| | "The truth is that I don't really have to know why people are willing to buy and sell shares of most companies at wildly different prices over very short periods of time. I just have to know that they do!" - Joel Greenblatt (from The Little Book That Beats The Market) | | Buffett reads this newsletter! Okay, so he probably doesn't. But it was a little bit spooky when, not more than 1 hour after I'd published my bullish Tesco article (below) on the web site, Buffett announces that he's buying more Tesco and taking his position to over 5%! I mean what are the odds of that? I suppose that at the end of the day the techniques that I use to value large and 'excellent' businesses are largely a development of his basic ideas, so it shouldn't be a surprise when we agree.
I know that retail is kind of the forbidden zone at the moment, but that's generally where you'll find value investors, so last week it was Marks & Spencer under review and this time it's Tesco. Not exactly your typical small cap with little institutional coverage, but I think it might be even easier to find value where there is a lot of interest from big investment firms and hedge funds. They typically have short time horizons which long term value investors can take advantage of.
On the other side of the value landscape I've put AGA Rangemaster under the asset based valuation microscope for the 21st century net-net series. As seems to be the case with these relatively sickly companies, the article immediately picks up comments from readers pointing out the various problems that the company has. But problems are inevitable when investing in net-net like companies because without problems Mr Market wouldn't value the company so cheaply relative to its assets! It's also why the position sizing for the model portfolio is only 1.7% per company.
One final snippet of news is that Robert Wiseman Dairies, a holding in my premium newsletter's model portfolio, has been taken over by Muller (of Muller rice fame) so I'll be doing a write up on that investment next week. The total return was about 25% in something under 10 months. That's more than I would typically expect but it's a nice surprise nonetheless.
As always, feel free to email me (just reply to this email) if you have any questions, issues, or if you want me to write about anything to do with valuations, portfolio management, markets or psychology.
All the best,
John Kingham
Contents:
Is it Time to Sell Tesco? Tesco is the largest supermarket in the UK with over 2,000 stores here and around half a million staff worldwide. It’s a monster. It’s the dominant player in a recession-proof industry and has Warren Buffett on board as a major investor. So if the Christmas results for a single year were a bit disappointing, investors would just shrug it off… right?
Wrong.
As is so often the case the short-term market players have the power, at least in the short term. With so many retailers struggling and more falling by the wayside every day, even the slightest bit of bad news seems to have massive repercussions regardless of who they relate to.
So the question is:
Was Buffett wrong to invest in Tesco?
Let’s take a look at a long term price chart:
That’s not quite as miserable for long term shareholders as some other companies, but we are still back at prices seen previously in 2005, some 6 or 7 years ago.
Investors over the last few years may be a bit disappointed (except those that bought in the depths of the credit crunch), but what about now? How does the investment case stack up from the point of view of an ‘average’ investor?
For this type of company I use a 6-step process for the initial review, which is an extension of the principles outlined by Ben Graham for what he called ‘defensive’ investors, who were typically people building or living off of a retirement fund.
Focus on defensive qualities first
Risk management is important for defensive investors, hence the name. Ben Graham suggested three main steps to check that an investment has sufficient defensive qualities.
If you already recognise that Tesco is a pretty indestructible company, feel free to skip on ahead to the ‘pay a low price’ section below.
Step 1 – Look for diversity
This primarily relates to holding a sufficient number of companies in a wide range of unrelated industries, but it also applies to the individual companies themselves.
There are many ways that a company can be diverse and for Tesco it comes primarily from operating in many different locations, both within the UK and internationally. If a particular store or geographic region performs badly because of local issues, the rest of the company should be relatively unaffected.
Step 2 – Demand long term success
Graham felt that the defensive (retirement fund generating) investor should focus on successful companies. He gave them various names, but typically he used words like large, leading, prosperous and prominent. The thread that ties all these terms together is long term success.
In Tesco’s case it has been growing profitably for at least the last 10 years and has increased revenue, earnings and dividends on a per share basis in every single one of those years. That’s pretty amazing.
You can see this success in the table below which shows approximate per share results:
Step 3 – Avoid excessive debt
Debt is a corrosive substance. As Warren Buffett has said, “Leverage is the only way a smart guy can go broke”. For a defensive investor there is no reason to take the risks that come with highly leveraged companies.
