Anthony Bolton is probably the City’s best known fund manager, having
delivered average annual returns of 20% while at the helm of Fidelity
Special Situations, which he ran from 1979 until the end of 2007. Over the
same period, the market grew just 14% a year.
He has stepped back from day-to-day fund management, but is still head of
investments at Fidelity. He called the bottom of the market in November —
admittedly too early as the FTSE 100 hit a new low of 3,512 in March — but a
growing number of fund managers, including rival Neil Woodford at Invesco
Perpetual, now echo his view.
In this extract from his new book, he gives the key lessons he has learnt from
more than three decades of investing.
1 SEE THROUGH COMPANY SPIN
I always start when looking at a share by assessing the company I’m investing
in. How good a business is it? How sustainable is its franchise?
Often I ask myself: “How likely is this business to be around in 10 years’
time and to be more valuable than today?” It’s surprising how many
businesses fail this test.
Another important characteristic is whether the business generates cash over
the medium term. I am convinced that cash-generating businesses are superior
to ones that consume cash and this has generally given me a bias towards
service businesses and against manufacturing in the portfolios I’ve run.
Regarding results statements, I always like to read them in the original
because managements spend a lot of time on the language and phrasing, which
is often lost in a broker or press synopsis.
Although not all managements will talk about other companies, when they do it
can be very revealing. The ultimate commendation is when a company talks
positively about a competitor.
When they say what you might expect — like business is great across the board
— I’m more sceptical and want, if possible, some form of independent
confirmation. It is not that the majority lie, but there is a lot of “spin”.
Seeing through spin is one of the most important aspects of the job.
Finally, it is worth considering how risky the business model is.
Take Northern Rock. There was nothing seriously wrong with the management or
the business in general (although maybe the bank was too focused on growth).
However, the business was much more wholesale-funded than its competitors
(relying on funding from other banks as opposed to their own depositors).
In most conditions this works. However, if conditions change, as they did in
2007, and the availability of wholesale funding decreases and its costs
increase, this can put the whole model at risk. This is what we witnessed
only too dramatically in July 2007.
2 WATCH THE MANAGERS
In my early years of managing money I might have bought shares in a company
where I liked the franchise but maybe had some doubts about the management
competence or integrity. But not any longer.
In the late 1980s and early 1990s I learnt my lesson with these types of
companies the hard way. Despite the protection offered by outside directors
and independent accountants, if a management wants to mislead investors it
has plenty of scope to do so and can get away with it for many years.
It is very difficult to summarise what makes a good manager and how to assess
this in a meeting, but the managements that normally impress me are those
that have a detailed knowledge of the business — strategically,
operationally and financially. They tend to be fanatical about the business,
working long hours and demanding high performance and excellence from their
team and they are reasonably self-assured and on top of what they do without
being arrogant.
Generally, I like companies where managers have a decent amount of “skin in
the game” in terms of shareholdings (I prefer shares to share options, which
are much more of a one-way bet). Sometimes, when I meet a large company
where senior managers own only a few shares, I have the impression that
their main incentive is the prestige and status (not to mention the perks)
of running a large company and shareholder returns are lower on the list,
despite what they may say.
One of the more important inputs into my investment process is watching
share-dealing by insiders. Every day I get a list of insider deals in UK
companies that ranks the deals by significance.
Some of the most significant deals are when an insider does a different deal
from what I was expecting. For example, the director who buys in size after
the shares have already risen considerably or the director who sells after
they have fallen a lot. Although not common, watch out for such deals.
My recommendation is to invest in management you trust. Warren Buffett said
that he liked to employ or invest in managers he would be happy to see
married to his daughter. I don’t think you need to go that far but the
sentiment makes sense!
3 CAN YOUR TEENAGER UNDERSTAND YOUR PORTFOLIO?
My colleague Peter Lynch said that you should be able to summarise in a few
sentences why you own a particular company’s shares in a way that even your
teenage son or daughter would understand. This is your investment thesis and
you should re-test this thesis at regular intervals.
