Questions and Answers
If you have any questions about the investment strategy or (almost) anything else, please have a look through the list of previous questions below to see if they’ve already been answered.
Click on a topic heading to restrict the questions to that topic and then click on a question to see the answer.
If you don’t find what you’re looking for then feel free to get in touch and I’ll be happy to answer any questions you have.
If I had to boil it down to a handful of resources, I’d probably say (in order of importance):
1. The New Buffettology – This is the book that got me on the road to quality/defensive value investing.
2. The Intelligent Investor – The bible of value investing, by the father of value investing, Ben Graham. I have the 1949 edition, but I’d also like to get the revised 1973 edition which has lots of additional content.
3. The Intelligent Asset Allocator – This book is a bit technical, but it’s where I learned about asset allocation, diversification, rebalancing etc.. It’s about managing an efficient portfolio rather than picking stocks.
4. Warren Buffett and the Interpretation of Financial Statements – By the same author as the Buffettology book, but covers the three accounting statements (balance sheet, profit and loss, cash flow) in more detail.
5. Revaluing Wall Street – This is where I learned about cyclically adjusted PE (CAPE), market valuation and valuation mean reversion. This is the foundation upon which my use of CAPE is based.
And of course there’s my Defensive Value Investor book as well. And here are a few related blog posts:
Cutting your losses and letting winners run is a popular tactic, but personally I prefer to rebalance “winners” for risk control reasons.
In the case of Victrex, if I let Victrex “run”, then the portfolio will probably have better performance over the next year if Victrex, say, doubles in price in that time. A doubling would take Victrex from 6.5% of the portfolio to almost 13% (assuming the rest of the portfolio remained static, which of course it wouldn’t but it’s a nice simplifying assumption) and that would give the portfolio a helpful boost.
But what about the following year? What if Victrex doubled again from 13% to 25% of the portfolio? The portfolio’s performance would definitely be enhanced by sticking with such a successful stock, but the risks of such concentration are huge.
What if one morning it turned out that Victrex had done something very illegal and/or its accounts were fraudulent? The shares could drop by 50% or more in a single day and within a few weeks they could go to zero. Who knows? In this example, 25% of the portfolio would be wiped out from a single mistake, which would be very hard for most people to take psychologically.
So instead of chasing every last drop of performance, I prefer to keep a tight lid on the risk side of things and then try to get as much performance as possible within that risk limit. And for me that means rebalancing.
Yes, I only trade once each month, and I agree that there is the possibility of missing some investment opportunities. However, I think the benefits, such as having a disciplined mindset, avoiding overtrading and avoiding knee-jerk decisions, should outweigh the occasional lost opportunity.
If a company has a defined contribution (DC) pension scheme then you won’t see any pension scheme assets or liabilities listed anywhere as these are managed separately from the company and don’t represent a financial risk.
For defined benefit (DB) schemes, you’ll find the surplus or deficit listed on the balance sheet, but not the total assets or liabilities. The surplus or deficit will be called something like Retirement Benefit Obligations or Retirement Benefit Assets, respectively, and in the annual report (although not usually the annual results) you’ll see a number indicated the related accounting note.
If you go to the related note you’ll see a huge amount of information about the pension fund, its assets, liabilities and all manner of other things. What you’re looking for in the note is a table listing the scheme’s obligations/liabilities. There is usually a total row at the bottom called Total Fair Value of Scheme Obligations, or similar, and a total column if the scheme is broken down into columns by country, business unit or something else.
To be honest I would say there is no reasonable way to exactly match the model portfolio’s weightings. For example, even though my own personal savings are invested in exactly the same 30 stocks, the weightings are somewhat different. That’s due partly to slightly different initial position sizes but also to top-ups in my personal portfolio from additional savings, which of course the model portfolio doesn’t have.
Personally I’m not overly worried about having slightly different weightings in my personal portfolio because the model portfolio’s weightings are not especially meaningful. In other words, it wouldn’t really worry me if BP was 3% or 5% of my portfolio compared to 4% of the model portfolio. As long as each position stays below about 6% then I’m happy. A couple of final points:
1) If a company’s share price shoots up very quickly and takes it above 6% then I’ll sell half of that position to reduce exposure to that one company, and this could happen in my personal portfolio but not the model portfolio, or vice versa.
2) When making contributions I only add them to holdings where the current position size isn’t too close to that 6% limit, and where the book cost (i.e. total cash amount invested in a stock) also isn’t more than 6% of the overall portfolio.
This is an interesting point. Using the list of 30 holdings from November 2016, the top 15 holdings sorted by profitability had increased in value since purchase by an average of 21%, with only four of the 15 showing a capital loss at that point in time. Meanwhile, the bottom 15 holdings by profitability had fallen in value by an average of 7% since purchase and 11 of the 15 were showing a capital loss. That is pretty compelling evidence that profitability is an important factor in stock selection.
