Southern Cross prelims - covenants further relaxed

As I expected last week, Southern Cross have announced a further relaxation in their bank covenants as part of their final results.  The fixed charge cover is now down to 1.1x.  No further news on a possible takeover, except to reiterate the earlier news that "the approaches are still preliminary in nature, and the Board continues to believe it to be in shareholders' interests to continue to hold exploratory discussions."


A fixed charge cover of 1.1x is pretty generous.  They only need to manage adjusted EBITDA of about £20m to hit that.  And they have about £30m of headroom in their revolving credit facility.  Perhaps the more important figure now is their cash-flow neutral point - I reckon they need at least £30m of adjusted EBITDA to be cash-flow positive.


I see no sign of this company going bust imminently - they seem to be within their covenants, they have headroom in their credit facility, and their bankers have repeatedly demonstrated their unwillingness to call in administrators.  But then I've just suffered a total wipeout with Rok, so what do I know?

De La Rue - fundamental value >905p per share?

I certainly seem to have picked a few exciting shares to buy recently.  My last 4 purchases were:

• (June) BP.  Down 15% at one point, now 27% above my purchase price.
• (August) Rok Group.  Bankrupt.
• (August) Southern Cross.  90% up within a week of purchase on a takeover approach, now down 13%.
• (September) De La Rue.  Down 20% at one point, now up 25% after a takeover approach.

Today has seen plenty of news for De La Rue shareholders to ponder.  First of all a belated announcement of a "highly preliminary and opportunistic" takeover approach, which drove the share price up to 780p.  Then confirmation that the bidder was Oberthur, a French rival - and the news that they had made an indicative offer of 905p in cash - that was enough for the shares to hit 840p.  Finally De La Rue responded with their justification for rejecting the offer (apparently it "in no way reflects the fundamental value of the Company").

In August I wrote an article about De La Rue where I said they were "worth in the region of 900p".  Perhaps I should become a full-time oracle?  Of course I also said "I think I‘ll sit this one out for now and hope for an opportunity to buy at 600p", which I singularly failed to do, taking a punt at 677p.

So what are De La Rue worth?  Oberthur obviously think >900p, otherwise they wouldn't be bidding at that level.  The board of De La Rue agree, otherwise they wouldn't have rejected the offer.  As for me, my valuation of 900p was based on De La Rue remaining independent - as part of a bigger company, dominating its industry, I can see it being worth a fair bit more.

I don't know how deep Oberthur's pockets are (and it's privately held, so I can't find out) but I suspect they probably have a bit of headroom for a higher offer - say 950p or 1000p, just enough for the board to capitulate and support it.  Whether a deal happens all comes down to De La Rue's big shareholders.  If they've been spooked by the recent quality problems and CEO resignation then they will probably be delighted to jump ship at this sort of price.

As for me, I'd be happy to sell my shares at 905p and take a quick 33% profit.  I'm in two minds whether to bail out now at 840p - but since my valuation was at 900p I suppose I should hold on for that.

Southern Cross update

I've posted an update on Southern Cross over at Shareworld.  There have been a few rumours flying around recently - the Sunday Times reported that their banks were willing to waive covenants (which is good, since I reckon they are within a whisker of breaching them), and the Sunday Telegraph thinks that Blackstone is considering a takeover bid.  That really would be news - Blackstone is the group that originally built the group and engineered the sale and leaseback that has left it with its present difficulties.

Their full year results are out on the 9th December, and I think we can probably expect some sort of update at that time.  In the meantime their shares will probably continue their rollercoaster ride.

Risk

After the recent Rok debacle I thought it might be a good time to look at the risk in my portfolio.  It may be shutting the stable door after the horse has bolted but, at the risk of stretching a metaphor too far, there are still 20 other horses in my stables and some of them are looking skittish.

I'm going to split my portfolio into a few broad areas.  From least risky upwards:

1. Safe.  No cause for concern
2. Solid.  Some concerns, but nothing major.
3. Speculative.  Known problems, but they should pull through.
4. Risky.  Acute problems - real risk of wipeout.

1.  Safe (36% of portfolio)

First into this category goes Berkshire Hathaway.  A book value of $150bn gives me a lot of confidence (even if $80bn of that is goodwill and "other").

NWBD is next on the list.  For this to suffer losses you would first have to assume that NatWest has gone bankrupt.  Then you would have to assume that its owner, RBS, would refuse to rescue it - i.e. either its losses are catastrophic, or RBS itself was bankrupt.  Given that didn't happen in 2008-2009, I'm happy that it is unlikely to happen in the future either.

LLPC follows close behind.  Although it is more exposed than NWBD (its dividends are currently suspended), it escaped the recent crisis with the loss of only 2 years' dividends - in the scheme of things that's peanuts.

Tesco makes it into this category thanks to its strong balance sheet (a fair amount of debt, but mostly long-term funding, backed with an extensive property portfolio), consistently strong profit margins, international diversification and a business that should be around for the long-run.

2.  Solid (31%)

British American Tobacco and Diageo make it into the top-end of this category.  They don't quite qualify for my top rank: BATS because worldwide tobacco use will eventually decline, and Diageo because of its heavy debt load.  Apart from those concerns, these are strong businesses with healthy profit margins, strong brands, loyal customers and international diversification.

I'm going to bundle in two of my 3 ETFs here: IDVY and IAPD.  These are both focused on high-yield shares, which I think on the whole gives you a pretty solid set of companies.  

GlaxoSmithKline looks, on the face of it, like a pretty healthy business, with massive margins, a decent balance sheet and good international diversification.  But they face reduced healthcare spending in developed countries, plus expiring patents and generic competition.

National Grid just about makes it into this category because of its reliable, regulated income stream.  My concern is that it has an enormous heap of debt, and I don't really understand the risks it could face.  

3.  Speculative (27%)

IEEM is definitely an ETF that fits better into the speculative category.  It invests primarily in large cap shares in emerging markets, and has historically been pretty volatile.

Greene King comes in at the solid end of my speculative category.  It has a lot of debt, and faces long-term headwinds in terms of fewer customers and higher taxes on alcohol sold in pubs.  But it makes a decent profit,  its debt is funded a long way out, and most of its pubs are transitioning well from "wet-led" to family-friendly pubs serving food.

BP has one big problem: the legal/political consequences of the GoM blowout.  Beyond that, it's a very solid, profitable business, with a strong balance sheet.

