Small Cap Value Report (Mon 27 Jan 2020) - Coronavirus, BEG, SFE, HAT, TPG, AMGO

27th Jan '20 by Paul Scott

68 comments 11758 reads

It's Paul here with Monday's SCVR.

Estimated timings: should mostly be finished by 1pm, but I'll carry on writing into the afternoon because I got bogged down in thinking about the possible implications of coronavirus, which I suspect could become quite serious. Fully done by 3pm.

Edit at 15:12 - today's report is now finished.

Red Flag Report

Issued this morning. Click on the heading above (everything in blue is a link, for anyone not aware) to read the latest quarterly report from Begbies Traynor (LON:BEG) - an insolvency practitioner and property services group.

...the number of businesses in significant1 financial distress has risen to 494,000 - the highest number recorded by this research, with the real estate and property, support services, construction and retail the sectors particularly badly affected.

Other points of note;

Q4 was worse than Q3
Not clear if this is due to short term confidence (affected by political situation) or more fundamental issues
Online retail - not immune from sector malaise, with 8% increase in companies suffering financial distress vs last year
Environmental credentials are becoming more important, to attract customers. BEG suggests that fast fashion such as "BooHoo and Primark models could fall from favour in 2020" - that strikes me as far-fetched. I think it's more likely that they continue taking market share from other retailers.
Plus some general waffle about the political situation, which doesn't really add any value.

PMI Data

Released late last week, which comes from IHS Markit. This is a widely followed survey of business confidence, because it's a forward-looking indicator - useful for gauging what share prices might do.

The Jan 2020 report is well worth reading, and only 3 pages long. UK PMI rose to a 16-month high, of 52.4 (anything over 50 is net positive). This confirms what the very bullish Deloittes CFO survey said a couple of weeks ago - that business confidence shot up after the decisive general election result.

The big question is whether this is a relief rally, or whether it has legs?

Fundsmith letter to investors

Of all the reading I did last week (thanks to Graham for holding the fort here!), Terry Smith's 10th annual letter to his investors was the best. I strongly urge readers to…

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Gromley

27th Jan '20

I'm not sure being undiversified is rubbish considering that if you are a business owner with a good business, you will certainly make more money than someone who buys a 'diversified' index.

You certainly will if you have the genius to pick the right market niche and perhaps a little bit of luck to avoid any totally unpredictable black swans.

We each have to play to understand our strengths and weaknesses and play to them, so it always annoys me when someone presents their view as the only way.

I don't actually know much about Terry Smith, but I would just note that if this is the 10th Fundsmith annual report, then it was founded in early 2009? Not a bad time to have started investing in the market really!

Possibly though, not such a great period to let your successes convince you that you are a genius, who is always right,.

Whilst there is actually imho a lot of wisdom in the report, there is an equal measure of self congratulatory hubris. Mr Smith uses the quote "To a man with a hammer, everything looks like a nail".

Hmm given that the last 10 years have fortuitously presented mostly nails to his investment style - I wonder it a it of self-reflection might be appropriate?

Ben1

Very good points. I read something similar supporting your point 3. There has been very little reporting of the fact that it is believed to a very low risk of serious illness to healthy people.

But what is not being reported is that although very many people could be affected, it is not believed to be a serious illness for those that are fit and healthy.

timarr

For several reasons indexes are terrible and that was previously discussed here but I'll just say this; Warren Buffet/Bill Gates/Jeff Bezos/Elon Musk/Bloomberg/Phil Knight/Jack Ma etc etc - and their are many many more - didn't diversify their 'portfolio'

Well, yes. But how many of those people are there? Is that handful of examples the shining evidence of a proper approach to investment or the last gasp of survivorship bias?

I'm not an investment genius or a smooth talking entrepreneur but I know if I can manage 10% to 12% portfolio growth while saving 10% of my earnings over 30 to 40 years I'll have a very comfortable retirement and my children will get a nice windfall when I finally drink my last dram.

Diversification is the closest thing to a free lunch that the markets have to offer, I think it's a real shame that it's given a bad name by a few great investors. Sadly, they're great because they either don't need to diversify or they got lucky. I don't know which, but I know I'm not in the former group and I don't want to trust that I'm in the latter.

greenhat2

Has anyone watched the footage of all the diggers building the new hospital?

It looked like a sham to me. . I mean there were so many diggers, they were getting in each others way!

I reckon this is China trying to spook the US in a 'look at how important we are' kinda way.

'This is what we can do to the markets!' (With a bit of centrally controlled spin).

