Investment Strategy: The Terminator

"That Terminator is out there! It can't be bargained with. It can't be reasoned with. It doesn't feel pity, or remorse, or fear. And it absolutely will not stop, ever, until you are dead."

This nearly effortless strategy will by far give you the best 'bang for your buck' in terms of time and effort required for its implementation and the portfolio return you get. Most people shun this approach though as it is seen as boring and to be honest just too easy.

I personally use this approach for a significant part of my investments such as pensions and children's savings. I use other strategies also which I will go into at a later date.

If you haven't already guessed it's a diverse portfolio of index funds held and rebalanced over the long term. No doubt some of you are already thinking about leaving this webpage, disappointed I haven't revealed a new and exciting strategy that will help you multiply your money over the next few months.

You may be surprised to hear though that this approach will crush the far majority of private investors in the long term. Why? History has shown us they (unsuccessfully) try to time the market, jump in at the top, run away when prices get cheaper, spend too much on commissions and chase after the latest hot tip with high hopes for the future.

Past performance also shows us that you will also beat most fund managers, especially after fees are taken into account. Of course, just matching an index and getting an 'average' return is not appealing to investors and doesn't feel a worthy goal for investing.

The big irony however is achieving an index return over the long term would put you in the high performing category of investors as most fail to match that simple benchmark. Check out the graphs below, shocking isn't it?!

Investor returns are a mere half of S&P 500 index, even less when it comes to bonds! Simply focusing on reducing that behaviour gap will give you huge returns over the long run.

To close this gap the investor must switch off their emotions, any thoughts on what the market will do next and pretty much just do one thing, relentlessly keep on buying and rebalancing. (Sounds simple doesn't it, but it's fraught with dangers as the human mind will want to tinker and want to predict - see pitfalls below).

It requires absolute discipline. Whatever the market sentiment, up or down, bull or bear, new highs, new lows, with no emotion you keep on moving forward, saving month after month, accumulating more and more index funds/ETFs for your portfolio. Overtime it will grow and grow and you won't have to think twice about what the market will do next.

Follow these steps to set up your 'Terminator Portfolio'

1. Asset allocation: First step is to choose the mix of bonds and equities. This depends on your age, risk/volatility tolerance and time frame. The younger you are, the more risk you are willing to take and further out in time you plan to use the money the greater the % of stocks. A very general guideline is your age in bonds, so for example someone who is 30 would have 30% of portfolio in bonds. This can of course be adjusted plus/minus 10%, I prefer a higher amount in equities.

2. Costs are key to higher longterm returns, the cheaper the better so choose low cost index funds  and ETFs; keep that obey for yourself and your investments. will smaller portfolios it is better to focus of funds rather than ETFs so as to keep commision charges low.

3. Diversify the asset classes over different indices.
Bonds: Sovereign bonds, High quality corporate bonds,  Low quality 'junk' bonds
Stocks: US, Europe, Asia, Emerging Markets, Small Cap and Value.

For example (there are many ways of doing this; the simplest example being a mix of Total world equity index/Total international bond index)

20% Sovereign bonds
5% Corporate bonds
20% US equities
20% European Equities
20% Asia
15% Emerging markets

3. Re-balance periodically. There is no hard or fast rule when and how to do this. One approach is to do it on an annual basis, another is to wait until there is more than a 10% deviation in the set allocation. For example emerging markets may be set at 20%, but has fallen by 2% to 18%. Sell those funds that are above their set allocation and use the money to buy more emerging market stocks.
This approach exploits the fact that asset class performances revert to the mean so rebalancing forces the investor to sell high and buy low.

Some pitfalls to avoid:

1. Timing the market, such as equity indices are now at new highs so reduce their allocation in prediction of a pullback. You will most likely fail.

2. Failing to rebalance. US equities performed really well in 2013. It may be tempting to keep any growing allocating as you want to capture any future outperformance. You will miss the next reversion to the mean of the underperforming assets.

3. Overconfidence. Believing you can tweak the strategy to improve the returns with adhoc decisions making e.g. timing, predicting the next turn, watching the news; or even outperform it by buying individual securities. I'm not saying it definetly can't be done but you will now be swimming with the sharks, one of them being your own behaviours and biases! Prove you can do it first before changing the whole portfolio.

