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ukvalueinvestor.com UKValueInvestor High quality value investing for income & growth May 2012 Back in recession again Contents Although we’ve managed to avoid it for quite some time, the UK is back in recession. I don’t Market Overview think this is much of a surprise to most people; the UK economy has gone pretty much With the FTSE 100 at 5,700 the nowhere since the credit crunch started back in 2007/8. market is once again back in the ‘cheap’ range, with 7-year total As always though, it isn’t the end of the world just yet. The US is starting to show signs of returns expected to be around recovery and in the past most recessions ended when the US pulled us out. With any luck, 10% per annum. the same process will apply this time round. Model Portfolio Obviously most people would much prefer that we got back to growth sooner rather than Annual results are in from JD later, but from an investing point of view it shouldn’t matter too much one way or the other. Sports One of the basic assumptions of sound investing is that the future will always hold unpleasant Buy Alert surprises and that prudent and rational investors should be prepared for them at all times. A leading home shopping retailer This means sticking to the basics of being diversified, picking high quality companies, buying will be joining the portfolio. them when they are attractively valued and selling them when they’re not. FTSE 350 Sorted by Rating Find the top rated stocks in next New name, new rating system to no time. This month I’m pleased to announce that we have a new name and a new rating system, all in the name of clarity. The Defensive Value Report is now the UK Value Investor and the old FTSE 350 Sorted by Name colour-coded stock rating system has changed to something which is hopefully a little more Compare one stock to another user friendly. Although the underlying mechanics of the rating system are the same as with ease. before, the end result is a more intuitive 1-to-5 star rating for each eligible stock in the FTSE 350. You can read more about it in the UKVI Rating System: A Quick Guide section on page 10. John Kingham, Editor [email protected] 7-Year forecast If you look at a chart of the FTSE 100 going back to 2009 you’ll see that since the tail end of that year we’ve been in a trading range between 5,000 and 6,000, so it should come as no surprise that we’re still hovering in that zone today. Current Level 7 Year Forecast Total 1 Description CAPE FTSE 100 “The fact that people will (5,700) Annual Returns be full of greed, fear or Bubble -3% to 0% 25 - 30 11,600 - 13,900 Bull Top 0% to 3% 20 - 25 9,300 - 11,600 folly is predictable; the Expensive 3% to 8% 15 - 20 6,900 - 9,300 sequence is not” Normal 8% to 10% 12.5 - 15 5,800 - 6,900 Cheap 10% to 14% 10 - 12.5 4,600 - 5,800 – Warren Buffett Bear Bottom 14% to 19% 7.5 - 10 3,500 - 4,600 Depression 19% to 26% 5 - 7.5 2,300 - 3,500 1 CAPE is the ratio between the current price or index level and the 10 year inflation adjusted average earnings 1 UK Value Investor May 2012 I recently read The Little Book of Sideways Markets by Vitaliy Katsenelson because his valuation approach has many similarities to the ones used here, and the name ‘sideways market’ certainly applies to the one we have now. In fact, Vitaliy is referring to the sideways market that we’ve been in since 1999 which gives you some indication of how long these things can go on for. You can see from the 7-year forecast table that we’re back into the ‘Cheap’ range once again, with forecast future returns (including dividends) of around 10% a year over that period. The Valuation System return from equities over the long-term has been nearer 8% a year, so this forecast expects Various studies have shown an the medium-term future to be better than average, which means that equities are more inverse relationship between the attractive than usual. value of stock market indices and their future returns. Target asset allocation The equity valuation system used This is a counter-cyclical asset allocation strategy to give index investors and multi-asset class here is based around a central investors some ideas on asset allocation. The default split is 1/3rd bonds and 2/3rds stocks, valuation of 15 times the 10 year which is similar to many pension funds. Since stocks are currently cheaper than their historic average earnings, which is a average the target allocation is overweight stocks and underweight bonds. historically average figure. You can see below that stocks are overweight by an additional 13%, taking the target Returns over 5 – 30 years are typically average from an allocation up to 79% from the default 66%. averagely valued starting point. The higher the valuation, the lower the future returns, and vice Asset Allocation - Overweight Stocks versa. In the long-term it seems that markets can swing from around half to double their long- term average valuation. Default Stocks (66%) The table to the right reflects Overweight Stocks (13%) those findings. Bonds (21%) Target Asset Allocation Actively adjusting asset allocations may lead to a reduction of volatility, especially Distinctive, simple and repeatable during speculative booms. Successful investing has more to do with a sound strategy than it has to do with skill. The The mathematical model used type of strategy focused on in UKValueInvestor is neatly summed up by three major here has a default stock guidelines from a new book “Repeatability”, by Chris Zook and James Allen. allocation of 66% when the market is normally valued. The book is about building an enduring business which can thrive in a changing world, but the key lessons apply to building a high quality investment approach: When the market moves below its average valuation the stock 1. Distinctive – If an investor expects to beat the market he has to do something different allocation increases as future to what the market is doing. Value investing’s approach to measuring the market is returns are expected to be higher. distinctive because it’s counter-cyclical and contrarian. 2. Simple – An approach to investing which is too complex will be too hard to follow for When the market reaches half its most investors. Many of the most important measures and metrics used to value average valuation the stock allocation is 100%. Alternatively, companies are relatively simple, requiring no more maths than simple algebra. No Greek when the market reaches double letters or mathematicians required. its normal valuation the stock 3. Repeatable – by using investment checklists an investor can easily repeat the process of allocation is 0% and the portfolio valuing a market or a company, while those that rely on news and gut feel are often would be 100% in bonds or cash. making it up as they go along. 2 UK Value Investor May 2012 Model Portfolio Earnings season has been surprisingly upbeat What are the goals of For the first time in a couple of months there is only one annual report to go over; so I’ll use this portfolio? this space to review the earnings season now that it’s mostly over. Dividend yield: 1% - 3% more The avalanche of annual reports began in February with Chemring and ended in April with than the current yield of the UTV Media. All in all there were 11 companies up for review and the good news is that in FTSE 100. every single case the 10-year average earnings (sometimes called the earnings-power of the Dividend growth rate: 1% - 3% company) and the dividend increased from the previous year. higher than the FTSE 100 over This may be an indicator that the intrinsic value of the businesses increased in each case, the medium term. although intrinsic value is not something that can ever be calculated with much accuracy. Capital growth rate: 1% - 3% It’s inconceivable that a portfolio of stocks can run on forever without having any bad news, higher than the FTSE 100 over so it’s especially important, when everything is going to plan, that investors steel themselves the medium term (with for trouble ahead. dividends reinvested). Exactly where and in what form that trouble will come from is unknown. The only thing we Volatility: Another goal of the can know is that at some point in the years ahead there will be trouble of some sort, and it’s portfolio is to be less volatile then the FTSE 100 in the at that point that the real investor is separated from the speculator. Speculators run at the medium term. first sign of a problem while investors tend to hold tight for the long-term. However, for now I think we can say the portfolio has done pretty well out of this earnings season. ICAP shares added to the portfolio After last month’s buy alert for ICAP I added 450 shares to the model portfolio at a price of 365.2p each for a total amount, including commissions and taxes of £1,661.78. JD Sport annual report – Still expanding at full steam "The leading retailer of sport inspired fashion apparel and footwear" - jdplc.com JD Sport had a positive 2011, despite all the gloom which surrounds the retail industry at the moment.