Dear Fellow Investor

Many seasoned of investors were startled - and millions were shocked - by the market's plunge in 2008 and the first quarter 2009.

I was one of them (more shocked than startled) and I am sure you were too.

The decline is best shown by the following graph of the STOXX 600 stock market index.

Source: Onvista.de
(The STOXX Europe 600 Index represents large, mid and small capitalisation companies across 18 countries of the European region)


Banks and asset managers attracts you with how much money you are going to make, how secure your investment will be, and how life will be easier and worry free as soon as you have bought one of their products.

It is a really attractive message and one I am sure we would all like to accept.

But reality is different and we should all know better.


Today I am going to tell you a hard truth about investing.

It’s probably the worse thing I can say if I want to attract you as a subscriber, but I have to say it.

I will start with the bad news and then help you to manage it and maybe even profit from it.

Here it is…

Dear Fellow Investor

As I have said in the past. In these newsletters I share with you what 20 years of equity investment have taught me – sometimes at considerable cost. 

I this issue I am going to tell you about an investment mistake I made. One from which you can learn a valuable lesson and prevent you from losing money the way I did.

I was going to tell you about two disastrous investments but will leave it at one today as the other is a longer story with larger losses.

I can only stand so much embarrassment at a time.


The lesson is about my investment in a small UK retailer of upholstered furniture, called SCS Upholstery (“SCS”).

Dear Fellow Investor

Through experience you have most likely realised that the human mind was not made for the world we are living in. Scientists have also proved it.

It was made for a time when quick decisions, fight or flight, was to our advantage.

Not for now when problems creep up on us over extended periods of time or when we have to gather information and make decisions over long periods of time.

I know I don’t need a scientific study to tell me that I sometimes make mistakes when deciding, don’t we all.

For example when investing I realised that I often made the mistake of hanging on to losing investments and selling profitable ones too soon.

It was frustrating and I decided to do something about it.

I had to look quite long but eventually I came across the, then new field of research, called behavioural economics.

Behavioural economics tries to understand the economic decisions we make and why we make them.

What it found was with awareness and certain tools there are ways you can improve our decision making.

And this is what this article is all about, tools to help you make better decisions.

Dear Fellow Investor


Have you ever heard of Ian Rushbrook?

If you haven't I won’t be surprised. 

He was one of those rare investment managers who, without much fanfare, gave his investors outstanding investment returns.

The only reason I heard of Ian was because in 2003 when I read about him in the excellent book called Money Makers (Stock Market Secrets of Britain's Top Professional Investment Managers) by Jonathan Davis.

Ian was investment director of the Personal Assets Trust PLC (“PAT”) investment trust (investment trust definition) from 1990 until his untimely death on 12 October 2008, in Edinburgh, aged 68. (Ian Rushbrook obituary)

From 1990 to 2008, investing mainly in large blue-chip British companies, Ian built up an enviable track record of substantially beating the market as shown in the following graph.

Dear Fellow Investor

Have you ever seen a book written on how to sell stocks?

Only when I consciously set out looking for one did I find one or two. It was a bit like looking for a needle in a haystack full of books on how and when to buy.

Before I go on let me ask you.

Have you ever given the selling of investments any thought, or better still developed a selling strategy?

I also did not until I looked at my buy and sell decisions over a number of years and realised that I made the classic investment mistakes of selling winners too early and hanging onto losers with the hope that they will recover.

Try as I may, I found it really hard to rationally break away from this tendency.

After a lot of research I developed a strict selling strategy which has substantially improved my returns. And I think it will help you too.

Dear Fellow Investor

If you follow or invest in the US markets here is the one investment blog I suggest you read.

I read it everyday.

The author is controversial, tells it like he sees it, and is probably one of the one of the most analytical market commentators I have come across.

He makes most so called market experts look like they just finished high school.

I am of course talking about Barry Ritholtz and his blog The Big Picture.


Early in 2010 Barry published a list of investment mistakes he made in 2009.

It's a list of mistakes I am sure you have also made and can learn from.

But more than that Barry also mentions possible solutions to the mistakes and here is where you can really learn a lot.

As you all know 2009 was an extremely difficult year for investors worldwide and thus an excellent year to learn from mistakes. Especially if you can learn from the mistakes of others.

Even though the mistakes Barry refers to were made in 2009 they are just a relevant in any market as well as today.

If you learn from just one of the mistakes Barry mentions the time you spent reading this article would have been really worthwhile.

Dear Fellow Investor


If you have been reading my newsletter for a while you may have noticed that I am very fond of articles written by Tim Price Director of Investment at PFP Wealth Management in London.


Past articles I have shared with readers are:

A case for gold

Indecent Haste

Happy New Fear

Hitting it out of the park


All are definitely worth a few minutes of your time.


What I like about Tim’s writing is that he tells you exactly how he sees it even if it may be to his determent.

This is very rare in today’s investment world where every so called investment expert spins current market developments to exactly fit with the latest product her company has developed.

In the article below Tim writes about a very important lesson a lot of central bankers around the word seem to have forgotten….

all except for one man, Axel Weber, the president of the German Bundesbank (Central Bank). Maybe because Germany suffered extensively when the lesson was forgotten the last time.

The lesson everyone seems to have forgotten is what happens…

Dear Fellow Investor

A while ago I had an interesting discussion with a subscriber.

He asked a question that at first sounded easy, but the more I thought about it, the more I realised it was very difficult to answer.

I could have come up with an answer immediately but I chose not to, to give me more time to think, but more importantly, to give him a better answer.

As I researched the question I found that it was an issue that every great investor I looked at struggled with, at some time in his career.

An this, irrespective of how successful he has been over the long term.

The question was…

Dear Fellow Investor

This article is a list, in no particular order, of the best investing books I have read and the ones I think you will find the most helpful.

Why nine books?

I looked at all the books on my book shelf and audio device and these were the ones I found the most valuable. I would have liked to make the list ten but could not find another that I thought would benefit you as much as the books I had already selected.
 
Besides nine books to read does not sound as intimidating as ten.

Dear Fellow Investor

Imagine the addition of one simple number, easy to calculate using simple arithmetic, to your existing method of evaluating companies, substantially increasing your stock market returns.

As you know I am constantly on the lookout for research papers with a brilliant insight that, when implemented lead to substantial index beating performance over long periods of time.

Dear Fellow Investor

In this article I would like to answer the questions most often asked by subscribers and visitors.

Even though I try to answer all the questions I receive myself, and manage to do so 90% of the time, it is not always possible.

I use articles like this one to answer questions that are asked often and the ones you may also have in mind.

If you have any questions, please do not hesitate to send them to me by going to the Contact Me page on my website.


On to the questions.



When or how do you decide to sell investments?

That is a very good question, and a very difficult one to answer.

When I did some research on selling a few years ago I found thousand of books written on buying investments but I could only find three on selling.

However having a strategy for selling is just as important as one for buying.

For me there are usually three reasons I sell a share:

• When a company is fully valued,

• When I find a better investment and I already have 30 names in my portfolio (in order to be able to follow most names in my portfolio are hardly ever have more than 30 positions)

• When a stock has fallen below my stop-loss limit

I used to sell investments when I thought they were fully valued however after tracking stock price movements after selling I changed my strategy.

I realised I sold investments too early and ended up losing out on further substantial gains. I started following a strict trailing stop-loss strategy.

After classifying an investment as fully valued and move into a separate part of my portfolio where I follow a strict trailing stop-loss strategy, which, depending on the volatility of the share price, varies between 15 and 25%. 

Should the share price decline more than 15 or 25% from its highest point the position is sold.

How has your investment process developed over time?

As long-time readers know, my investment process started from using technical analysis without success, moving to broker recommendations which were also was not successful.

My investment returns really started improving when it dawned on me that there were successful investors and I could improve my investment returns by studying what they have done.

