Free Capital

Book notes – Free Capital, Guy Thomas

Rating: 3/5

Vernon Section

Haynes thesis:

Core thesis – the shares have fallen ~60% since the start of 2008, but there is no reason to think the very strong competitive position of the Haynes franchise would be affected by a credit crisis or recession. Indeed, there is some evidence from past recessions that spending on DIY car maintenance actually increases in recessions

Secondary factors

  • Very cheap basic metrics – PER 5x, NTAV around the share price & dividend yield 11%
  • Directors buying shares recently, in substantial size
  • The popularity of DIY maintenance on cars is in slow long-term decline, but no reason to think this has recently accelerated
  • Main shareholders – a number of value-orientated funds whom I respect are long-term holders of the shares
  • Experience of management – long track record in a market niche they created themselves
  • No published forecasts or broker research. To the extent this means the share are neglected is positive

Checks on hygiene factors:

  • Debt? – none
  • Unusual dual share structure – ‘A’ shares have same votes and economic interest as the ordinaries, but can only be transferred within the Haynes family, who have control. A negative feature, but long history on stock market and outside shareholders never disadvantaged, so ok
  • GBP 10m pension fund deficit – a negative – but ok because GBP 7m PBT in each of the last three years
  • Director remuneration is high, but ok because unusually well-defined performance related structure – key execs each receive 0.5% to 1.2% of net profits for their divisions. Yield of 11% means that shareholders are not neglected
  • Capitalisation of software development costs is currently increasing profits – OK, be aware that the amortisation will be a cost in future, but a legitimate one
  • Checked bulletin boards (not many posts – good)
  • Glanced recent years’ account – no further issues
  • Glanced past two years’ RNS – no further issues

 

Hansard thesis:

Core thesis – share have fallen ~60% since the start of 2008, probably because of the worry that Hansard is a financial company affected by falling asset values and solvency risk. This is misconceived. The reality is that Hansard is a service company disguised in the ugly clothes of a life insurer

Secondary factors:

  • High dividend yield around 10% provides reassurance that the profits are real. The company promises to pay out 70% of earnings as dividends
  • Other metrics less useful because of complexity of life company accounting. The difficulty in understanding is a negative. But around 40% of the share price is covered by cash and the minimum solvency margin is covered more than 10x, so as far as I can tell it is a strong financial position
  • Broker research – several detailed notes by analysts whom I respect with positive recommendations and prices targets well above current levels
  • The CEO is 80 years old and owns around half the shares = bid possibilities in the medium term
  • 50% sales in dollars, so current USD strength helps

Hygiene factors:

  • Debt? – none
  • Management rem – ok
  • Buy the glitch: look to take advantage of profit warnings, demotions from indices, mistaken sector read-across, bid failures and other temporary problems
  • Structuring investment ideas – core thesis (one or two sentences), a few secondary factors and then checks on hygiene factors (due diligence searching for problems)
  • Be clear on your thesis. After a certain point, additional inputs to a decision may not improve its quality
  • Investing is a game with negative scoring – you win by avoiding mistakes

 

Highlights of various key sections

 

  • Vernon on where to find ideas
    • Index demotion, when a company is demoted from a stock market index, say the FTSE100 or FTSE All-Share Index, because its market capitalisation has fallen below the lower limit for inclusion in the index. This can lead to the share being indiscriminately sold by index-tracking funds and other investors who arbitrarily restrict their investment universe to companies included in a particular index. But the reasons for the company being demoted from the index are in the past. If prospects have improved, or at least stopped getting worse, the indiscriminate selling may be an opportunity to buy a substantial volume of an unpopular share at a low price.
    • mistaken sector read-across, which involves not an individual profit warning but a whole market sector falling out of favour; a particular company is wrongly perceived by casual observers to be suffering problems similar to other companies in the sector
    • bid failure, where a takeover fails to complete. Typically in a takeover situation a significant fraction of the shares of the target company will be held by hedge funds and other arbitrageurs, who have bought after the bid announcement hoping to make a small near-certain ‘turn’ in a short time (equivalent to a high annualised rate of return). If the bid fails, the share price will usually fall sharply, so that the arbitrageurs suffer large losses and the original rationale of their investment has disappeared. In these circumstances the arbitrageurs will often sell without reference to the longer-term prospects of the business. If they have suffered large losses on borrowed money on the failed bid, they may be forced sellers
    • “People say that profit warnings tend to come in threes. I’m not sure about that, but it is true that problems often continue for some time.” Although it is not necessary, nor even advantageous, always to buy quickly after a profit warning
    • The time window for buying can also be lengthened when company management, noting that the company is out of favour, shade discretionary accounting decisions so as to bring forward bad news from future periods – for example by writing down goodwill, or making full provision for doubtful debts – so that financial results in the future periods can then be unencumbered by these problems. This is known as ‘kitchen-sinking’ the results – throwing in all the bad stuff, even the kitchen sink. Vernon often cheerfully takes advantage of the gloom in such cases to buy cheaply. “Provided I am confident about long-term recovery, a further dose of bad news often helps me, because I accumulate more shares cheaply. That’s the misanthropic part!

