Wednesday, December 4, 2013

UK Portfolio 2014

The Premise

This is what I tell myself:

If, in the medium- to long-term, the prices of financial assets gravitate toward their underlying values it is because active investors identify mis-priced securities and buy them. Stock-pickers, in other words, are the invisible hand. 

And, within the set of stock-pickers, private investors enjoy important advantages over professional fund managers: (1) we have a wider range of equities to choose from; (2) we have the option to concentrate on our best ideas and to exclude our worst ideas; (3) we can refrain from buying stocks that we simply don't understand; (4) we can weight the components of the portfolio on a risk/reward basis (with special attention to risk) rather than on a volatility (or tracking error) basis; and (5) we can choose a time horizon of our liking without fear of the sack if we under-perform in the short-run; (6) we can invest according to any so-called "style" -- asset based, GARP, distressed, arbitrage, etc. And, most importantly, (7) we can't afford to blow up whereas, in many cases, they can.

If the above differences are indeed advantages, it follows that the success in investing comes from exploiting them to the extent that one can:  Don't blow up, ever (rule #1). Look everywhere, size-wise and geographically. Don't be a prisoner of a particular "style" of investing if you don't have to. Concentrate on your best ideas and weight them according to safety first (see rule #1) and potential reward second. Don't buy anything whose downside you haven't fully grasped. Choose an investing horizon that suits you and ignore volatility and tracking error in the interim. 

Grasping the whole story and the extent of the downside is, I think, a matter of practice and of effort, the rest is a matter of acting responsibly. 

Review of 2013

In line with the reasoning above, last December I constructed a model UK portfolio that I thought would outperform the FTSE 350 by at least 20% over this past year -- ~20% outperformance being, I think, reasonable compensation for exploiting the advantages listed above.

This was the outcome of the experiment in its first year:

There are a couple of errors of judgment in those picks and, if I had to do it over again, I would leave out the cyclicals (Dewhurst and Creston) and stick with the five "either-way" picks. (Or, if I were to include cyclicals I should have gone all the way --i.e. very cyclical and levered, like the construction companies.)


In this the second season of the great British bake-off, I've constructed a model portfolio that looks like this:

Again, I hope for (and expect!) year ahead returns that are at least 20% higher than the performance of the FTSE 350 and, to repeat what I soothsayed last year,  two-year returns that comfortably exceed that of any statistical strategy tracked by Stockopedia

I have previously written about Lombard Risk, Howden Joinery and Lamprell. I was introduced to Quarto by Lewis and to International Greetings by Richard. Senior is a wonderful business (moat, return on capital, long term secular growth, visibility, safety) that is obviously undervalued at 16x trailing earnings. And Creston is (still) in the portfolio because I'm being stubborn. 

They're all mis-priced in one way or another. One way of looking at Quarto, for example, is as follows:

And from that perspective, a market cap of £33 million may be too low for what is, after all, a stable, profitable and growing business. And, if you believe that Quarto has begun a serious effort to de-lever its balance sheet then you may be able to envisage £10 million in annual reductions in debt plus $2.5 million in dividends that, together, return ~38% to Quarto's shareholders each year, without a re-rating of the multiple.   

Please remember to do your own research and use your own judgment. It is entirely possible that I have no idea what I'm doing.

Disclosure: I own shares of Lombard Risk and I have sold out of Northgate