A note on Quality, part two

Earlier today, as I was pondering the quality of businesses - you will have noticed my style involves quite a lot of pondering and not too much doing, which may be a failing of mine – I stumbled came across a great article on a blog from 2011. I don’t know how I found it; sleepy little blogs come and go, after all, and lots of great ones languish in hidden corners of the internet… but this one made me smile.

It provided a better explanation of the value of high return companies than I could ever write and is a highly recommended read. Even more thought provoking, though, is the follow-up. Here, the author more or less runs through his take on the holy grail of investing; not just which companies generate super-normal returns on capital, which ‘any computer could do’, but why certain companies or industries generate consistently high returns. He uses airlines as an example of an industry which is basically structurally rigged to generate poor returns. See his intro, noting the following:

A note on quality

Clearly, now I work in the city (boo hiss), I spend even longer looking at shares than I ever had the opportunity to before. It drills some points home, because it’s given me longer to look at a whole bunch of stocks I never even considered before – ones that aren’t traditional value plays in my little niche, for instance, along with business models I never took the time to understand and geographies I never had the inclination to play around in.

If there’s one overarching message I take away from looking at loads of businesses, it’s this:

Really good companies – companies which return significantly above their cost of capital over the cycle – are incredible hard to find**. I don’t mean that on a valuation basis; I’m not necessarily trying to say that great companies are difficult to find because they’re usually too expensive, though that’s also true. I mean it on an absolute level – companies which have good return profiles, competitive advantages, competent management and are in a market which is, at least, not dying off –  are just very hard to find full stop. 

Tesco: put your money where your mouth is

In the interest of intellectual honesty, I should say I’ve been pretty positive on Tesco for a long time – most of the way down, to be honest, so I was a little sheepish after Tesco released yet another poor trading statement last week. The behemoth seems to lurch from wound to wound, dragging more investors down with it, and tanking sentiment along the way. Not many people are sticking up for it at the moment.

I have to say, I disliked the trading update too – though maybe for different reasons to most people. I’m completely with cutting the dividend – absolutely no problem – and the trading profit figure for the year looks fine, too. Entirely unsurprising. What I really dislike, though, is the line that they’re ‘implementing further reductions in capital expenditure’. I’m no expert – far from it – I’m just an interested observer. What I really can’t abide, though, is having no idea what’s going on at a company. Clarke, the outward CEO, was talking about the need for a wide-ranging store refresh – something which I shrugged and probably agreed with. 

Craven House Capital – A treasure trail

There’re often interesting stories in the companies right at the bottom end of AIM. Some of them are decidedly dodgy – Zambian mining stocks and deep-sea oil exploration companies that were taken for a ride for a while before getting unceremoniously dumped, for instance. As you probably tell from the examples I picked, there’s a lot of tar-brushing going on here. Paradoxically for a value investor, that means there’s value – because the places you find really interesting companies are often in places where other people don’t want to look.

Anyway, yesterday I was browsing through Investing Sidekick when I found his half-yearly review and something caught my eye – a 30% allocation to one stock? I consider myself a pretty concentrated chap – I’m aiming for maybe 8-10 holdings in my personal account, so 30% seems a rather strong signal of confidence. What’s the deal?

To grandly tie my opening two paragraphs together like a wizened old storyteller, I’ll tell you what I found – a rather interesting micro-cap AIM stock called Craven House Capital. Their website is full of the sort of value rhetoric we love to hear:

The most depressing thing about the Quindell saga:

… if you haven’t been keeping up with Quindell, some might say you’re missing out – it sort of depends how you get your kicks in life.  It is rare you get to see such a public back and forth between the long and the short side of a stock; usually those bearish stay out and stay quiet, but in Quindell’s case you have a fistful of public legal spats, accusations of impropriety and the usual festival of characters wading in on either side of the debate.

I have nothing to add on the equity side; it’s either cheap and legit or it’s expensive and isn’t, and I look at situations like this with a shrug of my shoulders. Maybe I’m missing some value by permanently sitting on the sidelines, but the level of due diligence it’d take for me to get comfortable with a stock blasted with a reasonably convincing 74-page short manifesto just doesn’t appeal. It’s the same deal as I’ve said before with mining and exploration stocks – I find myself agreeing with most points I read. I lack the capacity to critically analyse the arguments, and I lack the desire to figure it all out. As far as I’m concerned, the returns to my time are much better looking for solid companies with good returns on capital at reasonable valuations – not looking for diamonds among the rubble and hoping for multi-baggers. Fortunately, it turns out more ‘boring’ companies might be a more reliable way of doing that.

General / Howden Joinery (HWDN)

I’ve given the blog a bit of a refresh after a friend accused it of being a bit ‘stodgy’. It should also look a bit better on mobiles and tablets now – which apparently make up 25% of my readers! Direction-wise, I will hopefully be back on the small-cap equity bandwagon soon enough – pending some final job-related stuff. The markets are looking decidedly wobbly at the moment, but there’s always value to be found if you overturn enough stones.

I continue my love affair with Howdens, for instance, which is more or less flat year-to-date even after continuing and relentless improvement in their figures. I sold out far too soon, and am now left with the slightly more difficult decision as to whether to buy back in. I think the group will make £140m in net profit this year, which puts them at not-cheap P/E of nearly 16. Countervailing that, you’re buying a quality business with great returns on capital. The real lever you have to pull to shift Howdens from being a decent investment to a great one is how much of that (effective) capital – they lease their stores, so outlay is fairly minimal, and they have basically no traditional debt obligations – is actually able to be deployed. One of the things that caught me out was management’s growing confidence that they’re able to open more and more stores in the UK without cannibalising existing sales. They seem pretty bullish on this trend continuing, hence my optimism for the group generally, but I would like to hear management’s plans on France. They have a small depot toehold over there that they’re clung on to, but things are beginning to move: