Flybe Investment

Today I put just less than 10% of my portfolio in Flyby, the UK domestic airline.  I can't claim any credit for the idea.  Once again, I am indebted to Red Corner: http://quinzedix.blogspot.co.uk/2015/11/normal-0-false-false-false-en-us-x-none.html

My thoughts: It's rare idea that looks very cheap, and there is a clear reason why it is cheap.
If everything goes right, the upside looks very substantial.  However, this relies on capital allocation being very good, which seems unlikely.  Downside seems protected by cheapness and there is no premium to book.

My investment in Distribution Now will benefit highly from an oil price rebound.  Flybe benefits from oil prices staying low.  Therefore, they are a hedge for each other.

September Portfolio Update

Portfolio as at end of September
Asset	Bloomberg Ticker
Exova PLC	EXO LN	20%
Avesco Group PLC	AVS LN	11%
Markel	MKL	10%
Distribution Now	DNOW US	9%
AIG	AIG US	6%
Tessenderlo	TESB	4%
Alternative Asset Opportunities	TLI LN	3%
Plaza Centers	PLAZ LN	1%
Dolphin Capital	DCI LN	1%
GBP Cash		35%
Quarterly Return	Quarterly Benchmark Return
-3.88%	-5.48%
Return Since Inception	Benchmark Return since Inception
16.39%	30.12%
Annualised Return since Inception	Annualised Benchmark Return since Inception
5.67%	10.05%
Quarterly Leveraged Return	Annualised Leveraged Return
-2.60%	7.93%
Leverage
34%

Portolio Update

Over the past few months we’ve seen some downward volatility in markets:

-                Emerging market currencies have crashed.

-                The Chinese equity index has fallen sharply (although it had previously risen extremely sharply in the previous year or so.

-                Developed market indices have fallen and most are now in negative territory for the year.

So finally I am outperforming, partly because I am not fully invested, and partly because my bigger holdings have avoided losses reasonably well.  Of course this is a relief because it seems to be validating my thesis that I should preserve capital reasonably well when market are down.  However, I have mixed feelings because I haven’t hit my 12% target for the year, and psychologically this means a lot to me.  It’s funny because if I were a fund manager, my performance this year (which I’ll post an update on at the end of September) would probably have me popping the champagne but because I have a different benchmark my mood is muted.  Maybe that’s partly because I’ve had my share of disasters and my decent performance has been those disasters have been smaller holdings.  I like to think that I put most money into the biggest ideas but who knows if my escape was luck or skill?

Anyway, I’ve been stopped out of several of my smaller positions in the last few months:

Hargreaves Services 24/8 @316p

Hargreaves was a mistake, pure and simple.  I thought that the market had underestimated the length of its demand tail, and that a skilful operator like Gordon Banham could continue his policy of consolidation with success.  I further thought that falls in the coal price might be temporary and they might yet rebound.  But what I did not realise the sheer quantity of oversupply (partly caused by the rise of solar), and the effect of cheap production in places like Colombia and the US on the industry in UK.  Prospects for the industry look awful and while the company might yet successfully transform itself into a property company, and has done a lot of things right, I won’t be buying this any time soon.

Goodwin: 25/8 @2201p

While I believe this is an extremely good business with an outstanding management team, there is no escaping from the fact that a large part of its revenues are linked to oil and gas.  So it was no surprise to see it sell off.  I am keen to buy this again, but would need to do it within my pension portfolio, rather than via spread betting as the margin requirement is high and this really is the longest of long term holdings.  Recently Goodwin released a statement which said revenues were up on a quarterly basis but margins would be down. 

While they have a great management team,

Commerzbank:  6/7 @ 1119

Honesty forces me to say that I didn’t and don’t understand banks as an investment.  All I say when I put money into Commerzbank was a huge discount to tangible book, a general hatred of the banking sector, and no imminent risk of distress.  The stock sold off quite seriously during the greek crisis, which highlighted the enormous dislocations in the European financial sector, but also the underlying issue that Euro interest rates are going to be at zero for many, many years, and profitability in a structurally unprofitable sector is going to be even further stressed.  I have made a bit of money on Commerzbank but probably won’t be going back in.

Emeco:  I intend to close this out next week.  Another colossal mistake.  I thought I had protection buy buying at a substantial discount to book, but didn’t take account of the fact that liquidation was never an option.  I also didn’t realise that margins in the business would completely collapse as collapsing investment in the mining sector prompted miners to pass on their distress to equipment suppliers via significantly lower rates.  Emeco has a large debt to service with a 10% coupon and I don’t see much prospect for revenues and margins recovering.  Indeed, bankruptcy may still loom.  What have I learnt?  To focus more on margins and the competitive position of companies within the value chain.

