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Mantra for the moment

Created:
29 January 2008
Written by:
Mr Bearbull

It's at times like these that I take a deep breath, then quietly and rhythmically chant the mantra: "Normality will return. Normality will return." True, I am intoning an article of faith rather than an objective reality. After all, future normality for the UK and US equity markets could be as the darkest night compared with the glorious sunlight of the past 25 years. Or, at least, it could be much like the gloom that investors in Japanese equities have got accustomed to (the Nikkei Average is still 66 per cent below its 1989 high).

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But, in a way, such an outcome is too dreadful to contemplate. It's not that I'm dismissing its plausibility. Rather, I'm acknowledging that its likelihood is so remote that it's not worth factoring in - even though really remote events do come to pass. Besides, if I am disciplined about how I buy and sell, then, by the time the worst were to befall us, my exposure to equities would be limited.

However, if I assume that at some stage - and possibly sooner than we think - investors will once more recognise the merits of holding shares in companies that are likely to generate decent cash profits year after year, then it's as well to be ready for that. It's time, therefore, to dust off the upside/downside way to investment success. Not that I ever forgot this little share valuation tool, but it does not throw up many buying opportunities while share prices swarm around their all-time highs. That is because the key component of the upside/downside ratio is the humble price/earnings ratio and, in practice, it does not give "buy" signals when earnings multiples are well above their average.

By upside/downside ratio, I am expressing the possible gains from holding a share as a multiple of possible losses. Arguably, this quantifies the investment risk far more effectively than the ubiquitous beta measure. For example, take shares in building materials supplier Wolseley. At 700p, Wolseley's shares offer 3.2 times more upside than downside. In other words, within the next five years the profit from holding the shares could be 917p, while the losses could be 286p. Hence the ratio of 3.2.

But the logic behind the ratio is contentious, even though it's not daft. Let's explain it. In Wolseley's case, in the past five years its highest share rating has been 16 times the most recent year's normalised earnings and the lowest has been 7.3 times. Over the same period - plus, stretching five years into the future - its earnings will have ranged from 57p to 101p. So, we assume - and it's a big can opener - that, within the coming five years, Wolseley's earnings could be as high as 101p and those earnings would be rated at the highest of its past earnings multiples. That gives a maximum share price of £16.17 and profits of 917p. Simultaneously, we also assume that Wolseley's earnings could sink to their lowest level, at which point they would be rated at their lowest historic earnings multiple - giving a minimum share price of 414p and losses of 286p.

Clearly, the model is only as good as its assumptions. For example, will the forecasts for a company's highest and lowest earning per share be sensible? And, crucially, the model also assumes what statisticians call "mean reversion". In other words, that what has applied in the past will apply in the future. So shares, like Wolseley's, which are currently rated well below average, will, at some point, revert to their mean, or better. Now, it's true there must be mean reversion. The problem is that we can never know the mean level to which share values are reverting. It is possible that the future will be so miserable that mean reversion will still spell painful losses. But, as I said a moment ago, that remains a long shot and, I'm willing to bet, the upside/downside ratio will produce some interesting buying opportunities in the second half of the year.

That would be when I rebuild the Bearbull portfolios, which, in the case of the growth and speculative funds, have largely been turned into cash. That's a function of exercising stop losses, though, I confess rather tardily, so the losses have been greater than they should have. In the Bearbull Growth Portfolio, last week I sold the fund's holdings in Taylor Nelson Sofres (TNS) and Phoenix IT. The TNS shares went for 166p each, crystallising a 14 per cent loss, and the Phoenix IT shares were sold for 227p, crystallising a 19 per cent loss. In the speculative fund, stop losses were triggered in its Marks & Spencer holding, which was sold for 426p a share, an 18 per cent profit, and Filtrona, where the shares went for 166p, a 31 per cent loss.

However, one relatively clever purchase - or was it just lucky? - that I have made for the speculative fund was to triple its stake in Scottish & Newcastle (S&N). When the market, at its most pessimistic, was assuming that the Carlsberg/Heineken consortium's possible offer for S&N would melt away, I bought 5,000 shares at 740p each. Assuming the 800p-per-share cash offer goes through, I will realise perhaps a 30 per cent annualised gain on my additional S&N shares. In the teeth of a bear market that's not to be scoffed at.

That said, the consortium's agreed offer - when it finally materialised - was distinctly underwhelming because it excludes S&N's final dividend for 2007, which would have been 15p. In other words, the 20p increase, by which the consortium huffed and puffed its way to the S&N board's totemic 800p figure, was really a miserly 5p rise and S&N's directors were disingenuous to recommend it. So, for what it's worth, the Bearbull trustees will abstain from approving the scheme of arrangement that will sanction the deal, though the chances of a rival offer emerging are less than negligible.

I have also been active in the Bearbull Hedge Fund, where I have made contracts to sell approaching £60,000-worth of shares. In the event, I have short sold none of the candidates that I mentioned last week. Instead, I have sold positions in Bloomsbury Publishing (at 161p), Unilever (at £15.87), Ted Baker (at 461p) and Compass (at 306p). I make no claim that I have rigorously researched these situations. What they all have in common is that the companies' bosses have all made optimistic noises recently and their share prices have held up well, yet all these firms operate at the cyclical end of the consumer economy. So, my guess is that the bosses can do little more to sustain the share prices. Meanwhile, there is plenty of scope for disappointment.

It would be an exaggeration to say that the Bearbull Income Portfolio has escaped the carnage but, as yet, no stop losses have been triggered. That said, shares in BT are getting close. Then again, five stop losses were triggered in the second half of 2007 and these holdings have yet to be replaced. That's good and bad. Good because it means that approaching half the fund's assets are in risk-free cash. Bad because my cash only yields 2.5 per cent, about half the level on offer from the fund's equity holdings. That means the fund's pay-out in the first half of 2008 will most likely be less than the previous first half (see Income Portfolio Distribution table) and the yield will probably fall, too.

Income portfolio distributions

Yr ended Pay-out (£) Change (%) Fund yield (%) Cum. payout (£)
2005 1st half 3,163 11 3.5 34,046
2nd half 4,201 34 4.4 38,247
Total 7,364 23 4.0
2006 1st half 4,335 37 4.1 42,602
2nd half 4,779 14 4.1 47,381
Total 9,134 24 4.1
2007 1st half 4,789 10 3.9 52,170
2nd half 5,026 5 4.3 57,197
Total 9,816 7 4.1

On balance, I prefer to preserve the fund's capital to preserving its income growth in the short term. Long term, however, income distribution needs to rise at least in line with inflation. Finding the investments that will achieve that, while maintaining the real value of the fund's capital, is the challenge for the coming months. At least there is no longer a shortage of high-yield shares to choose from.

Now, deep breaths, relax those shoulders and back to mantra: "Normality will return. Normality will return . . ."

MORE FROM MR BEARBULL...

Read more Bearbull columns at his IC home page

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