It is the very essence of stock-picking, and whatever fans of passive investment might say, it works: our portfolios have beaten the FTSE All-Share index in 11 out of the 12 years in which we have run them. During that time, they've generated a compound annual return of 17 per cent, versus just 1.55 per cent a year for the FTSE All-Share. So £10,000 invested in our first , and reinvested every subsequent year in the following portfolio, would now be worth £66,350. The same investment in the FTSE All-Share would have only grown to £12,025.
Last year maintained this impressive track record, with my motley crew of six bargain shares producing a net 46 per cent return – and 50 per cent including dividends – handsomely outperforming the FTSE All-Share, against which all our portfolios have been benchmarked. That follows a 53 per cent gain from my 2009 actively managed portfolio.
This was partly driven by merger and acquisition activity, and that's quite common; there has been a bid for one of the bargain shares in every one of the past five years. It's also unsurprising, since the companies my search uncovers are lowly valued relative to book value.
So, once again I have run the rule over 2,800 listed businesses to come up with a portfolio of companies where the asset backing should be strong enough to overcome any short-term trading difficulties and, eventually, reward our loyal following of long-term investors.
| Bargain shares - rules of engagement |
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The bargain portfolio is based on the writings of Benjamin Graham, a US investor and writer, who is considered the father of value investing. In chapter seven of his seminal 1949 work, The Intelligent Investor, he explains thus: "If we assume that it is the habit of the market to overvalue common stocks which have been showing excellent growth or are glamorous for some other reason, it is logical to expect that it will undervalue – relatively, at least – companies that are out of favour because of unsatisfactory developments of a temporary nature. This may be set down as a fundamental law of the stock market, and it suggests an investment approach that should be both conservative and promising." How do we know whether the "unsatisfactory developments" are indeed "temporary"? Mr Graham's approach was to focus on the balance sheet, and specifically the net current assets – stocks, debtors and cash less any creditors. He believed that a bargain share is one where net current assets less all prior obligations – such as creditors falling due after one year, deferred taxation and provisions for liabilities and other charges – exceeds the market value of the company by at least 50 per cent. This means fixed assets, such as property, machinery, goodwill, etc, are in the price for nothing. Mr Graham's theory was that a strong balance sheet will usually see a company through any short-term difficulties; he called it his "margin for safety". Finding companies that match these strict criteria has become more and more difficult over the years as the link between market capitalisation and asset value has become more tenuous. In practice, only a handful of companies will have a bargain ratio of 1 or above. So to widen the net, and as in previous years, the cut-off point has been lowered to 0.4. Although the record of Investors Chronicle's has been exceptional over the years, you should remember that value investing is for the patient. You may find yourself in for two to three years, and it is also important to buy a decent number of our recommendations to diversify risk. Finally, bear in mind that market makers could easily raise their offer quotes for smaller companies by 10 to 15 per cent on publication day. If you're in for the long haul, don't feel you have to jump in on day one; prices and spreads may drift back over subsequent weeks. |
