Colm Fagan's Diary of A Private Investor

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By kind permission of the Sunday Times where they first appeared, I am reproducing Colm's articles.

While our Posting Guideline is clear:

11 We don't discuss individual shares
You won't find any messages suggesting investing in CRH or asking if AIB is a good investment. It is not the purpose of Askaboutmoney. We don't facilitate stock tipping or speculation about the future performance of individual shares. There are other forums which discuss individual shares such as The Investments and Markets Forum of boards.ie

This guideline does not restrict you from discussing
1) the mechanics of buying or selling shares in a flotation
2) Rights issues - pricing and mechanics
3) Dividend Reinvestment Plans - pricing and mechanics


It's worth making an exception in this case for a few reasons
  • They are historical articles
  • It is a good basis for discussing whether a very clever and experienced businessman who devotes time to it, can pick winners.
  • The primary purpose of the Posting Guideline was to stop the forum being used by people making wild claims about shares without knowing the first thing about them.
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Brendan Burgess

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Diary of a Private Investor Carclo Colm Fagan 6 September 2015

The broadcaster George Hook reckons buying shares is a form of gambling: “I don’t back horses and so I don’t buy shares”. Hook is wrong. There is a fundamental difference between the two. The average gambler may hit the occasional lucky streak but is a sure loser in the long-run, whilst the average share buyer should make a profit, provided they have a reasonable spread of investments and a sufficiently long investment horizon.

Five years is the generally recommended minimum, probably because that was the normal length of an economic cycle – when economic cycles were normal. Nevertheless, some shares are suitable only for gamblers and should be avoided by anyone seeking a good night’s sleep.

I am normally cautious when buying shares, but I have gambled occasionally, and have generally regretted it. Applying George Hook’s horseracing analogy, I have backed some nags that are still running.

One of my worst experiences started with a January 2013 decision to buy shares in a company called Carclo on foot of a recommendation in, of all places, the Financial Times, the finance person’s pink bible.

According to the FT’s columnist, Carclo had a good story to tell. It was a unique player in the world of mobile phones and small computer monitors; it had perfected a technique for printing thin metal lines, invisible to the naked eye, on special film. Without producing any numbers, the columnist claimed the share price had a good chance of doubling over the next 12 to 18 months. Foolishly, I believed his story without checking the numbers.

The share price, far from doubling, halved, and then halved again. I finally sold the shares in November 2014 at less than a quarter of what they had cost me. The only consolation was that the amount invested was less than I normally venture.

One lesson learned from that debacle was not to invest in a share that tells a good story but where the promise of great profits has no justification, or can only be justified on heroic assumptions for future growth.

I resolved to avoid high-risk shares in future. My resolve was strengthened by some recent findings in behavioural finance. This relatively new area of study recognises that none of us, not even supposedly super-rational investors, behaves rationally all the time. In fact, investors sometimes behave quite irrationally.

Classic finance theory, which assumes that everyone behaves rationally, says that, on average, risky investments should generate a higher return in the long term. That is no more than common sense - otherwise, why would anyone ever bother taking a risk? We would be just as well off putting our money in the piggy bank.

Things aren’t that simple though. At very high levels of risk, it seems that investors tend to behave more like gamblers.

A number of possible reasons have been adduced for this, one of which is called “lottery preferences” and works as follows: none of us is stupid enough to pay €1 to get back just 50c yet hundreds of thousands of us do precisely that on a regular basis, but in the guise of buying Lotto tickets where the individual punter may hit lucky but the overall pay-out ratio is not far off 50 cents in the Euro.

Much the same phenomenon manifests itself in high risk shares: the possibility of the occasional jackpot lures investors into overpaying.

In the light of this painful experience, I also resolved only to buy shares that I had researched carefully myself and not to put my trust in tips, even if they came from a respected source.

I hope to share some of that research with readers, so that you can make your own assessment of a share’s worth.

I recognise that my new-found resolve to stay on the straight and narrow path of investment righteousness means that I won’t profit from the next hot stock to take the investment world by storm but, by the same token, I hope to avoid the financial pain and indignity of another Carclo.

If the behavioural finance theorists are right, I’ll also earn a higher return on my investments as a reward for my virtue.

In the next column, I plan to tell of a much happier experience with a company that - in my opinion, of course - is worth far more than the value placed on it by the market. Such discoveries are the stock-picker’s equivalent of the Holy Grail.

