fair value has declined from $4200 to $3750 in the last 2 months, I don't think the "actual" value has changed much. The US market has been overvalued and is only now approaching a reasonable level. In the last year or two I would have looked for a very substantial discount before buying, I'm now prepared to accept a more modest discount. So my buying price has probably changed little - a 30% discount at end-2007 is the same as a 16% discount now.

$3000 is a 20% discount to my current fair value. $2600 is a 30% discount.

To buy or not to buy
Right now I have way too much US$ exposure, so I'm not a buyer yet. But in 1 month my dollar exposure will be halved, and at that point I would definitely be a buyer at $2600, possibly even at $3000.

Tesco - further detail

I thought I would post some extra information on the motivation for my purchase of Tesco shares.

Return on equity
The interesting thing about return on equity, or RoE, is as a multiplier on reinvested earnings. If company A earns £100, reinvests it at a RoE of 10%, it could expect (ceteris paribus) to earn £110 the following year. If company B also earns £100 but reinvests it at a RoE of 20%, it could expect to earn £120 the following year. At low rates of RoE, reinvestment becomes uneconomic and the company should logically pay all its earnings out as dividends.

Calculating RoE first requires a reliable figure for earnings. To avoid tax clouding the picture, I assumed tax of 30% and calculated earnings as (Operating Profit - Interest payments) * 0.7.

Inflation clouds the RoE picture by silently increasing the value of assets. The equity figure quoted by the company is therefore too low. To account for this I assumed 3% inflation of Tesco's equity per year from the start of my 14 year period.

With these adjustments, Tesco's RoE figure is remarkably consistent at between 11.5% and 13.5%. It averages 12.2%.

Consistent earnings growth
Tesco's turnover has increased by an average of 13% per year. In only one year out of 14 was it less than 8%. Margin (operating profit divided by turnover) has been consistently between 5 and 6%, averaging 5.6%.

Of course Tesco has operated in a benign retail climate over the last 14 years, but I think we can assume that it will at least weather the storm, if not continue with quite the same stupendous growth record.

Having said that, turnover has tracked inflation-adjusted equity remarkably closely. It has been between 3 and 3.75 times equity every year, averaging 3.29.

Conservative capital structure
For a company pursuing such an extraordinary growth path, Tesco has remained very lightly geared. With such amazingly consistent profitability, it would not be unreasonably for Tesco to gear up to the point of pre-tax earnings covering interest by, say, 3 times. At 6% yield that would suggest a sustainable net debt of £16bn. In fact they operate with only £8bn of debt, offset by £2bn of cash to leave only £6bn net debt.

This extremely conservative capital structure gives Tesco shares a level of security that is rare in today's highly geared market.

Annual return
Tesco pays a dividend of 3.1% on their current share price of 320p. They reinvest a further 5%, generating 7.7% earnings growth (based on RoE of 12.2%). Their earnings increase with inflation, adding 3%. This leaves Tesco generating a total shareholder return of about 13.8%, or 10.8% in real terms.

Numbers schmumbers
Of course, all of this is really just a mathematical parlour game. There is no guarantee that these numbers will hold in the future. On the other hand, I think they're as good a base as any. They've held true very consistently for 14 years. And a return of almost 14% leaves a good margin of safety.

Their tangible assets were about £20bn in February '08 (using their estimate of the value of their property rather than the lower book value). That will have suffered due to lower appetite for commercial property, but even so it leaves a comparatively small valuation in their £25bn market cap for their superb brand.

Downsides
Tesco faces a number of risks. Competition concerns are likely to stifle UK growth to some extent. A prolonged recession would lead to reduced margins and probably a loss of market share. Their global growth is meeting competition from Wal-Mart and others.

The risk with extrapolating from past trends is that you double-count. A fall in Tesco's margins will lead to a corresponding fall in their RoE, their earnings, and their potential for growth. A fall in margin to 3% would leave them with a P/E ratio of 24 and comparatively poor growth prospects. With no growth prospects a P/E ratio of 8 might be more appropriate, and in one fell swoop the shares would lose two thirds of their value.

Conclusion
Clearly, since I just bought a bunch of shares, I'm optimistic. I think Tesco have proved their growth credentials, and I have high hopes for Tesco Personal Finance taking market share from the discredited big banks. Their future growth might not come from ever more UK stores, but it doesn't need to.

Tesco purchase

I spent the weekend pondering Tesco, and studying their financials over the last 14 years. This morning I've made an initial purchase. Tesco now forms approximately 10% of my portfolio.

Briefly, the key points in Tesco's favour are:

• A return on reinvested earnings of approximately 14%.
• Price/Earnings ratio of 12.
• Extraordinarily consistent profitability.
• Very moderate debt.

The earnings yield is approximately 8%. I think we can expect that to be boosted to about 10% by the superior RoE. We can also expect that to increase with inflation, so that suggests a real rate of return of 10%, nominal 13%.

I think Tesco is in an extremely secure position to weather any short-term downturns, and I think that is an excellent base for its future growth.

MXM, BDI, QDG

These are the three technology shares that I currently hold. My holding in BDI was small to start with, and has declined about 65%, so it's currently only 1.4% of my portfolio. MXM is down 22% to make 6.8% of the portfolio; QDG is down 26% to 6.6%.

All of these are reliant to some extent on investment spending by UK corporations, and are therefore vulnerable to a recession. But their business models leave them exposed to very different extents.

Looking at their Cash Flow statements is educational. I've picked out the cash flow of the companies below, calculating this as (pre-tax profit + amortization - tax - development). Of course Maxima pursues growth by acquisition, while other companies do more development in-house, so you would expect Maxima to have stronger cash flow. Nonetheless, in a recession Maxima can simply put its acquisition strategy on-hold; it's harder for Bond to sack a bunch of developers.

Maxima
Pre-tax profit: £5208k
Amortization: £3410k
Tax: -£1861k
Development: -£432k
Total: £6325k

Market cap: £27m (at 110p)
Revenue: £46m

Bond
Pre-tax profit: £5250k
Amortization: £1883k
Tax: -£953k
Development: -£2849k
Total: £3331k

Market cap: £15m (at 48p)
Revenue: £30m

Quadnetics
Pre-tax profit: £4394k
Amortization: £160k
Tax: -£1037k
Development: -£1132k
Total: £2385k

Market cap: £19m (at 111p)
Revenue: £79m

Conclusion
Judging by these numbers, Maxima is better-placed to continue generating cash in adverse conditions. It converts about 14% of its revenue into cash, vs 11% for Bond and a mere 3% for Quadnetics. However, Bond came out of this stronger than I had expected. I'm not surprised at Quadnetics' superficially weak numbers, since its business model is fundamentally different.

Expectation of stock market returns

I've been thinking about the sort of returns that it is reasonable to expect from investing in the stock market. It's suprisingly easy to come up with a number, subject to a few reasonable assumptions.

Assume that listed corporate profits will remain roughly the same proportion of global GDP. This precludes any dramatic movement of unlisted firms onto the stockmarket, or any permanent systemic change to profit margins.

Assume that the amount of money reinvested by firms remains roughly the same. This means no permanent switch to forever paying higher or lower dividends as a percentage of profit.

Assume that P/E ratios remain roughly constant in the long run. This precludes any general re-rating, e.g. because of permanently higher or lower real interest rates.

Subject to these assumptions, the real return from investing in the stockmarket is (GDP growth + Dividend yield).

There are added complications when investing in the stockmarket of an individual country, since that country's firms may make profits abroad and therefore profits earnt on that country's stockmarket could rise as a proportion of GDP. But I would say the effect of that is likely to be minimal.

So, in the UK we could reasonably expect real returns of 6%, judged on GDP growth of 2.5% and a 3.5% yield. That would be 9% after adjusting for 3% inflation - better than a savings account, anyway.

Bond

Bond's shares have fallen heavily since I bought. Are they a screaming bargain?

Current share price: 49.5p
Market cap: £16.3m
Yield: 3.2% (1.6p per share)
2007 EPS: 11.4p
H12008 EPS: 3.1p
2007 EBITDA: 21p
H12008 EBITDA: 8.2p
Net tangible assets: £0m
Net debt: £0m

Almost two thirds of revenue comes from recruitment software, which companies may not be keen to invest in during a recession.

Almost half of their revenue is recurring revenue, which should hold up reasonably well.

But let's take a look at their cash flow. Basically, they don't have any. Their operating profit goes straight into development expenses. They may find it unpalatable to lay off development teams during a recession, so essentially you could roll these into costs and see them as an unprofitable company.

Assuming they're reasonably accurate about the capitalized value of the products they are developing, I suppose we're left to conclude that they are a genuinely profitable company, but are not going to create growth without investment. Their Return on Equity is about 10%, which is not stellar.

Assuming Bond reinvested earnings of 10p per share generate future EPS of 1p, that gives them EPS growth of about 9%. Added to their dividend yield of 3.2%, that means a total shareholder return of about 12%. Which is pretty good, although not jaw-dropping.

Maxima's ROE is also about 10%. Their dividend is 5.7%. Their retained earnings should drive growth at about 6%. So their total shareholder return is also about 12%. So at these prices Bond and Maxima are similar in value.

