Wednesday, December 4, 2013

UK Portfolio 2014

The Premise

This is what I tell myself:

If, in the medium- to long-term, the prices of financial assets gravitate toward their underlying values it is because active investors identify mis-priced securities and buy them. Stock-pickers, in other words, are the invisible hand. 

And, within the set of stock-pickers, private investors enjoy important advantages over professional fund managers: (1) we have a wider range of equities to choose from; (2) we have the option to concentrate on our best ideas and to exclude our worst ideas; (3) we can refrain from buying stocks that we simply don't understand; (4) we can weight the components of the portfolio on a risk/reward basis (with special attention to risk) rather than on a volatility (or tracking error) basis; and (5) we can choose a time horizon of our liking without fear of the sack if we under-perform in the short-run; (6) we can invest according to any so-called "style" -- asset based, GARP, distressed, arbitrage, etc. And, most importantly, (7) we can't afford to blow up whereas, in many cases, they can.

If the above differences are indeed advantages, it follows that the success in investing comes from exploiting them to the extent that one can:  Don't blow up, ever (rule #1). Look everywhere, size-wise and geographically. Don't be a prisoner of a particular "style" of investing if you don't have to. Concentrate on your best ideas and weight them according to safety first (see rule #1) and potential reward second. Don't buy anything whose downside you haven't fully grasped. Choose an investing horizon that suits you and ignore volatility and tracking error in the interim. 

Grasping the whole story and the extent of the downside is, I think, a matter of practice and of effort, the rest is a matter of acting responsibly. 

Review of 2013

In line with the reasoning above, last December I constructed a model UK portfolio that I thought would outperform the FTSE 350 by at least 20% over this past year -- ~20% outperformance being, I think, reasonable compensation for exploiting the advantages listed above.

This was the outcome of the experiment in its first year:

There are a couple of errors of judgment in those picks and, if I had to do it over again, I would leave out the cyclicals (Dewhurst and Creston) and stick with the five "either-way" picks. (Or, if I were to include cyclicals I should have gone all the way --i.e. very cyclical and levered, like the construction companies.)


In this the second season of the great British bake-off, I've constructed a model portfolio that looks like this:

Again, I hope for (and expect!) year ahead returns that are at least 20% higher than the performance of the FTSE 350 and, to repeat what I soothsayed last year,  two-year returns that comfortably exceed that of any statistical strategy tracked by Stockopedia

I have previously written about Lombard Risk, Howden Joinery and Lamprell. I was introduced to Quarto by Lewis and to International Greetings by Richard. Senior is a wonderful business (moat, return on capital, long term secular growth, visibility, safety) that is obviously undervalued at 16x trailing earnings. And Creston is (still) in the portfolio because I'm being stubborn. 

They're all mis-priced in one way or another. One way of looking at Quarto, for example, is as follows:

And from that perspective, a market cap of £33 million may be too low for what is, after all, a stable, profitable and growing business. And, if you believe that Quarto has begun a serious effort to de-lever its balance sheet then you may be able to envisage £10 million in annual reductions in debt plus $2.5 million in dividends that, together, return ~38% to Quarto's shareholders each year, without a re-rating of the multiple.   

Please remember to do your own research and use your own judgment. It is entirely possible that I have no idea what I'm doing.

Disclosure: I own shares of Lombard Risk and I have sold out of Northgate


  1. Small detail, but I believe Quarto's annual dividends are USD2.5M and not GBP2.5M...

  2. Red,

    I'm a bit confused as to how you get to your QRT numbers. Taking 2012 as an example I see $16,581k as the "Operating profit before amortization of intangibles and exceptional items" - yet you have $39.7m as EBITA. Can you help me reconcile?

  3. Sure, I've taken out the amortization of prepublication costs and the share based payments to get to my EBITA.

    I've added back Prepub capex below EBITA and share dilution resolves itself in the net payout to equity.

    I wanted to get a simple cash-based view of earnings. It should reconcile quite well with the cash flow statement.

  4. ps. I should have included Sprue Aegis in the above portfolio. It slipped my mind.

