Where Do I Get My Investment Ideas From?

30th Mar '13 by CantEatValue

31 comments 19811 reads

I've recently been thinking about my sources of investment ideas and how that's changed over time. Given I'm not a full-time investor time is a big constraint when it comes to finding good ideas given a lot of my time goes in to researching existing positions and checking and re-checking my current thesis. When I first started, I got essentially 100% of my ideas from two sources: The Motley Fool UK message boards and anything that came up on my share screener results. I used to use the Sharelockholmes screener but the new Stockopedia one is just brilliant - they have a selection of pre-prepared screens but you can customise and save your own so I've got plenty looking for things like negative enterprise value, low EV/Sales, low P/B & high 5y ROE etc.

As I've learnt more about investing I've slowly added more strings to my bow and now I get ideas from a much wider range of places: Blogs, twitter, bulletin boards, stockopedia, newsletters, company presentations, email contact and more. It's incredible the amount of ideas I have access to from a wide range of investors and a testament to the power the private investor can have in the internet age.

Right now I find I'm using blogs more and more as a great way to find initial ideas. I've got round to adding a 'Blogroll' to the site which contains all the investing blogs I regularly read - I recommend taking a look through them if you're interesting in finding more ideas from other investors (predominately small cap value investors, but there's a few others in there too) who are frequently far better than myself. Even if I don't find myself agreeing with the author's thesis I always find myself learning something so it's a great way to develop as an investor.

You may have noticed a fair few non-UK blogs in my blogroll (especially a number of US investors) and also noticed a distinct lack of any non-UK listed investments in my last portfolio update. This is not because my international counterparts have failed to convince me of the merits of their markets but, I'm embarrassed to say, largely a failure of my own investment process.

In the UK market I subscribe to two services (Stockopedia and Sharelockholmes) which together allow me to quickly investigate a company's financials within minutes and form…

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About the Author

CantEatValue

Premium Member

Part-time private investor predominantly in micro-cap UK equities or anywhere I can find inefficiencies.

31 comments

Mark Simpson

2nd Apr '13

CEV,

Thanks for the detailed reply.

Re: Cineworld (LON:CINE) I think the stockopedia figures for 2007 include an exceptional gain from the sale of a cinema chain prior to listing so you should probably take 2008 as a starting point and c8% EPS growth pa. This has been lower than you might expect given the recent capex however this is primarily because the recent capex has been necessary but lower return items (digital projectors - where the deal they signed had a 7 year payback via studio rebates so a ROCE of 15% - not including benefits such as reduced storage, handling and projection staff) whereas going forward capex will be focused on new cinema openings which should drive higher EPS. All dependent on the film market though where the strength of the studio releases can have a big impact on net results. And Cineworld (LON:CINE) have just completed an acquisition themselves which clouds the figures further.

Re: Judges Scientific (LON:JDG) vs Buffett - I'm not doubting the quality of Judges Scientific (LON:JDG) management and their investment skill just the price that you are currently paying for that:

BRK trades at a P/B of c1.3, Judges Scientific (LON:JDG) trades at a P/B of c8 according to stockopedia figures. To me the nature of Judges Scientific (LON:JDG) growth is mainly acquisitions not organic growth so they should be valued more like an investment company than an operating company (discount or premium to BV) or on a steady state P/E ratio not a growth one. I simply can't bring myself to believe that there are all these companies who are generating great cashflow and have great prospects who are lining up to sell themselves to Judges Scientific (LON:JDG) for much less than their true worth so that Judges Scientific (LON:JDG) can continue to deliver such high EPS growth.

Cheers,

Danger

Miserly Investor

2nd Apr '13

Hi Boros,

At present I would usually identify the historic goodwill write off by going to the goodwill/intangibles note in the annual report which will split the net amount on the balance sheet between cost and accumulated impairment.

I wonder if Stockopedia could do the same for goodwill/intangibles as they do for property, plant and equipment in their balance sheets, where they show the split between cost and accumulated depreciation - see here for example:

http://www.stockopedia.com/share-prices/vodafone-LON:VOD/balance_sheet/

The only goodwill that this won't capture (as far as I am aware) is the very old stuff prior to the change in accounting standards when you could write it off directly to reserves - although that won't affect the more recent history. Mucho kudos to some companies such as Pearson (LON:PSON) who even dig back out such previously unrecognised goodwill in their calculation of ROIC! (They also ensure it is an after tax ROIC which not all companies do, but that's another story).

marben100

2nd Apr '13

Hi Danger,

BRK trades at a P/B of c1.3, Judges Scientific (LON:JDG) trades at a P/B of c8 according to stockopedia figures.

Trouble is, as I pointed out implictly in my last post, "book value"* for Judges is meaningless! Book value represents past sunk investment (not a particularly useful metric anyway - except for judging whether management has invested wisely) less extensive amortisation over the years. A small amount remains for tangibles, but the beauty of the businesses Cicurel invests in is that they are not capital intensive - so book value will always be small.

