The problem with the Energy sector & Tullow Oil (LSE:TLW)

Energy stocks. 

They are cheap by (recent) historical standards.

Now the issue is when will the oil price rise again in order to drive up earnings and a recovery cycle in the sector. In a normal business cycle commodities tend to see a drop in demand, followed by a cutting of investment in production followed by a rise in demand and therefore a sweet spot of rising prices before a new capital investment cycle kicks in. As long as the music is playing they have to get up and keep investing.

[None of what I have to say about this is original it simply sums up the position for my own understanding of the energy stocks in my portfolio.]

So with the downturn in oil prices now well into its third year one might expect the cycle to start to turn around. The protracted downturn after such a strong price environment during the 2010-2014 period has rather caught the industry out hence the trouble for my investments in Tullow Oil and Diamond Offshore.

This time it is different. 

But also the same.

It is different because unlike the 2010-2014 boom in oil prices the US is not creating new money. In fact headwind no.1 US is tightening monetary policy. This is bad for oil and bad for all commodities priced in dollars. A reduction in the global supply for dollars means a reduction in the price of commodities as there are fewer dollars around to chase the goods of global trade. 

Headwind no.2; OPEC. Recent high prices mean many countries like Saudi and Venezuela have been able to fund huge social giveaways. Now the price has halved they need to pump twice as much to meet costs. They cant do this because they have a production quota in the cartel. But at this point to raise prices they need to cut more, just when they can least afford it – so the incentive to break ranks and pump more means discipline is poor. This is to be expected. (Conversely when prices are high OPEC exacerbates the problem as there is an incentive to slacken production to make maximum revenue on your finite resource.)

Now maybe OPEC cuts would be more effective, threats of further cuts even have bumped the price, but for headwind no.3 – US shale. US shale is back in fashion as this previously high cost operation has managed to get its costs down so it is profitable with $50/bbl oil. This means with the present oil price whatever Saudi and OPEC cut the US is trying to make up with domestic production. Therefore US shale can make up the shortfall as the marginal producer – this effectively damages OPECs power because their biggest customer is becoming more self-sufficient. 

Wikipedia: Oil producers (2016)

Now ultimately the attrition rates of shale wells are high – they need far greater capital investment and the best formations have been exploited first. But in the near term the pressure on the oil market is intense.

The residual headwind is no.4 – Global Growth. With China slowing down (world no.2 consumer) and European demand falling for several years who can pick up the slack on the demand side? With a tightening dollar being negative for emerging markets (as they all hold dollar reserves and dollars become more scarce) it is difficult to see what can drive the price higher in the near term.

Wikipedia: Oil consumers (2015)

So there you have it. This makes energy stocks cheap, especially ones like Diamond Offshore – who wants deep water rigs when you can just drill onshore shale. They are likely to stay cheap until this turns around. So I view them a bit like options.

That said with TLW recently showing some unexpectedly strong share price performance I have been trimming my position quite a bit as it rose above my near term (Oil ~$60) fair value of ~£2.30. I still like it long term but having risen above the price it traded at the time of the rights issue announcement (while being now ex rights) it seemed a good time to sell down some shares once they went ex-rights to fund buying the new shares in due course. I think the buying has been driven by the short term rise in the oil price since the rights announcement with Brent oil up ~10% principally it would seem on geopolitical matters.

Eventually the capital cycle will turn assuming the earth does not enter a permanent depression. 

This is because every year several million barrels of extracted production must be replaced just to meet current demand excluding any increase in demand from global growth. This requires investment and with available oil becoming harder to find on land more investment is likely to be targeting offshore. The investment of course won't come until there is a crunch in the supply/demand balance for oil. That may be driven by fundamentals or by the dollar or increasingly it is difficult to see which is the dog and which is the wagging tail.

What could change the current status quo for higher oil prices:

• A reversal in the direction of US tightening or at least dovish Fed comment
• Higher than expected global growth especially China
• Rising costs for US shale as less attractive fields are exploited driving down marginal production
• Tighter than expected OPEC compliance
• War and conflict

I would say the first and last reasons look the most likely over the next 6 months given slowing US data and problems in Syria.

What could extend the current status quo for higher oil prices:

• A hawkish fed and the reversal of QE
• A major onshore oil field discovery
• Better shale drilling technology and attrition rates
• Peace and serenity
• Serious OPEC non compliance

Disclaimer: I have an interest in LON:TLW and NYSE:DO shares at present. These are opinions only, not investment advice. If in doubt read my disclaimer.

Do 'Defensive' stocks with high dividends exist?

As part of my portfolio building exercise I have done some preliminary research on various UK companies looking for a defensive earnings profile and a high dividend yield. 

Unsurprisingly this is not such a simple idea. 

