Zirax

Zirax dropped about 20% yesterday. Gave me the willies a bit, but there doesn't seem to be any bad news out there. On such a thinly traded stock it can be triggered by one small investor selling up - looks like there was a big trade of about 70,000 shares (which on the latest share price is only £7000!), and total volume of 200,000. Average volume is only 50,000 per day.

This prompted me to investigate the stock a bit further. Clearly I should have done much more research before buying in the first place - as per my post the other day, I should automatically be looking to increase my stake if the share price drops so precipitously for no reason.

So, what value do I place on Zirax?

• Post-tax profit in 2006 was about £1.5m.
• Increased capacity in 2007 should mean profit of around £2m (my own estimate).
• An extra 55k tons of capacity at the new Rosignano factory should mean dramatically increased 2008 profit. My estimate is £3m. I think that's fairly conservative.
• Until their recent acquisition they had a cash pile of about £4.5m. The acquisition price is based on an "earn-out" which I think means they don't have to pay up immediately. They are taking on some debt, and paying an initial fee, but I think they should still be sitting on several million £s.
• All their profit will be reinvested for the moment, and as above this should be significant. This gives them a strong engine for growth.

Downside:

• Russian company. Woah - must be a bit dodgy.
• Not sure how open they are to competition.
• It's difficult to increase profits without capex in new factories or acquisitions.
• Not many shares in private hands (<10%)

So what sort of value does this suggest for the company? I think £30m is reasonable. That would suggest a P/E ratio of about 15 this year, 10 next year. We don't want to go too mad. After the latest drop its market cap was £17m, so a discount of >40%. I bought in at a discount of ~20% - not too bad, but perhaps a bigger margin for error would have been nice.

I will think seriously about buying more at this price.

Footnote: here's the latest performance of my portfolio. I've added a red line adjusting for stocks that are ex-dividend but for which dividends have not yet been paid (currently RBS).

Patience Grasshopper

I think I've been letting my exuberance get the better of me recently. Luckily the recent jump in prices put a brake on things for a while, so I haven't made any investments I might come to regret.

Here are a couple of reasons why I think I've been letting the excitement of investing get the better of me.

Bond International Software
Yes, back to that old chestnut. It's down about 20% when I bought it. And I've been thinking: "should I cut my losses" rather than "I should buy more". If I even need to ask myself the question, then I shouldn't have bought in the first place.

In contrast, when RBS was down 25%, I bought some more - the only reason I hesitated and/or didn't buy more was that I thought it might go down further and give me a better opportunity. I know enough about the company that I'm certain that it's undervalued and a lower share price only gives me a better buying opportunity.

I'd be gutted if RBS doubled in price tomorrow, because I want to buy as much of their stock as possible. I'd be over the moon if BDI did, because I want to make a profit on it and get out.

In future before I buy any shares in a new company, I'm going to ask myself the question: "how will you feel if the share price falls 25% tomorrow? Will you buy more?"

Shell vs GlaxoSmithKline vs Taylor Wimpey
My method for comparing companies in different industries has been quite haphazard. I've basically been picking a P/E for an industry - high for stable low-risk industries such as beverages or supermarkets, and low for cyclical higher-risk industries such as banks or housebuilders. However, there are other fundamental differences which need to be taken into account, and which I don't think I've been rigorous enough in calculating.

RDSB, GSK and TW are all well-established companies on a good underlying P/E ratio. However, I would still expect a decent rate of growth from any of them - at least keeping up with inflation and preferably outpacing it by a fair margin. So where will that growth come from?

• GSK spends £3bn per year on R&D. It has a strong pipeline of drugs in development. It needs this R&D just to maintain its position, but we can also expect decent growth over time.
• Shell spends £13bn per year in capital expenditure to maintain and grow its future oil production.
• Taylor Wimpey is currently depleting its land bank to generate cash, but over the cycle it should maintain/grow the size of its land bank.