IMO a more sensible way of valuing the business is to look at operating cashflow - a decent measure of what all the acquired businesses are actually earning investors. That stood at £4.66m - from which a minority interest shown as £0.44m in the P&L should be deducted, leaving £4.22m (up from £3.2m the previous year), which puts the business EV on a cashflow multiple of 17.4.

Certainly not cheap but not outrageously expensive either, if one presumes decent organic growth - which is indicated by the outlook statement in the 2012 R&A. I'd certainly be reluctant to buy at these levels but, having topsliced along the way, I'm happy to stick with my remaining shares being one of my larger holdings and see what DC can achieve. Would also be very happy to top-up at lower levels if the SP fell significantly on sentiment alone.

*Book value makes sense for an investment business that reports a "carrying value" for its acquisitions (e.g. HgCapital Trust (LON:HGT) ). Judges does not do this, so book value cannot sensibly be used as a valuation metric in this case.

Cheers,

Mark

marben100

2nd Apr '13

PS would like to correct another misapprehension re Judges:

The nature of their acquisitions means that there is little synergy between businesses

Let's take a look at their last 4 acqusitions:

A) Sircal:

...The two vendors were among the founders of Sircal in 1981 and since 2004 have been its only employees. It has been agreed that they will assist Judges during a three-month transition period while the business is transferred to FTT's premises, where it will be operated by the FTT team. Judges Scientific will not assume responsibility for Sircal's existing premises.

[FTT being an existing Judges business]

B) Deben - yes, a new standalone business

C) KED:

KED is based in Toft, Cambridgeshire and, like Deben, designs and manufactures accessories for electron microscopy. Management intends to transfer KED's business operations to Deben's premises in Woolpit, Suffolk, and all of KED's employees will be offered the opportunity to continue their employment at Deben.

D) GDS - another new standalone business

Also worth noting from the latest AR:

Planning permission was obtained to develop the Stonecross site in Laughton, beyond the area available at the time of its purchase, and construction is now under way. On completion in 2013, the businesses of UHV Design and of both Quorum locations will be consolidated into one factory, allowing us to improve Quorum’s operations and profitability. UHV Design will benefit from the additional space it has been lacking following its rapid growth of recent years.

So, yes, some of the acquisitions have been stand-alone but others have been suitable for bolting-on to previous acquisitions. There are certainly manufacturing efficiencies that the consolidated businesses can obtain and administrate overheads can be reduced, leading to improved profitability, as has been seen.

Cheers,

Mark

Mark Simpson

2nd Apr '13

Hi Mark,

I agree that book value doesn't fully capture the value of the business if, as the accounting rules seem to require, that even sustainable intangible assets such as customer relationships are amortized. For the avoidance of doubt I wasn't suggesting that exactly BV/share was a fair price for Judges Scientific (LON:JDG) just that even with amortization of intangibles 8x seems a hefty price to place on the non-balance sheet assets of the company.

To some extent this comes down to the age old value-investors paradox of how much value do you place on having asset backing to protect the downside (and mitigating the risk that others can muscle into your markets with little capital) and how much do you value capital efficiency (with the risk that the intangible assets of these sort of business tend to be the type of assets that walk out of the door each evening.)

I guess this is why we all focus on ROCE, it's various derivatives and its relationship to sustainable competitive advantage. Which brings me back to Judges Scientific (LON:JDG), where although you show that they do utilize shared facilities between business there doesn't seem to be any significant network benefits that would constitute additional sustainable competitive advantage.

In order to hold shares in a small cap company with the challenges of illiquidity, lack of diversification etc. then you must feel they are undervalued with a fair margin of safety, say 50%. When that company grows primarily through acquisition but without significant network effects in order to attribute that company with a growth rating you must feel that the acquisitions deserve a growth rating. However Judges Scientific (LON:JDG) are paying value multiples for the companies they buy. Does a company's value really increase 2-3 times the day Judges Scientific (LON:JDG) become their parent? Are these companies so undervalued that when Judges Scientific (LON:JDG) buy them and their earnings stream is now worth 3 times as much as they were the day before they are still undervalued by 50% to make it worthwhile you holding shares in the parent?

If this is really the case then surely they are going to run out of distressed sellers who are willing to sell their businesses for less than 25% of their true value?

Surely it makes more sense that a fair value for Judges Scientific (LON:JDG) is a slight premium to the multiples they are paying on recent acquisition earnings + a rating reflecting the underlying growth of the non-acquired businesses x non-acquired earnings and in order to continue to hold the shares one should be looking for the SP to be at a discount to this figure.

