I will shortly be launching a new model fund which will be called the UKVI 20. This fund will be separate from my personal investments, although the two will be very similar to start with and I expect them to eventually have exactly the same constituent parts but with slightly different weightings.
I’ll put up the facts and figures for the UKVI 20 onto the web site in due course and I’ll keep posting my private investment performance for several more years until the new fund has some reasonable amount of history behind it.
The fund consists of UK listed equities and has the goal of outperforming the FTSE 100 over periods longer than 5 years.
The target number of holdings is 20 to provide adequate diversification without excessively watering down the ‘best ideas’ approach.
Each holding will be allocated approximately 5% of the fund on purchase.
Each holding must have a better 5 year estimated total return than the FTSE 100. This estimate is based on past growth, returns on equity, dividend payouts, share price levels and other factors affecting the holding’s future total return.
Each month the holding with the lowest 5 year estimated returns will be sold and replaced with a new holding that has a 5 year estimated future return higher than the one it’s replacing.
The monthly buy and sell decisions will be posted to the blog, as well as re-valuations of the fund as a whole and constituent companies when annual reports come out.
Why the monthly trades?
This process of selling the least attractive holdings and replacing them with more attractive ones is my way of continually weighing the portfolio as a whole towards companies with higher expected returns than the benchmark.
So each month, rather than the quarterly review of the FTSE 100, instead of kicking out the smallest company by market cap I will kick out the company with the lowest estimated future returns and replace it with the company that has the highest estimated future returns that isn’t currently in the fund.
This approach should over time ensure that the fund is always holding companies that have better current earnings and dividend yields than the average, and that also have better long term growth prospects than average. That combination should help the fund to show the various FTSE UK indices a clean pear of heels in the long term.
One buy and one sell decision each month is also a good pace for the general stock picker I think. More often than that and they risk getting too close to the market and less often, perhaps once a year, means they may risk getting bored and switching to a different method, over and over again. Constant switching from one idea to another has a proven track record of under-performance and should be avoided at all costs.
When does it start?
The UKVI 20 will have a start date of 1st January 2011 and an opening balance of £20,000, which I think is a minimum amount for running this sort of fund due to trading commissions and tax. It already has several new holdings; in fact all of my private purchases since buying BP in March have been added to the UKVI 20. The buy dates and prices are the same as for my private investments and that will be the case going forwards.
Why are you doing this?
The reason for this split is that my private investments have had a fair amount of style creep over the years whereas the UKVI 20 will be starting with a clean sheet and strictly defined criteria based on my current approach to finding attractively valued companies.
Why should I care?
The UKVI 20 may be able to help investors in their stock picking efforts. Readers who see that I have added Vodafone to the fund, for example, may decide to take my thoughts and opinions to their financial advisor to discuss its suitability with them. The ideas on diversification and using a systematic approach to trading may give someone the disciplined framework from which to manage their own investments, again with their financial advisor to hand.
If that sounds like you then I hope it proves useful. If that doesn’t sound like you then I hope you find it interesting nonetheless.
Good luck, it sounds like a grand idea.
Will "book value" be one of the "other factors affecting the holding’s future total return"? (Yes, I did read "The Intelligent Investor by Benjamin Graham).
Hi Anon. Book value isn't a factor anymore. I used to invest purely on book value and it's a valid strategy, but now I generally think that a high price to book ratio is better, assuming a high earnings and dividend yield, growth etc. This is because if the PE is low (high earnings yield) and price to book is high then return on equity is likely to be high. That in turn means that any retained earnings may generate a high return.
It's like when Buffett bought See's Candy at three times book value, marking his first purchase above book value. The idea was that retained earnings are like buying shares at book value. So you buy the shares at three times book, get a good return on those and for every pound/dollar retained by management it effectively buys you another slice at the company but at book value rather than three times book, if you see what I mean.
The original share purchase is really just a 'ticket' to get in the door and get ownership of those retained earnings which can sometimes be returning 30% or more in some companies.
Buffett has a lot to thank Munger for, since I think it was his idea in the first place.
Hi John. Interesting thoughts, I had not considered the leverage effect of retained earnings on a high price to book value company.
Another thought; it must also matter if the company is in heavy industry or manufacturing (as these need more fixed assets, therefore a higher book value before they can open their doors to do business) or if they are in some of the knowledge based industries (which need less investment in plant & machinery so will naturally carry a lower book value for a given level of profitability). I realise some software assets cost a lot to produce, but valuation of such assets is difficult anyway, so I'd naturally discount those in my calculations.
Given these thoughts, and your point about the leverage effect of retained earnings on a higher price to book value company, I'll not be so black and white on my future judgements over acceptable book values!
John Kingham says
Hi Nigel. Your manufacturing and software example companies are like the chewing gum and broccoli example companies in The Little Book That Beats The Market.
Say both are earning £10 million a year, but the manufacturer needs £200 million in assets (one big factory) to generate that while the software firm needs only £20 million (a small office and some computers and a patent or two).
If they are both offered for sale at 10 times earnings then a buyer would pay £100 million, which is half book value for the manufacturer and five times book for the software firm.
What if they both win big new customers and need to expand?
The manufacturer is going to have to dish out £200 million to build a new factory which is twenty years earnings (!) before they can get the second factory online to start earning a second £100 million a year. It just isn't going to happen, not without a huge loan.
The software firm needs just £20 million or 2 years earnings. That amount could be borrowed or even saved up, the new office built and staffed and earnings would double in short order with little debt.
That's why high ROE or ROC or some measure of asset profitability is key to finding good or great companies. It allows them to expand much more easily when opportunities arise.
Joe Talent says
Sounds like a great idea.
Will be interesting to see if you apply a mechanical or dynamic formula to your 'expected returns' model…
John Kingham says
Hi Joe. The expected returns calculation is mechanical but the figures input into the system are subject to human adjustment (i.e. by me). Sometimes figures like average ROE or PE are wacky due to a small or negative book value or very low earnings in a single year.
These are adjusted but without a hard system. I just use 'gut feel'.