Next - The king of share buybacks

Next PLC (LSE: NXT.L) are a company most people in the UK will be familiar with as they are a large clothes retailer with over 500 stores and a FTSE 100 constituent. Perhaps what most people won't be aware of though is the phenomenal success of the shares over the past two decades. Since 1999 (as far back as I can see on Google Finance) the shares have compounded at a rate of 15.3% p.a., and that figure doesn't include dividends. Given other figures I've heard anecdotally from other investors, that figure is even higher if you go back further, rising above 20% p.a.!

Their latest financial report is a brilliant read and it's refreshing to have a company explain what they've done and what they intend to do so clearly without the usual waffle and management speak that's so common. In places they are brutally honest, even to the point where it's slightly comical! Check out this passage:

Planning remains a problem, though often more of a delay than a brick wall. We are actively working with planning officers, councillors and local communities to deliver new shops, investment and jobs. We continue to make a greater investment in the external architecture of our new stores, particularly on Retail Parks. Our aim is to transform the quality of construction associated with out-of-town retail and create the sort of buildings that communities will see as an asset, not an eyesore.

In our dealing with local councils it is noticeable that some are much more pro-growth and pro-jobs than others. Many local councils are enthusiastic and efficient; but a few remain an unhealthy mix of Luddite intransigence and incompetence. Going forward, in areas where councils traditionally have got away with just saying “no”, we will be more active in harnessing the law and the full weight of public opinion to campaign for growth

The part of the report that really surprised me though was the section where they explain their philosophy around share buybacks. Most companies don't really think very hard about share buybacks and when to do them but Next are explicitly clear that they see it as just another re-investment opportunity to be analysed alongside others. It's the kind of thing one expects to read in the Berkshire Hathaway annual letter and reminds me a lot of Outsiders (one of my favourite business books).

It's well worth reading the whole thing yourself, but here's some choice paragraphs:

Despite their increasing popularity, share buybacks are still widely misunderstood. There are still those who wrongly believe that they are some sort of share support scheme. This, of course, would be futile as any attempt to support a share price would evaporate as soon as the money ran out.

The only reason share buybacks can deliver long term value is because they permanently reduce the number of shares in issue and so increase the amount of profit attributable to each share (EPS). An important part of the logic of share buybacks is the implied link between growth in EPS and growth in share price. Whilst, in the short term there might appear to be no link, in the long run share prices tend to reflect the fundamental value of the earnings and dividend stream. If the share price did not rise with EPS, the buyback programme would eventually leave a single share owning all the profits and dividends!

Over the long term, we have been following these rules when considering buybacks:

1. Share buybacks must be earnings enhancing and make a healthy Equivalent Rate of Return (see below).

2. Only use the cash the business does not need. NEXT has always prioritised investment in the business over share buybacks.

3. Use surplus cash flow, not ever-increasing amounts of debt. We have never allowed our share buyback programme to threaten our investment grade credit status and will not do so going forward.

4. Maintain the dividend at a reasonable level through growing dividends in line with EPS. NEXT will continue to increase dividends in line with EPS.

5. Be consistent. NEXT has been buying shares every year for more than 10 years, reducing the shares in issue by more than 50%.

6. For share buybacks to be an effective use of shareholder cash, the core business must have the prospect of long term growth.

I'm not a shareholder myself as I focus exclusively on smaller companies (there's greater share mispricings to exploit) but for the LTBH large cap crowd I'd take a serious look at any company that has such a great record of capital allocation.

Where do I get my investment ideas from?

I've recently been thinking about my sources of investment ideas and how that's changed over time. Given I'm not a full-time investor time is a big constraint when it comes to finding good ideas given a lot of my time goes in to researching existing positions and checking and re-checking my current thesis. When I first started, I got essentially 100% of my ideas from two sources: The Motley Fool UK message boards and anything that came up on my share screener results. I used to use the Sharelockholmes screener but the new Stockopedia one is just brilliant - they have a selection of pre-prepared screens but you can customise and save your own so I've got plenty looking for things like negative enterprise value, low EV/Sales, low P/B & high 5y ROE etc.

As I've learnt more about investing I've slowly added more strings to my bow and now I get ideas from a much wider range of places: Blogs, twitter, bulletin boards, stockopedia, newsletters, company presentations, email contact and more. It's incredible the amount of ideas I have access to from a wide range of investors and a testament to the power the private investor can have in the internet age.

Right now I find I'm using blogs more and more as a great way to find initial ideas. I've got round to adding a 'Blogroll' to the site which contains all the investing blogs I regularly read - I recommend taking a look through them if you're interesting in finding more ideas from other investors (predominately small cap value investors, but there's a few others in there too) who are frequently far better than myself. Even if I don't find myself agreeing with the author's thesis I always find myself learning something so it's a great way to develop as an investor.

You may have noticed a fair few non-UK blogs in my blogroll (especially a number of US investors) and also noticed a distinct lack of any non-UK listed investments in my last portfolio update. This is not because my international counterparts have failed to convince me of the merits of their markets but, I'm embarrassed to say, largely a failure of my own investment process.

In the UK market I subscribe to two services (Stockopedia and Sharelockholmes) which together allow me to quickly investigate a company's financials within minutes and form a general picture of how the business has been run over a long time period. I find this is a great way to cover a lot of ground in a short period and to compare the numbers with the investment thesis I've read elsewhere. (As an aside, I'm a great believer in the ability of financial statements to tell the diligent investor a great deal about the business without even having to know anything about exactly what the business does. I can form an opinion rapidly on management's capital allocation ability, the underlying attractiveness of the historic business characteristics as measured by ROCE, margins, cyclicality etc.) I can also see at a glance all the usual 'core metrics' I'm interested in such as P/E, EV/EBIT, P/TB etc which is handy.