By way of comparison when I do a Stockopedia screen for companies that have a OCF Yield < 5.7% (equivalent to your 17.4 x OCF) then you get a lot of property companies (who are valued on NAV not earnings), companies that have very strong brands (e.g. Reckitt Benckiser (LON:RB.), £SAB), companies with short term OCF drops (e.g. £TLPR) and the likes of (Quindell Portfolio (LON:QPP), Ocado (LON:OCDO), ARM Holdings (LON:ARM), £CPR) (ok I cherry picked these ;-) So not looking that good value to me even in current markets.

Cheers,

Danger

CantEatValue

3rd Apr '13

A lot of points I want to respond to so here's me trying to catch them all!

Strongly agree with the suggestions for Stockopedia to add in ROTA as an extra field (though I'd rather it didn't replace ROA so I can compare them both) as well as displaying goodwill + accumilated impairment to help re-calcs of these metrics (even better if Stockopedia could do a ROIC metric based off these too, to show what ROE would be if you add back any impairment)

Re: Cineworld (LON:CINE) - I was actually using the adjusted figure for 2007 (without the exceptional gain) so I wasn't unfairly penalising them. I also used the higher adjusted EPS for 2012 which also helps boost the ROCE I calculated. My 'ROCE' would be negative if I hadn't made these adjustments.

Given you said they made an acquisition I find this very odd. If, as you say, they can earn 30% ROCE building new cinemas why would they then go and make a lower-ROCE earning acquisition? (I say low based off the total ROCE the company earns now includes the goodwill they've paid for acquisitions before - assuming this acq earns a similar return to all their historical ones) It doesn't make any sense to do so in an opportunity cost sense unless the hypothesis given above that they can't practically just go round building new cinemas and instead have to acquire them (at lower returns due to the premium they have to pay) is true.

Re: Judges Scientific (LON:JDG) again - As Marben points out, BV is a very bad indicator of intrinsic value here and a DCF approach (or rather an earnings multiple - which is a DCF shorthand really) makes more sense. The question then is, does JDG deserve a high multiple? Well, let's examine the two parts of their business (existing businesses and inorganic growth) separately.

The existing businesses were chosen not for any reasons of synergy or need to 'restructure' the businesses to achieve competitive advantage (although, as Marben points out, synergies are sometimes found anyway) but because the businesses already had very strong competitive advantages from being market leaders in very niche areas. If you're the only guy making electron microscope components, you can charge a tidy premium and your customers won't be price sensitive. The businesses are also asset-light and earn high ROTAs so any growth requires little capital investment and the excess cash can be re-deployed to shareholders - and they are indeed growing, JDG say organic growth was 7.5% last year (and GDS's growth rate appears to be much higher, so the new 'blended' organic growth should be even higher). These are very attractive characteristics for any business (sustainable competitive advantage, high incremental returns, decent growth) and so, in my opinion, deserve a decent multiple in their own right.

Then we get on to the acquisition side. Judge's make these acquisitions at low prices not because the buyer is 'distressed' in the usual sense but largely because a) there is no natural buyer at the sizes they tend to do and b) the founders are looking to cash out and retire. If they acquire a business at, say, 50% of what it would be considered 'fair value' then I do think that the excess economic goodwill does instantly accrue to the Judges' shareholders. If someone sells me a pound for 50p, I am instantly 50p richer, whether that pound comes from cash or intrinsic value (the present value of the cash I can take out of the business over its lifetime). Now how much of an extra 'premium' one should pay for Judge's ability to continue with this strategy in the long run is difficult to quantify. As they grow, it'll be harder and harder to find companies that want to sell to Judges at discounted prices and there will be more natural buyers for them. That being said, Buffett has proved that the strategy of offering owner-operators a safe home for their business when they retire which will run it the way they intended (and not to some private equity guys who will run it for short term profit or going public and being forced to run the business in an equally short term manner to make this year's "numbers") at a cheaper price than they could get elsewhere does scale fairly well - and at £70m market cap JDG is some way off being a 'large' company by any measure!

(P.S. I explicitly asked the JDG management when I last met them if their ROTIC (return on total invested capital) metric included the amortised intangibles and they said it did. Make their ROTICs even more impressive! It's also a big plus to me to see that this is the metric they focus on as I think it's the one that makes most sense)

I must admit it's very hard for me to put a multiple on JDG that I think is 'fair' because I strongly value capital allocation skills. Check out my previous post on why capital allocation matters for my reasoning - companies that are great at capital allocation are, in hindsight, hideously undervalued even when on high multiples. The growth rates they can achieve are just so high that they quickly erode even high multiples (check that ROE spreadsheet out I made in one of the previous posts on this thread and have a play with 20%+ ROE businesses over 20 years and work out what multiple seems 'fair' now). I appreciate this is a controversial viewpoint, especially for someone (like myself) who identifies as a value investor, but I'm confident Judges have many years of decent ROCE ahead of them and I'm happy to pay what looks like a 'high' multiple for it. They aren't silly cheap like they were 12 months ago so I've trimmed some as they were getting too high a % of my portfolio but I'm happy to tuck these guys away as part of the LTBH part of my portfolio and sit back and wait five years. Either way it'll be interesting to see how it plays out :)

marben100

3rd Apr '13

Hi Danger,

the intangible assets of these sort of business tend to be the type of assets that walk out of the door each evening