De La Rue is also a great business facing one problem - the loss of reputation/business from this year's quality issues.  Excluding that, it is consistently profitable, with good margins, a solid balance sheet, and is a world leader in their field.

I have a clutch of software companies that I think fall roughly here in my list: QDG, MXM and BDI.  QDG is not hugely profitable but has a solid balance sheet.  MXM has a very strong cashflow but quite a bit of debt.  BDI has a great product but is not massively profitable.

4.  Risky (6%)

Game Group comes at the more solid end of my risky category, but faces a number of issues: very low margins, a squeeze from supermarkets cherry-picking the most popular products, and online competition from the likes of Amazon and play.com.  Their balance sheet is not fantastic, so one bad Christmas could get them into rather a lot of trouble.

Carpathian is a business that will definitely be worthless in a year or so.  The only question is how much cash shareholders can extract in the meantime.  If they manage to sell their assets for the prices they expect, then shareholders should do OK - but a further deterioration in Eastern European property could rapidly see them become worthless.

Southern Cross comes right at the bottom of my list.  Tiny margins, declining occupancy, consistent unprofitability, hugely expensive rental contracts with guaranteed annual increases and reduced spending by local authorities all conspire to make this a share only for the brave.

Rok
So where would I have put Rok in my list if I'd written it a few weeks ago?  I think it would have gone in the Risky category, probably just above SCHE.  But that's why it was trading on a P/E ratio of less than 3.

Pan African Resources

Screening for some small, profitable, debt-free companies I recently came across Pan African Resources.  I've posted my thoughts on shareworld.  Since writing the article a week ago I've been dithering, and the share price is up more than 10% in the meantime.  I haven't yet decided whether to buy a few shares or hope for a better price.

Rok = Connaught

And here was I thinking Rok was a different kettle of fish to Connaught.  Turns out I was wrong.  1.2% of my portfolio disappears in a puff of smoke, and I have a new worst ever investment.

The next Warren Buffett?

Is Todd Combs the new Warren Buffett?

Bond's fishy deal

Bond International Software announced the acquisition of VCG today and the share price went up 24%.  That's a clever trick - companies usually overpay for acquisitions, and therefore their share price usually suffers when the news becomes public.

The reason seems to be that they have funded the transaction by issuing new shares at 75p each - a premium of almost 50% over the previous day's close of 53p.  But all is not as it seems.

The subscriber to all these new shares is Constellation Software, who now have an economic interest in 31% of Bond's shares.  Constellation's announcement is here.  As part of the deal Constellation have bought a large number of non-voting shares, and agreed not to buy further voting shares for 5 years - which seems a device to prevent them launching a takeover.  Why that's in the best interests of Bond's shareholders rather escapes me - if they want to make an offer, making me a profit in the process, that would seem to be rather good for me.  That's the first thing that smells bad to me - directors worrying about their own interests rather than shareholders.

The second thing is that over 50% of the money stumped up by Bond is going to (you guessed it) Constellation Software, in their guise as a holder of VCG promissory notes.  It seems that the vast majority of the VCG purchase price is going into paying off their debt, with only a small amount left for their equity.  The debt of a company like that is usually trading at a big discount to par - so I suspect the quid pro quo here is: you pay a premium for our shares, and we'll redeem your bonds at par.

Perhaps I'm too cynical, but I can't help thinking that there is more to this deal than meets the eye.

The beautiful game

I haven't researched any individual companies lately, but I do have a new article on shareworld about investing in football clubs.  In summary - I think it's a rubbish idea.

In other news: LLPC now trades higher than the offer price of 94p that I was so irritated to miss out on last year.  So I had to wait almost 12 months, but it got there in the end.  On the other hand if I'd managed to sell LLPC there was a decent chance I would have put the proceeds into NWBD - and that's returned 55% in the same timeframe.  Hmm...

Fairfax

I've written a new article on shareworld, on the subject of Fairfax Financial Holdings.  As it happens I like the look of them, but can't buy any shares, since my broker doesn't offer them (I'm limited to the UK, NYSE and a few selected others, but Fairfax is listed in Toronto).

Sometime in the next 3 months I need to sell my Berkshire Hathaway shares to realise the capital gain before I move to Norway (no capital gains allowance over there).  At the same time I'll be opening a brokerage account I can use from Norway - possibly with Internaxx - and that should allow me to buy shares in Fairfax.  I haven't quite decided yet, but there's a good chance I'll sell Berkshire and put some of the proceeds into Fairfax (probably not all of it, since I don't trust them quite as much as I trust Berkshire).

De La Rue - buy

3 weeks ago I wrote an article on shareworld about De La Rue.  The share price had suffered due to some quality problems, and although I thought it looked cheap, I was looking for a better entry point than 700p - preferably 600p.

Today De La Rue announced an update on the quality problems.  To me this looks like good news - the recognized financial impact so far has been a meagre £35m before tax (£25m after tax) vs a drop in market cap of almost £300m.  Although the final bill will likely be higher, I find it hard to believe it will be more than 10 times higher.

The market disagreed, and at one point De La Rue had dropped almost 10% to 640p.  I didn't manage to move quickly enough to get that price, but I was happy to buy in at 677p.  De La Rue is now just over 4% of my portfolio.

In other news I see that my views on Connaught (that there was an 80% chance of them being worth nothing) seem to have come true.  Today's announcement has put paid to any lingering hope that they might trade their way out of trouble.

Good timing (for once)

After buying a small stake in Southern Cross Healthcare on Monday, news emerges today that they are the subject of a "highly preliminary proposal with relation to a potential offer".  That was enough for a 56% jump in their share price, making them the top riser of the day.

As usual in these matters, events occurred in completely the wrong order.  First there was a 30% jump in the share price, then a statement from Towerbrook announcing an "indicative non-binding offer" (which triggered a further jump in the share price), followed by a sceptical response from Southern Cross: "the Board of Southern Cross has informed Towerbrook that it does not wish to enter into discussions at this time".

That triggered a brief downward blip, but the share price recovered to finish the day on 28.5p, up from 18p at opening.

I briefly thought about selling at 28p, but I've decided to hold on and see what happens.  Southern Cross started off so cheap that Towerbrook could still afford a pretty massive premium over the current price, and I did buy on the basis that they were worth 40-80p.

