Shareworld

I've been writing this blog for almost 2 years, and recently some people have even started reading it! I've mainly been writing it for my own benefit: doing so obliges me to justify my decisions rationally rather than emotionally, it stops me rewriting my past decisions in the light of events, and it provides a record that I can refer back to when analysing my mistakes.

I intend to continue maintaining this blog, but my writing may become slightly less prolific, since I am now also writing for shareworld. Every trade I make will still appear in this blog, since I think it's important that I keep this as a complete record, but I may now provide links to shareworld articles rather than providing all my reasoning here.

So far on shareworld I've written on Investment Goals, Random Walking, and a reaction to today's dividend declaration by Carpathian.

Lloyds Rights issue

I no longer hold any Lloyds shares directly, so I haven't personally had to make a decision on the rights issue. However, I am a member of an investment club that invested in Lloyds mere weeks ago (with the full knowledge of the capital raising) and the decision of the club was to execute a tail-swallow.

My personal interest was piqued by some of the recent articles on this topic. In particular Patrick Hosking in the Times argued in favour of taking up the rights because he could easily see Lloyds treble or quadruple in value over 10 years (http://business.timesonline.co.uk/tol/business/columnists/article6945355.ece).

I was sceptical. Since Mr Hosking didn't quote any numbers to back up his argument, I thought I'd do the exercise myself.

Post-Rights issue Lloyds will have 63 million shares outstanding. At the current price of 56p that's a market cap of £35m. They are raising £12.5bn of capital, added to their existing tangible book value of £30bn gives a new tangible book value of £42.5bn. So they currently trade at a P/TBV of 82%.

Let's assume:

• Lloyds pay no dividend for 10 years.
• Lloyds earn a RoE of 12%.
• At the end of 10 years Lloyds trade at a P/E ratio of 12.

That means that Lloyds will be trading on a P/TBV of 1.5 at the end of 10 years.

The compounding effect of retaining all those earnings mean that Lloyds' TBV at the end of 10 years will be £132bn, and therefore its market cap will be about £200bn, for a share price of 317p.

Even if we assume that Lloyds pay out a third of their profits as dividends, that would still suggest a share price of 218p, or pretty much a four-fold increase over 10 years.

So in conclusion, to my surprise, I think Mr Hosking has a good argument.

LLPC - Doh!

http://investegate.co.uk/Article.aspx?id=200911230700028997C

Says it all really. Missed out on ECA by one place, and ECN by 5. LLPD made ECA, which is frustrating - I deliberately went for LLPC because it was higher placed in the ECN list.

Enhanced Capital Notes - final decision

OK, the last time I posted I was choosing between taking ECN or ECA for LLPF. I've made my choice, and I've.... sold LLPF at £686.50 and bought a similar amount of LLPC at 71.5p, then chosen ECA followed by ECN.

My reasoning is:

• LLPF might have qualified for ECA, in which case I would only have got £13.50 per share more than the current bid price.
• LLPF might not, in which case I would get Enhanced Capital Notes with a yield of about 14%, with the downside of conversion.

On the other hand with LLPC the possibilities are:

• It qualifies for ECA at 94p, in which case I take a quick 30% profit.
• It qualifies for ECNs with a yield of about 16.5% - if these equalize to the LLPF yield then that's a quick profit of 15%.
• It doesn't qualify for either, in which case I'm left with a yield of 10.1%, after accounting for 2 years of skipped dividends. But I'm not exposed to conversion downside. And there is the potential upside that if LLPC did not participate in the tender Lloyds may take pity and make a later offer - you can certainly imagine a lot of disgruntled retail holders.

I'm satisfied with this position and I've registered my choice of Option 4: ECA then ECN.

Enhanced Capital Notes

My broker has confirmed that I can hold Enhanced Capital Notes in my sharedealing account, so I have the full range of options as my disposal.

Contrary to my earlier post, I'm now considering taking the cash option, with ECNs as my second choice, and investing the cash in NWBD. The current yield on NWBD is 11%, with the potential upside that they may trade significantly higher than their current 80p. The prospective yield of the ECNs (vs the cash alternative of £700) to maturity is 14%, and there is the potential downside that they may be converted.

I suppose the ECNs could approach par well in advance of the maturity date, so I'm not really comparing like with like...

Hmm. I have a week to decide. I think I'm definitely going to apply for both exchanges, I'm just not sure in which order.

NWBD

NWBD dipped just below 80p today, and I bought a chunk at 79.5p. The terms and conditions provide for the dividend being passed at the directors' discretion, but provided there are sufficient reserves it will be paid in new NWDB shares instead, at a ratio of 4/3 - fine by me.

RBS might tender for NWBD, or might not. I don't mind taking a quick profit, or holding for the long run. RBS might continue paying the dividend in cash, or decide to pay in new NWBD shares. The economic result is much the same.

NWBD now forms just over 5% of my portfolio. By comparison LLPF is 8.1%.

Lloyds tender offer

Slightly drunken update:

Today Lloyds unveiled their long-anticipated offer for holders of preference shares. There were hundreds of pages to wade through, but the essentials as far as I can see were:

• I can exchange my LLPF for cash or the equivalent in ordinary shares at a price of £700. That's vs a face value of £1000, a current price of £600 and a purchase price of £280.
• Institutional holders can exchange for "Enhanced Capital Notes", i.e. contingent capital notes, but since I don't have access to the clearing system these are unavailable to me.
• There is a limit of £1.5bn that will be paid in cash/shares. LLPF is 6th out of 52 in the hierarchy of who gets to share.
• If I don't take up the offer I lose 2 years of dividends and the likelihood is that LLPF will not be called in 2015 (from the RNS announcing the exchange offer: "It is the current intention of the Company that any decision to exercise capital calls in any Existing Securities that remain outstanding following the Affected Period and which belong to a class or series of Applicable Securities, will be made on an economic basis. ").

LLPF continue to trade at around £620. If I was an institution I have to say I'd be snapping up the Enhanced Capital Notes (ECNs). The downside is clearly a conversion to equity at an unfavourable time, but frankly I can't see another major bank capital crisis in the next 10 years (until the series 1 ECNs mature - others mature later).

So I think my choices are:

• Accept the tender at £700. They may or may not accept - but I have a good chance, being ahead of most of the securities being tendered for.
• Keep LLPF, suck up the 2 years missed dividends and keep fingers crossed for a call at par in 2015.
• Sell in the open market - where my slightly vain hope is that the institutions recognise the value of the ECNs and bid up the LLPF share price.

I think I'll keep my fingers crossed that the tender at £700 is accepted. A 150% profit in ~6 months is not to be sneezed at.

Update 7/11/09:

To make a decision I need to value LLPF vs ECN vs £700.

My assumptions are:

• LLPF will skip 2 years of dividends, then will pay 6.0884% until 2015, then will pay LIBOR+1.131%. It will not be called. LIBOR will be approximately 5%, and therefore this security will effectively pay ~6.1% perpetually after a two-year hiatus.
• The ECNs will not convert into common equity in the 10 year period that they are outstanding. They will pay 7.5884% for 10 years and then be redeemed at par.
• I will use a discount rate of 10%. NWBD is currently available with a yield of ~11% and is close to risk free.

As discounted cash flow analysis values the ECNs at ~£810, LLPF at ~£500. So my choices in order of preference are:

• Accept the offer of ECNs. It's not yet clear whether I can hold these with my current broker.
• Accept the offer of cash / shares to the equivalent of £700.
• Sell in the market at ~£640.
• Keep LLPF at a value of £500.

Zirax

A month ago I said about Zirax: "They do look quite cheap in terms of assets and potential earnings, but I'm giving up hope of the value ever being realised. At about 6p per share I'm probably out."

Well in the space of a few days last week, the price jumped from 3p to 6p. I'm not out yet, but I came very close yesterday (couldn't get a quote online, or set up a limit order - useless bloody stockbrokers).

Market cap: £10.7m = $17m
Earnings: loss-making / negligible
Revenue: around $33m
Shareholder equity: $19m - and the auditors won't sign off on $3m of that.

Zirax's balance sheet shows $6m cash and $6m of short-term borrowings. That seems to back up the auditor's opinion that not all that cash is genuine. Zirax seems to do business with Incarobank, which is under common control - this suggests that the majority owners of Zirax and Incarobank have siphoned off cash from Zirax to support the bank.

This is all extremely dodgy, and at a P/BV of around 1, I think I'm going to extricate myself from this situation and put my money somewhere a bit safer.