If I'm still interested after this quick check, then I go in to the next 'phase' and dig in to the original reports and detailed financials. The problem I have with international markets is I lack this 'quick investigation' phase which I rely on as a great filter of investment ideas already. Thankfully Stockopedia are looking to expand internationally soon so this should help on this front in time. I'd be interested to hear about what other private investors do when they invest outside the UK markets and what data sources & tools they use? (Or if any international readers have any tips for how best to screen data in their markets) It also doesn't help that my broker, TD Waterhouse, offer horrific FX rates for converting to international currencies!

Anyway, rant over. So what about the other methods I use? Bulletin boards are handy to keep up with news bits you might have missed on specific stocks but the signal-to-noise ratio can be terrible. I use ADVFN and they cover the UK markets (are there any good international BBs worth looking at?) but beware - some of the boards venture in to YouTube comment territory - I'm often worried that the stupidity might be contagious. That being said, often the companies I'm most interested in tend to be off the radar and it's a bullish signal if the only posters on the board of a new company I'm looking at are familiar value investors I recognise and not the ramptastic muppets. Also, I'd wager that the level of posting activity is inversely correlated with future investment returns - busy boards tend to signal that the crowd has arrived.

Twitter's a funny one, because you can't really convey an investment thesis in 140 characters but it does allow me to track specific investors I respect and see what they are buying and selling and why. I've already had one investment idea which I got off twitter (GFIR / SIGG courtesy of @marben100) but probably the other big intangible benefit has been from finding other investors who I end up following (both on twitter and on their blog, if they have one) and often end up communicating with about other investment ideas.

Despite all these modern internet methods of finding investments I've gotten a surprising number of ideas from the old fashioned method of attending company presentations and meeting management. I live in London so it's fairly convenient for me to attend the various private investor events that get organised around here and I only wish I had more time to attend these! My staple diet here consists of recurring dinners known as 'Mello' events. These are organised by @carmensfella who is a well known active UK private investor and I highly recommend going if you live nearby. There's also plenty of other company presentations going on all the time, as well as ShareSoc events, Blackthorn Focus events and more. I only wish I had more time to see more of these!

I am, however, highly cautious of being overly swayed by over-bullish management speak so I tend to try and form an opinion of the business first from the numbers and then use the Q&A time to understand specific aspects better and try and then try and get a feel for how competent management seem at important attributes like capital allocation. Management can talk and talk but it's their actions (which are reflected in the financial statements) that I'm most interested in.

What methods do you use to find good investment ideas? Which do you think work best? Ideas in the comments please!

A leisurely update

Now I'm not expecting to do frequent portfolio updates as I don't trade very often and most short-term market movements are just noise anyway but quite a lot has happened to my portfolio in the past month and a half so I thought I'd better get my thoughts together. Yesterday, my largest position - All Leisure Group (LON:ALLG) - announced their 2012 results. It's risen quite a lot this year, ~57% even after the pull back after the results, but I'm getting increasingly bullish on this share and don't see any need to trim it yet. It's actually my pick this year (and last year!) for the Motley Fool's share competition and I did a write up here as well as follow up comments so I recommend reading that first before reading this blog post.

The results at first seem very subdued. Revenue takes a large jump up but full year profits were tiny at £0.8m. What's there to be excited about? Well, 2012 is pretty much a transitional year for ALLG. Due to a weak cruising market (partly due to the Costa Concordia tragedy) and a fleet in need of a revamp the directors took the decision to pull three (out of four) of their ships out of service for a good part of the year for upgrades. Also, for one of their ships a third party charter pulled out and left the vessel out of service (during which they decided to do the upgrades). As a result, their cruising division showed a stonking loss for the year of -£6.9m - they say the loss of the charter 'contributed significantly' to this loss. However, this is in the past and we now have a fleet that's been recently upgraded and ready to operate at full capacity again. This appears to be paying dividends already:

"At the start of the winter 2012, mv Voyager was in the exceptional position of being 82% sold for that season prior to her inaugural sailing. Currently revenues per diem for mv Voyager are forecast to be 20% higher than achieved 2011/12 on mv Discovery. This is driven by the increased number of outside and balcony cabins and less capacity."

"Over the winter 2011/12, mv Minerva was out of service for just over three months, whilst a substantial technical upgrade was carried out. During this time the ship also underwent an extensive upgrade to both public areas and the 197 cabins. 73% of the cabins are outside cabins and clever use of space increased the number of balcony cabins from 12 to 44. A new observation lounge added to Promenade Deck increases the on board facilities. Passenger response to the upgraded vessel has been extremely positive."

So if cruising caused such a big loss, what made up the difference? Here we get on to what I see as being a very exciting development for ALLG - the acquisition of Page and Moy Travel group. They first announced the acquisition here where the headline figures got my attention. They paid £4.2m for a group doing £107.6m in revenues! How did they get it so cheap? The catch - it made an operating loss of £5.6m in 2011. Not great. The previous owners were two banks - HSBC & Credit Agricole - who ended up with it after the previous private equity owners, HgCapital, went bust with it in the 2008 downturn. It's probably worth noting at this point that HgCapital paid £180m for it. Whoa. Clearly they were far too optimistic but it's clear this business has done pretty well before in the past to have warranted such a price. Naturally the banks here just wanted this loss making business off their books so weren't price sensitive allowing ALLG to swoop in and nab it for a relative song.