Judges doesn't really fit into that category. Its intangible value/moat is that its businesses are market leaders (or even sole suppliers) in very small niches. It's simply not worthwhile a competitor trying to develop a competing product. The value isn't so much in current staff as in the many years of know-how that went into creating the products that it offers and establishing market presence.

This is evidenced by a gross margin that I calculate at 35% and an operating margin of 21%.

In order to hold shares in a small cap company with the challenges of illiquidity, lack of diversification etc. then you must feel they are undervalued with a fair margin of safety, say 50%.

There is a difference here between buying and holding. As I said, I am not inclined to buy more shares at the current price but, given what DC has achieved in recent years and future potential, I do not feel that the price has become so grossly excessive that I must sell.

The business has good diversity. Though it is all focussed on customers performing R&D and testing, it supplies a diverse range of sectors and is not dependent on a small number of large clients. Poor liquidity and short-term price volatility doesn't worry me overmuch as I am prepared to hold for a multi-year timeframe.

How to value it rests on the investor's personal view of the business's prospects. There you and I differ and only time will tell. :0)

Cheers,

Mark

Mark Simpson

3rd Apr '13

Mark/CEV,

How to value it rests on the investor's personal view of the business's prospects. There you and I differ and only time will tell.

Yes, I think we all agree about the value of good capital allocation and where we disagree is how confident we are in the skills of this particular management to deliver great capital allocation in the future as the business scales up and hence the price we are willing to pay for it.

I think my enthusiasm is also tempered by a couple of personal factors:

1. Past experience tells me that when a company's share price rises quickly this is more often due to fickle changing sentiment than a permanent re-rating due to operation performance of the company. E.g. one you may remember Mark - I thought the rise of Toledo Mining (LON:TMC) a few years ago from £1 -> £5 was because of the operational success of the management. The subsequent fall to 7p said that this was more to do with the short term price of Nickel! This is where your topslicing strategy on sudden rises makes a lot of sense (and is a strategy I've adhered to myself since Toledo Mining (LON:TMC).)

2. It feels to me like the current market is consistently overvaluing high-growth quality companies (those with high predicted EPS growth, high gross margins, highly rated management or all three.) e.g.

ARM Holdings (LON:ARM) - 83xOCF for a company whose product is already in all the smart phones, tablets etc. and is facing big competition from the industry's giant.

Ocado (LON:OCDO) - 25xOCF for a company that has a short term exclusive license to deliver someone elses food with an automated logistics system that isn't really any more efficient than picking by hand, and has never made a profit.

Lo-Q (LON:LOQ) - 33x OCF for a company whose EPS has been flat for the last 5 years.

Parkmead (LON:PMG) - £100m just becasue Tom Cross is on the board.

Monitise (LON:MONI) - £550m for a company that's never made a profit

£ASOS - 75xOCF for a clothes retailer when other retailers trade on 5-10xOCF

Although all of these have some significant positives to their businesses I think their rating means it's unlikley that the DCF of the dividends they will pay out over their lifetimes will exceed their current market caps.

Hence I'm getting more wary about paying for quality at the moment.

Cheers,

Danger

CantEatValue

3rd Apr '13

I actually agree with you on basically all those shares Danger, they all look quite expensive to me relative to their growth prospects! In a relative sense, Judges looks much cheaper IMO. Let's compare using stockopedia's numbers:

ARM: 83x OCF - historic EPS CAGR of 34%
OCDO: 25x OCF - no historic EPS growth as they don't show a profit! Revenue CAGR of 20%
LOQ: 33x OCF - historic EPS CAGR of 32%
PMG: What on earth is going on here? History of losses, horrible share dilution and a giant multiple of book value? This Tom Cross bloke had better be the next Warren Buffett and/or a deity...
MONI: Really hard to value this sort of company...

JDG? 17x OCF - historic EPS CAGR of 50%. Highest EPS CAGR historical growth of them all (out of the ones that have any profits!) and yet on a rating a fraction of the others.

I think you + Mark are completely right though that it comes down to confidence in the business model & the prospects. I don't see JDG as being that risky like your mining example because a) Even during the economic apocalypse that was 2008/09, they carried on churning out growth and profits like nothing ever happened. You know you have a collection of very strong business franchises when they can achieve that. b) The business is internally diversified due to having a collection of different businesses - even if one lost their strong competitive position (which I think is unlikely anyway) I can't see them all doing so.