At all costs avoid buying shares on impulses or tips. Peter Lynch used to
observe that he found it strange that, say, doctors would buy oil-
exploration companies based on tips from friends, newspapers or brokers rather
than invest in biotech companies where they should have a better chance of
being able to check out what is really going on.
Most importantly, you should forget the price you paid for a share, otherwise
it can become a psychological barrier if the share price subsequently falls.
The investment thesis is the key; check it regularly. If this changes for
the worse and the share is no longer a buy and probably therefore a sell,
you should take action regardless of the price being below what you paid.
Luckily, I have a poor memory for figures and seldom remember the prices I’ve
paid for shares (which often comes as a surprise to outsiders).
4 PERCEPTION IS AS IMPORTANT AS REALITY
The longer I’ve been in the business the more I’ve come to rate perception as
being as important as reality.
From a stock-market point of view, we are most likely to be wrong when we all
agree with one another on something. Perception is so important because when
it builds to extremes it can overwhelm the intrinsic merits of a share for
long periods of time.
I spend a lot of time analysing what sectors and companies are under-owned and
unloved by investors and stockbrokers and which sectors and companies are
over-owned. Generally, the risks of owning shares are much lower in the
first category and higher in the second, or over-owned group.
Another feature of the stock market is that it’s very difficult to insulate
ourselves from the price action of individual shares — everyone is partially
susceptible to this. When a share sells at 100p and you work out that 70p is
a good price at which to buy, if the price subsequently moves down to 70p
you will begin to doubt your own calculations. Subconsciously, you start to
think that maybe the seller knows something that you don’t. The price itself
influences behaviour — falling prices create uncertainty and concern, rising
prices create confidence and conviction.
Understanding this is a really important part of investing.
5 DON’T DO TODAY WHAT YOU SHOULD HAVE YESTERDAY
I strongly believe that too much performance analysis leads to a portfolio
manager spending too much time looking in the rear-view mirror and
correcting yesterday’s mistakes by doing what has been working rather than
identifying what will work in the future.
I am often asked about my “sell-discipline”. First, I try to avoid any
emotional attachment to my holdings. There are three main reasons why I will
sell a share: if something negates the investment thesis; if it meets my
valuation target; or if I find something better.
6 SCOUR THE ACCOUNTS
I’ve taught myself to read accounts and become reasonably proficient at
analysing them. Another thing I’ve learnt is to read the notes to the
accounts very carefully. Vital information about a company can be hidden in
these notes (where the company sometimes hopes it may be overlooked).
Although I always like reading the management’s original statements, I put
particular weight on what is said in a market listing or share-issue
document as every statement has to be independently verified.
When I’ve analysed the biggest mistakes I’ve made over the years they have
nearly always been in companies with poor balance sheets.
For a long time I’ve used Company Watch, which calculates an H-Score, a 21st
century version of the Z-Score, for each non-financial company it follows.
To make it possible to predict problems in any company, it compares a large
sample of the financial statements of businesses that got into financial
difficulties in the past (the “failed group”) with those that did not.
Companies are scored on a financial health rating of 0 to 100 with 100 the
strongest. It is very unusual for companies with scores higher than 25 to
experience financial distress.
7 LOOK FOR TAKEOVER TARGETS
Most of the time the financial ratios that attract a private-equity buyer are
the same ratios that attract a value investor (also the things that put you
off as an investor deter private equity, such as pension-fund liabilities
that are large relative to the market capitalisation).
Therefore a value approach should increase your chances of holding companies
that might be bid for.
8 BE UNPOPULAR
Many investors don’t like to be associated with businesses that are not doing
well and can miss out when a change for the better occurs. A great sign
often comes when analysts give up on a company and there are few people
making forecasts on it. Another opportunity can arise in companies coming
out of bankruptcy or Chapter 11. They tend to be completely off most equity
institutional investors’ radar screens. In a similar vein are companies with
complex or unusual capital structures, which put off many investors.