Update 26/10/09
Sold Zirax this morning at 5.75p, about 50% below my average purchase price. I can make use of the capital loss this year, so I was always going to sell before the end of of the tax year - and with no faith in the management I see no reason to wait.

Portfolio review

It's been a while since I took a look at my portfolio. The market has done well, and I'm in substantial overall profit. I'm not sure the market as a whole is tremendously cheap, but nor does it seem obviously overvalued.

In general I am happy to hold onto a fairly-valued share in a great company. But once a share in an average or mediocre company reaches fair-value, that should be the time to sell. So when looking at my portfolio I need to look at the quality of the company as well as the value of the share.

BRK-B: 9.6%

I am convinced by the intelligence, honesty and talent of Buffett and Munger, and would put Berkshire in the top rank of quality.

I recently assessed Berkshire's B-share value as being around $4000. Currently at $3270; I am up 40% in $ and 20% in £, but I will hold to $4000 and beyond.

IEEM.L: 8.8%
IAPD.L: 8.8%
IDVY.L: 8.0%

Relatively low-cost trackers, in markets that I think should do reasonably well in the long run.

I anticipate a yield of around 1.8% on IEEM and 3.6% on IAPD and IDVY. Considering I'm paying 1.24% on my mortgage, I'm satisfied that the value here is OK.

LLPF.L: 7.0%

A preference share, so the calculation here is different. I think Lloyds has made a huge mistake in acquiring Halifax, but with the help of the UK government it has built a large buffer of common equity and is in the process of reducing exposure to its most risky assets. From a capital safety point of view therefore, I'm satisfied that these are safe.

Looking at security of dividends, I think the key uncertainty lies around possible interference from the EU. Lloyds are unlikely to want to rock the boat, and given the UK government's enormous shareholding they are in that same boat.

On the other hand there is the potential upside of (a) Lloyds tendering for the preference shares eary, at, say, 75% of face value (currently trading at 53%), or (b) Lloyds calling the shares in 2015 at face value, giving a running yield of 25%.

If there is a tender offer at about 75% I am minded to accept, but for now I am happy to hold.

NXT.L: 6.6%

Next have a powerful brand and a UK-wide presence. They have an excellent RoCE and RoE, wide margins, moderate debt (approximately 2 years' post-tax profit).

Current yield is 3%. P/E ratio is around 12. Not as good value as when I bought it (at a P/E ratio of around 7) but certainly not excessive.

DGE.L: 6.1%

They have an excellent collection of brand names, which allows them excellent RoCE, RoE and margins.

Currently on a P/E ratio of almost 15, and a yield of 3.75%. Not cheap, but perfectly adequate.

SLXX.L: 5.9%

Most of the holdings in this ETF look pretty secure. It's heavily weighted towards the financial sector, but given the amount of government support in this area I don't expect any defaults.

On a running yield of about 6%, compared with the base rate of 0.5%, I'm happy to hold.

BATS.L: 5.3%

Excellent brands, good RoCE, RoE and margins.

On a P/E ratio of 16 and a yield of 4.27% it's not cheap, but not bad.

NG.L: 5.2%

I don't think I really have a good grasp of how safe National Grid's operations are. I'm hoping that they have extremely predictable revenues, and therefore their high leverage is sustainable. But there could be risks here that I'm failing to appreciate.

On a yield of 6% they are reasonably cheap, even if it does come off a P/E ratio of 16.

GNK.L: 5.1%

A decent company, with a mountain of debt. However, the debt is structured very favourably to Greene King - the have a secure source of funding for decades, provided they continue to meet the covenants on the debt.

Price/free-cash-flow of about 9. Reasonably cheap, if you ignore the debt. Expected yield of about 3.5%, covered about 2.5 times by free cash.

Market cap £950m, debt £1.6bn, so EV = £2.55bn. Earnings before interest payments are about £230m, minus tax at 30% = £160m. So on a debt-free basis Greene King would be on a P/E ratio of about 15. Expensive, but in fact in the current climate the structure of their debt is an asset, and means they are benefiting from cheap leverage.

GSK.L: 4.9%

Decent big pharma company, moderate debt. Pharmaceuticals face some headwinds at the moment, but I can't see Obama's plan making a significant dent in US healthcare spending.

P/E ratio of 13.6, yield of 4.7%.

TSCO.L: 4.8%

Tesco is the dominant supermarket chain in the UK, and is growing rapidly abroad. They continue to leverage the Tesco brand in non-food and financial areas. An excellent record of growth, superb margins (for a supermarket) and a good RoE and RoCE.

P/E ratio of 14, yield of 3%. Pretty cheap as far as I'm concerned. Definitely happy to hold.

BDI.L: 3.2%

Operate in a crowded marketplace of recruitment software. Seem to be decently run, but their accounting methods mean that profit is significantly higher than free cash flow.

They trade at a P/E ratio of about 10, but Price/Free-cash-flow of about 14. Not disastrous by any means.

BARC.L: 2.8%

Barclays have weathered the storm better than RBS and Lloyds. I have my doubts about the integrity of upper management, so I'm not sure this is a place I want to be in long-term.

Barclays now trade at about 1.1x book value. Reasonably close to fair value I reckon.

MXM.L: 2.4%

Maxima is the opposite of Bond. Their high amortization charge hides a stonking free cash flow performance.

Currently on a Price/Free-cash-flow of about 5-6. They look very cheap.

CPT.L: 2.4%

Carpathian seem to be a perfectly adequate, highly-leveraged property company. I'm not looking to hold them for the long term - this is a short-term play on them realising the value of their assets.

I reckoned Carpathian was worth about 40p per share a while back, after taking into account a fairly dismal performance from their property portfolio, but the strength of the euro probably means that that is now an underestimate. Let's say 50 euro cents, compared with their current price of 27 cents.

And while I'm waiting for value to out, they should generate cash.

QDG.L: 2.0%

Quadnetics doesn't seem the best-run company in the world. I think I'm looking for a way out.

On a dividend yield of 4.7%, a P/E ratio of 7-8, they do look pretty cheap. But if the price moved up to ~200p I think I'd be looking to sell.

ZRX.L: 1.2%

Zirax seem to be very poorly run. Letting a couple of Russian banks abscond with all your spare cash is not the smartest move.

They do look quite cheap in terms of assets and potential earnings, but I'm giving up hope of the value ever being realised. At about 6p per share I'm probably out.

Conclusion

I don't think anything in my portfolio is screaming to be sold on value grounds. There are some elements of the portfolio I'm not entirely happy with, but I don't see a pressing need to act.

Total systems

I've been having a look at a tiny company listed on the main exchange: Total Systems. Its profit record is patchy, but its share price is underpinned by a fantastic balance sheet.

Current assets
Trade and other receivables £1.45m
Cash at bank and in hand £3,35m

Non-current assets
Property, plant and equipment £0.9m (but see below)

Current liabilities
Trade and other payables £0.99m
Current tax liabilities £0.18m

So according to the balance sheet this company is worth £4.5m. However, they own outright a 6600 sq ft office in Central London, EC1. This is listed on the balance sheet at cost of £742,000. It was bought in 1987, and property prices have increased somewhat since then! I found a property nearby, 50% larger, on the market for £4m. That would suggest a value for Total Systems' office of around £2.7m.

Property in this area can be rented for around £27.50 per square foot. A 6600 sq ft property would therefore cost £180,000 per year. The long-term average commercial property yield is 6.4%, which would translate to £2.8m.

Let's have a stab at their being around another £2m of hidden value on their balance sheet. Not to mention their intangible assets - none of their R&D appears on the balance sheet, and they are carrying no good will.

So it looks like Total Systems have around £6.5m of tangible assets, no debt, and presumably some intangible assets to boot. The market capitalisation is £2.5m at Friday's close of 23.5p.

US shares

In January I am able to cash in my dollars. This means two things:

• I am no longer heavily exposed to the US dollar.
• I have a lot of cash available to invest (enough to increase my share portfolio by around 50%).

So the US stock market becomes a viable place to invest. Previously I've limited myself to buying Berkshire Hathaway at the irresistable price of $2380. At $3540 I'm up 50% in $ terms, but in £ I'm only up 25%.

At the moment I'm agnostic as to whether the US market is good enough value to be worth investing in. But rather than decide in January, I think it's worthwhile starting to investigate the possibilities now, and keeping an eye on how things move over the next 6 months.

Dividend tax

I'll be taxed 15% on any dividends paid by US companies. While I live in the UK (and have a wife paying basic rate tax) that's a significant disadvantage over buying UK shares. But once I move to Norway I'll be lumbered with some dividend tax no matter whose name the shares are held in - and the US witholding tax will be offset against the Norwegian liability.