RBS prospectus

I've been scrutinising the RBS prospectus for its placing and open offer, and trying to decide whether (and to what extent) to participate.

I don't think it's possible to simply read a bank's financial statements and come to a positive or negative conclusion, but thinking laterally may prove enlightening. So what conclusions can we come to?

Stephen Hester has hinted strongly that RBS may make a full-year loss, although I think he may be setting expectations low so that he can pull a trivial profit out of a hat to great acclaim. Let's assume they break even.

So - after possibly the greatest financial crisis the world has seen, RBS has one lean year. RBS has been forced to raise a lot of capital - but that money has actually boosted RBS's capital, it hasn't been swalled by subprime losses. RBS has successfully funded some massive losses out of profits - RBS was not in danger of running out of capital, but was in danger of running out of cash.

So what's different at the end of this year to the end of last year? RBS will have an 8% core tier 1 ratio. RBS will have access to plenty of liquidity. RBS will have regained the confidence of the financial community (i.e. have lower CDS spreads). Balanced against this, there is clearly a worsening economic climate.

Personally I think a recession can be dealt with. Yes, RBS will face problems from commercial property loan default, counterparty failure, sovereign debt default, further writedown in asset-backed securities, leveraged-loan default and rising impairments. But the recent changes to IAS 39 allow RBS to reclassify loans out of the held-for-trading category, which allows it to take losses as they come, rather than all at once. Hopefully RBS can continue to trade profitably, and cover writedowns out of profits rather than taking substantial hits to capital.

There's an interesting article at FT Alphaville that takes the opposite view:
http://ftalphaville.ft.com/blog/2008/11/04/17780/the-royally-rendered-bank-of-scotland/
I agree it's quite scary. But I think they're being a little bit one-sided.

Tesco

I thought I'd take a detailed look at Tesco.

Current price: 318p
EPS in 2008: 27p
EPS year-on-year growth: ~16%
Dividend in 2008: 10.9p
Dividend payout ratio: ~40%
ROCE: ~12%
ROE: ~16%

So 60% of earnings are reinvested at about 16% rate of return. That accounts for ~9% of growth. About 7% seems to come "free" - but are they just gearing up?

In 1999 they had debt of about £2bn, vs net assets of £4.3bn. In 2008 they had net assets of £12bn, but borrowings of £8bn. And £1.7bn in cash, so really only £6.3bn. So actually gearing has remained pretty static at 50%.

So this company has grown earnings per share at about 15% sustainably and is paying a 3.4% dividend. That's a total retun of 18.4%. Current P/E is under 12, whereas a safe company with such strong growth would normally command something like 15-20.

Even if we assume that organic growth moderates to 3% (i.e. only just keeping pace with inflation), you're still looking at dividend growth of 10% per year.

Refinancing debt may be more expensive in the future. Each 1% increase in finance costs equates to £80m off their pre-tax profits, which in the context of £2.8bn of pre-tax profits is not a problem.

This company has huge advantages:

• A stupendous growth record.
• Very strong cash flow.
• Low debt in the context of their massive earnings.
• A dominant position in their main market.
• Huge opportunities to export their business model abroad.

Concerns are:

• Growth will be difficult since it is so dominant in the UK.
• Economic conditions will hurt it, especially in the short run.

On the whole I'm struggling to find too many negatives. I'm convinced - I'll be looking to add some Tesco shares to my portfolio over the coming months.

Portfolio vs net worth

To cheer me up a bit, I thought I'd review the movement of my share portfolio over the last year, but also look at changes to my net worth in Norwegian kroner - since I plan to move to Norway in a few years.

Here is the disastrous performance of my shares, in order from best to worst:
MXM -5.34%
QDG -13.62%
NXT -20.62%
IAPD -28.06%
GNK -32.09%
IFFF -39.96%
IDVY -40.18%
LTAM -43.15%
IEER -58.82%
BDI -65.55%
ZRX -66.73%
RBS -75.33%
TW -90.16%

Movements in the dollar/pound exchange rate have almost exactly wiped out my share losses. The value of my house has also fallen over this period - I estimate this loss to be slightly greater than my loss on shares. Movements in the pound/kroner exchange rate have almost exactly wiped out this loss.

House prices, share prices and exchange rates have resulted in zero net movement in my net worth in the last year. It was a different story 6 months ago. Asset prices had not fallen so far, but I had made no profit on the dollar/pound rate, and had taken heavy losses on the kroner/pound rate. At that point my net worth in kroner had been hammered by approximately 25%.

So - my net worth is the same as last year, and I have an excellent opportunity to buy shares at reasonable prices. Reasons to be cheerful indeed.

What are RBS shares worth?

A bit premature, since I haven't seen the prospectus for the rights issue yet, but I thought I'd have a deep think about what RBS shares are really worth, and whether it's smart to continue holding. My gut says "hold at all costs", but am I just avoiding crystallising a big loss?

Net tangible assets
At the interims assets were £67bn, of which £5.8bn were minority interests, and £8.3bn were non-ordinary equity. £27bn were intangible assets. You could munge those in a variety of ways, but I reckon the ordinary shareholders have about £20.5bn of tangible assets.

At the moment there are 16bn shares, so 128p per share.

Post rights issue there will be about £35bn of ordinary shareholder equity, but 38bn shares. So about 92p per ordinary share.

Of course there are worries over further writedowns which might eat into these assets. On the other hand, this gives no value to RBS's brands: RBS, Natwest, Churchill, Direct Line, Citizens, Charter One, ABN Amro, Ulster Bank, Coutts, etc..

Earnings
This is the key question. Can RBS sustain anything like their previous levels of earnings? Obviously their funding costs will rise, but can they just pass this on to their customers? Securitisation and some other revenue sources will probably be blocked indefinitely. They still have the expertise to compete effectively, and many banks will be in the same boat, so surely they can earn an adequate return on their other business lines.

I'll have a stab at £5bn post-tax, as a hypothetical figure. That's 13.1p per share after dilution. At a P/E of 10 that would mean 131p fair value. But: is a P/E ratio of 10 reasonable? An ultra-safe (extremely well-capitalised) bank earning a RoE of 14% should trade on a premium due to its growth prospects. On the other hand, RBS is likely to have a curtailed appetite for growth for some time to come, so such a good RoE is largely wasted.

Shareholder return
Of course shareholder return is the only realistic way to value a company, but it's also the hardest. I think we can expect:

• Non-core disposals, such as insurance, etc.. helping to pay back preference shares ASAP. Let's assume a £5bn boost to capital attributable to ordinary shareholders, and the end of the 12% payout on the preference shares. But a hit to post-tax earnings of about £600m per year.
• Shrinkage of the balance sheet and risk-weighted assets in Global Banking and Markets. Perhaps a reduction in risk-weighted assets of £80bn over the medium-term, resulting in £8bn of surplus capital. A hit to post-tax earnings of £1.2bn.
• In the short-run, impairments running ahead of better margins, but longer term more attractive returns on residential mortgages.

That would suggest £8bn of excess capital to return to shareholders. Earnings around £5bn in the medium term. The potential for higher dividend payments in the absence of growth. So perhaps 21p per diluted share in capital return, combined with 131p per share value based on earnings. So around 150p as a reasonable value for the diluted shares.

Quality

The recent market turmoil is seeing some quality companies punished with the rest. This looks like a good opportunity to pick up some top quality shares on the cheap. Over the next couple of months I will have plenty of cash available to invest. At the moment I'm drawing up a shortlist of shares to consider.

In general I'm looking for Buffett-type shares that I can hold for the extreme long term. What I want is:
- Plenty of free cash flow
- Strong potential for organic earnings growth (i.e. not requiring investment)
- A wide moat protecting them from competition
- Large profit margin
- Stable, growing revenue
- Limited debt
- Not excessive P/E ratio
- A reasonable dividend yield

So far I'm looking at:
- Diageo at around 800p
- Tesco at around 300p
- GlaxoSmithKline at around 1000p

Market plummeting

I suppose I should say something about the plunging stockmarket. How about "hooray!". Cheap shares - fantastic. For someone who is going to be a net buyer for many years to come, the cheaper the better.

I hope the market doesn't recover too quickly.

Of course, some of the companies I own shares in have also seen their "real" value affected.

Royal Bank of Scotland, worth perhaps £7 per share if the credit crunch had fizzled out and gone nowhere, and maybe £4 if the US had rescued Lehman and avoided further panic, will now be worth maybe £2.

It remains to be seen how Taylor Wimpey resolve their funding issues, but I'm now far more pessimistic about the direction of house (and particularly land) prices. I think the value of their shares has probably fallen from £2.50 to maybe £1 at best.

Zirax are clearly having short-term problems, but I remain fairly confident in the long run.

On the whole I think pretty much all the shares in my portfolio are undervalued. So I clearly won't be selling. And in fact, I just put in an order to buy more IAPD, IDVY and GNK next week.

Government bank bailout

Well, with hindsight I did get a good price on Monday (about 160p I think) but I spurned it. Shame - RBS are now at 70p. Which I think is crazily low, especially given the government bailout plans. I suppose there's a chance RBS will have to suck up some big losses on Lehman CDSs - I would be seriously unimpressed if they have much exposure though. The other big worry is that shareholders will be massively diluted.