At the time of the acquisition I was a bit worried as it seemed a big risk to be taking on such a loss making business given the current one wasn't firing on all cylinders either. However the heavy degree of insider ownership re-assured me that if anyone was going to lose big here through hubris it was going to be the directors so I trusted they'd thought this through (I very, very strongly prefer owner-operator shares. Never forget the power of incentives!). The annual results give more detail on the acquisition so we can learn more about what's going on here. Let's take a look at some figures for Page & Moy in 2012:

Full year results:

Revenue: £93.9m, Profit: £4.6m

Contribution to results:

Revenue: £60.9m, Profit: £8.9m

Balance Sheet Pre-Acquisition:

Tangible Assets: -£14.7m

So this tells us another reason why they got the business so cheap - it has negative tangible assets. This has pros and cons: pro, it means the business probably operates on negative working capital (like the cruising business) so expansion is an extra source of cash which can be used in the business. con, it means if things turn south the business is in trouble. That being said, the directors also state the business is a "low-risk model and has no forward financial commitment for hotel costs, transportation costs, or aviation capacity", which it probably needs to be to make negative working capital operation safe and viable.

It also says that the timing of the acquisition flatters the profits by £4.3m, so the combined entities made a loss in this FY. However, the major plus is that management have already turned the £5.6m loss in to a £4.6m profit. It hence means they acquired the business for less than last year's profits! What a wonderfully shrewd move by management. Revenue is down from 2011, yes, but this is due to cutting unprofitable lines of business. To quote the results again:

Following a detailed strategic review of the Page and Moy Travel Group brands and product portfolio prior to its acquisition, a number of underperforming products and business lines have been discontinued for 2013. Ceasing to operate the ex UK coaching holidays and components of the Christmas programme was part of this strategy, along with the decision to phase out the Page & Moy brand and incorporate the profitable components of the business into Travelsphere's portfolio of tours. The Group then re-launched the Travelsphere brand as a value for money, yet quality product. The end of year results show this has been very successful and going forwards the flexible business model of our Tour Operating Division allows us to align our capacity to fluctuating demand.

This means the 'pro forma' results of the business in 2012 were:

Revenue: £160.4m

Operating profit: -£3.5m

However we now have all ships upgraded and back in action. Given the non-acquired business did £66.5m this year but did £80.4m in 2011 implies at least a boost of £14m in revenues just from ships coming back in. Stockopedia reckons that the brokers are putting them on £202m of revenue for 2013 (although these same brokers reckoned they'd do £192m of revenue this year and make a 5.2p profit - no idea how they thought that was possible!!) which seems high but potentially achievable given the ship upgrades in capacity and quality. For fun, let's imagine a set of  'pro forma' results that take the 2011 ALLG numbers (with no ships out of capacity) and the 2012 Page & Moy numbers and combine them:

Revenue: £174.3m

Operating profit: £8.0m

So this puts this hypothetical year (which is probably closer to an average year) on a P/E of 3 at the current share price! Now in this hypothetical year the directors are still complaining about how poor the results are due to the economic climate (they were in 2011 and in 2012's results,) so clearly they still see the margins here as being poor at ~4.6%. ALLG was doing solid >11% margins pre-2009 so clearly there's scope for improvement there (although I've no idea what P&M's average margins are). So, we have a business on a pro-forma P/E of 3 despite the E being disappointing. This is why I'm so very bullish on these shares and think there's still plenty more upside available when the true earnings power is revealed here in the next few years of results and the business gets re-rated to a more sensible valuation.

What are the risks here? Well, besides all the ones I've mentioned before in my other posts I think the big new one is balance sheet risk. The weak balance sheet of P&M means that the combined business only has £9.3m of net tangible assets and the previous tangibles are now intangibles. I think the benefit of increased earnings power here outweights this though.

That's my updated thesis on ALLG. Since my last update I've also added CLIG & SIGG to my portfolio. I got the idea for CLIG through a Motley Fool write up here (and there's more here) and I especially liked their shareholder-orientated incentive structure (as well as the dirt cheap price and wonderful business economics). This quote from the annual report really got my attention:

As shareholders are aware, we run a business with a very simple business model. We collect fees from our clients for our services, we pay our bills which are both forecastable and to a great extent fixed. We don't use leverage, nor off-balance sheet instruments, nor do we trade derivatives as principal (other than occasional low level hedging). There are no associated companies or minority interests within the Group. We do not use tax havens. We do not handle client monies. We have a significant amount of cash in the bank relative to our size and we basically stick to what we know.

With regard to remuneration we continue to distribute 30% of our profits as profit-share. Our staff, clients and shareholders understand this formulaic approach. It's a pity that this approach has not been embraced by the financial service industry generally. As it is, in many parts of the financial services industry it seems as if losses are not the responsibility of mangers rather it's the shareholders who take the rap. Whilst our formulaic approach seems out of keeping with many in our industry, at least our shareholders have an idea that our returns go up and down together with theirs.

We have continued to manage our business very conservatively. We have continued to attempt to keep costs down. We do not spend shareholders' funds entertaining and we generally attempt to manage our business as if shareholders were present in our offices every day of the week. One reason I would suggest that expenses are kept down is because staff are either shareholders themselves or own shares via the CLIG ESOP. At present staff own (including ESOP ownership) 27.9% of CLIG shares, and 75 out of 82 of us are incentivised in this way (a handful of more recent recruits do not yet hold options).

As for SIGG I got the idea from @marben100 on Twitter and read some notes @BrianGeee1 kindly sent me. Essentially it's a wind-up play for 96.4p of assets compared to a market price of 57p. There's a lot of worry on ADVFN about the quality of the assets and how illiquid they appear to be. The new management however take a low management fee of 0.5% but are largely compensated as to how quickly and effectively they can realise the assets for shareholders so I'm glad our incentives are aligned here. Even at a big hair-cut and a relative slow asset realisation process my IRR should be decent here. I currently also have one other share on buy list but I'm waiting for cash to build up before I buy it - I'll reveal more when I actually pick it up!

In other news, my big write up on LCG came good when not one but three potential bidders appeared! I made some comments in my stockopedia post here as to what I think could happen. I'm still very bullish on the shares. MGNS also announced their results today and they were pretty disappointing - especially the big dividend cut. The outlook is still grim but the price is so low for a business that is clearly only suffering from a cyclical downturn that I'm happy to still sit tight and wait it out. It's another owner-operator share and John Morgan has stepped back in as CEO to take charge so our incentives are aligned here - I trust him to focus on long term shareholder value.

