The dash to trash
Posted on May 11, 2009 by Richard Beddard
Filed Under Investing, Markets |
In practice:
Speculation is in the air
What a great Spring. The sun is out, the skies are blue, and unless you’ve been locked away in a bunker somewhere, investors and speculators have produced a remarkable turnaround in the stock market.
Here’s my plot:
The chart shows how we’re prepared to pay for UK shares (main market and AIM) relative to their average earnings over a minimum of five, and preferable nine years.
It’s a measure of sentiment, and value.
For a couple of weeks in March, investors were only prepared to pay eight times the average earning power of UK companies for a share of their future profits. Now we’re paying eleven times.
Back in 2007, we were paying twenty times! In hindsight, the market was expensive then, and investors were over confident, whereas in March, markets looked cheap and investors were nervous.
My policy is to write about value when I see it, and try not to be influenced by sentiment. The two companies I picked for Money Observer’s Share Sleuth column in March (pdf) and April (pdf) vindicated that approach. Carluccio’s (CARL), which may be taken over, and ITE (ITE ) are both up about 60%. Then they sold on earnings multiples in the low teens, now they are approaching twenty times average earnings, my upper limit.
Both companies, I thought, we’re good companies at cheap prices, although I had to convince myself not once, not twice, but three times about ITE. I’m not sure about some of the other companies that have rebounded strongly, though.
Every month Money Observer sends me a list of winners and losers over one month, six months and a year to comment on. Some of the percentage gains this time are extraordinary. Yell (YELL ), for example, rose 218% in April which might lead you to forget that despite its recent performance it’s down 91% over the last three years.
Yell shares are dirt cheap, in fact you can still pick them up for little more than their average annual profits, a PE ratio of one. But the company is awfully indebted, and therefore, I think, not a safe investment.
The popularity of shares like Yell is symptomatic of a “dash to trash”, as James Montier calls it, where the weakest companies do best as speculators throw money at the companies that fell the furthest in the bear market. He published this chart last week:
It shows that among the cheapest companies, the weakest (in terms of financial strength measured by Piotroski’s F_Score ) are doing best in this rally.
In contrast, the long-term is very different. The strongest companies, those with the highest F_Scores do best:
According to Sharelockholmes.com, Yell’s F_Score is a weedy four out of nine, and it’s Z_Score, another measure of financial strength is just 0.81 (less than 1.81 is usually considered dangerous, more than 2.99, safe, in between is the ‘zone of ignorance’).
Montier quotes Bill Hester, who observes that bear market rallies are characterised by violent turnarounds and low volumes, while relatively modest declines with matching rebounds on higher volumes are more indicative of true bear market bottoms. According to Hester’s charts the recent ‘V’ shaped explosion in the stockmarket much more closely resembles the former.
Looking at the kind of companies that have bounced most, I reckon the recovery so far is highly speculative.
Montier thinks it’s necessary to take out some insurance in case this rally peters out, and we face a lower low in the months or years ahead than we saw in March. His idea is to short the kind of stocks that would do worst in a renewed bear market, overvalued companies with deteriorating finances.
He’s hunting for candidates to short from a screen of companies that trade at more than 20 times ten year average earnings, and a low F_Score, exactly the opposite of the companies I write about, and hence exactly the kind of company I avoid.
His UK candidates are Balfour Beatty, Cairn Energy, Cohort, Hardy Oil & Gas, Hochschild Mining, Johnson Matthey, Mitie, Mondi, Oxford Instruments, PZ Cussons, Rotork, Spice, and Ultra Electronics.
To escape the dash to trash, I’ll continue writing about good companies at cheap prices. Here’s a list possibilities that meet my basic Thrifty 30 criteria, shares that:
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The market values at less than 20 times average annual earnings over the last ten years…
Companies that:
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Own twice what they owe (shareholders funds are at least 50% of total assets), and..
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…Have recently published full year results
As usual, the data is from Sharelockholmes.com. I’ve ordered the list so the cheapest companies with the strongest finances are at the top.
And, despite a 28% rise in the FTSE ALL-Share since March, with companies trading on eleven times average earnings there are still plenty of bargains around. I hope to dig a few of them up over the next few weeks.
For more on whether this ‘bull market’ is a bear market rally, and if it is, how long it might last, see the links at the bottom of Friday’s post, under the title ’seven lean years’. Jeremy Grantham’s essay (free registration required) and the interview with Russell Napier in particular
In theory:
Getting a better return on the capital employed by our politicians.
The Pragmatist recommends The Long and the Short of It by John Kay. The book with a lurid pink cover has an important message, which The Pragmatist sums up as ‘Your own your own: Pay less, diversify more, be contrarian‘.
iBall interviews Duncan Bannatyne. He looks for Return on Capital Employed, and he’s not very impressed with the way politicians employ our capital.
In the ‘dash for trash’, newspapers are among the big winners.
Comments
2 Responses to “The dash to trash”
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Hi Richard,
It is a shame Montier does not run a bear fund which specifically targets the ‘bad’ companies you mention above (plus an opposite fund for the good companies). I would certainly want to have some of my portfolio invested in this type of fund
Perhaps a reader knows a fund that officially uses this type of strategy.
Hi Robin, indeed it would be an interesting fund but not being a fund watcher I can’t help you with that one
One interesting snippet from Anthony Bolton’s book (highly recommended BTW) is that the rules have changed for unit trusts like his Fidelity Special Sits. Once long-only, they are now allowed to go short, something he did before he retired. He thinks more funds will be taking advantage.
One of my ambitions for this blog is to run a virtual Thrifty 30 portfolio - which would broadly resemble the long element of his portfolio (low long-term PE, high F_Score) - albeit restricted to the UK.