Monday, 8 November 2010

Rules is rules...

Having spent plenty of time reading around the subject and following the market, now is the time to incorporate a bit of discipline and set up my rules for investing.

I've published them on this blog as: (a) it helps me to think the rules through before I try to articulate them and (b) it's a matter of record as to whether I adhere to them or not!

My general objective is to increase my (family's) wealth through above-average stock market returns. This blog will generally focus on a value theme (ie buy low, sell high), but may cover the occasional bit of arbitrage or hedge-fund shenanigans from time to time.

My target net annual rate of return is 15%. I am expecting this to be achieved through a combination of: (i) dividends (4-5%), (ii) EPS growth (5-6%) and (iii) valuation re-ratings (5-6%). Time will tell.

I will start "proper" from 1 January 2011 to allow me time to reassess my existing portfolio and prune as required. I might even start earlier if I get my skates on...

Because the world works in decimal, I've shoe-horned my rules into 10... give or take a bit around the edges (however see Extra Considerations (a) - (c)!)

The rules (in no particular order):

1 - Assets to be no more than a 10% premium - that cap to be no more than 1.1 times balance sheet assets (shareholders funds). Conventional value wisdom suggests that it should be a discount, if not a deep discount, but for the time being, I'm happy to consider valuations at a small premium to net assets;

2 - Market cap > £50m - companies, I'm focusing on UK listed ones as that's my investment universe for this purpose, need to have a certain size and stability to them. £50m is arbitrary, I did toy with £100m, but £50m feels about right for now;

3 - Cash flow - two measures here: (a) positive working cap on the balance sheet (current assets - current liabilities > 0) to show that the company can meets its short-term obligations, and (b) positive operating cash on cash flow (operating cash after working cap movements, interest and replacement capex, but before discretionary items such as dividends) to show that net surplus cash is made which can be used to grow the business and/or be returned to shareholders in dividends or buy-backs;

4 - Limited debt - a bit of debt is efficient (CAPM and all that), but I don't like too much. Positive net cash is a big plus as this gives a company lots of wriggle room. I look at (a) debt to equity (balance sheet) being no more than 0.5 - ie for every £1 of equity there is no more than 50p of debt. I appreciate a gearing ratio of 33% (50/150) may sound reasonably conservative, but c'est la vie...and (b) EV/Adjusted EBITDA should be no more than 5 times. This shows (generally) that the total worth of an entrprise is valued at not more than 5 times its cash profits (after adjusting for replacement capex). Again, the 5 is subjective, but feels about right. I probably wouldn't kick a 6 out of bed, but we'll see...;

5 - Valuation - the PE ratio should be less than 12 times, which I'm taking as a conservative proxy for where I think the market should be. If it's lower than or higher than 12, then I think that the market is being either a bit bearish or bullish than (long-term) normal. See below for entry and exit points. Earnings should be the fully diluted basic EPS average over a 10 year period (or as long as you can muster) to smooth out any cyclicality;

6 - Yield - dividend yield > 3.5%. As there are plenty of studies which show that dividends account for the vast majority of value creation over the long-term, it would be churlish to ignore them. I'm setting my bench-mark as the 10 year gilt yield, at 3.5%ish . This implies that I will get the same return (ignoring market timings) on equities as gilts, but with the upside equity growth potential thrown in. One word of warning, rather than chasing yield...there needs to be (b) at least 1.25 times dividend cover over the average of the last 3 years to get me comfortable that the dividend is sustainable;

7 - Return on Equity > 10%. This is a new one for me. To get my increase in value, I need a sensible return on equity to be satisfied that management has room to grow the business with existing resources (ie without leveraging the business to the hilt or withering away shareholder value). Therefore, I'll set a target of an average RoE of 10% pa over the last three financial years and see how this gets on;

8 - Directors have skin in the game. It's reassuring, and profitable, to see directors acting as owners rather than just managers, and there is no better way than seeing them dip their hands in their pockets and buy their own shares (legitimately). I much prefer direct share purchases to share options, but want to be convinced that the directors are there for the long-term and are incentivised to grow the company for the benefit of the shareholders. The extent of their 'skin' will be subjective in nature;

9 - Buy, buy, buy! The convention entry point will be looking at a current valuation based on (a) 10 yrs EPS (as #5 above) x (b) the lower of the 10 yrs ave PE ratio or 12x (as #5). If this is 25% below the current market price and all of the other points (#1-8) are met, then fill your boots...;

10 - Bye, bye, bye... If the market price is 25% above the same calculation in #10, then it's time to take profits, subject to hitting my 15% IRR target hurdle.

My Extra Considerations, not formal rules, are:

(a) look for evidence of a moat / sustainable franchise - a la Buffett;

(b) look for net nets and cigar butts - market value is discounted to net current assets - L/T liabilities - a la Graham and Buffett; and

(c) set Buy/Sell price targets, but only reappraise these on final results (not interims), unless the world stops turning, in which case we're all doomed anyway.

Now that I've got my rules, I will retro-screen my existing portfolio and aim to analyse at least one new stock per week. watch this space...

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