Mello 2014 Presentations - My Notes

Thought I’d do a brief write up of the sessions I attended on Friday & Saturday at Mello 2014. These are based on the bullet point notes I made at the time which were the things that stood out to me rather than an attempt to capture the full nature of each talk. Summary & opinions of course are mine not the speakers. Looking back I realise I asked a lot of questions, I hope people felt they were good ones and didn’t feel I unduly monopolised proceedings!

First a big thanks to David Stredder for organising the event which was a big success in my opinion. Being midlands-based it was definitely a positive factor having it in Derby (which was a 1hr drive for me). As someone whose day job means I’m unlikely to ever make an evening event in Beckenham it was great to meet a few familiar usernames in person.

Speakers

Paul Scott – Morning Briefing

After a brief look at the morning’s news Paul gave us an honest account of his market history. I won’t repeat it here but the key takeaways for me were:

- Avoid combining leverage and illiquidity – need the ability to be completely out in 24hrs [edit: added combining for clarity]
- Avoid 100% losses by focus on balance sheet strength.

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Andy Brough – Small and Mid-Caps Are Where It’s At

Andy spoke about his strategy splitting stocks into 3 categories A,B,C. The A stocks were his ideal holds:

• It's about getting an increasing stream of dividends from increasing earnings.
• Biggest gains have come from finding winning business in growing sectors and holding long-term.
• Look at where inflation is its where pricing power is. [This was interesting concept to me that I hadn’t thought about before – the inflation reports are freely available information, inflation represents sectors that are raising prices so outside of commodity businesses (e.g. petrol retailing) this represents which sectors have pricing power = revenue growth = positive operational gearing = earnings growth = positive returns in general. So assuming you don’t overpay for that growth and can pick good stocks in those sectors it allows you to focus where you are ‘swimming with the tide’ not against it.]
• Top stocks - James Fisher and Sons (LON:FSJ), Photo-Me International (LON:PHTM) (Asian market driven growth).

C stocks were ones to avoid:

• Avoid industries that have overcapacity.
• Need to read between the lines in accounts – there’s a lot of spin in underlying earnings.

To be honest it wasn’t really clear to me from the presentation what the B stocks were. My thinking is they may have represented good opportunities that weren’t long term holds – more opportunistic trades but in conversation with others it seems none of us really understood clearly what they were. If anyone did understand this please comment below.

I also wasn’t clear what his buying strategy was. In his presentation he said something along the lines of ‘I’d be a buyer of James Fischer at £11 but not at £12.‘ As a value investor who always seeks a margin of safety of 50-100% vs. my value estimate, that seemed an incredible tight margin to go from undervalued to fairly valued to me so I challenged this in the Q&A. In his answer he seemed to suggest that it wasn’t possible to find that level of undervaluation in the market without buying very high risk companies but didn’t really explain what he was getting at with his original comment so I’m not really any wiser. Overall I think his skill is picking quality stocks that are in growing industries that have the potential to be market leaders and holding those for the long term. With that in mind, for stock ideas I would pay more attention to the fund’s new or increased holdings than to the larger long term positions.

He said his best personal trade of the year was selling Schroders (LON:SDR) and buying Schroders (LON:SDRC) shares (which are economically identical and your vote doesn't matter anyway because the family have enough shares to control the voting anyway) which I liked since I'm short the former and long the latter!

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Gervais Williams – The Future is Small

The main thrust of Gervais’ talk was that his belief that global GDP growth will be low in the future will drive fund managers to seek excess return where they haven’t before and the history of small cap returns will attract increased capital driving further returns. He has a book out soon called ‘The Future is Small.’

Now I have a bit of an issue with this since:

1. Over the long term, whether measured by time period or country, stock market returns are negatively correlated with GDP growth. [Intuitively this seems the wrong way round but like a lot of things in investment it confounds a simplistic assessment. Some of the potential reasons are that, as in individual stocks, people are good at predicting future growth but overpay for it, or that the returns of GDP growth go to new capital in fast growing countries/periods not the owners of existing share capital.] So it is by no means certain that stock market returns will be low even if you accept his argument of slow global growth.
2. I think the small cap effect while real is much smaller than people expect when you take into account transactional costs, illiquidity and correct for survivorship bias. Now it doesn’t need to be real for Gervais’ argument to hold just that enough fund managers believe it to be real, but the more widely it’s quoted the closer people will look at its veracity.