I understand your aversion to valuation risk though as any stock on a high rating can get 'torpedoed' if one year's numbers don't come in as expected. That being said, I struggle to foresee any scenario where in 5 year's time Judges aren't a much larger company having delivered great value to shareholders.

BrianGeee

4th Apr '13

CantEatValue, in belated reply to your post 6, re Judges accounting.
I'm not too familiar with this Stockopedia BB, so sorry if this turns out to be a mess!

Ref: http://www.gtcyprus.com/App_Directory/CMSEditor/Documents/Publications/IFRS/IFRS_3_Assets_Guide_May_2008%20(1).pdf

As for Judge's, you are correct in that the recent SP movements have been largely driven by a re-rating in terms of multiple rather intrinsic value growth. I don't expect Judge's share price growth from here in to be anything like the rate it was historically because multiple expansion cannot continue indefinitely. However, apart from the multiple re-rating, the rate of intrinsic value growth has been consistently high due to their acquisition policy as well as the growth from the businesses they own. I am happy for the multiple to stop expanding and to only benefit from an appreciation at the rate of intrinsic value growth (which is still very high).

I’m not sure what you’re meaning by “intrinsic value growth”. I guess you’re just talking about adjusted EPS growth.

Given Judge's model is to purchase companies that a) earn a very high return on tangible assets at b) a very low price this means they are capturing a great deal of excess economic goodwill that isn't reflected on the balance sheet, hence balance sheet related valuations I think are a poor value determinant here. I think fully diluted EPS is perhaps the best metric, although with caveats.

I agree that the acquired companies may have a considerable amount of their value not held on their balance sheets, and the pre-acquisition balance sheet may be a poor indicator of value.

A few people have pointed out to me that Judge's figures contain a lot of 'adjustments' and they are (quite rightly, I might add) very concerned whenever they see this kind of accounting. 90% of the time I see adjustments as 'expenses management would rather you didn't look too closely at' and are there to mislead but in this case I think there is a genuine reason for the adjustments and this requires a discussion on the thrilling topic of acquisition accounting to determine. Here goes!

My starting point (as a non-accountant) through investing experience is to treat IFRS accounts as pretty sensible. In my view the percentage trying to mislead is higher than 90%, but that may simply reflect my jaundiced view of companys' reporting and promotion, encouraged by dodgy brokers. Section 7 of the document below doesn’t deal with this directly, rather why companies try to avoid capitalising IFRS intangibles, but it’s similar.
http://www.intangiblebusiness.com/store/data/files/162-IFRS_3_The_First_Year.pdf

The new IFRS rules require acquirers to make estimates for the value of various things like customer relationships, order backlog etc etc and include them as intangibles on the balance sheet. The stupid thing they then do is require the companies to amortise these entries. This is ridiculous and doesn't reflect economic reality. Let me illustrate with a hypothetical example.

IFRS 3 requires the identification and recognition of intangibles if they meet certain criteria, which to me looks very sinsible sensible.
Those assets are then amortised appropriately if they have finite lives. It sounds like you’re suggesting that intangible assets with indefinite lives are being amortised. That’s nuts. Is this something that Judges has said they’re compelled to do? I assume they use IAS 38.
http://www.readyratios.com/reference/ifrs/ias_38_intangible_assets.html
If companies want have the best of both worlds and process the acquisition without creating Goodwill, and then quietly amortise the Intangible but exclude it from the Adjusted (dodgy) Profits, then there’s something amiss. They should at least itemise what they’re excluding and why.

Canteatvalue PLC sells rants about accounting from its eccentric founder. This is a great business as it requires next to no capital to produce the earnings and any growth requires no capital reinvestment. CEV PLC makes £1m in net profit a year and is expected to do so indefinitely. It has no net assets on the balance sheet (due to the founder paying out excess profits) and the £1m profit is equal to the £1m in FCF that the business throws off. Judges find this business and make an offer to the founder for £4m which accepts. Under IFRS rules, Judges adds say £3m of customer relationships to the balance sheet and £1m of goodwill (there's no net assets remember).

That sounds great so far. During the acquisition, Judges should carefully identify what they're actually buying, and attribute a value to it. It will then be identified in the asset register for all worthy Judges shareholders to see the true breakdown of what Judges spent its carefully guarded cash on! Sound fair? All nice and transparent.

Next year, however, CEV PLC contributes zero profit to Judges because the £1m it makes is offset by a charge to earnings due to amortization of 1/3rd of the customer relationships charge. It does, however, still make the same £1m in FCF. Clearly this lack of profit does not reflect economic reality because the customer relationship asset was never a cash cost in the first place - it should just be goodwill, which isn't amortised but tested for impairment.

