Go-Ahead: Eminently (un)investable?

Run with me for a second. If you don’t know who Go-Ahead are, don’t look them up, and let me take you on a tour of the company.

We’ll start with the financials. Here is a cash flow profile of the company over the last ten years. The gold bar shows operating cash flow – cash coming into the company in the course of ordinary business. The grey bar shows investing cash flow – cash they’ve invested in growing the business, or at least maintaining the asset base. The black line shows the summation of the two, namely the cash profitability of the business before we start talking about capital structure issues (like interest and dividends):

That’s what we like to see – every year, the company shows a cash inflow. And what’s great is the chart above in combination with the chart below, which shows the increasing revenue the business has generated:

Apparently Go-Ahead manages to pull in more and more cash, more or less every year, whilst also growing the absolute size of the business.

This, by the way, is the practical benefit of having a ‘good return on capital’, a phrase which is thrown around a lot in valuation memos. A good marginal return on capital, when it is really relevant, is such a boon because it allows the company to grow quickly without requiring any more of your cash. The best ones (think Rightmove) are able to grow rapidly while actively returning oodles of it.

Don’t get me wrong: Go-Ahead is not the best company in the world. I calculate the shareholder return since 2000 to be something like 13% – very good, to be sure, but I am not claiming it is a powerful and underestimated hidden champion.

What is unusual is the price. Go-Ahead’s market cap, at just shy of a billion, represents about 10x earnings; much cheaper than the market. We’ve already seen its cash characteristics are superb – much better than the market. And it’s also growing quicker than the market.

A tempting candidate for any portfolio!

On factor investing

But actually, I’m not here to make the investment pitch for Go-Ahead. Instead, I think it is a much more interesting case study on the benefits and dangers of ‘factor-based’ quantitative investing.

Stockopedia have pioneered factor-based investing here in the UK for private investors, but academics have been on the band wagon for a while, and brokerage houses are also increasingly piling into the fray with their own quant-type products. This is no surprise. Investing is like all human nature in that it has fashions, fads and hot flows of money into the trendy new products. As a brief primer, this new sort of ‘factor-based’ investing essentially screens the market for a number of characteristics that historically have been correlated with strong subsequent performance. Good balance sheets, good return on capital, earnings growth and so on.

And one thing you notice if, like me, you read quite a few of these quant-type products, is that Go-Ahead nearly always sits at or near the top of the quantitative ranks. It grows, it throws off cash, it has an excellent return on capital and it possesses an enviable net cash pile of £300m, or nearly a third of the market cap (though most is admittedly restricted, essentially representing government float). What’s not to like? The factoral check boxes are ticked with vigour!

I haven’t actually told you what Go-Ahead do yet, but that’s sort of the point. Quantitative investing doesn’t care. The numbers are the only thing that matter. Stories and annual reports cannot be parsed by algorithms. Besides, we’re probably all the better for it. Stories are windows to human biases, after all, and distractions from the clean beauty of screens.

But call me old-fashioned and indulge me. We’ll move from financial to operational.

The business of Go-Ahead

Go-Ahead has three different operating segments: Regional Bus, London Bus and Rail. The annual report has an excellent description of how these work:

  • Regional Bus operates largely on a commercial basis. Revenue comes from fare paying passengers, with the government reimbursing concessionary travel (pensioners with bus passes). There are also some ‘thin’ rural routes which are directly subsidised as a matter of public interest.
  • London Bus routes are managed and mapped by TfL, with private operators bidding on individual routes (you can find a fuller description of the tender process here). Supposedly TfL evaluates bids on a holistic basis – while price is an issue, ability to actually provide the service and not embarrass the procurement manager at TfL must be an important concern. There are bonus payments for outperformance vs. service standards, such as punctuality.
  • Rail operates three UK rail franchises. The UK rail network, since privatisation, has been split up into smaller route networks, which are tendered out to businesses. Network Rail owns the infrastructure – the operating companies take care of what happens on top of it.

In short: for the most part, it’s a collection of those cutesy private-public partnership affairs you get when you try to privatise services which are essentially, in economic parlance, natural monopolies.

It’s also excellent business for Go-Ahead. Digging a little further into the actual economics makes it obvious why the cash flow characteristics are just so good – and that’s because, contrary to what one might think, it’s actually an incredibly asset light affair. Go-Ahead have £500m of net PP&E on their balance sheet, but are making £1.1bn of annual lease payments for assets on other people’s balance sheets – an absurdly high figure, and almost a third of group revenue. This is debt by another name, but it is debt with an implicit government guarantee. Someone needs to run the trains, after all. On top of that, working capital is tight – the Government, apparently, is a prompt payer. Better than that, though; they actually fund train operating companies with some float at the start of franchise agreements.

Ramping up the business, hence, is relatively simple. Win a new contract, lease some more trains/busses, march off to the races.