Most of these companies have massive debt loads to manage and also large pension obligations which greatly increase their leverage and pull cash away from what should be ample dividends.

The basic opportunity set of the FTSE 100 is;

• Energy: BP & Shell 
• Utilities: SSE, Centrica, National Grid, United Utilities Group 
• Other: Royal Mail
• Telecoms: BT, Vodafone

Dividend Yields by Sector

Other stocks yielding > 5% include:

HSBC which offers a good yield but it is a bank and is cyclical therefore I want to look at that separately. Same for M&S. Similarly companies like Standard Life and L&G being financials are harder to compare to this sample set. Pearson offers a high trailing dividend yield but this looks set to be cut.

So what should I pick to give a defensive, large cap, high yield backbone to the portfolio.
I found objections to all those names but I want to sift out a couple for a deeper look.

Amiable Minotaur: The full data table

Firstly I think BP and Shell probably offer the best metrics and incidentally the highest yields at just under 7%. But this is due to the cyclical downturn in oil which may go on for some time. I think Shell is marginally more attractive than BP because it trades slightly cheaper at 9x against 10x ten year average earnings and has a lower overall debt load because BP is still carrying debt from the Deepwater Horizon issues of yesteryear.

The companies have comparable sized pension scheme liabilities and issues too with Shell’s around 7x average earnings at £94bn but with a large £13bn black hole, they are only paying in £1.3bn. BP has a £49bn gross liability at 8x average earnings with an £8bn deficit and paid in £0.6bn last year. I worry that these companies could have to increase payments to the pension schemes. However I think they can afford it – but the risk is to the dividend.

On an absolute basis RDSA & BP have huge pension schemes - but they have generally better profitability

So Shell makes my shortlist for further research due to (a) Potential for cyclical upturn (b) high dividend yield (c) marginally lower risk than BP. However I suspect dividend cuts for both oil majors in the next 12 months if the macro doesn’t improve – usually any yield much over 5% is a warning sign of a cut.

The Utilities are a trickier bunch:

SSE seems attractive with a reasonable consistency of earnings and a good 6% dividend yield. However the company has a huge debt load of ~£7bn against earnings of ~£400m a year in the last few years. This is a highly-leveraged business. Maybe typical for a utility but they need nearly £1bn for dividends. When you add in gross pension liabilities to the financial leverage with a further £4bn including a £400m shortfall it starts to look a bit scary. 

The dividend has been uncovered by earnings for several years now and looks under threat. I foresee shareholders taking a cut to that dividend in years to come if profitability can’t be improved. It looks pricey on 21x 10 year average earnings. It is a maybe. Because…

Centrica makes you realise it could be worse for SSE. The company has £6bn in borrowings too with much more earnings volatility including two large losses in three years. The icing on the cake is a £9bn gross pension liability with a £1bn funding gap! Centrica being the name of the former British Gas state monopoly unsurprisingly has a massive pension scheme. This is a pension scheme with a gas utility attached. 

The dividend is also under threat given poor profitability but there is cash headroom for now. That dividend is probably the only thing holding together this company’s share price. It looks cheaper than SSE on a 10 year average PE basis at 16.9x but still that is hardly cheap for a utility with a £1bn black hole in the pension scheme. [Also in my experience British Gas have the worst customer service mess I have ever had the displeasure of dealing with. A terribly run business]. So I think Centrica are off the cards.

National Grid offer a lower yield of ~4% and some similarly unattractive metrics like 19x 10 year average PE. Growth has been better at NG in the past 5 years which is a plus and hence the dividend here is generally covered by earnings. But NG has a £29bn debt load! Compared to £2-£2.5bn in annual profits. That is some serious leverage. Now throw in a £30bn gross pension liability with a £2.7bn shortfall! The company is paying £0.5bn a year to make up the shortfall which is 20-25% of earnings. Again being a former state monopoly with a pension scheme to match is a serious issue for investors.

United Utilities are a water group. Growth is meagre and the yield of 4% is not spectacular. At 14x 10 year average earnings the valuation doesn’t seem too stretched. But this company has massive debts of £7bn against average profits of £400m. That is some serious leverage. Throw in a gross pension liability of £3bn and it looks a bit problematic but the scheme does at least run a £250m surplus. 

It seems you either get a huge debt load like UU or SSE or you get a massive pension hole like Centrica or National Grid. I understand utilities need leverage to generate a meaningful return for equity holders but generally these companies have pretty poor economics. Yes they have regulated returns so can manage the debt load but if interest rates rise these stocks become anti defensive as their debt servicing cost increases at the same time as yield hungry investors abandon the stocks driving down prices as they can get their yield elsewhere in cash / bonds. Given I am investing to generate long term value rather than short term income I can generally choose to avoid these. 

