Small Cap Value Report (24 Apr 2014) - Risk Management, PURI, BVXP

24th Apr '14 by Paul Scott

51 comments 33477 reads

Good morning.

Risk Management

Before looking at individual company results, I must make some comments on portfolio risk management. A share that is very popular with retail investors, Quindell (LON:QPP) recently plunged almost 50% on a new shorters attack by a website called Gotham City Research. I won't go into the ins & outs of that here, as it's neither a small cap, nor something I can comment on at Stockopedia, because I have personally been short of the shares for some time, and indeed have been very bearish in my comments here about the company since 2012.

The reason I mention it though, is my shock and dismay at reading some bulletin board comments about how some people have said that the shorters have ruined their lives, inflincting huge financial damage on individual investors. The reason I am shocked is that anybody could be so reckless, and stupid, as to expose themselves & their families to huge financial loss on an AIM share dropping 50%.

This shows appalling lack of risk management, which is the vital first step that all investors must put in place before they even get started. You MUST have portfolio rules to manage risk in any circumstances, as follows;

1. Diversification - the simplest way of managing this is to set a maximum percentage of your portfolio that any share can reach. Personally I have a 15% rule - i.e. that I keep a running total of all my portfolio on a spreadsheet (which consolidates all positions, however held - e.g. ISA, SIPP, spread bet accounts, etc), and then ensure that no individual share can represent more than 15% of the overall portfolio. This ensures that when (because it is inevitable with small caps) something goes wrong, and your biggest holding drops by 50% on a profit warning, that you can emerge relatively unscathed. With a 15% rule, the maximum you can ever lose is 7.5% of your portfolio, if your largest share plunges by 50% in price. That's just happened to me too, but not on Quindell shares, but on SpaceAndPeople shares. It hurt me financially, but it came nowhere near causing me financial ruin. That wasn't an accident. It was because I had set a sensible rule on maximum position size. So position size is one thing, and diversifying into various sectors…

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intuitive6191

24th Apr '14

Hi Paul

I thought you had a speculative punt on Trap Oil?

cig

Do you know if the balance sheet of Bioventix has been reset during one of the various previous phases of its history? The intellectual property doesn't show up in the assets, so presumably wasn't capitalised, but was it all self funded as expenses, or did previous owner(s) write off some of the capital investment? That would explain the "astonishingly high profit margins" observed by Paul (collecting royalties on gifted capital).

It's a bit odd not to account for it: while intangibles can be abused, it's here a large part of the value of the company (what clients pay for) so having an estimate in the accounts would seem fair.

Also did they consider skipping AIM and listing on Nasdaq directly? Anything with "bio" in the name attracts muppets by the cartload there. Was it too expensive for a small company maybe?

Beginner

Thanks again Paul for being the still small voice of calm and offering some really good advice. I am one of the 'inexperienced, foolhardy investors' you mention. I am trying to change that though.15% in any one company seems an excellent idea, and one I try to keep to. However in two cases I have exceeded this by buying more in an attempt to average down. I actually bought more stock in Spaceandpeople (LON:SAL) and Goldplat (LON:GDP) after they fell because i thought both companies still offer potential, based on simple screening. What do you and everyone else think of averaging down as a tactic?

Avoiding over exposure to any one sector is, I think, a good idea. One faller will often drag others from its sector down, and it has occurred recently with the energy and insurance sectors that government statements impact a whole area.

By and large I have learned, through loosing money, that the resources sector on AIM should be avoided.

I also think that one or two foreign stocks could be potentially profitable depending on currency shifts.But they should be real quality items, not hopeful punts. I opted for £VZ and £CSCO .

I have also split my portfolio into two, with a third in established dividend paying shares, and two thirds out hunting for value and growth.

I never hold more than sixteen companies as this allows me time to follow them in some detail. I also never buy without doing a LOT of reading (which I can luckily do on my shift work!). Mind you I still get caught out!

I should also say I have VERY limited funds to work with (£50K redundancy money), and spotting a bargain and buying it usually means I have to sell to make the purchase. That brings me to a point that i do not think has been mentioned yet: that is, overtrading. I have been tempted too often to ditch shares to buy others that seem to have greater potential. My broker must like this, but I have spent way to much on fees and duty! If you find something decent, sit on it for a while. Investors will out win traders, if they do their homework!

Last of all I have a rabbit's foot: though it did not seem to do the poor old rabbit much good!

Good luck to us all.