The flipside

You knew the ‘but’ was coming. Here is my problem.

Of the three networks that Go-Ahead Rail runs, one of them has been in the news a lot recently. GTR – Govia Thameslink railway, runs the Southern route – a service so woefully poor it has received more or less constant coverage for the last year. Here are the punctuality stats from Southern’s own website:

Sub-50% implies peak time performance is off the charts bad, given off-peak services (which are less frequent, less busy and easier to schedule) are blended in there.

Normal market economics – and common sense – would dictate that a business providing a service this dismal – regardless of who is to blame – would be bleeding money to rectify the issue. But Go-Ahead’s RNS contains the following statement:

As previously reported, the additional resources being invested in GTR to support service delivery continue to impact margins in the short term. Our margin expectations for the life of the franchise remain unchanged.

And now we arrive at the crux of the issue, and the battle between quantitative and qualitiative investing. It can be summed up in one simple question:

Do I think Go-Ahead is a sustainable business? Will it be functioning in ten years’ time in much the same way it is today, and with the same or a better level of profitability?

Algorithmic and factor based investing does not care, per se. It is strictly a numbers game. Go-Ahead could’ve been a pork pickling company in Portishead, for all my nice Excel screening tools know. But ‘care’ is a vague word – more precisely, factor based investing relies on the generally correct rule that the market tends to underprice quality of earnings, cash generation, consistent growth and so on. Go-Ahead benefits from falling into a bucket of stocks that have historically outperformed.

By overruling the algorithms, I have to have a reason why I think the past won’t look like the future. Or, at least, for there to be enough uncertainty to make it not worth the attractive price. I think that is the case.

I worry that Go-Ahead have benefitted from an excellent political atmosphere over the last 15 years. New Labour, the Coalition and now the Tories have all pushed forward successive waves of privatisation. I worry the political tide may shift at some point. More specifically, I worry about contract risk. I think about G4S and the prison service, the tagging scandal, and Atos and the disability tests.

These were all examples of highly profitable contracts which went disastrously wrong. Highly profitable companies which went disastrously wrong.

They’re also symptomatic of the other issues with Government procurement, namely the degree to which the government gets woefully, hideously outclassed when it comes to contract negotiations. Go-Ahead has made a 10% operating margin effectively every single year on its bus contracts. Its rail contract will continue to be profitable despite arguably the worst conditions we have seen on a route in decades. And, what’s more, as far as I can calculate they are running this contract with negative capital. The float the Government gives them, and the implicit guarantee allowing them to lever up to the hilt through leases, means they are running a consistently profitable business with less capital than I have in my savings account.

It’s easy to forget, in the throes of a bull market, that even a modest 10x P/E ratio is making a bold statement about the way in which the future will unfold. In Go-Ahead’s case, it’s the statement that the future will look like the past. That the government will continue to underwrite exceptionally profitable contracts with essentially no risk to the operating company. That the public will not kick up enough of a fuss to end it or, worse, seek some sort of retribution. I’m not sure I’m comfortable making that statement.

The battle between quantitative and qualitative writ small

I have to battle my own biases – my own biases as a taxpayer, as a user of Go-Ahead’s rail services, and as an investor. The stock is hence almost a perfect example of the new, quantitative model of investing vs. the human-driven investing of old. The financials are great. Yet I choose to overrule the numbers based on a softer, qualitative assessment of the business.

Am I being that typical, fallible investor? Am I ignoring the obvious signs of cheapness in front of me? I’m open to those accusations. In fact, I can think of a few obvious accusations myself:

  • Maybe I’m committing the crime of eternal optimism. I’m arguing operating margins this strong aren’t sustainable. But maybe that’s just wishful thinking as a taxpayer – maybe my sin is not seeing that government is a structurally poor negotiator. What will ever change that?
  • Maybe I’m biased as a user of the service. Maybe my own experience clouds me against the company and gives me an overly negative opinion. Maybe Go-Ahead are actually excellent operators, running a business which is a net positive for the country due to their exceptional operational efficiency, and maybe we are all richer for it.

The funny thing is, for most people Go-Ahead should either be a bargepole stock or a real purchase consideration. If you think the business is sustainable, it is an absolute steal. If you do not, it’s very difficult to make a case even at very low valuations.

Where do you sit?

11 Replies to “Go-Ahead: Eminently (un)investable?”

  1. TomB

    Thanks for this article. I have a small position in Go-Ahead as well as in Stagecoach which has essentially the same business model, although the latter is stronger in the unregulated part of the business – regional bus.

    In both cases I am in for the bus operations, and I believe that the bus business in both cases could be worth market cap – so that the rail business is basically for free. But my conviction with Stagecoach is a little bit higher.

