1 Oct 2019

At the end of Q2 I wrote that part of my brain wanted to go on an equity buying spree but I wasn’t sure which part that was. It seems to have been the part that wants a quiet life because the FTSE 100 was unchanged over the last three months. The broader FTSE 250 rose by 2.4%, perhaps due to takeover activity. Sterling rose by 0.7% against the euro which is effectively also unchanged. The political noise of the last three months happened in a wind tunnel as far as the financial world was concerned (though that may change, especially if Britain’s MPs continue to risk their own legitimacy). As the global economic news continued to deteriorate government bond yields fell again. The US 10 year yield fell by about 0.25% to 1.75%. 10 year gilt yields dived from 0.86% to 0.55% and the German Bunds now have an even more negative yield (-0.30% to -0.57%). If these are unprecedented scary times, this is the reason. In my recent post entitled “Equities are the new junk bonds” I pointed out that takeover bids had favoured shares in my own portfolio no fewer than four times this year. I have been thinking some more about why this is happening and, by implication, how one might incorporate that into stock picking. Unlike purely financial investors, corporate buyers hate uncertainty. They like to know what they are buying and are put off by the thought of unquantifiable liabilities. This is one of the reasons why companies in trouble are rarely rescued. It’s far easier and safer to buy the assets from the administrator. The new accounting standard IFRS 16 is now kicking in and it invariably increases a company’s balance sheet financial debt – but it removes the uncertainty of obligations to pay future operating leases which were previously off-balance sheet. Now they are there for all to see. A business with reliable cash flow that easily covers its seasonal working capital requirements, its minimum capital expenditure needs and its annual interest payments is potentially of interest and if it is perceived as badly managed that is not necessarily an impediment. If times are tough, one...

13 Jan 2018

The following paragraph is not true. A neat way to value a company is to divide the share price by the earnings per share (EPS) which gives you something known as a P/E (price/earnings) ratio. A low P/E ratio (say <10x) implies that a share is cheap and a high P/E ratio (say >20) suggests expensive. Many people, some of them claiming to be investment professionals or financial journalists, still promote P/E ratios (which came to be the standard valuation method in the 1970s and the 1980s). Here are some reasons why they are wrong. MARKET CAPITALISATION IS NOT THE VALUE OF THE COMPANY The price of a share is a measure of one of a company’s liabilities (the equity owned by shareholders) but not the value of the company. The equity is what is left over after all other obligations have been met. The value of the equity is known as the market capitalisation of the company. EI Group (formerly Enterprise Inns) has 479.5 million shares trading at 143p giving it a market capitalisation of £685 million. Also with a market capitalisation of £685 million is Go-Ahead Group with 43.2 million shares at 1586p. Their earnings per share last year were 20.5p (EI Group) and 207.7p (Go-Ahead) giving them P/E ratios of 7.0x and 7.6x respectively. How cool is that? Are they both cheap and are they almost equally cheap? You will not be surprised to read that it’s not as simple as that. The balance sheet of EI Group reveals that it the business is carrying more than £2000 million of net debt whereas Go-Ahead has £200 million of net cash. Consequently, the enterprise value of EI Group is £2700 million (market capitalisation plus net debt) and Go-Ahead’S enterprise value is just £485 million (market capitalisation minus net cash). On that basis the pub leasing business is worth 5.6x as much as the bus and train operating business. This doesn’t tell us which share is more likely to go up but it gives us plenty of ideas about what might influence their prices. None of which involve reported EPS. EARNINGS PER SHARE Another reason why P/E ratios are nearly useless is that...