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Easy pickings

Created:
24 June 2008
Written by:
Mr Bearbull

When did you ever hear a punter bragging that he had made a tidy pile by backing a 5-4 on favourite? You didn't - it goes against human nature to admit to such things. Make a few quid by betting on a 50-1 long shot that comes through and you will bore your mates silly with variations on "How I knew it was a dead cert". But do the sensible thing, back the favourite and get the right result, and you will pick up your winnings and keep quiet.

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It's as if human nature demands that we need to make things difficult for ourselves. Which, of course, isn't a completely ridiculous proposition. Would you ever sit through a film in which the hero only took the easy options and made a fair amount without ever putting himself at risk? Watchability demands that the hero faces daunting challenges where the odds mount against him yet, implausibly but deservedly, he snatches victory.

This need to beat the odds certainly applies at the race track. It has been formalised into the so-called favourite-longshot bias - favourites are not favoured as much as they should be, while long shots are favoured too much. One upshot is that, according to research done on horseracing in California, the correct odds on nags offered at 100-1 against should really have been 730-1 against.

What applies at the race track applies to the stock market, too. We ignore the easy pickings and search for opportunities where the payback could be immense. In so doing, we seem to confuse the aim of stock-market investing. Is it to make decent profits or to make ourselves feel good? If it's the latter, that's alright but we should acknowledge that we won't build much capital from investing.

Bearbull is not free from this confusion. I spend too much time searching for stocks where I can answer "Yes" to the question, is the share price likely to double in the coming five years? Correspondingly, I ignore readily-identifiable opportunities that offer a better chance of returns that are lower but still above my benchmark. True, I have addressed this in the past year or so - getting decent paybacks from holdings in ICI, Baggeridge Brick and Scottish & Newcastle, all of which were in receipt of takeover bids yet where the market price of their shares offered returns well above the time value of money.

Easy pickings now

In these uncertain times it is sensible to focus on opportunities like these, which I might caricature as easy pickings - not that the pickings are easy to find or assured. Two such are shares in aircraft parts supplier Aero Inventory and specialist publisher Informa, both of which are in bid talks with private equity firms.

Aero Inventory looks more interesting because there is a fat upside rumoured to be in the offing yet, should the bid talks lapse, the downside looks limited, too. Compared with a market price of 584p for Aero shares, Bridgepoint is rumoured to be touting 720p. Basic probability theory tells me that if the odds against a successful bid from Bridgepoint are 7-to-1 or shorter, then I should take the bet (ie, buy the shares). Sure, those odds rely on some assumptions - namely that my target rate of return is 8.5 per cent a year and that a bid takes four months to complete. And there is no guarantee that the market's rumour on the likely bid price is correct. Even so, intuitively it seems to me that a one-in-eight chance of the event taking place - ie, Bridgepoint buying Aero at 720p per share- is reasonable as we know talks are in progress.

Besides, if Bridgepoint did pay 720p, the exit earnings multiple would still be less than 11 times Aero's forecast earnings for 2008-09. That's pretty cheap. For similar reasons the downside looks limited. After all, at the current 584p, the rating is below 9 times earnings, backed by a 3.9 per cent dividend yield, which is attractive for what's supposed to be a growth stock.

That "growth-stock" appendage comes from Aero's strong position in the emerging service to manage stock control for airlines and aircraft-maintenance companies. For Aero, that has meant securing 10-year contracts with both Qantas of Australia and ACTS, a Canadian maintenance company, for example. That's nice work, but it comes at a cost - in particular, the need to commit enormous amounts to working capital as Aero buys in the stocks that it is henceforth going to manage. For example, in the year to end June 2007, Aero's stock levels rose from £104m to £216m. Similarly, borrowings have risen relentlessly, from £2m in June 203 to £154m by December 2007.

It is this jumbo-sized appetite for capital that makes Aero an unusual proposition for a private equity firm. Unusual, but not necessarily outlandish - after all, private equity does not just invest in businesses with utility-type returns. And the situation in Aero's shares looks just right for the Bearbull Speculative Portfolio, so I have bought 5,000 at 579p. As for Informa, there are similar comments to be made about the upside and downside, and its suitors - Providence Equity Partners and The Carlyle Group - have been forced to confirm their interest. So its shares might yet go into the speculative fund, too.

But I promise one thing - if I make a tidy little profit on Aero shares, you won't hear me bragging. It was, after all, easy pickings.

■ Aero Inventory is one of the remaining companies in our Share Champions competition - and the current test is Takeover potential!

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