This process of discovery and learning lead me to an 84 page book written by an unknown South African mathematics professor called Winning on the JSE. 

This book, for the first time introduced me to a structured investment process where you work through a list of checklist items in order to determine if the investment is worth buying and to ensure that no important item is left out.

After that I went on to read books on Warren Buffett, Benjamin Graham, John Neff, Joel Greenblatt and too many others to mention.

Until today I have not stopped reading. I will basically read anything written by somebody that has a proven track record of investment success.

Over time through learning, reading and applying my knowledge I develop my own investment process with which I feel comfortable and have shown extraordinary good results.

I continuously seek to improve my investment process by reading academic studies that have shown substantial investment gains over long periods of testing. 

I do my own testing and then after proven success I incorporate what I've learned in my investment process.

You can read more about how to develop a successful investment process in my article titled.
The best investors have this... Do you?

What I forgot to mention is that the formulation of an investment process is an ongoing process whereby I incorporate new information all the time, re-evaluate existing processes, select the best and use that in my investment decision-making.

What broker do you recommend?

This is a very difficult question to answer even though I've thought about it a lot.

Probably the most important consideration before selecting any broker is to make sure that your funds and investments are kept completely separate from the assets and liabilities of the broker or bank. In most countries this is required by law but it is always worth double checking.

This means that should the broker go bankrupt your money will immediately be available to you to transfer to another institution.

Be especially careful when you leverage your portfolio as all securities and cash in your account may be used as security for the loan and the position, of your assets being completely separate from the broker or bank, may thus be lost. Read the fine print on the loan documentation and also general terms of business very carefully.

Because of my background and my confidence in selecting investments I do not make use of a full service broker (that also offers research) but use a discount broker where I can enter all orders through the Internet.

At the moment I use two brokers in Germany. The one is called Comdirect 80% owned by Commerzbank the largest retail bank in Germany and the other is called MaxBlue the online broker owned by Deutsche Bank.

I only opened the MaxBlue account recently, but so far am very am satisfied with their service and transaction costs.

I would recommend always having two banks or brokers through which you invest, as you never know when one of them has a change of strategy or no longer fills your needs. 

Having two brokers mean that you can quickly transfer your funds to the other and continue with your investment activities saving you the trouble of looking for a new broker when you may be pressed for time.

How do you track your performance?

I used to track my performance on an individual investment basis but during 2007 and 2008, when my portfolio had high amounts of cash it became very difficult to track the overall performance.

What I then started doing is tracking my investment performance like an investment fund does.

This means that you value your cash and securities in your investment account on a daily basis.

This makes it easy to track your performance even if you add and withdraw cash from your investment account often.

To start value your portfolio and add the cash you have available to invest. Divide this value by a number to give you a value of around 100.

For example if you have a portfolio with the value of Euro 100,000 divided it by 1000 to give you a value of Euro 100.

The 1000 you divided by is the number of units you have invested in your portfolio.

On a daily basis thereafter you then value your portfolio add that to the cash in your account and divide by the number of units (1000 in the above example).  This number gives you a value per unit that you can use to track your performance or compare to an index.

Should you add or withdraw cash from your account reduce or increase the number of units with the amount added or withdrawn. For example if your unit value is Euro 90 and you have 1000 units in your portfolio and you want to withdraw Euro 900. You thus remove 10 units (Euro 900 divided by Euro 90 = 10 units) and subtract the Euro 900 from your investment cash account.

After deducting the cash from your account the unit price should remain unchanged at Euro 90 but you will only have 990 units.

I hope this is understandable, after reading it I am not sure if I explained it well, but if you try it in a spreadsheet you will see is sounds more difficult than it is.

Where can I find investment ideas?

I read a lot of blogs, magazines and newspapers and anything else that looks interesting.  This used to be a large source of investment ideas to investigate further but over time I've started moving more and more to using investment screens.

Through my investment process I know exactly what type of companies I am looking for and at what valuation I start getting interested.  I then use a screening tool like the one available from my friends at MFIE
http://value-investing.eu/

to get a shortlist of companies that complies with my criteria which I then research further.

I use this as my main source of ideas but that doesn't mean I won't look at company suggested by other investors I respect or if I read an interesting article in the financial Times or Fortune magazine

You can find more information on stock screeners in my article The single best way to get investment ideas.

What do you do if the bottom drops out of a stock (the stock price declines sharply)?

This is a very timely question because it happened to me the other day. 

In March 2010 I invested in a company called Invocas in the UK and a few days ago they announced that management wants to delist the company and because the company does not have sufficient cash resources they won't be making an offer to minority shareholders.

In order to delist they need approval of 75% of this shareholders and just through the votes of management they already have 70%. 

On the day of the announcement the shares dropped over 60% leaving me with a company valued as follows:

• Price to earnings ratio of 1.1
• Earnings before interest and tax is to enterprise value of 575%
• Price to book value of 11%
• Price to sales ratio on 0.2

The company was clearly extremely undervalued and I had to decide if I wanted to be a shareholder in unlisted company holding physical share certificates or sell out at a 60% loss.

As the company was so extremely undervalued I decided to buy more and take my chances with the delisting.

The company was just so undervalued that it would have been a shame for me not to be invested.

But that doesn't really help you in making a decision regarding an investment that decline substantially.

What is important is to determine the reason for the price decrease.  If it is because of a profit warning, determine how attractive the valuation of the company is at this price level and make your decisions based on this valuation.

In most of the cases I have found that it's best to sell after the company has issued a profit warning as there is never just one cockroach in the kitchen.

But it may be worthwhile to wait a day or two after most of the sellers out of the market as you may then get a slightly better price.

My situation described above is little different because the company was already substantially undervalued before the 60% drop in price caused by the delisting.

I will have to wait and see as there may still be a long road ahead with me holding an unlisted investment and it may have been better to sell right after the delisting announcement.

I will let you know how things turn out.

That doesn't really clearly answer your question but in most cases I would say it's best to limit your losses and sell as soon as possible after bad news and move on to other attractively priced investments.

I'm a big believer in limiting the downside and letting the upside take care of itself.

Profitable investing

Tim du Toit

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When I first read the results of this academic research study I could hardly believe my eyes.

I had to read it again for grasp its full significance.

I had stumbled onto, what is most likely, the best tool you can use to substantially improve your investment returns.

In a research paper, written in 2000, an unknown accounting professor from the University of Chicago, developed and successfully tested a system where, with the use of a few simple accounting based ratios, so easy to calculate you can do it on the back of an envelope, you can achieve substantial index beating investment performance.

Beating the index may at first not sound that impressive but, if you consider that more than 80% of investment funds worldwide do not even manage that, using this system will easily put your returns in the top 10% of investors worldwide.

Remarkable is that this information still seems to be relatively unheard of amongst investors.

First something on the person behind the study.

The developer of the system is Joseph D. Piotroski is relatively unknown accounting professor who shuns publicity and rarely gives interviews.

He graduated from the University of Illinois with a B.S. in accounting in 1989, received an M.B.A. from Indiana University in 1994. Five years later, in 1999, after earning a Ph.D. in accounting from the University of Michigan, he became an associate professor of accounting at the University of Chicago.

In 2000, he wrote a research paper called "Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers" (pdf).

He wanted to see if he can develop a system (using a simple nine-point scoring system) that can increase the returns of a strategy of investing in low price to book (referred to in the paper as high book to market) value companies.

What he found was something that exceeded his most optimistic expectations.

Buying only those companies that scored highest (8 or 9) on his nine-point scale, or F-Score as he called it, over the 20 year period from 1976 to 1996 led to an average outperformance over the market of 13.4%.

This is truly outstanding if you think of 80% of investment funds, mentioned above, not even beating the index.

Even more impressive were the results of a strategy of investing in the highest F-Score companies (8 or 9) and shorting companies with the lowest F-Score (0 or 1).

