Dealing with the Time Value of Money

And J P Morgan Global Emerging Market Income Investment Trust

The Persistence of Memory, Salvador Dali, courtesy Wikipedia

Man has been charging interest, the time value of money, on loans for at least 2,700 years (it is recorded in Deuteronomy). Roman lenders charged from 4 to 48% p.a. depending on the credit worthiness of the borrower and the availability of credit. The same principles apply to the rate of return required for making an investment, only the starting point is much more complicated for an equity investor seeking a long-term investment.

Once the preliminary analysis of a company is complete and the investor is satisfied that it merits further study, he will require a methodology to help him find what might be its intrinsic value.

According to Mary Buffett (Buffettology, 1997), Mr Buffett projects a company's earnings per share for 5 or 10 years and no further. As the accuracy of any projection declines rapidly over time, this cut off has the advantage that it limits the enormous variations that can occur when projecting earnings for longer periods

But to call a stop at such a short period requires some further assumptions on the part of the investor. These further assumptions have the advantage of making explicit assumptions about a company's return on equity, dividend yield and payout ratio, the market's price earnings ratio and the growth of earnings per share and equity per share. All factors relate to the value of a company. They can be combined as follows.

Three simple models provide a contrasting source for the value of a company's share price 5 or 10 years hence.

1. A first route is to Project earnings per share for 5 or 10 years. Adding a multiple (say an average historical Price Earnings Ratio (PE) for the company's share price) to the resulting earnings per share gives a notional share price for that company in 5 or 10 years time.

2. A second route is to project the growth in the company's equity per share. Then multiply it by a selected Return on Equity and this gives a value for the future earnings per share. Repeat the PE multiple in 1 above to give another notional value for that company's share.

3. A third route is to apply a selected return on equity to the present equity per share, adding the earnings per share that is retained and not paid out as a dividend for each year. This model generates a notional earnings per share for the company concerned at the end of the 5 or 10-year period. Repeat the PE multiple in 1 above to give a third notional value for that company's share.

Changing assumptions and watching the resulting change in value, gives the investor a feel for the sensitivity of a company's share price to specific factors.

Purists will object that this method does not use cash flow. But before the investor uses these models, he will have satisfied himself that the company is generating cash in line with earnings. In any event, the only cash flow an investor will normally see is the dividend, and this depends greatly on the company's earnings per share.

All of the above valuations require a discount rate to allow for the time value of money. Mr Bearbull, columnist of the Investors Chronicle, uses 8.5%, because that is what he requires from his equity investments. This is a common approach, but as Seth Klarman (Margin of Safety, 1991) writes:

"The appropriate discount rate for a particular investment depends not only on an investor's preference for present over future consumption but also on his or her own risk profile, on the perceived risk of the investment, and on the returns available from alternative investments."

The required rate of a return on an equity investment is not the same when 10-year Gilts yield  2% than when they yield 17%, as they did in 1974. Equally, the required rate of return for a company such as Unilever, with an A+ long-term credit rating, will most likely be lower than for a company with no credit rating at all.

Similarly, the investor in foreign markets should be aware of the credit rating of those countries where the investment is located. Standard & Poor's country ratings are currently as follows:

Map courtesy of Wikipedia, click to enlarge

The return required from investments based in BBB and below rated countries should be higher than investments based in investment grade rated countries. The grey area, where there is no credit rating at all, indicates that any financial investment is subject to great risk. These countries are best avoided by the individual investor.

To summarise, the diligent investor will develop a tailor-made approach to arrive at the required rate of return (or discount rate) for a particular investment to discount it back to its present value. One possible method is:

1. Use the average cost of debt of a company as a base, for this does take into consideration the risk of company default. The mail order and internet clothing retailer N Brown's average cost of debt, for example, is 4.3%. Where a company has no debt, one can use investment grade corporate bonds as a proxy. The ETF SLXX, a fund that only invests in such bonds, currently yields 4.1% to redemption.

2. Add an amount for execution risk. The more ambitious the growth in earnings assumptions, the greater the risk of failure to meet them. In the case of Unilever, I use fairly conservative assumptions and add 2% as a risk factor.

3. Add an amount for profit and a margin of safety. I use 5% for all stocks.  

This approach habitually results in a discount rate of between 9 and 13% in the current low interest rate environment. To allow for the dividend payout of companies, which should reduce their growth in earnings and equity, the investor deducts the current dividend from the required discount rate. Or, to look at it from another viewpoint, if the investor requires 10.8% from Unilever and it regularly pays out a dividend equivalent to 3.1% at the present price, then the required capital gain from future earnings will be 7.7% p.a. 7.7% becomes the discount rate.

