Monthly Archives: April 2015

Investment Strategy update: The Discovery of Slowness

The discovery of Slowness

The last book  I read was a German novel called “The Discovery of Slowness” (in the English Translation) from German writer Stan Nadolny.

The book is a ficticious story about a real person, the famous English explorer John Franklin.

In the book, John Franklin is an extraordinarily slow person who has a rough start into life as a kid. He always needs a lot of time to answer questions or react to things happening. During his life, this weakness turns into a strength. More than once, his slowliness and deliberate long thought process leads to a superior solution compared to the “first impulse”.

For instance once, after their ship goes under, he and his comrades find themselves themselves stranded on a flat corall bank. Whereas his fellow sailors start shouting for help etc., he directly starts to build a platform in order to survive the high tide and thereby saves all his comrades. When he was asked later why he did this he says “As I am so slow, I have to start early”. In another situation, a ship under his command gets in into a storm in the Arctic seas and is at risk to get destroyed by Icebergs. His men start to panic and want to get away. He takes his time and finally contra-intuitively stears the ship into the solid ice as this is the only safe place in a storm and they survive.

During his life, he turns his weakness into a strength by preparing himself extremely diligent for any unforseen problems. As it turns out, good preperation is almost always better than fast reaction time. He is calling this preparation a “system”. One of the core pillars of this system is to have an organization run by two person: One “fast” one for the daily work and a “slow” one for the really important decision.

Despite the book being a good read itself (kind of a Forest Gump story with a Victorian English setting), the more I read the more I had to think of investing and Warren Buffett in particular.

Compared to today’s financial technology (Twitter, High Frequency Trading etc.), Warren and Charlie look as slow as John Franklin in the book. They are so slow that they actually missed the whole first dot.com bubble and many other hypes. However, by creating Berkshire as a permanent investment vehicle and holding a big cash pile, they prepared themselves well for any kind of troubles.

Both have stressed themselves the advantages of being slow many times, either Charlie with his “sit on your ass investing” or Warren’s “Punch Card”. From the outside I would even say that they employ the “Franklin system” to a certain extent. Warren seems to be the fast guy and Chalrie is the one who makes the big changes, like steering Warren to “great” companies many years ago.

For many investors, including myself, this often sounds counter intuitive. Real time stock prices, twitter feeds, mobile phone trading etc. enable us to do everything real time, so why should we care what those old farts say ?

Well, one aspect of this a pretty tangible one: Capital gains tax. In Germany, as a private investor, you pay around 30% capital gains tax. For fun, I made a quick table with the following assumptions:

– Underlying annual return 12% p.a.
– investment horizon 30 years
– Capital gains tax 30%

The following table shows the total return over 30 years depending on how often the portfolio is being “turned over”. So 1 means: The portfolio is turned every year, 5 year means 6 turns within 30 years etc.. These are the results:

turnover/year Total gain AT p.a. AT in% of max
1 1024% 8,4% 35%
2 1735% 10,2% 60%
3 2061% 10,8% 71%
4 2284% 11,1% 79%
5 2363% 11,3% 82%
6 2444% 11,4% 84%
7 2529% 11,5% 87%
8 2616% 11,6% 90%
never 2896% 12,0% 100%

The results are logical but still striking: Over a thirty year period, if one turns the portfolio every year, the result is roughly 1/3 of a portfolio which remains constant over the 30 years. It is also interesting that the total result increase over-proportionally with every additional year of the average holding period. Already with a 4 year holding period one captures almost 80% of the total yield.

One remark: Please don’t confuse this withe an advice for dax driven investments. This is just to illustrate that slow portfolio turn-over has adnatages.

Secondly, and even more important, being slow in my opinion is the best defense against any kind of behavioural biases. The book was written well before Danial Kahneman’s famous book, but clearly shows that slow thinking leads to better decisions which is especially important in investing.

In the past, I have often reacted to quickly, which resulted either in selling too early or buying to quickly. Especially when prices move significantly within a short term, some behavioural biases like anchoring become very strong. Maturing as an investor in my opinion means among other things, to become slower.