Tonysaparito

Hello Peterthegreat....I agree with you on Terry Smith but he is not for everyone..interestingly, I followed Fundsmith Equity for several years before actually putting money with him...I was too focused on other areas of investment at the time..which in hindsight was an error on my part.
Terry Smith has a very focused approach as you know , in that he is only invested in about 25 or so fabulous companies and whilst I am in no way comparing myself to Terry Smith , I have made my biggest profits in racing by betting on no more than 20 to 25 gold standard horse racing bets in any one year ...I do have bronze and silver bets and they are more numerous but my stakes on the bronze/silver bets are significantly reduced .
Fundamentally, I take no interest in “ inside information” as it’s the road to ruin...Newmarket is the HQ of racing in the UK and there are more betting shops in Newmarket than any other town...and so many of the punters with inside information are riding bicycles..and will continue to do so.
Inside information is from those most closely involved in the sport but the ‘noise of Newmarket” will lead you astray.
I spend thousands of hours per year, daily sifting through every horse in every race every day....I am looking for horses that meet my criteria , which is based on just 4 factors...Form, Class, Weight and Time..,,only a minute percentage on the horses I look at meet the stringent criteria I set for gold standard bets....When a horse meets the criteria I bet on it.
I know several full time professional punters and they have over 30 years experience like me and they rarely have more than 30 gold standard bets per year.

Terry Smith became attractive to me in that he is happy with what he does, even if many others disagree with him .The fiercely independent Terry Smith has proven over many years of investing , even before he established Fundsmith , “ he knows the time of day’ and his principles of success have made him fabulously prosperous ...and those currently invested in Fundsmith Equity .
Personally, I do not care what anyone else thinks about Terry Smith as his motto of “ Get Rich Slowly” is the motto me and my friends have used for 30 years in our approach to betting.
Most racing punters cannot sit on their hands to wait for 20 plus gold standard bets per year ..but those that do have been loyal clients of mine for 30 years and have made a level of racing success most regular punters only dream of.
I have invested my racing profits outside of racing and have a very nice residual income..
Terry Smith with Fundsmith Equity have averaged annual returns at circa 18%....however, if they halved I would still be happy with Terry Smith

TStubbs

The biggest problem is this is an airborne disease (unlike Ebola) that is killing, mostly the elderly and less well. But it’s the wide spreading potential and lack of antibodies in the world population that is going to make this more impactful than Ebola for example. An infected person might have picked it up despite never seeing a sick looking person. It really could become a big problem in the well traveled and highly populated parts of the world. Who knows? Tyvec, Avon rubber possibly and medical suppliers will do well off the back of it if we’re being brutal.

Thornabian

He made that quote to question his own investment strategy and went on to explain the reasoning for why he won't change it.

It is the same strategy of Charlie Munger over the last 40 years so I wouldn't get too caught up on 2009.....

Try reading the article again.

If you diversify and buy 100 stocks, the likelihood is 40% will be either badly run or in a bad industry at that time. However, you may even get some really cheap and at a 10% discount.

Now, if you take one brilliant business which is a market leader and controls logistics with a great brand and owners who are committed but pay 10% more.

In the first case, that 40% may not make anything or lose money but you might get some a little undervalued and the other 60% may make some ok returns. However, this is now averaged out with rubbish which is providing negative or flat returns year on year.

In the second case, the one business generates 20% return on equity year after year.

Which strategy will generate you greater compounded returns in 20 or 50 years?

I'm not saying only buy one company but also why diversify just for the sake of it?

Nick Ray

28th Jan '20

The mathematical basis for diversification (for those who fancy doing further reading) works like this:

Suppose you have a single stock with mean annual return μ and annual volatility σ which I will write as (μ,σ). The Sharpe Ratio is μ/σ (or (μ-r)/σ if you include a risk free rate r). The Sharpe Ratio is proportional to the probability of a return > 0 in the next year.

Now if you can find N stocks all with distributions (μ,σ) an equal-weighted portfolio of those stocks is (μ,σ/√N) giving a Sharpe Ratio of μ√N/σ provided that the covariance between the stocks is zero. You can see from this simplified case that a law of diminishing benefit applies as the number of stocks in the portfolio increases. The improvement goes with √N so you have to add more stocks than before to get the same amount of benefit each time.

If the covariance is zero then the stocks are completely independent and you have a fully diversified portfolio. In practice this never happens and a more complicated formula is required.

The full formula is the rather daunting (π'μ,√π'Σπ) with Sharpe Ratio π'μ/√π'Σπ where π is the vector of proportions of each stock in the portfolio, μ is the vector of annual returns and Σ is the covariance matrix for the stocks.

You can program a computer to maximise this expression across all stocks in a given market (with the constraint π'1 = 1) to find the highest Sharpe Ratio portfolio - which will maximise return and diversification (hence maximise probability that returns will be greater than zero). This is called mean-variance optimization (MVO) and it takes a computer a few seconds to search through 2000 stocks and find the solution.