Over the same period from 1976 to 1996 (20 years) this strategy led to an average yearly return of 23%, substantially outperforming the average S&P 500 index return of 15.83% over the same period.

This average outperformance of the index of just over 7% may not seem like much but over the 20 year period an investment of 100 in this long short investment strategy would have grown to 6,282 compared to an amount of only 1,860 if you invested in the S&P 500 index.

The difference between these two rates of return over the 20 year period is over 44 times your initial investment!

After getting really excited about the returns I asked myself if this would also work in Europe and in the current market environment. But more on that later.

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How is the Piotroski or F-Score calculated?

Profitability

1. Return on assets (ROA)
Net income before extraordinary items for the year divided by total assets at the beginning of the year.
Score 1 if positive, 0 if negative

2. Cash flow return on assets (CFROA)
Net cash flow from operating activities (operating cash flow) divided by total assets at the beginning of the year.
Score 1 if positive, 0 if negative

3. Change in return on assets
Compare this year’s return on assets (1) to last year’s return on assets.
Score 1 if it’s higher, 0 if it’s lower

4. Quality of earnings (accrual)
Compare Cash flow return on assets (2) to return on assets (1)
Score 1 if CFROA>ROA, 0 if CFROA<ROA

Funding

5. Change in gearing or leverage
Compare this year’s gearing (long-term debt divided by average total assets) to last year’s gearing.
Score 1 if gearing is lower, 0 if it’s higher.

6. Change in working capital (liquidity)
Compare this year’s current ratio (current assets divided by current liabilities) to last year’s current ratio.
Score 1 if this year’s current ratio is higher, 0 if it’s lower

7. Change in shares in issue
Compare the number of shares in issue this year, to the number in issue last year.
Score 1 if there is the same number of shares in issue this year, or fewer. Score 0 if there are more shares in issue.

Efficiency

8. Change in gross margin
Compare this year’s gross margin (gross profit divided by sales) to last year’s.
Score 1 if this year’s gross margin is higher, 0 if it’s lower

9. Change in asset turnover
Compare this year’s asset turnover (total sales divided by total assets at the beginning of the year) to last year’s asset turnover ratio.
Score 1 if this year’s asset turnover ratio is higher, 0 if it’s lower

Evaluation

Piotroski or F-Score = 1 + 2 + 3 + 4 + 5 + 6 + 7 + 8 + 9
Good or high score = 8 or 9
Bad or low score = 0 or 1


Back to the question if study works in Europe and in the markets of today.

The answer is a clear yes. And was convincingly answered by my friends at MFIE.

In their May 2010 research paper titled Studying different Systematic Value Investing Strategies on the
Eurozone stock market.

They did their comprehensive study of the returns of a few selected value investment strategies applied to European companies over the last 10 years. 

What they also did, here is the important part, is they took these investment strategies and looked if they can be further enhanced by applying the Piotroski F-Score.

What they found was truly astounding.

When they applied the Piotroski F-Score to the following investment strategies:

Joel Greenblatt’s Magic Formula 

Benjamin Graham’s net current asset value, and

Their own ERP5 strategy


In each case buying only the top F-Score companies led to a substantial improvement in the results of each investment strategy compared to buying the low F-Score companies.

For example using the Magic Screen of Joe Greenblatt on companies in Europe resulted in a 10 year average return of 12.71%.  Applying the Piotroski F-Score to the same results lead to companies with a highest F-Score (8 or 9) outperforming the ones with the lowest F-Score (0 or 1) by 15.1% on average over the same 10 year period.

In each case buying only the high F-Score companies substantially increased the performance of each investment strategy.

This means that ALL the, already proven, investment strategies were enhanced by using the Piotroski F-Score scoring system.

What is really remarkable is that, in spite of the substantial benefits the F-Score can add, it has not been taken up more widely by investors and asset management profession.

I have been using the F-Score successfully in my portfolio, and that of my subscribers, for quite some time.

Give the F-Score a try, if the evidence above is anything to go by, it may help you to substantially increase your investment returns, irrespective of what investment strategy you may be following.

Another important point I forgot to mention.

Investing in companies with a high F-Score substantially increases the number of companies with positive investment returns.

The Piotroski study found that over the 20-year period 50% of companies with a high F-Score, held for a year, had positive return whereas if you used a strategy of just buying low price to book companies only 43.7% of the companies you invested would have had positive returns.


Your Piotroski analyst

Tim du Toit

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As you know I am a big supporter of managing your investments yourself see 13 Advantages of actively managing your money yourself.

The most important reason is that only you truly have your own interests at heart.

This is unlikely in the money management industry where the interests of investors, in most cased, come a distant last.

You can read more on this in my article Get rid of your broker and your fund manager.


But in spite of all the negatives there are also good fund managers. They are not easy to find. But if you do not want to manage your investments, the time and effort you spend looking for one is the best investment you can make.

You must however be prepared to look beyond the well known names and companies.

What I have found is that the best fund managers are all relatively unknown. They focus on generating outstanding returns for their investors and not on marketing or interviews on television.

This article is an interview with just such a fund manager. One that I have recommended to my parents for part of their retirement investments.

He has been at it for a long time, his returns are excellent, and he and his company are relatively unknown.

He is based in South Africa and manages an international fund with an outstanding track record that has no initial charge or performance fees.

His name is Bruce Ackerman and the fund is called the Foord International Trust.


On to the interview.



How did you end up managing a very successful international investment fund from beautiful Franschhoek?

The unit trust has been run since inception in 1997 in conjunction with Dave Foord.

Given modern communications, one can run an asset allocation fund focusing on large quality companies / investments from most places in the world.

I work either from my homes in Cape Town and Franschhoek or twice a week from Foord Asset Management's Pinelands, Cape Town office. I had purchased a tiny farm in the centre of Franschhoek sight unseen in 1987 and this helped motivate me to return.

Prior to joining Foord Asset Management in 1994, I was for many years chief investment officer and managing director of Lloyds Bank' institutional investment arm in London. I was born in Cape Town and left in 1969 after graduating with BA[honours] in Economics and MBA at Cape Town university, returning in 1994.

Describe the investment philosophy of the Foord International Trust you currently manage?

A low risk fund seeking to outperform the developed world equity index but with much lower volatility, and in the process delivering annualized returns in US dollars over time in excess of 10%.

Describe your investment approach and how it has developed over time?

Assessing the likely returns of different asset classes, taking a long term view, and investing accordingly.

This has not changed over time and remain focused on what could go wrong, hence seek to buy with an appropriate margin of error built into the asset price.

We will not participate in market manias, hence our temporary under-performance during the technology boom of 2000.

On a micro level, focusing on high quality companies with predictable earnings per share growth where the valuations, in either absolute or relative terms, do not reflect this.

Over time, earnings growth drives share prices, whereas over the short term, rating changes can dominate.

How do you typically find ideas and what is your selection process before an idea gets added to the portfolio? How do you approach valuation?

Extensive reading of financial periodicals and broker reports and use of proprietory value based screening methods.

We look at various metrics such as return on equity, cash-flow, gearing, dividend yield, forward Price to Earnings ratio and Price Earnings Growth ratio.

Our approach is typically top down, identifying the appropriate [changing] mix of asset classes thereby controlling risk of losses and under-performance versus our twin targets of low volatility and a US dollar return of more than 10%.

On stock selection, we aim to invest in the best of breed companies in the themes we might focus on, provided valuations are attractive.

For example we would avoid a Google or Amazon despite their strong growth prospects due to earnings volatility and unpredictability.

We like companies with strong balance sheets and cash flow, typically self financing with robust business models.

We also favour hidden value where a particularly attractive aspect of operations is not fully reflected in the valuation.

So if either of the two very seasoned managers has an idea, it needs to be approved by the other before inclusion in the portfolio. This limits risk too.