4. Pulling you money out at the market bottom during the next bear market, the worst and hardest of all. Seeing your portfolio cut in half is most likely going to freak you out, especially if there aren't many years left to retiring. Unless you really need the money do not start selling your funds/ETFs. Keep rebalancing, some assets will perform better (or less worse!) that others. Even better you should still be putting in your monthly savings. You will actually now be buying more stocks/bonds for the same amount of money. You should get handsomely rewarded for this in the future.

Well that's about it, a simp mechanical portfolio that will terminate most of your peers and even some professionals!

Semcon: Time to jump in when others head for the exits?

First a bit of background on Semcon, a Swedish small cap stock with a market cap of 1.1bn SEK ($170m). Despite being fairly small it has operations all over the globe in 45 sites including Sweden, Germany, UK, Brazil, China, Hungry, india, Spain and Russia.

The following is a summary of their own description of operations
"The company is active in the areas of engineering services and product information, developing products, plants and information along the entire development chain."

Well, what does that really mean? The graphs below highlight pretty well their business, it can be mostly summarised as industrial services to car manufacturers in Germany and Sweden. These services provided include Automotive R&D, Design & development and Informatic.

The stock price peaked in July at around 80 SEK and has since been in a down trend where it is now at 61 SEK, down 23%.

In July the company came out with their half years report and gave a positive view to the market here, increased profits in the third quarter here but then in Decemeber gave a warning that profit expectations were too high here, as there would be one off costs due to project delays and restructuring executed earlier in the year.

It looks like the stock price got ahead of itself at the start of the year, shooting up 50% and is probably over reacting now on the downside. Here's possibly why

The P/E ratio for 2013 is now a reasonable 12.4, below market average, and the free cash flow yield (FCF= operating earning - CapEx) is an attractive 10%. The enterprise value ratios are also all under single digits (remember these figures still include the one off charges from restructuring and project delays).

That is not to say the company is struggling to return cash to investors, both ROE and ROIC (calculated from EBIT/(total assets minus non-interest bearing liabilities minus goodwill minus intangible assets) look very healthy. Last years dividend was 2.00SEK which will be increased to 2.5SEK (4.1% yield) this year.

Even better the company has paid off all its longterm debts and has a current ratio of 1.5. As an addition to understand the current valuation of Semcon the following is a valuation of the stock using an Earnings Power Valuation here and here. No future growth is predicted, only past performance is used as a guide.

Revenues and EBIT is shown for the past 6 years which captures the financial crisis of 2009. It's clear to see that earnings are can be volatile, however uncertainty can provide opportunity.

One time charges are added back to EBIT and an average margin is calculated (here I actually ignored 2008 in order to get a more conservative estimate). This margin is then applied to current revenues to give a normalised EBIT.

Tax and last years depreciation are deducted to give the 'earnings power' of Semcon. The enterprise value of the company is then obtained by dividing by the cost of capital of the firm, here I've used 7% (one data source has 6.85%). Adding in cash and removing debt gives an equity value of 56 SEK per share, just 8% below the current price.

Book value of equity has grown at a compounded rate of 13% per year from 385.4 MESK (2009) to 633.4 (2013), mostly as a result of paying off debts.

At this point it would be prudent to explore the risks and 'non-bull' case with this stock by following Charlie Munger's advice to 'Invert. Always invert'.  Some of Semcon's biggest customer are Volvo and Scania, companies that are currently undergoing difficulties of their own. This puts uncertainty on some of their future revenues.

Amazingly the company was trading at P/E 6 at the end of 2011 and 2012, this seems extremely low in the current environment. There was a multiple expansion in 2013 to around 12 with inflated 2012 earnings, which have since then fallen but the P/E ratio has held at the historically high 12.

The earnings multiple expansion was probably also a reaction to the first dividend payment in 2012 of 2.0 SEK. The proposal by the board is to increase this to 2.5 SEK, which should act as a floor to the share price.

P/B is currently 1.74, higher than in 2012 (1.5) and in 2011 (0.98); the book value of equity per share is currently 32 SEK, 50% below the current price. Although I doubt it will fall this far, that would result in a dividend yield of 7.8%!

Putting this altogether suggests a good price for Semcon would be between 1.5x BV, 48 SEK; 2.5 SEK dividend at 5% yield, 50 SEK; and from EPV 56 SEK. It's now a waiting game but I suspect the moment has passed.