Colm Fagan is an active private investor. He is a retired actuary and a non-executive director of a number of financial institutions.

Reproduced by kind permission of the Sunday Times
 
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Diary of a Private Investor Renishaw Colm Fagan 4 October 2015

The experts advise against getting attached to a particular share, that it can damage your financial health. I think they’re wrong.

Renishaw is a FTSE 250 company, which means it’s one of the 350 leading quoted companies in the UK, but ranking below the elite FTSE 100. It was founded over 40 years ago by a Dubliner, David (now Sir David) McMurtry and his colleague John Deer. Sir David is still the company’s chairman and chief executive - at a sprightly 75.

I bought my first Renishaw shares in 1998 at just over £4 a share. At the time, the yearly dividend was 11.44p, equivalent to an “interest rate” of 2.8% on my money. A pre-tax return of 2.8% was less than I could have got (net) from the Post Office at the time, but I was confident that Renishaw’s dividends would increase in future.

My confidence was fully justified. The dividend has increased more than fourfold, to its current 46.5p a share, equivalent to an “interest rate” of more than 11% on my original investment.

As I write, the share price is £20, almost five times the cost in 1998. Not bad, considering also the steady flow of dividends in the meantime. No wonder I’m attached to the share.

The problem with getting so attached to it is that I consistently think it’s worth more than the value placed on it by the market. Every time the price dips - and it fluctuates quite violently at times – I am tempted to increase my holding. The end result is that I now have far more exposure to Renishaw than the experts, who worship at the altar of diversification, think is reasonable. They advise me to sell some of my shares to reduce my exposure.

Should I take the experts’ advice? Let’s do the sums. I have learned the hard way (see last month’s column) not to buy or sell a share without first checking the numbers.

Most importantly, Renishaw’s future looks bright. It is a world leader in designing and making sophisticated measuring instruments for manufacturers. Increased complexity in all areas of manufacturing helps to ensure a strong demand for its metrology products. It also has exciting technologies in healthcare and 3-D printing.

Through good times and bad, Renishaw invests around 15% of its revenues in engineering and research and development (R&D). Published accounts must show R&D expenditure as money down the drain, but in reality it is the best possible protection against obsolescence.

Renishaw has no debt and millions in the bank. It owns many of the premises it occupies, from Swords to Shanghai. Another positive is that the two founder directors own more than 50% of the business between them, so their interests are aligned to mine.

The company refuses all requests for ‘nod and a wink’ meetings with analysts. The analysts don’t like this, but it means that I, as a private investor, know as much about the company as they do.

Renishaw normally aims to pay around 50% of its profits in dividends. It also aims for a smooth progression of dividends from one year to the next. In recent years, dividend growth hasn’t kept pace with the fast growth in profits, so the dividend payout ratio has fallen below the targeted 50%.

In the year to 30 June last, Renishaw’s earnings were £1.675 per share, but 2015 was exceptional. Profits were more than double their 2014 level, because of once-off orders from the Far East. The company projects middle- of-the-range earnings for 2016 of around £1.12 a share, down 33% on 2015.

In assuming virtually no repeat of last year’s once-off orders, I believe the company is over-cautious in its forecast for the current year. Despite the downturn in China - which in any event should have a greater impact on companies selling to consumers than on companies like Renishaw that sell to manufacturers - I expect earnings of the order of £1.30 a share in 2016, still a hefty 22% down on 2015.

Over the last 15 years, Renishaw’s earnings per share have grown by over 10% per annum on average. I expect growth of similar order from 2017, fuelled by the company’s unswerving commitment to R&D and its increasing focus on systems solutions rather than on product sales. Systems solutions create long-term relationships and generate dependable recurring revenues.

Given Renishaw’s growth prospects, I’ll be happy with an earnings yield of 5% in the current year (which implies a dividend yield of less than 2.5%). On my assumption of £1.30 earnings per share for 2016, I therefore value the company at £26 a share (£1.30 is 5% of £26). In other words, my valuation of Renishaw is 30% greater than the current £20 share price.

I have no intention of selling at such a large discount to Renishaw’s fair value – my assessment of fair value, of course. I also believe that the experts are wrong about diversification: it is a false god that will not shield me from the vagaries of the market. My experience tells me that I am better off investing in fewer than a dozen companies, ideally in un-correlated sectors, which offer the prospect of good long-term returns and limited downside risk. At its current price, Renishaw qualifies as one of those companies.