However this is more easy said that done. A large part of the investment industry is hard wired to make investors trade as often as possible in order to generate fees. If you watch CNBC or read investment magazines, they always emphasize to buy or sell things now and not wait until it’s “too late”.

Consequences

As I have written in some of my comments, I am aiming to lengthen my holding periods anyway, but I still think I am too fast. For me, I have come up with 3 very concrete action items which should hopefully help me in becoming a lot slower:

1. I will limit my news feed to high quality sources. I will abandon high frequency stuff like Zero Hedge and Clusterstock

2. I will stop writing monthly performance comments and switch to quarterly

3. I will create my own “soft punchcard”: I will limit myself to either 1 new position or 1 complete sale of a position per month. Increasing or decreasing existing positions is still allowed.

A little explanation for point 3, as this is a real “hard restriction”: This means that at a maximum, I can “switch” 6 stocks a year into new ones. I have to sell one first in one month and buy the new one in the next. As I own on average 25 positions, this should translate over time to a holding period of at least 4 years, preferably more.

This will of course limit my choice to do for instance soem short term special situations, on the other hand I hope that this will further improve my investment decisions and focus better on the long term. I would love to have an brokerage account which would actually limit me on the number of trades I could do in a month.

Deeply discounted rights issues – Serco Plc (ISIN GB0007973794)

Serco Plc, the British outsourcing company, used ro be a stock market favourite for a long time. Especially in the 2000s, Serco was able to increase its profit ~10 fold from 0,04 pence per share in 1999 to around 40 pence in 2012.

Then however, a little bit similar to Royal Imtech, problems and some scandals piled up and culminated in an accounting bloodbath for 2014. Serco showed a total loss of 2,09 pounds (!!) per share, eliminating pretty much all profits made from 1999.

After raising a smaller amount of capital last year, Serco announced a large 1:1 capital increase at a sharp discount in early March, the rights have been split of on March 31st. Serco wants to raise some 500 mn GBP with the majority being used to lower the outstanding debt (currently around 600-700 mn).

Looking at the stock chart, Serco shareholders have suffered a big loss, especially compared to competitor G4S which, despite relatively similar problems, has recovered well:

Normally, I would not look at a “turn around” case like Serco at all, but in this case it might be different. The difference is the new CEO, Ex Aggreko CEO Rupert Soames:

Soames surprised everyone in early 2014 when he left Aggreko after leading the company for 11 years and with great success. For anyone who has read an Aggreko annual report, one knows that Soames was not only a succesful CEO but also a very good communicator. I can highly recommend to read those reports as they are very interesting.

Before asking for shareholder money, he actually said that he will not take his guaranteed bonus for 2014 which I found was a very good gesture.

After enjoying the Aggreko reports I decided to look into the 2014 annual report and especially the “CEO Letter” from Soames to see what he has to say.

I was positively surprised by the openness how Serco’s problems were adressed, both from the Chairman and Soames himself. It is the classic tale of too much growth through acquisitions combined with a lack of integration and bad execution. Other than at Royal Imtech, it doesn’t involve outright accounting fraud.

One rarely gets to read such a good description of the problems of a company and the historic context (page 9 of a turnaround case. This is then followed by a clear change in strategy, namely to focus on Government services and get out of “private” contracts altogether. Overall the strategy section looked very well thought out and not unrealistic to me.

Further in the report, I found this interesting statement:

Historically, the key metrics used in forecasts were non-GAAP measures of Adjusted Revenue (adjusted to include Serco’s share of joint venture revenue) and Adjusted Operating Profit (adjusted to exclude Serco’s share of joint venture interest and tax as well as removing transaction-related costs and other material costs estimated by management that were considered to have been impacted by the UK Government reviews that followed the issues on the EM and PECS contracts). We believe that in the future the Group should report its results (and provide its future guidance) on metrics that are more closely aligned to statutory measures. Accordingly, our outlook for 2015 is now expressed in terms of Revenue and Trading Profit. The revenue measure is consistent with the IFRS definition, and therefore excludes Serco’s share of joint venture revenue. Trading Profit, which is otherwise consistent with the IFRS definition of operating profit,adjusts only to exclude amortisation and impairment of intangibles arising on acquisition, as well as exceptional items. Trading Profit is therefore lower han the previously defined Adjusted Operating Profit measure due to the inclusion of Serco’s share of joint venture interest and tax charges. We believe that reporting and forecasting using metrics that are consistent with IFRS will be simpler and more transparent, and therefore more helpful to investors.