Note the extremely high debt levels of the Utilities

My conclusion about the British utilities space is that it is the opposite of defensive. With huge debt loads, dividends positioned on a knife edge, popular disapproval and regulatory headaches and massive pension liabilities they are poised to deliver sub par returns to investors. 

I think the UK government has really been crafty in privatizing these businesses –as they take huge public pension schemes and debt loads off the public balance sheet and sell the shares to lure yield hungry investors (usually pensioners again!). The only reason to own them is for GBP derived income as few foreign stocks can offer such high yields after tax. The captive audience is probably supporting these valuations.

Note the biggest pension leverage is in the former state monopolies

Which brings me onto Royal Mail being the most recent privatization; It has a 5.5% dividend yield which is attractive. It also has low gross debt of around £400m (net debt £nil) which is not bad either given reasonable profitability. The pension liability of ~£5bn is a worry but the company actually has a net asset of £1.7bn so it is well funded. However note the company is still contributing £400m a year to the scheme. This is 2x what it pays in Dividends to shareholders. 

I note also the company is giving away 1% of its capital as free shares to employees amounting to £150m a year! I suspect Royal Mail Group may be something of an employee centred operation! Still worth a bit more in depth work given the low leverage and funded scheme as compared to the Utilities.

Which leaves Telecoms.

Vodaphone has a nice 5.5% yield and trades around 13.7x 10 year average earnings which seems attractive vis-à-vis the utilities. The pensions scheme is not really a concern at £5bn gross liability (£300m net deficit) against a similar level of average profitability. The debt load however is big. £57.5bn of big. That is >10x average profitability. A heavy load to carry but there is substantial £10.5bn in cash so net debt is £47bn. Also the company has experienced some revenue and earnings growth over the past 10 years and whilst slightly uncovered the dividend may be able to continue. Given the company it keeps this stock should be worth a second look.

BT Group. I think this is a no. Yes it has a reasonable 4.5% yield which is actually covered by earnings. Yes debt is not crazy at £14bn or ~7x average profits. Yes the stock trades at 15x 10 year average earnings so is not too dear. But, BT has a £50.3bn gross pension liability which is 24x the average earnings of the company. On top of that BT has a £6.3bn shortfall! They are paying £1.1bn a year into the scheme of which £880m is to make up the deficit. That is the same as they pay out in dividends a year. Or 1/3 of annual profits. Like National Grid and Centrica these former state monopolies are just pension schemes that throw off a little cash to investors seeking income. Ok yes it has some growth and a decent return on its massive capex but I fear that pension hole will continue to weigh on the shares for the foreseeable future. Vodaphone just looks a bit safer in the telco space. 

On a PE basis Centrica looks cheap as do the energy companies. SSE and NG look particularly expensive.

So my shortlist for a ‘defensive’ high yield payer are:

• Royal Dutch Shell (Cyclical upside, cheapest stock on 10 year PE)
• Royal Mail Group (Low debt, Pension surplus, Good yield)
• Vodaphone (No serious pension problems, decent yield, not BT!)

In depth research to follow.

Disclaimer: I have no interest in any of these shares at present. I may do in the future. These are opinions only, not investment advice. If in doubt read my disclaimer.

Why Bed Bath & Beyond (NASDAQ:BBBY) seems to offer a rare bit of US value

If you watch the work of a drug sniffing spaniel on TV you will note that occasionally they will have to plant some drugs in a car or container so the dog can find them otherwise it gets demotivated and gives up. Hunting for value at the end of a bull market is a bit like this for the humble analyst – one just wants to overturn a classic value opportunity occasionally to avoid becoming demoralized about the state of investment options. 

With US stocks trading at significant highs it is increasingly difficult to find any definitive value stocks. The so called ‘bricks and mortar’ retailers seem to be offering relatively low valuations with companies like Sears likely to go to the wall. This sector in the US is much like the one in the UK where the Next vs ASOS trade off with disruptive online retailers is driving down the margins and sales of established players – one stock in particular is often mentioned; Amazon.

Amazon is huge – the growth (especially top line) has been incredible. Amazon has managed to gain a wide moat from the application of network effects as consumers buy more and more from them utilizing their broad offering and impressive sales platform and distribution network. I will often see if an item is on Amazon first as the checkout is so straight forward as they already have my details. 

The success of Amazon is particularly pronounced in standardized items like electronics and books where price is the key determinant. I think retailers with things like clothes, home-wares, furniture etc have a greater chance of survival against total 'e-commercialization' due to the tactile nature of their products.

Where does that leave a stock like Bed Bath and Beyond? 