We focus chiefly on the top 500 companies by market capitalization. For smaller companies, we would invest indirectly by identifying specialist investment trusts or closed end funds with an excellent track record and management at an appropriate discount to net asset value

Describe some of your most notable investment mistakes and what did you learn from them?

That numbers e.g. screening can only provide a framework for further analysis. And that investors can be deceived by fraud as with Tyco for example.

What are your ideas concerning portfolio composition and the value of individual holdings in relation to the portfolio?

Importance of having a focused portfolio on a theme basis where each investment is well known to us and makes a difference to performance i.e. no closet indexing.

No equity position would exceed say 7% of the total portfolio or be less than 2%. We do not go short or gear the portfolio - consistent with the low risk approach.

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How did you manage to do so well in the turbulent markets since mid 2007?

The unit trust had a defensive bias in 2007 largely avoiding financials and companies with weak balance sheets.

We were also not fully invested in equities then but raised weightings significantly by end 2008 although unfortunately unwound this prematurely in 2009 as markets appeared to have risen excessively rapidly from the March lows.

This was done to protect the portfolio's gains.

What is  the  current  geographic  mix  of your portfolio?

About a third in Europe, UK and US.

In equities [2/3 of the trust]: about a third each in Europe, UK and US.

But most of the UK companies have limited links to the UK economy or the British pound.

However we are more theme driven than country focused e.g. currently: agriculture, power generation and energy, Asian consumer and healthcare.

The balance of the portfolio is in commodities [gold and grains], corporate bonds [$] and cash [$ and Singapore $]

How concentrated is your portfolio?

We run a very concentrated but marketable portfolio. For example when the trust was a mere $10m we had 20 equity holdings; now at over $400m we have the same number of positions.

Apart from the equity positions the fund has four corporate bonds, two commodities and two currencies.

Do you follow any key risk-management guidelines in managing the portfolio?

Not specifically apart from ensuring there is adequate [but not excessive] diversification by asset class, specific investment and currencies and that companies are soundly financed.

A minimum standard of corporate governance is expected from companies we invest in - one of the reasons there is currently a low emerging markets exposure.

We do not follow any specific sell disciplines like stop losses but prefer to use our experience.

How do you handle currency exposures?

Our neutral position is to hold cash in US dollars in the unlikely event we have no strong currency views.

We do not do any currency hedging or currency overlays.

What companies do you find interesting at the moment and why?

The top five positions that make up 36% of the funds equity investments are:

• Nestle

• General Electric

• Syngenta

• LVMH

• Vodafone

Our largest holding is Nestle which is attractive on a food peer group Price to Earnings comparison, adjusting for its marketable stakes in other companies.

It has strong emerging economy exposure, good cash flow generation and a management keen to enhance margins.

It is also defensive insofar as earnings are not economic cycle sensitive. Multinational growth stocks as a class within the world stock market remain attractively valued - this is merely one example of this.

General Electric has been de-rated owing to its financial exposure but we like its infrastructure involvement in emerging economies.

Syngenta is a crop protection and seeds company which should benefit from increasing farming acreage and commodity prices as the Asian consumer in particular upgrades his diet to more meat.

LVMH is an international luxury goods company. Its alcoholic beverages and luggage are much in demand from the increasingly affluent emerging economy consumer.

Vodafone is attractive on valuation grounds and the value to be extracted once dividends are eventually received from its US joint venture.

Are you and co-manager Dave Foord invested in the fund?

Both Dave and I have very substantial investments in the fund, directly and indirectly.

Furthermore it is the sole means for Foord institutional and private clients who are discretionary managed by us to access international markets. So it is pivotal to our clients' investment performance apart from those who give us a SA only mandate.

Our families, directly and indirectly are also holders of the fund and have been in many cases for some years.


Bruce, thanks for your time and insights

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In spite of the meteoric rise in the gold price and the current world economic instability I do not have any gold in my portfolio.

Source: Financial Times 27 May 2010 (COMEX GOLD 1 FUTURES CHAIN Front Mon summary)


Do you have any?

Maybe it is because inherently I am a very optimistic person, and to me gold has always been a sort of “all goes to hell” investment.

It may also be because soon after I started investing in the late 1980’s I lost a lot of the little money I had, investing in gold mining companies in South Africa using technical analysis. So I am a bit like the cat that is avoiding the stove, hot or cold.

Another reason is that, apart from price appreciation i.e. finding someone else to buy it for more than you paid for it, gold does pay you any income, does not grow intrinsically like a company, and furthermore incurs cost to keep it in safe custody.

This however does not mean that I avoid all articles making an investment case for gold. To the contrary, I actively search for articles advocating gold as, through studying behaviour science, I have learned to seek out opinions that do not agree with me.

This article does exactly that.

It is a guest post by Tim Price, Director of Investment at PFP Wealth Management in London.

I am an avid reader of Tim’s work and have already made use of his writings in the following two articles:

-  Happy New Fear

-  Hitting it out of the park

If you missed them, they are definitely worth a few minutes of your time.

Getting back to gold.


In the article below Tim paints quite a grim picture and makes a powerful argument for making gold a substantial part of your portfolio.

On to Tim's article (emphasis mine)

Angela triggers a gold rush

25th May 2010

“An almost hysterical antagonism toward the gold standard is one issue which unites statists of all persuasions. They seem to sense.. that gold and economic freedom are inseparable.”
- Alan Greenspan, unbelievably.

Philipp Bagus, on the consistently excellent Mises website, asks whether we have now crossed the point of no return. As Austrian economic theory essentially warned, a credit expansion led by a largely unchecked banking system triggered an unsustainable boom with all the attendant malinvestments.

The problem, however, is not that the free market has been allowed to run out of control.

Quite the contrary. Under a free market system, unsustainable financial organisations would have been liquidated. Instead, as Bagus explains, governments across the world chose to inject capital into the banks whilst guaranteeing their liabilities: “malinvestments induced by the inflationary banking system found an ultimate sponsor – the government – in the form of ballooning public debts”.

If the level of public debts before the crisis had been modest, the cost of the banking system bailouts might have been manageable.

But since the level of public debts was itself at crisis levels pre-crisis, it may now be beyond the point of salvageable return.

The example of Greece is hardly reassuring. Bagus suggests that the ultimate outcome of our present dilemma is the inevitable collapse of the welfare state.

But whatever the outcome, the tone of the public debate requires that electorates recognise that politicians are not and cannot be the solution, because they are unequivocally the source of the problem.

The also excellent Zero Hedge blog recently carried a damning polemic entitled “The Selling Out of Germany” which makes largely the same points, albeit in some more richly spiced language. Since most of the mainstream media remain unaware of or unable to satisfactorily report the issues, we make no apology for quoting liberally from it here:

“I feel very bad for the German people. Not only do I feel bad for them but I can empathize. I too am being forced to sit back and watch this comedy of errors as a corrupt, inept and increasingly dangerous class of elitist political and financial oligarchs destroys my nation.”

A former client asks what the writer thinks of the Euro zone bailout. His response:

“Basically, it’s a total joke as is everything else the politicians have done. No one and nothing is allowed to fail and this relates to the fact that the global monetary and financial system is a complete house of cards.

It’s insanely bullish for gold.

If Germans rioted they would be in the streets today. They totally got sold out beyond belief. But it doesn’t seem to be in their nature to riot so rather I think they will dump their Euros and buy gold. That’s how Germans riot.

With every passing day and every new bailout of the global banks (which is all this is, all TARP [the notorious US Troubled Asset Relief Program] was, and all everything has been) more and more people awaken to the fact it’s all a total scam. This will just accelerate the process of dumping the paper currencies we use today in favour of hard assets as this system is obviously coming down.

A lot of people keep asking, is this the same as post-Bear Stearns? I mean here is the biggest difference in my mind. Back then people believed in the system, the market and what we have going generally. Not now. Not any more. Thousands more people every day figure out it’s rigged and it’s a Ponzi scheme.”