This is something whcih I haven’t seen before that actually a company is going back from “adjusted” reporting to statutory which I find is very positive.

Another good part can be found later in the statement from the CFO (by the way another Aggreko veteran) regarding the implementation of ROIC:

A new measure of pre-tax return on invested capital (ROIC) has been introduced in 2014 to measure how efficiently the Group uses its capital in terms of the return it generates from its assets. Pre-tax ROIC is calculated as Trading Profit divided by the Invested Capital balance. Invested Capital represents the assets and liabilities considered to be deployed in delivering the trading performance of the business.

I always like to see return on capital as an important measurement for businesses and implementing this is clearly a great step forward.

Another interesting fact from the Renumeration report: Both new board members have significantly lower salaries than the old, outgoing board members. Soames has a 800 k base salary, Cockburn 500 k. both pretty reasonable numbers.

However the big problem for me is that I know next to nothing about the business of Government outsourcing. So for me it is at this time very difficult to assess how attractive the stock is and how long it will take to recover.

The current management is clearly a good one but I am not sure if the underlying business is a good one as well. Especially those long-term contracts do seem to contain significant risks. Page 50 and following pages in the report provides  a very good view in great on what can go wrong with long dated contracts. In many cases, Serco was locked into fix price contracts and costs went against them without having a chance to do anything about it.

On the other hand, the 1,5 bn write-off for sure is conservative and one could/should expect that it contains some “reserves” which might be released in coming years.

Deeply discounted rights issues in general

Another word of caution here: A couple of discounted rights issues I looked at in the past were actually not very good investments.

Severfield was a good one with around +50% outperformance against the Footsie since the rights issue in March 2013. KPN even outperformed the Dutch Index by ~+62% in the two years and Unicredit even more than 70%.

On the other hand, Monte di Pasci underperformed by -70% against the index since their rights issue  and Royal Imtech by -45%. EMAK finally performed more or less in line with the index over time after the capital increase.

So overall, the score of outperformers to underperformers would be 3,5:2,5. With Royal Imtech it was pretty easy to see that it would be difficult, as there was a significant accounting fraud involved. BMPS also looked like a big problem as the rights issue was to small and another one is in the making.

So the question is clearly: Is Serco more like Severfield/KPN or Royal Imtech ? For the time being I would rather look at Serco more positively, mostly due to management.

Not surprisingly, analysts hate Serco. the company has one of the lowest consensus ratings within the Stoxx 600. This alone is not a reason to buy, but at least might explain a potential under valuation. A final note: Soames might not be a bad choice for running a Government outsourcing company. His ancestry should ensure some viable contacts at government level:

Rupert Soames can just remember his grandfather, Sir Winston Churchill. His earliest memories are of playing cowboys and Indians with Britain’s wartime prime minister – and of not being allowed to attend his state funeral. He was six at the time and furious: “Watching it on TV was a very poor substitute,” he once said.

His family has long been part of the political establishment: his father Christopher was the last governor of southern Rhodesia, now Zimbabwe, who served in Margaret Thatcher’s cabinet and was also a European commissioner, while his brother Nicholas is a current Tory MP.

Summary:

Overall, the Serco case does look interesting. A brilliant management team is trying to turn around a troubled Government contractor with a transparent and plausible strategy. On the other hand, the business is a difficult one or at least I do not have a lot of knowledge about this sector so I need to digg more into it.

So for the time being, I will watch this from the sidelines and maybe try to learn more about this sector in general.

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