Is 3D Printing and Arcams Stock About to Pop?

"The market can stay irrational longer than you can stay solvent" - John Maynard Keynes

Yesterday 3D printing stocks fell sharply in response to 3D Systems cutting its profit estimates for 2013, causing its own share price to fall as much as 28%. Fears of a bubble in the whole industry continue.

Value investor Whitney Tilson has openly stated that he is short 3D Systems here as he thinks the company is extremely overvalued and will end badly for investors. He gives the following reason as to why the stock currently valued at $6bn is really worth a tenth of that.

• Trades x17 revenues
• x64 trailing EBITDA
• x63 next years earnings
• Slim gross margins 50% and net margins 15% (historically successful large companies with such P/S ratios have had 70-90% gross margins and 20-30% net margins)

He believes the company should be valued x2 revenues, a 90% drop from current prices. Shorting shares is a tricky game and can be akin to standing in front of a runaway train with these high momentum stocks. Part of the game of course is to go public with your short thesis, to plant the seed in investors minds that the stock is overvalued and encourage Mr Market to correct his mistake.

3D Systems was up 270% in 2012 and 161% in 2013 although this year may be the beginning of a correction. It looks like the 200-day moving average is the 'battle ground'.

Arcam AB is a Swedish based company that uses 3D printing technology to manufacture metals parts for the aerospace and implant industry here, here and here. The share price is up 365% in just the past year and unbelievably 2277% the past three years. That's a x22 bagger!

Below we can see Arcam's revenue and earnings the past 5 years, which have been constantly growing. The market cap is around 4.8bn SEK ($735m) and is currently trading at x22 revenues, x225 trailing earnings and with EV/EBITDA 164!

If we apply Tilson's x2 revenues valuation then Arcam also has a long way to fall. It should be noted that Arcam is significantly smaller than 3D Systems and could probably justify a higher P/S than 2.

The market is pricing in a lot of growth the coming years which investors are paying for today. To help understand how much growth is required to justify the current stack price we can do a 'discounted cash flow' analysis using a few assumptions (See Aswath Damodaran's blog for more details).

Firstly revenues for the next 10 years have been calculated. We start with current rolling figure of 195.1 MSEK and grow them at 50% for the next 3 years and then gradually slow this growth towards 3% in the preceding 7 years as the company grows bigger and bigger reaching a steady state. The companies after tax operating earnings are then calculated using current operating margins of 12% and a tax rate of 22%.

For the company to be able to grow revenues a certain level of reinvestment, such as R&D, will be required. Every 1 SEK increase in sales has been calculated to require 0.5 SEK in reinvestment.  Deducting this from after tax earnings gives us a 'free cash flow to the firm'.

At year 10 we can assume the company has fully matured and will grow at a steady state of 2.5% into the future, from this we can calculate a terminal value, in this case 3,867 MSEK. This value and the cash flows are discounted to a present value using an estimated cost of capital. This starts at a high 12% to reflect the associated risks of a small growth company and gradually reduces to 7.5% as the company grows and becomes less risky.

A total firm value of 2043 MESK is obtained to which current cash is added and debt removed to give a current value of equity of 2136 MSEK. Dividing by the current number of shares gives a share price of 127.6 SEK, 56% less current levels.

Rather than viewing this as a definitive value of Arcam it gives an idea of what expectations are baked into the current price. The market pricing in higher free cash flow generation either through greater/faster revenue growth and/or higher margins.  If Arcam fails to meet these expectations in the coming months and years then a big correction in stock price is likely to occur. Remember the above calauation assumes 50% revenue growth for the next three years, a level Arcam has not yet been able to achieve.

On a final note Arcam's share price finished today up 5.4% with 2013's report due for release tomorrow. Be on the lookout for any changes in profit guidance. As is always the case with high growth companies disappointments are likely to come at some point.

Biotech Boom Lifting All Boats

The following is a 3 year chart of the iShares Biotech ETF IBB. The 200-day (blue) and 100-day (red) simple moving averages are also shown to give a sense of the strong momentum and up-move there has been. The so called 'animal spirits' are back.

Returns on the ETF have been pretty spectacular 65% in 2013 and 32% 2012. There is a boom going on in biotech stocks that is lifting all boats.

Below shows some valuation metrics in this ETF. They are not shockingly high, especially for biotech's that are seen as growth stocks, although it should be noted they are forward looking an there rely on predictions of future earning etc.