After a one day fall in the price of gold following the Euro zone bailout announcement, it then rose to a new high in dollar terms.

“The Germans remember history and they do not disappoint. Muenze Oesterreich AG, the Austrian mint that makes the best-selling gold coin in Europe and Japan reported that buyers had purchased 243,500 ounces of gold since April 26, compared with 205,300 ounces in the entire first quarter.. what has happened in Germany in the last week (the elections in North Rhine – Westphalia and the rush to convert coloured pieces of paper to gold) is the financial equivalent of the shots at Lexington and Concord in 1775.

I give the German people a lot of credit for what they have done as this is not just a battle inside America. This battle is global and the German people just launched an impressive counter-attack on the control freak bureaucrats.”

The writer then cites a quote from the German Chancellor, Angela Merkel:

“In some ways it’s a battle of the politicians against the markets. That’s how I do see it. But I’m determined to win this battle.”

“What an incredibly sad woman she is. Now of course she believes every word of this as do her fellow political-class colleagues; however, to anyone that has worked and succeeded in the real world the statement sounds as if it is from an indignant infant.. In a seemingly simple statement, Angela Merkel said what every control freak bureaucrat that wants to run your life the world over thinks. They ARE the market. They decide who fails and when. They decide who is to succeed. This is prevalent across the entire developed world right now. They decided to bring down Germany and its currency because they want to save face and because the banks basically are forcing them to save them again (as if this will ever end).”

“The larger point which I have mentioned repeatedly in these emails is that the market always wins. The scary thing is that when the market does win within the context of a political class with excess power the political class turns on its people and attacks them, shuts down the market and then there is the potential for serious tyranny.

Every country in the OECD faces this now and we must be prepared financially and emotionally so that we do not allow the political class with their corporate oligarch allies to turn what’s left of the middle class (and a lot of what now can be considered the upper class) into a bunch of serfs in this nightmarish neo-feudalism we seem to be progressing toward. The more gold, silver and platinum in the hands of the people when the house of cards comes down the better. This way not everyone will be destitute and we can start over on our own without having more insane ideas shoved down our throats by our “kings and queens”.

You may question the tone of the polemic but the underlying thrust is difficult to challenge. When faced with the market’s verdict on years of fiscal irresponsibility – namely the dumping of government bonds and financial shares – the German political response is to unilaterally impose a ban on that selling. So much for European integration.

So yes, it increasingly feels like we are approaching the endgame. Political credibility, like fiscal credibility, is close to an all-time low.

The answer in large part – in the UK, in Europe, and in North America – is to shrink the state.

Since that is anathema to most of the political classes, particularly those of a socialist bent who are largely responsible for the current global fiscal crisis, we can be assured that we will not get there without a fight. But as we wait for that battle to be joined, gold represents the finest ammunition.

Tim Price
Director of Investment
PFP Wealth Management

Important Note:
PFP has made this document available for your general information. You are encouraged to seek advice before acting on the information, either from your usual adviser or ourselves. We have taken all reasonable steps to ensure the content is correct at the time of publication, but may have condensed the source material. Any views expressed or interpretations given are those of the author. Please note that PFP is not responsible for the contents or reliability of any websites or blogs and linking to them should not be considered as an endorsement of any kind. We have no control over the availability of linked pages. © PFP Group - no part of this document may be reproduced without the express permission of PFP. PFP Wealth Management is authorised and regulated by the Financial Services Authority, registered number 473710.Ref 1044/10/JD 250510.

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Tim’s argument is very compelling.

The determination of politicians worldwide not to let any business (GM in the USA and Opel in Europe) or bank fail has pushed sovereign indebtedness to the point that investors started demanding a higher return (interest rate) to lend them money. The prudent thing to do.

Greece has been the turning point in this cycle and luckily it happened to a relatively small country.

It showed all countries, in spite of them all trying to blame it on speculators, that there is a line they dare not cross.

Look at Germany for example. The Greek crisis turned the debate in Germany from tax reduction to deciding to save Euro 10 billion per year, something inconceivable a month earlier.

The politicians got the message alright, they just do not want to admit it but they are all taking appropriate action.

If it will be enough is still to be seen.

Your thinking of a gold bar analyst


Tim du Toit

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Dear Fellow Investor

The Internet has made the whole process of investing a lot simpler but it has not necessarily made it easier for investors to make money.

Contrary to what a lot of investors may think the same rules of investing still apply in spite of it being cheaper and easier to buy and sell securities.

All things considered investing online has probably brought as many negatives as what it has made our investing lives easier.

I have put together the main mistakes made by online investors I have discovered through experience, assisting subscribers and working with other investors

I hope it helps you with your investing.

Here is my list…

Trading too much

The biggest advantage of online brokers is the ease with which you can buy and sell securities. 

Everything from stock, bonds, preference shares, and you name it, can be bought and sold at the click of a mouse.

This has made it so easy to buy and sell securities that it has become a negative rather than a positive.

I am not a big believer in trading investments.  Believe me if I could I would, but I have tried it and I did not work. 

My answer to any investor is that the recipe for investment success is to find undervalued investments analyse them, and then invest.

Returns from undervalued investments are made while you sit tight waiting for the undervaluation to be discovered and the investment to be revalued.

If you buy and sell too often the only person that is going to make money is going to be your broker irrespective of how cheaply it executes your trades.

Checking your portfolio all the time

The Internet makes it so easy to keep track of the minute by minute movements of your portfolio and a lot of investors do it without thinking.

It is tempting to know what your investments are doing all the time but it is unlikely to improve your investment returns. 

In fact studies have shown that the returns of investors actually go down the more often they look at their portfolios.

This is mainly because the daily movement of your portfolio is mainly noise as it cannot be linked to any specific information.

Market commentators always seemed to have a ready answer as to why the markets are higher or lower, and their answers are convincing. 

The only problem is they are as clueless as we are as to the cause of the movements. The only difference is that they sound convincing and give a reason that seems plausible.

I check my portfolio on a daily basis. 

In the morning before the market opens to record the portfolio value (I have resorted to tracking my portfolio performance in the same way as a unit trust or mutual fund does as I have found this the most accurate) and once or twice during the day to see if there has been any major movements where I need to look for company specific news.

A few times a day I check the movements of shares on my watch-list. Mainly to also look for company specific news but also to identify possible buying opportunities because of sudden price drops.

For the rest I avoid any general market information and financial television as this leaves me more time to research new investments.

Selling your winners and holding your losers

This mistake is probably as old as investing itself but in spite of the advantages offered by online investing it hasn't gone away.

Investors that invest online have great tools available to limit losses through automatic stop loss orders but have largely failed to put them to use.

Automatic stop losses are controversial but as I explained in the article Do you know the first rule of investing?

I am a supporter of following a strict stop loss system of risk control. Letting your winners run and getting rid of your losers is a great strategy for long-term investment success.

Experience has taught me that most of my really good investment ideas paid off right from the start. And my past returns would have been a lot higher had I implemented a strict stop loss system earlier.

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The get rich quick idea

Getting rich quick through the stock market is not a new myth. However online investing, the internet bubble, or both seems to have given it new life in the form of day trading.

As I have said above I would have loved to be able to trade my way to riches but I've just not been able to do it. 

Sure I have had some short-term profits but it has been the exception rather than the rule.

Successful investing is the implementation of a proven investment process over a long period of time which, because of its proven track record, guarantees you success.

Short term trading has no track record that I could find, and thus no reasonable chance of being successful.

You can read more about the investment process in my article The best investors have this... Do you?

Following the media

The whole idea behind financial media is to get you to start watching and to keep you watching.  They make money through advertisements and the more people they have watching the more they can earn.

It is thus highly unlikely that anybody in the financial media has got any interest in increasing your investment returns.

