Latest Updates

Updated the newsletter to align it with a new Quality / Defensive / Value framework.

This is a way to think about the main attributes a defensive value investment should ideally have.

This has involved updates to the Current Status page in the newsletter and, more importantly, the Company Review Checklist.

Here’s the related blog post:

The ultimate value investing checklist

ROCE: After receiving several questions in recent months about whether “net prof.” on the stock screen referred to net profit margins, I have decided to change the column name to ROCE. Hopefully this will be less ambiguous as most subscribers will no doubt know that ROCE means return on capital employed.

Specifically, ROCE on the stock screen is the ten-year average return on lease-adjusted capital employed.

Quality:  This column on the stock screen refers to my Growth Quality metric, which to be honest is a bit tricky to describe in just a few words.

The Growth Quality score is based on growth consistency and growth sustainability.

Growth consistency is based on the number of times capital employed, revenues, earnings and dividends went up over the last ten years.

Growth sustainability is based on the amount of external funding (debts, leases, etc) used to fund growth over the last decade, relative to the earnings generated over that period.

This gives a total of five factors (four consistency factors and one sustainability factor). Previously these were equally weighted, so that growth sustainability only had a 20% influence over the overall Growth Quality score.

I have decided to change this so that growth sustainability has an equal weighting with growth consistency, i.e. 50/50. For more detail on how this works, have a look at the updated spreadsheet on the free resources page.

Summary: The Debt Ratio is being updated to include lease liabilities. This is being done on a company-by-company basis and the entire stock screen should be updated by mid-year.

Currently the Debt Ratio is the ratio of total borrowings to ten-year average earnings.

Recent changes to international accounting rules (specifically IFRS 16) have forced companies to put lease liabilities onto their balance sheets. This is correct in principle because lease liabilities are very similar to borrowings in terms of fixed financial obligations.

This has caused a minor problem with company results because some companies now lump their lease liabilities in with borrowings on the balance sheet, while others list lease liabilities elsewhere or under “other borrowings” or similar.

So if two companies had borrowings of £1m and lease liabilities of £1m, one balance sheet might show “borrowings” as £2m while the other shows “borrowings” of £1m and “other financial liabilities” of £1m.

This is a problem because ShareScope (our data provider) only lists “borrowings”, which are then used to calculate the Debt Ratio. This means some companies will have leases included in their Debt Ratio while others do not. I have asked ShareScope if they can separate out lease liabilities automatically, but so far the answer has been no, because the data they purchase is not that granular.

To fix this I have decided to make sure the Debt Ratio includes borrowings and leases for all companies on the stock screen.

I will have to collect lease liability data for all companies on the stock screen and then adjust borrowings depending on whether they include leases or not. This takes time. I have updated about half of the stock screen so far, and the rest should be done by the middle of the year.

The end result will be an improvement in the Debt Ratio as it will take into account a broader definition of debt, i.e. borrowings and leases.

Summary: 1) Net Profitability of banks and insurers has been brought into line with non-finance companies. 2) Return on sales (or assets for banks and insurers) has been removed from the metric.

1) Updating bank and insurer Net Profitability to use return on capital employed instead of return on equity

Just over a year ago I added net profit margin to the stock screen’s Net Profitability metric so that it would lower the rank of low margin companies. Here’s the related blog post.

So for the last year Net Profitability has been calculated as:

Net Prof = the average of 1) 10yr avg net ROS (return on sales) and 2) 10yr avg net ROLACE (return on lease-adjusted capital employed)

ROS is lower than ROLACE for many companies, so Net Prof on average went down across the stock screen. However, banks and insurers don’t have “sales” so they weren’t included in this change. This gave them an advantage over non-finance companies, so I changed Net Prof for banks and insurers to include return on assets (assets are loans for banks and premiums for insurers, so they’re a bit like revenues for these companies as they represent the source of future earnings), which is typically even lower than ROS.

Net Prof for banks and insurers = the average of 1) 10yr average ROA (return on assets) and 2) 10yr average ROE (return on equity)

As you can see, banks and insurers used ROE while non-finance companies used ROLACE. The difference between these two ratios is that lease-adjusted capital employed includes equity capital, debt capital and leased capital, while ROE only includes equity capital.

The reason for the difference is that operational borrowings data isn’t available in bulk for banks and insurers (operational borrowings are borrowings used to buy equipment or property, rather than to lend out or strengthen the company’s liquidity).