BBBY is a retail group principally composed of home-wares stores alongside a limited number of other concepts. Established in 1971 the company has grown to have a strong retail presence across the US with 1,530 stores across the US and Canada. BBBY like most traditional retailers is suffering a downturn which I think is in part structural and in part cyclical. Therefore my value thesis is that the cyclical element of the downturn is being underplayed and the structural disruption created by Amazon and other online retailers is being overplayed.

My view looking at retailers is that companies like Amazon and ASOS which grow top line, offer the lowest prices, and have therefore very low margins are successfully taking market share from traditional retailers. 

Amiable Minotaur Amazon Model: Revenues & Margins

However I think some of this is cyclical. I believe the wider economy is slowing and this is pushing consumers to be increasingly price conscious playing into the hands of the new web discounters. I think we are seeing a cyclical slowdown in consumer spending and we will see this before we see a real drop in GDP. 

I think therefore that the structural story which has been so prevalent in the media about Amazon and other disruptors is being slightly overplayed because it is a more exciting story about technological change. If this thesis is correct Amazon could suffer a sharp correction in due course as the tail end of the consumer slowdown starts to impact their top line growth and the trajectory of their world domination.

Now my thesis could well be wrong. But I take the view that there are two maxims to investing; the classic EM political argument ‘buy when there is blood in the streets’ and my own DM maxim ‘buy when the media can’t stop going on about a trend or crash.’

BBBY are adapting to the new environment and seem to have a decent website proposition. I think some good operators can take advantage of their physical retail operations in combination with E-commerce to give a broader offering. By which I mean sometimes the ability to order online and take back to a store and exchange can be highly convenient for consumers. There may also ultimately be a backlash against this move online if physical retailers can offer a different ‘experience’ and something more exclusive. 

Trends change. Right at their extreme the consensus becomes a foregone conclusion.

I think we have reached peak Amazon because of this;

The Economist

These things tend to hit the press right before a significant fall, remember this (before the worst recession in a generation):

The Economist

Now I don’t like to do too much macro prognostication and I don’t think I need to with BBBY because this stock is a rare combination of cheap and decent quality. Looking bottom up let us take a view of the numbers.

BBBY trades on 8x trailing P/E and 4x EV/EBITDA. That is cheap for a company which over the past 10 years has consistently created significant value for shareholders. The stock has 10 year CAGRs of 9.4% EPS growth (3.6% excluding buybacks) and 6.2% revenue growth. Decent numbers for a mature business. It has generated an average 14% ROA and no less than 20% ROCE every year for 10 years. This business has low capital intensity averaging 2-3% Capex/Sales ratio and around 20-30% Capex/Net income.

BBBY has not paid a dividend until recently having commenced a $0.125 quarterly dividend last year. The pay-out remains low with around a 1%-2% yield but could easily be increased depending on the scale of buybacks. BBBY has consistently been buying back stock for many years. 

The company has repurchased 42% of the shares in issue 10 years ago with 120m shares bought back. This has flattered the EPS but is a common if muddy method of capital returns often employed in the US due to high taxes on dividends. Better yet until recently all the buybacks were purchased with cash generated rather than debt. 

In 2014 the company issued a series of bonds totaling $1.5bn in three tranches with $300m due 2024 at 3.749%, $300m due 2034 at 4.915% and $900m due 2044 at 5.165%. Note these bonds are investment grade. Prior to this debt raising the company ran net cash:

Amiable Minotaur BBBY Model: Net debt & ROE

On the one hand the additional gearing should lower the cost of capital and enhance returns on equity – furthermore the attractive financing rates and long maturities give ample flexibility to BBBY in the future. They got the bonds away during a stronger period in their results which was smart.

The bad bit is any debt reduces financial flexibility. The present debt load is manageable being around 1 x operating profits so gearing is low. However, leverage works best with a growing business not a potentially declining one – still I think the modest gearing is a net positive for BBBY and it should enhance returns of cash to shareholders over the medium term.

The greater form of debt that BBBY has is the burden of a leased store base. The company has $3.2bn of future minimum lease commitments (undiscounted) with around $585m in annual costs at present. The good news is they appear to have a very flexible short term portfolio. Only 29% of that $3.2bn is due after 2020 suggesting the weighted average portfolio of commitments is short term ensuring greater flexibility to the company to change and close under performing stores if we have indeed reached ‘peak physical retail.’

Using my 8x lease multiple for $585m per year assumes a PV of leases at $4.68bn. This would give the company a total debt load of ~ $6bn if we treat those leases as debt. However as above we can see the actual undiscounted future minimum lease payments are substantially less than this. If we take a worst case $6bn of debt ‘like’ items on the balance sheet this still amount to ~4x operating profits (not adjusting for depreciation vs interest). So the operating leverage is clearly higher than the initial indebtedness would appear – but still the combination of the operating and financial leverage is manageable.

