Editor’s note: In the October Chapter meeting Investment Director, Andrew Vaughan, explained the methodology that underlies the club’s share recommendations. The following is a summary of Andrew’s presentation for the benefit of those members who were unable to attend.
Before I go into how we select investments, we need to define what our objectives are. Contrary to popular belief, The Zurich Club portfolio is not a list of our best shots. It is a list of our best shots within the confines of The Zurich Club’s stated objectives and its nature as a newsletter. Our investment selections must, therefore, comply with the following requirements:
* Preservation of capital
* Global, not blinkered UK-only, view
* Monthly communication via The Zurich Club Communiqué newsletter
* No daily, let alone minute-by-minute, communication
* Investing for the long-term, not trading
* Provide ideas for both new and well-established portfolios
* Where possible, tax efficient (using funds, AIM and wrappers – SIPPs, PEPs/ISAs)
At a stroke, our overriding wish to preserve capital lets us exclude all of the following:
* Investments that put our capital at excessive risk (high gearing or low predictability)
* Unproven businesses – yet to make sales or profits (biotechs & start-ups)
* Unsustainable businesses – made untenable by new competition (e.g. Clinton Cards)
* Uncertain businesses – at whim of regulatory or legal intervention (internet gambling)
* Businesses vulnerable to technological advances & obsolescence (e.g. Kodak)
Six categories to help you find what you’re looking for
The portfolio’s current holdings split neatly into just six headings. Indeed, the portfolio table at the back of the newsletter has been revised this month so as to reflect this simplicity.
The headings are:
1. Globally Diversified Funds
2. Specialist Funds (for more complex markets
and sectors)
3. Large Companies
4. Smaller Companies
5. AIM/IHT Sub-Portfolio
6. Income Stocks (combining high yield and some scope for capital appreciation)
Within these headings, we follow some additional guidelines. We generally no longer feature small overseas companies. This is because of the liquidity and information flow issues with small companies quoted on overseas stock exchanges. The smaller companies that we do select are therefore UK-only and, with the exception of the AIM/IHT sub-portfolio, have market capitalisations in excess of £200m and exceptionally strong track records.
We favour larger companies, both listed overseas and in the UK. Amongst these, we will occasionally feature recovery stories, but tend to avoid them. Funds are used for their specialised investment management, their ability to magnify returns with gearing, and for their tax advantages. We always include at least one globally diversified fund, such as our current holding Bankers Trust. Such funds can act as core equity holdings, and can be useful as a one-stop first purchase for members creating a new investment portfolio. Funds also have appeal for members who do not want to get involved with the complexities and risks of individual stocks.
Our investment performance has been impressive. Ignoring dividend income, the growth portfolio open positions had an average gain of 43% as at the December newsletter cut-off date. Positions closed in 2006 to date achieved average gains of 49.9%, with an average holding period of just less than 18 months. In broad brush terms, this is twice the gain of the FTSE All-World index over the preceding 18 month period. Furthermore, thanks to our policy of cutting losers and running winners, our biggest winner was 302% from DTZ. Our biggest loss was just 14.9% (from Investor Group, purchased in April 2006 at SKR148 and sold at SKR126 in June 2006). Our winners-to-losers ratio of 2.6:1 further underlines the effectiveness of our approach.
Why the “bargain bucket” is no place to buy
Our potential universe is vast. There are hundreds of thousands of investment instruments. The UK equity market is one of the world’s largest, but overseas markets in total are worth some 10 times that of the UK so how do we select our investments?
Well, one popular method that we do not use is “stock screening”. This process involves scanning databases for shares with “value” attributes. These may be a low price earnings ratio, a high dividend yield, or a low price relative to net asset value. These are all measures of valuation. Each of them is linked to the share price in an attempt to see if there is “value” in the proposed investment.
Our view at The Zurich Club is that searching for stocks on the basis that they must first of all be cheap is a recipe for bad performance. It is akin to shopping only in low-end discount stores. We will find things that are cheap, but probably outmoded or close to their “sell by” date. Are they really what we want? We are talking about creating the foundations for our longterm prosperity here. The bargain bucket is no place to start our search.
We never use valuation measures to identify potential new investments. We use them only to qualify and “second screen” investments that we find attractive on grounds irrespective of valuation. So what are these favourable attributes?
Let’s go back to fundamentals here. Why are we looking to own shares of a business at all? We are venturing out of the security of holding cash and indirectly giving our money to a business in the hope that the business will prosper and generate high returns on its capital. For a business to prosper, it needs to be able to maintain or enhance its pricing, its profitability, and the return on the assets that it employs. We like to see growing demand for its product or services and a high degree of predictability.
The traits that identify great businesses...
It is easy to spot strong demand for a product. The personal computer, the mobile telephone, the flat screen TV – no prizes for seeing on their introduction that these products would be bought by every household in the land. The skill is in identifying which suppliers of these products would prosper and which would fall by the wayside.
