Dan's Investment Blog

Portfolio tweaking & 4-year performance review

2012-01-24T12:12:00.000-08:00

Tweaks
I've done some fiddling around the edges of my portfolio. Nothing major, just tidying stuff up.

In summary:

Sold my paltry holding of Game Group shares (on which I had an ENORMOUS capital loss).
Bought it again immediately in a different account (in fact, about 3 times as many shares - still a paltry holding though!).
Sold Bond International Software, crystallising another capital loss.
Sold Maxima, for another capital loss.

The latest snapshot of my portfolio is here:

http://www.danieltebbutt.com/portfolio.html

I've now rated Rok shares as zero and put them in the "sold" category. I'm not entirely sure if they're officially worthless yet, but my sharedealing account no longer shows them as a holidng, so...

Now everything is much tidier: only 6 shares in my portfolio: Berkshire, Tesco, NWBD, IS15, BP, GMG. And only one real tiddler: GMG.

Review

While I'm here I may as well post some performance figures for my portfolio in 2011. Bit misleading since my trading was almost entirely driven by external factors rather than trying to beat the market, but anyway... lets compare with previous years. I can't remember how I've worked this out before, but attempting a new and fairly simple method I get:

2008: Down 53%

2009: Up 42%

2010: Up 19%

2011: Down 3%

i.e. if I'd been a fully-invested closed investment trust then £100 at the start of 2008 would now be worth £77. Boo. Luckily my funds under management were very approximately:

2008: X

2009: 2X

2010: 4X

2011: X

Meaning I have an overall profit of 60%, or an annual return of 12%. Hurrah!

I don't have data to compare with the FTSE, but staring at a graph and making up some dividend yields I come up with:

2008: Me -53%. FTSE all-share -30%

2009: Me +42%. FTSE +28%.

2010: Me +19%. FTSE +14%

2011: Me -3%. FTSE -4%.

So if I'd invested exclusively in a tracker then I would have made 39% overall, or about 8.5% per year.

Fully invested in a tracker throughout the period I would have been down 2%.

And finally just for fun: so far in 2012 I'm down 2.6% while the wider market is up 3.3%. Ouch - a 6% disparity already, and it's not even February...

Portfolio now up-to-date

2011-11-28T13:25:00.000-08:00

It's been a while, but I've finally updated the portfolio page on my website:
http://www.danieltebbutt.com/portfolio.html

Key things of interest:

My current portfolio is about a third of its peak size (because I sold almost everything when buying a house in Norway and started reinvesting when I sold my house in the UK).
I have some big losers in my portfolio. I kept all my losers for the tax benefits (which are worth more in Norway than in the UK) but it turned out that the losers kept on getting worse, so overall this has proved a bit stupid.
I got lucky with the timing of some of my new purchases, and as a result BP is up 15% and Tesco 12%.
2 shares make up 55% of my portfolio and 5 shares make up 94%.

I have no immediate plans to make further changes to my portfolio. I have some cash available to invest, but I don't fancy it at current prices. If prices fall then I'll probably put it into shares, otherwise I may stick it into bonds (e.g. more IS15). Or just hold onto cash.

Portfolio update

2011-10-24T13:05:00.000-07:00

I haven't unpacked my desktop computer yet (!) so the portfolio page on my website is woefully out of date. Here's the current situation, with the dates and prices of my recent purchases):

Cash 50%
Berkshire Hathaway 17% (bought 20/10/11 at $74.25)
Tesco 10% (bought 27/9/11 at £3.53)
NWBD 9% (bought 27/9/11at 93p)
BP 5% (bought 28/9/11 at £3.79)
GBP 1-5yr corporate bond ETF 5%
Bond International Software 2%
Game Group 1%
Maxima Holdings 1%

The last 3 I'm only holding for the tax losses - Once I'm well-ensconced in the Norwegian tax system I will sell and reap the rewards. For Game Group in particular the tax losses are worth almost as much as the shares themselves :-)

For now I'm taking a bit of a breather. I'm ready to invest about a third of my cash. I'm still not sure whether to spend or invest the rest.

Hei fra norge

2011-09-21T12:57:00.000-07:00

It's been over 4 months since I last posted, and I'm now living in Norway. I've sold my house in the UK, which means that once again I have funds available for investment. At the moment I'm a bit too busy renovating my house and learning Norwegian to do any in-depth research, so my plan is:

Get a sensible overall asset allocation.
Invest funds that I'm happy to tie up for the long term.
Invest in safe, low-maintenance shares I already know well.