Now comes the interesting bit: GSK funds R&D out of costs. GSK made £5.5bn last year, bought £3.75bn worth of its own shares and paid £2.8bn of dividends. It also borrowed in order to invest: £1.5bn in property/plant/equipment and £1bn in acquisitions (mainly ID biomedical at about £900m). But mostly that juicy profit is there for the benefit of shareholders - it doesn't need to be reinvested in order to secure growth.

Shell, on the other hand, counts £6.5bn of its investment against depreciation and depletion, but the other £6.5bn comes out of its profits. It's expected to keep that investment up for years to come, and will see the benefit over the very long term. If it wasn't investing like this, its oil production would be declining.

Taylor Wimpey presumably passes land prices straight on to housebuyers, so the value of its land bank can increase with inflation without any additional investment. Growth is possible by simply buying more land - not nearly as speculative as pharmaceutical R&D or oil capex.

Now, after all that, which is better value, GSK, RDSB or TW? I don't know - and yet I've been pontificating about their discount to my valuation. More research required - and more number crunching.

Bear (Stearns) Rally?

Ho ho ho. First trading day after being amazed at how many bargains are out there, and there's a pretty substantial jump in all the stocks I thought were cheap:
TW: up 12%
RBS: up 9.3%
WMH: up 6.75%
TPK: up 6%
LAD: up 5.5%
RSDB: up 2.5%

So is this the end of the bear market? I don't think so. TW is up on better than expected US housing data, but I'm still pessimistic on the UK housing market, so I think that's only temporary. RBS is up on the Bear Stearns bailout being raised to $10 per share - that could well be a permanent rally in bank stocks. No idea why WMH and LAD are up. TPK is clearly following the housebuilders. No idea about RDSB - just bouncing back after a pre-easter fall?

I think:

• House prices will fall in the UK over the next 2 years.
• The UK will go into recession over the next 2 years.

Based on that opinion, I think we haven't seen the bottom for TW, TPK, WMH and LAD. I could well believe that RBS has seen its lowest price this year, since it is ridiculously oversold. I have no idea about RDSB, but it's still cheap even after today's bounce (30% discount to my valuation).

I think I will wait and see. At a 40% discount things will just be too tempting, but at 25-30% I'm happy to wait.

More prospects

I've been looking at a few other potential prospects, so I thought I'd note them down here. I'm not yet wholly convinced by any of them, but they all look cheap right now.

TPK: Travis Perkins. The share price on this one has been in steady decline for about a year, presumably over concerns about falling house prices. It's almost a straight line decline (on a logarithmic chart) for the last 10 months. Almost enough to make me a Technical Analysis convert. Looking at the fundamentals, it's clearly vulnerable to a housing market crash and/or a recession causing lower demand, and has a medium-sized heap of debt. It's on a P/E of 7, yield of just under 4%. They're still expanding, opening new stores. I'm guessing they have pretty high fixed costs, so could end up making a loss in a severe downturn, but otherwise things look pretty solid. It's currently on 967p; I think 1250p would be a fair price, so a discount of 25%. I don't believe in TA, but.... just this once I'm going to keep an eye on the chart and try to time the bottom. Let's see if I regret it.

LAD & WMH: Ladbrokes and William Hill. Now I wouldn't normally lump in two companies in the same boat, but I crunched my numbers on these two and decided that they're identically good value (at LAD 284 and WMH 348). I put a fair price of 400 and 480 on them, which means they're trading at a 30% discount. Interesting. I believe that historically bookmakers have done reasonably well in a downturn, so a looming recession shouldn't be too much of a concern. However, they're both quite old-fashioned compared to the likes of BetFred and Paddy Power who are rapidly stealing market share and are clearly more competent on the internet side of things. Paddy Power, interestingly, doesn't carry any debt, while WMH and LAD have a fair amount (nothing too worrying though). Ladbrokes benefited last year from some quite stupendous profits from "Telephone High Rollers" which I can't imagine will be sustainable, so I've assumed that their earnings will fall. William Hill is in the process of replacing its proprietary internet platform with something built on a standard platform, so I'm expecting an improvement there offsetting a recession-linked decline in shop-based profits.