In fact I do think higher profitability companies generally perform better, which is why I added the profitability score to the stock screen in November 2014. However, before that date I did not take account of profitability and that has impacted the holdings currently in the portfolio.
For example, the 13 holdings purchased since the profitability score was added have an average profitability of 21% while the older holdings have an average profitability of 16%. So the average profitability of newer holdings has (unsurprisingly) been higher since I started taking account of it. Also, eight of those newer 13 holdings (62%) are showing a capital gain while only seven of the older 17 holdings (41%) are showing a gain. So companies purchased using the profitability score have so far been better investments than those purchased before profitability was included. Overall then I would say yes, focusing on higher profitability companies is a good idea, and that is what I have been doing since November 2014. However, there are still some legacy stocks in the portfolio that, on average, are less profitable and have so far underperformed.
There are two main reasons why I buy and sell more frequently than a buy-and-hold investor:
1) I don’t think I can reliably spot companies that are likely to grow over decades, so I don’t expect to hold for that long. I think the companies I pick should have a fair chance of prospering over say 1-10 years, but beyond that I just don’t know. So that’s the sort of period over which I hope my holdings will be able to perform well and that’s the sort of period over which I expect to hold them.
2) Since I don’t expect to stay invested in a particular company for decades I need to be willing to jump from one company to another as time passes. If I’m going to be jumping around anyway (although jumping fairly infrequently) I think it would be best to jump from company A when its share price is high to company B when its share price is low. The result is a buy-low-sell-high strategy with a low (monthly) trading frequency and with expected holding periods in the 1-10 year range rather than the “forever” range.
Q: There is an accounting change due in 2019 where the value of lease liabilities will be shown on the balance sheet. What impact will this have on property-dependent companies such as The Restaurant Group, as effectively it will be showing liabilities similar to pension liabilities in the annual results?
A: So far I haven’t found capitalising lease expenses (i.e. some variation of calculating the present value of future lease obligations and putting that amount onto the balance sheet as an asset and a liability) particularly helpful, at least not with the sort of market leading, highly profitable businesses that I prefer to have in the model portfolio. In my limited experience, when times are tough leases tend to be easier to renegotiate, or get out of, than borrowing agreements.
For example, a large retailer will have hundreds of sites with many dozens or even hundreds of landlords, and lease agreements can be re-negotiated (at a cost) either on an individual basis or in small groups. That doesn’t seem to be the case with most borrowing agreements, which are usually with a handful of banks rather than many dozens or hundreds.
As for the accounting rule changes, it will depend on how the changes are adhered to by each company as well as financial data providers, but personally I would rather continue using the figures that are not lease-adjusted for now. Hopefully it will still be possible to differentiate between borrowings and capitalised lease obligations, both in the actual accounts and in the data feed which I get from ShareScope and other data providers.
If I run into a case where lease costs obviously caused an investment to turn out badly then of course I would factor in those obligations, possibly by capitalising them. But until that happens I will continue to focus on borrowings and other problematic expenses such as acquisitions and capex.
I think that looking at the liabilities alone is a more sensible approach than looking at the pension surplus or deficit (i.e. whether or not the pension assets exceed the pension liabilities).
As you point out, pension assets can change in value as the underlying investments change in value. Not only that, pension liabilities can also change in value (typically upwards) when actuaries reappraise the expected remaining lifetime of retirees. Given that both liabilities and assets are subject to change, the deficit or surplus can change dramatically in a relatively short period of time. So for example a company with a £100m pension liability and pension assets worth £101m has a £1m surplus. But if the liabilities increased to £110m while the assets fell to £90m it would find itself with a £20m deficit, and possibly in a relatively short period of time. Whether or not a £20m deficit was a problem would depend on how much profit the company typically made. If the company made £20m profit a year then it might be a bit of a problem, but if the company only made £2m a year then fixing a £20m pension hole would be an enormous problem which could require a rights issue to fix.
So pension scheme risk is closely related to the size of the pension deficit we could reasonably expect the scheme to have at some point in the future, and that is determined primarily by the size of the pension liabilities.
This is a question that comes up from time to time and the answer is no, I do not use stop losses.
The reason is that a stop loss puts the decision to sell into the hands of the market. If a company which you own hits some tough and uncertain times, then the share price may drop considerably. However, this does not mean that the long-term value of the company has dropped because markets do not have perfect foresight. Sometimes, perhaps quite often, the market is wrong.
One example from the model portfolio is Braemar Shipping Services. This was bought in May 2011 at about 480p. By October 2011 it had dropped almost 40% to just over 280p. If I had put in a stop loss at 335p (30% below the purchase price) then the investment would have been ‘stopped out’, resulting in a realised 30% loss.