Southern Cross Healthcare

I picked up a few shares in Southern Cross Healthcare this morning at 19.47p.  This article on shareworld explains why.  SCHE now forms 1.4% of my portfolio.

De La Rue

I just can't stop looking at "bad news" companies.  Although I suppose a shipment of faulty banknote paper is in a different league to a 5 million barrel oil spill.

Today it's De La Rue.

Rok Group and Connaught

Two building services firms have recently seen their share prices hammered after announcing financial mismanagement, write-offs and warning over profits.  But while I think Connaught shares are probably heading to zero, I think Rok offer an opportunity - albeit a risky one.

Full details on shareworld.  (I disclaim all responsibility for the pun in the headline).

Update 16/8/2010:
Bought a very modest amount of Rok Group shares today at 17.97p.  They now form 1.4% of my portfolio.

BP - when to sell?

I've watched BP hit 420p a couple of times in recent weeks and started to think about selling.  So I've had another ponder about BP's value in the light of their recent results, and decided at what price I'll offload my shares.

As usual I've published my thoughts over at shareworld.  In a nutshell I'm going to hold on for 450p-480p, or a profit of about 30%.

Ocado

Ocado are doing an IPO.  Every analyst I can find is slagging it off, and there is speculation that it might not get airborne.  Being a contrarian investor, I decided to....  go along with the crowd.  The price is way too high.  Here are my thoughts:
shareworld - Ocado

More BP

Made a second purchase of BP today, at 335p, which should be my last (barring a further fall from here of 30% or more).

As you can see from my portfolio page BP now makes up a little over 8% of my share holdings, and is my second largest holding (after Berkshire Hathaway).

BP update

I still have cash on the sidelines that I'm prepared to use on BP shares.  They've fallen a little over 10% since I bought some last week, and there's been a lot of news since then - so do they still look like good value?

The market cap is now about $94bn, down from $174bn pre-spill.  Over the same period Shell is down 10%, so the BP-specific drop is $62bn.

BP have now promised to put $20bn into a fund to pay compensation claims.  If there is any money left over at the end then they'll get that back - but if the $20bn is inadequate they are still liable.  I'm happy to accept $20bn as a likely total for the compensation claims that will be paid out.  That's up from $15bn I estimated last week.

On the positive side, with this administered by a 3rd-party, BP hopefully won't be fighting too many cases through the courts.  So at least their legal bill should be kept under control - last week I estimated $15bn, but lets reduce that to $5bn.

The Clean Water Act seems like it may come into play, and that provides a fine of up to $4300 per barrel of oil spilled.  The latest estimate puts the top-end of the leak at 60,000 barrels per day.  The oil has been leaking for 56 days now, and it seems like it won't be finally capped until mid-August - so lets say 120 days.  That suggests a total leakage of 7.2 million barrels.  BP is going to capture some of that, but I think it's unrealistic to assume it can manage more than about 2 million barrels.  Let's say a total of 5m is going to get out there.  That means that BP's maximum liability under the Clean Water Act is $21.5bn.  Surely the fact that they are cleaning up the oil, and the fact that they are bending over backwards to pay compensation will weigh in their favour?  I think $15bn would still be a very conservative estimate here.

Finally there are the cleanup costs.  I estimated $10bn last week, and I see no reason to change that.

That makes a total of $50bn - exactly the same as last week.  Having said that, my feeling last week was that this was "apocalyptic", whereas now it only seems "conservative".  BP still look pretty cheap to me, but I think I'll hang on a little longer before committing more cash.

Update 17/06/10:
Another point in BP's favour - presumably the fines, cleanup costs and compensation claims are all paid pre-tax.  Last year BP paid a tax rate of 33%, so costs of $50bn should only equate to a reduction in value of $33bn.  That means the $62bn drop is well overdone, and in fact a fair price is about 440p.

Update #2 17/06/10:
Apparently fines are not tax-deductible, but the rest should be.  Therefore my $50bn estimate is actually $38bn post-tax, and a fair price is about 425p.

BP - Blooming Preposterous?

I've just bought some BP shares at 377p.  My reasoning is posted on shareworld but essentially I think the share price is already pricing in the worst-case - and therefore any surprise should be on the upside.  Of course that's not to say the share price won't go lower in the short run.

I was in two minds whether to go in big at the current price, or average in over a couple of purchases.  I've decided to commit about half of the total I'm willing to put in, and I'll keep an eye on the share price for the next few weeks looking for a good time to commit the rest.

BP is now 4.6% of my portfolio.

More tax fun

More mucking about to avoid tax today.  Shuffling IEEM and IAPD around, while also slightly reducing my holdings.  They both now form ~6.4% of my holding.  My last remaining tax conundrum is Berkshire Hathaway - and I can't use ISAs to get around that one.  I haven't yet decided what to do.

In other news, I'm considering buying shares in BP.  More on that later!

Shareworld part 2

After my brief stint in December/January, I've now returned to writing for shareworld again.  So far I've posted one new article there, on investing pitfalls.

As before, I'll always post every trade here on my blog as soon as I make it, and generally put more chunky stuff on shareworld.

Tax shenanigans

Today I've been twisting and turning like a twisty-turny thing to avoid paying capital gains tax when I move to Norway.  Overall I've basically sold SLXX and raised my stake in Tesco, British American Tobacco and Diageo.  In the process I've crystallised all my capital gains in all 4 stocks (by moving things in and out of ISAs).

Tesco, British American Tobacco and Diageo are now each 6.4% of my portfolio, up from 4.1%, 4.5% and 5.5% respectively.  SLXX was 5.1% of my portfolio.  There has been no overall change in my portfolio size.

I still have 3 capital gains that I need to crystallize:

• Berkshire Hathaway
• iShares Emerging Markets
• iShares Asia/Pacific Dividend

My gains in NWBD and LLPC are significant, but the bid/ask spread in these shares is large enough that it is not worth selling and rebuying them.

Trusts and funds

A slight departure from my usual material in this post - I'm going to look at some of the ways for a novice to invest in the stockmarket without going to the trouble of actually researching and buying individual shares.

Unit trusts vs Investment trusts vs ETFs
A unit trust is a vehicle that pools investors' money and uses it to invest in shares, bonds or other instruments.  When an investor buys units in the trust, these are created fresh and the fund manager uses the investor's cash to buy new investments.  When an investor cashes in their units, the fund manager must sell investments to realise the money required or (more usually) keep a small amount of cash on hand to deal with redemption requests.