However, this is inconsistent, so I have started to gather lease and operational borrowings data for banks and insurers so that they can use ROLACE instead of ROE. This will reduce Net Prof for banks and insurers, and rightly so.

2) Removing return on sales (or assets) from Net Profitability

I added return on sales (or assets for banks and insurers) to Net Prof because I wanted to factor in weak profit margins which are quite highly correlated with weak businesses.

However, having spent another year in the investment trenches, I think combining ROS and ROLACE into a single metric may be a mistake.

ROLACE is probably the single best measure of a company’s competitive strength. Of course it isn’t perfect, but companies that can consistently produce returns on total capital (equity, leases, debts) above 10% are very probably above average businesses. This is exactly what I’m looking for in an investment, so I want the stock screen to use ROLACE for profitability, and not to have that information diluted by including ROS or ROA.

ROS is still important, and I will still have a hurdle rate of 5%, but the stock screen will no longer use ROS or ROA to rank stocks directly.

Following the sudden collapse of Ted Baker’s results and share price I have spent some time reviewing the situation for relevant and usable “red flags”.

One thing that came up repeatedly was the pace of Ted Baker’s growth and the fact that the company was not generating sufficient returns on capital to fuel that growth.

In my opinion the most sustainable form of growth is organic growth, i.e. growth funded purely from retained earnings. Ted was growing so rapidly that it had to make use of inorganic (i.e. external) funding, primarily in the form of rapidly increasing debt and lease obligations.

One way to track inorganic growth is to compare the amount of retained earnings with the growth of capital employed (including leased capital). If capital employed grows by more than the amount of retained earnings then that growth must have required outside funding in the form of additional equity capital (through rights issues), debt capital (through increased borrowings) or leased capital (through increased leases).

Even if inorganic funding is from a low risk source (such as equity capital), excessive growth in and of itself is a risk factor. Rapidly growing companies have lots of new people, new systems, new equipment and new managers, and existing management may quickly find themselves out of their depth.

Growing too fast is a bit like driving too fast. It doesn’t matter how safe the car is. Even the sturdiest Volvo will crash and burn if it’s being driven down a bumpy and twisty road at full throttle.

By aggregating inorganic funding (if there is any) over a ten-year period and comparing it to average earnings, it’s possible to form a view on the degree of inorganic funding used.

In Ted Baker’s case, its inorganic growth funding over the last ten years was almost nine-times greater than its average earnings during that period.

To convert that ratio into a value that fits in with the rest of the Growth Quality components (e.g. number of times revenues went up over the last ten years), I subtract the inorganic funding to earnings ratio from 10 and cap the range of values to zero to 10.

So Ted Baker’s organic growth quality component is 10 – 9 = 1, which is very low, reflecting the fact that most of Ted’s growth was funded inorganically.

This “organic growth quality” value will replace “the number of times the dividend was covered” in the Growth Quality score. However, dividend cover will still be implicitly measured because an uncovered dividend will result in negative retained earnings, and that will usually require inorganic funding to offset.

Other clothing retailers like Burberry and Next have an organic growth quality of 10, reflecting the fact that all of their growth was organically funded through retained earnings. In my opinion organic growth is preferable to inorganic growth, and this will now be reflected in the stock screen.

I will add a link here to the full Ted Baker review after it has been published on the website.

The stock screen has had a minor update to Growth Quality for banks and insurers.

Growth Quality for banks and insurers

• Before: Number of times (as a percentage) that net assets, earnings and dividends per share went up
• After: Number of times (as a percentage) that total assets, earnings and dividends per share went up

For banks and insurers, total assets is (approximately) total loans outstanding or total premiums retained, respectively. This is a better replacement for revenues than net assets.

2019 continues to be a difficult year and some of the model portfolio’s retailers and other property-heavy businesses (such as restaurants) are having a hard time.

This prompted a review these companies, centred around their often exceptionally high returns on capital employed (ROCE). A key reason for their high ROCE is that their main capital asset (their stores, restaurants and other properties) are usually not recorded on the balance sheet, nor are the financial obligations that go along with them.

The reason is that these properties are usually rented, or leased, and this can seriously skew a property-heavy business’s ROCE figure. To adjust for this I have decided to lease-adjust capital employed, changing ROCE into ROLACE (return on lease-adjusted capital employed).

Here is the related blog post.