If we take a look in the Swedish markets there have been some huge moves the past year in healthcare related stocks

Orexo 206%
Sectra 65%
Allenex 175%
ELOS 109%
Oasmia Pharmaceuticals 101%
Vitrolife 128%
Swedish Orphan Biovitrium 95%

Even large cap stock AstraZeneca is moving up with big returns of 35% the past year and 20% in just the past 3 months! It is now trading at a P/E 17 and P/FCF 33, this is a generous valuation for a company that has had falling revenues and net profit the past years. Some of its drugs will be coming off patent so further reductions are expected in the coming years.  Growth however is expected to return earlier than previously thought with sales in 2017 matching 2013 here. Clearly the market is much more willing these days to believe and price in positive future scenarios.

Biotech stocks are popular with private investors (or should I say speculators) because of their big moves, however understanding these types of stocks and valuing them is very tricky. Future cash flows depend on the success and predicted sales of a multitude of projects and potential drugs in the pipeline. One negative announcement or a clinical trial failure can crush a stock price.

You either have to be a very good analyst or diversify over many stocks or have very strict money management trading rules such as stop losses. Take for example, Active Biotech. Its stock price fell 50% when CHMP (Committee for Medical Products for Human Use) surprised investors when they recommended a refusal to market Nerventra (Laquinimod) for the treatment of multiple sclerosis. The sales of this drug have now been completely discounted from the share price here.

Drillcon: An anti-Buffett stock

A small drilling company called Drillcon AB has had my attention the last week or so. I've called it an anti -Buffett stock as it is a capital intensive business, with as far as I can tell no moat, no economic goodwill nor brand. On top of that its performance relies heavily on commodity prices.

First a bit of background. It is a Swedish small cap that whose main activities are diamond core drilling above and below ground, directional core drilling, raise boring and horizontal raise boring. It's operations cover Sweden, Finland and Portugal.


I've not been able to pinpoint exactly how many machines it has but the end of year report 2012 report refers to about 51 being in use in it's three geographical operations (double counting is highly likely as the Swedish arm of the business hires out machines to the Portuguese arm.)

Anyway, since mid-2013 the company has suffered a drop in revenues in Finland due to reduced prospecting activities and lower precious metal prices. The company of course has a high level of CapEx as fixed costs, meaning a relatively small drop in revenues (-8%) caused operating profit and net income to fall off a cliff by over 70%! (Of course this world both ways if these lost sales are recovered, profits will bounce back.)

Interestingly I think this has resulted in a situation where the company looks expensive in respect to its earning power and cash flow, yet looks cheap relative to its assets. For instance, all rolling P/E, EV/EBIT and EV/EBITDA ratios look relatively high and are significantly higher than end of 2012, despite the 26% drop in stock price. 

In contrast to its income the share price is trading just above it's book and tangible book value of 3,07sek. The vast majority of the companies equity is made up of its tangible assets (i.e. drilling machines) and it has little debt.

P/B & P/TB 1.02
Current ratio 1.64
Total debt/Equity 29%

An investor buying this companies stock is effectively buying its drilling machines at book value, nice, but unfortunately overpaying the current income stream (such is the case with these type of situtations). This leaves an interesting dichotomy about which is more important in determining the company's fair value. 

A deeper look in the notes shows that Drillcon's machine purchases total about twice the current tangible book value, the difference has been depreciated away over the years. This begs the question, what is the real market value of these assets and what would be their value in the event of a liquidation? I assume the latter would be significantly lower as the company would be a forced seller and the market for drilling machines wouldn't being very liquid.

Clearly Drillcon is in a cyclical industry and mining is in a depressed state at the moment. The key is knowing whether Drillcon specifically is in a permanent decline and whether it will get it's profits back. What I've been trying to decide is whether the current price gives a sufficient margin of safety to protect from this potential negative outcome.

No doubt the share price could fall significantly below tangible book, especially if the company continues to loose sales and profits. In actual fact the share price could fall at a constant P/TB ratio as the value of its assets are depreciated away and the company can no longer afford new CapEx. The company would then be worth more dead than alive.

It should be mentioned at this point that both the Swedish and Portuguese businesses are still growing (albeit slowly). Plus investment company Traction increased its stake in the company back in the summer by making an offer to share holders at a share price of 2,90sek. This may put a short to medium term support level.