Analysts have been saying that RBS will raise about £10bn. I think they're probably not far wrong. The government said that banks would raise about £25bn between them. To take them up to a 10% tier 1 ratio, I reckon they need:
Barclays about £5bn
RBS about £10bn
HBoS about £5bn
Lloyds about £3bn
HSBC about £1bn
That adds up to £24bn.

RBS's market cap is currently about £11bn. Some newspapers are suggesting that they will try to raise £10bn via a rights issue underwritten by the government. Surely not? That would be hugely dilutive at the current share price.

I think they would be far better off giving the government preference shares. Alastair Darling strongly pushed the benefits of preference shares in his Commons speech, so it seems that's what the government has in mind.

If RBS give the govt £10bn of perpetual, non-cumulative, non-convertible preference shares paying a dividend of 10%, what would that mean? Maybe we can assume some sort of normality in a few years - let's say £7bn of profit after tax. The govt would take £1bn of that. With a total dividend payout of 45% that would leave 13.4p per share for ordinary shareholders. And crucially, the remaining 55% will be reinvested to benefit ordinary shareholders - preference shareholders will just continue to get their 10% per year. So that's £3.85bn reinvested - even with a lower return on equity (say 10%) that means 5.5% growth of total profits, but 6.4% growth in profit attributable to ordinary shareholders. A yield of 5%, growing at 6.4% a year would be perfectly acceptable. That would suggest shares will be worth about 270p. A P/E ratio of 7, which you could also imagine rising to around 10 in a future bull market.

On the other hand, things do not look so rosy if governments receive convertible shares, or ordinary equity. The lower RBS's share price goes, the worse this option looks. Preference shares convertible at 62p, or a rights issue at the same price, would mean 50% dilution. Using the same profit calculations you end up with earnings per share of about 22p and a 10p dividend. So a share value of perhaps 200p.

It will be interesting to see how this turns out. I'll hold onto my shares, since I since there's little point bailing out at this low price, but my highest hopes at the moment are to break even in a few years.

RBS uncertainty

I've been reading some worrying things about RBS over the weekend, and if I can get a reasonable price on Monday morning I may well sell off some of my shares. I'm already nervous about quite how large my stake is as a percentage of my total portfolio.

Paul Mason's blog suggests that he knows "for a fact" that the government is considering taking an equity stake in major UK banks and financial institutions.
http://www.bbc.co.uk/blogs/newsnight/paulmason/2008/10/pretty_big_steps_does_the_real.html

Alastair Darling says he is looking at a "range of proposals".
http://news.bbc.co.uk/1/hi/uk_politics/7653194.stm

European leaders say they are prepared to lift borrowing restrictions.
http://news.bbc.co.uk/1/hi/world/europe/7648249.stm

What I find scary is that on the one hand government talks about providing all the liquidity that the banks need, whereas on the other it wipes out shareholders in Northern Rock and Bradford and Bingley - when as far as I can tell their main problem was one of liquidity. They seem to be a bit more willing to bend the rules for the big banks, but I don't really like the inconsistency.

Government also seems determined not to tell the market anything - Robert Peston blogs about pretty much everything of substance before the government announces anything.

Portfolio news

In all the recent excitement, there have been various bits of news from some of my smaller holdings.

Zirax
Zirax are putting out a variety of press releases leading up to their interim results on Monday. Good that they're trying to drum up a bit of interest.

25 September 2008 Second Moscow De-Icing Contract Win
Zirax plc ("Zirax" or the "Company"), the AIM quoted speciality chemical company focused on the development, production and sale of oilfield process chemicals and de-icing solutions is pleased to announce that it has won a second contract this year to supply an additional 8,000 Metric Tonnes ('MT') of calcium chloride based de-icers to Moscow City Council for its 2008/09 winter season. Read more

18 September 2008 Zirax signs Heads of Agreement to acquire its Principal Limestone Supplier in Russia
Zirax plc ("Zirax" or the "Company") is pleased to announce it has signed Heads of Agreement to acquire its principal limestone supplier in Russia. The acquisition is scheduled to complete later in 2008 and will cost the Company Euro 400,000 (USD 560,000) for 25 million cubic meters of reserves. Read more

15 September 2008 ZIRAX secures two new supply agreements in Romania and Azerbaijan together worth USD 1.5 million
Zirax plc ("Zirax" or the "Company") is pleased to announce it has won two new contracts together worth initially USD 1.5 million, to supply Bucharest City Council with de-icing products and supply PelletOilTM calcium chloride pellets to oil drilling operations in Azerbaijan. Read more

Nothing earth-shattering there. I don't have huge hopes for the interims, but hopefully it will be a solid set of results providing a good springboard for the next couple of years.

BDI
Bond's interims are out. They don't look hugely pretty, but they're by no means disastrous. Their profit is inevitably somewhat "lumpy" since it depends on the timing of quite large contracts. They're generating good amounts of cash.

Their market cap is currently £29m at 88p. I bought my shares at way more than that - 145p. They only made £1m after tax in the first 6 months - if that continued they'd be on a P/E ratio of 15, which seems excessive. However, I think £3m would be a reasonable assumption for the year, meaning a P/E ratio of 10 (last year was £3.6m). Not great, but OK. Looking forward a few years, I think they clearly have the capacity to drive earnings higher - say £5m.

The pay a paltry 1.6p dividend - a 1.8% yield. I imagine they're looking for a 10+% growth rate for several years so they can demonstrate the famous "progressive dividend policy". At the moment I think this is doing more harm than good. Investors looking for dividends have a mouth-watering array of 5+% yields, and growth investors don't care.

I think I'll continue to hold. They don't look overvalued. I may add to my investment, possibly funded my selling off my emerging market ETFs - I have no conviction that these are worth holding, and at least I think I understand Bond's business. Life will be simpler if I consolidate some of my smallest investments - they're not large enough to provide meaningful diversity. While I think emerging economies will do well, the best way to benefit from them is not necessarily to invest in shares that track their stockmarkets.

FSA bans short-selling

Remarkable news.
http://news.bbc.co.uk/1/hi/business/7624012.stm

Motley Fool reported that RBS was up to 245p briefly, but is now down to 215p. Not sure if 245p was a glitch. It will be interesting to watch today.

Update: even more remarkable:
http://online.wsj.com/article/SB122186549098258645.html?mod=googlenews_wsj

The Fed is devising an audacious plan to bail out financial institutions. I can't help worrying about how inflationary this could be... it will be interesting to see some details.

RBS finished the day 32% up, having been over 50% up at one stage.

Here's the state of my portfolio at close of play (in order from largest to smallest market value). Not hugely pretty even after today's big gains:
RBS.L 213.50 -- bought at 246.45p = -13.37%
GNK.L 590.00 -- bought at 538.30p = 9.60%
IAPD.L 1432.31 -- bought at 1557.90p = -8.06%
IDVY.L 1767.00 -- bought at 2051.07p = -13.85%
ZRX.L 6.55 -- bought at 11.42p = -42.65%
MXM.L 183.55 -- bought at 145.79p = 25.90%
NXT.L 1247.00 -- bought at 1099.78p = 13.39%
TW.L 55.00 -- bought at 100.37p = -45.20%
QDG.L 129.00 -- bought at 150.50p = -14.28%
LTAM.L 1169.75 -- bought at 1232.87p = -5.12%
IFFF.L 1828.00 -- bought at 2167.90p = -15.68%
IEER.L 1679.00 -- bought at 2135.62p = -21.38%
BDI.L 104.50 -- bought at 145.13p = -28.00%

Down an average of 14%.

Whisper it quietly: I've bought more RBS

I was moderately determined not to buy any more RBS shares. But I must admit I had second thoughts when it briefly hit 145p over the Fannie/Freddie scare.

Now that its share price is suffering again, I decided to take one more bite of the cherry. I increased my stake by just over 60%. I bought the latest shares at 168p; my average purchase price is now just over 246p. RBS now forms about 23% of my portfolio. That's too much for such a risky share - but my portfolio is going to be about 3 times larger in 18 months, so it's less than 10% of my anticipated portfolio size.

So why invest so much money in an admittedly risky share?

I think a fair P/E ratio for a big bank is about 12. RBS's future earnings are uncertain, but I'm going to put them at about £6bn after tax in "normal" economic conditions. The final consideration is the risk of (a) significant dilution, or (b) total failure.

Let's assume RBS gets into trouble: depositors are withdrawing cash and/or other banks won't lend to it. What's going to happen?

• The government will not allow savers to lose money - that would be political suicide.
• They can't arrange for a buyer for RBS - it's too big. So the A&L option is out.
• The government cannot afford to take RBS onto its books - again, it's simply too big. So the Northern Rock option is out.
• Another big rights issue is not going to help a liquidity crunch. And getting that away in the current market would be impossible.
• There's no point flogging shares to outside investors, since even another £12bn is not going to be enough to cover the loss of interbank lending or customer deposits.

That pretty much rules out all the options that would punish shareholders. The only remaining options are:

• Government promises that all savings are protected in the event of a bank going bust. Savers are no longer spooked.
• Bank of England extends its special liquidity scheme. RBS no longer so reliant on wholesale lending, and paradoxically will now find it easier to get such funding.

