London Value Investor Conference, May 2014 - Part 2 - Charles Heenan

This is the second in a three part series of articles from the May 2014 London Value Investor Conference.

Part one, on Jon Moulton's speech is here.

This article concerns the speech from Charles Heenan of Edinburgh-based Kennox Asset Management, who describe themselves as "true value investors". I very much like the approach that Heenan outlined & illustrated in his speech.

Although on checking Citywire for the performance of their fund, it appears to have only been average over the last five years - it is ranked 93rd out of 197 in its sector. Although note that it scores very well for risk, and limited drawdown (9th and 10th respectively out of 197), so I suppose they would argue that they are meeting market returns, but with lower risk, which has something to be said for it.

However, these returns really are nothing to write home about, and if I couldn't beat the sector average over five years, personally I'd go back to the drawing board on strategy. Hmmm, does that undermine the speech too much in advance? Maybe I should move this section to the end? No, facts are facts, so I'll leave it here, as it was still a useful speech.

The Joys of Pessimism

A quirky title for the speech, and Heenan began by quipping that he's been a pessimist from an early age;

I always carried a raincoat as a kid!

So the theme of this speech was all about how pessimism can help you make better investment decisions, and is an advantage in value investing.

He explained how his Fund is long only, unhedged, and concentrated - 29 stocks at the moment - which doesn't sound very concentrated to me. Maybe he meant in terms of weightings? On checking Citywire again, their largest holding is 5.35% in Statoil ASA, then 5.06% in Royal Dutch Shell, 4.75% in Western Union. That may be concentrated by fund management standards, but it's not concentrated in private investor terms - many of the best performing private investors I know quite routinely put c.20% of their portfolio into their top stock - which is why they out-perform, because they concentrate money into their best ideas, and usually get their best ideas right!

Heenan explained how they find cheap companies, then question why the company is cheap. "Can we get conviction?"

Fujikon Industrial Holdings (927:HK)

Heenan then illustrated his stock picking approach, using an example company Listed in Hong Kong. Founded in 1982, and Listed in 2000, it is a family controlled maker of audio equipment such as headphones, microphones, handsfree headsets, etc.

Its market cap is $100m (ie. small - "we look at all sizes of companies").

His approach is then to use a checklist, with key questions being;

Track Record

Heenan looks long term, with the key question being;

Is it s flash in the pan?

Ideally he likes to see how the company has performed over two economic cycles, or longer. With this company, he noted how they have ridden the economic cycle in the past, dealing with problems and emerging stronger after each cycle.

Margin of Safety

i.e. Don't overpay!

We look at a range of valuation measures, the main ones being;

PER - this stock looks cheap, on a PER of 9, although earnings are expected to fall this year to give a PER of about 12.

EV:EBITDA is only 2.5 times for Fujikon, i.e. very cheap! So this indicates the company has net cash, and has good underlying cash generation ability, i.e. with non-cash depreciation & amortisation removed.

PTBV is 1 times here, which gives them comfort about break-up value, in the worst case scenario.

Discount Peak Earnings!

This is the most useful point from this speech, in my opinion, which he expanded on using the example of Coca-Cola.

The problem is that most investors make a fundamental mistake when researching companies, of assuming that earnings growth will continue at the current trend rate forever. This leads to investors overpaying for stocks at the top of the market, i.e. when peak earnings have been achieved by many companies.

The economic cycle then intervenes with a Recession, and company earnings reduce, often very sharply due to operational gearing. This blows apart the valuation assumptions of bulls, and results in share prices dropping substantially.

Therefore investors should be pessimists, and ask the question,

When will growth end?

Accordingly, if you think peak earnings have been achieved, then the pessimist should apply a discounted PER to a share, not pay what the market thinks is a reasonable, or even high PER at the peak of the earnings cycle.

(My view is that this all sounds great in theory, but he didn't tell us how we're meant to know in advance where we are in the economic or earnings cycle! If we knew that accurately, then we'd all be billionaires! Although I do think these are questions that investors should be asking - can a company keep growing its earnings? Will the economy continue growing over the next few years? If we have doubts over that, then we should mark down the valuation of shares, and/or move into cash).

Coca-Cola

This was used as an example of a high quality stock, but which the market priced too highly in 1998. At that time investors buying the stock thought they were buying a business with a great "moat", a long-term compounder, and at a reasonable valuation.

However, the pessimist would have (supposedly!) seen that the company was near to peak earnings, and also peak earnings multiple. Hence the stock was far too expensive. It then took 13 years for the share price to recover to its 1998 level.

(Again, I feel that's great with hindsight, but very difficult to predict in practice).

However his key point is a good one if you can foresee it accurately, namely;

Don't buy at the peak of the earnings cycle.

Dividends

We're huge fans of dividends!

(well, find me a value investor who isn't!)

Back to the Fujikon example - it has paid special divis in good years, so has averaged a 10% yield - impressive.

Conservatively Financed Companies

Again, standard value investing stuff, Heenan likes soundly financed companies;

We like companies with net cash, because bad things happen!

Fujikon has 50% of its market cap in cash, and has no debt.

So, based on its value characteristics, 

We've bought 4% of the company (Fujikon).

Conclusions

The pessimist knows that bad things will happen.

Don't even try to predict the future.

Don't rely on traditional diversification (by geography, market cap, or sector) - instead think about the key economic drivers (e.g. the US consumer) behind a business - then try to invest in companies where the profit drivers are not linked, "so no one bullet can kill all our soldiers".

Unleash your inner pessimist!

Q&A

Q. "I note you are 17% in cash, what's your attitude to cash holding?"

A. 0-20% is our usual range for cash holding in the Fund. We're finding it difficult to find ideas at the moment (May 2014).

(My overall conclusion - on writing up this speech, it's not anywhere near as insightful as it seemed at the time. Maybe it was due to the charisma of the presenter, or that I'm writing it up over a month later, but really most of it is pretty bog standard value stuff.

That said, I really like his point about trying to work out where a company is in the earnings cycle, so thinking longer term, and making sure that you don't end up holding a lot of over-priced shares right at the point when earnings have peaked.

Also, as mentioned at the start of the article, if your Fund has only performed as average over five years, then it's difficult to claim much in the way of insights! Although I do think this solid value approach should mean that the drawdowns in a bear market are likely to be far less for this fund than others. So maybe it will out-perform over ten years?!)

I hope the above is interesting/helpful.

Regards, Paul.