November 2018: Average profitabilityThis 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).
November 2018: Profitability and current borrowingsThe 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 liabilitiesHowever, 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.
October 2018: Revenue per shareUpdated 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.
September 2018: Lots of online stock screen changesSector 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.
August 2018: Added new filters to the online stock screensYou 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.
July 2018: Added new columns and colour-coding to stock screensAdded 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.
June 2018: Dropping Key Performance Indicator questionOne 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.
October 2017: Additional restrictions on highly cyclical stocksFollowing 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.
- Oil & Gas Producers
- Oil Equipment, Services & Distribution
- Home Construction (added December 2017)
April 2017: Change to the limit on cyclical sector stocksAs 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.
April 2017: Purchase price added to the online current holdings tableAs 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).
March 2017: New capital ratio rules for banksIn 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:
- 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.
- 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.
- 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.
November 2016: Current status page updatedThe 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?
July 2016: New capex to depreciation ratio addedAdded 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) high levels of demand drive high profits and high returns on capital which in turn attract new capital investment from existing and new competitors; 2) This new capital investment massively increases supply; 3) supply eventually exceeds demand, although there may be a considerable lag between capital investment and increases in supply; 4) supply exceeds over-optimistic demand expectations which leads to declining prices, profits and returns on capital; 5) Low returns on capital drives low capital investment, which eventually leads to a lack of supply as demand gradually grows, leading to higher profits and then 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.