We're clearly in a full on bull market in UK small caps at the moment, with the FTSE Small cap index (ex. investment companies) up 8.25% YTD and the AIM index up 6.64%. I'm a bit torn between the worrying signs of increasing optimism from other investors however I still think I can find companies on cheap valuations so I'm not taking money off the table yet. I've had a good start to the year so far - I made only one short-term performance prediction in my 2012 performance review and that was that there was no chance I'd better my IRR of 97% (which I made entirely through lucky timing). Currently I'm being proved very wrong and my IRR for 2013 YTD is 166% as my portfolio is up 13.8%! As much as I'd love to put this down to skill I have to hold my hand up and admit I'm just the lucky beneficiary of a bull market - a lot of my out-performance has been driven by a handful of concentrated positions (especially ALLG) so it's statistically meaningless unless I can repeat this over many, many years.

Right, that's the end of this update. My current portfolio allocation can be seen below (Disclosure: I own all the shares shown):

What's your investing edge?

There's a number of parallels between the twin worlds of investment and gambling. It's no surprise that many hedge fund managers also enjoy playing poker (Like David Einhorn) and both Buffett and Munger have used the analogy of the pari-mutuel system to describe investing. To quote Munger from this talk (italics are my emphasis):

The model I like—to sort of simplify the notion of what goes on in a market for common stocks—is the pari-mutuel system at the racetrack. If you stop to think about it, a pari-mutuel system is a market. Everybody goes there and bets and the odds change based on what's bet. That's what happens in the stock market. 

Any damn fool can see that a horse carrying a light weight with a wonderful win rate and a good post position etc., etc. is way more likely to win than a horse with a terrible record and extra weight and so on and so on. But if you look at the odds, the bad horse pays 100 to 1, whereas the good horse pays 3 to 2. Then it's not clear which is statistically the best bet using the mathematics of Fermat and Pascal. The prices have changed in such a way that it's very hard to beat the system. 

And then the track is taking 17% off the top. So not only do you have to outwit all the other betters, but you've got to outwit them by such a big margin that on average, you can afford to take 17% of your gross bets off the top and give it to the house before the rest of your money can be put to work. 

Given those mathematics, is it possible to beat the horses only using one's intelligence? Intelligence should give some edge, because lots of people who don't know anything go out and bet lucky numbers and so forth. Therefore, somebody who really thinks about nothing but horse performance and is shrewd and mathematical could have a very considerable edge, in the absence of the frictional cost caused by the house take.

Whilst many gamblers consciously try to find their edge through techniques like statistical analysis and informational advantage I find many investors have never really sat down to think about what their edge is. There's a famous saying in poker that if you sit down at the table and can't tell who the fish (the worst player) is, you're the fish. You don't want to be the fish at the investing table! Ray Dalio, the founder of Bridgewater, has similar thoughts on investing:

The bets are zero sum.  In order for you to beat me in the game, it's like poker, it's a zero sum game.  We have 1,500 people that work at Bridgewater, we spend hundreds of millions of dollars on research, and so on.  We've been doing this for 37 years and we don't know that we're going to win.  We have to have diversified bets.  So it's very important for most people to know when not to make a bet.  Because if you're going to come to the poker table, you're going to have to beat me, and you're going to have to beat those who take money.  So the nature of investing is that a very small percentage of the people take money essentially in that poker game away from other people who don't know when prices go up whether that means it's a good investment or if it's a more expensive investment.

There's a number of ways to gain an edge in investing and beat the market. The most obvious is an analytical edge - you have the same information as everyone else, you're just able to process it better than others and see what the market doesn't see. If your valuations are consistently better than everyone else then over time you could beat the market. The problem with this approach is that it's very hard for stocks that have a large analytical following. For stocks in an index like the S&P500 or the FTSE100 you are up against thousands of analysts who pour over every result and are also looking for valuation discrepancies. Especially for the lone private investor, beating the large cap indexes consistently is very tough. The high degree of competition makes out-performance harder and harder. Michael Mauboussin addresses this concept in his book, The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing:

The key is this idea called the paradox of skill. As people become better at an activity, the difference between the best and the average and the best and the worst becomes much narrower. As people become more skillful, luck becomes more important. That’s precisely what happens in the world of investing.

This is the foundation of the 'Efficient Market Hypothesis', that stock prices reflect all information known about them and hence cannot be beaten. Whilst I don't believe that the EMH is perfect (and certainly some of the stricter forms of it seem completely barmy to me!) there is a degree of truth to the idea that having more and more analysts tracking a security will tend to make it more efficiently priced.

Another route to investing edge is an informational one - you know something about the company that no one else does and it's significant in determining a valuation. Again, for stocks that have a large analytical following we run in to the same problem - many people are doing all they can to talk to customers, suppliers and industry experts to glean further insight in to a company or an industry and profit from anomalies. For the private investor it's tough to compete against big research teams with huge budgets. It's also illegal to act on insider information, not that it always stops some hedge funds.

So what can the private investor do to find a source of edge? I think PIs have a number of ways they can gain an edge over the investment professionals - they just need to pick their bets carefully. Private investors aren't managing huge amounts of capital so they can explore smaller opportunities that bigger managers can't. It's worth the time for a PI to spend hours reading up on some small micro cap stock that only has the one house broker because the lack of research competition is likely to throw up big mis-pricings that can be taken advantage of by the good investor. Private investors can get both an analytical and informational edge over the market by focusing on the less-followed securities because the wider investment community is neglecting the opportunities. Howard Marks sums it up best:

People should engage in active investing only if they're convinced that (a) pricing mistakes occur in the market ... (b) they - or the managers they hire - are capable of identifying those mistakes and taking advantage of them.