Fortunately, Tesco seems to have an aversion to excessive debt even though they are in a very stable industry and could probably borrow far more than they currently do. The interest payments are covered around 11 times by earnings and total borrowings are only about 3 times operating profits. Both of those figures are relatively conservative and in no way excessive.
So far Tesco ticks all the preliminary boxes for a safety first, defensive holding; but what about excess returns? Surely the whole point of stock picking is to beat the market in the long run? Indeed it is, so let’s turn from Defence to Value.
Pay a low price relative to the V-A-L-U-E of the investment
Price is what you pay and value is what you get, as many have said.
The value that you get from an investment can be broken down into 3 main parts and these are steps 4 to 6 in the initial analysis phase.
Step 4 – Buy as much long term earnings power as possible
The future is uncertain, but some companies have already proven that they are capable of generating a certain magnitude of earnings. Companies that have generated consistent and unbroken profits for many years are more likely to continue to generate a similar level of profit than those that have not.
One way to measure this earnings power is by using the 10 year average of historic earnings. This number provides a baseline figure that may be a reasonable expectation for future earnings.
As an investor it would make sense to get as much of this earnings power as possible for each pound invested and so a key metric is the PE10 ratio, or the current price relative to the 10 year earnings average. For this ratio, a lower value is better and currently the FTSE 100 index has a PE10 figure of around 13.9 (with the index at 5,690).
For Tesco the PE10 is 14, so it’s almost identical to the index that most investors are trying to beat.
Step 5 – Look for a high and sustainable dividend yield
Most investors focus on capital gains as that is where the action is. Price swings of 5 or 10 percent in a single day have an amazing ability to focus the mind. Generally though, this is a mistake.
Many studies have shown that the dominant factor in long term returns is reinvested dividend income and so a high yield combined with a sustainable dividend are likely to be far more important than the gyrations of the stock market.
The FTSE 100 currently offers something like a 3.5% yield which history shows is probably as sustainable a dividend income as there is. The chances of the dividend being stopped or even just cut are slim. On top of that the dividend is likely to continue growing at something like the historic rate of 5% or so.
Tesco, on the other hand, currently offers investors a dividend yield of around 4.9%, almost 1.5% clear of the index. While that may not sound like much, it is true that every little helps. What may be more important is the possible future growth rate of that dividend.
Step 6 – Prefer growing companies but do not overpay for them
As the results table above showed, Tesco has grown in every one of the last 10 years. The growth rate of earnings is around 10% a year which is comfortably above the market’s growth rate of around 5% a year. This growth rate, plus the fact that they retain around 60% of earnings means that they are generating something like a 19% return on retained earnings, which is pretty solid.
Given that we already know that the PE10 is about the same as the market’s at 14, it’s unlikely that the current price could be considered ‘overpaying’ for Tesco.
Future total returns
Sadly the future returns are completely unknowable. But, it is possible to say something simple about what they could be.
With a dividend yield of about 5% and a growth rate of around 10%, if we assume that the PE ratio stays where it is then future total returns over a period of years may be in the region of 15% a year which is more than reasonable.
If the share price refuses to budge back up towards 400p then you’d have a share that yields 5% with a yield growing at close to 10% a year. In 5 years the yield would be close to 7.5% if the share price stayed flat.
So you either have Tesco with a growing share price giving a 15% return per year, or a Tesco with a flat share price yielding 10% more every year. Either way, that sounds pretty attractive.
So what does that all mean?
In direct comparison to the FTSE 100, the price (PE10) you’d pay for Tesco is about the same, but both the current dividend yield and the historic growth rate are considerably higher.
For investors looking to beat the market with a diversified portfolio of leading companies I think Tesco should definitely be on the short-list.
P.S. You may have noticed that I didn’t analyse the current bad news surrounding the poor like-for-like Christmas sales figures. Those kinds of minor bumps in the road will typically have next to zero impact on the long term intrinsic value of a company like Tesco. The only time you should care about that kind of news-fluff is when they create fantastic buying opportunities.
3 Signs that AGA Rangemaster Could be a Bargain AGA Rangemaster, owner of a truly iconic kitchen brand, could well turn out to be an incredible bargain. In fact, investors can buy the company today for little more than the cash it holds in the bank.
It may be that – for the moment at least – a price of around 75p is justified as the dividend last year was only 1.7p and is unlikely to be much better this year. Earnings have also fallen during the recession and could stay well below 10p for the foreseeable future.