Given the uncertainties in any forecast, the resulting valuation is but an indication of what a company's share might be worth. A benchmark is most useful, but it is not a substitute for understanding the quality of a company's management, its market position and potential threats to its business. 

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J P Morgan Global Emerging Market Income Investment Trust (JEMI)

Courtesy Financial Times 29 June 2013, click to enlarge

This graph compares the price to book ratio* of emerging markets to developed markets since 1996. On this basis, emerging markets are at their lowest level since 2005 and stand at a 20% discount to developed markets. *Market capitalization/Net asset value for all companies. 

John Authers of the Financial Times (29 June 2013) concludes,

"There is no great case for buying emerging markets en masse, as an asset class. That is the way the sector pumped up over the past decade, as investors poured into passive funds that tracked emerging market indices.  But not all countries or companies deserve to be trading at the sector’s biggest discount in eight years. The job is to identify them."  

Quite so. Stock and country picking is the order of the day, and this eliminates the use of Exchange Traded Funds. The investment trust J P Morgan Global Emerging Market Income (JEMI) is one of the few such GBP trusts that cover this area and are income oriented. JEMI (price in blue, net asset value in red) has a superior performance to the MSCI Emerging Market Index (in green):

Graph courtesy of the Investors Chronicle, click to enlarge. 

JEMI, which yields 4.4%at 123p, is invested in emerging markets with a BB or better credit rating:

 

Country	Percent of portfolio	Credit Rating
South Africa	15%	BBB
Brazil	12%	BBB
Taiwan	12%	AA
China	12%	AA
Hong Kong	7%	AA
Turkey	6%	BB
Russia	6%	BBB
Other*	30%	BB or better

*South Korea, Poland, Indonesia, Thailand, India, Saudi Arabia, Kazakhstan, Qatar, Philippines, Mexico, Malaysia. 

By sector, JEMI is mainly invested in consumer goods (22%), financials (16%), telecommunications (16%), information technology (11%) and general industrials (10%). 

JEMI is well diversified and by the standards of emerging market investments low risk. Not only is the fund invested in a wide range of better quality markets, but also no single company accounts for more than 2.2% of the portfolio. And: 

1. Though the statutes permit JEMI to borrow up to 30% of the value of the fund, currently JEMI is fully invested and it holds 9% debt. 

2. Though the statutes permit JEMI to invest in a wide range of financial instruments, the 30 largest holdings, accounting for 51% of the fund, are all in equities. 

3. JEMI is capitalised at 283 million pounds, which is big enough for a fund investing across so many markets. The investment trust has a policy of issuing new shares to keep down the price premium to net asset value. This currently stands at 1.8%. 

4. Revenue earnings per share after charges more than cover the dividend payout, currently 4.4%. However, as 70% of the fund's charges for commissions and the cost of debt are charged to the capital account, 15% of dividends were, in practice, paid from the capital account.  

5. The total cost of operating JEMI, including the cost of debt, a 1% annual commission on net assets, a 1% performance fee on the fund's outperformance of its benchmark index and all other administrative and trading costs amounted to 3.3% of the value of the fund in 2012. From April this year the performance fee is capped at 0.75% of net asset value; in practice, this is unlikely to make any difference to management charges. 

It never hurts to pick the best fund managers and the best performing funds, though both can suddenly change. City Wire rated J P Morgan as the best fund manager in the UK in 2012. JEMI is managed by Richard Titherington since its launch in 2010. He has a staff of 38 professionals, who work on this and other emerging market funds at J P Morgan, at his disposal. With 14% of global market capitalization, up from 5% in 1992, emerging markets are a worthy part of an investor's portfolio. 

The cautious investor will note: 

1. The risks mentioned in JEMI's 29 June 2013 prospectus for its latest share issue. It is available from the internet. 

2. Emerging markets are more volatile than developed markets, though JEMI is less so. JEMI's share price reached a 12-month low of 110p in July 2012 and a high of 140p in May 2013. 

3. Emerging markets have gone through phases of exceptionally good performance followed by catastrophic falls, and there is no guarantee that this will not recur. So it is wise not to commit more than 5 or 7% of a portfolio to this area. 

4. Unlike an open-ended fund, JEMI, as a close-ended fund can and does leverage its portfolio. This increases the funds volatility.