So while I’d love it to be true I’m not basing an investment strategy on it.

He said that he expects AIM will be best performing market in the future. I asked him whether he thinks that AIM needs better regulation before enough people can trust it to drive a bull market, with a follow up question of if he has any screening criteria like avoiding certain NOMADS as some academic research has pointed out that NOMAD quality is a predictor of future returns. His response is that while better regulation may help it was not a prerequisite since professional investors should avoid poor quality companies. He doesn’t avoid specific NOMADs since if they have a poor reputation the company issue may actually be cheaper so he looks for good value over screening out particular companies based on any NOMAD quality criteria. This was a reminder to me that while rules can be good in investing (e.g. I do avoid certain NOMADs’ companies) one shouldn’t become fixated on the rule above what you are trying to achieve.

Overall he says he has a very simplistic process to assessing companies: top line growth, good margins, strong balance sheet and good value.

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Lord Lee (Combined notes from two sessions)

• 2 things for successful investment - common sense & patience
•  Avoid the losses...uses 20% stop loss
• Don't be put off by the spread...think longer term, if you have a 10-bagger you won’t care if you paid 52p or 55p.
• Must have directors owning a big chunk of shares to align incentives
• Avoid leverage
• Dividends are the signal that the company is or will generate significant cash
• Buy when cheap on value metrics.
• Ignore the general stock market level
• Hold for at least 5 years
• Have a good understanding of the nature of the business
• Look for positive director outlook comments
• Cash rich or low debt companies
• Must enjoy investing to do the level of work required to be successful
• Pay fees for ISA from outside of ISA to keep maximum tax free shelter

Mistakes - overrating the people managing the business e.g multiple FD's in a few years means that the management team have serious issues.

Not many shares on the kind of ratings that you could buy in the past e.g. 7xP/E & 7% Yield. Mentioned Vianet (LON:VNET) as current one that he holds that meet these criteria. However generally have to relax your criteria to match low interest rate environment.

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Philip Hayton - What Works For Me

Philip is an explicitly and intentionally Fischer growth investor and sets up screens to look for these companies. In the Q&A it became clear that he starts with very demanding screen criteria but will often relax these to remain fully invested – he doesn’t hold much cash and prefers to sell his weakest holding when he finds a new investment idea.

• Work hard - it pays back
• Running your profits and cutting your losses - takes a long time to be good at it - trailing 20% stop loss is a good principle.
• Use tax shelters as early as possible and maximise contributions
• Bad companies often have a week chairman, if the chairman isn't aligned to shareholders or doesn’t have the strength to hold the board to account then you won’t get a good investment result.
• Selling a share to buy a new one is a good discipline since it forces you to sell your weakest holding.

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Katie Potts – The Failure of My Career

Unfortunately I found Katie’s presentation was the least inspiring of the conference. It focussed on the lack of capital available to invest in start up or growing businesses and the impact on the UK economy. While this is an important issue she didn't really share any solutions and there wasn’t much relevance to PI’s. Relevant comments she did make though were:

• Lack of capital and professional investors gives opportunities for PI's.
• Don't buy more than 5% into a loss making company so you can double up if they need more cash.
• Completely intolerant of companies that are dishonest.

I asked about her transition from a UK focused fund to a global fund, something that a lot of investors struggle with due to language, cultural and accounting differences. Her answer was about the language skills of the staff she hired, a realistic answer for a fund manager but I hoped for an answer more relevant to the PI audience that wasn’t forthcoming.

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Peter Gray – Inside My Kitchen

Peter brought an insight from both his professional life running the Wellcome Trust Investments and his experience as a PI:

Think about what your investment culture should be like. Given your freedom as a PI it should be absolute return, global, risk based, diversified, liquid, based on real assets to protect from inflation, flexible, fee-minimising, long term and leveraging your networks.