None of this is exactly surprising. Given that AGA’s products are a big discretionary purchase for consumers, it’s entirely sensible that many of them put their dream AGA purchase into the someday / maybe folder.
A quick look at the company’s 10 year price chart shows why past investors may be less than happy.
As was the case with the review of Marks and Spencer, looking at the past share price can be very misleading. If instead we look at the company in terms of its assets rather than its price chart or even its earnings, then things start to look a little different. It turns out that AGA fits the 21st Century Net-Net criteria.
Sign #1 – Plenty of cash
At the last annual report AGA had around £35m net cash, which just means that if they turned all their liquid assets into cash they could pay off all their borrowings and have £35m left over.
Any company with net cash is likely to have a relatively small amount of interest bearing debt, which means that surviving tough economic periods becomes that bit easier.
Partly as a consequence of the £50m cash pile in the bank, the quick ratio is over 1 and the current ratio is over 1.5, both of which are relatively healthy numbers.
I don’t expect excessive debt or cash flow problems to be the downfall of AGA anytime soon, so I think it has a fair chance of weathering the continuing recession.
Sign #2 – Very low price to book ratio
P/B is currently 0.29 which is very low by normal standards. The price is also well below the tangible book value, giving a P/TB ratio of 0.59, which means a buyer would be getting a lot of assets for their money.
A low price to book ratio is one of the key valuation metrics when valuing companies where profits are uncertain.
Sign #3 – Very low price to sales ratio
With a market cap of about £50m and revenue last year of around £260m, AGA is priced well below its single year sales figure.
This indicate that the assets which can be bought cheaply today (via the low price to book ratio) are actually being used to generate a meaningful volume of sales.
This doesn’t mean that sales will automatically turn into profits, but without sales there is not even the chance of generating a decent profit in the future, so sales are important and may be a better indicator of future earnings potential than current earnings.
Bet the farm, or spread your bets?
Ben Graham was probably the first person to outline an investment approach based purely on balance sheets rather than income statements. His net-net strategy has proven time and again in various back-tested studies to be capable of trouncing the market indices over long periods of time.
What is often forgotten is the extent to which he used diversification as part of the strategy.
Companies that are so far down the price to book scale are not great compounding machines. They don’t generate an endless stream of profits that grow year after year as the company profitably reinvests retained earnings.
What you’ll typically find instead is companies that have:
· Fallen on hard times recently
· Been struggling through hard times for many years already
· Cut the dividend to zero, or never paid a dividend
· Made a loss this year or perhaps for several of the last few years
· A reputation among investors as a ‘no-go’ area.
· Highly uncertain futures. It’s not obvious how they’ll make a profit in the next few years, or if they’ll survive.
To counter that level of uncertainty Ben Graham diversified extensively, holding upwards of 100 positions in his portfolio.
In the same vein, I will be adding AGA to my 21st century net-net model portfolio, but only with a 1/60th weighting, which is about 1.7% of the total portfolio.
Using time to your advantage
Many active investors are constantly worrying about their holdings; watching the market and the talking heads on TV to look for any news that might affect their hard earned capital.
In most cases this is a mistake and one way to take advantage of the short-termism of other investors is to have a fixed holding period for an investment. Usually the period used in academic studies is one year, which may be too short for value investors.
Studies (such as Time and the Payoff to Value Investors) have shown that holding periods beyond 12 months can generate higher returns than shorter periods.
For that reason, as well as to minimise the workload of managing 60 positions in this portfolio, my target holding period is 5 years during which time each position will be effectively ignored.
In some ways this is like private equity. The asset is bought; an extended period of time is given for the management team to turn things around, and then it is sold, hopefully for a handsome profit.
This may be an unusual strategy, but as Ben Graham said:
“the investor cannot enter the arena of the stock market with any real hope of success unless he is armed with mental weapons that distinguish him in kind – not in a fancied superior degree – from the trading public”
Further net-net reading:
1. 21st Century Net-Nets
2. PV Crystalox Solar
Or alternatively:
1. Mega-cap value with BHP Billiton
And finally... Sometimes while surfing the web I'll spot something of interest which isn't worthy of a full write up or post, but still makes a useful point. This week I saw this slide presentation which shows what can happen when a fund is successful for a long period of time. Management can become complacent about risk; in this case having large positions which eventually went to zero. Look at the 'glory days' chart compared to the 'humbling period'. Click the link to see the slides: bit.ly/wDBgOD
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