value and opportunity

Opening remark: This is a pretty long post. There are now new investment ideas in there but is rather part of the “diary” aspect of the blog and might not be of interest to anyone…..

One of the great things of this blog is that I can always go back and check what I have written before and compare that against what I have actually been doing. So after almost 3 years into the blog, it is time to revisit the initially stated investment philosophy.

In general, I think such a written investment philosophy is extremely helpful. I remember how stupid I found this concept when I was preparing for the CFA level III exam and you are supposed to draft something similar for potential clients. Clearly one doesn’t have to follow this blindly and as we will see later, such a philosophy will and should evolve over time. On the other hand, I think it served me very well.

You could think of it as a kind of hiking map for unknown territory. clearly you can leave the path if you see something interesting along the way, but especially in “bad weather”, such a “map” can be your best protection against falling down a cliff by enabling you to stay on the path laid out before.

But before this is becoming too philosophical, lets jump into it:

Introduction

This blog started out to be a common effort between 2 enthusiastic value investors. In between, one of them got a full-time value investing job, whereas the other keeps doing this in his free time.

The blog should also function as my personal investment diary and as a platform to discuss investment ideas with anyone willing to share his/her thoughts.

Well, basically no change here. I have to say that the both goals, having an investment diary and using it as a discussion platform have been succesful above my “wildest dreams”. As there is some confusion about the nature of my virtual portfolio, I will rephrase the introduction like this:

“The blog mainly functions as my personal investment diary and as a platform to discuss investment ideas with anyone willing to share his/her thoughts. The blog portfolio is a VIRTUAL portfolio, meant to test if the strategy works at a starting level of 10 mn EUR”

Next the “technical part”, which are effectively portfolio management rules:

Further rules for the model portfolio:
1) max. position limit : 25% of total fund
2) 50% of the portfolio has to have weight of 10% or less
3) minimum net long position of 50% of net asset value, max. 30% short positions  max. of 130% long positions
4) no taxes
5) transaction cost: EUR 15 / order
6) interest: current deposit rates for retail brokerage accounts
7) max. trading limit: 25% of VWAP per day. We assume that within this limit we could trade without moving the stock price.
8 ) Short positions are allowed, up to 30% of net asset value
9) Permitted investment: Stocks, bonds, fund certificates, convertible bonds and other listed securities
10) Permitted stock exchanges: All exchanges available through normal retail brokers (DAB, Consors etc.)
11) All currencies are allowed
12) currency risks could be either hedged or increased through currency derivatives

Here, I actually did follow this rules with one exemption:

– I did cut positions if they got above 10% (Draeger)

In general, I would not be comfortable with a single position above 10% of the portfolio, so I should change this to a max. position size of 10% and I can skip point 2)

Next part: Benchmark

Benchmark:

I recommend my readers a broadly diversified investment into ETFs. Ourselves, we consider a combination of:

50% Stoxx50 Europe
30% DAX
20% MDAX

as an adequate benchmark.

I try to achieve a higher return for our portfolio against this benchmark, We also try to realise lower volatility of returns. In between, portfolio and benchmark will differ significantly as many of the investments will not be included in the benchmark and will have little or no correlation to those benchmark securities.

Choosing benchmarks is always a tricky thing, especially if you want to charge outperformance premiums. In my case, i think the Benchmark is still valid, although small caps are underrepresented here to a certain extent. Clearly, my relative performance benefitted from the weak performance of the Mega Cap Stoxx 50 index, on the other hand, the MDAX was one of the best performing indices worldwide. Nevertheless, I will split the 50% benchmark weight of the Stoxx 50 Europe into 25% Stoxx 50 Europe and 25% Stoxx 200 small Europe. So the new bench (from 1.1.2014 on) will be:

25% Stoxx 50 Europe
25% Stoxx small 200 Europe
30% DAX
20% MDAX

Next part of the “Old” statement

The investment philosophy is based on fundamentals and “value” based. 50% or more of the portfolio should be allocated into stocks of “good” or even “great” companies whose share price is lower than what we would consider as fair value (“Core value”). Up to 50% of the portfolio shall be dedicated to special situations (“Opportunity”).

Some Criteria for “Core value” investments:

– fundamentally “cheap” (P/E, P/B, P/S)
– historically cheap (average P/E 10 years
– low debt leverage
– focus on tangible book values (goodwill only considered in special cases)
– organic growth
– “Moat”
– comprehensive income vs. reported profits
– dividends, share repurchases
– low beta/volatility

This is the part, where both i experienced some “developement” in my thinking over the last 3 years. Lets go through them one by one:

Firstly, I would add the following paragraph regarding the general philosophy (which implicitly was always there):

“I do not attempt to do any active market timing. Stocks will be bought if they are fundamentally cheap and sold if they are expensive irrespective of general market conditions. However I do not attempt to be fully invested either. If I don’t find cheap stocks, I won’t invest.”

– fundamentally “cheap” (P/E, P/B, P/S)

Here, I would add: Dividend yield, EV/EBIT, EV/EBITDA. Honestly, P/B and P/S are not that important for me any more. This might make some “graham” fans nervous, but I do think that correctly calculated EV ratios which take into account debt, pension, leases etc. are much much better.