In contrast an investment trust is a company that owns a pool of investments.  An investor buys shares in the investment trust at the market rate, and must buy them from another shareholder who is selling.  The shares are bought via a stockbroker in the same way as any other shares.  No new money is given to the fund manager, and the fund manager never has to sell investments to deal with redemption requests.  The share price of the investment trust will bear some relation to the value of its portfolio, but will not usually track it very closely.  The share price of the trust can diverge by more than 20% from its underlying net asset value, depending on supply and demand of its shares.

An Exchange Traded Fund (ETF) is like an investment trust, but one in which new shares can be created, or old ones destroyed.  This mechanism serves to keep the ETF share price very close to its underlying net asset value.

Active vs Passive management
ETFs are nearly always passively managed, i.e. they don't attempt to beat the market, simply to track a particular index (such as the FTSE 100).  Unit trusts and investment trusts are most often actively managed, i.e. they are run by a fund manager who buys and sells in order to try and outperform.

Superficially you might think that actively managed funds were a good thing - after all it's better to beat the index than just to match it.  The trouble is that the average fund manager will be exactly that - average.  There's no telling which manager will manage to beat the market, and which will underperform.  And this is where the really important part comes in - fees.  An average fund manager will give an average market return minus fees.

Fees
Unit trusts will usually charge a fee upfront when you initially invest (although you should be able to avoid this by buying via a fund supermarket), and then an annual management charge.  Investment trusts and ETFs will have no up-front fee, but you will have to pay stockbroker charges (say £15 or so) and (if the investment trust or ETF is UK-listed) stamp duty of 0.5% - and then an ongoing management charge is deducted from the investment trust's assets.

Actively managed funds will typicall charge a lot more than passively managed funds.  Here are some examples:

• Invesco Perpetual Income is an actively managed unit trust.  It has an initial charge of 5% (although you should be able to avoid that if you buy via a fund supermarket rather than a normal financial adviser) and an annual management charge of 1.5% plus 0.19% other expenses
• Legal And General UK Index is a passive unit trust.  It has no initial charge and an annual management charge of 0.4% plus 0.15% other expenses.
• Foreign and Colonial is an actively manageed investment trust.  It is UK-listed so you will pay 0.5% stamp duty up-front, plus stockbroker fees.  It has a total expense ratio of 0.58%.
• iShares FTSE 100 is a passive ETF.  It has a total expense ratio of 0.4%.  It is listed in Ireland, so there is no stamp duty to pay.

So what is the best type of fund?
I don't believe it's possible to pick a winning fund manager in advance, and therefore I am totally ambivalent about whether a fund is actively or passively managed.  What I can predict in advance is the fees that will be charged - and a fund that charges the lowest fees should, on average, give the best return over the long term.

Personally, therefore, I would opt for the cheapest type of fund, which usually means one that is passively managed and tracks a popular index such as the FTSE 100 or FTSE All Share.  The Legal and General fund is pretty good at 0.55% per year, but the iShares ETF is even better at 0.4% (plus £15 or so up front in stockbroker fees).

But which fund should I invest in?
I'm not here to tell you which fund you should invest in - except that you should keep the fees as low as possible.  I think for a UK-based investor a FTSE 100 or FTSE All Share tracker is perfectly adequate.  The FTSE 100 will tend to be more internationally diversified, whereas the All Share will cover a more diverse set of sectors.

Resources
trustnet has details on a huge number of unit trusts, investments trusts and ETFs.

If you want to invest in an actively managed unit trust then your best bet is probably going through a fund supermarket such as sfs (there are many others - google "fund supermarket").

If you want to invest in the Legal and General unit trust then you can do so directly through their website.

There are many online stockbrokers who will let you invest in ETFs, investment trusts and ordinary shares.  I use Motley Fool.

Vero - mission accomplished

My usual investing style is buy-and-hold, but last week I made a purchase for the very short term - Vero Software.  As I wrote here, Vero seemed on the verge of being acquired at what I thought almost certain to be a price higher than they were currently trading at.

Yesterday the announcement was made - and although it was marginally below the lower end of my expectations, it still gives me a 17% profit for what will be a holding period of ~2 months.  Enough shareholders have already committed themselves to voting in favour that the deal looks done and dusted.

I was expecting the offer to come in at about 18-24p, but in the end the offer was made at 17.5p, 40% above their recent average of 12.5p.  So I was slightly on the optimistic side, but left myself plenty of margin of safety by buying at 15p.

The purchase should be complete in mid-July, at which point I can collect my 17.5p per share.

I don't expect to do much trading of this sort, but when the opportunity presents itself I'm certainly not going to spurn it.

Goodbye Next, Hello Vero

Vero Software is a tiny IT company that provides software for the mould and die sector. They are on my radar because I'm a member of an investment club that has held their shares for the last year or so.

Their preliminary results came out today (http://investegate.co.uk/Article.aspx?id=201005101452136441L). The news was unspectacular - their revenue was down a bit, EBITDA up a bit, EPS down a bit. What caught my eye was this paragraph:

On 16th September 2009, the Company announced that it was in talks which may or may not lead to an offer for the Company. Discussions with more than one party subsequently followed and the Company is pleased to report that negotiations are now at an advanced stage and it expects to be able to make an announcement within the next two weeks. There can however be no certainty that an offer will be made nor as to the terms on which any offer might be made.

Now I was aware that Vero had been in talks about a potential offer, but at no point had they given a hint that negotiations were at an "advanced stage". So this came as a pleasant surprise.

Vero have been wibbling around at 12-13p per share for ages. Since talks about an offer have reached an advanced stage, I can only assume that someone is willing to offer a reasonable premium above the market price - lets say 18-24p. And if an announcement is due in under 2 weeks, the share price could move very quickly.

On that basis, I quite fancied a punt at ~15p, for a very quick 20-60% profit. Consistent with my aim for this year of realising most of my accumulated capital gains, I sold all of my Next shares (for a profit of 99%, including dividends) to free up some cash, and put up a little more than half the proceeds towards a buy order for Vero at 15p.

A bit under half my order was fulfilled before the end of the day's trading, and the rest remains outstanding as a limit order.

The shares I have manged to pick up now form 1.7% of my portfolio, and if the limit order is completed that will rise to 3.7%.