Fortunately defined benefit pension liabilities are only ~$20m and therefore negligible. 
Share based payments on the other hand are a little excessive. The company recorded $67m (2015; $66.5m) of share based payment expense in the last period. The post-tax values were $42.4m (2015; $42.4m) which represents 5% of profit after tax. Not a huge hit for shareholders. But I do question whether management really need this much of an ‘incentive’ to perform their jobs. I suspect this will be reduced in the current fiscal year due to the decline in the share price.

I do however like the feel I get from the governance report and the management. The CEO has worked his way up through the company over 25 years (CEO since 2003) and despite a mandate to hold a minimum of $6m in stock (~150,000 shares) he holds more like 2m shares. The co-chairmen are octogenarian founders. This is a family business with long serving directors. Now I think they are a little self-serving reading through the compensation disclosures. But I can live with that as they appear to be decent operators with the right level of investment and therefore incentives to grow value in the long term.

BBBY have no particular 'moat' or sustainable competitive advantage other than physical presence and scale. This is a big company with 1,500+ stores so some level of scale helps the business. The lack of any greater unique advantages makes this kind of retail subject to commodification and price wars that drive down margins.

What about the valuation?

I think BBBY shares are worth around $60 a share. 

I am baking in a relatively modest cyclical downturn and slow growth going forward. Forecasting 1% top line declines in 2017 and 2018 with 1-2% growth thereafter and operating margins dipping to 10% rising to 10.5% over 5 years (only in 2009 did the operating margin dip below 10%). I foresee capex at ~3% of sales over the medium term as the company invests more in its online offering. Using a 7.4% WACC I get a DCF value of $61.15. 

Amiable Minotaur BBBY Model: Revenue& Operating Margins

Unsurprisingly the stock screens less well on a DDM model due to the paltry pay-out at present. Given an assumed 2017 dividend of $1 a year and a 4% growth rate the DDM gives only an $18 a share value. But if we assumed they spend ~$1bn giving back cash rather than buybacks a dividend of $6 a share would be possible meaning a DDM of $107 per share (BBBY has spent > $1bn a year for the last 3 years on buybacks).

The 10 year average PE for this business is 11.3x – this seems low – paying 10x 2017E earnings suggests a value of $47 a share and there is a margin of safety here as these are likely to be cyclically depressed earnings. 

Amiable Minotaur BBBY Model: EPS

Therefore my floor value for BBBY would be $47 in the medium term and $60 in the longer term assuming a relatively modest downturn. I think the market is discounting the death of traditional retail at present many years before its time. Again I think from a value perspective much like Next vs ASOS paying <10 P/E for a decent quality and highly profitable retailer vs 185x P/E for Amazon - albeit an obviously brilliant and highly disruptive business looks a bit protracted.  

Things I like about BBBY:

• The valuation is cheap (by my metrics)
• Financial flexibility - Debt levels are modest and long duration / leases are short duration
• Well established management team
• It retails items that are tactile

Things I don't like about BBBY:

• The business of BBBY has no particular sustainable competitive advantage
• The company pays out some pretty generous share based comp
• The retail industry is in a cyclical downturn and faces divisive secular trends and disruption
• The dividend payout is a bit low 

Disclaimer: I have no interest in BBBY shares at present. I may do in the future. These are opinions only, not investment advice. If in doubt read my disclaimer.

Are Tech stocks Value stocks? (ii) Lenovo Group limited (HK:0922):

I have been considering whether Lenovo may offer value in the tech space. The company is the world's largest producer of PCs mostly laptops as well as desktops and tablets. I have decided to add Lenovo to my tech series as I suspected it may offer a valuation which is actually appealing for the portfolio. Microsoft and Facebook look expensive at first though so I will look at these later.

Lenovo shares have lost 60% of their value from their mid 2015 peak due in part to the cyclical downturn in emerging markets and in particular China alongside a more structural trend of slowing demand for PCs globally. The stock screens as rather cheap with a 5% dividend yield and 12x trailing PE. These kind of metrics get my value instincts going so I decided to dig a little deeper.

In the annual report Lenovo blames the cyclical slowdown in China and general macro for the poor 2015/2016 results. They do acknowledge the slowing growth of the PC market calling it their core business but they are restructuring and looking to innovate going forward. 

Qualitatively speaking this is not good news. 

The way I see it building PCs is a commodity business. Back in the 1990s and 2000s the under penetration of computers was very high and so assembling systems was a profitable and growing business. However in 2011 we reached 'peak PC' and since that time sales globally have been declining. This is now an ex-growth business. 

Statista & Business Insider

I think Lenovo continued to outperform the other PC majors (Acer, HP and Asus) since 2011 due to growing its market share and a predominant position in China. However since 2015 the stock has collapsed. 