Asset allocation

I'm no longer tied very tightly to the UK. I still have family and friends there, so I will be visiting regularly, but it doesn't make sense to have most of my funds tied up in sterling. On the other hand, investment opportunities in Norway are limited, so I don't want my money tied up in kroner. I have a vague future entitlement to some US dollars through my work, so I don't want to be overweight in dollars now. I need a decent mix - lets say 40% UK, 30% US, 30% Euro/other. I don't mind if shares are denominated in sterling if they're really international.

Funds for the long term

Of my available cash right now I'm going to invest half and keep the rest in cash. I'm not yet sure if I'll spend that cash in the near future, or invest it later.

Shares I know well

Here are some of the various shares that I owned recently and was happy with:

Berkshire Hathaway. I need look no further for the US part of my portfolio.
Tesco. I like Tesco a lot, and they look pretty cheap on a P/E ratio of 11.
Next. I like Next, but they are in a difficult industry. They've done fantastically well, but will they continue to do so for the next 10 years? I wouldn't like to say. And therefore they fail the "low-maintenance" test.
NWBD. Currently on a yield of just under 10%. Seems a pretty good deal, although this is obviously totally UK focused.
Lloyds. Look very cheap, but beyond my powers of research, so I'm going to rule them out.
Diageo. Moderately expensive, and they do have a lot of debt, but I also like them quite a lot. They're also a good international company - although the share price is in sterling the UK is not a big market for them.
British American Tobacco. Too expensive on a P/E ratio of 19.
BP. Pretty cheap, and very international.
Greene King. Very UK focused, and although they are well-led I wouldn't like to predict how they will do in the next 10 years.

So putting it all together my candidates are:

US: Berkshire Hathaway.
UK: Tesco, NWBD.
Euro/other: Diageo, BP.

I expect to invest my funds over the next few weeks.

Quick update

2011-05-09T11:55:00.000-07:00

Since selling off 90% of my portfolio I haven't really been on the lookout for anything new, so I've been pretty quiet recently. Sadly the world at large hasn't remained quite so static:

Game Group continued to plummet, before staging a minor recovery.
Maxima has cratered.

At the moment all my trading decisions are driven by tax / administrative reasons. Accordingly I have:

Held onto BDI, GMG and MXM in order to realise the tax losses when I move to Norway. (Also ROK, but I can't sell those even if I want to).
Sold IAPD to realise the capital gain at £18.82.
Made a small investment in IS15, a short-term sterling corporate bond ETF from iShares at £102.52. (I've recently opened a new trading account that I can use after moving to Norway and you need to hold some shares to avoid inactivity charges).

As always my entire portfolio (plus all the shares I've ever held) is available here:

http://www.danieltebbutt.com/portfolio.html

And every trade I make will appear on this blog.

P Z Cussons

2011-02-25T13:53:00.000-08:00

As a follow-on to my recent article on Unilever, I've now written about a potential acquisition target: P Z Cussons.

Unilever

2011-02-20T13:16:00.000-08:00

After a couple of months of being distracted by (a) buying a house, and (b) selling 90% of my portfolio, I've finally written a new article at shareworld. I was looking for a company that I'd be happy to invest in after moving to Norway, which means it must be:

International. Working for a UK company gives me quite enough exposure to the £ already. I don't mind it being listed in the UK as long as its revenues come from all over the world.
Safe. I am going to have a lot more debt, and far fewer financial assets. My personal risk threshold will be much lower than it has been in the past.

So I took a look at Unilever.

Sell shares, buy Norwegian property

2011-01-31T13:04:00.000-08:00

Not the best investment advice I'm pretty sure, but nevertheless that what I've done over the last week.

The big move
I have bought a house in Norway. The price of houses in Norway is ludicrous, and the exchange rate is extremely unfavourable. But needs must when the devil vomits in your kettle - I need somewhere for my family to live when we move, and renting is not exactly cheap out there.

Anyway, for the next few months I need every penny I can lay my hands on, and accordingly have today sold 80% of my investments. Between now and July I will sell another 14%, leaving me with just the 6% of my portfolio which has an associated capital loss (which is deductible against income tax in Norway, and which I will sell later in the year).

Once the big move has come and gone (late July / early August) and we can sell our house in the UK, I should once again have some money available to invest. When this happens I hope to be a better investor:

I will have far less disposable income, and fewer liquid assets, so I will be more risk-averse and more concerned with liquidity (fewer micro-caps).
My cost of funds will be higher (because I will move off my fantastically cheap UK mortgage), so I will set the bar higher in terms of the return I am looking for.
My portfolio will be smaller and more concentrated - less like a closet tracker.
My transaction costs will be higher (because I will have to use an off-shore or Norwegian broker), so I plan to trade less often.