Reproduced by kind permission of the Sunday Times
 
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Diary of a Private Investor CRH Colm Fagan 1 November 2015

A proud tradition can be a source of strength for a family, a community, or even a business, but it can also be a millstone for its custodians. Last year, I decided that CRH, the Irish building materials company, was weighed down by its proud tradition, so I sold my shares. I’m now wondering if it’s time to buy some back.

I bought CRH in May 2006 at €27 a share. The dividend for the year was 52 cents, so the dividend yield was under 2%. This was less than I could have earned elsewhere but CRH had a proud tradition of increasing its dividend every year for more than 20 years. I was hoping for more of the same.

Things started promisingly. The dividend for 2007 was increased by over 30%, to 68c a share. It was increased again for 2008, this time by just a single cent, to 69c a share, but by now the recession was approaching its nadir and CRH, as a major player in the construction industry, was suffering. On the very day it announced the higher dividend for 2008, it also asked shareholders for extra money by way of a “rights issue”. We thus had the peculiar situation that it was giving money to shareholders with one hand and asking for some back with the other. Why didn’t it bite the bullet and cut the dividend? Was it a reluctance to break with the proud tradition?

It was a 2 for 7 rights issue, meaning that I could buy 2 extra shares for every 7 I already held. The cost of each additional share was just €8.40, considerably less than the €15.065 share price ruling at the time. The “special offer” was being funded with our own money, so the price had to fall to €13.58 immediately afterwards. (The numerically minded can check the numbers, based on the fact that every 7 shares I owned beforehand, plus twice €8.40, should be equal in value to the 9 shares I owned immediately afterwards).

Since then, the dividend has been maintained at 62.5c a share. Technically, this is marginally higher than the 69c dividend that applied before the rights issue, so the proud tradition lives on - but at a cost. In 2010 and 2013, CRH had to dip into reserves to pay the dividend as profits in those years were less than the cost of the dividend. There was also some severe cost-cutting during this period.

In April 2014 I decided that CRH’s preoccupation with maintaining the dividend was not good for the business. I sold my shares at €21.49. This was less than the €27 they cost me in the first place, but my loss was mitigated, firstly by the dividends received in the meantime, secondly by the profits on the €8.40 rights issue shares, and thirdly by my decision to opt for scrip dividends instead of cash on a number of occasions. Scrip dividends were another device aimed at persuading shareholders to reinvest in the business; for example, instead of taking the October 2013 dividend in cash, when the price was €17.85, I succumbed to the lure of additional shares at the discount price of €15.79.

I was lucky in the timing of my decision to sell: the price fell from €21.49 at which I sold in April 2014 to less than €16 four months later. More recently however, the market has looked more favourably on CRH. One of the main reasons for the market’s optimism is that CRH agreed two potentially transformative deals in 2015. The first was a by-product of the merger of two of its competitors, Lafarge of France and Holcim of Switzerland. Competition authorities approved the merger but only on condition that the merged entity sell some of its businesses. CRH bought them, presumably at a knockdown price given the forced nature of the sale. The second potentially transformative deal is the proposed acquisition of a Californian glazing company. The total cost of the two acquisitions is over €7.5 billion - a lot of money in anyone’s language. Money for the acquisitions came partly from issuing €1.6 billion worth of shares and the balance from extra borrowings and retained cash.

The share price, now hovering around €25, reflects this newfound optimism. The dividend is still 62.5c a share, so the dividend yield is around 2.5%. A yield this low is only acceptable if there are good prospects for dividends to grow in future. Profits for 2014 were just 78.9c a share, less than 30% more than the cost of the dividend. Assuming that the directors’ long-term goal is to pay 50% of profits in dividends and to reinvest the other 50%, profits will have to increase to around €1.30 a share before the dividend can be increased.

Profits of 130c a share may seem a long way from last year’s 78.9c, but the recent acquisitions could work wonders for earnings, probably not in 2015 but definitely in 2016 and beyond, when management should be able to realise savings from streamlining the various businesses. Some analysts are forecasting that earnings per share in 2017 will be more than double their 2014 levels.