Very importantly, it either reflects reality, or the accounting is faulty. Surely that has to be the case?
I assume it has been decided that the purchased ‘customer relationships’ have a fair value of £3m, and that value is finite and say erodes in a straight line manner over 3 years. The £1m in FCF is fine, but sooner or later it needs to be invested to replace that £1m or lost CR.

If you’re saying that the CR actually is permanent and doesn’t erode they why on earth is Mr Judges eroding it at £1m pa?
You’re correct to say that Goodwill isn’t amortised, but that doesn’t imply that Intangible assets have to be. It also doesn’t imply that Intangible assets can’t be tested for impairment surely? In fact, doesn’t IAS 36 say that if the intangibles aren’t amortised, they have to be tested for impairment at least one a year?

Now how do you meaningfully test the Goodwill for impairment. It hasn't been broken down helpfully during the acquisition, so you know to what it relates, so it's now more difficult to test it for impairment. At least if it was an assigned intangible, you know better how to judge.

OK, accounting rant over. There's also a second rant I should have about convertible bond accounting but I can imagine faces glossing over so I'll stop (if there is demand perhaps I should actually start that business...). Essentially, I believe that the adjusted, fully diluted, EPS figure from Judges is the best metric off which to base intrinsic value. The only adjustment you might want to add back is potentially the cost of acquisitions, because they are an acquisitive company, but I leave that to the reader to decide.
I’m certainly not an accountant, but my feeling is that IFRS is pretty good, and the rants ought to be directed at the accounting of the companies producing “adjusted” earnings figures.

Given this metric, you can see adjusted fully diluted EPS has risen from 5.45p in 2005 to 73.5p in 2012. I consider this to be pretty outstanding growth. Their business model is simple and largely Buffett-like. They look to acquire quality businesses (by which I mean businesses that dominate a tiny niche market, earn very high returns on tangible assets and show decent growth prospects) at low multiples. The trick here is that they are capturing lots of excess economic goodwill as businesses that show these characteristics should be worth high multiples due to these highly favourable characteristics - this is why intrinsic value per share is growing so rapidly. The businesses they own are, collectively, growing at high single digit rates but require almost no capital to do so and so the excess earnings are re-invested in acquisitions of great businesses at great prices. This double combination of organic and inorganic growth is what is so potent here.

It would certainly be interesting to have Mr Buffet cast an eye over Judges and to hear his comments :-)

Personally, I haven’t looked too closely because what I saw on a cursory view didn’t encourage further effort. I would pay much more attention to the non-adjusted figures, or at least ask the company if they have mis-applied useful lifetimes to the identified intangibles. Why else are they amortising assets that they say have indefinite lives?

That being said, I am not without my concerns for Judges. I think the businesses they own do have strong competitive advantages due to being very niche players in their markets (and this is reflected in the high returns they make) however acquiring cheaply is not necessarily a competitive advantage. Capital is a commodity and especially in a time of low interest rates and increasingly bullish private equity competitors Judges must be having a harder time finding acquisitions that meet their price requirements. So far, they have managed to avoid competition by hunting in the very small segments of the markets that others don't look however as they grow this cannot go on forever. They have some advantage in that now they have a reputation for not 'doing a private equity' and heavily restructuring the business but rather letting them be run the way the founders wanted them to be.

That being said, I simply hope that management show price discipline and can walk away if they don't find anything that meets their requirements now and can wait until the next phase of the cycle when everyone is scared again and then pick up bargains. Like all investing this requires patience, a lot of searching, and the ability to strike when attractive opportunities arise. In the mean time, the businesses they own will still be growing nicely and throwing off lots of cash, building up dry powder for when the environment for acquisitions becomes more attractive.

It will be interesting to see how FCF matches profits over the longer term.

marben100

5th Apr '13

Hi Brian,

Judges answer some of your questions in their report, which states:

In accordance with IFRS 3 Business Combinations, an intangible asset acquired in a business combination is deemed to have a cost to the group of its fair value at the acquisition date. The fair value of the intangible asset reflects market expectations about the probability that the future economic benefits embodied in the asset will flow to the group.

Amortisation charges are included as adjusting items in operating costs in the income statement. Amortisation begins when the intangible asset is first available for use and is provided at rates calculated to write off the cost of each intangible asset over its expected useful life, as follows:

Customer relationships 3 years
Non-competition agreements 2 years
Distribution agreements Between 2 and 5 years
Research and development 5 years
Sales order backlog On shipment
Brand and domain names Between 1 and 5 years

Subsequent to initial recognition, intangible assets are stated at deemed cost less accumulated amortisation and impairment charges.

I'm not sure that the company has much flexibility over the original valuation of these intangibles and their amortisation rate. In my experience of running a smaller business, these factors have to follow "standard practice" which auditors will advise/insist upon, without taking too much account of individual circumstances.