    It’s really tough to value the rail divisions, because of the factors you write about (and others). I do not live in England and have no experience with the service levels. But anyway you slice it, I would have no problem with both companies exiting the rail contracts and concentrate on bus.

    We will see how this plays out, but you made a great point. The cash flow profiles of these companies were, of course, a major factor for investing in these companies and you provided me with something to think about 😉

    Tom

    • Lewis Robinson

      Hi Tom,

      Thanks for the comment. The bus business deserves a further look, actually. But I am deeply suspicious here, too – National Express, Stagecoach and Go-Ahead are all earning excellent margins and returns with apparent impunity.

      It looks like a very cosy club for what should be a low barrier, asset intensive, simple business. This is my fear – I see significant excess returns with little reason beyond, I suspect, the inefficiency of government.

  2. John @ UK Value Investor

    Hi Lewis

    I think pure quant investing will only work for most people if they use it to invest in a large number of stocks. Trying to run a portfolio of 20-30 stocks on a purely quantitative basis is asking for trouble (i.e. massive volatility). I think 50 positions would be a reasonable minimum, although the more the merrier definitely applies.

    As for Go-Ahead, I’m slightly more negative on the valuation side than you. The dividend yield is around 4.2%, which is above the market average of about 3.6% but it isn’t massively high. The dividend has been going up by about 5% per year in recent years, but whether or not that’s sustainable for any meaningful period of time is anybody’s guess. I certainly don’t see any good evidence which suggests that it is.

    However, I agree that it’s very good at what it does, has good margins and so on, but yes there is massive risk from its dependence on large rail contracts (I think, from memory, that the bus business is much less risky).

    • Lewis Robinson

      Hi John,

      You and PJH (below) have the same thought but different sizing on diversification!

      Re: Go-Ahead’s dividend; I would suggest that the incredibly strong cash flows and the strength of the balance sheet would suggest that they can comfortably increase the dividend well into the near term, absent any big shocks to the business model. Dividend growth is running slightly ahead of EPS growth over the last few years but looking further back it isn’t way off kilter.

      I would find the valuation compelling if it wasn’t for the big contract risk and the concerns I highlighted… which is a meaningless statement, but hey-ho.

  3. PJH

    If you’re going to go in for factor investing it should, obviously, be carried out by investing in a reasonably large number of stocks. Something like 30 sounds about right to strike a sensible balance between diversification and overwhelming any returns with excessive transaction costs.

    With that in mind, individual criticisms of stocks that qualify under the factor model probably aren’t fair.

    However, I think that the dichotomy that is often drawn between quantitative, factor based investment and old school, stock specific, fundamental research based investment is not necessarily right. The best “fundamental” investors tend, in my view, to have an investment process that is akin to a factor model. It’s just that the factor model is based on qualitative as well as quantitative factors (for example, having an understanding as to why a company may be able to continue to earn high returns for some long period into the future).

    Applying that to Go-Ahead, for me, leads to a conclusion of “dunno” – I have no idea if its high returns will persist. I can certainly see why there have been high returns in the past – for example, the natural tendency towards monopoly or oligopoly in the regional bus market. But there are some clear and present threats to that – the legislative proposals to allow local authorities to control their bus networks is reasonably likely to lead to those returns being eroded IMO.

    For that reason I see Go Ahead (and other bus operators) as difficult investment propositions at the moment.

    • Lewis Robinson

      Hi PJH,

      Thanks for taking the time. The problem with writing a piece like this is that I neither do the factor argument justice nor fairly appraise Go-Ahead. Your comment is an excellent step further into the real meat of the topic.

      I agree individual criticisms aren’t fair, and I agree the right way to approach factor investing is to pick a reasonable sized subset of stocks, adhere to rebalancing rules, and then ‘set and forget’. The problem, as I see it, is that where the rubber meets the road there is almost invariably some element of judgement. Sector weightings in a factoral allocation strike me as one area where bias might creep in.

      More obviously, from tools like Stockopedia we see that the desire of the vast majority of stock pickers is to use factoral tools as a guide or ‘first screen’ to what stocks are then worthy of further research. This sounds temptingly logical, but it is not. Greenblatt identified the problem back when he first wrote about the Magic Formula – and this is that tinkering with the simple criteria tends to make returns worse, not better.

      I don’t disagree with your characterisation of good active investors essentially having internalised some of the principles in factor investing. The blurring of the lines between the two is a fascinating area of conversation. I know quants who think you can essentially break down any hedge fund into its factoral components – they might look at Expecting Value and say:

      “Gee, Lewis, all you’re really doing is milking the small-cap and illiquidity premiums with a value and quality bias. You’re not really outperforming, you’re just exploiting a number of different premiums and adding no alpha beyond that.”