We'll see.

Regrets

Of the shares I've sold today, I've been pretty sanguine about selling most of them. The ones that have given me pangs of regret are:

Berkshire Hathaway. I think this remains cheap, and would like to hold it for many more years.
De La Rue. Personally I would have taken 935p from Oberthur, but I can understand why other shareholders were reluctant - I think De La Rue will trade north of £10 again in the not-too-distant future.
Tesco. Has remained cheap ever since I bought my first shares, and is another one I'd like to hold for the long run.

And some others that I'm not too unhappy about:

Carpathian. Has done very well, and probably worth a bit more than the price I sold at, but the easy money has already been made here.
National Grid. I never really felt I understood it well enough, and the scary balance sheet has made me nervous ever since I first bought shares. Happy to have this one off my mind.
Diageo. Great business, but a bit too highly leveraged to be worth a P/E ratio of 19.

2010 / 2011

2011-01-05T12:01:00.000-08:00

Looking back
On the whole it has been a good year for the Danfolio. Over the year I've made capital gains of 20% and earned 3% in dividends, outperforming the FTSE 100 by about 10%. Thanks to ISAs, capital gains allowances and my wife's basic-rate tax status none of the gains are taxable. In fact, because this year I am moving to Norway (where capital losses can be offset against taxable income) I have earned about 1% in tax assets.

I've been a net investor over the course of the year, adding 18% to my portfolio, so as a result I have 40% more funds under management than at that start of 2010.

The 3 largest constituents of my portfolio (together making up about 35% of its value) are:

Berkshire Hathaway, which rose by 25%.
BP was up 41%.
LLPC, the Lloyds preference share, returned 39%.

None of the 3 pay a dividend.

Some highlights from the rest of my portfolio.

Carpathian, unfortunately one of my smallest shareholdings, returned a capital gain of 60% and capped it with dividends worth another 24%, for a total return of 84%.
British American Tobacco returned 28% capital gain and a further 5% in dividends, for a total of 33%.
Barclays returned 30% even though I sold it in March(!). If I'd held it for the rest of the year I would only have broken even.

And just in case I was getting too smug, let's not forget:

Rok, a complete wipeout in terms of capital, although it did pay 3% of dividends before expiring.
Game Group, down 22% in only 8 months, slightly redeemed by 6% in dividends.

Looking forwards

As I said above, this year my family and I will move to Norway. Property is rather expensive in the area we'd like to live in, and therefore I expect to sell off the majority of my shares to fund the purchase of a house. I hope to continue investing, but (initially at least) my portfolio will be smaller and more concentrated. Longer term I expect to build it back up to its present size and beyond.

Southern Cross prelims - covenants further relaxed

2010-12-07T11:37:00.000-08:00

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?

2010-12-06T12:50:00.000-08:00

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

2010-11-29T11:56:00.000-08:00

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

2010-11-22T13:45:00.000-08:00

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:

Safe. No cause for concern
Solid. Some concerns, but nothing major.
Speculative. Known problems, but they should pull through.
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

2010-11-14T12:21:00.000-08:00

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

2010-11-08T01:24:00.000-08:00

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?

2010-11-03T12:28:00.000-07:00

Is Todd Combs the new Warren Buffett?

Bond's fishy deal

2010-10-21T11:50:00.000-07:00

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

2010-10-20T14:33:00.000-07:00

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

2010-09-24T12:22:00.000-07:00

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

2010-09-07T12:43:00.000-07:00

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)

2010-08-27T12:10:00.000-07:00

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

2010-08-23T14:22:00.000-07:00

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

2010-08-16T04:12:00.000-07:00

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

2010-08-15T06:43:00.000-07:00

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?

2010-07-29T12:54:00.000-07:00

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

2010-07-15T07:27:00.000-07:00

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

2010-06-22T11:30:00.000-07:00

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

2010-06-16T12:46:00.000-07:00

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?

2010-06-10T03:17:00.000-07:00

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

2010-06-09T14:21:00.000-07:00

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

2010-06-01T10:45:00.000-07:00

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

2010-05-25T13:00:00.000-07:00

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

2010-05-18T12:59:00.000-07:00

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

2010-05-18T12:07:00.000-07:00

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

2010-05-10T11:30:00.000-07:00

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

2010-04-21T11:55:00.000-07:00

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

2010-03-18T12:09:00.000-07:00

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?

