Companies
May 12, 2011
Richard Beddard
9 Comments

Exit Quadnetics

To recap: Surveillance equipment supplier Quadnetics passes all the basic criteria for inclusion in the Thrifty 30 portfolio. Statistically it looks like a good business, with healthy finances, available at a cheap price.

But the Return on Equity figure I use to value the company and judge its profitability is based on the company’s accounting profit. Free Cash Flow, the actual money the company earned excluding what it spent on acquisitions and gained from disposals, was less impressive over the last decade.

2010QDG-FCF

In five of the last ten years, 2002, 2004, 2005, 2007, and 2009, Quadnetics produced near zero or negative FCF (green bars). The company lost money despite recording accounting profits (blue bars) in four of them. 2007, in fact, was a record year of accounting profit and a record year of FCF losses.

That year, Quadnetics used up cash buying a £2m property to expand its Synectics business in Sheffield and financing a £3.8m increase in working capital (money spent on stock and customer credit, less money owed to suppliers). It also bought equipment. In other years, it’s capitalised some of its product development costs, recording them as a depreciating asset on the balance sheet rather than deducting them from profit.

These transactions explain much of the difference between £4m net-profit and a £2.5m FCF loss and they’re not particularly alarming. A company’s cash performance can be lumpy but the accounting measure of profit is supposed to smooth it out and be a reasonable indication of the company’s underlying performance in a single year. If a company buys equipment, or spends money developing it, in one year, it depreciates the cost over many years. Increases in working capital in one year might be offset as the company collects payment from its customers in another (although a growing business will require some increase in working capital).

It’s the margin of the failure of free cash flow to match net profit on average over the last decade that may be alarming. Quadnetics’ average adjusted net profit was £1.9m (average basic net profit was £1.3m), and average free cash flow was less than £500,000. This discrepancy means I don’t think Quadnetics’ past returns are a reliable guide to future earnings. If I plug average Free Cash Flow Return on Equity of 3% into my Earnings Yield calculator I get a return of about 3% for investors instead of 12% when I use Return on Equity. It’s not enticing.

There are two kinds of business in the Thrifty 30, recovering companies like Quadnetics, and hidden champions. Recovering companies are cheap because their managements have made mistakes. I include hidden champions because their managers haven’t made mistakes, but they’re often more expensive. I’m more likely to add a hidden champion to the portfolio if the managers that had a hand in its good performance still run the company. It’s almost a pre-requisite that the managers responsible for a recovering company’s poor recent performance have gone.

2010QDG-ceoJohn Shepherd joined Quadnetics in November 2008, and its previous ceo and founder, Russ Singleton, left the board last year to ‘focus his entrepreneurial flair on a new venture’. The lingering notion that Shepherd’s tenure might be different, less entrepreneurial perhaps, and more focused on profits and cash flows, is encouraging me to hold on to the company.

I like the rhetoric in the annual report. Shepherd immediately restructured the company and developed its focus on complex and critical surveillance markets, like mobile surveillance and systems for oil rigs, where competition from generic surveillance products would be less severe. As a more specialised firm, he expects to be able to reduce overheads, improve profit margins, and expand overseas.

Its legacy Integration and Management Services division is still responsible for over half of sales though and in the final analysis, numbers mean more than words to me.

Quadnetics may well be a success in the future, but my doubts about the quality of its earnings in previous years mean its too speculative to remain in the Thrifty 30. I’m looking for companies that only need to do as well as they did in the past to give the portfolio a good return and Quadnetics must do better.

The Thrifty 30’s done well enough out if it. At the last portfolio valuation the shares had returned 29% and the company has paid three dividend payments too.

9 Comments

  • Nate May 12, 2011 at 1:55 pm

    Richard,

    I really like how you look at future performance, “that a company only needs to do as well as it has in the past”. I believe this criteria was used called out by Ben Graham as well in judging cheap stocks. A company that earned large profits in the past and is currently cheap is a good bet that performance will recover.
    I know I use that as a qualifier when I’m looking at net-net’s, if the company has never performed at a high profit in the past why would I expect it. But a company that earned high profits and is currently depressed is a good candidate.