Boros10

The development of the intellectual property has been fully expensed or amortised with the exception of around £10k which will be expensed this year. As you say the high returns on tangible assets reflects the fact that the value of the intellectual property is not on the balance sheet. It would not be possible under accounting rules for the Company to capitalise this "value". In any case where would it stick the credit!

If the Company was sold to another the acquirer might seek to attribute some of the goodwill to the intellectual property and amortise that over a period of time.

I don't think there was any consideration of a Nasdaq listing.

marben100

Excellent original article by Paul.

My attitude is guided by the fact that I don't need the amounts I'm investing in order to maintain my lifestyle. So I can take comfort from the fact that if all of my investments went to zero I would live no differently. Yes, I would be upset, but it wouldn't change how I lived.

This is a key point and a pretty obvious one, now you've made it. Paul, Terry and I all depend on our porfolios for our income & well-being. Therefore, our attitude to risk necessarily must be different to someone who wouldn't have a problem with all their investments going to zero. Because we're all reasonably full time, we can also devote the required time to monitor portfolios of ITRO 50 investments - yes, it does take a considerable amount of effort.

However, my own experience has been that my overall returns are improved by taking a more disciplined approach to portfolio diversification, rather than diminished. As others have mentioned, I not only limit the size that any individual position can reach, by topslicing when necessary, but also set specific size targets for groups of investments of particular classes (e.g. high yield equities, fixed interest, real estate, natural resources etc). These size targets are generally contrarian: i.e. I will favour more out of favour classes, and lower my target allocation to "hot" asset classes. Dividing my investments into such classes necessarily means a large number of investments in total, to have sufficient diversity within each class.

Currently, my largest holding (RIT Capital Partners (LON:RCP) ) represents 5% of my total portfolio, but I have two closely related holdings that together represent 5.6% (Doric Nimrod Air Two (LON:DNA2) and Doric Nimrod Air Three (LON:DNA3) ).

Like Paul, I have often been surprised by which investments turn out best, with sometimes those I've considered riskiest being the best performers and conversely being let down by some that I was most confident about. I try to welcome those that point out problems they perceive with my chosen investments, to overcome confirmation bias, but I find that's one of the hardest things to do.

I recommend this excellent article by Tim Richards on the subject of portfolio diversification.

Cheers,

Mark

Hi beginner,

What do you and everyone else think of averaging down as a tactic?

I think "averaging down" is a misnomer... I think of it this way: the price of one of my holdings has fallen. Why? Sometimes the fall is justified (by actual or imminent negative news) but sometimes not. After a fall the investment will (obviously) be smaller than it was before, therefore in terms of diversification rules, you can afford to put more into it. However, to do so, you have to be very confident that your analysis is correct and "Mr Market" is making a mistake. In my experience, sometimes I'm wrong on this... but, conversely, my largest gains have come from buying shares in companies that I know well and the market has incorrectly assessed.

A good illustration was Renew Holdings (LON:RNWH) , which I originally bought @ 56p in 2006, took a nice profit @ 100p in early 2007 but then re-entered - too early - in late 2007 at the slightly lower price of 94p. During the financial crisis the SP declined all the way to the 20p region and I added @ 27p in 2009, then as the company made progress, without gaining market recognition, I added further tranches at 33p, 36p and 34p, giving me quite a chunky holding. The shares today stand at 212p (a little off their peak). I have topsliced heavily along the way, banking nice profits considerably in excess of my investment, but it remains one of my larger holdings as I do not believe the shares are expensive at the current price, in light of the substantial progress the business has made, being 2.8% of my portfolio. "Wins" on this scale outweigh my losses in cases like MBL (LON:MUBL) , where my assessment of the company was wrong and topping up turned out to be money down the drain.

NB I always keep a significant % of my portfolio in cash (currently 9.4%) so that when opportunities arise, I do not have to sell other holdings to take advantage of them. I keep that cash pile topped up with dividend & interest income and top slices of holdings that have either become too large or where I feel the undervaluation has reduced.

Paul Scott

Hi fek47,

I'll bet you a 3 Michelin * dinner that Spaceandpeople (LON:SAL) put out another profit warning in the next 12 months!

I was tempted to take you up on this offer, then realised it's exactly the sort of thing that, as rational investors, we should be avoiding - because it's an emotional response to an investment problem!

I accept that it's possible that SAL might issue another profit warning, we don't know. Equally, it might get back on track and put out a positive trading statement later this year. At this stage we don't know which it will be.

Cheers, Paul.

ChangFai

25th Apr '14

Paul, I remember you telling us you had a small punt on Trap Oil at 10.4p.