It is notable that maintaining/growing the above once businesses are acquired (except product development expenditure) is not capitalised but forms part of normally expensed sales & marketing activites. You have to form your own judgment on whether the "replacement cost" of these assets is likely to be anywhere near their original acquisition cost. A highly "intangible" factor is also Carmensfella's very long acquaintance with DC, knowing him to be a very conservative, honest & shrewd investor. It's hard to put a value on knowledge of that nature. ;0)

As I've said before, only time will tell.

Cheers,

Mark

BrianGeee

7th Apr '13

Thanks for those amortisation figures Mark.
I've now had a bit more of a think about this issue, and I think it's finally clicked with me why some 'adjustment' is valid.
The IFRS 3 recognition of intangibles on acquisition seems sensible. I like the way all aspects of the business to be acquired are fair value tested.
The amortisation of these intangibles also seems reasonable. Most spend on intangibles often has a finite life.
The problem comes however as the ongoing business isn't permitted to capitalise its own intangibles in the same way. So, for a period, it suffers amortisation of acquired intangibles PLUS expensing of what should be capital expenditure on maintaining the intangible assets.
Of course there are probably some reasons why such internal intangible expenditure shouldn't be capitalised, but since it is on acquisition, why not at other times? As an investor, I know it makes me a little uncomfortable to see such capitalisation, but if we want quality metrics such as ROA or ROE to work correctly, then we need to know the assets in the business. Remember that in the steady state capitalising such costs doesn't have an effect on profits, since amortisation will balance capitalisation. I know it makes it easier again for business to fiddle their profit figures, but until intangibles are properly capitalised, ROA just won't work properly. Remember, just because intangibles lack physicality, they are often no less tangible and necessary than many tangible assets. Management wouldn't spend money on them if they weren't necessary for the business to operate, so they should be recognised as such.

CantEatValue

7th Apr '13

Brian,

Let me reply to each of your points in turn,

As for 'intrinsic value' I define this as the present value of the cash you can take out of the business over its lifetime, discounted at a suitable rate of return that the investor requires given the perceived risk. Now because for most operating businesses this requires perfect knowledge of the future to calculate we have to settle for other methods besides a discounted cash flow model - earnings multiples and so forth. Leon mentioned in an earlier post about how he likes to think of stocks as being like bonds and I think that's a very useful approach as it focuses the investor on the cash generation (the coupon) and then what the company is doing with that coupon (paying it out as a dividend/buyback or re-investing, and if so at what rate?)

For Judges, it is clear that over the past year a) FCF has increased significantly, b) adjusted EPS has increased significantly and that these are likely to be an ongoing increase rather than a cyclical one so my estimate of Judges' intrinsic value has increased.

Back to the IFRS intangible debate, the reason I chose that example of Canteatvalue PLC is because it's a service business for which the intangible value of that service generates economic goodwill that, and this is the critical point, didn't cost any cash to generate. That £1m of profit a year doesn't require any cash outlay in order to maintain it and it didn't require any spend in the first place (all the people who paid to hear my accounting rants found out by word of mouth :)) - if there's no cash spend, there can't be a balance sheet accounting entry for it.

This is why the extra 'charge' to profits from amortisation that happened after the acquisition made no sense, it was reflecting a cash 'cost' that never existed in the first place - hence why we ended up with the bizarre situation where beforehand the business was generating £1m in profit and also £1m in cash (so the accounting is reflecting reality) but after was generating £0 'profit' but was still generating the exact same £1m in cash (the accounting is not reflecting reality).

If, say, CEV PLC spent £1m a year on marketing costs (a real cash expense) in order to maintain customers then this would be a fair charge to profits, however if that were the case then there would actually be £0 cash generation and also £0 profits (a fair reflection of reality) but this isn't the case.

This distortion of economic reality can also be seen in Judges and again it's the cashflow statement that shows the truth. If Judges really reported a 'loss' in 2012, how come they also showed £3.6m in FCF (despite also investing in new facilities to support growth)? The accounting isn't matching reality at all because these charges don't reflect real cash expenses.

I broadly support the intention of IFRS to categorise the various components of goodwill on acquisition (even if I think it is sort of like asking someone who has just spent £1m on a painting to allocate their spend to factors above the book cost of the canvas, paints etc... "Well, £200k of that is due to the painter being famous, £100k to the fact I really like what he did with the goat in the background...") I don't think it actually achieves the broader goal of helping investors understand whether management made a sensible deal or not. I'd rather they forced more disclosure around the acquisition's historical financial performance (rather than just one year's numbers, which don't tell me much without the context of history) as well as what returns on capital they expect to earn under management's scenario analysis - that would be far more useful IMO. The fact they force companies to create these bizarre 'costs' that aren't related to economic reality just confuses the situation more especially for less accounting-savvy investors.