Google Finance: 2011-Present

So the principal questions are:

(i) Is this merely a cyclical downturn or is the PC market now a declining industry?

(ii) Is Lenovo capable of reinventing itself to grow in future?

In answer to (i) I struggle to see the PC market growing globally in future. The production of PCs is already heavily consolidated by the three big players; Dell (private), HP and Lenovo. There is limited scope for further consolidation. Demand is likely to remain relatively high due to business use of PCs with Windows and MS Office - I don't foresee a total collapse in the short term so this is not quite a 'Kodak' moment. 

However Moore's law has now made PCs as powerful as they generally need to be. I think people and businesses will replace their PCs more slowly in future. This means lower demand. The last 5 or 6 generations of Intel processors have been becoming progressively more energy efficient and smaller but not really a lot faster - because they dont need to be. Therefore obsolesce is becoming less of an issue than it was in the 1990s - manufacturers need to build it into the product. Even Apple are struggling to really get consumers excited about each new iPhone or iPad development.

Beyond this PCs are a commodity business. Unlike Apple who own both the hardware and the software for the Mac platform - Windows will run on any of the PCs produced by Dell, HP and Lenovo. 

I recently bought a Lenovo laptop. I only bought it because I got a good deal and it was cheaper than competitors. I wanted a laptop with Windows so I could use MS Office while being mobile. Now that means Lenovo produce a commodity. Commodities lack pricing power. I want Office and Windows therefore Microsoft have something of a moat here. But the hardware is of no interest beyond the basic specifications I get for the price. [Except I wanted a decent screen but realised at my price point they were all bad so I just went on price.] So without any real brand loyalty to the assembler the market becomes a race to the bottom pricing wise to gain the most market share. 

The PC as a commodity is best highlighted by looking at Apple. Personally I prefer Windows and PCs for work and browsing however I have had three iPhones and I love the iPhone. Apple can price the iPhone well above an equivalent Android or Windows phone and I will still want the iPhone. 

Why? Because I can migrate my old phone to the new one seamlessly. I like the design and feel. I am used to the operating system. This is the same reason really that I want a Windows PC with MS Office. But that Windows PC can be made by anybody. Remember those Microsoft adverts 'I'm a PC' - well think how that devalues the given PC manufacturer and captures value of Microsoft - the marketing is very clever - you want a PC but you don't think 'I want a Dell' or 'I want a Lenovo.' 

So essentially Lenovo, HP, Dell etc add very little value. They simply assemble and package a set of components. Microsoft take a lot of the value for the software license with almost zero incremental cost for each unit Lenovo sells. Intel or possibly AMD will capture most of the value of the CPU. Seagate or WD or Samsung make the hard drive etc etc. 

This is different to the great success of Apple. They made the Mac, Ipad, Iphone - the device to have - by packaging it and imbibing it with intangible value  through design and ergonomics to be greater than the sum of its parts. It is all about marketing the product to create desirability and this allows Apple to charge more than the sum of the parts of the device and thus have a higher margin. 

The underlying hardware in an Apple device is very similar to any other device but the key is they market their devices simplistically which appeals to humans view of quality and desirability. For instance the iPhone - they have generally kept it simple - one phone with a series of numbers '4, 4S, 5' which builds continuity and encourages an upgrade. The specifications are also simplified with an A8 chip or an A9 everything feels progressive. The first thing you see on the iPhone shop with Apple is the colour options for the phone! Yes recently they have added 'Plus' models but these are clearly larger - a plus size model - pardon the pun. Or the 'pro' designation on an iPad or Macbook. 

Apple have recognised the key to making a product that is technically complex into something simple and desirable. You have to find external sources to see how much RAM or what clock speed the ipad operates at. In general PC manufacturers have a myriad of names and brands and numbering practices which instantly make comparing products even within the manufacturers own portfolio extremely taxing and confusing.

I don't see how any of the PC manufacturers have managed to make their products as desirable probably because Microsoft capture more of the value, a very clever move really because software is scaleable and capital light - let the manufactures assemble the PC and stick a copy of windows in it. I am certain Microsoft make more margin out of every PC Lenovo sells than Lenovo do.

Therefore this leads to my take on (ii) - can Lenovo reinvent itself to grow in future in a declining PC market? I doubt it. They have a very limited offering in mobile and are well behind the market shares of Apple, Samsung and Hauwei. In H1 PC and tablets made up 70% of sales. Mobile is 17% of sales and is declining too. Other revenues were around flat. It is therefore possible, but unlikely, that Lenovo can substantially change their offering and gain the intangible value that Apple has created for its products.

