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Secrets of successful investing

Our small-cap stockpicking expert Simon Thompson offers an insight into the techniques and strategies he deploys, and highlights several investment opportunities for 2022
Secrets of successful investing

Having followed financial markets for over 30 years, it’s clear to me that adopting a disciplined approach to investing, and adhering to sensible ground rules, greatly improves the odds of making successful investments. There are a multitude of factors that need to be considered, but the following strategies and investment techniques have certainly enhanced my own stockpicking success.

 

Assessing investment risk

It is important to be aware of the risk embedded in a company's valuation. The aim is to maximise the return available by taking as little risk as possible. Personally, I carry out 16 different risk assessments to get a picture of the overall level of investment risk.

It's not an exact science, but as part of my due diligence process I carry out rigorous research, delving into key areas including:

  • Understanding how profits are made and the potential for growth
  • Robustness of cash generation and balance sheet strength
  • Quality of management team and track record
  • Shareholder structure
  • Succession risk
  • Pricing power
  • Level and sustainability of profit margins
  • End markets being sold into and scope for growth
  • Impact of currency fluctuations on profitability
  • Potential for earnings-enhancing complementary acquisitions
  • Profit warning risk
  • Geopolitical and legislative risks
  • Economic risk
  • Liquidity risk
  • Volatility risk

I also assess how a company fared in the last downturn to ascertain the robustness of its profitability, and to understand how quickly profits returned in the ensuing upcycle. In addition, I assess whether a company is trading on a premium rating to peers and the market, and quantify the likelihood of the earnings multiple contracting.

Ultimately, you can only have conviction in making an investment if you have carried out thorough due diligence and have a complete understanding of the industry trends, business models and risk factors.

So, having carried out the risk assessments and determined the main bull and bear points, I then calculate a fair value for the equity. I take account of financial forecasts and sum-of-the-parts valuations to do so. The aim is to focus on companies where the upside potential is at least two to three times the downside risk.

If a company ticks the right boxes, and the risk-reward ratio is favourable, then it’s sensible to weight your shareholding accordingly, skewing the portfolio weighting towards companies where you have the greatest conviction. My fellow Investors' Chronicle columnist and former fund manager, John Rosier, does exactly that, and successfully so.

Although holdings with the highest portfolio weightings may not deliver the greatest financial returns, the probability of a positive outcome should be enhanced, thus reducing the chance of making a capital loss. Ultimately, it’s a balancing act between having a spread of investments that offer potential for decent capital growth, and a smaller number of holdings that could produce once-in-a-lifetime returns – assuming of course you are comfortable with the risk in the first place.

 

The impact of macroeconomic and monetary policy

I always consider the bigger macroeconomic picture and ascertain how central bank and government fiscal policy are impacting financial markets. Quantitative easing (QE) is by far the most dominant factor at play in today’s markets.

Having been slow off the mark in realising that QE money-printing programmes were a gamechanger for equity markets at the bear market bottom in March 2009, I had a plan in place to profit from the next round of QE when the world’s largest central banks next ramped up their digital money-printing presses. To do so I studied the QE monetary transmission mechanism for my book Stock Picking for Profit to pinpoint likely stock market winners and losers.

This knowledge proved invaluable when stock markets tanked in March 2020 and central banks in the G10 countries and China pumped vast amounts of liquidity into the monetary system through their QE programmes. It's worth remembering that the primary aim of QE is to drive long-term bond yields lower, force investors up the risk curve in search of higher returns relative to bonds, boost asset prices, and create a positive wealth effect.

However, it is more than a liquidity-driven process, because cheaper money has been recycled directly back into the real economy. Indeed, by soaking up the additional sovereign debt issuance resulting from government fiscal stimulus packages and pandemic-induced budget deficits, monetary authorities' prompt actions went a long way to ensuring the Covid-19 induced global recession was short-lived.

As was the case during previous QE programmes, equities have been a major beneficiary. That is particularly the case in the period since March 2020, because alternative sources of yield have been thin on the ground in a zero-interest rate policy environment. The scale of the money-printing programmes was the primary reason why I nailed my flag to the equity bull market mast 18 months ago (‘Bull market rules’, IC 12 June 2020). Both the FTSE Aim and Small-Cap indices subsequently rallied a further 49 per cent to their autumn 2021 highs, outpacing UK mid and large-caps in doing so. The outperformance reflected a higher weighting to fast-growing sectors (technology, ecommerce and healthcare) that are beneficiaries of benign monetary and fiscal tailwinds.

