The market is cheap (but specify your inputs)

Lots of people think the market is dangerously expensive. They take a look at the S&P 500 graph, which looks like this:

S&P500

And they’ll point out that we’re now about 50% higher than we were in 2007, just before the last crash. Has there been a stupendous improvement in the real economy since then? No, they’ll argue, and so the index level must have been frothed up. You’ll probably hear something about printing money at this point.

But the graph in itself doesn’t tell us a great deal, since it’s raw data without any comparator. Much better to look at how the companies making up the index are doing, and how they are valued in aggregate relative to a proper measure, like earnings. At this point the Shiller PE graph often gets trotted out. It is basically a ‘normalised’ price-to-earnings graph, which shows the current multiple you’re paying for the average last-10-years earnings for the companies making up the index.

Hogg Robinson: Waiting for the Smoke to Clear

Disclosure: I have an interest in Hogg Robinson shares

Introduction

I classify investments into ‘themes’ in my head. The theme explains why or how the market is mispricing a security. It might be that the asset is in a sector or geography which is particularly unattractive for whatever reason, but the company involved is more insulated than a casual glance would betray. It might be that the company has a number of very valuable assets which are obscured by fluff, by investment in the future (opex as capex), or by loss making divisions which drag down the group picture while allowing management a clear remedy, should they choose to take it. Either way, it helps me if I can see why smarter people than me might be unable to see the attractiveness of an asset.

Hogg Robinson, thematically, fits in with Quarto in my mind. Every investment is different, but the premise is similar:

The business is being attributed a very high cost of equity – similarly a very low P/E – because the market thinks that the business has a combination of declining cashflows from a dying business and substantial cash obligations. One of these factors alone is a cause for concern. Both, together, raise fundamental questions about the value of the equity.

In Quarto’s case, their supposed millstone is the debt pile. In Hogg Robinson’s case there is also a touch of debt, but a much more sizeable pension deficit. In both cases, the black mark – QRT’s debt and HRG’s pension deficit – in combination with one’s inner reaction to the business they’re in – is prominent enough to turn the vast majority of investors off before getting to know the company.

The market view

To set up the mental model before we knock it down, then, here is what the market sees when it looks at Hogg Robinson:

HRG_Revnue

Judges Scientific: A Textbook on Value Creation

Disclosure: I have an interest in Judges Scientific shares

 

History

Judges Scientific – in your author’s humble opinion – is one of the best companies on AIM. How do we define ‘best’?

Here’s the share price performance over the last 10 years, overlayed with the normalised diluted earnings-per-share. The first measure shows how the market perceives the company. The second shows their delivery in growing shareholder wealth in a more tangible way.

JDG_SP_EPS

As the caption at the bottom shows you, Judges has a phenomenal track record. I spend most of my waking hours looking for companies that compound wealth in this way, and I don’t find many. Assuming that the history of the company has whetted your appetite, we’ll go a step deeper.

Political Odds

I have more of an interest in all the kerfuffle leading up to the election than the actual election itself… which is either a sad reflection on political apathy, or of my love of markets and probabilities. I’m not sure which.

That interest was somewhat dampened, it must be said, by having had the misfortune of watching the BBC Panorama program a couple of weeks ago where Nate Silver (the renowned US statistician) trucked around dreary English towns in a pantomime-esque attempt to drag out a forecast of the UK election.

That aside, the game of trying to figure out what will happen in the next election is a fascinating one from the point of view of a market watcher. London related shares moved when Labour announced their proposals around res non-doms (a nice tax structure for wealthy ‘foreigners’, basically), which investors saw as a threat to the status quo at the top end of the London market. The journalists also have a field day, since it gives them a nice event they can attribute market movements to – ‘the FTSE dropped 20 points as fears of a Labour-led Government grew..’ and the like.

So how to think about what is likely to happen?

As always, the best thing to do is probably to follow the money. For those who aren’t familiar with Betfair, it’s a betting site whereby the bets you place aren’t taken up by the house (which is adversarial - when you win, they lose), but instead by other people. It’s a functioning market, where the opinions of participants are aggregated to create at price at which you can back the bet – take the bet on – and a price at which you can lay it – bet that the outcome will not happen.

Berkeley Group: A builder, but not as we know it

Last time, I laid out my framework for thinking about housebuilders. It was convoluted and a bit mixed, frankly, but in that it did quite a good job of reflecting my thinking. I suspect it also captured some of the market’s struggle to value these assets. I left by saying that Berkeley Group and Bovis were particularly interesting to me, for different reasons. Bovis is a volume housebuilder – I’ll cover them in a separate post – but Berkeley is a law unto itself.

So for this post: welcome to London!

Berkeley Group

Valuing housebuilders

I have a warm affection for housebuilders. This is unusual among value investors, who (if the blogs I read and the people I talk to are anything to go by) typically tend to see them as horribly cyclical, commoditised land banks run by executives with an uncanny knack for leveraging into recessions and mis-timing the market. There is certainly some truth in this.

I’d probably hate them too, if it wasn’t for the good they’ve done me. My first ever investment was in Barratt Developments in the depths of the recession when, armed with only a notebook of valuation metrics and the sort of blind confidence only a true rookie could muster, I stuck the vast majority of my (admittedly meagre!) savings on the beleaguered builder. Sure enough, it was a blow-out bet, and probably has a small part in me being here today. Had the coinflip come up tails, I’d probably have quit and become a dentist. I’m thankful for my early fortune - ‘Expecting Dentures’ doesn’t have quite the same ring to it.

But let me lay out the discussion in this post. This is that, in my eyes, housebuilding is one of the few sectors the market understands well. It values housebuilders in a way fairly consistent with what I’ve highlighted in the first paragraph above. How is this? Typically, it is on a book value basis. A book value basis makes sense in a commoditised industry where your biggest input is capital; because the capital you employ in your operations will be the best guide to how much profit you make. It is difficult to see how any one player could earn a supernormal return on capital – the biggest chunk of your cost base (land) is subject to intense competition from other builders, and the margins on your finished project are inherently constrained by the availability of other houses nearby… which is doubtless the basis on which the acquired land was priced. Consider that Bovis called the biggest challenge in 2014 ‘the availability and cost of subcontract labour’. This bears all the hallmarks of a commoditised sector, where the economic profits flow through to the inputs.

Homebuilders