There seems little point targeting high-yielding shares (although I don't rule them out).

S&P fair value

Based on historical earnings and P/E ratios, fair value for the S&P 500 is about 900. It's current trading at about 1000, so is moderately overpriced at the moment. I'm not averse to investing at these sorts of levels, but I will be selective.

Possible candidates

A few different sorts of investment appeal:

• Good quality blue chips beaten down by the market. General Electric springs to mind here, but there are undoubtedly others.
• Large-cap growth shares that are reasonably valued. Buffet-type shares: Johnson & Johnson, Coca-Cola?
• Technology shares, if they are reasonable valued. Google, Microsoft, Amazon?
• Corporate bonds - a decent yield, US$ exposure, and adding some diversity to my portfolio.

One investment I'm definitely excluding: US treasury bonds. An uninspiring yield, and a vast programme of money-printing by the Fed: not a good combination in my view.

Google

Let's take a look at Google first:

Net tangible equity: $22bn

Revenue: ~$22bn

Post-tax earnings: ~$6bn

Dividends: No

Selecting info from their latest 10-Q:

"as of June 30, 2009, our two founders and our CEO, Larry, Sergey, and Eric, owned approximately 90% of our outstanding Class B common stock, representing approximately 68% of the voting power of our outstanding capital stock"

"We currently intend to retain any future earnings and do not expect to pay any dividends in the foreseeable future"

How enduring is Google? I'm sure it will be around in some form in 10 years time, but it relies largely on having a large share of the search market. I think it could be displaced by Microsoft - Microsoft can leverage their dominance of the OS and browser markets to drive search traffic through their own site.

What is a fair value for Google? They dominate a fast-growing highly profitable market, have an impeccable financial strength, a strong history of earnings and revenue growth, wide margins, and a powerful brand.

On the other hand, we should not get too carried away. Google will likely face increased competition in the future; their margins and growth will come under pressure. The future of the internet is inherently unpredictable. They are not run for the benefit of ordinary shareholders. Their earnings could very easily be frittered away on unprofitable acquisitions, or simple hoarded, benefiting shareholders very little.

I think a reasonable P/E ratio is around 20, which equates to a market cap of $120bn vs their current market cap of $144bn (at a shareprice of $457).

So Google is a little overpriced at the moment. I'd say $380 is a fair price.

Microsoft

Net tangible equity: $26bn

Revenue: ~$58bn

Post-tax earnings: ~$15bn

Dividends: 52c per share (yield: 2.2%)

I would say that Microsoft have a more secure revenue stream than Google, but without the same growth potential. They return a large part of their income to shareholders via share repurchases and dividends - in the last year about 1/3 to dividends and 2/3 to buybacks.

I would say a fair P/E ratio for Microsoft is a little lower than that of Google: 18. That is a market cap of $270bn, which is a share price of ~$30. That compares to their current share price of $23.50 - so I'd say MSFT is undervalued.

Amazon

Net tangible equity: $2.2bn

Revenue: ~$19bn

Post-tax earnings: ~$600m

Dividends: No.

So, what is a fair value for Amazon? They dominate a sector of online retail, they have a tremendous growth record and the prospect of continuing it into the near future. Their size gives them strong purchasing power and fantastic economies of scale when it comes to distribution. I'd say a P/E ratio of 20 is reasonable. That's a market cap of $12bn, or around $28 per share.

Their current share price is an astonishing $85. Assuming that eventually their growth rate will moderate to ~10% per year, and at that rate they justify a P/E ratio of 20, that means their current 30% growth rate must continue for another 4.5 years. I reckon I can get a 10% return on plenty of other shares, so applying a 10% discount stretches that required growth period out to about 7 years.

Amazon's net profit is around 3% of revenue. If that continues to hold true, then in year 7 their revenue will have to be $125bn. That compares with:

• Walmart $400bn
• Carrefour $140bn
• Tesco $80bn

So to justify their current share price, we are looking at Amazon leapfrogging Tesco to become the world's 3rd biggest retailer - without selling any consumer staples. Or, alternatively, they may start to achieve a better margin, improving profitability and boosting their share price. That seems more likely - but can they do that and continue to fight off competition?

There is way too much growth factored into Amazon's share price.

General Electric

Net tangible equity: $8bn

Revenue: $183bn

Post-tax earnings: $18bn (allegedly - but they somehow only paid $1bn in tax!)

Dividends: $1.24 (yield: 8.3%)

GE is a behemoth. Their growth in the recent past has been driven by GE Capital Services - the financial crisis has rather put the skids on that one.

Their earnings for the first half of 2009 are down on 2008. This year they might earn ~$12bn. On those reduced earnings I'd be prepared to put a P/E ratio of 15 on them. That's a market cap of $180bn, a share price of $18.

They current trade at $14.70 - they look reasonably cheap.

Johnson & Johnson

Net tangible equity: $15bn

Revenue: $64bn

Post-tax earnings: $13bn

Dividends: $1.795 (yield: 3%)

Johnson & Johnson don't have a great deal of debt: $12bn, easily covered by one year's earnings. About 17% of their earnings come from consumer healthcare; the remainder is split fairly evenly between pharmaceuticals and diagnostic devices.

JNJ's growth comes from (a) R&D, which counts as a cost and therefore reduces profits, and (b) acquisitions, which are paid for out of earnings. Their is a constant rate of attrition as their drugs lose their patent protection and suffer from generic competition.

JNJ increase dividends by around 13% per year. Their dividend cover has remained consistent at around 2.5 times.

Their gross margin is constant at around 70%, so their growth has not come from squeezing margins.

The split of sales between the US and international has remained roughly equal. So the growth is not wholly dependent on rampant US healthcare expenditure.

Long-term debt is constant at around 10% of assets, so growth has not come through leverage.

All of this is quite impressive. A consistent 13% growth rate is not to be sneezed at. It can't be maintained forever (because JNJ would take over the universe) but there seem few signs of it moderating yet.

I'm going to give JNJ a P/E ratio of 16. That puts fair value at $73, or a market cap of $210bn. They current trade at $60, so JNJ are somewhat undervalued, in my opinion.

Coca-Cola

Net tangible equity: $8bn

Revenue: $32bn

Post-tax earnings: $5.8bn ($6.4bn underlying)

Dividends: $1.52 (yield: 3.1%)

What is there to say? Coca-Cola dominates the non-alcoholic beverage market. Most of its revenue now comes from outside the US, primarily from emerging markets. Its tremedous return on equity means that it can grow successfully while distributing most of its earnings as dividends.

I would give Coca-Cola a reasonable P/E ratio of 16. Multiplying by the underlying earnings of $6.4bn that gives a market cap of $102bn. With 2.3bn shares outstanding, that gives a fair price of $44 per share. They currently trade at $49, and therefore I reckon they are slightly overvalued.

McDonalds

Net tangible equity: $12bn

Revenue: $23.5bn

Post-tax earnings: $4.3bn

Dividends: $1.625 (yield: 2.9%)

McDonalds have about $10bn in debt, or about 2.5 years worth of profits. Not too bad.

Like Coca Cola, McDonalds is a very powerful brand with global appeal. They have growth prospects in emerging markets. Like Coca Cola they have spectacular return on equity.

I would give McDonalds the same P/E ratio as Coca Cola: 16. That equates to a market cap of $70bn, or $62 per share. Currently the share price is $55, so McDonalds is slightly undervalued.

Portfolio status

I haven't made any changes to my portfolio recently. But my personal circumstances have changed significantly. I've gone from being one half of a two-income couple / no children to the sole earner supporting a wife and baby daughter. That means I'm no longer generating spare cash each month, and I need to be more careful with cash reserves.

In January my US dollars will become available. I plan to invest these in non-sterling assets, mostly denominated in US dollars. In the meantime, I can expect a few dribs and drabs here and there, but nothing dramatic.

My reserves of cash aren't huge right now. I can afford to increase my portfolio by perhaps 20% between now and January. That's a little more than half the rate I was investing over the first half of the year.

Recent market movements
The move in the wider market have been good for my portfolio. Particular highlights over the last 3 months:

• Bond doubled. Quadnetics were up 40%, Maxima 20%.
• LLPF are up over 50% since purchase.
• RBS and Barclays continued their strong runs to be up around 40% each.

Shame my US$ fell 10%, but overall I was well in profit.