– historically cheap (average P/E 10 years

This has been replaced by my “boss score” which in my opinion is superior in order to quantify “historical cheapness”.

– low debt leverage

Still valid, I would add that preferably I would even want to see net cash.

– focus on tangible book values (goodwill only considered in special cases)

This holds true for financial stocks. Otherwise there has been a certain “evolution” in my thinking. A good Software company for instance might have intangibles which are very valuable. Overall I am less focused on the “asset based” investment approach for my “core value” part. I am still willing to look at “asset plays” in my special situation bucket of course.

– organic growth

this is a criteria which I honestly didn’t use a lot. But clearly, organic growth is worth much more than acquired growth. Less risky and most likely more sustainable. I need to look at this more closely in the future.

– Moat

As a I am still not a fully convinced “moatee”, I would change this that into “good competitive position”. This is something where I am still in the early part of the learning curve, but it is important.

– comprehensive income vs. reported profits

This still holds and is very important. I would just make it clearer in the following way: “Quality of profits – adjusted earnings vs. comprehensive income”.

– dividends, share repurchases

Still valid. Slightly rephrasing it to ” shareholder yield: dividends, share repurchases, deleveraging”

– low beta/volatility

No change here.

Finally I would add 1 new, also very important items:

Return on capital / capital allocation

Over the 3 years, this is maybe the most important “discovery” I made for myself while analyzing companies. The book “outsider” is maybe the best book to illustrate the powerful impact of good capital allocation over long periods of time. Although it is hard to really nail down good capital allocation, it is relatively easy to identify a really bad one.

Next part:

I try to achieve a “margin of Safety” at current market prices, which should protect the protfolio if adverse changes happen to the companies or the economy as a whole.

Well, this rather sounds generic, so I skip that one.

Finally, this is what i said about the “Opportunity” part:

Some criteria for “opportunity” investments:

– capital structure opportunities
– special situations like closures of open investment funds
– cheap option premium
– forced selling by some market participants

Here I think it makes sense to add something in order to explain why those “opportunities” are interesting and how they differ from the “core value” investments:

“Opportunity investments are investments where due to special circumstances, the price of the investment is significantly lower than it normally would be. This can happen because of a variety of reasons. In many cases, those special situations are very unique and are uncorrelated to the overall market development. Examples are:

– spin off / demerger
– deeply discounted rights issues
– law suits / cartel fines
– uncommon types of securities
– intransparent company structures /Holdcos)
– subordinated or convertible bonds

So putting it all together, the updated version of the investment philosophy will look like this:

”
The blog mainly functions as my personal investment diary and as a platform to discuss investment ideas with anyone willing to share his/her thoughts. The blog portfolio is a VIRTUAL portfolio, meant to test if the strategy works at a starting level of 10 mn EUR.

General portfolio management rules:

1) max. position limit : 10% of total fund
2) minimum net long position of 50% of net asset value, max. 30% short positions  max. of 130% long positions
3) no taxes
4) transaction cost: EUR 15 / order
5) interest: current deposit rates for retail brokerage accounts
6) max. trading limit: 25% of VWAP per day.
7) Short positions are allowed, up to 30% of net asset value
8) Permitted investments: Stocks, bonds, fund certificates, convertible bonds and other listed securities
9) Permitted stock exchanges: All exchanges available through normal German retail brokers (DAB, Consors etc.)
10) All currencies are allowed
11) currency risks could be either hedged or increased through currency derivatives

Benchmark:

I recommend my readers a broadly diversified investment into ETFs. Myself, I consider a combination of:

25% Stoxx 50 Europe
25% Stoxx small 200 Europe
30% DAX
20% MDAX

as an adequate benchmark.

I try to achieve a higher return for the portfolio against this benchmark, but also try to realise lower volatility of returns. In between, portfolio and benchmark will differ significantly as many of the investments will not be included in the benchmark and will have little or no correlation to those benchmark securities.

The investment philosophy is based on fundamentals and “value” based. 50% or more of the portfolio should be allocated into stocks of “good” or even “great” companies whose share price is lower than what we would consider as fair value (“Core value”). Up to 50% of the portfolio shall be dedicated to special situations (“Opportunity”).

I do not attempt to do any active market timing. Stocks will be bought if they are fundamentally cheap and sold if they are expensive irrespective of general market conditions. However I do not want to be fully invested at all time either. If I don’t find cheap stocks, I won’t invest.

Some Criteria for “Core value” investments:

– fundamentally “cheap” (EV/EBITDA, EV/EBIT, P/E, P//B, P/S, P/FCF)
– historically cheap as meassured by my “Boss Score” model
– low debt leverage / net cash position
– organic growth preferred
– good competitive position
– Quality of profits – adjusted earnings vs. comprehensive income
– shareholder yield – dividends, share repurchases, deleveraging
– low beta/volatility
– return on capital / capital allocation

Opportunity investments are investments where due to special circumstances, the price of the investment is significantly lower than it normally would be. This can happen because of a variety of reasons. In many cases, those special situations are very unique and are uncorrelated to the overall market development. Examples are:

– spin off / demerger
– deeply discounted rights issues
– law suits / cartel fines
– uncommon or complex types of securities
– intransparent company structures /Holdcos
– subordinated or convertible bonds