In 2 weeks time I might be looking rather foolish, but I think the shares look pretty cheap even ignoring the offer, so my downside should be limited. If it looks like I'm going to be lumbered with them for the long term then I'll make a more detailed post with my rationale for holding - at the moment this is purely a short-term play on this potential offer.

Game Group

It's been a while since I bought a new share, but I'm seriously considering dipping my toe in the water for the sake of Game Group. They announced their preliminary results today, with the following highlights:

• Operating profit down 28%.
• Revenue down 10%.
• Their CEO and UK Chief Operating Officer are both stepping down.
• For the first 11 weeks of the year like-for-like sales are down 14%.

How could I resist?

Background

Game Group are the market leading game store in the UK with 600-700 stores. They have another 700 abroad, but derive over 60% of their revenue from the UK. They also sell online, but their online revenue is only ~5% of the total.

Prospects

Game faces competition from other games shops (HMV is probably their biggest threat, given that it's desperately replacing its diminishing CD revenue), non-specialist retailers like Tesco and Argos, and online retailers such as Amazon and play.com.

The key question is whether they can continue to trade profitably despite this barrage of competition. They have some points in their favour:

• 20% of their revenue comes from their pre-owned offering, and their gross margin on these sales is over 40%. In this segment they are relatively immune from online and supermarket competition, so it's basically them and HMV.
• Their reputation as a specialist retailer means that they will be a popular choice when buying peripherals - these form 13% of their revenue, and have a gross margin over 30%.
• People may be reluctant to make a very large purchase online, which means that Game and the other terrestrial retailers have an advantage when it comes to new hardware sales. New hardware forms 25% of Game's revenue, with a margin of ~22%.

I think it likely that online sales of new software will continue to increase, which will eat into Game's store-based revenue. But at least some of that growth will go to Game's online business, and they should be able to close stores as they become unprofitable. They may turn into quite a different sort of business over the long run, but I don't think their business model is going to implode anytime soon.

Income

If we're looking at a business in slow decline, it's important to make sure that they are not going to be strangled by fixed costs and tip into unprofitability in a few short years.

Their total gross margin is about 28%. About 80% of that goes into selling, distribution and administration (including about 30% in staff costs), to leave a net operating margin of 5.6%.

Assuming their fixed costs are entirely fixed, then a 10% fall in revenue should result in a 10% fall in gross profit, and that should then carry through into a fall of 50% in their operating profit. Nasty! 10% may even be optimistic, since like-for-like sales so far this year are down 14%.

Clearly there are substantial risks to the downside here.

Balance sheet

Game have a Net Tangible Asset Value of £150m. They have £176m of inventory, but this is more than funded by their £260m of trade and other payables. They have £86m of cash, offset by £40m of debt.

It's interesting to compare their £176m of inventory with their total revenue of £1.7bn. That suggests products sit on their shelves for an average of only 36 days before being sold. Crikey - that's far less than I would have guessed. Suggests they're running a pretty tight ship.

Price

Now we come to the interesting bit. Clearly this is a company facing some significant risks and uncertainty. It will need to be trading at a pretty decent price for it to be worth investing.

Today Game has a share price of 89p, and a market cap of £354m. In 2009 they earned £64m after tax, for a P/E ratio of 5.5. In 2008 they earned £103m after tax, which would mean a P/E ratio of 3.4 - that's unlikely to represent an ordinary year, but shows what is possible if the market picks up a little.

If the game market stages a recovery, then I think Game could achieve post-tax earnings of ~£80m. If that persisted for a couple of years, then uncertainty may recede, and Game Group might be accorded a P/E ratio of 12. That would mean a market cap of £960m and an increase in the current share price of 170%. Add in four years of steadily increasing dividends and the total return would be 200%.

On the downside, a continued decline in revenue could quickly lead to Game making losses. A couple of years of that would result in them running out of cash, and once that happens Game would be staring into the abyss - the shares could easily go to zero.

Conclusion

This is by no means a dead cert, but I think a 200% upside makes it a decent punt.

Update 22/4/10:

Bought this morning at 92.6p. Game now forms a little over 4% of my portfolio.

Letting the tax tail wag the investing dog

Today I sold a share for tax reasons. I'd rather not be doing that, but unfortunately the treatment of capital gains tax in the UK and Norway is so different that I'd be mad not to take advantage of the UK rules while they still apply to me.

I'm planning to move to Norway late in 2010 - late enough that I'll still be resident in the UK for the 2010/11 tax year. We're still a couple of weeks short of the end of the 09/10 tax year, so I effectively have two tax years to play with, and two capital gains allowances (I invest on my wife's behalf as well as my own).

In the UK I can make a capital gain of £10100 before I pay capital gains tax. When I do pay tax, it is charged at 18%. In Norway, although there are some minor allowances, the tax rate is effectively 28% on the entire sum. Furthermore, although I have some of my investments in ISAs, these do not shelter me from Norwegian taxes.

Over the last 12 months I've made some significant capital gains - and I'd rather not give up 28% of my profit to the Norwegian state. So I've reluctantly decided to sell any of my investments with a significant capital gain attached. Using up the remainder of my 09/10 allowances means selling Barclays - which I did today for an overall profit since purchase of 289%.

Over the next 6 months or so I will be selling up other shares where I can save tax in doing so. I'll need to take account of dealing costs (selling and buying), stamp duty, and the bid/ask spread. Once I have the cash in hand, I may buy straight back into the same share (after waiting the minimum 30 days to avoid HMRC's bed and breakfasting rules) or I might put my money to work elsewhere.

I'm going to end up selling the vast majority of my portfolio, with the exception of LLPC, BDI, QDG, CPT, MXM.

As to whether I will reinvest in Barclays, I'm not sure I can make a convincing enough case. I think it is probably worth more like 450p than 350p, and a potential 30% increase is not to be sneezed at, but I think there are probably better alternatives. I'll be looking into some of those soon.

SLXX - should I sell?

Today I'm going to look at whether SLXX still deserves a place in my portfolio, or whether I should sell. I've held them for almost a year, and in that time I've earned a capital gain of 20% and 7% of dividends. Pretty good, huh? Well, actually no. In that time the FTSE is up over 50% before dividends. On the other hand, if I'd kept the money in cash I would have earned less than 2%, and at least SLXX did better than that.