Of course, central banks started reining in their QE programmes at the end of 2021 as economies rebounded. Financial conditions have also started to tighten as bond investors demand higher yields in order to mitigate inflation risk. From my lens, the easy gains have been made, and a market environment facing the headwinds of inflationary pressures, lower growth rates and tightening monetary policy will favour thematic stockpicking strategies rather than riding off the coat-tails of rising markets. I also feel at this point of the economic cycle that increasing exposure to low price-to-book-value plays offering decent dividend yields is a sensible strategy.

 

Understanding commodity price drivers

The potential for a strong global economic recovery in 2021 was one reason for being long of commodity stocks in 2021 (‘Reasons to be bullish’, IC 18 December 2020). It was not the only one. I was also heeding the bigger picture across the commodity spectrum.

In the oil sector, I felt that the combination of well depletions, underinvestment in new oil and gas fields, and an uptick in demand driven by a global economy on the rebound, could all construe to create a perfect storm for black gold in 2021. The oil price subsequently rallied 68 per cent by the autumn of 2021 and the natural gas price soared 144 per cent. Although markets have become volatile following the recent emergence of the Omicron coronavirus variant, relatively strong global demand means it’s sensible to expect the oil price to remain at elevated levels unless national lockdowns return for prolonged periods.

It's worth noting that a robust oil price supports an accelerated transition to environmentally friendly energy alternatives. The shift away from fossil fuels is clearly gathering momentum and this has major implications for other commodities.

Copper is a major beneficiary from greater demand for electricity given that a higher portion of future power generation is forecast to come from renewable energy. Wind farms and solar panels require up to five times more copper than is needed for fossil fuel power generation, and electric vehicles use four times as much copper as internal combustion engine vehicles.

Analysts at research consultancy CRU estimate that wind turbines, electric vehicles and other 'green' technology will require 6m tonnes of refined copper by the 2030s, accounting for 20 per cent of forecast global consumption. Commodity experts at investment bank Bernstein forecast that copper demand from renewables and electric vehicles could grow more than seven times by the 2050s, if the world is going to meet its net-zero greenhouse gas emissions target. That’s a good reason to have exposure to copper producers. Three companies on my small-cap watchlist –  Aim-traded Metal Tiger (MTR:21p), Jubilee Metals (JLP:17p) and commodity royalty group Trident Royalties (TRR:38p) – offer exactly that.

Rising copper demand augurs well for miners’ profits at a time when there are constraints to supply growth. Colin Bird, chairman of Jubilee Metals, notes that “the outlook for copper in particular remains buoyant, with many predictions that the year 2030 will see a doubling in demand. I see the supply side being severely challenged, with Chile, as a major contributor to the copper supply, being challenged technically and socially. The large copper systems that are now in favour are few and far between and have a gestation period of some 12 years.”

Jubilee’s exposure to platinum group metals (PGMs) has green credentials, too, given that the emergence of the fuel cell, particularly in China, is likely to drive up the PGM price as demand for such energy increases over the coming years. The same dynamic is positive for Sylvania Platinum (SLP:90p), a cash-rich, fast-growing, low-cost South African producer and developer of platinum, palladium and rhodium.

Another way of playing the green revolution is through companies that will profit from increased demand for electric vehicle battery metals. It’s already happening: the lithium carbonate equivalent (LCE) price has risen fourfold since the start of 2021. That’s good news for Trident, which owns a valuable royalty over the Thacker Pass lithium open mine project in Nevada, one of the largest known lithium deposits in North America.

 

 

Trident has acquired a 60 per cent interest over the Thacker Pass lithium project, one of the largest known lithium resources in North America

 

Trident’s royalty has an estimated post-tax net present value of $152m (£114m, or 62p a share) at a long-term LCE price of $24,000 per tonne (spot value $31,000 per tonne) after applying an 8 per cent discount rate to projected royalty streams. To put that valuation into perspective, it’s 22 per cent more than Trident’s own market capitalisation.

It's worth noting, too, that many investors buy commodities as an inflation hedge. Assuming central banks around the world maintain relatively benign monetary policies as QE programmes are wound down, then the commodity complex should continue to perform well in a negative real interest rate environment. Talk of a commodities supercycle is not without merit.