Prospective trades
At the right price:

1. Offload my Lloyds shares to eliminate the concentration of risk I have (given my large holdings of LLPF). Invest the proceeds in GSK, bringing my holding up to ~5% of my portfolio.
2. Sell my last remaining RBS shares, add some cash to the proceeds, and then bring my holdings in BAT and NG up to around 5% of my portfolio each.
3. Sell my Zirax shares and use the capital loss to reduce my taxes this year.
4. Invest further in IAPD, IDVY, IEEM, bringing each of them up to ~10% of my portfolio.

That would account for 2-3 months worth of my investment budget.

Update 24/07/09

I've executed some of my plan:

1. I've got out of my Lloyds Ordinaries at 78.5p, and invested the proceeds in GSK at 1164p. GSK is now 5.2% of my portfolio.
2. I sold out of RBS at 42.4p and invested in BATS at 1796p and NG at 566p. They are now each 5.4% of my portfolio.
3. I've decided to leave my Zirax shares alone for now. I think they are undervalued, and I can sell them anytime before the end of March 2010 and still get the benefit of the capital loss.
4. I'll leave IEEM, IAPD and IDVY for now. Depending on whether I find other opportunities worth investing in, I may wait until January before investing further.

My portfolio breakdown is now as follows:

BRK-B: 9.6% of stock/bond portfolio (excluding currency)
IEEM.L: 8.8
IAPD.L: 8.4
IDVY.L: 7.3
NXT.L: 6.8
LLPF.L: 6.4
DGE.L: 6.3
SLXX.L: 6.2
GNK.L: 5.8
NG.L: 5.4
BATS.L: 5.4
GSK.L: 5.2
TSCO.L: 5.0
BDI.L: 3.6
BARC.L: 2.7
MXM.L: 2.2
QDG.L: 2.0
CPT.L: 1.7
ZRX.L: 1.3

Here's the breakdown by asset class (including currency):
USD: 31.9% of total portfolio (including currency)
Large UK Shares: 25.6
Small UK Shares: 8.7
UK Bonds: 8.5
Large USA Shares: 6.5
Large Emerging Shares: 6.0
Large Asia Shares: 5.7
Large Europe Shares: 4.9
Small Europe Shares: 1.2
Small Emerging Shares: 0.9

So my portfolio is 42.8% in UK assets, 38.4% in US assets, 18.9% in Europe/Asia/Emerging assets. But bear in mind that a lot of my UK assets are actually international companies, e.g. GSK, BATS, DGE.

Carpathian in, HSBC out

I decided that Carpathian was worth investing in, but didn't want to invest any new cash. I therefore sold my HSBC shares, since they seem to be close to fair value, and used that to fund the purchase.

Carpathian is now 2% of my portfolio.

Carpathian

I've been challenged to find a property company worth investing in, and on minimal research have plumped for Carpathian Plc. http://www.carpathianplc.com/news/2752987.go

Let's see if it's actually worthwhile.

Price

Share price is 15.75p, Market cap £38m.

Earnings

Underlying earnings of £12m for last year, on a net rental income of £34m.

Balance Sheet

£508m of investment property, £406m of debt. All debt is non-cross-collateralised, non-recourse.

Equity of £185m, minus £13m of goodwill leaves £172m of tangible assets. 72p NTAV per share.

£41m of uncommitted cash at holding company level = 17p per share. £20m earmarked for injecting into subsidiaries to satisfy banks.

Plans to return at least 8p per share to shareholders this year. That accounts for the rest of the cash.

Value

Taking a realistic view of Carpathian's situation, I think we can expect:

• Returning 8p per share to shareholders this year. They wouldn't put that in their results if they didn't think they could deliver. Not sure if they plan to do this via a dividend or buybacks.
• Investing of the rest of their cash into their properties to satisfy bank requirements.
• Abandoning perhaps 25% of their portfolio and letting the bankers take it. I would expect this to have little impact on their NAV, since their LTV ratio is so high, and presumably the properties they abandon would be likely to be those where there is little to no equity remaining.
• A further decline in property values. Currently the yield on their property is 6.7% - assuming that increases to 8% (which I would consider reasonable) that suggests a fall of £83m, or 35p per share.

That would leave a tNAV of 29p per share, even after a cash payout of 8p.

Conclusion

I think Carpathian is a wothwhile, if risky, purchase.

TW

Bye bye TW. My new shares were admitted to trading and sold at 33.538p. I didn't really cover myself with glory in that investment, and perhaps I've now sold out too cheaply, but I'm happy to see the back of it.

At least I can comfort myself that I held on in expectations of better times when they fell to 5p. I 10-bagged from that point, it's just a shame that I was 95% down to start with, for an overall loss of 50%.

Capitalisation of development costs

One thing that irks me about IFRS vs GAAP is the way that software companies can capitalise their development expenses. This can give a very misleading picture of the financial position of a firm, and in extreme cases make the headline profit numbers entirely misleading.

This recently came to my attention while looking at ACS, which isn't even a software company, which managed to make an accounting profit of £2.5m, almost entirely comprised of capitalised development expenses. They had not previously capitalised any development expenses, so had negligible amortization to counterbalance the development costs.

I tihnk the key thing to be careful of is when capitalised development expenses far outweight amortization. In that case the profit will be far higher than cash flow, and the firm may need to borrow or issue shares to survive. On the flipside, if amortization far outweighs capitalised development expenses it may indicate a highly acquisitive company - needing to buy other firms to grow, but with the potential to scale back in a downturn and simply generate large amounts of cash.

Let's look at my 3 firms.

Bond International Software

2008

Profit: £2011m

Capitalised development expense: £2788m

Amortization: £2576m

Free cash flow: £1799m

2007

Profit: £3645k

CDE: £2849k

Amortization: £1883k

Free cash flow: £2679k

Conclusion

Bond largely grows through internal development, so it is reasonable that their profit exceeds free cash flow. Their free cash flow is still very healthy.

At a current market cap of £21m (at 65p) they certainly don't look expensive.

Maxima

2008/2009 (guess)

Profit: £3m

CDE: £400k

Amortization: £4m

Free cash flow: £6600k

2007 / 2008

Profit: £3745k

CDE: £430k

Amortization: £3410

Free cash flow: £6725k

Conclusion

Stonking free cash flow. They grow through acquisition, so you would expect cash flow to exceed profit, but a solid free cash flow is a huge advantage if the market turns against them. Compare their market cap of £21m to their free cash flow of £6m+ - they look very cheap indeed. They do of course have some debt - about £17m worth - so maybe not super cheap, but definitely cheap.

QDG

Free cash flow doesn't look too pretty, but £7m of cash means that at least they can ride out the bad times.

GSK + portfolio maintenance

Bought GSK this morning at 1052.25p, top-sliced Barclays and reinvested the proceeds in MXM. I accepted the TW open offer yesterday. Time to leave my portfolio alone for a while.

BATS + NG

Per my earlier post, I've made a modest investment in BATS and NG. Money transfer delays mean GSK will have to wait until later in the week. I plan to make a similar investment in GSK, and then in a few months double my holding of each (depending on prices).

British American Tobacco and National Grid now each form ~3% of my share portfolio.

A back of the envelope calculation suggests the yield on my portfolio is about 4.5% (taking appropriate account of dividend cuts and cancellations). Not bad, considering my mortgage is 1.24%.

Cyclicals vs defensives

The premium commanded by defensive shares over cyclicals seems to have disappeared over the last couple of months. Since the beginning of March, Greene King has advanced by 27%, Next by 30%, Taylor Wimpey by 150%, and the banks by up to 200%.

On the defensive side my portfolio has some bonds (heavily weighted towards banking, so not that defensive - up 9% since March), Diageo (17%) and Tesco (9%).

I'm not ready to sell out of my cyclical shares yet - I still think they're below fair value - but I think my next investment will be into some more defensive shares.

I'm looking at British American Tobacco (BATS) and GlaxoSmithKline (GSK). By sheer coincidence, Neil Woodford was quoted in the Times today as saying he thought these two plus National Grid (NG-) were some of the best buying opportunities out there. So I'm also taking a look at National Grid :-)

There is also a bit of portfolio maintenance to be done:

• Take up the TW open offer, and then probably sell out completely once the shares start trading on 1 June. Anything over 33p (about half book value) would be OK - less than that and I'll probably hold onto them.
• Top slice Barclays and reinvest the proceeds in Maxima. Maxima is underweight compared to my other small-caps, and Barclays is over-weight compared to the other banks, so some reallocation makes sense here.
• Crystallise a capital loss on Zirax, to offset some of the capital gain I am making this year (through my job, not my stellar stock-picking). Looks like there's a grey area whether I can repurchase them in my wife's name within 30 days without them being picked up by the bed and breakfasting rules... I'll probably get away with it.
• If I can get a decent price (~110p) sell out of my Lloyds ordinaries, since I have quite enough exposure through the preference shares.