The other big edge PIs can have is that of patience. Big institutional funds are often forced by redemptions to sell their assets even if they think them to be cheap and equally compelled to buy assets if they have inflows. This creates a buy high, sell low approach that means that investors as a whole under-perform the funds they invest in. The smart private investor can manage his affairs such that he never needs be a forced buyer or seller and can be patient in waiting for attractive opportunities. Institutional investors are compelled to do what their (frequently irrational) clients want them to do. To quote Buffett:

The stock market is a no-called-strike game. You don't have to swing at everything -- you can wait for your pitch. The problem when you're a money manager is that your fans keep yelling, "Swing, you bum!"

Obviously none of these edges come easily. The PI needs appropriate analytical skill, an understanding of the economics of the businesses (the 'circle of competence') and the emotional strength to act against the crowd when they spot big opportunities. None of these abilities come overnight but they can be learned with time, discipline and patience. However, if you want to outperform the market through active investing, having a reliable source of edge is the only way. You don't want to be the fish at the poker table!

London Capital Group - Worth a (spread) bet

OK, so the title isn't winning any awards for the terrible pun but hopefully the rest of the post will compensate. I'm a fan of London Capital Group (LON:LCG) as I believe it's a business that is fundamentally very attractive and is suffering from a number of headaches in the short term which don't really impair the long term value anywhere near as significantly as the market is pricing it to.

So, what's the story? LCG are a spread betting firm, a mix of their own brands and white label to other big names such as TD Waterhouse, Betfair, Bwin.Party and Saxo bank. They offer a number of products but by far the most significant is their UK Financial spread betting service (£26.6m revenues in 2011) followed by their Institutional FX business (£8m revenues in 2011). Whilst you might think this business is something similar to a stock exchange in characteristics I see it far differently; the economics share far more similarities to the gambling sector, an area I used to work in and know fairly well. The vast, vast majority of clients do not use spread betting like true 'investors' but instead they speculate heavily on margin - and they don't speculate very well. Nearly all the clients end up as net losers. A few people have asked me how such a model is sustainable, how does the business survive if the customers keep going bust? It's simple really - the same way William Hill & co survive, through a combination of recruiting new accounts and having old accounts redeposit. You'd be amazed at the gamblers who deposit year in, year out and somehow convince themselves that they are actually 'winners' and 'the sharp money'. Spread betting is, as the name suggests, gambling. The average revenue per user is much higher than traditional gambling too, at ~£1.4k per annum compared to more like £300 for a bookie.

At the end of 2008 LCG were riding high with their share price touching 400p. Now they are hanging just over 33p. What happened? The classic case of high profit multiple (20x in 2007) meets profit collapse in the 2009 recession. Since then the company has lurched from disaster to disaster; first the FSA forced them to pay a significant fine on grounds that seem very harsh, then the company had to write off millions of pounds worth of software assets after they proved unsatisfactory. To top if off, the most recent trading statement shows that profits for this year have collapsed to a loss after revenues took a big dive. How can this happen? Well, spread betting revenues are inherently more volatile than that of traditional betting as they depend on volatility in the markets. Big swings in the markets encourage clients to trade more and generates high revenues. Having a quiet year in the markets is the equivalent of William Hill having half the football matches they'd normally get in a season.  To get an idea of this volatility, here's a graph I lifted from the last annual report:

Looking at the graph, it's almost pure fluke that revenue growth has been so smooth for the past few years - good half years can be almost double bad ones. IG Group, LCG's much larger listed competitor (LCG are number 2) also reported significant drops in revenue for the past six months so this is clearly an industry issue rather than just an LCG issue. This is a big crux of my argument for this share - I believe this is not a structural decline but rather a cyclical one. It's folly to value a cyclical business on one year's results and a far better method is to look at average earnings over a decent period. Joel Greenblatt calls this kind of investing 'time-arbitrage', I'm able to 'arb' the difference between the price now, caused by investor's short time horizons, and the price sometime in the distant future due to my long time horizon.

Given everything is so terrible with LCG, why do I like it the share today? Essentially it all comes down to valuation. The market has looked at the most recent result and decided the company will never make a profit again, as the company now trades at a discount to the net cash on the balance sheet (£20.3m of cash against a £17.7m market cap) and about half of book value (which contains intangibles - it trades at 0.84 of tangible book). This is for a company which has, historically, earned an average of 20.7% ROE for the past five years even including all the disasters.

The business also has a number of qualities that are very attractive. For one, it's number 2 in it's main market (although the number 1 is 10x larger in revenues) which is still growing overall. LCG has achieved a huge CAGR of 35% in sales for the past five years and IGG has also done 27%. Whilst I don't think this level of growth can be achieved in the future I don't see why double digit revenue growth, on average, shouldn't be achieved. This is a growth company in a growth industry. Secondly, the company has a number of competitive advantages. Whilst regulation is a burden for this company it does massively increase the barriers to entry - if you want to be another FSA regulated spread better you'd have to comply. Whilst it's possible to relocate offshore (and a number of their competitors do) the FSA badge of approval is valuable in it's own right. It'd be especially tough to come in and try and win the white label contracts that LCG already have. Also the product is not a commodity - it has to be good to attract and win clients and a new competitor would need to reach their standard to compete. The competitive advantages LCG and IGG enjoy are reflected in the very good economics of their businesses: Both are non-capital intensive and generate high average ROEs despite the large cash regulation requirement and both have huge margins. So we have a growth company with good competitive advantages earning a huge return on capital and enjoying high margins (key phrase here - on average) - what's not to like? :)

Some more tasty facts and figures: Including the broker's expected profit for 2012 (-0.4p), the 4 year average profit of the business is 4.53p. Given the current share price, that's an average P/E of only 7.36. An average of 2.18p was paid in dividends over the period too (assuming no final dividend this year) giving an average yield of 6.53%. Now, I've chosen the 4 year time period to be as harsh as possible as it excludes the good 2008 & 2007 results. The same figures for a 6 year period are 8.94p of average earnings for an average P/E of 3.7 and an average dividend of 4.36p for an average yield of 13.11%. Even going on just the horrible 4 year numbers though, which includes two years where essentially no profit has been made, the share price still looks excessively cheap. It's worth pointing out that I don't include the net cash at all in my valuation. This is because almost all of it the company is required to hold under FSA regulations and so it's more like working capital than free capital - don't expect any IND style large special dividends any time soon.