2019 has been a year of learning and improving, largely because the economic environment and stock market have both been difficult.

Following a number of dividend cuts and other problems in the model portfolio, I spent some considerable time reviewing the UKVI investment strategy and the end result was an updated Company Review Checklist and Company Review Spreadsheet, both of which are available from the Free Resources page. There was also a related blog post.

The main idea was to increase the depth of the pre-purchase review in an attempt to uncover more of the strengths, weaknesses, opportunities and threats facing any potential investments.

The second idea was to come at each review with a negative rather than positive mindset; looking for reasons NOT to invest in the company rather than reasons TO invest. This negative mindset is often characterised as the “Abominable NO-man”, and in the world of investing it has many benefits.

In January there were several updates to the stock screen and investment strategy which were designed to fix some of the issues the model portfolio ran into during 2018.

There was a series of related blog posts, listed below:

Why I’ll be looking at reported earnings instead of adjusted earnings from now on

Why I’m measuring capital employed growth instead of earnings growth

Companies with thin profit margins often make bad investments

Factoring in the risk of excessive corporate debt

Investing in turnarounds, recovery stocks and corporate transformations

This is a very small change. Previously, profitability was calculated as the 10yr median annual ROCE (or ROE for banks and insurance companies). Now, profitability is calculated as the 10-year average EPS divided by the 10-year average capital employed (to give ROCE-based profitability) or 10-year average equity (to give ROE-based profitability).

The Profitability metric is based on return on capital employed.

Previously the stock screen used a simplified version of capital employed (fixed capital plus working capital), i.e.

Total assets - current liabilities

However, a more accurate version of capital employed is:

Total assets - (current liabilities - current borrowings)

And this is what the stock screen will use from now on.

This change has only a minor affect on profitability for most companies. The main difference is that high debt companies with lots of current borrowings will see their capital employed increase and their profitability score decrease.

Updated the stock screen and spreadsheets to use revenues per share instead of revenues. This is because shareholders should primarily be concerned with results per share, not results for the company as a whole.

Sector colour-coding: Defensive sectors are now highlighted in blue. Highly cyclical sectors are in pink.

RNS link: Added a link from the stock screen to each company’s RNS (Regulatory News Service) page on FE Investegate so that you can quickly find the latest regulatory announcements (annual/interim results, acquisitions, etc.) for each company).

Current holdings pages: Added a company-specific page for each of the model portfolio’s holdings (you can access these pages using the ‘info’ button on the Current Holdings screen). Each page includes links to the latest annual report, the company’s PLC website, the latest Company Analysis Spreadsheet, and each review (purchase, annual, interim) from the monthly newsletter.

Ten-year data: Previously the stock screen was built using nine years of historic data, even though The Defensive Value Investor talks explicitly about using ten years of data. This was due to limitations in what data was available. However, those limitations no longer exist and so the stock screen has been updated to use ten-years of data.

You can now select multiple stocks at once using the filters at the bottom of the Name and EPIC columns. This makes it easier to compare stocks and to view data for a list of stocks, e.g. stocks you own.

Added PD10 to both stock tables and UK% and Purchase Date to the Current Holdings table.

Added new colour-coding (dark green) to show PE10 and PD10 below 10 and 20 respectively. This is the maximum value for companies operating in highly cyclical sectors.

One of the investment checklist questions used to weed out high risk stocks relates to the company’s Key Performance Indicators. This question doesn’t seem to add any value to the analysis so it’s being dropped.

Following weak results from an investment in Braemar Shipping Services (primarily a tanker shipbroker) it became clear that highly cyclical companies can be problematic for the defensive value investing strategy.

To avoid further issues with these companies (primarily buying them just after the peak of their cycle, but a long way from the bottom) I have decided to restrict the valuation ratio rules for the most obviously highly cyclical sectors.

The new rule is:

• Only invest in a company from a highly cyclical sector if its PE10 and PD10 ratios are below 10 and 20 respectively.

Highly cyclical sectors are currently defined as:

• Mining
• Oil & Gas Producers
• Oil Equipment, Services & Distribution
• Home Construction (added December 2017)

These very low valuation ratios are typically only reached towards the bottom of the cycle for these companies. This should help the strategy and the model portfolio to buy these companies low and sell them high, rather than the other way around.