Looking forward if the Finnish operation claws back some sales and manages to generate zero EBITDA, instead of a loss so far seen in 2013, then EV/EBIT becomes 5 (about the same as 2012). I would like see a bit more pessimism and a better margin of safety to get me interested.

I expect a correction in the market soon (yes timing the market is not a good idea!) and combined with the possibility of poor report in February could present an opportunity as this stock goes lower.

It looks like Mr Market may deliver with another 2.2% loss yesterday. This is despite Catapillar's better than expected EPS numbers which pushed up related mining companies.

Buying what nobody else wants

Want to run the opposite way to the crowd and buy a stock that no one else wants? Well according to this article by Avanza there are three Swedish companies that top the most hated list of equity analysts.

PA Resources - an oil company that has been raising capital all year via bonds/shares and whose stock that has been crushed, down 85%.

SAS - an airline company that has made a small profit for the first time since 2008 but is in need of further financing. Interestingly it fell to a low of 5kr in Nov 2013, down 80%, but has since recovered most of that loss and back up another 300%, what a ride!

Axfood -a food retail company whose stock is near its three years high. It's at historically high valuations and I assume this is why it has several sell recommendations.

For me, only the first stock PA resources really passes the 'bombed out' and hated test. However, it's already up 21% this year and in an up trend, sentiment is starting to change from bad to less bad, from hated to less hated.

When sentiment is at its lowest then markets over react on the downside and opportunities arise. Most investors are looking at PA Resources and thinking 'get me out of this!' or 'no chance, I wouldn't buy that!' The sellers get washed out and there is none left to sell and take the stock lower.

This is certainly isn't a 'wonderful company' that you would want to hold forever, however all that is needed is a change of view from 'this is a terrible stcok' to 'this is just a bad stock' for a large pop up in price to occur.

One way I would play this is to treat the share like a call option but with no expiry date and invest no more than I would be prepared to loose completely or at least 50% on the downside.

I will keep track of these three stocks and post an update in the months to come.

Money for Nothing?

On Thursday Dagens Nyheter reported that Roburs vd Tomas Hedbrg had admitted that their most popular stock funds Allemansfonden and Kapitalinvest have probably not tried hard enough to beat their respective indexes (here).

He is quoted as saying that the funds had copied the indexes too closely resulting in just beating them just the once in the past 10 years. To fail to beat an index in itself is no big deal, plenty of others have tried and failed, but to not even try whilst charging a 1.42% fee is a complete failure to deliver value for its customers.

Both funds currently hold 70 billion sek in assets and pull in 1bn in fees avery year for funds that should be charging 0.4% as 'index' funds. That's 700m sek extra for doing nothing extra for their customers, a 175% markup! It's very easy too be cynical here and suspect they were treating these funds as easy money cash cows.

Why have so many people chosen these funds? Perhaps it's a lack of knowledge on their part and/or poor advice. The latter is more disturbing. Surely it goes against exactly what the professional advice should be telling their clients, 'avoid closet index funds'!

The following is a graph showing the funds performances over the past 10 years compared to AMF's World Share fund. All three hold a mixture of Swedish and global stocks, predominantly US and European.

AMF's is the clear winner over the past 3, 5 and 10 years (the Sharper ratio is also superior). The main difference? A far cheaper 0.4% fee. Interestingly in their material AMF claim this fund is actively managed based on low valuations and fundamentals.

The fund has a benchmarks that is 60% OMXSBGI (Swedish index) and 40% FTSE World Index.
Its relative performance is shown below, the benchmark normally wins but it's close; yearly compounded at 8.83% v 9.96%. Even with this better performing fund there is some room for improvement.

The take home message is fees really count. Some actively managed funds will be able to beat the indexes but they are few and far between. Without knowing specifically what strategies are being used by these funds it is unlikely you will find a future winner.

The absolute worst you can do is overpay for a fund that is no different to a passive fund. Know what the comparable index fund is charging and then try to find out what potential value the active fund is offering for the extra fees.

As an end note, Robur's admittenace of their mistakes is to be commended and they now say their two funds are being managed more actively in an effort to beat their index.

The question though investors should still be asking themselves is, will these funds be able to do so when so many others have failed and by a margin that will compensate for the high fee. Only time will tell!