The way I see it, even if things carry on being terrible the company is still going to earn a decent return, on average, for shareholders at the current price. The other thing to remember is that margins have come down from a high of an average of 44.7% for the four years 2005-2008 to an average of 18.1% (on adjusted profit figures) for the past three years. Profit growth hasn't come close to matching the revenue growth because of this margin contraction. IG Group have managed to hold their margins in the 40%s over this period so clearly LCG have under-performed in this regard. This is due to a number of factors: First, management have launched a number of smaller products that have more or less all made losses so far and so dilute the margin. Secondly, costs in the core business have also shot up without a corresponding rise in revenue. This is something management are now taking action about and are looking to trim back the cost base & try and get the smaller divisions to focus on achieving profitability. They believe they've found some 15% of the cost base that could be taken out and Simon Denham mentioned at the Mello meeting that IT costs should be dropping after a period of investment anyway. This is a source of further upside - if the company can execute on their cost cutting promises profits should recover.

Another factor to consider is the current interest rate environment. LCG benefit hugely from higher interest rates because they carry so much gross cash they can't do anything with (cash from customers and regulatory capital) other than invest at close to base-rate levels. At June 2012 they had £67.3m of this gross cash so each 1% rise in interest directly adds an extra £0.67m of profit to the bottom line - it's that simple. Not only that, but LCG also charge their customers financing charges to hold bets open based on LIBOR. Again, an interest rise plays nicely in to generating extra revenue here. This is yet another potential source of significant upside should interest rates begin to rise.

One last thing that stood out to me in the presentation Simon did. I knew from my time in the gaming industry that the customers tend to follow an extreme pareto distribution - 50% of your revenues come from the top few % of your customers. The big 'whales' as they are known are very important. However, when I asked Simon about his customer concentration he replied that his top ten customers account for no more than a handful of % of his revenues. This was pretty surprising to me, so I asked how this was the case. It turns out it's a deliberate risk management strategy, which makes sense, but it does mean LCG are turning away their biggest and most profitable customers! Again, I see further potential upside here should they decide to change this policy.

In the dream scenario here, revenues recover, margins go back to historical highs & interest rates rise. Any combination of these three would see PBT shoot back up and trigger significant multi-bagging from the current price. The downside is fairly well protected due to the very strong net asset position, of which a large chunk is held in cash. In my mind, this creates a really attractive risk/reward proposition. Simon mentioned at the Mello talk that a number of potential acquisition suitors had come knocking after the share price decline which I take as a good sign - people who know the industry well are coming around making opportunistic bids. I doubt a bid will take place around the current price any time soon though, LCG has big insider ownership from the three co-founders who will demand fair value for any purchase (which they believe, as I do, is significantly above the current market price). Personally, I'd much prefer a slow but big recovery than a quick 30% gain from a bid and am happy that my incentives are closely aligned with management.

So what are the big risks? Well, cash has fallen significantly over the past 6 months - down from £25.5m to £20.3m, far more than the actual profit loss. I remember Simon Denham saying something like only £4m of that £25.5m was 'excess cash' so it must mean they are close to eating in to regulatory capital (although in the 2011 annual report they say that, of the £25m of net cash, they had £10.7m of surplus regulatory cash requirements so maybe I'm misinterpreting him?). I'd expect that the company have anticipated such liquidity needs and are prepared accordingly. Another big red flag is the COO, who is also a major shareholder, has quit to 'pursue other interests'. This is a big worrying although the optimist could interpret it the other way, that after a number of years of poor margin performance we are seeing a replacement in a very significant senior position. There's also regulatory risk present, as we saw when LCG had to pay a large fine to the FSA. I see this kind of risk as an unpredictable cost of doing business, which decreases my valuation of the business but not in a significant way. A more serious regulatory risk would be if the government changed the rules to remove the tax advantages of spread betting, which would be very harmful to the industry.

The other really big risk is that I've completely mis-read the revenue decline and it's the start of a serious structural collapse. If that's the case, the assets could become significantly impaired by losses and the downside protection would be eroded. However, I personally believe the odds of this are pretty low given the obvious cyclical history of the company. There's also a bit of a stigma for these companies recently after the MF Global and Worldspreads frauds with the companies both dipping in to client funds. I think this risk is in reality very, very tiny due to the insiders owning such a large proportion of the company. Why ruin a great long-term business by engaging in short term fraud? I don't see the incentive here and as Charlie Munger says "Never, ever, think about something else when you should be thinking about the power of incentives".

With all that in mind, I've made LCG a 4.8% portfolio allocation (down from last time due to the price fall and appreciation of the rest of the portfolio) and I'm tempted to top up after even more recent falls. As for the rest of my portfolio, since my last post I've sold out completely of FCCN and redirected the proceeds in to KENZ and MGNS (which have both gone up since, nice to have a bit of good luck!). The losses at FCCN were worse than expected and due to the high operational gearing of the company the risk here is too high for me. Against weak comparables from last year the company still reported a revenue fall. The company has net cash of ~£25m, granted, but they burned £10m of cash last year. Even if things don't get worse, which there's no reason why they couldn't, they'd burn through that pile pretty quickly. Operational gearing could make the situation either very, very good or very, very bad here - it's kind of an all or nothing punt. Since I'm an investor who likes to be fairly concentrated and I can't protect the downside here it's one I'm going to pass on.