9 IT’S ALL IN THE CHARTS
When I look at a stock almost the first thing I will want to review is the
stock chart (normally a three- or five-year chart) because I like to put
today’s price in the context of the stock’s recent price history. I will
look at a stock differently if I know it has performed really well over
recent years compared with one that has been falling for a long time or one
that has moved sideways.
Where a stock has done very well, then a lot of the good news must already be
in the price. I am normally wary of these stocks.
An example of this came in 2007 after four years of a bull market when many
cyclical manufacturing and metal-company shares were up three or four times
from their 2003 lows. This was on the back of exceptional demand for their
products from Asia and in particular China. I remember one of my younger
colleagues saying that the China demand story was one of the most attractive
he had heard.
My observation was that it was indeed a very attractive story, but how many
other investors had been influenced by the same argument? The most
successful investors had already bought these shares probably in 2004, 2005
and 2006 (I was too early in my caution, as the stock did very well until
mid-2008; then they started to decline).
I particularly dislike what I call “pass the parcel” stocks — those where the
valuation is very high, but they still have good momentum and investors hope
there is a bit more to go and they can sell them to someone else before the
music stops.
10 THE ECONOMY DOESN’T MATTER
When evaluating the market outlook there are three things I particularly focus
on — and one I don’t consider. The one thing that I don’t look at is the
economic outlook, as this invariably looks great at tops and horrible at
bottoms.
The three factors I do look at are: the historical patterns of bull and bear
markets, for example for how long and how far have we risen in a bull market
and how long and far have we fallen in a bear market?
When the length of time and the quantum of the rise or fall are high relative
to history, the odds of a change of trend increase significantly. I then
look at indicators of investor sentiment and behaviour, such as the put/call
ratio, adviser sentiment, breadth, volatility, mutual-fund cash positions
and hedge-fund gross and net exposure.
When these indicate extreme optimism or pessimism it normally pays to bet
against them. Finally, I look at long-term valuations, particularly ones
like price to book or free cash flow. Again, when these move outside their
normal range it represents risk or opportunity.
When all three factors confirm each other, the odds are that you are near a
turning point. You won’t spot the right day, week or month, but you should
get the right quarter.
Chartwatch
Before I meet a company there are things I want to look at. First, I will
examine a chart, probably the three, five and ten-year graphs, to see how
the stock has been performing.
Then I want to look at valuation measures (see below). Less than ten-year data
can be misleading as they will not contain enough variety of business
conditions.
Then I will look at a chart showing the history of director deals and a
financial-strength report, which shows the net short position and how it has
moved over time, a chart of the credit-default spreads where these exist, as
it can be an early indicator of problems ahead, and whether it is highly
owned or lowly owned by the institutional investors.
I will also look at a chart of earnings upgrades or downgrades, so I can see
whether average expectations are improving or deteriorating, and the latest
company results.
How to work out if a company is cheap
For most companies, and particularly non-financial ones, I look at five main
types of ratio. My first is the price/earnings (p/e) ratio in the current
year and predictions for up to two following years. As well as the absolute
p/e, I look at the relative p/e. Then I look at a prospective ratio of the
enterprise value (EV) (market capitalisation plus debt minus cash) to gross
cash flow, or EV to earnings before interest, taxes, depreciation, and
amortisation (a measure of cash earnings). Then I consider the prospective
free cash flow, the cash the company is expected to generate per share
divided by the share price.
I will look at the price to sales chart or, even better, an EV to sales chart.
The fifth measure is a valuation method that looks at the cash flow return
on investment in relation to how the share price trades relative to invested
capital.
Extracted from Investing Against the Tide by Anthony Bolton. Published by
FTPH, price £14.99. © Anthony Bolton 2009