On the other hand, there are risks - lots of them. One is the high level of debt (around €10 per share) and the associated interest cost. The challenge of integrating the various businesses carries execution risk and operational risk is also higher because CRH is now so much bigger than before.

CRH may no longer be weighed down by its proud tradition, but there are too many unknowns and too many risks for my liking. I have therefore decided to pass for now.

Reproduced by kind permission of the Sunday Times
 
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Diary of a Private Investor Apple Colm Fagan 6 December 2015

Apple Corporation, famed for its iPhone, iPad, etc., sharply divides investor opinion. Some think it is grossly undervalued, but the market price sets the equilibrium between buyers and sellers, so the believers must be balanced by an equal weight of investors who think it’s overvalued. I have been a believer ever since I took my first bite of Apple in December 2012 at $73 a share. (The actual share price at the time was $510 but a 7 for 1 stock split in June 2014 gave me seven times as many shares at one-seventh the price.) I added to my holding a number of times since then at prices ranging from $72 to $130, compared to the current $117 a share. On average, I am just about breaking even in dollar terms but the stronger dollar ($100 was worth €77 in December 2012, is worth €92 now) puts me ahead in Euro terms.

Apple’s results announcement for the year to 30th of September 2015 was an opportunity either to reaffirm my faith or to join the ranks of nonbelievers. The company’s profits for the year were $9.22 a share, equivalent to an earnings yield of 7.9% at the current share price. That is a very high yield for what is arguably the leading technology company of our age. It is the type of return we want from a staid company operating in a mature industry; we demand a higher return from such companies to compensate for the risk that earnings may stagnate or even fall in future.

Apple’s earnings per share grew by 43% in 2015 and by an average of 34% per annum over the last five years. For companies that consistently achieve growth of this order, investors are normally satisfied with an earnings yield of 5% or less; equivalent to a Price/Earnings (P/E) ratio of 20 or more (P/E ratio is the inverse of earnings yield). Facebook, for instance, has a P/E ratio close to 100. Applying a P/E ratio of 20 to Apple’s earnings of $9.22 implies a share price of $184.40, more than 50% above the current price.

Why is Apple’s share price so low? The reason is that the market – the unbelieving part of it anyway – apparently thinks that Apple’s best years are behind it, that it has limited scope to grow and could even decline in future. It is easy to see where the sceptics are coming from. The iPhone is Apple’s most popular product, selling a phenomenal 231 million units in fiscal 2015, up 37% on 2014. It accounts for two thirds of Apple’s total revenues. iPhone sales must eventually decline and the market is unsure what will replace it.

In my opinion, Apple is far from a spent force. Sales in greater China are still growing strongly: they grew by 84% in the last fiscal year and the momentum is expected to continue through fiscal 2016. India, another massive market, has been a relative laggard but is now the recipient of a strong marketing effort and sales there are expected to grow significantly. Apple has also demonstrated a great ability to persuade existing customers to upgrade to newer models and, contrary to expectations, is winning customers from Android devices. This success has much to do with the fact that Apple is close to, or has already attained, the status of a luxury brand. Luxury brands have greater longevity, command premium prices - and normally have high P/E ratios.

Apple is investing $8 billion a year in research and development. Some of that goes on upgrades to existing products but Tim Cook, Apple’s CEO, has said that the car is the ultimate mobile device, hinting at where some of the R&D money is being spent, and I would not be surprised if Apple moves into the motor market in the not too distant future, either on its own or in partnership with a major motor manufacturer. That could create an entirely new revenue stream.

Apple’s dividend is only $2.08 per share, equivalent to a dividend yield of just 1.8% at the current share price. The low dividend yield is not because Apple is short of cash: on the contrary, it has net cash of more than $150 billion, or over $27 a share. Instead of paying a higher dividend, Apple is using its excess cash to buy back shares from investors, thereby reducing the number of shares in issue. In effect, it is making its own shares something of a luxury item. For example, in 2015 Apple’s profits grew by 35% but earnings per share (EPS) grew by 43% because the denominator in the EPS calculation, being the number of shares in issue, fell by 5.4% due to share buybacks.

The strong dollar means that sales growth outside the US can translate into zero growth or even sales declines in dollar terms. Arguably, by investing now when the dollar is strong I am also exposed to the risk of the dollar depreciating against the Euro, but a weaker dollar would mean higher sales in dollar terms, which would compensate in large measure for any loss of value from a weaker currency: it’s a case of swings and roundabouts.