 

Going global

It would be foolhardy not to consider global trends to diversify portfolios and enhance performance. Investing in international markets has never been easier. With the benefit of low-cost online sharedealing, it is possible for any retail investor to capitalise on overseas investment opportunities that were once only available to large institutional funds. I take a thematic approach to identify global themes and then seek out an investment vehicle to play them out.

That’s exactly what I did at the start of 2021, having selected two international investment funds in Vietnam and Canada for my 2021 Bargain Shares Portfolio. Vietnam Holding (VNH:357p), a closed-end fund that holds a concentrated portfolio of 20 to 25 mid to small-cap companies, is a play on three secular growth trends in Vietnam: industrialisation, urbanisation and domestic consumerism. The fund offers geographic exposure to a high-growth economy that has fared well during the Covid-19 pandemic, and which has a manufacturing base that is now benefiting from trade tensions between China and the US, too.

Vietnam Holding's eye-catching returns
 NAV per share (USD)Vietnam All Share Index (USD)
3-year CAGR26.1%26.1%
5-year CAGR14.8%20.1%
10-year CAGR17.0%15.7%
Source: Vietnam Holding at 5 January 2022

A combination of earnings growth and multiple expansion from the fund’s investee companies, and foreign direct investment flows that have buoyed Vietnam’s stock market, increased the fund’s net asset value (NAV) per share by more than 60 per cent in 2021. The current ratings of the investee companies, coupled with an 8.5 per cent share price discount to NAV, suggests further upside is likely.

The inclusion of Canada’s second-oldest closed-end fund, Canadian General Investments (CGI: 2,620p and Can$43.65), in my portfolio was based on its overweight position in US technology stocks, as well as it being a play on the North American economic recovery. Both themes have played out to deliver a 23 per cent total return on the holding.

I will be seeking out more international plays in my 2022 Bargain Shares portfolio, details of which will be published in Investors' Chronicle next month.

 

Correlations and trends

Uncovering correlations in the way sectors perform, and markets in general, can be a great way of boosting financial returns and reducing risk at the same time.

A good example is my first-quarter seasonal housebuilding sector trade (‘Alpha alert for housebuilders’, IC 5 January 2018). It’s proved a standing dish of the stock market, with the sector posting an average first-quarter gain of 11 per cent, or three times the return on a FTSE All-Share tracker fund, since 1980. Moreover, the sector has risen in 85 per cent of those first quarters, too.

Last year was no exception, with the FTSE 350 housebuilders again notching up a double-digit gain by early April. I wouldn’t bet against the strategy delivering for investors in 2022 given that several housebuilders have seen their share price gains pared back from their 2021 highs and trade on sub-market earnings multiples. Importantly, the drivers are in place for a first-quarter rally: tight housing market supply-demand, ultra-low mortgage rates and government-incentivised schemes for new home buyers.

 

Inflation

It’s not just the level of inflation that has an impact on asset allocation decisions and the likely returns investors can expect from equities and bonds.

Equally important are future expectations of inflation. These have a major bearing on real bond yields (nominal bond yields adjusted for inflation). It is the combination of the level and direction of real bond yields, future expectations of inflation and the inflation rate itself that determine the sectors likely to perform well or badly.

I for one will be keeping a keen eye on government bond yield curves and inflation expectations as central banks adopt a hawkish stance on monetary policy given the inflationary risks facing the global economy.

 

Monitor earnings cycles

The holy grail for investors is to identify companies with the potential to turn an early-stage recovery story into a multi-month earnings upgrade cycle. There are several ways to achieve this, but the most common is when operational leverage in a positive sales cycle kicks in, whereby an increasing amount of incremental gross margin earned drops through to the bottom line.

It’s not just a case of identifying companies with a relatively fixed cost base that have reached such an inflection point. What's also important is to identify those companies operating in industries where end-market demand is strong, that have the potential to enter new markets, and that can benefit from cross-selling opportunities and may even be making earnings-enhancing acquisitions.

The long-term gains can be material, as shareholders of cybersecurity software provider Kape Technologies (KAPE: 415p) will testify. A combination of organic sales growth and shrewd acquisitions has driven up Kape’s share price eight-fold since I included the shares in my 2017 Bargain Shares portfolio. A 2022 price/earnings ratio of 16 indicates the re-rating has further to run in what is a consolidating industry.