      Something about that argument feels deeply unsatisfactory to me, but my tentative fray into the topic in the piece could be better stated more simply: yes, factor investing captures a subset of stocks which are significantly more interesting to me than the general market. But it’s what I exclude that really highlights the difference between active and factor investing, and it’s here where there’s still a lot of value to be added.

  4. Paul

    Great thought provoking article.

    I think precisely the reason that simple quant investing continues to apparently work so well (without factor returns being competed away) is that many investors prefer to try to ‘add value’ using their own insights about the economics of the business, management, the macro picture etc. without following a coherent strategy likely to beat the market over the long term. Unfortunately adding value this way is incredibly hard and it’s also hard to tell even ex post whether you are getting it right or not. Most inevitably end up reducing value by putting weight on the wrong things, succumbing to behavioural biases and as beating the market is a zero sum game.

    Though if you are able to combine qualitative and quantitative analysis well you could do really well so got to give it a go, right? Well nothing ventured
    nothing gained but for this to work I think discipline is key. You need to follow a not too complicated strategy that you are confident will work over the long term.

    For what its worth Go-Ahead is a barge pole for me. I’m too ignorant to accept the risks on offer here. As well as the risk that the govt. will change the rules, it appears to be a ‘commodity service’ and I don’t really understand whether or why Go-Ahead would have a sustainable edge over its competitors. Its done well in the past while some of its competitors have suffered but who knows if this will continue? Consequently I would be worried about the risk of it losing big contracts in the future. Though perhaps these concerns are behind the cheap price? Who knows?

    • Lewis Robinson

      Hi Paul,

      Thanks for the comment. I don’t disagree with anything you say. The only slight tweak I might add is that having a ‘coherent strategy’ to beat the market (or, at least beat a factor portfolio) is almost by definition impossible. Semantically, at least, it’s extremely difficult… because as soon as you do beat the market systematically someone will quantify it and claim you’re just exploiting a new factor!

      Factor investing is a coherent strategy. Doing what I am doing here is rarely going to be!

      • Paul

        I see where you are coming from but personally I wouldn’t equate factor investing to ‘systematic investing’ – another relevant characteristic of factor investing in my mind is that it exploits quantitative data rather than qualitative assessment i.e. factors can be measured.

        I believe qualitative assessments can still be systematic in the questions they ask, the logic they follow and ultimately the way in which they are employed to inform what shares to buy or sell and when, even if the questions they attempt to answer are too complicated to quantify practically (and turn into factors).

        To put it another way I think there is a useful distinction between things that are useful and practical to measure directly (e.g. a PE ratio) and things that are useful but not practical to measure directly (e.g. a competitive advantage). A lot of the aspects that are more forward looking in nature (e.g. thinking about risks) tend to be less amenable to quantification.

        • Lewis Robinson

          Fair enough. I struggle with the combination of systematic and qualitative. Now we really are arguing semantics, but as soon as you allow decision paths which require a judgement to be ‘systematic’ I think you lose any differentation in the word. Everyone’s investing is systematic in some sense if you go down that route… at least those who are putting some thought into it. Even the penny stock punters seem to be rather systematic in their selection of the ropiest, raciest and most obviously promoted vehicles.

  5. ebdem

    Doing business is a social practice, that is happening in reality. To get investing right you need to understand this reality with its own logic, rules, language, practices, power structures and so on.
    To understand you should use both techniques – qualitative and quantitative. There is no sense in just using one technique. I like the methaphor that these techniques are your tools. If you want to build a house you need a lot of tools, not just a hammer.
    For a better understanding you need to control your thinking and your blindspots. Reflexity and a good knowledge of the limits and blindspots of the concepts you are using helps you to better understand reality. It’s also very helpful to get a lot views and opinions on the business/reality you are researching. They help you to get deeper insights.

    I have a limited insight on the business Go-Ahead is running in GB. But I learned sth about their new train business in Germany. They have won some train lines in Baden-Württemberg. They did win it, because the Deutsche Bahn, which was running the lines before, made a mistake in their application. Also the application was created with 3 so called tickets. Applicants were only allowed to win 2 tickets. Go Ahead wasn’t the cheapest competitor, but won, cause if the mistake and the rules.
    The economy of the train business has changed from the previous period. It is not proven, but there seemed to have been a deal from the former government with Deutsche Bahn to make Deutsche Bahn support Stuttgart 21. So the contracts were negoiated very lousy and in favour of the Deutsche Bahn. They could make a RoE of over 20% – if I remember it right. The new green goverment changed this and also reduced the government spending by increasing the quality of the trains (the old trains were from the 60s). If Go Ahead will make more profit by selling more tickets to the customers, the government will get a good share of these profits.
    To put it in a nutshell: By law you have visibility of the contracts Go Ahead has and I think the margins will stay till there is a new contract. But of negotiations fail margins and/or revenue might decrease or even vanish.

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