Where are we in the Stock Market Cycle?

And a high-yield stock on AIM

The best advice for the private investor often comes from America. Howard Marks, one of the founders of Oaktree Capital Management, a fund manager based in Los Angeles, summarises what he has learnt from his working life in an economical 180 pages (The Most Important Thing: Uncommon Sense for the Thoughtful Investor). While he writes that "Successful investment requires thoughtful attention to many separate aspects, all at the same time", understanding market cycles are key to four of his nineteen aspects. Oaktree Capital Management applies Marks's principles to the $71 billion debt, property and equity investments the company manages. Mr Marks has a personal fortune of $1.5 billion. 

Investors who base their decisions on the price of a company's stock by estimating its intrinsic value are, in theory, immune to the stock market cycle. Nevertheless, a feel for where we are in the stock market cycle is, in practice, most useful.  Returns are accelerated and risk reduced by buying at a time when conditions are favourable and the cycle is somewhere near a low, or at least not near a high.

To understand where we are in a market cycle, Marks sets out a simple checklist that he calls "The poor man's guide to market assessment". For each consideration he has set up a pair of answers. Check one of the two for each consideration. "And", he writes, "If you find that most of your checkmarks are in the left-hand column, hold on to your wallet."

Considerations	Unfavourable	Favourable
Economy	Vibrant	Sluggish
Outlook	Positive	Negative
Lenders	Eager	Reticent
Capital Markets	Loose	Tight
Terms	Easy	Restrictive
Interest rates	Low	High
Spreads	Narrow	Wide
Investors	Optimistic	Pessimistic
Investors	Sanguine	Distressed
Investors	Eager to buy	Uninterested in buying
Asset Owners	Happy to hold	Rushing for the exits
Sellers	Few	Many
Markets	Crowded	Starved for attention
Funds	Hard to gain entry	Open to anyone
Funds	New ones daily	Only the best can raise money
Funds	General partners hold all the cards	Limited partners have bargaining power
Recent performance	Strong	Weak
Asset prices	High	Low
Prospective returns	Low	High
Risk	High	Low
Popular qualities	Aggressiveness	Caution and discipline
Popular qualities	Broad reach	Selectivity

Note: not all the conditions are applicable to all four markets (equity, bond, property, and housing). The technique can be applied to any segment of these markets.

This list is of no use to day traders, but it is an aid for long-term investors. And checklists are useful. They impose a degree of objectivity and discipline that are necessary for successful investing (see How We Can Learn from Sherlock Holmes at http://thejoyfulinvestor.blogspot.co.uk/2013_03_31_archive.html).

Marks's checklist seeks to be contrarian. But then he opens his chapter Contrarianism with, "There's only one way to describe most investors: trend followers. Superior investors are the exact opposite."

Any investor would be wise to run through Marks's guide regularly. It should give him or her a feel for where we are in the market cycles for bonds, equities, property and housing.

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A high-yield stock on AIM

Personal Group Holdings (PGH) is a small company that provides insurance services to company employees via direct selling. The company floated on AIM in 2001 and its share price (in blue) has comfortably outperformed the FTSE 100 (in green):

(Courtesy of Yahoo, click on the graph to enlarge)

PGH has a successful, though not unique, business model. PGH offers payroll services and employee benefit schemes to major companies and organizations. Then it cross-sells insurance policies, for health, accident and pensions, to these same customers. Thanks to its purchasing power, it can source such policies at a discount to the general market. Underwriting casualty insurance is risky, while underwriting life insurance is low margin. PGH does neither. It underwrites sickness, accident and private medical insurance for its own, captive market. The capital requirement of 4 million pounds for this underwriting is more than twice covered by qualifying reserves.

In 2005 PGH purchased Berkeley Morgan Group, which offered financial services, at a cost of 13 million pounds. This has proved to be a mistake, and its activities have been sharply scaled back and much of its goodwill written off the balance sheet.

The founder and major shareholder retired from the company in December 2012. PGH appointed a new CEO, CFO and Commercial Director in 2011 and 2012. The new team has been charged with modernising company processes and seeking growth. Initial results are promising: final quarter 2012 revenues are 15% ahead of 2011; the company has stopped taking new business into its financial services company Berkeley Morgan (no doubt as a result of the new, unfavourable, fee and commission structures required of IFAs); management report improving response times to claims etc. from days to minutes; they have introduced iPod direct selling to replace paper and improve productivity; staff have been retrained; and more is to come with much new business 'in the pipeline'. As sign of confidence in the future, the Board has declared an increased dividend to be paid in 2013.

PGH offers a dividend yield of 5.1% on an historic PE of 16. The company has net liquid assets of 15 million pounds, about 15% of its market valuation of 106 million pounds. It has no defined benefit pension scheme to provision for, nor any other worrying balance sheet entry.

Using a discount rate of 10.8% gives a valuation of 339p for the shares, an average of the Earnings per share (growth 7.5% p.a.), Return on Equity (the company generates a high, 26% ROE) and equity per share growth models. The offer price for the shares is 373p. The company's shares have traded at a 12 month low of 286p (in May 2012) and a high of 394p (on 30 March 2013).

PGH shares qualify for business relief for Inheritance Tax purposes (see an explanation of the special considerations and benefits from investing in AIM stocks at http://thejoyfulinvestor.blogspot.co.uk/2013_02_10_archive.html.)

Assessing the special conditions of companies quoted on AIM:

1. The 'free float' is 53% of outstanding shares, much larger than the 25.1% required to block unilateral inside shareholder decisions. The remaining shares are held by the founder, C W Johnston, with 43.1% and senior management with a further 3.9%.

2. PGH is a long-established company that has high governance standards.

3. The offer to bid spread for its sharers is 5%, which is typical for this size of company on AIM. It is not suitable for short-term investors.

4. The company is cash generating and holds no debt.

The prospective investor will note that, although the new management team offers the possibility of a significant improvement in PGH's performance, the current share price of 373p is substantially ahead of its valuation of 339p.

 However, the valuation does not take into account the IHT concession, and if this is important for the investor, PGH's value would rise considerably. For example, if the 40% IHT relief were to kick in one year beyond the required 2-year holding period, the current valuation for the shares would be 448p.