However, after dropping to 280p the shares subsequently rebounded to 400p. That’s a gain of almost 43% from the low point, and about 19% up from the stop loss.
So In Braemar’s case, since 2011 it has been through some ups and downs but the underlying fundamentals (revenues, earnings, dividends, etc.) didn’t show – in my opinion – that the company had lost 40% of its long-term value.
Instead, the market was spooked by some short-term bad news and decided to sell off. That’s how the stock market works.
One of the reasons that I run a diversified portfolio is so that I can sit and watch an investment drop 40% and not panic. With each holding at around 3% of the whole portfolio, a 40% drop in any one of them makes little more than 1% difference to the portfolio overall.
So in summary, I don’t use stop losses because I like to decide when to sell, rather than letting the market make that decision, and I like to concentrate on what the company’s doing rather than what the share price is doing.
Yes, but it isn’t a key metric for me. I realise that free cash flow ratios are popular, but I prefer to stick to my approach of looking at revenues, earnings, dividends, debt levels, pension levels, and so on.
If over time it became obvious that companies with stronger free cash flows were producing better returns, and that looking at free cash flows was better than looking at earnings, then I might integrate it into the stock screen. So far though I don’t have enough data to arrive at any meaningful conclusions.
However, if you like to use free cash flow yields or other similar metrics, you can see the 10-year free cash flow to dividend ratio for each stock on the online version of the stock screen.
My approach is to generally ignore “bad news” and concentrate on the company’s rank on the stock screen. This gives me a consistent approach to deciding which companies to hold and which to sell.
So if a company:
- Cuts the dividend – This will weaken the company’s rank as its Growth Rate and Growth Quality scores will fall, but this is often offset by a falling share price which makes the company look more attractive as its PE10 and PD10 ratios would likely improve. Typically dividend cuts are not a reason for me to sell.
- Issues a profit warning – Again this is unlikely to make much of a difference to the rank overall and so probably wouldn’t be a reason for me to sell.
- Makes a loss, even in adjusted earnings terms – This might have a significant impact on the company’s rank, depending on the size of the loss. However, I might still hold onto the company if it looked like the loss was a one-off.
- Suspends the dividend – There is a reasonably good chance that I’ll sell a company if it suspends the dividend, but it would depend on how long the dividend was suspended. If it was for just one or two payments I might hold, but if it was for more than that then I would almost definitely sell and look for a more secure income elsewhere.
So in general I use the stock screen rank as the primary means of making buy and sell decisions, although in the end there will always be some judgement involved. However, I certainly do not like to make “knee-jerk” decisions if a company announces a disappointing set of results.
Whether I’m selling winners or losers depends on what sort of timeframe we’re talking about.
Selling short-term winners and holding short-term losers
If a company’s share price doubles in a year then it is very unlikely that its intrinsic value (the value of all future dividends discounted at perhaps 10% a year) will also have doubled. Intrinsic value generally changes quite slowly.
So if the price has gone up but the true value hasn’t changed (much) then it will be a less attractive investment. Also, the PE will probably have increased and the dividend yield decreased.
In that situation I’m likely to sell, even though some people would consider that stock a winner because it has done well.
On the other hand if a company’s share price falls by 50% I’m unlikely to sell because, assuming it’s a good company, its intrinsic value is unlikely to have fallen that far that quickly.
Therefore the shares will be even better value than before, because the price has dropped more than the intrinsic value. The shares are now effectively “cheaper”, so if anything I would be looking to buy more rather than sell (although generally I don’t buy more when an existing holding’s shares fall).
So I will sell short-term “winners” and hold short-term “losers”, where “winners” are those companies that see their share price rise rapidly and “losers” are those that see their share price fall rapidly.
Holding long-term winners and selling long-term losers
In the long-term the situation is reversed. If a company continues to grow its revenues, earnings and dividends then it is a long-term winner. As long as the share price doesn’t go up too quickly (turning the company into a short-term winner, which I would sell) then I would continue to hold it for as long as it remained a long-term winner.
On the other hand if the company declined consistently, with falling revenues, earnings and dividends over several years, then the company would have become a long-term loser. Unless the share price falls incredibly far it’s very likely that I will sell long-term losers.
So I will hold long-term “winners” and sell long-term “losers”, where “winners” are those companies that grow their revenues, earnings and dividends over the long-term and “losers” are those whose revenues, earnings and dividends decline over the long-term.
The full question was:
“One thing that puzzles me is the 10 year P/E calculations (CAPE) which appear to suggest literally an average of 10 years’ reported earnings. Am I missing something or should each really be adjusted by some cumulative inflation factor prior to arriving at a meaningful figure ? Surely the money represented by earnings ten years ago is worth more than today (as is the case with, God forbid, never done one,”discounted cashflow” calculations).”