Either of those would be provide a stupendous boost to UK bank shares, not just RBS. The government doesn't want to do it, but I don't think they will have a choice. If RBS gets the jitters, then Barclays for one will also be vunerable. A solution to benefit all banks would be required.

So what are the odds that RBS will get into trouble? I'd say about 1 in 4. They have access to liquidity from the US, UK and European central banks, which gives them more options than a bank like HBoS. They've savagely written down their subprime assets, raised capital and are deleveraging. They don't have such a scary UK mortgage book as HBoS or B&B. But, their shares seem to be the focus of a lot of short-selling, and I think it's possible for shareprice volatility to spook the other banks into freezing their lending. And they do rely on about £150bn of interbank lending.

If RBS did get into trouble, then I think there is around a 3 in 5 chance that they will be bailed out without any shareholder dilution.

So, that adds up to a 10% chance of shareholder wipeout. Let's be conservative and double it. That's an 80% chance that RBS is worth £72bn, and a 20% chance it's worth nothing. So fair value is approximately £57bn. That's 350p per share. 168p is a screaming bargain.

Other risks
To be fair, I'm probably over-egging the chance of total failure, and underestimating some more moderate risks, such as increased impairment charges due to a UK recession. On the whole I think things will probably balance out, so my fair-value assessment is pretty close.

New share: Next

Per my last post I was planning to buy some more Quadnetics shares. I've had a change of heart, and instead I've bough some shares in Next.

I bought at 1088.86p. It forms 6.7% of my portfolio at close of today.

So why Next? I've so far been holding fire on Retail shares, expecting a better purchase price next year. But having looked at Next, M&S and Debenhams, I think they're all cheap and Next is the pick of the bunch. I don't expect it to survive unscathed, but I think it's the only one of the three that could take a hit of 10% of revenue (assuming costs remain the same) and keep on going without a major crisis. Debenhams would take a big loss. M&S would break even. Next would still make a moderate profit. Obviously if sales really fall that much they would save money on the cost of sales, lay off staff, etc... It was just an idle test of their profitability.

Cash flow is also extremely strong. M&S spends all of its cashflow on purchase of property, plant and equipment. Who knows what that really means? Next spends its cashflow on share buybacks and dividends. Nice.

Next is the pick of the bunch because:

• It has a substantial margin which provides a buffer in a downturn.
• It has a fantastic history of buying back shares.
• It doesn't have excessive gearing.
• In the long-run it is focusing on the right market.

I would like to see Next fall in price next year and give me the opportunity to buy more shares at a cheap price. But given that I've decided I want to take a significant position in the share, I see little point delaying my first purchase. Here's hoping I make a short-term loss and get the bulk of my shares at a favourable price.

Emerging ETFs

I'm starting to rue my investment in emerging market ETFs. Not because they've fallen in price, but because I'm not convinced they're the best way to take advantage of emerging markets, and also because the amounts I've invested are too small to make sense.

For now, since I expect a strong cash inflow over the next few years, I won't sell. But if an opportunity arises that requires the sale of my emerging ETFs, I won't hesitate. Their days are numbered.

Quadnetics preliminary full-year results

Quadnetics preliminary full-year results are out:
http://www.quadnetics.com/ir/Press_Centre/News/Latest_News/Preliminary_Results_for_the_year_ended_31_May_2008/news.aspx?id=436

No big surprises. Stripping out exceptionals and assuming a realistic tax rate their profit is £2.6m. The market cap of the company is about £22.5m at the moment, so that's a P/E of about 8.5.

The balance sheet looks very healthy. £8m of cash. NTA of about £15m.

I remain very positive about this company, and per my original post I think fair value is around £60m. I plan to buy some more shares later this week.

GNK, IAPD, IDY

Roughly doubled my investments in GNK, IAPD and IDVY on Friday. They're now each about 12% of my portfolio at present prices, slightly ahead of ZRX.

Maxima Preliminaries

Maxima's preliminary full year results are out:
http://www.maxima.co.uk/pdfs/maxima/Prelims%20Statement%20Final.pdf

There's been a big increase in profit, but share dilution has left EPS down on last year (19p down to 15p). Adding back in amortization leaves EPS flat on about 25p.

At the current share price I'm hoping Maxima won't issue many more shares to finance acquisitions. Debt was only 1.2 x EBITDA at year end, but a post-balance-sheet acquisition of DXI pushes that up to more like 2 times. I think that still leaves scope for about £10m of extra borrowing - and combined with next year's earnings would hopefully leave room for about £18m worth of acquisitions this year without further dilution.

2008-2009
So... predictions for 2008-2009. Nothing like sticking your neck out.

I'm going to assume about £10m of EBITDA from the business excluding DXI. That's flat on last year.

DXI's EBITDA last year was £1.25m. I'll assume no integration benefits in the first year. I have no idea what DXI's growth prospects are, but I'll assume it remains flat. So that's a contribution of £1.25m to the bottom line.

I'll assume Maxima make a further 3 acquisitions at £6m each, with a similar price / EBITDA multiple to that of DXI. Let's assume the first acquisition contributes 6 month's worth of EBITDA to the bottom line, but the others happen too late in the year. That's an extra £500k.

So for the financial year 2008-2009 I have:
- EBITDA £11.75m.
- Number of shares still 25m.
- Amortization will probably be about £5m.
- Interest payments will be about £1.5m.
- Tax at 30% on £5.25m is about £1.5m.
- Post-tax earnings of £3.75m.

That suggests:
- EPS of 15p. Flat year-on-year. Disappointing.
- Putting back amortization, 35p per-share. An increase of 40%. Tasty.

2009-2010
The EPS number really depends on whether Maxima's acquisitions continue to increase in scale as the company grows. If so, amortization will continue to eat up a large part of the profits. However adding back amortization really does give a more accurate picture, and I could see this hitting 50p.

Value
I think the amortization will continue to cloud the picture for Maxima, but a record of strongly increasing cash flow, and a strong performance throughout a recession could leave Maxima deserving a multiple of, say, 12 on (EPS+amortization). In 2010 that could be 600p, for a 300% gain on my purchase price.

Conclusion
Maxima are definitely on my "buy" list when I have a few more pennies to spare. Probably in November.

Buffett

I've just got back from holiday. At the airport on the way back I picked up Buffett: The Making of An American Capitalist by Roger Lowenstein. I thought it was a great book - I devoured it in about 48 hours.

I was familiar with bits and pieces of Warren Buffett's life, but it was really interesting to read a properly researched, in-depth biography.

On the investment side, the things that stood out were:

• Being greedy when others are fearful, and fearful when others are greedy. This is a famous quote, but I'd always thought that being "fearful" for Buffett meant not investing (rather than actively selling). In fact, periodically, when the market is irrationally exuberant, Buffett has sold almost all Berkshire's stocks, with the exceptions of a few core holdings. That jars slightly with his ideal holding period of "forever" - I had no idea he had moved almost entirely into municipal bonds in the mid-80s.
• His key departure from Graham, in assigning value to intangibles such as brand. This still follows the spirit of Graham, i.e. buying something for less than it is worth, with a decent margin of safety, but goes a step beyond in recognising value in something other than tangible assets.
• His focus on good management, but the recognition that a well-managed company in a crap industry is still not a good investment.
• Free cash flow is crucial. Berkshire Hathaway (i.e. the original textile company) wasn't in a great industry, but had plenty of cash, and had decent free cash flow. That funded everything else. Investing that cash back in the textiles business would have left the company worthless. Berkshire is able to buy entire companies now, and take all their free cash flow for their own. For someone just buying shares, they need to look at companies that produce exceptional free cash flow, and, crucially, companies that decide judiciously whether that should pay for dividends, buybacks, acquisitions or internal investment.
• The influence of Charlie Munger in persuading Buffett to invest in great companies at a fair price, rather than focusing exclusively on extreme good value.

Carpetright

I haven't bought or sold any shares recently. My finances are in a state of flux right now, and I'm waiting until they settle before investing any more. I will have a series of cash sums becoming available over the coming months - I'll probably be investing fairly steadily from mid-August onwards.

My post today is a reminder to myself over the next few months to take a good look at CarpetRight. I took a 15-minute look today, and I like what I see:

• Strongly cash-generative.
• Strong growth possible with minimal cash requirements. They maintain high payables and low receivables, so get by with negative working capital. Provided they are prudent, that makes growth very cheap.
• They give a lot of the cash they generate straight back to shareholders - last year's dividend was a meaty 52p (on a current share price of 621p that's a yield of 8.3%).
• I think it's unlikely that carpets will start being sold online. There are big advantages to the biggest player in the market.

Lord Harris and family own about 25% of the shares. He aborted a recent offer at £12.50 per share due to funding issues. Could be a double-edged sword - I don't think he would let the company go down the pan if it got into financial trouble, but on the other hand he might look for a takeover on the cheap.

My concern would be how they would cope in a recessionary market with very few house sales happening. Carpets are presumably sold in two circumstances - when a family is feeling flush and confident, and when a family moves house. I expect both of those will be squeezed over the next year or two, hence the low share price.

I may decide to keep a watching brief on this one. It looks like a quality company, but I'm concerned that it doesn't have enough cash on the books to survive a downturn.

Portfolio review

I haven't posted a graph of my portfolio performance recently. Two reasons for that:

• Yahoo's historical share prices for Taylor Wimpey are broken, so my graph is inaccurate.
• It's down almost 30%.

