GNK rights issue

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

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

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

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

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

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

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

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

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

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

Next annual results

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

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

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

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

In summary:

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

SLXX and Diageo

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

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

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

SLXX

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

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

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

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

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

Diageo

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

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

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

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

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

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

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

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

Conclusion

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

Update 23/03/09

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

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

Japan

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

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

Here's the table:

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

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

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

This looks pretty good value to me.

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

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

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

UK bank valuation

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

Lloyds Banking Group

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

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

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

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

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

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

Barclays

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

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

HSBC

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

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

RBS

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

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

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

Conclusion

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

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

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

Berkshire annual report

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

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

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

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

Offset by:

• $200m gain on Tesco.

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

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

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

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

Moment of banking madness

Yesterday was an exciting day for RBS shareholders:

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

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

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

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

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

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

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

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

Update

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