So, some more prospects for me to consider. I've continued to research my other prospects and come to the conclusion that Taylor Wimpey and Shell are the two best value at the moment, trading at a discount to my valuation of 36% and 32% respectively. (My latest top-up of RBS at 305p was at 34%). I can see TW getting cheaper over the next 6 months to a year. I can't fathom Shell at all (the soaring oil price doesn't seem to be doing them any favours) so won't try to make predictions.

GSK and MKS still look too expensive. Yell looks cheap (even after assuming a 20% chance of complete wipeout due to their debts) but not cheap enough at a 16% discount to my valuation.

5% down

As you can see from my little graph, I'm currently just over 5% down across my entire portfolio. Given that I made my first purchase only two months ago, that's pretty steep! In terms of total return I'm actually doing better than that - about 4% down - due to the impending RBS dividend payment.

The question is: should I be happy or unhappy about this? The answer depends on whether I am fully invested, and whether I plan to sell out soon. I'm not, and I don't, so falling share prices are good. It means my future purchases will cost me less. That's assuming, of course, that the drop is based on rumour or short-termism rather than the prospect that future earnings will be less.

I've recently updated my python script to give me a snapshot of my portfolio breakdown. The numbers I posted the other day were based on purchase price - here they are by current value:

Emerging ETF: 19.7% (IEER, IFFF, LTAM)

Chemicals: 6.0% (ZRX)

Finance: 34.4% (RBS)

High yield ETF: 26.8% (IAPD, IDVY)

Software: 13.1% (EDD, BDI)

In terms of future purchases, I'm debating:

TW: Taylor Wimpey. The share price is low for various reasons: the current US housing market, the prospects for the UK housing market, its relatively high level of debt and an inferior operating margin to its peers. However, I think things have been overdone. I only haven't bought so far because I think it could go lower - I think a UK housing crash is in the offing, and that might give me a better opportunity in the future. I think anything below £2 is pretty good value. They were at £1.51 the other day. I should probably stop dithering and just buy. I've satisfied myself on the financial side. Might be my first purchase in the new tax year.

RDSB: Royal Dutch Shell. They are making huge piles of cash and giving them straight back to the shareholder via dividends and buybacks. I think a long-term high oil price will do them a lot of favours. My concerns are that they are heavily involved in Russia, and the government can cause a lot of trouble for them. I don't understand their business well enough yet, but I think they look good at the current price of £16.

GSK: GlaxoSmithKline. Another one making oodles of cash and giving it all back. Their R&D prospects also look good. Two problems: I haven't yet researched them enough, and I don't think they're quite cheap enough. I'd like to buy at about £9.50. That may or may not materialize - I suspect it would take some seriously bad news to drive them below £10.

MKS: Marks and Spencer. I think they have a very strong brand, and the prospects of decent earnings. They briefly looked attractive at about £3.50 a share, but have since gone up again. I think anything below £3.70 looks pretty good. I need to look in more detail at their financial reports before I would buy though.

YELL: Yell Group. I don't really want to touch this one with a ten foot bargepole due to its mountain of debt, but it's getting cheaper and cheaper. I think the plummeting share price might have been overdone. I certainly won't be buying without a lot of research, and only in the full knowledge that a complete wipeout is possible. Superficially I think £1.40 is reasonable, but that's only based on a cursory glance at the numbers.

Diving into turbulent waters

I bought shares in two tranches today, under very different circumstances.

High yield ETFs
Last week I arranged to invest in two sorts of high-yield ETF: IDVY (Europe) and IAPD (Asia-Pacific). The trade was executed on a fixed day to keep commission charges low. These ETFs are mechanically traded, and have reasonable charges (<1%). The main thing I'm looking for is geographic diversity. Before buying these 70% of my portfolio was invested in UK stocks. I don't have the time to research companies all over the world - the UK occupies all the time I'm prepared to spend researching shares. I like the idea of high-yielding shares, especially in the current market mood - I think they have a certain amount of downside protection. Mechanically traded ETFs and trackers appeal to me more than actively managed funds, mainly due to the low commission.