Ah well. I'm sure starting my investment career in a bear market is a good experience. Here's how each of my purchases is doing, after accounting for dealing costs and dividends (all data produced by my python script):

RBS.L 2008-07-12 182.70 -- bought at 293.84p = -37.82%

BDI.L 2008-07-12 103.00 -- bought at 146.73p = -29.80%

IEER.L 2008-07-12 2158.00 -- bought at 2136.00p = 1.03%

IAPD.L 2008-07-12 1499.95 -- bought at 1587.32p = -5.50%

GNK.L 2008-07-12 427.75 -- bought at 526.06p = -18.69%

QDG.L 2008-07-12 132.00 -- bought at 150.50p = -12.29%

MXM.L 2008-07-12 125.00 -- bought at 145.79p = -14.26%

LTAM.L 2008-07-12 1354.19 -- bought at 1232.87p = 9.84%

ZRX.L 2008-07-12 7.25 -- bought at 11.42p = -36.52%

IDVY.L 2008-07-12 1815.00 -- bought at 2170.61p = -16.38%

IFFF.L 2008-07-12 1929.00 -- bought at 2176.70p = -11.38%

TW.L 2008-07-12 37.75 -- bought at 104.43p = -63.85%

The biggest losers are TW, RBS and ZRX. They're also my biggest holdings. Perhaps I should take a hint.

Some lessons to take out of this:

• Management tend to be either lie or be incompetent. Do not trust what they say.
• Leverage is very bad in a downturn.
• A low share price can materially hurt a company, e.g. by denying them a rights issue.
• A downturn can lead to a general sell-off, even of companies unaffected by recession.

I will continue to invest over the next few years; I will learn my lessons but continue to pursue value.

Taylor Wimpey - Trading Update

The big news in the TW trading update is that they have failed to agree an equity placing. That's not good.

However, they also released a market update presentation which was quite enlightening:

• After cutting costs, and freezing land spend, they can still generate cash with a 40% lower sales volume and 30% lower prices. But a lot of that will go on interest payments, which they cunningly do not mention.
• Their financial covenants are: EBITDA > 3 times interest cover. Tangible Net Worth > £1.8bn. Gearing <>

The share price is down 50% on this news. I'm not surprised. The possible outcomes from here:

• TW fail to get new equity but survive. Value ~ 250p (in the long run).
• TW fail to get new equity and go under. Value ~ 0p.
• TW get new equity on ruinous terms for existing holders. Value ~10p.
• TW get new equity on decent terms and survive. Value ~200p.
• TW get new equity on decent terms but then need a further raising. Value ~ -40p to +150p.

The odds of TW failing to get new equity has just got hugely more likely. They need new equity as a quid pro quo for renegotiating their banking covenants. Say ~£500m, and their market cap is now well below that. Pete Redfern needed to get this right first time, and he's failed.

I think there's now only a 25% chance that TW raise new equity on decent terms. Perhaps a 10% chance that they survive without needing new equity and without breaching covenants. A 10% chance that they renegotiate covenants without new equity. A roughly 55% chance of ruinous dilution.

That's not great, but at 30p I think it's well priced in. I will definitely hold, and may add more - but only after a lot of thought, and a look at their competitors.

Taylor Wimpey RNS

As per yesterday's post, TW have announced:

• They are raising equity, probably via a placing and open offer. No surprises there.
• They have renegotiated their financial covenants, to remove the EBITDA interest cover requirement, and replace it with one based on operating cashflow. Good - they had essentially no chance of meeting the EBITDA cover.
• They will write-down assets by £660m. Suspect this is just the first of many write-downs.

http://production.investis.com/taywim/regulatory_news/rnsitem?id=1214805927nRnsd8167X&t=popup

So no surprises there. This is a good first step to TW's survival of a UK recession. Now we need to see how much cash they can generate over the next 6 months.

Taylor Wimpey - Open offer

The Telegraph and the Times are reporting that Taylor Wimpey is finalising a £400m - £500m open offer:
http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2008/06/29/cnwimp129.xml
http://business.timesonline.co.uk/tol/business/industry_sectors/construction_and_property/article4232047.ece
(the Times reports bank debt of £1.9bn, but I think they're confused - £800m of that is debentures).

Good news if they can avoid the dragging out of a rights issue - and per my last post I thought this sort of cash injection would be needed as a condition for banks relaxing their financial covenants.

According to Berkeley, land prices are down 25%:
http://business.timesonline.co.uk/tol/business/industry_sectors/construction_and_property/article4227871.ece

Accounts
So where will this leave TW's accounts? Taking the numbers from mid-2008 in my last analysis:

Inventory: £5.4bn (this assumes they are depleting their land bank and slowing new builds)
Receivables: £300m
Cash: £200m

Current Payables: £600m
Non-current payables: £300m
Debenture loans: £800m
Bank loans: £1bn
Retirement benefit obligation: £200m

Assets of £5.9bn, liabilities of £2.9bn.

25% land write-downs would suggest about £1bn write-down on inventory. A £500m injection of cash would mostly go to paying down bank loans. So things might look something like this:

Inventory: £4.4bn
Receivables: £300m
Cash: £300m

Current Payables: £600m
Non-current payables: £300m
Debenture loans: £800m
Bank loans: £600m
Retirement benefit obligation: £200m

Assets of £5bn, liabilities of £2.5bn. Net debt is £1.4bn, vs. net assets of £2.5bn - gearing of 56%. The key challenge is then to keep things on an even keel throughout the credit crunch.

Prospects
Let's look at two potential outlooks for the next couple of years.

Positive scenario
A mild recession spreads across much of the world. Falling demand means that oil prices fall back to under $100 a barrel. The pressure on inflation in Britain eases substantially. The Bank of England keeps interest rates at 5% for the remainder of 2008, and then makes some modest cuts in early 2009. Particular sectors in Britain such as construction and retailing lay off workers, but these are not enough to substantially affect the economy at large.

In 2009 the economy begins to pick up in the US. Subprime-related write-offs are reversed at some institutions that have taken the biggest hit, such as RBS. Large, well-capitalised banks begin to compete harder for mortgage business.

House prices undergo a prolonged, slow decline, falling 20% peak to trough. Construction costs fall along similar lines, due to widespread unemployment in the construction sector. Land prices fall by 40% peak to trough. Lower interest rates start to have a galvanising effect towards the later half of 2009.

Taylor Wimpey rides out the slowdown, keeping margins at around 10%. Gradually volume begins to pick-up.

Negative Scenario
Oil prices continue to soar. The inflationary pressures cause the Bank of England to raise interest rates to 7% by the end of 2009. Significantly higher mortage payments lead to widespread economic malaise. Repossessions and bankruptcies spike. For those without at least 30% equity in their homes, mortgage rates are approaching 10%.

House prices fall 50% peak to trough. Barratt and Taylor Wimpey are forced sellers of land, driving prices down 90%, and causing all indebted housebuilders to breach financial covenants. Ruinous debt-for-equity swaps leave existing shareholders holding pennies. Meanwhile, small builders with no debt snap up land on the cheap, and take advantage of plummeting construction costs.

Conclusion
We live in interesting times.

The 4 Cs

What makes a bad company? My answer is the 4 Cs:

Cyclicality
The company sells a product for which demand is strongly cyclical. During a downturn their sales plummet.

The company's margins are wafer-thin, so they have no room for cutting prices to boost demand.

The company has high fixed costs.

The company has a negative tangible book value, and no reserves to help them see out a downturn.

Competition
The company produces a generic product which is easy for others to copy.

The company is not the lowest-cost producer.

The company has many competitors.

The company does not have a strong brand.

Capital
The company requires substantial capital investment in order to expand.

The compant is heavily leveraged and pays a high price for it.

Competence
Management is inexperienced in the sector or over the business cycle.

Management takes credit for successes and blames failure on external forces.

Warren Buffett
This has come across a very Buffet-esque post. WB invests in companies that avoid these pitfalls, like GEICO, Coca-Cola, Gillette, etc..

Me
Most of my purchases have looked at value rather than the real quality of a company. I've been reluctant to pay a high price for a great company. Perhaps that's because prices really are too high, or perhaps I've not paid enough attention to the 4 Cs.

RBS - Has operated with insufficient capital, and that cost me as a result. Management has blamed problems on the "unprecedented" credit crunch, when this seems to be a normal part of the credit cycle.
TW - This does badly on most of the tests.
ZRX - Broadly speaking I think ZRX avoids most/all of these pitfalls.

I'll take another look at some quality companies that are moderately priced, and see if I am interested.

Keeping score

Keeping score
Here's a simple question. How important is the purchase price of my investments?

Here's a simple answer. Not at all.

For a long-term investor (which I am, or would like to be), there can't be any debate about this. Once I have put down my money, the deed is done. If I own 1000 shares in company XYZ, it doesn't matter if I paid 1p or £1 for them. Any decision to sell the shares, or buy more, must be purely rational based on the current share price, and not take any account of my purchase price.

The only reason to keep track of the purchase price (besides tax reasons) is to keep score. Interesting, perhaps. But not relevant to any future decisions.