Revenue including TTM has flat-lined

Ultimately the feeling I got when I started looking at Lenovo was this company is a bit like Berkshire Hathaway - by which I mean the declining textile company that Warren Buffet really cut his teeth on, and lost, before it became the namesake of his mega conglomerate. This is a declining industry or at least one that is ex-growth. Lenovo run the risk of going the way of Blackberry and Nokia - i.e shrinking into obscurity in the long term.

Earnings too are struggling to grow (2016 had restructuring costs)

The question that remains is therefore; Is Lenovo a value trap? Or a value proposition?

I think Lenovo may be a value trap. 

The 5% dividend yield looks good and with the predominant market share Lenovo may be able to run itself for cash over the medium to long term. Taking the HK$26.5 dividend for the year and assuming they pay say HK$27 next year, with a Ke of 8.68% and a 3% long run growth rate (ambitious given the declining industry but they could up the payout and run for cash) - I get a DDM valuation of HK$4.75. That is 12% less than the value of the shares today at HK$5.40. At a 4% growth rate we get HK$5.77 - so the present share price implies a 3.7% long term dividend growth rate. Ambitious for a company with declining revenues - but possible over the medium term given the current payout ratio is around 30-40% - assuming they can generate the cash flow.

However it is most likely that they will expend large amounts of cash trying to grow instead having recently acquired the carcass of Motorola Mobile from Google. I would like to see management focus principally on the PC market such that they do the one thing commodity companies can do; have the low cost advantage. Earnings may decline but the business could be well managed and cash generative. Trying to make up for lost ground in mobile seems fruitless at this point. As I say, I suspect in their desire to remain relevant Lenovo will waste a lot of money and not grow at all.

I note also the debt load has risen quite a bit recently presumably due to acquisitions - this increases the risk of the company going forward and makes the dividend less sustainable.

I think I will leave it there for Lenovo. I feel it is not cheap enough for me to get excited given the structurally poor long term prospects for the business. I could well be wrong but I tend to go with my intuition and back it up with solid analysis - I would review Lenovo again around HK$3 to 4 per share on the basis that my DDM valuation with a 0% dividend growth rate suggests a HK$3.11 value per share. That would be my baseline value for Lenovo assuming the underlying business is still viable.

Disclaimer: I have no interest in Lenovo shares at present. These are opinions only, not investment advice. If in doubt read my disclaimer. 

Portfolio Strategy: A Manifesto of sorts

The principal reason for undertaking this blog is to share my thoughts and ideas for stock selection while investing my pension portfolio. One of the advantages of being relatively young and having money tied up in a pension wrapper is one cannot take that money out for about 30 years and therefore one can take quite a long term and also quite a risky strategy. I find this time 'lock up' strangely liberating. You know you can stay invested and do not need to address the short term volatility as you can't take the money out anyway.

Seeing as the pot is solely my own and having no outside investors I have zero career risk from disgruntled limited partners. The main risk is permanent loss of capital. The secondary risk is a failure to grow that capital in the long term at a reasonable hurdle rate.

So the plan is to select a series of investments, principally equities, but I will also permit ETFs as required. This is the purpose of my research. To screen markets for stocks trading cheaply (by obvious metrics like low PE, high dividend yield, low price to book, ) and to analyse these both bottom up, top down, qualitatively and quantitatively to see if they add value to the portfolio.

Why?

Why not?

I enjoy stock picking and all aspects of investing. This process is something I enjoy doing and have done professionally. 

I agree that passive index investing is probably safer long term as proven by many models and market statisticians. However at present almost all markets and areas look expensive, a function of low rates and a surplus of capital, so I see better medium term opportunities in individual names with their own special drivers. 

Also the weight of money now invested passively is likely to be a problem for efficient markets going forward. We are yet to see a real extended bear market that tests these passive ETFs and their flows. Active managers tend to be more defensive and can outperform at capital protection on the way down. We shall see.

What is the strategy? 

Defensive value investing. I would define this as seeking companies with a clear margin of safety in valuation and some form of sustainable competitive advantage. 

This basically creates a paradox which is hard to find being undervalued stocks with good prospects. Generally stocks are undervalued due to bad prospects so the key with value is to look through those bad scenarios and search for a baseline valuation that gives a margin of safety even if prospects are bad or impaired for some time.

In a stock specific sense I am looking more for stocks that can and have paid some dividend with reasonable consistency, trade relatively cheaply by common metrics, generate decent cash flow. It will most likely have recently had a downturn in their popularity and price due to macro or structural issues. (Somewhat like a credit analyst; will they survive.)

How many stocks?

I think concentration is important:

"diversification is protection against ignorance. It makes little sense if you know what you are doing." - Warren Buffet

Therefore I believe it is better to build a concentrated portfolio of very strongly held, high conviction ideas rather than a portfolio that replicates closely many small pockets of similar companies. This is especially possible with a small and nimble portfolio where concentration risk related the size and liquidity of the companies is negligible.