Yield
Right now SLXX has a yield to maturity of 5.6%. Its Macauley Duration is 8.7 years. How much of a risk premium is built into that yield? IGLT holds UK government gilts - it has a yield to maturity of 3.3% and a Macauley duration of 8.3 years. We can consider that the risk free rate, and the durations are close enough to afford a direct comparison. The risk premium in SLXX is therefore 2.3%.

Is 2.3% a reasonable figure? To work that out we need to know the default risk of the bonds making up the ETF. That is unknowable, but we do have the ratings. Here's how the holdings break down:
Aaa -- 5%
Aa1/2/3 -- 26%
A1/2/3 -- 42%
Baa1/2/3 -- 27%
Ba1 -- 2%

So they're grouped fairly evenly around a central rating of A2. That is defined as "Safe investment, unless unforeseen events should occur in the economy at large or in that particular field of business". Not super-helpful. Moody's historical default rates for bonds rated A2 is about 0.4%, according to this paper. The economy is in a pretty dire state, so we could legitimately assume the actual default rate could be higher than 0.4% for a few years. Call it 0.8% for safety.

That suggests that holders of SLXX are being rewarded with an extra 1.5% of yield, over and above the expected default rate. That seems a little on the high side, but it is never going to reduce to zero.

This chart suggests a long-term average yield premium for AA corporate bonds over US gilts is about 1%, and for BBB bonds it is about 2%. So for A2 bonds ou might expect a normal yield premium of 1.5%, and a best-case of about 1%.

According to wikipedia a decrease in yield of 1% will increase the value of a bond by its Macauley duration. So if the 2.3% yield premium on SLXX decreased to 1.3%, its price might increase by about 8-9%. If we assume it takes 2 years for that to be achieved, then the total return on SLXX will be about 10% per year (5.6% of interest/dividends, and 4-4.5% of capital growth).

Currency
If I was planning to live in the UK indefinitely, then I would probably hold onto SLXX. But I'm not - I'm expecting to move to Norway within the next year. 43% of my shares are linked to the pound to a large extent - they are either UK companies with most of their revenue in sterling, or UK bonds. In addition, I have a house, and some cash, and a mortgage.

The net of that is that about two-thirds of my net wealth is tied up in sterling. That's a long way from the ideal - I'm facing significant currency risk. SLXX is not helping - but selling it and holding the cash will not help either, so I need to have a plan in mind for what to switch into before I sell.

Conclusion
I'm content that SLXX is worth holding for its expected return, but it's not giving me the international diversification that I require. I will start looking for an alternative to switch into.

Tinkering vs masterful inactivity

Over the last 2 years I've sold 10 shares out of my portfolio, and every time I've felt a sense of unease. I know that tinkering too much with your portfolio is a way to lose money - after all, every trade eats into my returns via dealing costs and stamp duty.

Thus far I've been reluctant to look too closely at what happened after I sold - after all I don't really want to know that I've missed out on oodles of potential profit. Today I've decided to bite the bullet and go digging, to see whether I really would have been better sitting on my hands.

Firstly, here are the shares I've sold, and what I replaced them with:

• IEER, swapped into IEEM.
• IFFF, swapped into IEEM.
• LTAM, swapped into IEEM.
• EDD, sold in order to buy more ZRX.
• ZRX, sold because I was fed up; the proceeds went into NWBD.
• TW, sold because I was fed up; the proceeds went into BATS and NG.
• HSBA, sold in order to buy CPT.
• RBS, sold mostly in order to buy LLPF, although some proceeds went into BATS and NG.
• LLOY, sold in order to buy GSK.
• LLPF, sold in order to buy LLPC.

Let's take a look at those and see how I did.

Emerging market ETFs

I swapped IEER, IFFF and LTAM into IEEM in order to simplify my portfolio. I expected the returns from IEEM to be almost identical.

Since then IEER, IFFF and LTAM are up an average of 94%, whereas IEEM is up 79%. Not disastrous, but clearly I would have been better off not interfering on this occasion.

EDD

This one stings. I sold EDD to buy more ZRX shares. Since then EDD is up 220%, and ZRX is down 90% (although I sold ZRX after it had fallen a mere 40%). Ouch. I should really take a look at what's been happening at EDD since I sold, and work out where I went wrong - but let's save this for another day.

ZRX

I sold my Zirax shares after a brief rally, and for once managed to get my timing spot on. After I sold they fell over 80% (and will be delisted next Monday). Shame I ever held the shares in the first place, but at least I picked a good time to sell. Furthermore, the proceeds went into NWBD, which is since up 22%.

TW

Taylor Wimpey is another share where I sold out after taking heavy losses. They're unchanged from when I sold (although along the way there were better selling opportunities at about 50p). I didn't really sell in order to buy anything in particular, but after a couple of weeks the cash went into BATS and NG, which have since returned about 20%, so I think I'll count this one a success.

Bank shares

HSBC has risen 33% since I sold them (not including dividends), whereas CPT has returned a total of 18% even including dividends. So chalk that one down as another error.

RBS is down 30% since I sold; the proceeds of this sale went into NG (up 15%), BATS (up 25%) and LLPF (up 152% when I sold).

LLOY is down 37%, although there once you adjust for the rights issue that's only about 20%. All the proceeds of that went into GSK, which is up 7% since then.

Finally there's the trade I made from LLPF into LLPC. There were 3 outcomes for LLPF: holding onto them, taking Lloyds' cash offer, or exchanging for LB1G ECNs. Holding onto them would have lost me 12%, but realistically I would never have done that. Exchanging for cash would have given me an extra 2%. The ECNs are now trading significantly above the level that LLPF was pre-exchange, and they would have netted me 15%. In the meantime I'm roughly where I started with LLPC, down only 1%.

Conclusion

OK, so 6 out of 10 sales lost me money once I take into account what I did with the proceeds. On the other hand, my average profit on a successful sale was more than triple my losses on a bad sale. And that disastrous EDD to ZRX swap was more than outweighed by the stonking profits when I traded in RBS for LLPF.

On the whole I've done pretty well. If I'd kept these 10 shares, they would now be up 8%. But the shares I've replaced them with have given me a return of 35%.

So tinkering turns out to have been a smart move after all - although I think I'll be resisting the temptation to do much more of it. Masterful inactivity is the order of the day.