I need to be on my guard here. My instincts are to place huge weight on purchase price:

• Not wanting to sell at a loss. This would be tantamount to admitting a mistake, which is hard to do.
• An urge to average down when share prices fall. If I'm 50% down I want to double my investment so that I'm only 17% down.
• Not wanting to increase my holding at a higher price than my initial purchase. If I'm 50% up I don't want to double my investment and end up only 25% up.

Now this doesn't mean that it is irrational to buy more shares when the price falls - as long as I'm doing it for the right reasons, i.e. because I have spare cash and want to increase my holding because the share is good value.

Equally if I buy shares at a 50% discount to true value, and they then shoot up 80% without any change to the real value, then there is no point buying at only a 10% discount.

Timing

An attempt to rough out my investment strategy for the next 2 years.

H1 2008

I would like to build a reasonably diversified portfolio. But I want to buy shares cheaply. I think the next few years will give me the opportunity to do this. I need to be on my guard for opportunities as they arise, but I need to be patient as well.

So far I have a large number of bank shares, bought too soon. Patience would have paid off here.

I have a moderate number of building shares, bought too soon. Patience was definitely warranted here.

I have a large number of chemicals shares. No particular timing problems.

I have a large number of diverse IT shares. No particular timing problems.

I have a small number of pub shares. These are hard to call - I think they will probably go lower. I have probably bought too soon, but will be patient before buying more.

I have various ETFs. No particular timing problems.

H2 2008

I have some money left to invest. I will get some more in a month or two. I will get more in November, and a lot more in January.

For the moment I think my focus should be on increasing my ETF investments. I think a 50/50 split between ETFs and my own choice of shares is a reasonable split. I'm currently at 28/72. I will try to focus on that for the rest of the year.

H1 2009

I will look at bank shares again in the light of a full year's results. I believe RBS's earnings will remain robust, and that banking shares may be amongst the first to benefit from a recovery.

If a general bear market has been in force, I will look at defensive shares such as GSK, DGE, in the hope of picking them up on the cheap.

I will look out for any heavily oversold quality shares in sensitive sectors such as housebuilders, big-ticket retailers, etc..

H2 2009

In the hopes of recovery I will look at builders, retailers, office owners and others that have suffered in the downturn, trying to pick up a mix of quality companies well placed for a recovery.

H1 2010

Assuming a recovery is taking hold, I will look at companies that will benefit from expaning corporate investment: software services, building supplies, etc...

Ouch

Not a good day today:
RBS down 9%
ZRX down 8%
TW down 19%
GNK down 4.%
QDG down 5.5%

Overall I'm down 6% on the day, and 20% in total. Not pretty.

It's very depressing to see such a sea of red, and I can't help wishing that the prices would go back up to near where I bought. But that's not rational - I'm going to be a net buyer of shares for the next several years - I want them to be cheap. It's obviously unfortunate that I bought shares a few months ago when I could be buying now and getting (a lot) more for my money, but I don't pretend to be able to time the market.

Are there any genuine reasons to be concerned?

• Does the market know something I don't? I'm pretty sure insider trading does go on, so this could indicate that something is happening that I'm simply unaware of. If I was going to believe this, then I'd have to give up investing altogether, on the basis that I could never beat the market. I'm not ready to do that just yet.
• Have I miscalculated and bought at too high a price? True as this might be (and I'm not convinced it is), waiting for the share price to tank before making such a judgement is clearly the wrong way to approach things.
• Will the share price affect the prospects for the company in question? This is the key question, and for some companies the answer is clearly "yes". Let's examine that in more detail.

How can a depressed share price adversely affect a company's prospects?

To take a far from random example: Taylor Wimpey (Barratt would be an even better choice but I know more about TW). TW's balance sheet is essentially:

£0.82bn intangibles

£6bn inventory

£0.85bn receivables, cash, tax and other assets

Assets = £7.67bn. Net tangible assets = £6.85bn.

£2.08bn payables (inc tax)

£1.55bn loans

£0.33bn retirement obligations and various other miscellaneous liabilities

Liabilities = £3.96bn.

So at the moment TW has net assets of £3.71bn, and net tangible assets of £2.89bn.

TW's inventory is split £3.88bn land and £2.02bn development costs, with the rest fairly miscellaneous stuff that I don't understand.

A typical house's price at the moment is made up:

25% land

15% gross margin

60% construction costs

So that £2bn development costs represents about £3.3bn worth of houses. About £700m of the land will be part of them.

Let's assume house prices fall 20%. What can TW get for its inventory? £2.64bn. Its other land might be worth only £640m (an 80% fall). That would suggest TW's true inventory value might be just £3.28bn, for net tangible assets of £4.13bn. That leaves TW only just solvent, and with gearing close to infinite.

Assuming they successfully reduce both assets and liabilities somewhat, they could end up with tangible assets of £2.5bn and liabilities of £2.25bn. Net debt of £1.2bn, but net assets of only £250m. To get gearing back under 80% they would need a cash injection of about £600m.

TW's market cap at the end of today's trading? £554m. Tricky to raise more capital than the market says you're worth (but not impossible). If TW was valued at £2bn it would be a different story. If TW was valued at £5bn it would be dead easy. A lesson to be learnt there? TW was valued at about £5bn less than a year ago. How quickly things change.

Taylor Wimpey - Conclusions?

Further to yesterday's post on Taylor Wimpey. What banking covenants are they likely to have? I'm expecting:

- Minimum interest cover - EBITDA to interest costs: let's say 3 times. For 2007 this was just over 4. Are they dumb enough to leave themselves this little margin for error? Probably.

- Gearing - net debt to net asset value: assume no more than 50%. At the end of 2007 this was 38%. Again, a fairly small margin, but that wouldn't surprise me.

Expect both to be calculated at year end. Net debt will vary through the year, e.g. at the moment it is up to £1.9bn from 1.4, but I think they're expecting it to fall again.

So what does this mean for this year? My (very pessimistic) guess was something like a 40% reduction in volume and 50% drop in margins. That would mean profits drop to about £120m, combined with interest payments up to £180m. Not good!

At year end my numbers suggested net debt of £1.7bn vs. net assets of about £2.4bn. Again, not great.

So TW have a lot of debt in debentures with a long life. These shouldn't have any covenants associated with them, which is good. My estimate for end-2008 was for bank loans of £1bn. If my 2008 estimate happens I think they could be a bit scuppered there. A significant rights issue would almost certainly be a condition of renegotiating the financing terms. I'd imagine getting gearing back under 50%, i.e. a rights issue of £500m, or about 50p per share, would be required, and TW would pay higher interest costs in the short-term (so wouldn't see much reduction in interest payments in exchange for that capital).

I'm prepared for that rights issue to happen, and I still think the shares would be good value if it happens. However, I'm not going to go crazy and buy more unless I see some indication that things are improving, since I think I hold enough of this share at this point in the cycle. It could go a lot cheaper.

Taylor Wimpey short term prospects

Until now I've been looking at the longer-term prospects for Taylor Wimpey, but I think it's worth looking at what its balance sheet, cash flow and income might look like over the next few years. The main point is to see whether a rights issue is likely to be needed, but it's also an exercise in testing my predictive powers - I'll come back to this post when TW publish their interim and annual reports.

Base point - end-2007
Inventory: £6bn
Receivables: £400m
Cash: £130m

Current Payables: £1540m
Non-current payables: £400m
Debenture loans: £820m
Bank loans: £700m
Retirement benefit obligation: £200m

There are various other assorted items that are small enough to ignore for my purposes. At the moment TW has assets of £6.54bn and liabilities of £3.66bn, according to my numbers. That's close enough for my purposes.

TW's average house price is about £200k. Their gross margins are about 15%, so £30k of that. About £50k is the land. So construction costs are about £120k per house. £2bn of construction suggests that they have the equivalent of about 15k houses (e.g. 5k complete houses and 20k half built). They sell about 20k in a year, so this is about 9 months supply.

Mid-2008
Over the whole of 2007, TW had revenue of £4.7bn. Their latest trading statement (in April) stated that their order book was down 26% by value, so lets assume a further worsening and say that total sales were down 35% over the 6 months. That suggests about £1500m in positive cash flow, or 7,500 houses.

Assume a 25% decline in receivables, which will represent a positive cash flow of £100m.

Assuming they are building at 50% of the previous rate, that suggests they will have added 5k houses, but sold 7.5k, so a decline in the inventory from 15k to 12.5k. They will pay £600m in construction. They have operating expenses of £150m, and interest costs of about £90m.

Assume no land spend. Assume no more share buybacks.

The dividend will cost them £110m after tax, so about £160m before tax.

That's a net positive cash flow of £600m, generated by using land faster than they are replacing it and a reduction in inventory.

Net debt in April was reported as £1.9m. Assuming no new debentures, that suggests bank loans up to £1.2bn. Perhaps fewer land creditors, if they are depleting their land bank? Assuming this comes down to about £1bn by mid-2008, I estimate their balance sheet as looking like this:

Inventory: £5.4bn
Receivables: £300m
Cash: £200m

Current Payables: £600m
Non-current payables: £300m
Debenture loans: £800m
Bank loans: £1bn
Retirement benefit obligation: £200m

Assets of £5.9bn, liabilities of £2.9bn

End-2008
Let's assume conditions continue to deteriorate. Volume continues to decline, average sale prices are down from £200k to £160k (20% decline). There has been a freeze on new development, and the inventory is being further depleted. TW have laid off a third of their staff but redundancy payments mean that the benefits have not been seen yet.