As I said above, financial television has an explanation for every market movement which is highly unlikely to be correct or even if it was it would be too late you do anything to make any money from it.

They love talking about what I call yo-yo news, what has gone up or down.  Also company’s hitting new highs or, are subject to exciting upward developments, are most likely to feature.

If you want to increase your investment returns the best way to go about it is to do the exact opposite from anybody else.

Investing against the crowd in unknown companies that are undervalued, the ones I recommend to my subscribers, is a far better way to make money.

Keeping your emotions under control

This point has a lot to do with the point Trading too much but it is so important I wanted to mention it separately.

Online investing because of the instant feedback we get in terms of gains or losses put a lot of stress on risk averse and emotional investors.

If you are likely to calculate the amount of money you've lost with the movements of any of your investments you have most likely taken on too much risk or you have invested money you cannot afford to lose.

The one thing about investing that I can say with 100% certainty is that there will always be some investments that you will lose money on.

If you have problems sleeping or if you feel uncomfortable with any loss situations on your investments you should either reduce the size of your investments or you should invest in less volatile companies or through funds.

Accepting responsibility for your decisions

This may also seem rather obvious but can cause you lot of problems.

When investing online you decide, you decide to buy or sell after you have done the research. 

It is thus of little or probably negative use blaming any losses on somebody else.

As soon as you do that you take away your decision making power and the decisiveness you need to limits losses or take profits.

Not doing enough research

All the information available on the Internet has led us to literally drown in it. You can most likely find an opinion on any investment in the Internet, buy or sell.

The risk lies in the possibility that investors see the reading of a few such articles as the only research they need to do.

Over time I have put together a structured research process that works through a checklist to ensure that I do not miss anything important.

For more information see the article What does your investment check-list look like?

Relying on someone else’s research is unlikely to be as thorough as your own investment process.

It is also important to avoid the temptation to first look for research on the Internet, and then with this possibly wrong or biased information in mind, try to form your own opinion.

These are the important mistakes made by online investors I have come up with.

That said I would be the last one to give up the benefits of online investing; real time prices, buy and sell volume, and the ease of entering orders, stop losses and watch lists.

I am sure there are some points I have missed.

Should you have a good one please send it to me through my contact page and I will included it in the article.


Your online analyst


Tim du Toit

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Dear Fellow Investor     

13 May 2010

Each year in May, with the bulk of the previous year's financial reporting behind us, I compile a list of the UK and Europe's highest dividend yield stocks to identify attractive market sectors and possible high yield investments.

Previous articles can be found here:
Dogs of Europe - May 2009

Dogs of Europe 2009 - Update


I have also selected my top 10 high dividend picks form the list based on the “Dogs of the Dow” investment strategy popularised by Michael O’Higgins in his book Beating the Dow.

The strategy proposes that an investor annually select the ten Dow Jones Industrial Index stocks with the highest dividend yields. All stocks are sold after one year and then reinvested in the then ten highest dividend yield shares.


The average dividend yield my top 10 European high dividend yield portfolio is 6.9%. Not bad when compared to the low interest rated available on bank deposits and high quality bonds.

What is also surprising is that the share prices are not much above their 52 week lows. On average my top 10 picks is trading at just over 15% above their 52 week lows. This means these high dividend yield companies have not participated in the market rally at all.

Similar to last year utilities, telecommunication and integrated oil companies make up the largest part of the highest dividend payers.
 

Here are the UK and European highest dividend yield companies:

Disclosure
I have a position in Deutsche Telekom, Vivendi and Vodafone all companies I have recommended to my subscribers


Table description

My Selection - My top picks for a UK and European high dividend yield portfolio.

Name - Name of the company

Price - Share price on home exchange and currency as at 10 May 2010

Industry - Industry the company operates in

Dividend Yield - Yield calculated using the most recently announced net dividend divided by the current market price

Debt / Equity - Total debt to total shareholders equity.

Market capitalisation - Market value of the company in its home currency in millions

Dividend payout ratio - Cash dividend / Net income before extraordinary income after minority interests and preference dividends expressed as a percent. This ratio indicates how sustainable the dividend is. A payout ratio of 100 or higher is most likely not sustainable.

% from 52-week low - This indicates the current share price movement from the 52-week low price. A number of 10% shows that the price is currently 10% above the 52-week low price.

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Methodology:

I compiled a list of companies from the following indices:

• The 50 highest market capitalisation companies in the United Kingdom FTSE 100 and European Euro Stoxx 600

• German DAX 30 index companies

• European Euro Stoxx 50 index companies

• European Stoxx 50 index companies

From the combined list I eliminated duplicate names and sorted the companies from highest to lowest on historical dividend yield.

From this list I selected the 25 companies with the highest dividend yields.

Please remember a list like this is just a start to identify attractive investments. Each company on the list should be further analysed using your normal research process.

Happy dividend hunting

Tim du Toit

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Dear Fellow Investor


Do you have a list of the most important points to consider when analysing a company or more specifically reading the annual report?

I have developed one over time and I think it is something you can benefit from.

When investing in a company there are thousands of things that can go wrong. Some of these you can anticipate but most of them not. So it is not really something we can incorporate into our analysis.

What we however have a high degree of control over, is the state of the company when we invest. We read the annual reports, analyse ratios and possibly talk to customers and competitors.

The future is uncertain, but at least you can determine that the current state of the company is stable and healthy before investing.

Be sure to read through to the end of the article as I have included a handy shortcut for you.

Here are my top warning signs investors should look at when analysing a company.

Do you understand the annual report?

One of the simple things that I have learned about investing is that if you have difficulty understanding how a company makes money the investment is best avoided.

Most businesses are relatively simple, they buy or manufacture something, add value of some sort, sells the product or service and earns a profit.

If you cannot understand a business in these simple terms from reading the annual report it would be in your best interest to invest your money elsewhere.

An example for me would be an investment in a large investment bank like Goldman Sachs or Morgan Stanley. The businesses of these companies are so complex, and if you add on their own trading and risk taking it is beyond my understanding.

Is the operating cash flow higher than or equal to earnings?

If the operating cash flow (also called cash from operations) the company generates is not equal to or larger than net profit the company generates it is a definite warning sign to investigate further as it means that the company is not making cash profits.

Contrary to the popular belief, it is not the lack of profits but rather cash flow that drags a company under quickly.

Depreciation is a non-cash deduction from net income but not from operating cash flow, with the result that operating cash flow should normally be higher than earnings except when the company is investing heavily into working capital (inventory and accounts receivable).

If the company is growing it usually means increased investment in working capital is required, and it is then perfectly understandable that operating cash flow will be lower than earnings. As long as the days of inventory outstanding or they days accounts receivable outstanding is not increasing at an alarming rate it is acceptable.

Have there been changes in accounting policies?

It is definitely worthwhile having a look at the company's accounting policies to determine if there have been any changes in the current financial year.

Most of the time it is nothing to be worried about as accounting policies have to be adjusted because of new accounting rules but be careful if the company makes adjustments on their own.

Changes may be perfectly legitimate because of changing business conditions but make sure that management is not trying to artificially inflate the profitability of the company by for example, changing the recognition of sales or capitalising expenses to the balance sheet that should really be in the income statement.

Has there been a restatement of past financial periods?

Any restatement of past financial figures is worth looking into. 

This goes along with the previous point of changes in accounting policy, which may be the reason to restate previous financial periods.

Most of the time restatements simply relate to legitimate accounting policy changes and is nothing to be worried about.

However be careful when the company restates results to make it look more profitable especially if there is no clear reason for them to be doing so.

Just a simple commonsense test here is more than you'll ever need.  Ask yourself what management is trying to achieve with these changes and if it makes good logical sense.  If not, it's a warning signal.

Are there recurring extraordinary expenses?

If a company year after year has quite high amounts grouped under extraordinary expenses in its income statement it is a sign to be weary.