However, to be honest, there are so many uncertainties that you will get similar results by choosing the one or two stocks with the highest Sharpe Ratio from each sector (thus forcing low covariance fairly crudely) which even a lowly human can do in a few seconds using a Stocko screen. But the trade-off rule-of-thumb still applies. The benefit to adding more stocks rises with √N and also the the difficulty of finding additional uncorrelated stocks as the portfolio grows.

davidelliott52

Yes, ive got my cynical hat on too. How this is legal I will never know

jwebster

"diversification is protection against ignorance" - Warren Buffett

Buffett is a clever bloke who researched firms in huge depth. He used to call up their suppliers and customers to figure out what you can't see from annual reports. All amounts of scuttlebutt and information edge. He always went for firms he knew a lot about and this gave him the confidence to back the truck up or buy firms outright.

But if we don't know a firm and industry to this level of detail, we are more playing to probabilities and then diversification does work.

Zoiberg

The mayor of Wuhan reports that 5m people have left the city both for the new year and in advance of the lockdown. An infected person on average infects 2.5 other people. What will the authorities do when the virus takes hold in Shanghai and Beijing?

Rustbucket

Yet he has about 100 different holdings and has some really large mistakes fairly recently, Tesco is one and there are a few other that he had very large holdings in. I’m very surprised he even bought Tesco’s.

"Yet he has about 100 different holdings and has some really large mistakes fairly recently, Tesco is one and there are a few other that he had very large holdings in. I’m very surprised he even bought Tesco’s."

Yes, that's true.

His returns in the last few years have been poor, relative to the SPX. I suspect that is a function of size, his AUM is too large now and he sits on a lot of cash. Recently he said if his fund was smaller he could find great opportunities 'again'.

When I was reading about his early days, his returns were good and he appeared more concentrated, I recall one year he loaded 40% into one stock.

His investment pond is too small and too expensive for him to find hidden value now. So he just has to wait for the next market meltdown to deploy billions.

That just gives you the best return of the average, there are many ways to make an average.

That doesn't mean it will outperform.

It goes back to my prior point but this is the common investment ideology now as can be seen from the number of likes for people just following the crowd logic of buying everything in sight. Or in other words, throw mud at the wall and hope something sticks.

Howard Marx

"Despite an over 50% increase in the VIX today it still remains at just 17 so protection is still cheap"

Cheap or not cheap dscollard, history would definitely not favour buying VIX given it's elevated momentum.

As the chart below shows, spot VIX closed yesterday with a14-day RSI above 75:

When VIX did so in the past, its forward returns leaned HEAVILY bearish:

Meanwhile, forward Equity returns (SPX) leaned bullish on all time frames:

Hope this helps.

Data courtesy of SentimenTrader

I'm always conscious of the risk of living in an echo chamber, but I do not think that is the case here and I think you are wrong to identify the balance of "likes" as crowd behaviour.

I think rather you are in danger of creating an army of straw men.

Diversification absolutely does not mean "buying everything in sight".

Early on you made this comparison :

If you diversify and buy 100 stocks, the likelihood is 40% will be either badly run or in a bad industry at that time. However, you may even get some really cheap and at a 10% discount.
Now, if you take one brilliant business which is a market leader and controls logistics with a great brand and owners who are committed but pay 10% more.

You need a time machine to be sure that your "brilliant business" continues to be brilliant in perpetuity. On the other side,you again appear to be assuming the 100 stocks (that's even to diverse for me) is the product of monkey's throwing darts at a copy of the FT.

Picking business with positive investment profiles is not mutually exclusive to diversification.

There have been several times in my investment journey when I have been thoroughly convinced that I have found brilliant investment opportunities. I have not always been right!

In the early days there was an element of arrogantly dismissing the negative possibilities (because I followed the well worn path of starting my serious investing career with a couple of big wins and then developing a god complex).

I am more discerning now (I think & hope) but I still call some wrong, perhaps because of things I could not have predicted.

I am right sufficiently often to make a return and if I had concentrated my investments over the last couple of years into my very best returns - then I would be in San Tropez right now, but there is an equal chance that I would have concentrated into my very worst performers in which case I might be sleeping in a shop doorway.

Extremely concentrated investment is absolutely the way to go if you are a genius grade investor and also lucky.

I don't think I qualify on either front, so I'll stick with selective diversification.

Nothingventured

29th Jan '20

Hiya,

Where can I find the sentiment dashboard?

Thanks in anticipation.

Jim

Small Cap Value Report (Mon 27 Jan 2020) - Coronavirus, BEG, SFE, HAT, TPG, AMGO

Red Flag Report

PMI Data

Fundsmith letter to investors

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Paul Scott

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