 

Contrarian strategies work

The long-term performance of my annual Bargain Shares portfolios highlights how contrarian investment strategies can work. Over the past two decades the portfolios have produced an annual return of 21.5 per cent in the first 12 months.

Simon Thompson's Bargain Shares portfolios performance (2016-21)
PortfolioPortfolio total return to dateFTSE All-Share total return to dateFTSE Aim All-Share total return to date
2016104.5%64.1%88.1%
2017141.9%31.1%43.8%
201879.9%19.9%18.7%
201967.3%24.0%37.3%
202055.1%9.0%27.8%
202124.3%19.1%1.5%
Source: London Stock Exchange, FTSE International, Bargain Shares Portfolio total return calculated on offer-to-bid basis with dividends un-invested. Latest prices at 5 January 2022.

 

The point is that investors habitually undervalue shares in companies that have previously underperformed, or are simply below the radar, and are inclined to overpay for those that are doing well. So, by seeking out unloved companies with solid finances and the potential for improvement in operational performance, it’s possible to reap hefty returns as and when investor perception turns for the better.

If market volatility remains a theme of financial markets in 2022, as I suspect it will, then adopting a contrarian stockpicking strategy is likely to reap rewards, because it takes advantage of the elevated equity risk premiums embedded in the attractive ratings of companies following periodic market sell-offs. Once volatility drops, ratings will rebound as the equity risk premium unwinds.

 

Capitalise on capital returns

Capital returns form a major part of shareholders' investment returns. There are several ways companies can produce such returns for investors. Fortunately, it's possible to make money from all of them. Share buybacks, tender offers and special dividends are the three I focus on most in my stockpicking.

The Aim-traded investment company formerly known as Gresham House Strategic (GHS), now Rockwood Realisation (RKW), highlights how investors can potentially make a profit from capital returns. I included the shares, at 796p, in my 2016 Bargain Shares portfolio, and the holding had produced a healthy 116 per cent total return (including 101p of dividends) when the board recently announced that it would be winding down the fund over the next two years.

The decision was made following the change of investment manager to Harwood Capital, a move that met opposition from previous fund manager Gresham House and some other shareholders, too. The shares were trading at 1,625p, a 13.5 per cent discount to the NAV of 1,888p, on 1 December 2021.

Having realised bumper gains from takeovers of two investee companies (waste management group Augean and Universe Group (UNG), a supplier of retail management solutions, payment and loyalty systems), the £65.7m fund proposed a £25m capital return (300p a share through a compulsory B share issue and a £14.6m tender offer at 2 per cent below NAV), subject to shareholder approval being granted at a general meeting on 15 December 2021.

This meant a holding of 1,000 shares worth £16,250 received £3,000 from the B share issue and around £4,200 from the now-closed tender offer which redeemed 27 per cent of the 3.48m shares in issue. Post the capital return, the company has 2.54m shares in issue and a NAV of £40.5m (1,594p a share).

So, with the shares being bid in the market at 1,500p on 11 January, the remaining holding of 730 shares is now worth almost £11,000. Effectively, the shareholder has made a gain of nearly £2,000 per 1,000 shares held as a result of the capital returns while also releasing cash representing 44 per cent of the holding’s value.

It also means that followers of my 2016 Bargain Shares portfolio have recouped all their initial capital outlay, so have a free ride on the balance of their holdings.

 

Monitor success and failure

Finally, I measure the hit rate of my winners and losers to understand why I have been successful, or made a poor investment call. Identifying why investments have proved successful or not is crucial, as it enables you to avoid making the same mistake in the future as well as maximising the return on your invested capital.

The process also raises the question as to whether the laggards should have a place in your portfolio, a point to which I'll be paying closer attention in forthcoming articles.

 

■ Simon Thompson's latest book Successful Stock Picking Strategies and his previous book Stock Picking for Profit can be purchased online at www.ypdbooks.com, or by telephoning YPDBooks on 01904 431 213 to place an order. The books are being sold through no other source and are priced at £16.95 each plus postage and packaging of £3.25 [UK].

Promotion: Subject to stock availability, the books can be purchased for the promotional price of £10 each plus £3.25 postage and packaging, or £20 for both books plus £3.95 postage and packaging

They include case studies of Simon Thompson’s market beating Bargain Share Portfolio companies outlining the investment characteristics that made them successful investments. Simon also highlights many other investment approaches and stock screens he uses to identify small-cap companies with investment potential. Details of the content can be viewed on www.ypdbooks.com.