This could well turn out to mistake and a number of investors are still bullish here, including Paulypilot who knows the sector far, far better than I ever could given he's worked in it but I don't feel like I'm able to calculate the upside/downside scenario probabilities here. If the upside scenario materialises I won't kick myself, there's always plenty of other opportunities out there. I will, however, be paying close attention to this graph on Google trends as it's probably a useful indicator of any turnaround success. The current graph direction isn't all that pretty though...

For the record, here's my portfolio as it currently stands now:

Disclosure: I am long LCG, KENZ & MGNS

Why you're undervaluing good capital allocation

"All I can do is remind them of the truth of Albert Einstein’s alleged response when he was asked, “What do you, Mr. Einstein, consider to be man’s greatest invention?” He didn't reply the wheel or the lever. He is reported to have said, “Compound interest.”"

There's nothing so much fun as playing with a compound interest calculator and seeing the crazy numbers that get spit out for one's investment lifetime. Money invested at 15% for 50 years multiplies a thousand fold. The difficultly, of course, is achieving 15% - no mean feat at all. I like to think of there being two general 'routes' to compounding: Closing discounts and intrinsic value growth.

Value investing disciples love to trot out the lines about buying £1 for 50p. Obviously, that's kind of a good deal. The problem with it comes down to what is that £1 made up of? How do you know it's worth £1? Sometimes you can find stocks which have liquid assets that have market values of X and the security is selling at less than X. This is a case where the return is largely going to be driven by the closure of discount - you don't expect X to grow necessarily over time but you reckon that the gain possible justifies the time you'd have to wait in the investment to realise your return. This approach works very well and is essentially the true 'Graham and Dodd' approach to investment and one that worked nicely for Buffett during the early years of his partnership.

The downside to this approach is that it requires the constant finding of good reinvestment opportunities - once the discount is closed, where do you go from here? You have to sell and find another discount to close. This is why this style of investing is commonly known as the 'cigar butt' approach; you're getting one last puff but that's it. Whilst you're buying £1 for 50p that £1 isn't going to grow in to £2, or £10, or £100.

The alternative approach is to find opportunities where intrinsic value can be compounded internally by the management of the company over a very long time period. These kind of situations are exceptionally rare but incredibly lucrative if they can be identified ahead of time. Some companies are just 'born with it' - the nature and characteristics of their business mean they only need to deploy a small amount of capital to grow significantly. This was Buffett & Munger's insight in to Coca Cola; the presence of a large, sustainable competitive advantage in an industry where the economic conditions are fairly stable meant that the business could earn incredibly attractive returns on the capital it kept inside the business and give the excess back to the shareholders.

I was very interested to read this article in the FT recently where they cite Jeremy Siegal's work indicating that the 'fair value' of Coca Cola in 1972 was a staggering 92x earnings. Can you imagine paying that much for any business? Coca Cola was hardly growing at Facebook style rates then, yet the combination of highly predictable business dynamics and fantastic compounding returns on invested capital produced these outstanding results when given a long time frame.

This leads me on to the main message of this post: Good capital allocation is systematically undervalued. It almost has to be due to the difficulty of comprehending the power of compound interest. Financial students are taught to discount future cash flows to compute present values, but what happens when the compounding rate is higher than discount rate? The maths says as the growth rate tends to the discount rate, the multiple one should pay rises asymptotically to infinity. Our valuation methods just cannot deal well with excellent long term compounding. Of course, trees don't grow to the sky, but sometimes even small textile mills do grow in to giants.

As another demonstration of what I mean, let's consider Berkshire Hathaway. The year is 1966, and you've just noticed that a talented young investor has taken control of this textile mill. You've seen his results under his partnership and can't help but believe that he's going to do a great job of capital allocation when he's there. Fortunately, a wormhole from the future opens next to you and out drops two things: a piece of paper with Berkshire's share price at the start of 2011 (~$120,000) and the average annualised returns of the market since 1966 till then (9.38%). You eagerly do a quick bit of maths and work out the fair value you should pay to get the same return as the market - $2123 (120,000 / 1.0938^45)

What is Berkshire's current share price? $20. Book value? $28.3 The fair value of Berkshire Hathaway, a textile mill with terrible economics, is 75x book value. Anyone buying now isn't buying $1 for 50c. They are buying $1 for 1c. The compounding effect of a manager highly talented in capital allocation is worth a premium so large it's completely unfathomable. Man's failure to conceptually grasp the power of compound interest creates this gigantic valuation discrepancy.

Now, there's an obvious criticism to my conclusion here. I've deliberately picked examples of two companies that have been utterly exceptional. You can't identify winners like this ahead of time, you cry! Hindsight investing does no one's wealth any favours.

I disagree with this verdict. Whilst you're highly unlikely to identify the next Buffett you can identify managements who excel at capital allocation by examining their actions and modus operandi because they follow patterns. I recently read a fascinating book that lead to me making the conclusions I've outlined in this post: Outsiders. In it, William Thorndike identifies eight CEOs who most outperformed the market over their reign of operation. Obviously Buffett is one of them, but have you heard of Henry Singleton? Tom Murphy? I highly recommend reading the book itself as I can't do it full justice in only a blog post but the lessons are clear; here's a good extract from the book description:

"Humble, unassuming, and often frugal, these "outsiders" shunned "Wall Street" and the press and shied away from hot management trends. Instead, they honed specific (and less sexy) characteristics including: a laser-sharp focus on per share value rather than sales or earnings; an exceptional talent for allocating capital and human resources; the belief that cash flow, not reported earnings, determines a company's long-term value; and, a penchant for giving local managers autonomy to release entrepreneurial energy."

