Thrifty 30 Portfolio
Dec 5, 2011
Richard Beddard
6 Comments

Frustration

One month in the life of the Thrifty 30

November was such a frustrating month. Every new idea crumbled into dust. The result: £7,500 of the Thrifty 30 portfolio in cash and one demoralised investor.

I started with high expectations. The addition of Smith & Nephew would be a departure. Valued by the market at £500m, it’s ten times bigger than any the companies in the Thrifty 30. It’s also expensive, trading at nearly three times book value.

Investing in a company like Smith & Nephew requires supreme confidence in the business, because it must remain highly profitable to justify its price. Assuming the accounting value of the company is accurate and we require a 10% return, we can say that a company must earn a return on equity of nearly 30% in a typical year to be worth paying three times book value.

It’s possible. Smith & Nephew’s median return on equity over the last ten years is 28% and it’s a market leading supplier of endoscopy devices used in minimally invasive surgery and devices to manage wounds like pressure sores. Its biggest division supplies replacement joints, like hips and knees, a competitive but still lucrative market. Since its products are targeted at the elderly and people with sports injuries, it has growth credentials.

Although Smith & Nephew is having to cut costs and relocate manufacturing to low-wage economies to stay competitive, the resulting concern of investors, might, I hoped, be an opportunity to buy shares Warren Buffett style, in a great company at a fair price.

But it failed at the final hurdle; free cash flow. Profits are adjusted and can vary dramatically from the amount of money that flows into a company’s bank accounts in a particular year. Over long periods though, the differences between net profit and free cash flow should roughly even out as, for example, the cost of plant and machinery bought in one year is depreciated, deducted year-by-year as it is used.

In fact, Smith & Nephew’s median free cash flow return on equity (13%), although improving, is far lower than the 28% accounting return on equity and although my measure underestimates free cash flow, published accounts rarely contain all the information required to calculate it, the size of the discrepancy is sufficient to worry me.

I’m also nervous about profitability at three other stars of the ‘naughties’, shipbrokers Clarksons and Braemar Shipping Services.

I don’t usually allow the parlous economy to put me off an investment, often that’s why shares are cheap, but the 2000’s was a period of unprecedented globalisation fuelled by Chinese production and Western consumption that in turn fuelled a huge boom in shipping.

It seems most unlikely the next decade will be as profitable for shipbrokers. Their profits are already under pressure as a glut of ships forces charter rates down and makes shipowners and shipbuilders more cautious. History shows that down swings in shipping can last decades, which would test even my patience. That said, Braemar is encroaching so deeply into bargain territory that the new reality may be factored in the price.

And that’s really the positive ending I’ve been searching for as I’ve been writing this depressing dirge. They’re all good companies, so time spent researching them now is not wasted. They may not be cheap enough to add to the portfolio today, but they probably will be one day, and if that’s the case, the payoff is merely delayed.

111201T30performance

111201T30portfolio

6 Comments

  • George Ladds December 7, 2011 at 4:37 pm

    Rather than writing a blog perhaps you can deal with your frustrated customers – check out twitter and the web.

    Reply
    • Richard Beddard December 7, 2011 at 4:48 pm

      Hi George, I’m afraid writing is my job! But we have people who can help frustrated customers. Details here (telephone and email): http://www.iii.co.uk/help

      Reply
  • Monevator December 10, 2011 at 12:05 am

    I could imagine shipping holding up in terms of volumes increasing, and even perhaps a bit more two-way trade. I don’t see globalisation ending anytime soon, and plenty of countries are still not plugged into trade like we are.

    The real worry is probably over-capacity. If shipbuilders and shipowners are cautious, that might be a blessing in disguise?

    Reply
    • Richard Beddard December 14, 2011 at 11:39 am

      Hi Monevator, well you’re probably right about globalisation. I don’t know! It’s over capacity I fear and the fact that even during the phenomenal global growth since the second world war there have been decades in which shipping has been a very difficult industry for investors due to overcapacity. Unfortunately I don’t have data going back far enough to understand how sensitive the profits of ship brokers are to freight rates, but they somewhat. I suppose more cautious ship owners and ship builders are the first sign of a more rational market, but I think it can take a long time for that to translate into the demand for charters matching the supply of ships. As I understand it new ships are still being added to the supply, commissioned in the boom years (or at least that’s been the case until recently)!

      This is essentially my difficulty with property companies, and mining companies too. They cycles of boom and bust are so long, if you get your timing wrong it could be a decade or more until you get your money back and if it’s a particularly strong down cycle companies could go to the wall in the mean time. I’m thinking the rational thing is to wait until the shares trade at well below book value, which rather begs the question; why aren’t I adding housebuilders now!!!!

      Reply
      • Monevator December 21, 2011 at 11:27 pm

        I think you have to be looking at housebuilders if you’re a value player personally. If only to reject them if it comes to it, but they’re fully smashed up, have raised capital via rights issue and asset sales, and I think they’ve all returned to modest profits now.

        They have arguably already gone through the trough, in other words, second recession notwithstanding. And at least they’re being rated for some trouble ahead.

        Reply
        • Richard Beddard December 22, 2011 at 9:04 am

          Hi Monevator. I agree with all that and I think you’re helping me come to the point where I reject them! I’ve just extended my fears about the ‘deep cycle’ for housebuilders in response to another comment on another post, here: http://blog.iii.co.uk/the-full-spectrum-of-value/#comment-3768

          So I won’t repeat myself here. It could be bullshit – it’s just the way I’m thinking at the moment, and it’s very helpful to see what other investors like you think.

          Reply

Leave a comment

Comments

RB on Twitter

Latest posts

Sections

Companies

AGA AIE AIEA ALG ALU AMR CARL CFX CGS CHW CTO DCG DPLM DTG DWHT DWN EDD FCCN FDL GAW HDT HOME HYNS IGR ITE JPR JSG LDSG MAE MRX NAR NTG OPD OPE PDC PRV QDG RM SN SSP TNI TON VCP VLK VP

Archives

Blogroll