As detailed in this article, the maximum allocation to cyclical sector stocks has been relaxed, from 50% to 66%. There were two main reasons for this change:

First, having to hold at least 50% of the model portfolio in defensive sector stocks was proving to be somewhat restrictive. Sticking firmly to the rule would have meant missing out on some attractively valued cyclical stocks.

Second, it was probably excessive. One of the portfolio’s goals is to be more defensive and less risky than the FTSE 100, but growth and yield also matter and an excessive focus on defensives could be detrimental. For example, the FTSE 100 is around 63% invested in cyclical sector stocks, so a limit of 50% for the model portfolio was probably too high, especially considering that the model portfolio will tend to hold cyclical stocks that are already more stable and defensive than the average cyclical stock.

As a result, the maximum allocation to cyclical stocks was increased to 66% to bring the cyclical/defensive split closer to the FTSE 100.

As the headline says, by popular demand the purchase price of holdings has been added to the online table (but not the newsletter due to width restrictions).

In March Standard Chartered was sold and incurred a capital loss, largely because the bank’s balance sheet wasn’t strong enough. In response to this, new capital ratio rules have been added to the bank analysis process. This review of Standard Chartered outlines the new rules and the thinking behind them.

Hopefully these rules will still allow banks to be viable investments, but only if they have extremely robust balance sheets:

1. Core Equity Tier 1 Ratio: This is the existing metric used to measure bank balance sheets. The new rule is that it must have been over 12% in every one of the last five years.
2. Leverage Ratio: This is the ratio between tangible assets and tangible shareholder capital. It must have been below 15 in every one of the last five years.
3. Gross Revenue Ratio: This is the ratio between total income (interest income plus other income) and tangible shareholder capital. It must have been below 100% in every one of the last five years.

The newsletter’s Current Status page has been updated to include additional information relating to the likelihood that additional funds would be either be: a) bought today, if they weren’t already in the model portfolio or b) topped up with addition funds, if such funds were available.

The idea is to provide readers with additional information about how I would deploy new cash into the model portfolio. This is a hypothetical situation as the model portfolio doesn’t have cash inflows or outflows, but hopefully the information is useful to investors with real-world portfolio where cash inflows and outflows are common.

The new columns in the Current Status table are broken down as:

• Would this stock be added to the portfolio today: YES or NO?
• Would this stock be topped up as a FIRST, SECOND or LAST resort?

The answers to these two questions for each holding follow the method outlined in this blog post:

• Regular investments: How I add new money to existing shareholdings

Added a new ratio to the investment analysis process to try to reduce the number of value traps which end up in the portfolio. Specifically, value traps which relate to the capital investment cycle, also known as the capital cycle. This cycle occurs in industries which are more capital intensive, i.e. where large capital investments are required in order to bring on new supply.

Very simply, the cycle is:

1. Demand outstrips supply: High demand and/or a lack of investment in supply drives high profits and high returns on capital.
2. Capex and supply increase: High returns on capital attracts new capital investment which increases supply
3. Supply exceeds demand: After a period of time, supply eventually exceeds demand
4. Prices and profits decline: When supply exceeds over-optimistic demand expectations, prices, profits and returns on capital deline
5. Capex and supply decrease: Capex falls as returns on capital are now. This eventually leads to a lack of supply and the cycle begins again

Capital cycle value traps occur when a company has been growing quickly for years, but where recent profits are below expectations and so the share price is ‘cheap’. This is stage four of the cycle. The problem is that the price looks cheap relative to the past record of revenue/earnings/dividend growth, but these are likely to fall during stages four and five, possibly for several years. It may be worth avoiding stocks that are at stage four and instead wait for several years until the end of stage five, if possible.

To do this I have added the 10-year capex/depreciation ratio to the investment process (where depreciation also includes amortisation). This measures the ratio between the growth of capital assets from new investment and the decline of capital assets due to wear and tear and other factors. Companies that are investing far more than the depreciation rate of their assets are probably growing their capital assets at a very optimistic and perhaps unsustainable rate, and the risk is that too much supply will be created.

The new rule of thumb is:

• Be especially careful around companies that have a 10-year capex/depreciation rate of more than 200%, and where the capex/depreciation ratio is above 200% in more years than not over the last decade.

This rule will be used in conjunction with the existing capex/profit rule (be wary of companies where 10-year capex/profit is above 100%), so companies with a 10-year capex/profit ratio above 100% and a 10-year capex/depreciation ratio above 200% are very unlikely to be added to the portfolio, no matter how attractive their other features such as growth and price.