And my answer was:
The PE10 / CAPE issue is perhaps a bit ambiguous. CAPE is the inflation adjusted version and it’s usually applied to market indices, although it can of course be applied to individual stocks too. The reason inflation adjustment is important for market indices is that CAPE is typically used to compare today’s CAPE value to whatever CAPE was at some point in the past.
So the classic example is Professor Robert Shiller’s S&P500 CAPE, where has calculated a long-term average value of about 16 and then we can compare today’s CAPE to that average, or CAPE 10 years ago, or whatever.
CAPE is the ratio I use to value the FTSE 100 on page 2 of the newsletter.
With PE10 it’s a bit different. It isn’t inflation adjusted and it’s more commonly used with individual companies, although even then I’m one of very few people who use it. PE10 when used for individual companies is used to compare one company at one point in time with another company at the same point in time, i.e. Shell and BP today. Because both 10-year periods are the same the inflation adjustments would be the same, and so there is far less (if any) point in adjusting for inflation. That’s different to CAPE which might be used to compare CAPE today (low inflation during the 10 years) and CAPE in 1980 (high inflation in the 10 year period).
So CAPE is used to compare the same investment (typically) at different points in time and PE10 to compare different investments at the same point in time.
I look for PE10 (not CAPE, i.e. not inflation adjusted) to be under 30 because there are very few companies that could reasonably be called “good value” at that sort of valuation. There could be some, but it’s more likely that such shares are relatively expensive.
Over the years I have used quite a few different software and data providers. I’ve written about some of them here:
The main tools I use are:
Nowadays I mostly use ShareScope, both for tracking the model portfolio and more recently for the data which underpins the UKVI stock screen. I used to maintain my own database of fundamental data and share prices, but it was a real pain and a combination of ShareScope and the newer SharePad seems to do the job.I still have to do a lot of work in Excel to build the stock screen, but most people ShareScope/SharePad are very powerful right out of the box.
If you subscribe to one of their products via the link below you’ll get one free month:
I use this site to subscribe to RNS announcements for all of my holdings.
I might occasionally cross-reference something in ShareScope with Sharelockholmes if it doesn’t look right. Sharelockholmes is my favourite low cost data site. It’s basic-looking, but very comprehensive:
I think that’s it. I’ll add more here if the list changes.
Averaging down is the process of buying more shares in an existing holding when the value of those shares fall. It’s a way to reduce the average price of an investment.
I used to average down on falling shares a few years ago but got bitten by a couple of companies that I kept averaging into as they went down, until finally they went bust. That was back when I invested in much smaller, riskier companies than I do now, and of course the odds of Tesco going bust are virtually non-existent, but I’m still wary of averaging down.
I prefer to make one buy decision and one sell decision per company, and in between those two decisions I don’t pay too much attention to the share price, other than rebalancing if a position gets too large or selling if the share price gets “too high”.
I can still see the logic in averaging down, but it’s just not for me.
This question was originally asked in November 2014 when Tesco appeared to be on its way to an early grave, or at least a major rights issue or worse.
My answer is that I try not to have an opinion on where a company’s share price or financial results might go because I just don’t know, and neither does anybody else.
It’s an easy trap to fall into, to see the news, whether good or bad, and build up a picture in your mind as to how things will pan out in the future. But in the case of individual companies I think it’s effectively impossible, at least most of the time. Even in terms of whole economies it’s usually impossible to know what will happen, which is why rule number one is diversify, diversify, diversify.
It can be uncomfortable to invest with such uncertainty, but I think that, perhaps unfortunately, investors have to have an element of faith that on average, over the long-term, a sensibly invested portfolio will work out well in the end.
This question was asked in January 2015 in regard to Serco’s rights issue, but it applies equally to a rights issue from any holding.
I generally sell the rights rather than take them up. I prefer to invest in a company once and once only, putting in the usual 3% or so, and if management make mess of things and need additional equity capital then in my opinion they can get it from institutional investors. I expect that’s what I would do for any company in the model portfolio.
There could be some situations where I might take up rights. A deep discount on the share price might do it, but then again a deep discount might suggest a company in very deep trouble that needs to discount the offer in order to raise the money it apparently so desperately needs.
I would also expect that in most cases rights issues from companies the model portfolio would be fully (or at least very heavily) underwritten by investment banks, so there would be no “need” for private shareholders to put up the money. If that wasn’t the case and existing shareholders were needed to raise the money (otherwise the company might go bust), then again I would wonder why I should invest more when the investment banks weren’t willing to do so.
In either case it suggests a very risky situation where I would be more interested in learning the lessons required to not repeat the same mistake rather than buying more shares at a discount to lower the average purchase cost, but where the purchase is of a company I’d have rather not invested in in the first place.
Probably not, or at least not in the short or medium-term.
I want to keep UK Value Investor focused on the UK and more specifically on developing an investment approach which is highly likely to produce market-beating portfolios.