What happened ?

Kahledfan

Paul,

I would be interested to hear your views on using Modern Portfolio Theory and the efficient frontier as a guide to diversification? MPT suggests that the benefits of diversification start to diminish beyond a holding of around 15 shares - that the more shares you hold beyond 15 the more likely you are to achieve the return of the market as a whole (everything is mean reverting).

Hence if you are prepared to hold up to 15% of your portfolio in one share that implies that you may only be holding around 7 shares, which sounds like under-diversification. However, given the number of shares you actually write about and from spreadsheets you have let us see in the past I am guessing your holding is actually significantly above the 15 shares efficient frontier (i.e. about 7% of total portfolio in each share).

I would be very interested to know how you go about choosing the number of shares you do hold in your portfolio.

For me this would be very useful to understand as i am now fully invested with last year's ISA and SIPP money and need to invest this year's allocation, which implies a rebalancing of my portfolio. My own portfolio is now at 14 shares and I don't want to be adding many more shares to it

Thanks!

K

superrupededupe

Many thanks for this Mark. I'll read the article with interest.

Rupert

Monty9

£50K is a pretty good stake for a small cap portfolio IMV. And way too much to loose carelessly. I subscribe to a tipsheet "The small company Share Watch" written by Smit Berry (i.e. I pay them not the other way round!). They started a £50K portfolio in March 2001 which is now worth £710K. They publish trades done with each publication including full dealing costs. Divs are ignored (for what that may be worth in a small cap portfolio). Holding period is up to forever but they do top slice a bit. Currently they hold 25 positions - including Quindell net of topslicing so it might be c. £700K today.

I have benefited from a number of their recommendations, but usually sold too quickly, e.g. Photo-me.

Anyway the main point I want to make is that it is possible to produce exceptional performance within decent risk parameters.

I just got bored with TRAP and moved on.

P.

narp

Khaledfan,

You need to read the interesting article by Tim Richards referred and linked to, by Marben, in post 36.

Hi Kahledfan,

I don't follow any portfolio theory ideas, I've just worked out through trial & error what works best for me.

So for my long term portfolio, I hold 15-30 stocks, but weight them very differently. So the top 3 or 4 positions would be between 10-15% of the total portfolio each, so I could quite easily have half my money in my largest 4 stocks. This is because it makes sense to concentrate my money into the best stock ideas. However, you have to put in a limit (hence my 15% limit) to avoid the inevitable mistakes doing too much damage. You also have to make sure that you generally get more stock ideas right than wrong, and that the wrong ones aren't disastrously wrong (which I generally achieve through strict Balance Sheet testing - this eliminates 100% losses, or should do anyway).

I tried out an even more concentrated portfolio approach publicly on a website I set up called SmallCapValue funnily enough! The idea was that I'd got access to some excellent stock screening software developed by an academic, which virtually eliminated the risk of insolvency in individual companies (based on a modern redevelopment of Z-scores). So the idea was to build a portfolio that theoretically contained companies that could not go bust, and then hold massively overweight positions (up to 33% in each stock). That should then outperform.

Trouble was, both the 2 largest holdings unexpectedly warned on profits, and the portfolio performed dismally for a while. Although interestingly enough, it's still going, and has actually recouped all the losses now thanks to one big out-performer (FCCN). Although it was on the back of this experiment that I realised how vital it was to put in a much lower individual position size limit, and I've settled on 15% as being about the right level for me. However, that is after screening out all stocks with weak Balance Sheets, and requiring a track record of decent profitability, etc.

Then I also have a personal trading account, where I do pretty much anything I fancy doing. That can have another 20-30 different stocks in it, which I might hold from a few hours to several years. Anything goes in that account basically.

Overall then in terms of portfolios, the key thing for me is;

1) Making sure that money is concentrated into my best ideas - otherwise you just end up building a closet tracker. If I do my job properly, this usually leads to (often significant) outperformance.

2) Limiting that amount so that no individual share going wrong can do me serious damage.

3) Avoiding marginal ideas, and only going for conviction buys where risk/reward is heavily skewed in my favour.

4) Starting off new positions small, until my research has deepened, then gradually adding to the position if I become more convinced that I'm right. Equally, cutting back or exiting positions where more research makes me realise I was wrong.

5) Keeping a totally open mind at all times, and being prepared to perhaps instantly change my mind, if the facts change materially.

6) Sitting in cash if nothing sufficiently attractive is available at the right price.