International diversification

I've recently added a pie chart to my portfolio page showing the breakdown internationally and (within the UK) the split between shares and bonds. At the moment it looks like this:

The UK represents a scarily large proportion of that pie, given that I'm attempting to be well diversified. But appearances can be deceptive. I've rated shares like GlaxoSmithKline, British American Tobacco and Diageo as "UK shares" just because they are listed in London. But in fact the huge majority of their revenue comes from abroad. So even if the UK economy tanked, these companies would still do well.

I've attempted to come up with a more accurate picture by dividing up the UK shares according to the source of their revenue, and then allocating that to the other slices of the chart. The result looks much healthier:

Although this looks like I'm now rather overweight in UK bonds, that is no bad thing while I still have a mortgage denominated in sterling. It suggests a good home for my next investment is in Asia or Emerging Markets.

Inflation

Today I'm going to talk a bit about inflation. I was recently asked whether I thought investing in gold is a good hedge against inflation. In short, my answer is "yes, but I think there are better alternatives". I'll try to cover as many alternative approaches as I can here, and work out roughly what return an investor might expect, and what risks they might run. As with everything on this blog, this is all my own opinion, it's not intended as investment advice, and you should use it at your own risk.

In my examples I'm going to work out the expected return for a taxpayer paying tax at 20%, assuming two different rates of inflation: 3% (which is pretty much what I expect) and 8% (as a reasonably plausible worst-case scenario).

Physical cash
I'll start with an option which is almost certainly not smart: holding physical cash. Under the mattress for instance. You earn no interest, but there are no associated costs. Every £1 of your money will still be there in 10 years time, but inflation will have reduced its purchasing power. Assuming 3% inflation per year, your £1 will only be worth 74p in real terms. Your annual real return (i.e. after inflation) using this method is minus RPI.

Expected real return: (0 - RPI) e.g. -3% / -8%
Risk: moderate (theft, fire)
Flexibility: very high

UK-based Savings account
The best-buy savings accounts tend to pay an interest rate roughly equal to the Bank of England base rate. If you put your money in a UK-based savings account, and switch accounts regularly to take advantage of the best rate, you can probably earn a return roughly equal to the base rate.

But would that be more or less than the rate of inflation? In normal circumstances you would expect the BoE base rate to exceed the rate of inflation. Most people would rather consume goods today, rather than next year. The rate of interest is the reward for delaying consumption. If the rate of interest is lower than the rate of inflation, then in real terms the interest rate is negative - people are being penalized for delaying consumption. That might prevail for a period, but over the long run you would expect the real interest rate to be positive. In recent times the real interest rate has been approximately 2%.

Tax muddies the water here. If the rate of inflation is 8%, the base rate is 10% (and you earn this in a savings account), then your real return is +2%. But if you pay tax at 20%, then your real return is zero.

Expected real return: ((BaseRate * (1 - TaxRate)) - RPI) e.g. 1% / 0%.
Risk: Low. zero capital risk (assuming you spread your money around enough to benefit from the government savings guarantee) but you run the risk that the BaseRate may fall below RPI, or that banks may pay less than the BaseRate on their savings.
Flexibility: very high

UK gilts
Buying government gilts gives you an almost identical return to a UK savings account. If you stick to short-dated gilts there is minimal price risk, and it removes the risk that you might not find a savings account paying the BoE base risk. On the other hand, buying and selling is slightly harder than just withdrawing cash from your account.

Expected real return: ((BaseRate * (1 - TaxRate)) - RPI) e.g. 1% / 0%.
Risk: Zero.
Flexibility: High

NS&I savings bond
National Savings and Investments offer a 3-year and 5-year index linked savings bond, paying (RPI + 1)% - and it is tax free.

Expected real return: 1% in all circumstances e.g. 1% / 1%
Risk: Zero (guaranteed by government)
Flexibility: Low. Your cash is tied up for at least 3 years.

Gold
Gold is an interesting case. Over the very long term you would expect it to track inflation, but over the short run the price is extremely volatile. There are also costs associated with it - holding physical gold involves significant dealing costs, and even holding it through an Exchange Traded Fund will usually incur an annual charge of 0.4%. Capital gains are also subject to tax unless you hold physical gold that is legal tender in the UK (e.g. gold sovereigns).

Expected real return: (0 - fees - tax) e.g. -0.4% / -0.4% (assuming you keep below the threshold for paying capital gains tax and hold it through an ETF.
Risk: High. The gold price is extremely volatile.
Flexibility: High. If you hold through an ETF you can sell some of your shares at any time to realise cash.

Sterling corporate bonds
Corporate bonds will typically pay a rate of return higher than the BoE base rate. An investment grade corporate bond might pay around 1% more than base rate. The tax situation and overall return is similar to that of a savings account, but there is greater risk (companies can default on their debts, although if you hold high-quality bonds that is extremely rare - Lehman Brothers is the only recent example that springs to mind). There is also greater volatility if you hold longer-dated bonds, since these will fluctuate according to economic circumstances.

Expected real return: (((BaseRate + 1) * (1 - TaxRate)) - RPI) e.g. 1.8% / 0.8%.
Risk: Moderate. Your capital is at risk (albeit quite a low risk) and there can be short-term fluctuation in bond prices. There is also the risk that bond yields may fall below inflation.
Flexibility: High. You can sell your bonds at any time.

Foreign currency savings, gilts, bonds
I'm not going to cover all of these in any great detail. Anything denominated in a foreign currency brings the serious disadvantage of currency risk. Theoretically, over the long term, exchange rates should be determined by the relative rates of inflation in two countries. Therefore, If inflation in the UK is 8%, and the rate in the US is 3%, then in one year the pound should fall by 5% against the dollar. However, investing your money in the US should earn you a lower rate of interest, since you would expect the interest rate to be 5% lower in the US. So in theory these should cancel out, and you will be no better or worse off investing abroad. In practice, however, exchange rates fluctuate far more than this, and therefore you are exposing yourself to substantial currency risk for (in theory) no greater rate of return.

Expected real rate of return: identical to similar UK investment.
Risk: High. Exchange rates can be very volatile.
Flexibility: High.

Inflation-linked annuity
If you are at or close to retirement age, an annuity might be a sensible choice. Current inflation-linked annuity rates for a couple aged 65, with the payout to the surviving spouse reduced to two-thirds after the first spouse dies, are about 2.9%. You would then have to pay tax on that income, so that would equate to about 2.3%. You can try out other numbers here: http://www.fsa.gov.uk/tables/bespoke/Annuities.