At the current share price I am more than happy to maintain my high exposure to Apple. I’m hoping that this particular Apple will not fall to earth.

Colm Fagan is an active private investor. He is a retired actuary and a non-executive director of a number of financial institutions.

Reproduced by kind permission of the Sunday Times
 
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Diary of a Private Investor General Colm Fagan 17 January 2016

“Are you beating the professionals?” It’s a question I am regularly asked at this time of year, when the financial sections of the newspapers publish tables showing the past performance of various fund managers. My answer is that I am doing well, but I won’t claim any expertise until l have survived a severe downturn. Like most investors, I suffered badly in 2008; I don’t want to fall to a similar fate in the next recession.

Guaranteeing no repeat of 2008 carries a hefty price tag. The most I can earn from genuinely risk-free investments is around 2% a year- if I’m lucky. I need to earn more than three times that to have a reasonable income in retirement: 6% per annum plus inflation is my target. For that reason, bonds and deposits don’t feature in my portfolio other than for short-term cash needs and the unexpected rainy day.

I have put my faith in ordinary shares for around 90% of my portfolio, believing that they will deliver the required return in the long-term. Over the last seven years, returns have been comfortably ahead of target, but that has been a good period for stock markets; I don’t expect the good times to last forever. Indeed, recent market falls portend that the good times could end much sooner than we thought just a few short weeks ago.

Temporary price dips don’t worry me: on the contrary, I see them as buying opportunities if the fundamentals of the business are unchanged. Temporary price dips would be a concern if investments had to be redeemed when prices were down but up to now dividend income and normal turnover of investments have been sufficient to meet voluntary and compulsory cash withdrawals. (Because of my age, Irish pension regulations compel me to take some money from my investments every year, whether I want to or not.)

Permanent loss of value is a different matter. I try to reduce that risk by investing in companies that are strong enough to weather a severe recession. Often, that means choosing companies with little or no debt, even though that can be a drag on performance in good times: just as someone who borrows to invest in property can earn a higher return than one who risks only what they can afford, the same is true for companies that borrow to expand or to acquire other businesses. The danger with such companies is that, in a downturn, all the profits could be eaten up by borrowing costs; worse, if loan covenants are breached, shareholders could be wiped out. I am prepared to pay the price of lower returns in the good times in order to reduce that risk.

Some of my worst investment decisions have come from buying shares recommended by others. As a consequence, I now only buy shares that I have studied myself. I don’t have much time for research, which means that there are only a small number of companies in my portfolio. That doesn’t worry me unduly. It creates concentration risk, but I believe that less than a dozen companies provides sufficient diversification if the companies chosen are financially and strategically resilient and if there is little overlap between them in terms of risk exposures – a tall order, I know.

Nevertheless, I recognise that I am running extra risks with a concentrated portfolio and one of my New Year resolutions is to increase the spread of companies in which I am invested. That means disposing of some of my current holdings to make room for the new arrivals. In mulling over which stocks to sell, I discovered that I have a condition that psychologists and behavioural economists call the endowment effect. People with this condition ascribe more value to things merely because they own them. I recognise myself in that description: I am prone to believing that the stocks I own are worth more than others I could buy for the same price. Now that I know I have the condition, however, I hope to be better able to counter it.

A significant proportion of my investments are in UK companies, probably because the Financial Times is my investment bible. In the last two years, UK exposure has delivered windfall profits: sterling rose by over 7% against the euro in 2014 and by over 5% in 2015. In mid-2015, partly in anticipation of Brexit risk, I decided to hedge some of my sterling exposure. I have locked in a fixed euro/ sterling exchange rate until mid-2016 and the present intention is to renew the lock when the current one expires. I have not hedged my exposure to UK companies that have significant international operations, on the grounds that the underlying businesses are already multicurrency.

I discovered the hard way that I know very little about commodities: I incurred significant losses on Tullow Oil and Barrick Gold (a Canadian mining company), believing about two years ago – wrongly as it transpired – that oil and gold had hit rock bottom. I cut my losses on both stocks in 2015. I have resolved to stick to stock-picking in future and not try to predict macro trends, whether in commodities, currencies, or in the overall level of the market.