marben100

7th Apr '13

Just for interest, thought I'd do some analysis of just how much Judges has invested over the years, to reach the current level of profits. NB R&D is not capitalised, except where it forms part of acquisition costs. The acquisition costs I've booked include advisors fees. Here is what I found:

£m	CAPEX	Acqns.	Annual Total	Cumulat-ive Total

Opening book value				2.82
2006	0.05	1.05	1.10	3.92
2007	0.04	0.00	0.04	3.96
2008	0.66	0.00	0.66	4.62
2009	0.11	1.45	1.56	6.18
2010	0.12	1.08	1.20	7.38
2011	0.51	3.46	3.97	11.35
2012	0.95	8.06	9.01	20.36

So, I arrive at a total of £20.36m as the total invested, over the years. After excluding D&A and acquisition costs (as those are fully accounted for as capital invested), and allowing for minorites, NPAT for 2012 comes in at £4.13m - leading to a return on that investment of over 20% p.a. Bear in mind that the 2012 figure doesn't include a full year's contribution from GDS.

ISTM that Judges has produced a pretty good return on the investments it has made to date.

Cheers,

Mark

CantEatValue

9th Apr '13

http://greenbackd.com/2013/03/04/how-to-find-high-quality-stocks/

An excellent blog post on quality investing. Another metric I'd love to see at Stockopedia! (wink wink, hint hint and all that ;))

marben100

9th Apr '13

Novy-Marx’s The Other Side of Value paper showed that a simple quality metric,gross profits-to-assets, has roughly as much power predicting the relative performance of different stocks as tried-and-true value measures like book-to-price.

Hmmm.... it strikes me that such a metric is going to favour "people businesses": low tangible assets and high gross profits. I wonder how much that success is skewed by a small number of firms: Microsoft, Google and Apple, which would score highly on that metric? Is there a strong element of survivorship bias?

Once again, such a metric will highlight firms that are doing very well at agiven point in time. The questions investors have to ask are: a) Is the competitive advantage those firms enjoy sustainable?; b) Is their advantage "already in the price". Apple (last year) being a prime case in point.

CantEatValue

9th Apr '13

True, but I think we're similar in that we both use mechanical screening methods to throw up ideas for further screening to do the qualitative analysis the computer can't do, such as your points a & b. I'd use such a screen to generate ideas that show this characteristic (which is associated with above average returns), possibly even in combination with other high return characteristics such as value ones.

Edward Croft

9th Apr '13

Yes - the Novy Marx paper I do have issues with. The whole "How do we quantify quality?" debate is running hot in academia and it seems that whenever someone comes up with an idea that's novel the whole blogosphere gets its knickers in a twist.

To me, Gross Profits / Assets is definitely not the best judge of a company's 'quality' no matter what the backtesting suggests. The whole idea that you can judge two companies before any of their selling, general and admin costs are taken into account is a nonsense and could only have been conjured by someone with no experience of running a business. Some companies have an economic moat entirely based around their sales techniques - including their marketing and advertising techniques.

I haven't heard a single bad word said about the Novy-Marx paper. I have wanted to blog on it, but alas have not had the time yet.

Regardless, what he has shown is that yet again we see that higher quality companies (however you define their profitability or franchise value) in general outperform. One thing that puzzles me about all of this... I really don't know why it should be a surprise that low quality, expensive companies in general are terrible investments... !

CantEatValue

10th Apr '13

Ed,

I agree in the sense that GP/assets can't capture every company that would qualify as being a 'quality' business but I'd imagine a disproportionate number score highly on this metric, especially those that derive quality by having considerable pricing power on their core product (a common form of quality). Looking down the list of my own investments at those I consider to be good 'quality' most would indeed score highly on this metric. Consider a classic example of Reckitt Benckiser (LON:RB.) (which also qualifies for the Buffettology-esque Sustainable Growth screen) - looking at Stockopedia's figures they made £5.5bn of GP on tangible assets of ~£4bn. Compare this with a much more capital-intensive business like Tesco (LON:TSCO) - £5.2bn of GP on tangible assets of £46bn!

Like all these metrics, it's not something I'd consider in isolation or make my sole criteria for purchase, but I believe it is a useful indication of one type of quality and would potentially throw up ideas in a screener worth investigating further.

Murakami

10th Apr '13

Hi, just on that note, we have actually now added the Gross Profit to Assets ratio to the Screener as an option- it's still in "beta" testing but it's now available: http://www.stockopedia.com/ratios/gross-profit-to-assets-5365/

Feel free to give it a go and we'd welcome any comments on it via the Green Button.

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CantEatValue

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Customer relationships	3 years
Non-competition agreements	2 years
Distribution agreements	Between 2 and 5 years
Research and development	5 years
Sales order backlog	On shipment
Brand and domain names	Between 1 and 5 years