From an investment perspective, it is rarely wrong to back the market leader. The company with the largest market share almost always has the greatest ability to increase its prices, to match the requirements of the biggest customers, to afford bigger marketing spend, and to drive a harder bargain with its suppliers. In selecting our investments, we therefore look beyond the company in question. We try to gain an understanding of where the company sits relative to its competitors and its customers. That it operates in a growth market is never enough. The ideal proposition for us is a company whose suppliers operate in a fragmented market, but which sells its product or service in a fashion that is as close to being a monopolist as is possible.
We use our “top-down” view of the world to identify sectors, asset classes or even entire countries that are likely to provide attractive investment opportunities. This narrows our search for individual companies or funds significantly.
Strong businesses tend to have certain characteristics in common. Their products are often either branded or can be clearly differentiated from the rest of the pack. They may dominate their markets or certainly be important players. The sheer size of capital required to finance some of the biggest businesses can deter competition and create a “barrier to entry”. However, in investment terms, the strongest businesses will require small capital investment relative to the returns that they generate.
Weak businesses tend to have characteristics in common too. They often supply generic products or services to markets in which they have no significant share. They are “price takers” rather than “price setters” with little ability to increase their prices and often forced to absorb higher input costs, rather than pass them on. Indeed, such weaknesses can affect entire industries, prompting us to avoid certain sectors altogether. The UK food manufacturing industry springs to mind. Companies such as Northern Foods seem forever squeezed by their powerful supermarket customers. Rising energy and raw material food prices can play havoc with their cost structures, and factories
require significant capital investment. Why should The Zurich Club get involved?
Business first, share price second
We are looking firstly for good businesses. Only if our prospective new investment passes muster as a business do we look at its share price and valuation. We use a variety of yardsticks here, but tend to favour price earnings ratios (PER) and cash flow attributes for individual companies, and long-term net asset value performance for investment trusts and other funds.
PERs by definition only look at one year’s earnings in isolation. We therefore look way beyond what may superficially seem to be an expensive or cheap PER, at the long-term outlook for the business. Indeed, some of our best performing shares, such as Domino’s Pizza, always looked expensive on the basis of its PER. Similarly, a cheap share is often cheap for a very good reason; its business is in decline or going nowhere. Bear in mind too, that with interest rates at around 5%, we are effectively paying a PER of 20x (100/5) when we put cash on deposit in the bank. While many commentators would describe an equity PER of 20 as “high”, we would argue that 20x is a modest rating for a share that can combine low risk to our capital with strong prospects for growth.
Our reluctance to make a trade-off between price and quality means that The Zurich Club will typically miss out on recovery situations and on the speculative shares that sometimes produce headline-grabbing gains. We can be confident, however, of avoiding the investment disasters that go hand in hand with recovery and speculative situations. With so many potential investments out there, we can afford to say “no” more readily than we say “yes”.
Ease of trading important too...
We try to apply a further round of testing before making our final selection. Our ability to buy into a share without spiking the price is important, as is our continuing ability to exit. We therefore look at a share’s liquidity, and this tends to go hand in hand with the company’s size, or market capitalisation. Poor liquidity is reason enough for us to avoid very small companies in addition to the business risks associated with them.
We look at ownership. Directors’ stakes and share transactions, and the presence or lack of well-regarded institutional names on the share register can all give useful insight. Far from drawing comfort from widespread brokers’ tips, we prefer to see abstainers or negative views which could turn positive later. This is at odds with widespread private investor practice. If everyone is already fully weighted in a stock, we prefer to ask the question “who is there left to buy?”
Our recommendations always disclose the share price high and low points for the preceding 52 week period. It can be comforting to buy a share below its recent high. However, if we are buying with a view to the share achieving ever greater highs, where is the logic in waiting for a set-back? We are not averse to buying at a high, and indeed DTZ was a notable success here. We recommended the shares at a 150p high when they had already moved up from a 52-week low of 60p. Two years later we exited at 604p.
Similarly, we will never recommend a share that is trading at a low. In this situation, sellers still have the upper hand. Instead, we look for a share to have established a base and started moving up again. We miss out on the biggest gains, but avoid attempting to “catch a falling knife” with its inherent risk of injury. A recent example is Carnival, which joined the portfolio in June 2006 at 2,044p. The attraction was in part the share’s slide from its 52-week high of 3,397p. We bided our time, however, until the shares had moved up from their low of 2,023p.
Why real “value” is performance!
As private investors, we recognise that we are small fry compared with the big institutional investors that determine prices. We are humble to market prices and always use a stop-loss. That said, we try to identify catalysts that will make a share price rise. This may be a conviction that institutional perceptions towards a company are about to change, or that its results will surprise on the upside. We will not select a cheap stock on the basis simply that it will have to rise sometime. Instead, we try to have a clear idea of justifiable price targets.
In conclusion, we want to own great, dependable businesses. We refuse to pay excessively to get them, but we know that greatness rarely comes cheap. We emphatically do not want to own weak businesses at all, no matter how cheap they may be. A cheap stock that goes nowhere is not a value stock. Value to Zurich Club means performance. A share that performs, even if it is deemed expensive, is the real deliverer of value.
P.S. If you enjoyed this article then we encourage you to sign up for The Zurich Club. Gain access to a seasoned panel of expert’s, whose tips and advice are intended to deliver top notch gains.