That would leave me roughly:

• 6% in bank ordinaries, 5% in bank prefs
• 7% bonds
• 11% small caps
• 13% Berkshire
• 8% each in GNK, Diageo, Next, 6% in Tesco
• 11% in emerging markets, 9% each in Europe and Asia

In the medium term I'm looking to increase the amount in emerging markets, Europe and Asia. I may add some more bank preference shares.

British American Tobacco

Tobacco looks like a good business - highly cash-generative, stable returns, brand loyalty. BAT doesn't have a lot of debt, and at its current price of 1700p is on a yield of 5%. It has a history of growing earnings at about 10% per year. The P/E ratio is a little steep at 14, but they can pay most of that out and still grow, so those are good-quality earnings.

GlaxoSmithKline

At 1050p this is on a P/E ratio of 12 (10 if you strip out some exceptionals), a dividend yield of 5.3%. I've looked at them before, and noted that their R&D and marketing expenses aren't capitalised, so like BAT these are good-quality earnings.

National Grid

Dividend yield of 5.65%, P/E ratio of about 12 (adjusting for exceptionals). Very high Return on Equity. Very stable revenue.

Conclusion

I like all three of these shares. They're not glitzy, but they earn good money and should be safe. Comparing them to some tremendously good value small caps, I don't think they are necessarily going to outperform. But comparing them to cash or bonds, they should. And that is the more realistic choice I face - I'm already heavily invested in quite risky shares, and I need some balance to my portfolio. Currently that's provided by having plenty of cash, but I'm steadily investing it, and need to buy some safer shares too.

Taylor Wimpey placing and open offer

I don't like it. They've reduced the NAV per share from 150p to 109p through dilution. It's probably good for the company, but I can't be bothered with them any more. I don't see that they have any competitive advantage, and even after all this dilution they're still saddled with £1bn of debt. I sold this morning at 42.5p. I'll look for a better long-term home for my money.

Update 9/5/09:
Just realised (well, my broker informed me...) that the ex-date to qualify for the open offer was yesterday, so I can still take this up if I choose. I'll see what the share price does, but at the moment it's at 37p, so I would gain 12p per share, raising my effective sale price to 54.5p.

LLPF

Today I sold about 70% of my RBS shares at 49.92p (held in a separate sharedealing account to the remainder) and used the proceeds to purchase LLPF at £284.75 per share.

The yield on LLPF is about 21%.

Comparing bonds, prefs and shares

Preference shares
The return on a preference share is actually pretty simply, simpler even than bonds, assuming you hold it forever. Provided the issuer doesn't default, then annual return = yield * par /price.

Bonds
If a bond trades at par, then annual return = yield. Otherwise it needs to be adjusted for its maturity date and price.

Shares
If you ignore the problems of reinvestment, then the return on a share should be straightforward to calculate, provided the RoE of that share remains constant.

For instance, Company A has a RoE of 12%. It distributes all earnings as dividends. Company B has a RoE of 12% and reinvests all earnings. You purchase both at book value (100). Company A pays you 12 per year in perpetuity - a return of 12%. Assuming you can always buy shares in Company A at book value, then you could reinvest each year and compound that 12% growth - Company B simply takes care of that reinvesting for you. The return on both is the same.

As a second example, what if you buy shares in Company A and B at 50% of book value. Company A distributes 24% of your purchase price per year in dividends. You earn a 24% return. Company B reinvests its earnings at 12% RoE, which is 24% return on your investment. If the share price recovers to book, then the owner of A or B is getting a 12% on his newly valuable portfolio. He is still earning 24% compounded on his original investment of 50% of book.

What if you buy shares at twice book value? Now Company A is paying you 6% per year, and Company B is reinvesting at 12% RoE. But if this is the most attractive investment opportunity around, and you own Company A, then you are stuck reinvesting dividends for a 6% return. Company B is reinvesting dividends at a 12% return.

Company B clearly seems a more valuable company. When Company B's RoE exceeds the dividend yield available on Company A, i.e. when companies trade above book value, an investor has a dilemma as to where they can reinvest their dividends. The most attractive option is therefore to invest in a company with high RoE, which has opportunities to productively reinvest earnings, i.e. the Buffett approach.

When companies typically trade at below book value, then it is much less important whether they have opportunities to invest earnings. The biggest driver will be their P/E ratio and P/B value (i.e. the Graham approach). This probably reflects the different investing environments that Buffett and Graham have worked in.

LLPF / LLPG

Of the UK bank preference shares, Lloyds fixed/floating rate preference shares appear the most interesting. These are LLPG, paying 6.3673% and LLPF paying 6.0885%.

At current prices, LLPG is yielding 23.6%, and LLPF 23%. LLPG is callable on or after 2019 at par, LLPG on or after 2015 at par. If LLPG was called at the earliest opportunity that would increase the yield to 37.6%. For LLPF the rate is 48%. If neither are called they revert to 1.3% above LIBOR - assuming LIBOR is ~5%, that means the rate will remain more-or-less unchanged.

The fact that LLPG/LLPF are callable limits the upside - they aren't going to exceed 100% of par value, but when they're trading at ~26% of par, that's not a significant limit.

If interest rates are ~5%, and the banking system recovers to the point of safety, then a yield of 8% would be reasonable. That would suggest 9.75% prefs trading at 122p - a gain of 80% from here. The 6.3% prefs would trade at 79p - a gain of 203%.

If interest rates are 0% (e.g. deflation is rampant) then a yield of 3% might be reasonable. In that case you'd see a 377% increase on the 9.75% prefs, but the 6.3% series should only trade at ~43p, because they will have reset to yield only ~1.3% - only up 65%.

Assuming the economy will recover and banks will become trustworthy again, LLPF and LLPG do seem to offer the best value, both in comparison to other prefs, and also in comparison to the ordinaries. I'll see if I can pick any up next week, and convert some (possibly all) of my bank shares into preference shares.

Bank ordinary vs preference

Ordinaries
The recent run up in bank share prices has left me with something of a dilemma. Back in January it seemed obvious that they were good value, but since then they have rather outperformed:

• Barclays up 220% at 279p
• RBS not far behind: up 214% at 44p
• Lloyds up a mere 61% at 109.6p
• HSBC have had a rights issue, and adjusting for that and their dividend are up a paltry 20% at 482p.

Barclays
I'll updated my Barclays numbers only slightly to take account of the sale of iShares. I make net tangible asset value 333p. Current discount: 16%.

RBS
I'm adjusting RBS's value per share to 47p to take account of their bond swap. Current discount: 6%.

Lloyds
I've realised that my Lloyds valuation in February was thoroughly misleading. In February I rated the shares as having 82p of tangible asset value. But that was after the conversion of preference shares (which at the time was at a price only slightly below the prevailing share price).

We have 13.6bn new ordinary shares after conversion of govt B shares, 10.3bn from conversion of preference shares, and the 16.4bn shares outstanding right now. At the end of the day the tangible net assets are about £35bn (previously assessed at £33bn, but I'm adding in a bit extra for their recent bond conversion) so 87p per share.

Buying one share now and paying 26p to take up your share of the open offer will get you 1.63 shares post-offer. So the value of one share now (in terms of tangible assets) is 116p.

So currently Lloyds are trading at a discount of 6% to tangible net assets.

HSBC
HSBC hasn't changed since my calculation in February: value 353p per share. Current premium: 37%.

Ordinaries conclusion
Assuming a reasonable, conservative valuation is 1.2x book value, Barclays could still rise 44% from here, RBS and Lloyds a further 28%. HSBC is already trading at a premium to this valuation measure. Assuming a RoE of ~12% (pretty conservative), at a premium to book of 1.2, the banks would be on an earnings yield of 10%.

Preference shares
Lloyds have preference shares with a gross yield of 9.75%, currently trading at 68p. A return to par would see these rise 47%.

RBS (via NatWest) have 9% preference shares trading at 66p, so a similar situation.

These would appear to be marginally better value than the ordinary shares. They share the downside of complete wipeout, have an additional risk of banks opting not to pay dividends (they are non-cumulative), but do not have the same dilution risk.

IEEM, IAPD, IDVY

Increased my holdings of all 3 of these a few days ago, at the following prices:
IAPD @ 1112p now 8.6% of my share portfolio
IDVY @ 1233p now 8.7% of my share portfolio
IEEM @ 1678p now 10% of my share portfolio

The breakdown of my entire portfolio including US dollars is:
USD: 39.7
Large UK Shares: 23.3
Large USA Shares: 8.1
Small UK Shares: 7.0
Large Emerging Shares: 6.1
Large Europe Shares: 5.3
Large Asia Shares: 5.2
UK Bonds: 4.3
Small Emerging Shares: 1.1

GNK rights issue

Nothing much to report on the Danfolio recently. My last trade (before today) was the purchase of DGE and SLXX.