If it relates to a truly once-off event it is perfectly legitimate to have an extraordinary expense, but year after year is highly unlikely.

What I have also found is that a lot of companies attempt to list normal expenses as extraordinary with the hope that investors will ignore these expenses when evaluating the company, thus inflating profitability.

For example, why would a retail company list lease payments due to store closures as extraordinary when its business is the opening and closing of retail stores?

Any related party transactions?

This is the one item in the annual report I always look at.

The ideal would of course be that there are no transactions between the company and its management or directors, directly or indirectly.

Related party transactions immediately give me the impression that management is trying to profit personally at the expense of shareholders.

Here is a recent experience I had.

As Germany did not participate in the worldwide property bubble that developed from 2005 and 2008 I started looking at property companies in Germany that were at the time, trading at less than 50% of book value and had a quite attractive dividend yields.

Closer investigation however revealed that most of the companies had a laundry list of related party transactions where management, usually also a relatively large shareholder, develops properties and sell them to the property company.  And this happened year after year in quite a few cases.

This gave management the ideal opportunity to profit at the expense of shareholders.

It simply looked too dodgy for me to invest.

Is the tax rate unusually low?

In most developed economies companies have a tax rate of 35% to 40%.

As soon as the company you are looking at has a tax rate that deviates substantially from this number is worth investigating.

The company may have assessed losses which is keeping its tax rate low but watch out when these run out as earnings will then decline by up to 40%.

That may lead to that low price to earnings ratio you thought was attractive, look very high all of a sudden.

Any large “other income” and “other expense” amounts?

Large amounts in the income statement with heading other income or other expenses should make you curious as it may mean management is trying to hide something.
 
Under “other income” they may be trying to hide a deterioration of the company’s operating performance or may be looking for a way to boost its profitability with large once off items not related to the company’s main business.

Under “other expenses” management may be trying to hide expenses that they would rather not name by name.

Are there large directors and management payments?

It is always worthwhile having a look at directors and management compensation.

I look at the numbers in total to see they are reasonable compared to the profitability of the company. 

If they look large or excessive the company has to be very undervalued for me to invest.

Also be careful of consulting fees paid to directors, retired management or existing management this is usually an item that shows that management and directors do not have the best interests of shareholders at heart.

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I usually read through the last three annual reports of the company I am analysing but I also use a time saving shortcut to zoom into the areas where problems may lie.

As annual reports are now available electronically it is very easy to find specific words or phrases in the annual report.

To quickly identify if and where potential problem areas may lie I have put together a list of phrases I search for in the annual report.

Here is my list of phrases:

"related party"
restatement
"bill and hold"
extraordinary
"percentage of completion"
"unbilled receivables"
"change in revenue recognition".
"materially and adversely affected"
"substantial doubt"
consulting relationship
restatement
“capitalised expenses”


You may want to want to copy the list and have it handy when you read through the next annual report.

Keep in mind that the accounting terms vary from country to country and, depending on the country you invest in, may have to change the search terms somewhat.

Not all the phrases will bring up something important but should they come up it is usually something that deserves your attention.

Profitable investing

Tim du Toit

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Dear Fellow Investor

Do you consciously evaluate the management of a company before you invest?

I don't. 

Sure I read the annual report, I read what management says to make sure it makes sense, I check to see that they keep their promises and I look at salary and option levels to make sure they are not excessive. 

Should I be uncomfortable with any of these factors the company has to be extremely undervalued for me to invest.

But I never consciously evaluated the management as such.

Fortunately I stumbled onto something that will make my evaluation of management a lot more structured and scientific.

I discovered a book called Why Smart Executives Fail written by Professor Sydney Finkelstein a professor of management at Dartmouth College in the USA.


I have not read the book (it is on my reading list) but I found an excellent summary here: Why Smart Executives Fail - Presentation (pdf).


Prof. Finkelstein wrote the book after he, over a 6 year period evaluated 51 corporate failures and conducted over 200 interviews to determine the reasons for the failures. 

The surprising finding of the study was that, even though the companies were all different and in different industries, and had nothing in common, they all failed for the same reasons.

This means that the failures could have been prevented and avoided.

The findings in the book are thus the 80/20 principle of management evaluation. The 20% you can do to accomplish 80% of what you need to do, to accurately evaluate company management.


The study determined that in all cases management was intelligent, saw the failure coming, had good track records and had all the necessary facts, but they either did not act or acted wrongly.


The book identified the following four major themes present in the management of the 51 failed companies:

1.  Executive mindset failures

Management got a strategy of the company completely wrong and even though it may not have been enough to make the company fail it put the company on the road to possible failure. An example was the blow up of the hedge fund Long Term Capital Management after they failed to allow for disruptions in different markets at the same time and used excessive leverage.

2.  Delusions of a dream company

The organisational culture of the companies was such that nobody ever questioned anything, mistakes were never raised and nothing was ever criticised.

3.  Organisational breakdowns

The companies operations were simply wrong. It wasn't that the company didn't carry out its operations badly they carried out the wrong activities and had the wrong incentive systems.

4.  Leadership pathologies - The seven bad habits

This is probably the most important part of the study and the most helpful for us as investors. It gives us the seven bad habits management exhibited, which led to the downfall of the companies.

1.  They saw themselves and their companies as dominating their environment is, not simply responding to developments in those environments

2. They identified so strongly with the company that there was no clear boundary between their personal and corporate interests

3.  They seem to have all the answers, often surprising people with the speed and decisiveness with which they dealt with challenging issues

4.  They made sure that everyone was hundreds percent behind them, they ruthlessly eliminating anyone who might undermine their efforts

5.  They were skilful company spokespersons, often devoting a large portion of their efforts to managing and developing the company image

6.  They treated difficult obstacles as temporary hurdles to be removed or overcome

7.  They never hesitated to return to the strategies and tactics that made them and their companies successful in the first place

I have turned the seven bad habits above into the checklist below that I am going to add to the existing checklist I use when evaluating companies. You may want to do the same.

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Management evaluation checklist:

1. Does management see their companies dominating their market without the need to adapt all the time?

2. I there no clear boundary between management’s personal interests and that of the company?

3. Does management have all the answers, even on difficult strategic issues where the outcome is at best uncertain?

4. Does management not allow healthy debate on important issues in the company? Do they eliminating anyone who might undermine their efforts including reporters and analysts?

5. Does management excessively promote the company image?

6. Does management treat difficult obstacles lightly, as temporary roadblocks to be easily removed or overcome?

7. Does management plan to return to the strategies and activities that made them and their companies successful in the first place? Is this realistic considering changed markets, customers and technology?

Profitable investing

Tim du Toit

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Dear Fellow Investor

What is the first, and most important, rule of investing? 

It is not:

• to only invest in undervalued investments, or

• to look only at the best investors for ideas, or

• to buy high dividend shares

The first rule of investing is Don't Lose Money as so clearly put by Warren Buffett. 

And to emphasise the rule further Warren’s second rule of investing is never forget rule number one.

But what exactly does the rule mean?

It took me a while to find out but when I did it made a lot of sense and increases my investment returns.

The rule can probably be best explained by first saying what it is not.

The loss of money the rule refers to, does not mean the simple price decline below your purchase price. The loss refers to a permanent loss of capital realised when you sell an investment of which the underlying or intrinsic value has declined.

If the share decline is not related to any change in the value of the underlying investment it gives you the opportunity to increase your investment because the company has just become even more undervalued.

You must thus avoid is selling out at a loss where a company has not declined in value.

The problem however is how do you tell the difference between a company that has declined in value and one that hasn't.

It is easier said than done as the following examples show:

• Investors buying into banks and insurance companies as a property bubble started to burst in the first quarter of 2008 based on cheap price to book values. We all know what happened shortly thereafter...

