Diversification

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

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

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

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

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

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

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

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

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

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

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

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

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

Update:

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

Here are the top 5 holdings:

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

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

Next and Tesco

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

Annual review

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

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

• Interest on my dollars.


• Dollar / sterling exchange rate movement.


• Dividends


• Share price movements
  

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

• Interest: +2%


• Exchange rate: +23%


• Dividends: +1%


• Share price movement: -20%

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

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

Insufficient research

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

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

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

Emotional involvement

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

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

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

Excessive contrarianism

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

Portfolio

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

The dismal performance over the year is as follows:

Actions

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

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

Carpetright Look 2

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

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

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

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

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

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

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

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

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

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

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

Greene King, Tesco updates

Two updates out this morning. Initial reactions:

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

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

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

Consolidation done

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

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

Consolidation

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

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