  5. You leave out the biggest one. Small investors can buy and sell in seconds, not weeks. That is HUGE.

  6. Hi I am a follower from Spain (currently living in London), I just discovered the blog. Great Ideas.

  7. This comment has been removed by the author.

  8. Andres,
    I agree with your points about Lombard Risk's share issuance. The problem with companies based in London is that they can't help but mess around with their capital structure (and they can't seem to shut up).

    Still, I think the share issuance is in the past: it was used to fund product development costs in lieu of debt. That should be a non-issue going forward because the company is now generating cash flow sufficient to fund those costs.

    As for its competitive position, it seems to me that the market for collateral management and regulatory compliance software has been segmented geographically. LRM's market share in Western Europe is minimal as is its competitors' market share in the UK.

    There is, I think, some stickiness involved: clients stick with the software package that they know and that is embedded in their system; it is easier to upgrade than to switch. (There are some similarities to the ability of CEGID to fend off competition from SAP and Oracle. I've written about CEGID before).

    This stickiness, though, can fail when there is a major overhaul of regulatory requirements such that financial institutions etc are encouraged to review and overhaul their entire system. It seems, though, that LRM has come through this risky period intact, with clients retained and new ones added. (The US clients were, of course, acquired).

  9. Hi,

    I noticed on your "Tracking Portfolio" page that you closed out the Mayur Uniquoters position. Do you no longer view it as attractive?

    Looking at the business, I think there are tailwinds (in auto) and huge growth ahead.

    What do you think?

  10. Dave,
    Mayur is very attractively priced. There is a long, steady boom in revenue and profit ahead of it yet.

    I closed it out because I'm playing silly buggers and hoping that a rise in interest rates in the US will throw emerging market stocks into a tizzy, allowing me to buy Mayur back at a lower price in a few months time.

  11. What broker do you use ? I use InteractiveBrokers and I cannot buy Lombard Risk, Quarto or Mayur.

  12. Mayur's pretty exotic & how to buy it can be found in the comments to that post.

  13. I must admit that I too have been guilty of trying to time my purchases in a similar sense.

    I do remind myself WEB's quote:

    "Lethargy, bordering on sloth should remain the cornerstone of an investment style."

    And the fact that one gets rich by INACTIVITY rather than ACTIVITY.

    Do you have any other stocks with a similar conviction at Mayur? I can't find too many no-brainers at this time so I'm considering allocating up to 15-20% of my portfolio into Mayur and sitting on my ass for the next 5 years.

  14. Any reason why you did not include Judges Scientific in your 2014 portfolio? You had a pretty good write-up on it.

  15. Dave,
    None that are quite as convincing as Mayur,but I'd be inclined to think that Valmont (VMI) and AGCO offer pretty good buy-and-hold opportunities over a 5 yr horizon.

  16. Stephen,

    I think Judges is a good LT investment but who knows, really, what it will do in the year ahead period? My 2014 picks are mostly situations where something has to give: either sentiment or fundamentals.

  17. Red,

    Having spent a while playing with QRT's numbers I think you may be overestimating the real earnings power - I'd be interested to hear your thoughts on these comments.

    I was struggling to reconcile your estimate of the FCFE generation capacity of Quarto (£10m in debt reduction + $2.5m in divis, so approximately £11.5m in FCFE?) with the Operating and Investing cash flows. I often like to use Operating cash flow before working capital movements (which net out over time for a low-growth business like QRT with little need to adjust WC) minus Investing cash flow before acquisition spending and growth capex as a good estimate of normalised 'owner earnings' / normalised FCF generation. However, when I do this analysis I get:

    Op CF (pre-WC movements): $29.833m
    Inv CF: -$18.996m
    FCF: $10.837m
    'Normalised FCF': $10.837m
    'Normalised FCF' + After-tax Exceptionals: $13.76m

    Op CF (pre-WC movements): $32.591m
    Inv CF (pre-acq): -$19.758m
    'Normalised FCF': $12.833m
    'Normalised FCF' + After-tax Exceptionals: $13.87m