    Nate

    Reply
    • Richard Beddard May 13, 2011 at 8:44 am

      Hi Nate, thanks for your comment. Yup I definitely got that attitude from Graham! The one exception I make for high past profitability is net-nets and since you are specialising in them at the moment I’m wondering if that’s something you look for? The basic premise of a net-net is you’d get your money back if it went bust (although I wouldn’t want to rely on that if net-nets routinely did go bust) so I allow the extreme value they offer to lower my profitability threshold. Basically, as long as they have been generally profitable in the past I’m happy.

      Reply
  • Nate May 13, 2011 at 12:28 pm

    Richard,

    My general rule with a net-net is to make sure I have a solid margin of safety with regard to assets. I would prefer to have most of the ncav be in tangible assets like cash or receivables rather than inventory. But with regards to profitability the biggest thing for me is making sure the operating business isn’t destroying my thesis as it tries to recover. So generally I want it to be cash flow positive, or FCF positive if possible. If there is no history of profitability at all I will usually stop researching at that point.

    Nate

    Reply
    • Richard Beddard May 13, 2011 at 1:00 pm

      Thanks Nate, that’s a useful perspective.

      Reply
    • blippy May 16, 2011 at 1:30 pm

      Nate,

      What kind of net-nets in the UK are you spotting at the moment? Just housebuilders? Some really nanocap companies?

      If memory serves, Peter Cundill pretty much backs up your requirement that “the operating business isn’t destroying my thesis as it tries to recover”. He looked for a least some real chance that the business will revive itself, because it was too easy for the value to keep going down and down.

      Reply
  • blippy May 16, 2011 at 1:22 pm

    “There are two kinds of business in the Thrifty 30, recovering companies like Quadnetics, and hidden champions.”

    And the key question is: of the type kinds of business that you’ve held in the portfolio, which performed best in terms of price performance?

    Also, how did you find the operational performance of the two types of businesses (let’s call them the “good”, and the “bad”)? Did you find that the good businesses continued to perform well operationally, whilst the bad ones hit even worse speed bumps; or did you find the reverse to be true?

    I’m very interested on hearing your views on this.

    Reply
    • Richard Beddard May 16, 2011 at 3:00 pm

      Oooooooh. Hard, and very good questions.

      The only Hidden Champions I can think of off the top of my head are Dewhurst, FW Thorpe, and Games Workshop (bit of a hybrid that one!) and they’re all doing well. So it’s a small sample in relation to the 20 odd recovering companies (which encompass the best performer (French Connection and the worst Armour – which may not actually be recovering!).

      Regarding operational performance (and price performance really) it’s too early to say. I only expect to beat the market handsomely over five years.

      The Thrifty 30 is basically an experiment to answer the questions you’ve asked! I’m trying to invest in three situations (I excluded net nets – ultimate bargains in the post because it wasn’t really relevant to Quadnetics), which I think of as the whole spectrum of value:

      1. Net-nets/Ultimate bargains – i.e. companies at rock bottom prices where (in theory at least) it doesn’t matter if they go out of business. They’re still cheap relative to what you might get in a liquidation.
      2. Thrifty – i.e. viable companies that are cheap, preferably because of management mistakes, typically they’ve overreached, and with reasonable prospects of recovery back to their long-term average level of profitability,
      3. Hidden Champions – consistently profitable companies that are likely to remain so so long as they keep doing the same thing well, that are priced such that investors might still get a 10% return out of them.

      Maybe after five or ten years of this I’ll decide I’m a net-net investor, or a Thrifty investor, or a Hidden Champion investor, but I don’t think so. There are advantages to doing it this way. Few companies fit neatly into just one category, and there are times when there just aren’t that many decent Thrifty or Net Net companies around. The more likely scenario is I’ll end up with a core of Hidden Champions which I hold for a long long time, and I’ll be adding net nets and Thrifty company’s and removing as and when I can.

      That’s the plan, any way, such as it is :-)

      I’m very interested to hear your views on this!

      Reply
      • blippy May 16, 2011 at 4:27 pm

        Hi Richard,

        Although I have been investing for a little over a decade, I would describe myself as being “mostly asleep at the wheel” during that period. I would typically invest once a year by selling my holdings and buying a new batch. I was mostly into low-PE stocks.

        It is only over the last year that I have taken a more active interest.