This was a good quarter for me, driven by a big jump in Avesco as the market became aware of its profitability.  There is probably some further upside there as the non US business stops being a drag on performance.  However, since month end, I have taken some profits and put them in Exova.  I am trying to transfer my Exova exposure from my spread betting account to my pension because the margin requirement is high (illiquid mid cap).  However, the bid/ask spread is so big that I haven't yet managed to execute the "sell" part of the rebalance.  That's ok because I continue to love Exova as a long term undervalued quality stock and I look forward to its results in a few weeks.

In the next few days, I am going to buy Distribution Now (DNOW), which is a distribution business within the oil + gas sector.  It's international but mostly in the US.  It is, various, liked by a great investor (Allen Mecham); a spinoff; a consolidator with liquidity for M&A and room for operational improvements, and operating in an industry at a cyclical low.  There is a long thesis on VIC which I like, and a short thesis which has a target price we are not at.

I may also buy more AIG at some point because I think it's still long term cheap.

Portfolio as at end of June
Asset	Bloomberg Ticker
Avesco Group PLC	AVS LN	16%
Exova PLC	EXO LN	13%
Safestyle PLC	SFE LN	12%
Markel	MKL	10%
Tessenderlo	TESB	5%
AIG	AIG US	6%
Emeco Group Holdings	EHL ASX	4%
Commerzbank	CBK FP	4%
Alternative Asset Opportunities	TLI LN	2%
Goodwin	GDWN LN	2%
Plaza Centers	PLAZ LN	2%
Hargreaves Services	HSP LN	2%
Dolphin Capital	DCI LN	1%
GBP Cash		21%
Quarterly Return	Quarterly Benchmark Return
11.32%	-6.02%
Return Since Inception	Benchmark Return since Inception
21.10%	37.76%
Annualised Return since Inception	Annualised Benchmark Return since Inception
7.96%	13.64%
Quarterly Leveraged Return	Annualised Leveraged Return
7.50%	15.56%
Leverage
33%

My Investing Confession

It’s time to talk about my little investing secret – one that I’ve been thinking about for the last year or so and one that I put into action when I re arranged my portfolio a couple of months ago to include proceeds from a flat sale and newly self managed pension.

I have started using leverage.

This is something that our hero – WEB – famously warns against, and for good reasons, which we are well aware of.  I’m going try and explain why I am ignoring the wise advice of many my investing heroes and pursuing a path that introduces a brand new risk to me – liquidity risk.

First, I should point out that as with so much about WEB, there are many layers of nuance to what he says, and while one can learn a lot by taking his statements at face value, when one peels back the layers, one really realizes the genius of the man.  So, OF COURSE Warren has always used leverage.  He used leverage in his pre Berkshire Hathaway partnership days when he paid his partners to deposit cash with him early and he used it when he did merger arbitrage.  And for the last 50 years or so he has used it in Berkshire Hathaway by acquiring insurance companies and using their investment portfolios (or “float”) to buy equity securities – something that most insurance companies don’t do because they perceive it as too risky, but something that WEB can do because of his stock picking skills.  This strategy is described in many of the Berkshire letters, and also by many external commentators, including academics (http://www.economist.com/node/21563735).  What Buffett has done brilliantly has been to use a form of leverage that is a) cheap and b) reasonably permanent – as long as people are using insurance, they will be giving Berkshire money to invest.

So how did my decision evolve?  Well the first step was the fact that I use spread betting anyway to synthetically buy lots of my equities.  This is because, in the UK, spread betting is tax free and allows me to avoid paying c30% on capital gains, as I would have to in the majority of my portfolio.  Of course I take advantage of the £15k per year allowance that I have to put into ISAs and one day I hope that my whole equity portfolio is in ISA accounts.  But that day is a couple of decades away.  Of course, there is a cost to using spread betting and that is their cost of funds, which is around 0.5%, plus around 2% per year to roll positions quarterly.  So let’s say 2.5%.  If one is earning around around 12% per year on an investment portolio, being charged 30% tax on gains and 40% on dividends brings the return down by about 3-4%.  So already spread betting compares favourably with a taxed portfolio, even if fully collateralized.

But the thing is, spread betting doesn’t require full collateralization.  Indeed, depending on the liquidity of the shares you are trading in, and where you are prepared to place stop losses, you can get by with as little as 10% margin, though that would be very aggressive.   Of course, using the ability to margin to lever up into more shares is a fool’s game.  But what if it were possible to buy an asset that offers full downside protection (like cash), but with a juicy yield far in excess of 2.5% that will compensate for the costs of spread betting as well as juicing up returns?

Well I believe that asset is TLI – Alternative Asset Opportunities.