7) Balancing up the longs with a few shorts, if suitable candidates appear, but keeping individual short positions small enough to mean they won't hurt me too much if the underlying share doubles. Larger caps are better, as the risk of a massive upside move is less likely).

Regards, Paul.

timarr

As the aforementioned author, just an additional point on Modern Portfolio Theory. It's not just about diversifying to 15 stocks it's about the right 15 stocks: it's about making sure that the stocks aren't correlated such that if one goes down, another goes up. So in terms of risk management this is about minimizing volatility, not protecting total returns. These are very different things.

All too often, I think, people just pick a random bunch of shares and assume that they're diversified. Worse still, people sometimes pick a random bunch of shares in the same sector (oil, tech, etc). I might even go so far as to argue that small cap stocks as a group don't offer the diversification you might expect. At least when the market collapses I can sell my Big Pharma stocks, but try getting rid of small cap companies when there's a liquidity crunch ... There are two solutions to this: (1) make sure you never need the capital invested in shares in a hurry or (2) make sure you diversify across market cap as well as sectors, asset classes and geographies.

But as for MPT: well Harry Markowitz (who invented it) coudn't be arsed to use it because it was too complex, so I can't see most private investors doing so either. Who here really bothers calculating cross-correlations? Otherwise my thoughts are set out in the article Mark references: it's hard to be too diversified.

timarr

Anecdotally, talking to the most successful investors I know, most tend to have fairly concentrated portfolios - i.e. they are experts at picking the best investment ideas in a specialised niche, and they then concentrate their money quite highly in those best ideas.

Although that's not necessarily a good approach for everyone, it's a trait I frequently spot with wealthy & consistently successful investors. They also tend to spend a lot more time & effort on research than less successful investors - who typically flit from one thing to another, doing minimal research.

You also find that many very successful investors have a great sense of smell - they always seem to somehow sidestep trouble, but sensing that something wasn't right about a company. Not always, but usually, as everyone makes mistakes some of the time, it's unavoidable.

One other trait I've noticed with the best investors I know - they quite often just sit in cash, if there's nothing available at the right price, so they tend to side-step big market sell-offs, which has a dramatic impact on long term performance.

Oh, and they rarely buy story stocks, unless we're in a roaring bull market, and then they will just ride the wave, and jump off at the first opportunity.

Hi Paul

Arguably that's a survivorship bias effect. It's hard (impossible probably) to become very wealthy with a highly diversified portfolio so the people who are the most successful investors will tend to be very concentrated. Unfortunately that's a bit like looking at Richard Branson and deciding that becoming an entrepreneur is the way to become a billionaire. It is, but the odds against succeeding are astronomical: we never hear about the tens of thousands of entrepreneurs and concentrated investors who end up bust, it's only the successes that make the headlines.

For the majority of us, especially if we don't have a lot of time, a highly diversified approach built on very focused rules is likely the best approach. We may not shoot the lights out, but we'll not end our days eating cold baked beans and drinking Special Brew on a park bench either.

26th Apr '14

Thanks Mark
This is very sensible, and stated in a way I had never really considered before. Essentially we should consider all our stocks and their related movements individually, and in the light of all the available evidence. Thank you also to all the posters here, from whom I have learned a great deal.

super05sport

27th Apr '14

First day of the 14 day trial so am finding my way around. I'm approaching retirement and through a great deal good fortune and generous tax breaks have built up a sizeable pension which will give me a comfortable lifestyle. I now need to use my time to research my investments better as historically it has been gut feeling and newspaper tips, mostly. I fully endorse your remarks about bulletin boards. Been there seen it and got the tea shirt, wishing I hadn't, but hindsight is a great thing and it's all experience.

evoh_1

28th Apr '14

With regard to Bioventix and the patent litigation they have out, I would draw attention to the company's admission document:

Whilst the Company does not operate under granted patents, the Directors believe that the Company has a significant set of know-how and skills that are unique. The Company may face competition from companies in business at present or not yet established that are or will be better funded, staffed or equipped than the Company. There is also a risk that the Company’s principal target customers (blood testing manufactures) may choose to use alternative antibodies. Competition from any source would adversely affect the Company’s ability to generate income.

http://www.bioventix.com/217431PLUS.pdf

I am invested here and think the company will do well long-term, but feel the lack of patent protection is probably the biggest long term threat to the company. This is over and above the issues with concentration of intellectual know-how if a few individuals within the company. i would be interested to see how they intend to fight a patent without proper protection granted for their intellectual property.

Small Cap Value Report (24 Apr 2014) - Risk management, PURI, BVXP

Risk Management

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Paul Scott

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