For every investment ask - is the return enough, what is the real risk, am I in control, could I sell tomorrow?

Themes for the next two decades:

• Globalisation, urbanisation
• Scarcity: energy, food, water
• Ageing
• The knowledge economy

A portfolio with real and growing cash flows combined with optionality from disruptive technologies should provide out-performance and low risk.

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Keith Ashford-Lord – Manager of UK Buffetology Fund

For me Keith was the unexpected highlight of the event. Unfortunately I didn't watch the time close enough during lunch and missed the first 10 mins of his presentation but this is what I caught:

We want to invest in quality businesses with:

• Easy to understand business model
• Transparent financial statements
• Steady or improving earnings power
• High incremental ROCE & ROE
• Prefer organic growth to acquisition

Value these businesses using FCF NPV and demand a large discount to provide a margin of safety.
Portfolio construction – concentrated portfolio and happy to live with the volatility. [I was concerned with this because I find a lot of people who talk about a concentrated portfolio are overconfident – however during the Q&A Keith revealed that he holds 28 stocks with a limit of 5% which seems pretty much the ideal level for a good stock picker to me.]

Reasons to sell:

• Permanent determination of franchise, growth prospects or management
• If you made a mistake.
• If asset price becomes very overinflated. 
• Weak reason is finding an alternative Investments

Selling purely to crystallise profits is a bad reason to sell.

The best investment you can find is a stable economic business with a high beta so that the share price jumps around. You can take advantage of the market drops to buy a quality business whose business prospects remain the same whatever the share price level.

Top picks are: Hargreaves Lansdown (LON:HL.), Dart (LON:DTG), Liontrust Asset Management (LON:LIO), Spirax-Sarco Engineering (LON:SPX)

I took the opportunity to chat to Keith later in the afternoon since one of my friends had some questions about Spirax-Sarco. He had excellent knowledge of the company and the sector. He also had some tips on how to make sure you buy companies whose incremental ROCE/ROE is high and don’t get caught buying a company who can no longer deliver their historic ROCE or whose market doesn’t allow them to deploy any more capital which was very useful. All in all I got the impression that Keith would be a safe pair of hands and his fund a good place for someone who wanted access to a quality based strategy but didn’t have the time or skill to implement it themselves.

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Leon Boros 

Leon started by sharing with us some background info on the current state of the ISA market . The majority of holdings are in cash and then the majority of the minority of capital allocated to shares is in unit trusts. Only a relatively small amount is directly invested it seems.

Leon then shared his journey to becoming an ISA millionaire from 1993 to the present day. What really struck me was how despite some really high gain years in the early years the lack of capital combined with some big down years meant that the vast majority of his money was actually made in the more recent times, from 2005 onwards. The effect of compounding more consistent positive returns including avoiding the carnage in 2008 by going to 95% cash are what really delivered for him. To me it highlighted that it really does take 10 years+ of consistent dedicated practice to become a good investor but the returns make it worth it when you get there.

Some shares that Leon mentioned that looked worth further investigation were:

• IG Group (LON:IGG); Quality, market share and great cashflow
• LXB Retail Properties (LON:LXB); 20% discount to NBV on liquidation
• Victrex (LON:VCT); High current CAPEX = high future earnings growth?

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Panel session on risk management with Mark Bentley, Katie Potts, Peter Gray & David Stredder

How to protect the downside:

• Judicious use of options to protect against specific risks. E.g. Scottish Independence
• Diversification – Mark Bentley shared how some of the picks he was most confident about turned out to be his worst however that didn’t matter because he was diversified and didn't significantly overweight his 'best' picks.
• Tell tale sign of a company struggling to make the numbers = increasing Days Sales Outstanding
• Other red flags - missed promises, debt
• Hold a big cash balance when scared to avoid making poor emotional decisions.

David mentioned his experiences shorting companies. I asked a question of how he manages the volatility since ridiculously overvalued companies often still double . His advice was to keep it small so you can ride out volatility e.g. he’s been short carpet right for 6 years and only now is it starting to pay off.

And that was it for Mello 2014, hope people found those notes useful. Here’s to Mello 2015.