• Investors buying into newspaper companies in 2005 only to see their investment decline for the next five years due to the rise of the Internet

• Investors buying into Kodak in 2001 believing the company can be revived after losing its main product to digital photography

Here is an example from my own portfolio:

In 2003 I bought into the French luxury goods company S.T. Dupont.  The company was going along fine until all of a sudden its earnings collapse completely.  The decline was a complete mystery to me and it happened without a warning.

The company's main product, expensive cigarette lighters, was mainly sold through retail stores located in airports.

With the increased security after the 9/11 terrorist attacks the carrying of lighters in aeroplanes were banned. This led to a complete collapse of the sales of the company’s main product and the reason for the profit warning.

Before I could sell my shares the company's share price had lost 66% and the company needed new capital to survive, even though its financial position was not weak before the crisis.

Now you may be thinking, these are interesting examples but what is the point.

From the above examples you can see that it is very, very difficult for investors to foresee the impact of seemingly unconnected events on the value of the companies we are invested in.

It is thus very difficult to be able to say if a price decline is because of a decline in the value of the business or just because of market movements.

I have thought long and hard about this problem and have come up with a solution that works for me and one, you may want to consider.

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It is the following of a strict stop-loss system. I know it’s controversial but hear me out.

I have implemented a system that works as follows:

• As soon as the loss on any of the positions in my portfolio exceeds 16% I do a thorough review of the company also looking at the size of historical price movements as the loss may just be because of normal market movements.

• Once I have determined that the loss was not caused by any company specific developments I buy more.

• Should the same investment, after I have reduced my purchase price through buying more, decline by more than 20% I sell the investment without any further analysis. My thinking being that there is something going on with this investment that I do not understand.

This has in a lot of cases saved me substantial further losses as the share price went on to collapse completely.

It has of course also happened that the share price turned around and substantially exceeded my purchase price.  But I have learned to live with that, knowing it could also have gone in the other way.

What I have also realised is that if I had made a really good investment is typically works right from the start.

I urge you to give a system like this some serious thought.

What is important to keep in mind is that a 25% loss requires a 33% gain to reach break even, a 50% loss a 100% gain and a 75% loss a 300% gain to break even. 

Limiting large losses are thus very important.

For me investing is an activity where you place a bet with a certain probability of a positive outcome. Because I know that my investment process only selects investments with a high probability of success the only thing for me to do is to limit my losses.


Once I have limited my losses, profits will take care of themselves.


Wishing you profitable investing


Tim du Toit

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Dear Fellow Investor 

As I've written the past, a lot of my success in investing has been attributable to studying other successful investors and learning from them.

My investment process started from basically nothing moved to technical analysis, which was not successful.

Then onto the use of brokers for ideas, which was even less successful.

My returns improved substantially when it dawned on me to study other successful investors. I started reading Benjamin Graham, Warren Buffett, Peter Lynch, John Neff, Joel Greenblatt and numerous others.

From their returns I knew they were successful, but I could not quite put my finger on what exactly made them successful.

Until I realised, their success had a lot less to do with what they were reading or even what they were investing in, it had to do with a successful investment decision making process they have developed and the fact that they stick to the process through thick and thin.


But what is a successful investment decision making process?

The best research I could find on the subject is from an article called Decision making for investors (pdf) written by Michael Mauboussin, strategist at Legg Mason Funds Management. 

The whole article is definitely worth reading but the basic point is this:

Investing is a probabilistic activity like gambling, betting at card games and horse racing, and if you look at who is consistently successful, over long periods of time, and learn from them you substantially increase your chances of success.

What he found was that the best performers in all probabilistic activities tend to have a similar approach, which consists of the following:

• A focus on the process rather than the outcome

• A constant search for favourable odds

• An understanding of the role of time

Focus on process rather than outcome

Successful investors have to focus on process because, as in all probabilistic activities, good decisions will periodically result in bad outcomes, even if the probability of a good outcome was a lot higher then that of  a bad outcome.

Think of you rolling a dice with one black side and the rest red. Your chance of getting red is high, 83% (5/6), but you may also get black side even with only a 17% chance.

If your investing process is good (with a high probability of success) good outcomes will be deserved and bad outcomes will be bad luck.

If this disappoints you think of the alternative, if you have a bad investment process (with a low probability of success) decision resulting in a good outcome will be because of blind luck and a bad outcome will be what you deserve.

Always look for favourable odds

In all probabilistic activities like gambling, investing, batting in baseball or cricket, opportunities come in the form of probabilities. 

Relatively few of these opportunities, be it the cards you received or the company you have read about have favourable odds of a successful outcome.

If you thus only invest or bet when the probability of success is in your favour, you substantially increase your chances of a favourable outcome.

How do you find companies with attractive odds to invest in?

Luckily a lot of academics and investors have done most of the work for us already.

The best place to look is studies that have determined what has worked in the past.

A good source I have found is a document by the fund manager Tweedy Brown called What has worked in investing (pdf) (updated last year).


The document lays out numerous investment strategies and then lists studies that have tested their returns over long periods of time.

Examples of the strategies tested are:

• Low price to book strategies

• Low price to earnings strategies

• Significant insider purchases

• A significant decline in the stock price

• Small market value companies

The document for example shows the returns achieved with an investment strategy defined by Benjamin Graham. 

The strategy requires the following:

1. An earnings yield of more than two times the AAA bond yield
2. Total debt (current liabilities plus long-term debt) less than equity
3. Hold for two years or a 50% gain, whatever comes first

In the six year period from 1974 to 1980 the strategy generated an average return of 38% per year versus a 14% per year return of the S&P 500 index (including dividends).

Another example would be the Magic Formula as explaining in the book The little book that beats the market by Joel Greenblatt.

In the 10 year period from 1 October 1999 to 30 September 2009 the Magic Formula generated a total return of 288.9% versus a -1.5% return of the S&P 500 index.

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The importance of time

The key to winning at probabilistic activities is to stick to it over long periods of time.

Even if you have a larger than 80% chance of winning it does not mean that you will win every time. But if you keep at it, playing only when you have a greater than 80% chance of winning, it is assured that you will win over the long term.

If you make the right decisions for the right reasons enough times the results will take care of themselves in a long run.

This is also unfortunately where the biggest risk lies. The risk that you will abandon your proven winning strategy on the first signs that it is under-performing.

With the increasingly short-term view of investors, focused on monthly and quarterly returns, very few investors or fund managers take the time to develop and stick to an investment process that leads to positive long-term results. 

This can be seen from the increased turnover of mutual fund portfolios from 20% in the 1960s to over 110% today.

Joel Greenblatt in his book said that he is not worried that, in spite of its outstanding historical returns the Magic Formula has produced, it will be so widely adopted that its returns will be eroded. For the simple reason that the formula does not always work. The Formula sometimes experiences periods of three to four years of market under-performance, which will lead to most investors abandoning the strategy.

This creates a huge opportunity for us if we invest for the long term.

Investors with a proven investment strategy and a long-term focus have a huge advantage over short-term traders and quarterly performance orientated fund managers.

In summary what should you do?

• Identify and study investment strategies that have generated outstanding long-term market out-performance

• Choose one that fits with your investment style and draw up an investment process of how you will identify, analyse and buy and sell investments

• Implement the process and stick to it through thick and thin

Also carefully document your investment process. Do this not only to review and update it from time to time but more importantly to read it at times when you are frustrated and close to the point of abandoning your strategy.

The document should serve as a reminder of why you chose the strategy and motivate you to stick with it.

If your investment strategy is based on sound research and you stick to it over the long-term you cannot have anything else but superior investment results.

 Prosperous investing

Tim du Toit

PS Do you simply not have the time to formulate your own investment process? Take a look at my Investment Alert subscription service. It follows a very successful proven system, tells you when to buy and sell and how to construct your portfolio. And I invest in every idea along with you. I eat my own cooking. Click here for more information

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