        I don’t keep much in the way of records, but I’ve beaten the Footsie fairly consistently – I reckon I’ve made about 7% pa over the last decade, during which time the market has basically been flat. It’s an OK performance, but I’m no Warren Buffett.

        A lot of luck, both good and bad, has befallen me. For example, I bought Cadbury’s a few months before the Kraft deal, and made about 50% on that during the course of 6 months. That’s an amazing return for such a stodgy company. I also bought Amstrad just before it was announced that it was being taken over, so I got a quick return out of that. Incidently, I was attracted to it because it had a good cash position in relationship to its market cap. Another one was Bluebay Asset Management, which pretty much flew out of the gate when it was a takeover candidate soon after I bought in. It was acquired at well over the odds, in my opinion; not that I am complaining, of course. Other lucky breaks was selling De La Rue a few months before its printing debacle.

        I’ve held BATS (Brit American Tobacco) for a couple of years now. It’s been a strong performer due to high growth rate, and I thought of it pretty much as a “no-brainer”. Growth rates seem to be flattening off now, so I don’t think I’ll get similar performance in future. BATS is interesting because it is a well-known company, and I’m somewhat surprised that the market didn’t pick up on it sooner. A fairly stodgy company, but making it amazing just how good returns can be even out of mundane companies.

        Pure bone-headed plays include a quick dabble with Connaught – fortunately I came to my senses on that one quickly and got out at a small loss. HMV was also a poorly-considered purchase by me. Fortunately, I got out last year, thus averting its ever-worsening fortunes. A writer at the Motley Fool got out at the end of last year, which happened to be the correct move, too. I don’t think there are many people who regret having gotten out of HMV. Another company I’m also glad I’m shot of it TCG (Thomas Cook Group), which seems in pretty poor shape. My current disasterous pick is PIC (Pace), which isn’t doing as I expected at all. I still hold; it’s a price versus value thing. Given its price, I don’t think it’s a sell. It’s difficult to call it a buy, either, owing to the deterioration in its position.

        I am increasingly beginning to believe that different phases of the market favour different types of companies. Going into 2008, my value-type plays underperformed the market, whilst in 2009, they crucified it. Since then, things have tapered off. I believe that Neil Woodford may well be proved right that now is a good time to go on the defensive. I think a great pick at the moment would be Morrisons, at a PE of 13, good balance sheet, double-digit expected growth, and good downside protection. It’s not a company in the bargain bucket, nor can one expect it to be a five-bagger in five years, but I think it will do a good job of grinding out the profits.

        A time like at the end of 2008, when the market tanked, was a good time to choose value shares. Just choosing companies on low PE and good balance sheets was a winning strategy. You didn’t even have to have particularly good insights; just buy a selection of shares in different industries and wait. Something like the FT250 with companies with a long track record are likely to be the place to bet.

        It’s difficult to judge how things will pan out over the next year. We’ve had a bit of a bull run, although valuations don’t seem stretched at this point. I do get a sense that risk is being taken off the table, and anything that’s a little bit weak is being punished. This is why I’m quite cautious about “value” shares at this stage, and I think it might be better to pony up for companies with good downside protection.

        Reply
        • Richard Beddard May 16, 2011 at 4:53 pm

          Wow, thanks for the history. I find other investor’s stories fascinating (incidentally that’s why I’m enjoying Free Capital so much, which is essentially profiles of twelve very successful private investors – expect a review shortly).

          I may be in a similar position to you, albeit less driven by top -down considerations. The hidden champions theme is a kind of like defensives. The value’s there, but so’s the quality. But I’m also reappraising each company in the Thrifty 30 as their annual reports are published and getting rid of those companies I perceive are low quality in one way or another (hence Quadnetics and T Clarke have bitten the dust).

          That’s not because I think the market will punish them – I envisage this being a continuous process. I’ll always be trying to optimise value and quality.

          I really appreciate your comments on this blog (everybody’s of course) and despite your ‘unsophisticated’ background, which bears a pretty good resemblance to mine (which no doubt you’ve seen: http://blog.iii.co.uk/about-us/about-richard-beddard/ ), they often inspire me to rethink or clarify what I’m doing.

          Cheers.

          Reply

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