Greene King
GNK announced a rights issue today. That came as something of a surprise, and I'm in two minds over it. Their claim seems to be that they're doing it from a position of strength - they intend to buy back debt at a discount, and take advantage of distressed rivals to pick up assets (pubs) on the cheap.

KBC Peel Hunt claim that some of their debt is trading at 47p, so £1 spent buying that back adds £2 to their book value. They only pay ~6% interest on that debt, but even so the annual return on that £1 will be >12% (depending on how long-dated it is). Not a great return, but OK.

The prospect of buying up high-quality assets from distressed rivals is broadly similar value. Greene King's RoTA (EBITDA / tangibles) is 12%. Assuming they are getting good quality pubs for below book value, I would expect the return on those assets to be >12%.

So Greene King should produce a decent return on their £200m. It also achieves a small delevering of the balance sheet. Not a stupid idea.

However, I've already invested plenty in Greene King, and I have no interest in investing more. I'm guessing that others will sell their rights rather than take them up, and that will put a short term pressure on the share price. I therefore sold 20-25% of my holdings this morning at 570p, which will give me enough cash to take up the rights in full on the remainder.

Danfolio
Here's the breakdown of my portfolio by investment type:
USD: 44.7
Large UK Shares: 23.0
Large USA Shares: 8.3
Small UK Shares: 7.6
UK Bonds: 4.6
Large Emerging Shares: 4.1
Large Asia Shares: 3.4
Large Europe Shares: 3.0
Small Emerging Shares: 1.3

In the short-run I'm looking to get the numbers up for Emerging, Asian and European shares.

Here are some of my best and worst purchases - top 5:
149.71% BARC.L Bought @ 87.00 now 217.25 earned 0.00
125.50% RBS.L Bought @ 13.97 now 31.50 earned 0.00
66.60% GNK.L Bought @ 341.71 now 562.00 earned 7.30
42.08% NXT.L Bought @ 1088.86 now 1529.00 earned 18.00
41.18% LLOY.L Bought @ 68.00 now 96.00 earned 0.00

Bottom 5:
-72.92% ZRX.L Bought @ 12.00 now 3.25 earned 0.00
-76.79% ZRX.L Bought @ 14.00 now 3.25 earned 0.00
-81.25% RBS.L Bought @ 167.99 now 31.50 earned 0.00
-86.32% RBS.L Bought @ 399.22 now 31.50 earned 23.10
-89.68% RBS.L Bought @ 305.20 now 31.50 earned 0.00

Next annual results

Next's annual results are out today. No surprises, but a slightly gloomy outlook for the coming year. Last year's EPS was 156p, so they are on a historical P/E ratio of 8 (at 1274p).

Next have £550 of debt, maturing in 2013 and 2016. Their £450m of bank facilities are committed until November 2010, but they expect to use no more than £200m of these in the coming year.

Next's expectations for the coming year are downbeat, but they still expect to meet analyst's expectations, which apear to be ~126p. So they are on a forward P/E ratio of 10. That is based on a healthy net margin of >10%.

Last year's ROCE is 42%, based on earnings of £302m, average net assets for the year of £76m and average net debt of £638m. Expectations for the coming year are still >30% by my calculations.

In summary:

• Next will weather the storm.
• Based on reduced margins and profits they are still cheap.
• When recovery comes, they have excellent potential for growth.

SLXX and Diageo

I have a large pot of cash to be invested. It amounts to a little over 20% of my existing portfolio. The investments I'm considering are:

• SLXX. A sterling corporate bond ETF.
• DGE. Diageo, an international beer wine and spirits company.

I will probably invest the money next week. I want to make sure I've done my homework and know what I'm investing in.

SLXX

The majority of the corporate bonds in this ETF are financial. At a price of £95.24, it has a flat yield of 8.08%, and a gross yield to redemption of 9.67%. The expense ratio is 0.2%. The interesting thing is how those numbers will be affected by some defaults.

I plugged in the entire list of holdings into Excel, and postulated what the effect would be if every bond trading at below 50% of its face value defaulted. That's 11 defaults out of 49 holdings, or 22.92% default rate. The net asset value would fall to £86.94. The flat yield would fall to 6.04%. The gross yield to redemption would only be slightly higher. But what if the other 38 bonds returned to par value? That would mean the net asset value increased slightly, to £95.96.

I think that's a pretty pessimistic scenario, but it still gives an acceptable return. I don't actually believe governments will let large banks default, even on their subordinated debt. In the rosiest possible scenario, no defaults at all, the par value of the fund is £121.51.

My concerns over SLXX are not just over defaults. I'm also concerned about the erosive effects of inflation. But I am funding the investment from a £mortgage, so my debts will be eroded along with my assets in SLXX.

In conclusion, I think SLXX warrants a place in my portfolio.

Diageo

Diageo is a great example of the sort of company that Warren Buffett likes to invest in. It has an excellent Return on Capital Employed and a moat (premium brands) to sustain it indefinitely. It has excellent free cash flow. It spends a substantial amount of money investing in its brands through advertising, widening its moat all the time. This sort of investment genuinely adds value, but is accounted as an expense, in much the same way as R&D at a pharmaceuticals firm.

The problem is that shareholder equity is only £4.6bn, vs a market cap of £18.4bn. Investors are paying a high price for that RoCE. They have £8.4bn of debt. But Diageo's really valuable assets are its brands. Many of these don't appear as assets in the books, and those that do will be accounted for at purchase price rather than current value. I cannot put a value on those brands except by looking at their earning power.

If Diageo had no debt it could borrow money, return it to shareholders, and get to its current position - so theoretically its current fair value should be no more than its debt-free value minus the level of debt.

Debt-free Diageo has shareholder equity of £13bn. It makes something like £2.7bn per year pre-tax, so let's assume £2bn post-tax. It would be an almost totally risk-free investment, and would be in a position to pay all of its earnings to shareholders or reinvest in the business. A P/E ratio of 20 would seem reasonable for such a stupendous company, so £40bn. Subtracting £8.4bn of debt, that puts a cap on its present value of £31.6bn (1264p per share).

But Diageo has taken on a lot of debt. Has it weakened its financial position far enough to affect its value? I don't think so. It has a good credit rating (A-, A3, A). It has reached a point where it is unwise to borrow further, but I don't think there is any real risk of it defaulting on its debt. It claims to have no financial covenants on its debt, and only a 2x interest cover requirement on its committed banking facilities.

One issue is that it has spent a number of years purchasing its own shares at high prices, and has now decided to stop, in order to avoid piling on more debt. I suspect this has a lot to do with the current slide in the share price.

What other potential problems does Diageo face? It has a negative tangible book value - it has negligible value except as a going concern. It has a £5bn+ pension fund, with a large portfolio of equities - that will certainly be suffering at the moment. It is certainly not recession-proof, although I expect it to be reasonably resilient.

In conclusion, I think Diageo is a good buy at its current price. It's on a P/E ratio of about 12, and I think a fair valuation is closer to 20.

Conclusion

I plan to invest on Monday, splitting my cash between SLXX and DGE, probably 50:50.

Update 23/03/09

Bought SLXX at 96.76p, DGE at 741.44p. My portfolio now looks like this:

BRK-B: 16.7%
SLXX: 9.1%
NXT: 8.9%
DGE: 8.7%
GNK: 8.2%
IEEM: 7.6%
TSCO: 7.5%
IAPD: 5.9%
IDVY: 5.6%
RBS: 5.0%
BDI: 3.2%
ZRX: 2.9%
BARC: 2.2%
HSBA: 2.2%
QDG: 2.1%
LLOY: 1.6%
MXM: 1.4%
TW: 1.2%

Japan

So far I don't have any Japan exposure in my portfolio. Their stockmarket has gone nowhere for so many years now, it's tempting to write them off. But if shares there are genuinely undervalued, it's foolish to ignore them - sooner or later value will out.

I'm unlikely to invest in specific shares. There's an ishares ETF - IJPN - which deals with large corporations. So what I'll do is take a quick look at the top few holdings in IJPN to give me an idea of valuation.