As we enter a new year, I look forward to continuing to share with you the ups and downs of life as a private investor. I also hope that 2016 will not be the year that will test the quality of my defences against another 2008-style collapse.

Colm Fagan is an active private investor. He is a retired actuary and a non-executive director of a number of financial institutions.

Reproduced by kind permission of the Sunday Times
 
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Diary of a Private Investor Renishaw Colm Fagan 7 February 2016

Owning shares is not for the fainthearted. That was proved to me once again by recent gyrations in the share price of Renishaw, a British engineering company that is my largest individual investment, accounting for over 25% of my portfolio. In the past four months, the share price has fluctuated from a high of £20.50 (€27) to a low of £16, a difference of 28%. This volatility is despite the fact that there have been no price-sensitive developments of note for the company in the period, with the results for the half-year to December 31, 2015 confirming guidance given for the full year to June 30, 2016. God knows what would have happened to the price if the company had made a big announcement. This is the sort of volatility shareholders must live with.

Short-term price fluctuations don’t concern me unduly - what matters is the long-term. In the long-term, Renishaw has delivered. I bought my first shares in the company over 17 years ago at a dividend yield of slightly more than 2.5%. The dividend has grown by an average of more than 8.5% a year since. The dividend yield is once again slightly over 2.5%, which is close to the average for the entire period. This means an average return of more than 11% a year over the 17 years, comfortably beating inflation, which averaged 2% a year. Nice.

My target return for the future is inflation plus 6% a year. I will get this return if the dividend yield stays around 2.5% and dividends grow by an average of inflation plus 3.5% a year - 2.5% dividend plus 3.5% real growth in dividends equates to my target 6% real return. The company aims to pay around 50% of profits in dividends, and to reinvest the other half in the business, so the question becomes: will profits grow on average by the same 3.5% a year in real terms in future?

There are a number of drivers for Renishaw’s success. One is the strength of the commitment at the top. The joint founder and chairman, Dubliner Sir David McMurtry, owns more than a third of the company; his shares are worth approximately £460 million at the current price of £17.43 a share. It’s good to know that his interests are aligned with mine.

Another success driver is the company’s unswerving long-term focus on a set of core competencies, centred round metrology, the science of measurement. From this core competence, Renishaw has branched out, with an appropriate degree of caution, into specialised areas of healthcare and additive manufacturing, more colloquially known as 3-D printing.

The company eschews mergers and acquisitions, other than small bolt-on acquisitions aimed at enhancing its competencies in key areas. It prefers to grow organically. This is in tune with my own philosophy. I believe that organic growth is best, and that mergers and acquisitions generally fail to deliver long-term value for the acquiring company.

It also helps that the company’s strengths are in a specialised and obscure area of business, where there is likely to be less intense competition. It is said that, during the Californian gold rush, the only guaranteed winners were the merchants in the unglamorous business of selling picks and shovels - not the prospectors who used them. Renishaw is a modern-day equivalent of those merchants. Manufacturers of electronic consumer products, modern-day equivalents of the Californian prospectors, are among its biggest customers. Let them have their occasional bonanzas; I’m happy to stick with the company that generates a steady income.

The most important driver for Renishaw’s success to date, however, is the strength of its commitment to research and development (R&D). Year after year, through good times and bad, it invests around 15% of revenues in R&D. The chairman firmly believes that there is a strong correlation between the proportion of revenues invested in R&D and the rate of growth in profits. If he’s right, and I have no reason to doubt him, then my target return of inflation plus 6% per annum is safe.

Of course there are risks, lots of them: demand could fall, particularly in China; margins could be hit by competition; the supply chain could fail, causing the company to be unable to meet customer deliveries; R&D could be misdirected. My biggest concern is the need to ensure a successful transition of the management team to the next generation: the chairman and chief executive is 75; his deputy is 76; the finance director is 66. I love to see fellow senior citizens doing well, but we can have too much of a good thing. Nevertheless, I am confident that the board will be able to oversee a successful transition to a new management team when McMurtry and his colleagues at the top eventually decide to call it a day.

While I may reduce my holding slightly to keep my New Year’s resolution of reducing risk by diversifying my portfolio, I still believe that Renishaw will deliver the target long-term return.

Colm Fagan is an active private investor. He is a retired actuary and a non-executive director of a number of financial institutions.

