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All questions are answered by John Kingham, editor of UK Value Investor.
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How strictly should your investment criteria be applied?
Personally I’m not 100% strict with the rules. In my book (The Defensive Value Investor) I refer to the rules as “rules of thumb” for exactly that reason. They are rules, but they don’t have to be set in stone.
For example, I bought Domino’s Pizza when its PE10 ratio was 34, which breaks the “rule” that PE10 should be below 30 for all purchases. However, I thought Domino’s PE10 was high but reasonable because:
- Domino’s had grown rapidly, leading to low profits a decade ago (and therefore a higher PE10 ratio)
- Domino’s pays out most of its earnings as a dividend because it’s ‘capital light’ (i.e. does not require much in the way of capital investment), so dividends were quite high relative to dividends and therefore the PD10 ratio wasn’t especially high.
So while you could stick 100% to the rules, I prefer to think of them as an aid to decision making, rather than as commandments to be followed.
Could you suggest some investment books?
There are lots of great books out there, but if I had to narrow it down to a small number of books that gave the biggest bank for the buck, I’d have to say read this blog post:
And of course my book, The Defensive Value Investor.
What is your opinion on letting winners run?
Cutting your losses and letting winners run is a popular tactic, but I prefer to rebalance “winners” for risk control reasons. For example, let’s say you’ve invested about 3% of your portfolio in Victrex.
- If your portfolio stays flat but Victrex doubles in the first year then by the end of the year it will be from 6% of your portfolio.
- If Victrex then doubles again in the following year, and you let it run, then by the end of year two it will be 12% of your portfolio (assuming that once again your overall portfolio stays flat).
- If Victrex doubles again by the end of year three and your portfolio stays flat then Victrex will be 24% of your portfolio.
That’s an unlikely scenario, but it shows what can happen when you let winners run. Yes, you portfolio will do better because of the bigger “bet” on a winning stock, but the risks of investing so heavily in one company 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. Stranger things have happened. If that happened then 24% of your portfolio would be wiped out from a single mistake, which would be very hard for most people to take, both psychologically and perhaps financially.
So instead of chasing every last drop of performance, I prefer to keep a tight lid on the risk side of things by staying widely diversified, and for me that means regular rebalancing by “top-slicing” winners.
Do you only ever trade once per month? Won’t you miss opportunities?
Yes I only trade once each month and I completely agree that this will lead to some missed opportunities.
However, I think the benefits of trading just once each month – such as developing a disciplined mindset, avoiding over-trading and avoiding ad-hoc knee-jerk decisions – should outweigh the occasional lost opportunity.
Where are the pension liability figures in the annual results?
If a company has a defined contribution (DC) pension scheme then you won’t see any pension scheme assets or liabilities listed anywhere in the annual results. DC pensions 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 (e.g. Note 23).
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 is a table listing the scheme’s obligations/liabilities. There are usually rows called Total Value of Scheme Obligations and Total Value of Scheme Assets (or similar), although this may be broken down by business unit, geography or some other category.
Why do you look at pension liabilities and not pension assets?
I think looking at liabilities alone is a more sensible approach than the usual approach of just looking at the pension surplus or deficit (i.e. whether or not the pension assets exceed the pension liabilities).
For example, a company with a £100m pension liability and pension assets worth £101m has a £1m surplus. 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. The lesson here is that a pension surplus is not a good measure of pension risk.
Now, 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 should only be a small problem. However, if the company only made £2m a year then fixing a £20m pension deficit 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, not the current surplus or deficit position.
Wouldn’t it be better to focus on higher returns on capital companies?
Possibly. Research and my own experience suggests that higher return on capital (or capital employed) companies produce better long-term returns, which is perhaps not that surprising.
However, I’m a value investor and I think valuations are always at least as important as corporate performance. So while I do like highly profitable companies, I only want to buy them when they’re relatively cheap.
Having said that, the Model Portfolio has become more focused around higher profitability companies since the Profitability Score (ten-year average return on capital employed) was added to the stock screen in 2014.
So I agree that it would be better to focus on higher profitability companies, but only if they’re attractively priced.
Why do you buy and sell more frequently than a buy and hold investor?
There are two main reasons:
1) Companies go from good to bad. I don’t want to artificially lock myself into a “forever” holding period if ten years after I invested in a company it starts going down the pan. I’d rather have the option of selling if the company is going nowhere or worse.
2) Shares go from cheap to expensive. I don’t want to be locked into holding a companies shares if those shares have gone up by 500% and are no longer cheap. If a rapid price increase leads to a low dividend yield and high valuation, then the risk is that future returns will be lower (because of that lower yield) and riskier (because of the risk of valuation mean-reversion, i.e. high valuations falling to historic averages.
In summary, I prefer to have the option of exiting an investment, typically after one to ten years, if (and only if) the company is no longer good and/or the shares are no longer cheap.
Do you use stop losses?
The short 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.
Do you look at free cash flow when reviewing companies?
Yes, but it isn’t a key metric for me. I realise that free cash flow ratios are popular at the moment, 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.
Do you ever sell if a company produces a bad set of results?
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.
Will underperforming companies recover to the price at which they joined the portfolio?
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.
Do you exercise your right to buy new shares in a rights issue?
The Model Portfolio never takes up rights in order to keep things simple. In other words, each investment involves only one buy decision and one sell decision.
Personally, I may or may not take up some of my rights depending on the specific situation.
If the rights issue is for negative reasons, i.e. to pay down debt or to re-capitalise the business for one reason or another, then I won’t get involved. I don’t want to invest in companies that have been run badly.
However, if the rights issue is for a positive reason, typically an acquisition, then I might take up my rights if a) I have cash available and b) if I think the acquisition is “sensible”, which usually means the acquired company is in the same business as the acquirer and that the acquisition isn’t an attempt to move into a new industry.
Are you going to add US and EU stocks?
Possibly, but probably not before 2020. There are other goals for the website first, such as including ten-years of financial data for each company on the stock screen.