Here's the table:

Rank Company Price Country Percentage
1 TOYOTA MOTOR CORP 32.50 Japan 5.60
2 MITSUBISHI UFJ FINANCIAL GRO 4.64 Japan 3.19
3 HONDA MOTOR CO LTD 24.43 Japan 2.52
4 TOKYO ELECTRIC POWER CO INC 28.36 Japan 2.16
5 TAKEDA PHARMACEUTICAL CO LTD 40.78 Japan 2.07
6 NINTENDO CO LTD 291.17 Japan 1.81
7 CANON INC 25.96 Japan 1.73
8 NTT DOCOMO INC 1,572.90 Japan 1.55
9 NIPPON TELEGRAPH & TELEPHONE 43.44 Japan 1.41
10 PANASONIC CORP 11.79 Japan 1.35

Toyota
Based on their last Annual Report (from March 2008):
3.2bn shares outstanding
Market cap ~$100bn
Revenue of $262bn
Operating income of $22.6bn
Net income of $17bn
Shareholder equity of $118.5bn (no intangibles or goodwill in there that I could see)
Net income per share $5.39
Dividend per share of $1.40

So at $32.50 per share they are trading on a historical P/E of about 6, a dividend yield of 4.3%, and a P/TBV of 0.88.

This looks pretty good value to me.

Mitsubishi UFJ Financial Group
Can't be bothered to look at their report, so pulling numbers from Yahoo. Tangible assets about $50bn. Market cap $60bn. So it's trading at a P/TBV of 1.2. Not disastrous, but not great either.

Honda
P/TBV about 0.89, P/E about 7. As per Toyota, looks pretty good.

Conclusion
Obviously more thought required before investing, but things look promising so far. These shares certainly don't look overvalued.

UK bank valuation

There have been a number of developments since my last purchase of bank shares. Are they still worth holding?

Lloyds Banking Group

Currently trading at 43.7p. 16.3bn shares in issue prior to the most recent government intervention. The most recent government intervention comprises:

• £4bn of preference shares converted to ordinaries at 38.43p, so an extra 10.4bn shares.
• £15.6bn of B shares at 42p which will eventually convert to ordinaries at 115p, so an extra 13.6bn ordinary shares.

So Lloyds will have just over 40bn shares outstanding after full conversion.

The £4bn of preference shares will accrue to the ordinary shareholder, but the £15.6bn will simply be paid back to the government over the next 7 years.

Lloyds reported £29bn of tangible asset value (pro forma) in their results. Core tier 1 was reported as £32bn, but includes some minority interests. Adding in £4bn from the preference share conversion, we should expect £33bn of tangible assets for 40bn shares, which is 82p per share

Prior to the latest government intervention fair value would have been 217p. So this has been hugely destructive to shareholder value.

Barclays

Currently trading at 61.6p. 8.4bn shares in issue. No change to capital position since annual results, which reported £26bn of tangible assets. That's 310p per share.

What if Barclays participated in the Asset Protection Scheme but couldn't pay the fee in cash? £10bn at 50p per share means 20bn new shares and a value per new share of 91p.

HSBC

Currently trading at 349.25p. 12bn shares in issue, rising to 17bn after their rights issue. They have £47bn of tangible equity, rising to £60bn after the rights issue. That's 353p per share. The rights attached to the share have some value, but I forget how to do the calculations....

Let's assume HSBC don't need to participate in the Asset Protection Scheme.

RBS

Currently trading at 18.95p. 39.5bn shares in issue, rising to 55.2bn after the government's preference shares convert, rising again to 85.2bn after the conversion of the government's B shares.

Tangible assets attributable to ordinary shareholders were £19bn, rising to £24bn after the conversion of preference shares, rising again to £37bn after the government's purchase of B shares. That's 43p per share.

Prior to the announcement of the latest government scheme, RBS had 39.5bn shares and £19bn in tangible assets, or 48p per share. So the dilution cost of this scheme is minimal

Conclusion

Barclays is trading at about 20% of tangible asset value, RBS at about 45%, Lloyds at about 55%, HSBC at about 100%.

Barclays participating in the Asset Protection Scheme is the big unknown, and marking them down on that basis seems reasonable.

I plan to keep holding my bank shares. Surely there can't be much more dilution to come (except for Barclays), and in the long run a recovery to 120% of tangible assets should be achievable.

Berkshire annual report

Berkshire Hathaway's 2008 annual report is out:
http://www.berkshirehathaway.com/2008ar/2008ar.pdf

Warren Buffet is his usual candid self about mistakes he's made in 2008, and as usual his annual letter to shareholders is worth a read.

Berkshire's shareholder equity in 2008 fell by a substantial amount - over $11bn, or 9%. But by my reckoning it's fallen by at least the same again in the first 2 months of 2009:

• $5.3bn off Wells Fargo.
• $1.3bn off Conoco Phillips.
• $1.3bn off Proctor & Gamble.
• $1bn off American Express.
• $800m off US Bancorp.
• $500m off Kraft Foods.
• $400m off POSCO.
• $400m off Swiss Re.
• $300m off Johnson & Johnson.
• $300m off Sanofi Aventis.
• $100m off Wal-Mart.

Offset by:

• $200m gain on Tesco.

The derivate put liabilities are bound to have substantially increased due to the fall in world stock exchanges.

BRK-B shares are currently trading around $2500. I think fair value is around $3500, possibly more if Berkshire is now holding a substantial number of undervalued securities. I think its prospects in the current market are excellent - the yield it is getting from Wrigley, GE, Goldman Sachs, Swiss Re, etc... is superb.

Update 2/3/09
I bought some Berkshire B shares today at about $2380. It is now my largest shareholding, forming 19.5% of my portfolio. My python script required some work to incorporate a US-listed share, but it's all up to date now. Here's my portfolio breakdown:
BRK-B: 19.6%
NXT: 10.4%
TSCO: 10.0%
GNK: 10.0%
IEEM: 8.6%
IAPD: 7.0%
IDVY: 7.0%
RBS: 6.0%
BDI: 4.2%
QDG: 3.4%
ZRX: 3.2%
MXM: 2.8%
BARC: 2.3%
HSBA: 2.2%
LLOY: 1.8%
TW: 1.5%

My regional breakdown (still heavily UK weighted, but I'm getting there):
Europe: 7.0
Emerging: 11.8
Asia: 7.0
UK: 54.6
USA: 19.6

Moment of banking madness

Yesterday was an exciting day for RBS shareholders:

• Expected loss of £22-28bn, the largest in UK corporate history.
• Further shareholder dilution as the govt swaps its preference shares for equity at a price of ~32p, meaning that it will own about 70% of the company.
• A 70% fall in the shareprice to under 11p.

By the afternoon my bank shares constituted only about 1.2% of my portfolio, and a moment of madness spurred me to increase that to about 11%.

I think nationalization is a real possibility, but there is also a real possibility that banks have sufficient capital and no further dilution will occur. In the event of nationalization it's possible that ordinary shareholders might get some compensation, but I wouldn't count on it. So the downside is 0p for RBS, BARC, LLOY and HSBA.

On the other hand, if no further capital is required, then we can expect RBS, BARC, LLOY and HSBA to dominate UK banking and for all but LLOY to have a reasonably substantial global banking operation. Barclays claims to be capable of making about 40p per share even in difficult circumstances. RBS has previously made about £7bn per year, so perhaps £4bn is a reasonable expectation in the future, which is about 7.5p per share. The forecast for Lloyds is about 25p per share. HSBC is forecast to make about 85p in 2010.

Assuming a fair P/E ratio of 10 (although it could be a while before we see the markets agreeing), that gives an upside of:

• 75p for RBS
• 400p for Barclays
• 250p for Lloyds
• 850p for HSBC.

I therefore bought roughly equal shares of these 4. At my purchase price the upside represents 5.5 times for RBS, 4.6 for Barclays, 3.7 for Lloyds and 1.8 for HSBC. I don't expect to achieve this with all 4, but even 2 out of 4 would put me in profit.

This is clearly a bit of a punt, but if these 4 all go under (or even just RBS) sterling will be trashed and my non-sterling assets (IEEM, IDVY, IAPD and actual dollars) will more than offset any losses.

Update

After 1 day my purchases are already down: -35% for LLOY, -25% for RBS, -17% for BARC. HSBA is up 1%. Woohoo! Luckily today's $/£ exchange rate movement ($1.47 to $1.39) more than offset any losses. So far this year my portfolio is very slightly negative, down about 1%.