Reproduced by kind permission of the Sunday Times
 
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Diary of a Private Investor Phoenix Colm Fagan 20 March 2016

In today’s climate of extremely low interest rates, which forces savers to become investors, an investment that gives an income close to 6% per annum looks like a treasure, but is it fool’s gold? That’s the question posed by one of my largest investments, Phoenix Group Holdings (“Phoenix”), which accounted for over 15% of my portfolio at the end of 2015 and delivered a total currency-adjusted return (dividends and capital gains) of almost 23% in the year.

Phoenix is a life assurance holding company with an unusual business model. It doesn’t actively sell insurance policies. Instead, it buys life assurance companies that are closed to new business and administers them until the final policies are claimed, which could be 50 years from now or even longer. Its Irish customers include long-standing policyholders of Scottish Provident.

Phoenix’s main attraction is the dividend of 53.4p (€0.68) a share, which equates to an annual yield of 5.9% at the current £9.10 (€11.65) share price. A dividend of close to 6% is very attractive, but only if it can be maintained. My first job therefore is to check if the dividend is safe.

The main source of cash for dividends to shareholders is money that Phoenix receives from the underlying insurance businesses. Cash emerges from those businesses as policies go off the books; this allows safety margins in reserves to be released. The business has been a cash cow in recent years: dividends increased by over 25% between 2011 and 2014, and debt fell from 63% of gross book value in 2009 to 34% in 2014. In 2014, “normal” business generated net cash of three times the cost of the dividend and the sale of the non-core asset management business generated almost as much again. Results for 2015 will be published on Wednesday next.

Looking at projected cash flows for the next few years, I estimate that receipts from the underlying businesses, net of expenses and interest on borrowings, will be more than twice the cost of the dividend each year from 2016 to 2019, and will remain strong thereafter. Assuming everything goes to plan, cash flows over the next five years at least will be more than sufficient to cover scheduled debt repayments as well as dividends at the current level. A large chunk of debt is due for repayment in 2019. There should be enough cash on the balance sheet to meet the repayment; alternatively the money could be borrowed in the market, given the strong balance sheet. Therefore, the conclusion is that the dividend is safe for the foreseeable future.

Maintaining a high dividend is no good if it erodes book value. That hasn’t happened in the past: despite the high dividend, book value per share increased from £10.58 at end 2013 to £11.43 by mid-2015, but the run-off nature of the underlying businesses means that Phoenix cannot defy gravity forever. Barring further acquisitions, book value must eventually fall as policies go off.

But acquisitions are very much on the agenda, thanks to the strong balance sheet. Acquisitions –at the right price - would boost book value. Phoenix missed out on a major acquisition opportunity towards the end of 2015. That particular company went for well in excess of book value, much more than Phoenix was prepared to pay. As a shareholder, I admire the directors’ discipline in not overpaying, but they may not exercise the same discipline in future.

Phoenix’s current share price is just 80% of book value. The fact that a company operating in a similar space was sold recently for well in excess of 100% of book value means that Phoenix itself could be a takeover target – and at a price well north of the current share price. Any thoughts I may entertain of getting a windfall profit from a takeover must be tempered however by the knowledge that book value is an arcane concept in life assurance - we are dealing with stocks of insurance policies that could stay on the shelves for decades, not bars of soap or packets of cornflakes that are easily valued and will be sold for cash within days or weeks - so it doesn’t necessarily follow that Phoenix is a possible takeover target for a larger competitor. Nevertheless, the fact that the share price is at a discount to book value provides some upside potential.

As always, there are risks. Recent market volatility will have affected the values of Phoenix’s insurance businesses, but thankfully not by much. I estimate that a 10% fall in equity and property values would cause only a 4% fall in book value. Other factors, for example an unanticipated increase in longevity or a widening of credit spreads, could have a bigger impact. Another risk is that regulators could ask insurers to do more to compensate customers for past failings. That is a live issue in the UK at present. Sterling could also fall further against the Euro, but I have hedged that risk.

Despite the risks, I believe that Phoenix is still a good long-term investment. Nevertheless, I recognise the risks associated with a high level of exposure to a single stock, so I have decided to reduce my holding to closer to 10% of my total portfolio.

Colm Fagan is an active private investor. He is a retired actuary and a non-executive director of a number of financial institutions.

Reproduced by kind permission of the Sunday Times
 
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