(https://wexboy.wordpress.com/2012/11/21/an-investment-to-die-for/), This has now made two distributions of cash, and the maturities have been coming at a decent pace, with the average life expectancy being less than 5 years now.  As time goes by, the share price will become less and less volatile and more and more will begin to mirror the performance of the portfolio.  That, I believe, puts a floor under the shares.  That is important, because I need to be able to sell these shares in case there is a sudden liquidity requirement in the spread betting account – a market crash.  But if the spread betting account is able to operate with, say 35% margin, then returns might look like this:

Spread Betting Portfolio Return Assumption: 12%

Costs: 2.5%

TLI Return: 10%

Portfolio: 100

Annual Return = (0.65*10%) + (1*0.12%-2.5%) = 16% overall return.

The crucial thing with this strategy is not to suffer any losses in the spread betting portfolio, permanent or not, that require me to sell TLI and put cash back into the spread betting account.  The disaster scenario would be a 2008 esque crash that depresses all assets well below their intrinsic value.  In that event I might have to sell TLI at a loss to prop up my spread betting portfolio or alternatively close out spread betting investments at an inopportune time.  That’s why I need to believe TLI is now on an inexorable path upwards at a clip of 10% or more per year.  And also why I need to concentrate more on finding cash generative, low beta, “boring” stocks that will outperform in a downside scenario.  In addition, because larger and more liquid stocks have lower margin requirements, I should  favour these, although it’s tough to find fair or undervalued large caps in the current market. 

Anyway, that’s the path that I’ve chosen to go down.  Only time will tell how it works.

Onto my current portfolio performance:

Last year I was hurt in a big way by a collapse in Emeco and Hargreaves Services.  They were classic value traps in an industry I don’t understand – commodities.  I was looking for bargains but was way too early and bought them both while they both had a long way still to go down.  With Emeco I failed to understand how margins could collapse as much as they did.  In retrospect it is obvious – when there is a massive over supply of equipment, rental companies will obviously be price takers.  Today Emeco looks vulnerable to its huge debt load and I am minded to sell.  That said, rivals have talked of contract wins and recovering second hand prices for machinery.  In addition, a rival has proposed a merger, with resultant cost savings and a bigger footprint, so I might just wait a while.   My focus going forward will be on rotating into these “risky” small caps into low margin larger caps.  IBM and Deere both look interesting to me at the moment.   Today I also put in an order to buy Markel.  The reasons are fairly straightforward.  First, it’s exactly the sort of company I described above – low risk due to an outstanding management team that are focused on shareholder value and a Berkshire Hathaway like model.  The reason I preferred Markel over Berkshire is size.  With a market cap of only $10bln, the universe of available investments is far larger than those that WEB can access.  At 1.45* book value, it’s not super cheap, but I think there is downside protection in that management have a proven record of conservatism and buybacks will always put a floor on the share price.

Portfolio as at end of March
Asset	Bloomberg Ticker
Safestyle PLC	SFE LN	11.9%
Exova PLC	EXO LN	11.2%
Avesco Group PLC	AVS LN	11.8%
Emeco Group Holdings	EHL ASX	6.1%
AIG	AIG US	6.3%
Commerzbank	CBK FP	5.0%
Hargreaves Services	HSP LN	2.1%
Alternative Asset Opportunities	TLI LN	2.9%
Plaza Centers	PLAZ LN	2.1%
Dolphin Capital	DCI LN	1.6%
GBP Cash		38.9%
Quarterly Return	Quarterly Benchmark Return
-2.354%	7.65%
Return Since Inception	Benchmark Return since Inception
10.16%	46.5%
Annualised Return since Inception	Annualised Benchmark Return since Inception
4.39%	18.50%
Quarterly Leveraged Return	Annualised Leveraged Return
1.13%
Leverage
35.4%%

Q4 2014 Results

Portfolio as at end of December
Asset	Bloomberg Ticker
Safestyle PLC	SFE LN	11.5%
Exova PLC	EXO LN	11.0%
Avesco Group PLC	AVS LN	11.0%
Emeco Group Holdings	EHL ASX	7.4%
H&T PLC	HAT LN	6.2%
AIG	AIG US	6.1%
Commerzbank	CBK FP	4.6%
Hargreaves Services	HSP LN	3.2%
Alternative Asset Opportunities	TLI LN	2.9%
Plaza Centers	PLAZ LN	2.7%
Dolphin Capital	DCI LN	1.8%
GBP Cash		31.6%
Quarterly Return	Quarterly Benchmark Return
-5.04%	5.57%
Return Since Inception	Benchmark Return since Inception
11.40%	36.1%
Annualised Return since Inception	Annualised Benchmark Return since Inception
5.55%	16.66%
Leverage	55%