For many years, I regularly compared the level of the FTSE All-Share index (ASX), its price, to the aggregate earnings of its constituent firms averaged over the previous nine years.
I was curious to see if this measure could guide my investment decisions. If the market was overheating, I would ease off on buying shares, and hold more cash.
If shares were at bargain levels I’d gobble up equities in the expectation of big profits.
I gave up taking the temperature of the stockmarket a long time ago. My version of the cyclically adjusted price earnings ratio (CAPE) was a blunt instrument.
The market could look expensive, but I would still find shares I thought might be good investments. I felt I didn’t need it. I could tell by looking at the valuations of my own shares whether they were expensive or cheap, and that’s what mattered to me.
This month, I’ve been jolted out of my complacency by a number of signals. They may indicate, in my niche at least, things are heating up.
The performance of the model portfolio I run, Share Sleuth, has been noticed. I’ve written a one-page column about the portfolio in Money Observer magazine every month since September 2009 but, to my knowledge, the first time a letter praising its performance made the letters page was last month.
This month, there’s another letter. And the Share Sleuth portfolio featured on the front cover…
You might think a modicum of recognition, and it is a modicum – after all I’ve had to circle it – would be a cause for celebration.
Every writer wants readers so if the word is getting out, a mini fist pump is warranted. I’ve actually done one – you have to savour these moments.
Magazine covers, though, are often ridiculed gleefully by traders as contrary indicators. In other words, if a business magazine lauds an investment on its front cover, it’s time to sell. If it trashes an investment, it’s time to buy.
According to Wikipedia, the most famous contrary indicator is BusinessWeek’s 1979 cover “The death of Equities”. It presaged the mother of all bull markets. As I writer I may celebrate, but as an investor I feel a little more conflicted.
To be fair to magazines though, I suspect people remember the covers that look ridiculous in hindsight more readily than the ones that look prescient.
This month’s ‘star letter’ writer in Money Observer noted the recognition the portfolio had received the previous month and worried it might be a victim of its own success. Everyone might pile into the shares I write about and they’d all become too expensive to buy.
While I doubt I’m popular enough to make a dent on the market, other investors might be. This thought has been burrowing away at me for a while, and it coalesced on Monday, as I interrupted my portfolio review of Tristel (TSTL) (the subject of a forthcoming article) to watch an interview with Keith Ashworth-Lord, who runs the CFP SDL UK Buffettology fund.
Ashworth-Lord is an impressive interviewee. All the shares he mentioned, picked using criteria modelled on the celebrated investor Warren Buffett’s approach to investing, are either in the Share Sleuth portfolio or on my watchlist.
Nothing he said led me to doubt any of my picks, except one thing…
He said the flows into his fund have been very strong. In 2016, it increased in size from £25 million to £75 million and in 2017 it increased to £205 million.
Although he’s invested the money, largely in shares the fund already owns, cash is building up in the fund.
Buffett is a living legend and in the UK, investors like Ashworth-Lord, Nick Train, and Terry Smith are all you might think a modicum of recognition, and it is a modicum – after all I’ve had to circle it – would be a cause for celebration. Every writer wants the rage. They advocate buying shares in good businesses for the long-term, like I do.
I’d just plugged Tristel’s results into my spreadsheet. The enterprise is valued at about 36 times adjusted profit. Tristel shares are popular. Games Workshop (GAW) shares are popular at 24 times adjusted profit. So is James Halstead (JHD) at 26x, Porvair (PRV) at 26x, Quartix (QTX) at 32x, Renishaw (RSW) at 42x, Treatt at 28x, FW Thorpe at 31x, and XP Power at 29x.
Could my portfolio be a victim of its constituents’ popularity?
There are two kinds of speculation, noted the grandfather of value investing, Benjamin Graham, as long ago as 1958.
There was the traditional kind, where a trader bets a cruddy business will come good, at least temporarily. And there was a new kind affecting strong firms earning high returns on capital and growing profits.
These firms have good prospects and ought to make good investments, but in their enthusiasm traders bid the share price up so high even these firms are unlikely to meet their expectations. In this case, it’s not the business that’s speculative, it’s the price.
Speculators focus on the extremes, leaving good firms at reasonable prices in the middle – unloved and undervalued.
Quoting Ovid, he said “You will go safest in the middle course” (see ‘The New Speculation in Common Stocks’, an address to the Financial Analysts Society).
Making the tough calls
And so to the Decision Engine, the vast collection of spreadsheets that weigh my judgements on the businesses I follow, their simplicity, stability, adaptability and management, against the their valuations. It tries to find the middle course: them to be ‘buys’, the Decision Engine is neutral about the shares in yellow, they’re ‘holds’, and the reds are ‘sells’.
Buy and sell decisions don’t just depend on the quality of a company and its valuation, though, they also depend on what we already own, which brings me back to my model portfolio, Share Sleuth. In the final column, headed ‘Trade’ the Decision Engine is telling me what to do to improve Share Sleuth.
It’s telling me to sell off the shares I’ve lost confidence in, the shares highlighted in red at the bottom of the list.
And it’s telling me to reduce my holdings in FW Thorpe (TFW), Games Workshop, Treatt (TET) and XP Power (XPP), four of the portfolio’s best performing shares, highlighted in orange. These shares have grown to be the biggest holdings in the portfolio, while they have slipped down the rankings due to their increasingly demanding valuations. They’re the most popular shares.
The Decision Engine would like me to invest in System1 (SYS1), Alumasc (ALU), and Vp (VP.), the highly ranked shares that are least well represented in the Share Sleuth Portfolio. They’re highlighted in green in the ‘Trade’ column.
To prevent me from overconfidence (I could be wrong in my assessment of these companies) and overtrading (there’s not much point in swapping one company ranked just above seven for another ranked just above seven), I won’t trade unless one share is obviously better than another.
In practice, that means a share I want to buy must score at least two more than the share I’d sell to fund the purchase. For now, this rule protects the popular quartet, which are still reasonably highly ranked.
The shares are ranked by their scores (out of ten, see the ‘score’ column). Generally speaking, the shares in green are the most attractive, I consider the shares in red are in the firing line.
Additions and revisions
This month I’ve added one new company to the Decision Engine. It’s Haynes Publishing (HYNS), but it’s not looked too kindly on by the Decision Engine. I’ll explain why in a forthcoming article.
I’ve re-evaluated Ricardo (RCDO) (see What makes Ricardo Special?), Solid State (SOLI) (see Here’s who should buy Solid State shares), Alumasc (see Could Alumasc shares be a bargain?), Colefax (CFX) (see Why Colefax will be sticking in this portfolio), Finsbury Food (FIF), and Tristel.
Contact Richard Beddard by email: [email protected] or on Twitter: @RichardBeddard
This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.