I expect to invest more in these two ETFs in the future - this is just the first chunk of investment.

Royal Bank of Scotland
Yes, again :-) Since seeing the share price plummet from just under £4 when I made my last investment, my fingers have been itching to pick up more. It's gone ex-dividend since then, which means my previous purchase price was effectively £3.76. Today it dropped down to £3.05 due to the concerns about Bear Stearns, and at this point I pulled the trigger. This was not a planned trade, but as soon as I heard the Bear Stearns news I thought there was a possibility of Mr Market giving me a good price.

Mr Market is clearly worried by the Bear Stearns fiasco, but I am not. I believe my valuation of RBS already takes into account the downsides, and RBS is a very different beast from Bear Stearns. I think there are three points that give me confidence in RBS:

• It is well diversified. There is less chance of a total wipeout, since it is very unlikely that all of its divisions will simultaneously lose money, or that one or two will lose enough to overwhelm it.
• It has assets that it is the process of disposing of. These will strengthen its capital position significantly.
• UK banks do not have to mark-to-market in the same way as their US counterparts. RBS will not have to declare massive writedowns due to the vagaries of the market, and therefore it is unlikely that other banks will become spooked enough that they will stop lending to it.

My risk-weighted valuation of RBS puts it at a market cap of about £50bn. Mr Market values it at about £30bn. I like that margin.

In £ terms, my latest investment in RBS is half of my previous total. In terms of shares, it's about 64% due to the drop in price. I have the same amount again waiting in case the market goes even more crazy over the next couple of weeks. In the new tax year there is a whole lot more coming on stream.

Summary

(all percentages are at cost price)

IDVY - European high-yield ETF - 17/3/08 - 2208p - 12.5% of portfolio

IAPD - Asia-pacific high-yield ETF - 17/3/08 - 1616.8p - 12.5% of portfolio

RBS - Royal Bank of Scotland - 17/3/08 - 305p - 12.5% of portfolio, for a total of 37.5%

So the cost-price make-up of my portfolio is now:

• 12.5% small-cap UK software
• 6.25% small-cap UK-listed chemicals
• 18.75% emerging markets ETFs
• 25% high-yield international ETFs
• 37.5% Royal Bank of Scotland

Our survey said...

So the RBS results are out, and it's time to see how my predictions turned out. Basically things were pretty much as I expected, except for the subsequent behaviour of the share price.

I predicted:
Some further, relatively minor, writedowns due to subprime or similar. Less than £1bn.
The results say:
The annual report doesn't make this as clear as I would have liked, but I think I'm right in saying that there were further writedowns, but these were not much higher than those already reported. There was a "reduction of £978 million in the carrying value of financial instruments we acquired" from the purchase of ABN Amro, which I hadn't predicted. On the other hand the sale of Thames Water brought in over £1bn in exceptional profit.

I think I'll chalk this one down as a near-miss, since it sounds like total additional writedowns were over £1bn.

I predicted:
Record profits
The results say:
Record profits

I predicted:
A moderate increase in the dividend
The results say:
Total dividend up 10%.

I predicted:
Confirmation that a rights issue is not on the cards
The results say:
Only referred to fairly obliquely, but core tier 1 capital was reported as 4.5%, which is close to the regulatory limit of 4%, but not dangerously so. There were some reasonably reassuring words about "rebuilding" the capital ratio, and mentioned hte profitability of ABM Amro as a factor that would help that - suggesting to me that retained earnings and asset sales would be the most likely route to rebuilding capital ratios.

I predicted:
A subsequent jump in the share price, probably settling at about 425p.
I got:
Obviously predicting share prices in the short-term is a mug's game, and I'm already regretting I made any prediction on this one. We had an instant jump to 425p, followed by a steady decline to 385p.