This page outlines the latest changes to the investment strategy, newsletter or website layout, or some other aspect of UK Value Investor.
October 2017: Additional restrictions on highly cyclical stocks
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 the Mining, Oil & Gas Producers or Oil Equipment, Services & Distribution sectors if its PE10 and PD10 ratios are below 10 and 20 respectively.
This is a more specific (and more easily applicable) version of a more general rule:
- Only invest a company that is heavily influenced by commodity price cycles or capital investment cycles if its PE10 and PD10 ratios are below 10 and 20 respectively.
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.
April 2017: Change to the limit on cyclical sector stocks
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.
April 2017: Purchase price added to the online current holdings table
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).
March 2017: New capital ratio rules for banks
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:
- 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 50% in every one of the last five years.
November 2016: Current status page updated
The 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:
July 2016: New capex to depreciation ratio added
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) 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.
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.
November 2015: Tighter rules for bank capital ratios
Following a rights issue and dividend suspension at Standard Chartered I have decided to tighten up the bank leverage rule of thumb. Previous the rule was that a bank’s 5-year average common equity tier 1 (CET1) ratio should be above 10%. This was true for Standard Chartered but still it has had to raise equity capital through a rights issue in order to strengthen its balance sheet.
Standard Chartered has now set a goal of keeping its CET1 ratio between 12% and 13%. I think this is reasonable and so I have changed the bank leverage rule of thumb so that a bank’s 5-year average CET1 ratio must be above 12% before it will be added to the model portfolio.
October 2015: Simplifying the diversification metrics
Changed how the portfolio’s cyclical/defensive sector split is calculated. Previously it was based on the sector of each holding and the position size of each holding, with the rule of thumb being that at least 50% of the portfolio should be invested in defensive sector companies.
For the sake of simplicity this rule has now changed so that at least 15 out of 30 holdings should be invested in defensive sector companies. The outcome will be more or less the same but the measurement is much easier to calculate and explain.
The calculation of the portfolio’s UK exposure has also changed. Previous it was calculated as the average of each holding’s UK exposure (measured via the percentage of revenues generated from the UK for each holding) weighted by position size. To simplify this measure I have now changed it so that it will be calculated as a simple average of the holdings’ UK exposure (still measured using percentage of UK revenues).
August 2015: Added the Current Status page
Added a Current Status page to the newsletter. This page briefly outlines the current status of each holding in the model portfolio. It also indicates whether I would buy, hold or sell shares in each holding at their current price. Note that this is my opinion of what I would do, not my opinion of what you should do; your investment decisions remain entirely your responsibility.
June 2015: New selection features added to online stock screen
Added new checklist selection functionality to the “Index” and “Sector” columns in the stock screen. This means you can now select say “FTSE 100” and “FTSE 250” stocks at the same time, and/or “Banks” and “Beverages” sector stocks at the same time. Previously it was only possible to select one index or one sector at a time.
May 2015: Updated the Portfolio Analysis Spreadsheet
Added a new worksheet to the Portfolio Analysis Spreadsheet (available on the Resources page). This new sheet ranks stocks in a portfolio based on the stock screen ranks (Growth Rate, Growth Quality, ROCE, PE10, PD10, Dividend Yield). It will also update share prices automatically although this does mean you need to “enable” macros for it to work (a macro is a small program, in this case to download share price data from Yahoo).
March 2015: A variety of updates and improvements
1. Added “Purchase Rank” and “Purchase Price” to the newsletter version of the stock screen.
2. Updated the Stock Screen so that the Debt Ratio for banks is “N/A” for Not Applicable. Previously it was zero which was misleading as the Debt Ratio isn’t used when analysing banks.
3. Updated the Stock Screen so that the Debt Ratio for insurance companies is “N/K” for Not Known. Previously it was zero which was misleading as the borrowings figures for insurance companies isn’t part of the UKVI database. The Debt Ratio is calculated manually for insurance companies in the UKVI portfolios. The Debt Ratio for insurance companies (or any company) can be calculated using this formula:
Total borrowings / Current Earnings Power (where Current Earnings Power is the 5-year average adjusted earnings per share)
4. Added the Portfolio Diversification Spreadsheet to the Resources page.
5. Added the Company Analysis Checklist/Worksheet to the Resources page.
6. Updated the Stock Screen to exclude companies where total earnings per share have been less than total dividends per share over the last 10 years.
February 2015: Added cyclical and defensive sector definitions
Added cyclical and defensive FTSE Sector definitions to the Stock Screen pages. FTSE Sectors are defined as cyclical or defensive in the Capita Dividend Monitor quarterly report.
December 2014: New and improved debt and profitability metrics
1. Changed the Debt Ratio to be more conservative as several UKVI portfolio holdings with high, but acceptable, debts ran into problems that were exacerbated by their debts. The new Debt Ratio is calculated as:
Total borrowings / Current Earnings Power (where Current Earnings Power is the 5-year average adjusted earnings per share)
2. Added a range of new leverage and liquidity rules for banks and insurance companies. For banks the new rules are based on regulatory measures which you can find in recent bank annual reports (older reports may not have these ratios), and those rules are:
Common Equity Tier 1 Ratio greater than 10% – This measures the ratio between “common equity” and “risk weighted assets” on the balance sheet. Common equity is effectively a buffer to absorb loan defaults.
Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) both greater than 100% – LCR is the ratio between the amount of liquid assets a bank has and how much net cash outflow it could expect during a 30-day period. NSFR is the ratio between “sticky” funding, e.g. bonds, and “flighty” funding, e.g. deposits.
For insurance companies the rules are:
5-Year average Premium to Surplus Ratio (or Net Written Premium to Tangible Book Value Ratio) less than 2 – As the name suggests, this is calculated by dividing net written premium by tangible book value. It measures how much of a capital buffer the company has relative to the amount of premium it is writing.
5-Year Combined Ratio less than 95% – A combined ratio of less than 100% shows that the insurance company’s underwriting activities (i.e. writing insurance) is profitable. Insurance companies that continually have combined ratios of over 100% typically hope to make up for making a loss in their insurance business by making larger profits from investing their insurance float. That approach tends to be more risky.
November 2014: Added profitability (ROCE) to the stock screen
Added Return on Capital Employed (ROCE) to the stock screen. This is a measure of the profitability of a company. A high ROCE may signify a company that has a competitive advantage of some sort as it is able to earn high returns on capital employed, which in a competitive market should be eroded away by competitors. As with most things I’m not happy with the standard approach so the ROCE measure in the stock screen is non-standard.
The first difference is that it is the median 10-year ROCE rather than ROCE calculated using last year’s figures. This fits in with the rest of the metrics in the screen which measure 10-year growth (Growth Rate), 10-year growth quality (Growth Quality), price relatively to 10-year average earnings (PE10) and so on.
The second difference is that the returns are calculated from post-tax profits instead of the usual operating profits. ROCE is usually calculated by dividing operating profits by operating capital (fixed assets plus working capital) in order to measure the profitability of the operating business whilst ignoring how those operations are funded (i.e. borrowings and interest are not in the calculation). However, I want to avoid indebted companies and currently there are no debt-related metrics used to calculate the stock screen rank. By using post-tax profits, interest payments are factored in. That means companies with lots of debt and high interest payments will have lower ROCE scores and will therefore rank lower, which makes them less likely to be bought.
The third difference is that the ROCE figure in the stock screen for banks and insurance companies is in fact Return on Equity (ROE) rather than ROCE. ROE is used for these companies because of the structure of their balance sheets, which render the ROCE calculation meaningless.