 

  • Vernon on buying the glitch
    • This progress was clouded by a glitch – a legal dispute in 2002 in which a Polish subsidiary issued more shares, so that the UK company lost control of the business in Poland. For much of 2003 and 2004 the share price was a tiny fraction of the possible value if all or even just part of the Polish business was recovered.
    • “The key point was that the legal dispute was always likely to be resolved by a compromise, although the timescale and exact terms were unknown. In the meantime, the Polish business was growing exponentially, so even if only a modest fraction of the value was recovered, that would be many times the market capitalisation of the UK company.”

 

How does Vernon find glitch stocks? One starting point is alerts on stock market news websites for relevant phrases such as ‘below market expectations’. Scanning lists of four-week and 52-week ‘new lows’

 

“Hygiene” factors are potential catches or deal-breakers – matters that cannot provide positive reasons for buying the share, but which might put him off buying if they are sufficiently negative. For example: excessive director remuneration, the chief executive’s bad record in a previous business, a sinister disclosure buried in the notes to the full accounts, credible negative comments posted on a bulletin board by a disgruntled employee, etc. Checking hygiene factors is in the nature of due diligence work – broader investigation around and beyond the core thesis and secondary factors, searching for hidden problems

 

One of his rules of thumb is “when it doubles, always sell some”

Another rule is “when it’s tipped, sell some”

 

For organising his work he keeps a file on each holding, and writes lots of notes, which he keeps mainly electronically. “The notes are not important in themselves, but they help me to maintain mental consistency over time. They are a stabilising influence when some news comes out which might tempt me to trade impulsively.”

 

“keep several competing ideas or insights in your mind in parallel, accepting uncertainty for long periods, and choosing between them at the last possible moment.” He calls this operating with “multiple mental models”

 

He recognised an important paradox about small companies: they are less well researched, and yet easier to research. Compared to larger companies, the accounts are simpler, the directors are more accessible, and the business can usually be explained in a sentence or two. The resolution of the paradox is liquidity: for most institutional investors, it is not worth researching a smaller company, because even if the research shows it is cheap, only a small investment could be made. But it is worth researching for private investors.

 

He closely monitored sales at each of the company’s sites. “All the developments and the details of available units were on the internet. Across the family, we had half a dozen mobile phones. So I developed a programme of periodically ringing the sites, posing as a potential buyer in a variety of names, and gleaning what I could on sale numbers and prices, and how many units were left on each site. I knew the names of all the sales agents, and I kept detailed notes on every enquiry I made.”

 

He undertakes detailed research on current business levels at all his larger investee companies, at a level which is probably more detailed than the one or two City analysts who typically follow a small company. He often telephones sales staff seeking information as a potential customer, for a “school project”, or with some similar pretext for assessing current levels of business. He summarises his objective in these calls as follows: “You can’t always get an inside track, but you often find someone who lives near the stadium.”

 

Why does an extreme under-valuation like this arise? Usually because of a distressed seller, combined with institutional neglect of small-cap companies. In Union Discount’s case, a Greek investment company had bought a stake intending to make a full bid, but had run into difficulties with unrelated internet investments and so had become a distressed seller.