TW sell only 2,500 houses, for revenue of only £400m. Receivables decline a further £100m for total positive cash flow of £500m.

The interim dividend is paid in stock.

The inventory remains static at 12,500 houses, due to completing existing developments. £300m is spent on development. £100m on interest payments, operating expenses are £150m.

There are various write-offs on the value of land and developments in progress, to the tune of £1bn.

Balance sheet:
Inventory: £4.3bn
Receivables: £200m
Cash: £100m

Current Payables: £700m
Non-current payables: £0m
Debenture loans: £800m
Bank loans: £1bn
Retirement benefit obligation: £200m

Assets of £4.6bn, liabilities of £2.7bn

Mid-2009
Volumes are starting to pick up in the UK, but prices are still low. North America is beginning to recover.

Average sale price is now £150k. 5,000 sales for revenue of £750m.

TW begin developing at a reduced rate. They spend £300m on 2,500 houses. £100m on interest payments and a now-reduced £100m on operating expenses.

TW resume a modest and very selective land-buying program. The final dividend is not paid. Land spend is £150m for 5000 plots, ensuring their land bank remains neutral in size.

Total positive cash flow of £150m.

Balance sheet:
Inventory: £4bn
Receivables: £200m
Cash: £100m

Current Payables: £400m
Debenture loans: £750m
Bank loans: £1.1bn
Retirement benefit obligation: £0m

Assets of £4.3bn, liabilities of £2.25bn.

End-2009
Continuation of the earlier part of the year. Market appears to have bottomed in the UK, and there is a slight improvement in sales prices to £160k.

5000 sales for £800m revenue. Construction costs are squeezed somewhat, and construction spend is £500m for 5000 houses, keeping the inventory neutral at 10,000. £200m on interest payments and operating costs.

Land continues to decline in value. TW buys 5000 plots for £100m.

Due to decline in land values, TW writes down the value of its land bank by a further £500m. But: gross margins are now up to 25%.

Balance sheet:
Inventory: £3.4bn
Receivables: £200m
Cash: £100m

Current Payables: £600m
Debenture loans: £720m
Bank loans: £800m

Assets of £3.7bn, liabilities of £2.15bn.

Mid-2010
Volumes are returning to normal across the board. Land values are bouncing back, reducing gross margin to 20%. Average sale price is £170k.

TW sell 8000 houses for £1.4bn, clearing £280m gross profit. Interest payments and operating costs are £180m.

Due to the recovering market, TW's balance sheet is no longer an issue. Pre-tax profit is £100m.

End-2010
Volumes are pretty much back to normal. TW sell 10,000 houses for £1.7bn. Margin remains at 20%. Gross profit is £340m. Costs are £180m. Pre-tax profit is £160m.

TW start building their land bank, which will drive future growth.

End-2011
TW sell 25,000 houses during the year for revenue of £4.5bn. Gross margins have declined to 15%. Costs over the year are £325m. Pre-tax profit is £350m.

End-2012
TW sell 30,000 houses during the year for revenue of £6bn. Margins remain at 15%. Gross profit is £900m. Costs are £400m. Pre-tax profit is £500m.

Taylor Wimpey - add

Per my post yesterday, TW is cheap at 85p.

I've added to my holdings at 85.5p, which reduces my average purchase price to 103p, or a smidge under 100p if you take the dividend into account. TW is now my third largest holding at 10.6%.

Bye bye EDD, hello more ZRX

My resolution to stop buying more Zirax lasted 17 days and another 1.5p drop in the share price. Ah well. I didn't put it any new cash this time - instead I sold out of EDD for a modest 12% profit after fees and taxes.

I've also committed to taking up my RBS rights. I can't see the share price falling below 200p tomorrow, so there's no advantage to delaying further.

Zirax is starting to catch up RBS as my biggest holding...
RBS: 23.8%
ZRX: 16.3%

Details
EDD - Education Development International - 29/5/08 - 42.65p - SOLD - 4.3% of portfolio.
ZRX - Zirax - 29/5/08 - 9.35p - BUY - 4.3% of portfolio.

Average holding time
Now that I've made a sale, my average holding period is no longer infinite. I've therefore added an extra output to my python script: average holding period based on actual sales, and average holding period assuming I sold out entirely today.

My values so far: 1780 days and 74 days. The first of those is the meaningful one in terms of minimising churn. Just under 5 years is perfectly reasonable. I believe I've read somewhere that investment funds average less than 1 year. Warren Buffett probably has something like 1000 years, which I doubt I will get close to.

Taylor Wimpey
I expect to add to my TW holding at some point in the next few days, as funds become available. 85p is really getting silly. Forget about house prices for a moment: the UK's rate of housebuilding is unsustainably low. Over the medium term, the UK needs several hundred thousand new houses per year, and there are only a handful of builders. Provided TW survive, as I think they should, they will take a share of that business. If the margins aren't there, the builders will not bother building, and therefore they will be there.

Land of leather
I took a look at Land of Leather today. It is trading on a fantastically low price. I'm starting to think that even if it only has a 20% chance of survival, it might be worth a punt. Perhaps I'm crazy.

It's on a P/E ratio of less than 1 and has a yield of 65%. Nice.

It had about £16m in the bank at the end of January and has a market cap of £10m. But obviously there are many many problems with it... In particular: high fixed costs, very negative working capital (fantastic when growing, not so good in a downturn).

I'll continue to watch. I think it's probably going bankrupt.

Taylor Wimpey

Taylor Wimpey continues its downward plunge, from my purchase price of 130p down to a low of 90.5p today (recovering to close at 95.75p). Given my expectations of a house price plunge, followed by a UK recession, you might think that this share will continue to tank. But at what point should you buy? Sooner or later the value argument just becomes irresistable - but can that happen before the house price plunge has even occurred? Will TW plumb the depths of 50p, 20p, 10p?

This is my attempt to do an in-depth analysis of TW and identify where fair value occurs. Previously I have set a fair price of 215p on the share, based on expected earnings of £230m and a fair P/E ratio of 10. I still think that is not unreasonable, but due to its debt there is significant downside - perhaps that will outweigh any possible upside?

Worst case
Lets address the worst case first. This assumes that TW goes bankrupt, or is forced to sell itself to a Sovereign Wealth Fund, or similar catastrophic outcome. In that case, I will assume it will be valued at whatever its assets will achieve on the open market (which is not NAV).

Let's assume £200m for the brand. Well below what it's recorded as under Goodwill and Other Intangile Assets, but what can you expect? Brand loyalty to a housebuilder?

Sundry other non-current assets: £295m. Call it £250 since some of these may fall along with TW's value. That makes £450m for Non-Current Assets.

Current Assets: £538 for the simple stuff. £6018m inventory, split £119m I don't understand, £3879 land and £2020 development and construction costs. The land will be recorded at less than fair value - but let's assume a 50% drop on top of that down to £1440m. Development and construction costs you would hope that they could achieve most of... but let's take 80% for safety, to make £1616m. That's £3594 for Current Assets.

Assets = £4044m. Lets round that down to £4bn for simplicity's sake.

Now on to liabilities. These are easy - assume they all apply: £3964bn. Let's round up for simplicitly's sake, and we discover that in the worst-case Taylor Wimpey is worth precisely £0.

Best case
I'm not going to go too mad here, but let's assume the UK housing crash and/or recession don't happen. Prices stabilise at current levels, volume returns to normal. The US and Spain return to normality. Canada and Gibraltar remain robust.

Last year pre-interest, pre-exceptionals was £476m. Slap on some synergies, something for the recovery of the US and Spanish markets, and assume pre-tax, pre-interest earnings of £700m.

Interest payments of 6.5% on debt of £1.5bn (assuming they are not paying interest on payables) makes £100m. They actually paid £122m last year, so that's not realistic, especially since they took on more debt mid-year. Let's assume £150m finance costs, so £550m pre-tax.

Tax at 30% makes £385m post-tax.

Valuing on earnings... I still don't fancy a P/E ratio better than 10, so £3850m market cap. That's about 335p.

Middle case
Now for the tough part :-)

I'm going to make a whole series of assumptions.

• House price decline of 25% over 3 years.
• Volume well down on normal levels, averaging 60% of normal over 3 years.
• Taylor Wimpey cuts costs (they've already announced a 30% cut in staff numbers).
• Synergies are not fully achieved due to cut-back in build activity.

So, currently, on an average house price of about £200k, land costs are £50k, construction costs are £125k, and TW operating profits are £25k. In a tough market average house prices are £150k, land costs are £20k, construction costs are £110k, TW operating profits are £10k.

Current volume is about 22,000 houses per year, so assume a fall to 13,000. That means TW operating profit of £130m. Doesn't cover interest payments, but not too far off. TW depletes land banks to cover interest payments and achieve positive cashflow, paying off debt (cancelling the dividend).

But then: the market picks up. Prices are still subdued, but volumes begin to recover. TW is leaner and meaner. Volume is back to 20,000. Margins improve, so TW is now making £15k per house. Operating profit is back to £300m, which is £180m after interest payments (some debt has been paid back), and £125m after tax.