2010-03-13T09:16:00.000-08:00

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

2010-02-18T11:07:00.001-08:00

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%.

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

2010-02-02T13:22:00.000-08:00

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

2010-02-01T08:02:00.000-08:00

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

2010-01-27T11:04:00.000-08:00

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

2010-01-20T14:07:00.001-08:00

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

2010-01-16T11:56:00.000-08:00

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

2010-01-15T12:13:00.001-08:00

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

2010-01-15T11:53:00.001-08:00

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

Shareworld

2009-12-17T04:34:00.001-08:00

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

2009-12-05T12:05:00.000-08:00

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!

2009-11-23T00:35:00.001-08:00

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

2009-11-13T13:49:00.000-08:00

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

2009-11-10T11:18:00.000-08:00

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

2009-11-04T10:51:00.000-08:00

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

2009-11-03T15:30:00.000-08:00

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

2009-10-24T04:08:00.001-07:00

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

2009-09-27T08:32:00.000-07:00

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

2009-08-16T03:59:00.001-07:00

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

2009-08-08T05:41:00.000-07:00

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

2009-07-23T07:52:00.000-07:00

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:

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.
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.
Sell my Zirax shares and use the capital loss to reduce my taxes this year.
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:

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.
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.
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.
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

2009-06-25T12:38:00.000-07:00

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

2009-06-11T11:08:00.000-07:00

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

2009-06-01T12:31:00.000-07:00

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

2009-05-19T13:20:00.000-07:00

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

2009-05-19T00:52:00.001-07:00

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

2009-05-18T14:14:00.000-07:00

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

2009-05-16T09:10:00.000-07:00

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

2009-05-08T00:32:00.000-07:00

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

2009-05-05T00:45:00.000-07:00

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

2009-05-04T13:09:00.000-07:00

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

2009-05-03T07:13:00.000-07:00

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

2009-05-02T10:00:00.000-07:00

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

2009-05-01T00:46:00.000-07:00

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

2009-04-23T11:40:00.001-07:00

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

2009-03-26T11:43:00.000-07:00

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

2009-03-21T08:12:00.000-07:00

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

2009-03-19T12:22:00.000-07:00

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

2009-03-09T11:37:00.000-07:00

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

2009-03-01T03:37:00.001-08:00

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

2009-01-20T10:11:00.000-08:00

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

2009-01-17T04:08:00.001-08:00

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

2009-01-10T10:22:00.000-08:00

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

2009-01-10T01:12:00.001-08:00

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

2009-01-08T10:29:00.000-08:00

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.

Carpetright Look 2

2008-12-16T12:55:00.000-08:00

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

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

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

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

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

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

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

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

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

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

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

Greene King, Tesco updates

2008-12-02T00:44:00.000-08:00

Two updates out this morning. Initial reactions:

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

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

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

Consolidation done

2008-11-24T10:34:00.000-08:00

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

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

Consolidation

2008-11-23T06:57:00.001-08:00

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

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

Berkshire Hathaway

2008-11-23T03:56:00.000-08:00

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Tesco - further detail

2008-11-18T11:48:00.000-08:00

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Tesco purchase

2008-11-17T00:38:00.001-08:00

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

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

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

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

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

MXM, BDI, QDG

2008-11-15T04:30:00.001-08:00

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

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

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

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

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

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

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

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

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

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

Expectation of stock market returns

2008-11-11T12:09:00.000-08:00

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

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

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

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

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

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

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

Bond

2008-11-08T07:49:00.000-08:00

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

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

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

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

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

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

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

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

RBS prospectus

2008-11-05T12:11:00.000-08:00

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

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

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

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

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

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

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

Tesco

2008-10-26T08:45:00.000-07:00

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

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

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

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

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

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

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

This company has huge advantages:

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

Concerns are:

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

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

Portfolio vs net worth

2008-10-25T03:16:00.000-07:00

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

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

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

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

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

What are RBS shares worth?

2008-10-19T06:47:00.000-07:00

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

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

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

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

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

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

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

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

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

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

Quality

2008-10-18T12:52:00.000-07:00

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

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

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

Market plummeting

2008-10-11T05:25:00.000-07:00

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

I hope the market doesn't recover too quickly.

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

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

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

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

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

Government bank bailout

2008-10-11T04:20:00.000-07:00

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

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

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

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

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

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

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

RBS uncertainty

2008-10-05T08:14:00.000-07:00

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

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

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

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

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

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