Regular rebalancing

Rebalancing a portfolio once per year, either by buying and selling, or adding to investments that have become underweight can produce better returns than a passive strategy, provided:

• The elements of the portfolio have broadly similar expected returns. 50/50 cash/shares would do better by being left alone, since the shares (which should have better returns) would progressively dominate the portfolio. Property and shares should have broadly similar returns, so are good candidates for rebalancing.
• The elements are not perfectly correlated. Obviously with perfect correlation rebalancing is unnecessary.
• The market displays a certain amount of mean reversion. This is the key thing that makes rebalancing work - if future returns are unrelated to past returns, then rebalancing is pointless. But if a period of outperformance is typically balanced by a subsequent period of underperformance, then rebalancing can help -it also requires no insight into the relative valuation of the different asset classes.

I don't currently plan to pursue a rigorously balanced portfolio, but may do so at some stage. Currently my portfolio looks like this:

• 46% UK large cap.
• 25% UK small cap.
• 22% International large cap.
• 12% Emerging markets large cap.

I'm heavily weighted to the UK, mainly because of my familiarity with UK companies, and my preference thus far for avoiding index funds.

A more reasonable portfolio might look like:

• 20% UK large cap.
• 10% UK small cap.
• 15% US large cap.
• 20% International large cap.
• 15% Emerging market large cap.
• 20% Property.

I will be roughly tripling the size of my portfolio over the next 2 years, so my current holdings account for:

• 15% UK large cap.
• 8% UK small cap.
• 0% US large cap.
• 7% International large cap.
• 5% Emerging market large cap.
• 0% Property.

So to get the sort of balance I'm looking for, I should be avoiding UK shares almost entirely, and looking to pick up US shares and property as a first port of call.

Diversification

I've been reading "A random walk down wall street" recently. I don't entirely agree with B.G. Malkiel's enthusiasm for efficient markets, but getting a different point of view on things is always welcome.

One thing it has done for me is to reinforce the positive effects of diversification. Unlike Malkiel I do not equate risk with volatility, but reducing volatility is a Good Thing provided it does not significantly increase risk or decrease return. My criteria for adding a new investment to my portfolio should therefore be:

• It must have a similar/better risk/return trade-off compared with my existing portfolio.
• It must not be strongly correlated with an existing investment.

At the moment many asset classes are moving in harness with one another due to the global shortage of liquidity, but this won't last forever.

My current portfolio (considering such things fairly broadly but excluding my pension fund) consists of:

• Residential property, one of, i.e. the house I live in.
• A negative net Sterling cash balance, i.e. cash + mortgage.
• A positive net US Dollar cash balance, coming due in January 2010.
• A share portfolio.

If my house is worth 100, the other components of my portfolio are roughly:

• Sterling balance of -40.
• US dollar balance of 20.
• Share portfolio of 15.

The share portfolio is clearly a relatively small component, but is likely to have superior returns, so I think it's fairly obvious that I should continue to buy shares. In a year or two I think a reasonable position would be: house 100 / sterling -50 / dollars 0 / investments 60.

I've been mulling over whether I should diversify into bonds and/or real estate. Clearly I'm heavily overweight in UK residential property, so any real estate investment will need to be sufficiently different to provide diversification benefits. Any any diversification needs to fulfill my criteria above.

I'm looking for an after-inflation return of approximately 6% over the long-term. The ishares International Property Yield ETF (IWDP) has a yield of 9.66%, although that is skewed by an abnormally high dividend payment almost a year ago. Stripping that out, the yield is about 6.3% - and commercial property has historically been a good inflation hedge. So the return on this is adequate. It will be correlated with shares and UK residential property to some extent, but the correlation should be less than 1.

The ishares £ corporate bond (SLXX) has a gross yield to redemption of 8.16%. With no defaults and inflation of 2%, that gives a real return of just over 6%... but I don't fancy predicting the rate of inflation given the current circumstances. Also, most of the holdings appear to be banking-related, which isn't necessarily the safest place to be.

I think for now I'll continue to monitor these two. I think IWDP is reasonable at its current price, and SLXX needs to be a little bit cheaper. But I probably won't be adding any new investments for a month or two.

Update:

In the last 5 days IWDP has shifted in price so it now has a yield of 10.97%, which I estimate to be about 7.3% adjusting for last year's freakish dividend. That's at a price of $11.18. However, I do have some concerns about some of the REITs that constitute this ETF.

Here are the top 5 holdings:

• Sun Hung Kai Properties, weighted at 5.1%. Hong Kong properties. Payout ratio of 0.5. Gearing 25%. Interest cover 7.5 times.
• Westfield Group, weighted at 5.1%. Australia, NZ, US, UK property. Payout ratio 1. Gearing 70%. Interest cover 3.5 times.
• Unibail-Rodamco, weighted at 3.6%. French. Payout ratio 0.9. Gearing 85%. Interest cover 7 times.
• Simon Property Group, weighted at 3.1%. US commercial property. Gearing 600%. Payout ratio 2.2 or 0.6 (depending on whether you look at net earnings or FFO). Interest cover 1.6 times.
• Vornado Realty Trust, weighted at 2.5%. US commercial property. Gearing 260%. Payout ratio 1.1 or 0.6. Interest cover 2.1 times.

The US REITS seem to be very heavily geared. By contrast, REITs from other countries have relatively modest gearing. I would not be surprised to see some of the more heavily geared REITs go down the pan - so I would need to take account of that before investing.

Next and Tesco

I've added to my investment in Next and Tesco. The portfolio breakdown is now:
GNK: 14.0%
TSCO: 13.8%
NXT: 13.5%
IEEM: 11.9%
IAPD: 10.9%
IDVY: 10.5%
RBS: 6.5%
BDI: 5.4%
MXM: 4.0%
ZRX: 3.9%
QDG: 3.5%
TW: 2.1%

Annual review

2008 has drawn to a close. It's a year to forget in terms of my share portfolio, but luckily the appreciation of the dollar against sterling has resulted in an overall profit of just over 6%.

Over the course of the year my returns have come from 4 places:

• Interest on my dollars.


• Dollar / sterling exchange rate movement.


• Dividends


• Share price movements
  

The effect of these 4 on my total portfolio have been:

• Interest: +2%


• Exchange rate: +23%


• Dividends: +1%


• Share price movement: -20%

With hindsight, my best decision was made at the start of the year and was to avoid hedging the currency risk I faced. I've since decided that my decision was based on faulty reasoning, and that the "correct" thing to do was to fix the rate. So I think we can place that result firmly in the camp of luck.

My share purchases have substantially underperformed the market. I believe I've learnt from my mistakes and can apply greater discipline in the future.

Insufficient research

I made my first investment in RBS based on very little research. I didn't even look at the annual report. The P/E ratio was low, the dividend yield was high, and I listened to what management were saying without applying sufficient scepticism. I failed to assess the possible impact of a rights issue, and failed to think logically about the impact of the credit crunch.

I made a similar mistake with Taylor Wimpey, failing to correctly analyze the nature of their debt and the effect on their land portfolio that a sharp fall in house prices would have.

I've learnt two lessons here: that more research is required, and that I need to focus on companies that I can understand.

Emotional involvement

Having made faulty investments, and watched the share price punish me, I refused to accept that I might have made a mistake, and compounded my original error by averaging down. While spreading purchases over time is sensible, automatically purchasing more shares on a price drop is not.

I have ended up investing a very large amount of money in RBS, Zirax and TW, and these have been the worst performing shares in my portfolio.

In future I plan to be more cautious, leave much longer gaps between adding to an existing investment. I'd like to think that I will be more self-critical, but I doubt I will ever fully learn that lesson.

Excessive contrarianism

While I think being a contrarian is a good thing, much of the time the crowd is actually correct. I need to be much more selective about when I move against the crowd.

Portfolio

As of today, a week after New Year, my portfolio breakdown is:
GNK: 15.9%
IEEM: 14.2%
IAPD: 13.0%
IDVY: 12.7%
TSCO: 9.4%
RBS: 7.3%
NXT: 7.3%
BDI: 5.1%
MXM: 4.7%
QDG: 4.1%
ZRX: 4.1%
TW: 2.0%

The dismal performance over the year is as follows:

Actions

Looking at the portfolio breakdown, I think my next steps will be:

• Bring my investment in larger companies up to a similar level as GNK. That means adding more Tesco, Next and RBS.
• Take a decision on Taylor Wimpey. Either add to the investment or sell. I think I'll wait for the outcome of the debt refinancing.
• Add to my investments in IEEM, IAPD and IDVY. These currently constitute around 40% of my portfolio, and I want them to keep at least that ratio.
• Consider investing in US shares to increase my international exposure. Another dip in the Berkshire Hathaway share price would be perfect, since I don't want a large number of US shares.
• Avoid adding to my investments in smaller companies. My instinct is to double up on these, and I may do so at some point, but think I'll wait to see how they do this year.