At a fair P/E ratio of 10, that means fair value is £1.25bn, or a share price of 120p (pretty much where I bought after the dividend was taken into account).

Conclusion

Dividing the future into 5 equally likely quintiles seems a fair way to calculate fair value. So here goes:

• Worst case. 0p.
• Rights issue. Middle cast diluted by 50% =60p.
• Middle case. 120p.
• Not as bad as feared. Earnings of £230m. 215p.
• Best case. 335p.

So that puts fair value as the average of those 5, which is 146p. This is significantly below my previously assessed fair value of 215p, and I am well aware that I'm probably being influenced by the current share price and indeed by the drop since I bought originally.

Comparing to the deciles that I based my previous valuation on, the difference is very much to the downside. Taylor Wimpey's leverage means that a wipeout is a very real possibility. My previous valuation gave it a likelihood of <5%,>

Having said all that, I think today's analysis is very much on the pessimistic side. Who knows whether the correct approach is more or less negative? Time will tell.

In the meantime I think I will happily purchase more at up to 100p (a 30% discount to my 146p valuation).

Portfolio review

I'm getting to the point where I'm starting to run out of spare cash - and that's likely to remain the case for the next 6 months or so. So for the first time I might want to sell some shares in order to free up funds - with due caution about the costs of trading too often.

So, I think it's time for a portfolio review. For each of my shares I will do the exercise of working out the fair price, and comparing to the current price. Some shares I will want to invest more heavily in, and others I may wish to sell off.

RBS. Fair price (post-rights) 330p, representing a historical P/E ratio of 8 and a future P/E ratio of 10 on lower expected EPS of 33p per share (last year 41p). Anticipated dividend of 15p per share, representing a yield of 4.5%. Current price: 245p - a discount of 26%.

ZRX. Fair price 17.5p: a historical P/E ratio of 16, a future P/E ratio of 10 (based on anticipated EPS of 1.9p in 2009). Current price: 10.6p - a discount of 40%.

GNK. Fair price 800p: a P/E ratio of 11. Current price 533p a discount of 33%.

MXM. Fair price 230p: a historical P/E ratio of 12. Current price 135p for a discount of 42%.

TW. Fair price 215p: a future P/E ratio of 10 based on my expected earnings of £230m after the housing crash. Current price: 101p a discount of 53%.

QDG. Fair price 350p: a historical P/E ratio of 16 (on underlying earnings) and a future P/E ratio of 12. Current price 152p a discount of 57%.

EDD. Fair price 45p: a historical P/E ratio of 15 (assuming tax were paid at 30%), and a future P/E ratio of 11.5. Current price 42.5p a discount of 6%.

BDI. Fair price 170p: a historical P/E ratio of 12, and forward P/E ratio (in 2009) of 10. Current price: 138p - a discount of 19%.

High dividend trackers. Still reasonable dividend yield of 4-5%.
IAPD 1792p. IDVY 2395p.

Pure trackers: no idea of fair price.
IEER 2506p. LTAM 1582p. IFFF 2310p.

Summary
All of my shares remain undervalued. Prime candidate to be sold is EDD, but since it forms only a small part of my portfolio and the dealing charges are significant on such small transactions, I think I will continue to hold.

Prime candidates in which to invest further are Taylor Wimpey and Quadnetics. Taylor Wimpey will almost certainly win out since it can be held in an ISA.

The average discount across all my investments is just under 30%.

I hold a disproportionate amount of my funds in RBS, but at a discount of 26% I will continue to hold. I have RBS in two accounts: if it recovers to 297p (a discount of 10%) I will sell at least one of the lots if not both, assuming there are still bargains in the likes of QDG and TW.

Quadnetics - Buy

Per my update the other day, I've just bought some Quadnetics.

QDG - Quadnetics Group - 19/5/08 - 149p - 7.5% of portfolio at purchase price

It may take some time to see a return from these, since I don't expect full-year results to be particularly good. I can wait.

Leisure and Gaming

Another company that I think I may take a small position in: Leisure and Gaming. Its main business is as an Italian bookmakers. I've previously considered William Hill or Ladbrokes, but the price hasn't been attractive enough... LNG is cheap, and hopefully they are about to become quite profitable.

The last two quarters they've made a gross profit of EUR2.1m and EUR1.8m. Admin costs are about EUR1.3m per quarter, so I reckon that's a pre-tax profit of EUR1.3m in 6 months. Let's extrapolate over a year: EUR2.6m is about £2m. They've got so many losses they won't be paying tax for a while, but for the sake of argument assume 30%, giving a net profit of £1.4m.

Their market cap is £6m at 7p. A reasonable P/E ratio for a small illiquid accident-prone bookie like this is, I reckon, 8. £1.4m by 8 is £11.2m. So fair value is 13p. They are definitely cheap.

Quadnetics

I think I will invest in Quadnetics. It's another AIM company and my non-ISA cash is running a bit low, so I'll need to think carefully about whether to fund it from cash or sell some other shares.

Quadnetics
Quadnetics sell and support digital security systems. There are two parts to the business:

• Quadrant Security Group are the service side.
• Synectics provide the software, systems and products.

Turnover

2005: £27m

2006: £50m

2007: £67m

2008 (e): £80m

Profit (underlying, pre-tax)

2005: £2.7m (margin = 10%)

2006: £3.6m (margin = 7%)

2007: £5.3m (margin = 8%)

Dividends

2005: 4p

2006: 5p

2007: 6p

Balance sheet

Strong, no debt. Should have about £7m of cash at year end.

Segments

Services account for £46m of turnover; Products and software £20m. Margins are slightly higher on the products and software.

Most of the sales are currently in the UK, but their North American operation is growing, and they have various toeholds elsewhere.

Prospects

Over the medium to long term, excellent. There are various short term issues that will lead to disappointing profits in 2008, but I see no reason for these to continue longer than that.

They expect turnover of £80m in 2008. Lets assume £90m in 2009, which doesn't seem unreasonable given their growth to date. Margins seem to hover around 7-10%, so let's assume 8%. That suggests pre-tax profit of £7.2m, so £5m after tax.

This company is in a reasonably recession-proof industry, it is consistently profitable, suveillance is clearly a growth industry benefiting from the some significant technical developments. It has had some problems and it seems to have a very heavy management structure, so I'm not going to give it a crazy target P/E, but a fairly modest 12. That suggests a value for the company of £60m.

At a share price of 149p it is currently valued at £25m. In my opinion that's a crazy discount, and I see no reason for it not to move up to 350p for a gain of 140%. And if the market continues to be crazy I have the dividends to comfort me in the meantime.

Must. Stop. Buying. Zirax.

Zirax
So over the weekend I decided that it was silly to sit on the sidelines while Zirax was selling at 12p a share, when I think it will be between 50% and 100% higher in 2 years, with really very little risk. I was hoping I could get some at 11p, but decided if it shot up I'd kick myself for missing out.

Logged on at 8:15am, got a quote for 11.475p. Bargain - I'd been happy to pay 12. Increased the size of my holding by 56% (50% by purchase price).

I noticed Yahoo quoting a bid/ask spread of 10/11 at about 10am, so logged onto my sharedealing account again to take a look. Got a quote for 10.83p, and bought my final tranch of shares. I'm now entirely happy with the number I hold, and won't be buying more unless there is another significant drop (say, to 9p).

Zirax is now 14.6% of my portfolio, my second-biggest holding after RBS:

RBS.L 22.8%
ZRX.L: 14.6%
IAPD.L: 8.9%
IDVY.L: 8.8%
GNK.L: 8.2%
TW.L: 7.5%
MXM.L: 7.1%
LTAM.L: 4.9%
EDD.L: 4.6%
IEER.L: 4.6%
IFFF.L: 4.3%
BDI.L: 3.7%

It's the inaugural meeting of my investment club on Monday 19th. I plan to present on Zirax - it will be interesting to get some other opinions.

Metal Tech
This is an extension to my rambling post the other day about Metal Tech. I'm writing it as I read the annual report.

Revenue up 15%.

Net loss of £375k - £3.8m writedown of Uzmetal, £1.25m writeoff of accidental Calcium Molybdate inventory. R&D up to £1m.

Cash down to £3m (from £8m)

£26m shareholder equity (not counting £1.5m minority interests)

Operating profit down from £8.5m to £6.2m.

"Minority interest" seems to be taking £600k even though the company made a loss. I think that suggests Metal-Tech owns > 50% of a subsidiary, and has fully integrated their income onto their books, but has to pay a percentage of the profit out the other shareholders. All a bit confusing. Why that's on the balance sheet as only £1.5m I don't know...

Woah, no wonder the accounts are confusing... I'm just reading the variety of subsidiaries and joint ventures that Metal-Tech is involved in. It might all be completely legitimate, but it's too confusing for me to understand, and therefore I'd be worried about investing.

So let's have a stab at how much profit it can make... add back in the £5m on writedowns, a bit more for the Mongolia plant coming fully on-stream, let's say £6m profit. "Minority interests" might take £1m of that, so the shareholder would get £5m. On a market cap of £25m, that's a P/E ratio of 5. So it's cheap at least... but I'm not sure that compensates for how accident-prone it is.