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Forever kind of love

Created:

6 May 2008

Written by:

Mr Bearbull

Never fall in love with a stock because one thing is sure - it won't fall in love with you. The odd thing about this stock-market aphorism is that it's never questioned. It's simply accepted as self-evident. At one level, of course, it must be true. A stock is not sentient, so it can't fall in love with anyone. What's less clear is why it is so bad for investors to fall in love with the stocks they own. Indeed, if you rephrase this notion it can sound perfectly reasonable. How about this? – only hold stocks in companies that you truly and deeply admire. Put that way, it sounds like the avuncular advice dished out by Warren Buffett.

So, say I put aside the cool and rational approach to equity investing and embrace the warm and cuddly side - in other words, I buy and hold shares that I really like because they are in outstanding companies - then what sort of portfolio do I end up with and, more important, what investment performance do I get?

The danger is that performance becomes poor because I no longer give attention to the price I am paying. That would, indeed, be risky because it runs contrary to a basic rule of investing - there may be many ways to skin the cat, but you must always be fussy about the price you pay for it.

But, if price paid becomes an irrelevance, then other factors must take its place. In particular, I would have a soft spot for shares in companies that compete in industries where the growth prospects look decent. Although that does not mean I would necessarily ignore companies operating in low-growth sectors. Note, for example, that West Midlands-based engineer Castings is among my 10 chosen loved ones. Few UK industries have duller growth prospects than good old-fashioned metal bashing - or, more accurately in Castings' case, metal melting and forming. Yet Castings seems to have built itself a competitive advantage that can only come under the heading: "We try harder". Or, at least, years of practice means it can deliver, and customers trust it to deliver, at prices that satisfy both sides.

Over the summer I will be developing the idea that companies can make themselves strong - ie, can erect barriers to entry - by practising at being better than their competitors. When that happens, companies build themselves quite a high barrier because it is reinforced by customers' preferences. But first a company has to get itself in this enviable situation and, for that, continuity of management may be important. At least it may be no coincidence that three of the companies in the table - Air Partner, Castings and Renishaw - have built strong positions in sectors where there are no commanding barriers to entry and have bosses who have been with their company for more years than they care to remember. The most recent arriviste is Renishaw's chairman, Sir David McMurtry, and he founded the business back in 1973. He was preceded by Air Partner's Tony Mack, who joined his father's company in 1970. But even by that date Castings' boss, Brian Cooke, had been at his company for 10 years.

Then there is the need for a good financial record. After all, a barrier to entry cannot really exist if it does not translate into good performance ratios, especially for profit margins, return on capital and growth rate in earnings per share. The average annual compound growth rate over the past five years for the 10 is 14 per cent. True, five years is an arbitrary period, and it tells us nothing about future growth. Even so, it’s an impressive figure and it does say that most of the 10 must have been doing most things right most of the time.

So do I simply say “Damn the price” and put shares in the 10 into the Bearbull portfolios? Hindsight tells us that would have been a good thing to do pretty well any time in the past 30 months. For example, take the periods from end-2005, end-2006 and end-2007 to the present - the average price performance of the 10 would have comfortably beaten the All-Share index over each of those periods. The trouble is, it's difficult to break the habits of a lifetime and I can't help but spot that shares in the 10 are, on average, rated at over 17 times forecast earnings for 2008, which is a bit rich. However, whichever ones I may add to my funds in the coming months, I will make a note to review the performance of the 10 this time next year when we may learn whether Bearbull was cautiously astute or just a cautious old fool.

● This has to be the easiest short sell of the year. Famous last words, perhaps, but, at the risk of looking a real plonker in a few months, I have short-sold shares in property website operator Rightmove for the Bearbull Hedge Fund. This is a stock that INVESTORS CHRONICLE has been bearish about for some months, yet its price has not suffered as much as I would have expected given the unadulterated misery that is about to be visited upon estate agents and housebuilders. These are the people who use Rightmove's website and it is a racing certainty that they will cut their advertising spending in the coming months. Combine that with the tough competition that Rightmove faces and it looks odd that the shares still trade on a rating - maybe 20 times 2008's forecast earnings - that has a dot-com feel to it. I have short sold 3,600 Rightmove shares at 415p via a contract for difference. Simultaneously - and in order to keep the hedge fund in balance between short and long positions - I have bought back its short position in 4,900 Compass shares, sustaining a 10 per cent loss. I still feel that the revival in Compass's share price will run out of steam and may sell them again if the price pushes beyond 350p.

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