Therefore I presently plan to limit the portfolio to 20 stocks / positions with no less than 5 positions at any one time. These limits are arbitrary but provide some framework for a minimum of diversification.

Within this I plan to have no more than 3 stocks from any particular sector globally and no more than 2 stocks from any particular sector in any given country. This is because sometimes a whole sector e.g energy is cheap globally and without a sector view one could end up putting the whole portfolio in energy due to the cheapness of all the stocks.

Position sizes will be discretionary based on my evaluation of risk and reward. I will put a limit on concentration at no one security being > 20% of the portfolio.

Will I be fully invested?

No. I think the present market conditions give a poor risk/reward offering. The US market in particular is trading at very high cyclically adjusted PE levels consistent with poor future returns. Therefore I want to be selectively invested with a substantial amount of cash on hand to take advantage of better price opportunities in the future. One must always try to be somewhat invested because;

'Time in the market is more important than timing the market'

So I think a minimum of 40% invested is fair with a maximum of 100% invested. We can always be invested more defensively whilst not risking the zero returns of cash.

What is the style bias?

Value. 

The focus will be value stocks, either big or small, which usually means looking at companies going through difficult cyclical downturns, regulatory or political uncertainty, structural issues or just out of favour industries. In essence I am naturally always attracted to value stocks over growth stocks being something of a realist. I would rather buy a slower growing troubled company at a price that ensures a margin of safety than buy a darling growth stock that promises the future.

It is hard to set this out in a really specific way - value for me is just 'what i am attracted to look for' when I am screening and analysing stocks.

What is my benchmark?


tbc; FTSE All world or some such global benchmark.

Where will I be invested?

Everywhere I can be.

Currently I can access UK, US, Canada, Belgium, France, Germany, Hong Kong, Ireland, Italy, Netherlands, Singapore and Spain.

So not a bad basket because the US and the UK have a lot of international exposure especially via ADR/GDRs. 

What would I like to have?

Maybe; Japan the most. Obviously as many other markets as I can get.

Investing globally allows the broadest range of opportunities and also a level of regional and currency diversification. Being based in the UK I want to diversify some of my long term wealth away to other countries and areas - a bit like not investing in one's own employer (beyond those share matching schemes) - because if it goes broke why lose your savings as well as your job.

The issue with global investing is the difference in macroeconomics and local culture. One needs to understand to some extent the individual circumstances of the investment. I consider the UK my home ground, I know the country and have day to day interactions with many businesses here. 

I think I also understand the US and Canada fairly well. I have a less developed knowledge of the European arena more generally but that can be improved. Finally I used to work professionally as an analyst in emerging markets specifically Latam so I feel I have a good base of knowledge there. So my weakest spot is probably Asia. Something to focus on in the future!

How will I be invested?

Mostly stocks. 

That is my background. I am happy to consider bonds, commodities etc via ETFs if a glaring opportunity arises or in the case of bonds or gold these seems more appealing than cash while being defensive. I am also happy to hold a country basket via an ETF where the country generally offers value and local access / stock specific selection is not possible.

All dividends will be reinvested within the portfolio.

The portfolio is tax free in the UK for both gains and dividends (except foreign withholding tax) so taxation is not an issue really for investment decisions.

This is a long only portfolio - there is a possibility of using short ETFs but shorting cannot be performed within the portfolio at this stage. No leverage is available.

No particular currency exposure, positions or hedging. I may retain some FX cash (likely USD) in the portfolio to avoid spreads and fees on foreign exchange. 

(Any mention on my blog of shorting means I am doing this more speculatively via my CFD/Spread betting account)

What are my current positions?

Currently I am building up the new pension portfolio as I have previously been principally invested in other brokerage accounts and an ISA account.

Current positions are:

• Tullow Oil
• IG Group 
• CMC Markets
• Next 

I have researched these positions in detail and my conclusions are on this site and will be reconsidered periodically. Note that both CMC and IG are in the same sector and the same country, so within my rule of 3 and 2 stocks per sector. Why hold both? Some level of diversification given the varying regulatory risk profiles of the two companies and the fact that CMC is more oriented around equity products.

Stocks I plan to add to this portfolio shortly depending on market conditions and pricing:

• Diamond Offshore  
• BLADEX 

Diamond offshore will probably max out my desired exposure to Energy E&P. I may look to add a major oil company to take my total energy stocks to the limit of 3 globally in the medium term.

I am currently looking to add another 5-10 stocks to the portfolio and perhaps a couple of ETF positions; maybe a small holding of gold. 

So the research process continues. Enjoy the updates.

Disclaimer: I have an interest in the shares mentioned in this post at present. These are opinions only, not investment advice. Construct your own portfolios with due care and attention. If in doubt read my disclaimer.