Reading through it certain attributes come out time and time again. Only making acquisitions at incredibly attractive prices. Buying back stock when it trades at a discount to intrinsic value (and the corollary, using stock to make acquisitions when it's over-priced). A tough focus on the rate of return from capital expenditure. Avoiding hot trends and the 'de jour' market hypes.

Whilst identifying the next Buffett may be close to impossible, checking whether management display the signs of skillful capital allocation is not. The results of their endeavours should be obvious - good capital allocation has to lead to excellent growth in intrinsic value per share.

When analysing companies, I always look to see if I can find that elusively rare find - management which display all the calling cards of excellent capital allocators. In my portfolio today, I think Judges Scientific (LON:JDG) best display these properties and it's the reason it's my number one position despite not being dirt cheap on any valuation multiples. Management repeatedly make acquisitions of wonderful companies at ridiculously low multiples. The inevitable result of this is CAGRs of sales and earnings at rates of 32% and 49.7% respectively over the past five years. The company currently trades on a multiple of expected 2012 earnings of only 14x. I'm not saying the company is a Coca Cola or a Berkshire and worth gigantic multiples of current earnings but I'm willing to bet it's significantly above the current market price. I'm happy to sit back, wait, and let intrinsic value grow for me. The market can do what it likes in the mean time.


Disclosure: Long JDG

Tracsis - Late to the party

In the past few days I've been researching a company which I've just added to my portfolio called Tracsis. This is one I've heard mentioned before on the zulu thread on ADVFN, amongst other places, but never got round to investigating it properly - sadly one of the constraints of only investing part time means I don't get a chance to do the amount of research for new investments as I'd like.

Now, I'm pretty late to the Tracsis party. The shares went from ~55p to ~160p last year - wow! Shareholders of 2012 are dancing hard but I still reckon the party has a way to run yet and I'm getting involved. Now I'm not going to do a full write up of TRCS as thankfully, as part of the NFSC on TMF, TheKingsGambit has done a brilliant, comprehensive write up here. What I will do is highlight a few aspects and themes of the investment I think are important.

High quality of earnings

I'm a strong believer in the power of the accrual anomaly. I'm going to steal Stockopedia's description of it for their screen because it's so good:

"This screen is loosely based on the influential work of Richard Sloan from the University of Michigan, published in 1996 documenting what is referred to as the “accrual anomaly”. A pound of earnings can be comprised of assumed non-cash earnings called “accruals.” His landmark 1996 paper revealed that shares of companies with small or negative accruals vastly outperform (+10%) those of companies with large ones His paper found that investors focus too heavily on earnings and not on cash generation. They value the earnings of a high accrual company just as highly as the same earnings of a low accrual company, even though the high accrual company’s earnings are more likely to reverse in future years. When future earnings reverse, investors are “surprised” and sell off the stock causing the stock price to decline. Similarly, when a low accrual company’s earnings accelerate in future years, they are surprised in a good way."

Tracsis have very high cash generation from their profits and hence very low accruals. In fact, if you ignore the one-off acquisition earn-out payment, they generated £3.57m of cash last year compared to a reported profit of £2.42m. Now part of this is due to improved working capital management which can't be a long term source of cash but even before working capital movements they generated £2.78m of free cash flow (excluding the acquisition payment, because I'm trying to work out the current 'steady state' cash flow production going forward).

This is very different to a number of software companies who love using capitalisation of software development costs to boost profits. Too many investors ignore the cash flow statement and treat all profits as being equal. I can tell you right now, I'd take hard cash over an intangible asset any day. You can't spend intangibles. This keeps me away from investing in companies like Globo (GBO), a software company that makes lots of accounting profits and so many investors go "Low P/E, good profit growth, must be cheap!" but this logic is flawed. Free cash flow has been negative for many years, so for GBO to be cheap it must demonstrate that the present value of the FCF it can generate in the future is greater than the market cap. It may well be that Globo's investment in it's software will generate these cash profits in the future and the intangibles are justified, but it hasn't proved it can go FCF positive in it's results - yet. This is the kind of situation I find hard to appraise and so I avoid.

Niche markets as a source of competitive advantage

I like companies that address small, niche markets. That sounds a bit counter intuitive, as surely investors want to find the next Facebook which have the potential to grow in to giants? Possibly, but I think it's far easier to identify companies that operate in markets in which only a very small number of companies can operate in. This specialisation allows for high returns as it generates pricing power - if you're the only guy with the best rolling stock planning software for railways then you can capture a lot of the value you create. Also, niche markets aren't necessarily low growth - they are just small in absolute terms relative to wider economy. It's also a highly defensive proposition if you're a niche, non-commodity product business. It'd be hard for someone to come along and win Tracsis's current contracts unless their software is of at least a vaguely comparable standard (which is hard to achieve given how specialised the knowledge base is) and a decent cost saving to the existing deal TRCS have.

Good capital allocation ability is under-rated

What I really, really like about Tracsis is how much they emphasise how disciplined they are in the acquisition process and make an effort to outline their approach. They also mention in their annual report about how they've looked at many potential acquisitions this year but none met their strict criteria. This makes me even happier that they a) have excess cash on the balance sheet and b) are retaining most of their earnings for growth. I strongly believe that investors under-estimate the power of good capital allocation (which is a skill surprisingly few managements tend to be good at) and the power of compounding - companies that can reinvest their earnings at high rates of return will do very well for shareholders in the long run and are worth a premium. I'm going to do a blog post about this topic at some point as I think it's a very, very important investment lesson many investors under-estimate even if they are aware of it.

I'll end this blog post with an update of my portfolio as it now stands. I trimmed some PVCS as well as adding funds to buy TRCS - still need to get around to adding more MGNS!

EDIT: Just realised I've missed off JD. from my Stockopedia portfolio, here's my updated list:

Disclosure: I own shares in TRCS