    So in both years I get ~$13.8m cash generation, ignoring exceptionals (which I think is generous, given there have been significant exceptionals every year for a decade for QRT). If you subtract finance costs of ~$5.5m, I'm left with $8.3m of FCFE to pay dividends/pay down debt. Now, this isn't that bad a result, and indeed the shares trade on effectively only 6.4x this amount, but it's quite away from the figure you have in terms of divi/debt reduction. Also, I think that ignoring the unexceptional exceptionals is too generous - for 2012/2011 they've averaged $2m off profits after-tax so not insignificant - if I take these in to consideration then FCFE is only $6.3m and the shares trade at more like 8.4x.

    Looking at the balance sheet, I think part of the difference from our estimations come from quality of earnings differences. From 2010 to 2012 Goodwill + other intangibles increased by $4.7m and Pre-publication intangibles increased by $1.9m (despite underlying profitability not really moving much in this period)

    Still, this is arguably pretty cheap regardless (especially if they can do something about their exceptional problem), I just wondered what your thoughts were on this analysis.

  18. Mark,

    I hear you, although I think I've probably understated the earnings power by a little. I should write a separate, fuller post on what I see in Quarto so I'll do that next.

  19. Red
    The link to richard's comments on int greetings make it sound like a dog, so I don't understand the buy case..

  20. hi - what software/tool do you use to track your performance versus the S&P?

  21. Red,

    Hope you're well.

    Senior is all over my screens and really interesting, and I remembered in the back of my mind - as is often the case - that you and Richard had beaten me to it.

    The one thing I need to get comfortable on is the continuity of their returns. You say they have a moat - and I can't disagree, given their performance in what is a typically uninspiring sector, but I don't really understand where it comes from. I've looked at companies doing components in large supply chains before, and I've usually found them to be pretty squeezed.

    I guess the argument with a company as large and integral as this is that - given the importance of quality control in their products and a history of performing - once you're imbedded, you're in unless you screw up. A proposition something a la Precia - switching just isn't an attractive prospect given relative costs and benefits.

    They also expense £13m in R&D (none capitalised), which is non-trivial.

    Am I missing a key tenet?


  22. Hi Lewis

    Focusing on the aerospace segment, I'd venture critical parts + low unit value + modest margins. There's no particular reason for the OEMs to kick Senior to the curb.

    Relationships with both OEMs and the visibility that comes with it gives the company the opportunity to really turn its assets over; to design the parts itself; and to spend on R&D knowing that it will recover the investment.

    Underlying all this is that aerospace is different from, say, cars. The end customers are corporates not retail consumers and the OEMs are a duopoly that compete along more dimensions than just price.

    So, if a aerospace is a good place to be over the next 10 years then SNR is a reasonably good bet.

  23. Thanks for chewing it over with me Red, I appreciate it.

    On a side note, I also had the pleasure to see Howden Joinery at a conference in London a couple of weeks ago - and I walked away with the same warm feeling I get when I read their annual reports. My worry was that they wouldn't be able to deploy much more capital, but as they open more depots, they seem to endlessly revise up their estimate of how many depots the UK can support..

    .. which is to say nothing about their activities on the continent, which are (as one would expect from them) prudent and even-handed.

    I still have question marks about those, but there's more of a runway here than I thought.

  24. Do either of you have an eye on Heico which operates in a similar space and run by outstanding owner/operator?

  25. Interesting. Thanks, Lewis.

    anon - HEICO is a better business than Senior: taller barriers, aftermarket steadiness & margins, taking share, management that's just as good etc. HEICO and Moog are my favorites in the supply chain.

  26. I see now that HEICO's share price has been weak

    I suspect that there's been some discomfort about owning/paying 30x earnings in the face of a global fleet that's getting younger.

    30x is not a great price to pay for anything but I'd be interested in HEICO at 18x trailing earnings. If HEICO can rely less on engine MRO and moreon PMA distribution and I think it can/will) 18x would be a great entry price, imo.


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