Expected real rate of return: n/a since capital is used up, but pays a post-tax income of ~2.3%.
Risk: Low.
Flexibility: Zero.

Shares
Finally, lets get onto shares. To predict the return from shares you have to make a lot of assumptions, but here goes:

• Let's assume that publicly listed companies form a roughly static percentage of the total economy.
• Let's assume that profit margins at publicly listed companies are roughly static.
• Let's assume that new capital investment in the stock market is negligible compared to the total market size (bit of a stretch).
• Let's assume that the UK stock market is a reflection purely of the UK economy (this is simply wrong, because it is very diversified internationally).

At the moment you can earn a dividend yield of about 3.5% on the FTSE100. If the assumptions above hold true, then the earnings of the FTSE100 should increase at a rate of (inflation + GDP growth)%. The real rate of return to the shareholder is therefore GDP-growth + dividend-yield - tax. There is no dividend tax for a basic rate taxpayer, and provided you keep below the capital gains threshold, your return is therefore GDP-growth + dividend-yield.

Expected real rate of return: GDP-growth + dividend-yield, e.g. 6% / 6% (assuming 2.5% GDP growth)
Risk: High. Share prices are very volatile.
Flexibility: High. You can cash in shares at any time.

Summary
There are clearly a lot of choices here, and different options suit different people, but in my opinion there are some options that are inferior in every respect. I rate gold as one of these, and can see no circumstances in which it would be preferable to hold gold rather than an NS&I Savings Bond (unless you are speculating rather than investing).

The investments I rate as worthwhile are:

• UK savings account, for maximum flexibility while still roughly keeping pace with inflation. If banks stop offering such generous rates you could switch into short-dated gilts.
• NS&I Savings bond, for a guaranteed above-inflation return, with no risk and no tax, at the expense of flexibility.
• Inflation-linked annuity, if you are of retirement age, cannot afford the risk associated with shares, and are willing to sacrifice capital for an inflation-linked income.
• Shares, if you can afford to tie up your funds for the long term (at least 5 years) and have the temperament to ride out the volatility.

Shareworld and I part company

After 6 weeks or so of writing for shareworld we've agreed it isn't really working out, and therefore I'm returning to this blog as the main repository for my investment thoughts.

One thing I did do to shareworld which I think needs a permanent repository is an at-a-glance portfolio page. I've therefore created one here:
http://www.danieltebbutt.com/portfolio.html
I'll be updating this regularly - it's autogenerated from my portfolio tracking script, so I can re-publish it at the press of a button.

Berkshire Hathaway convinces me again

After looking at a whole bunch of US shares, I've returned to the only one I currently hold: Berkshire Hathaway. I still think it's cheap, I still think it's a great company, and I see no reason to go elsewhere. I doubled my holding today, making Berkshire almost 17% of my portfolio.

Full details here:
http://www.shareworld.co.uk/index.php/dan/articles-2/berkshire-hathaway.html

US shares - updated

In August I looked at a handful of US shares to see what I might like to invest in once my US$ exposure vanished. That time has now come, and from now on I am ready, willing, and able to invest in US shares. If they're cheap, that is.

In August I thought fair value for the S&P 500 was 900, and it's since risen from 1000 to 1136. At that sort of price I need to be very selective. Every share I looked at in August has increased - some more than others. Amazon seems to be the best performer, rising 50%, and I thought that was ludicrously expensive to start with!

In August I thought Google, Amazon and Coca-Cola were all over-valued - they've only got more so.

I thought Microsoft and McDonalds were cheap, and they've since recovered to what I consider fair value.

I thought GE and Johnson & Johnson were cheap, and they remain so (although they're pricier than they were).

I'll be taking a closer look at some of these in the next few weeks. Johnson & Johnson doesn't fit particularly well in my portfolio, since I already hold GlaxoSmithKline. Microsoft and McDonalds offer a bit more variety. It's difficult to say whether General Electric fits well or not, since it's already so diversified.

Zirax possible de-listing

I must say I'm feeling pretty smug about getting out of Zirax at 5.75p (even though it crystallised a 50% loss). On Wednesday they announced that their largest shareholder (M. Baranov, who directly or indirectly controls 67.2% of the company) has requested a general meeting on which to vote on de-listing from AIM:
http://www.investegate.co.uk/Article.aspx?id=201001130700064528F

In order for the motion to be carried, it needs the consent of 75% of the votes cast at the general meeting. This is AIM rule 41 (you can see all the AIM rules here: http://www.londonstockexchange.com/companies-and-advisors/aim/documents/aim-rules-for-companies.pdf). Note that is 75% of the votes cast, not the total voting rights - if 11% of the shareholders don't bother to vote, then Baranov can get the motion passed purely based on his own holdings.

Zirax's major shareholders (from the Zirax website: http://zirax.com/major-shareholders.html) account for 90.2% of the voting rights, and I think we can assume all of these will exercise a vote, so Baranov will need some support. But I can't imagine he would ask for a general meeting without knowing which way the vote will go - so I assume he has support from Andosov, Pennygold or Metropol, each of which on their own would probably be enough to swing the vote his way.

I have no desire to hold shares in an unlisted company (especially one with Zirax's history of financial mismanagement) so I'm glad I'm no longer a shareholder. If I was, I guess I'd be selling out right now at about 2p.

Further shareworld articles

So far in January I've written 3 further articles for Shareworld.

A look at the supermarket sector, keeping an eye on whether my investment in Tesco remains a sensible hold.
http://www.shareworld.co.uk/index.php/dan/articles-2/supermarkets.html
I plan to continue holding Tesco shares, and I'm debating adding a few more to the pile.

A look at Next's share buybacks, where they appear to have unerringly purchased their own shares at the wrong time over the last 3 years.
http://www.shareworld.co.uk/index.php/dan/articles-2/next-share-buybacks.html
Since I wrote the article they've spent another £45m buying 2.2m shares and reducing the share capital of the company by a further 1%.

A review of my portfolio performance over the last two year vs the FTSE 100, taking account of sharepicking, market timing, yield and volatility. Thus far I'm modestly outpeforming on all counts - but 2 years is far too short a time to draw any meaningful conclusions, so the jury is still out on whether I'm skilful or just lucky.
http://www.shareworld.co.uk/index.php/dan/articles-2/2008-2009-review.html