5. JEMI's share price is currently at a small premium to net asset value. If emerging markets go out of fashion, this could turn to a discount.

 

 

Research for the Individual Investor

And Aberdeen Asset Management

"Research holding the torch of knowledge" by Olin Warner, Library of Congress, courtesy Wikipedia

Research material has never been more abundant for the individual investor. As far as information is concerned, the diligent individual investor is now on an equal footing with the institutional investor. This may seem unlikely but consider:

1. Publicly listed companies in the UK make available a wide range of information on their websites. The individual investor has the same access to raw company data as the institutional investor.

2. Company specific news is available from online brokers, financial websites, and from publications such as the Financial Times or the Investors Chronicle.

3. Online broker websites provide information on broker forecasts and recommendations. Many provide free advice.

4. Credit rating agencies offer credit ratings on the debt of bond issuers. Pay a small price and you can get the full report.

5. Newspaper business sections, the financial press and bloggers offer tips on a wide range of companies and asset classes.  

All this is available from the internet without moving from one's desk.

 Institutional investors are reckoned to hold two significant advantages over the individual. They have access to company management and they have financial models that can churn through large amounts of data. But are these really advantageous?

Meetings with company managers are fraught with problems. Naturally, management see an investor meeting as an opportunity to promote their company. As managers are invariably enthusiastic and optimistic exponents of their company's activities, the fund manager or researcher may well leave a meeting with a good narrative to tell about the company. It looks good, but a narrative obscures the rational approach required of a good investor. Benjamin Graham avoided such meetings, as they might have clouded his judgement.

Company analysis is a cottage industry. It does not require the processing of large quantities of data. Indeed, the danger of processing large amounts of information is that the investor will lose sight of what is important and will ignore what cannot be quantified.

It is useful to know the opinions of other investors. The weekly magazine and website, Investors Chronicle (IC), is the best source of new, interesting investment opportunities I know of. And it covers a very wide range of companies, provides basic data and a summary to support its Buy, Hold or Sell recommendations.

If the individual investor feels that he is labouring at a disadvantage to professional fund managers, he should think again. Robert Schiller, in Finance and the Good Society (2012), writes:

"Professional investment managers do not seem to do particularly well in selecting their own portfolios either. A 2011 study by Andriy Bodnaruk and Andrei Simonov obtained data on the personal portfolios of mutual fund managers in Sweden. (It is possible to get these data in Sweden because the country levied a wealth tax until 2007, and so wealthy people had to report their entire personal portfolios to the government.) They found that the investment managers did no better on their investments than the average investor, nor were they more diversified."

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Aberdeen Asset Management

Where are the yachts of Aberdeen's clients? (Cover of Aberdeen's 2012 Annual Report)

Aberdeen Asset Management (Aberdeen) was selected by the Investors Chronicle (18 January 2013) as the best of the ten pure asset managers that are large enough to be included in the FTSE 350.

Aberdeen has grown, via a series of acquisitions, to be the 67th largest asset manager in the world. Pooled funds, from retail investors, account for 45% of Aberdeen's business. The remaining 55% come from institutional investors such as pension funds, insurers, sovereign wealth funds and governments. 54% of assets under management are in equities, with the remainder in fixed interest, hedge funds, property and money markets. Aberdeen does not offer any Exchange Traded Funds (ETF).

The UK, with 41% of Aberdeen's revenues (fees and commissions), is its prime market, though Singapore (25%), Europe ex-UK (16%) and the Middle East (12%) are also important sources of business. It has a small US operation, which accounts for 7% of its annual revenues of 869 million pounds.

 In its 29 April 2013 edition, the Investors Chronicle rated Aberdeen a Buy at 456p a share. "Risk-hungry punters have sunk so much cash into equities recently that first-half profits at Aberdeen Asset Management (ADN) smashed City forecasts and propelled shares in the fund manager to an all-time high. Underlying pre-tax profit rocketed over a third to £222.8m and analysts at JPMorgan have upgraded their full-year underlying EPS estimate by 9 per cent to 30.9p (from 22.6p in 2012). Even that, they say, may be too cautious."

And, "Earnings upgrades have helped drive Aberdeen's share price recently. But a forward PE ratio of under 15 still looks attractive given the likelihood of a cash return and estimates of double-digit profit growth for at least three years. Buy."

Aberdeen's share price (in blue) has fluctuated wildly when compared to the FTSE All Share Index (in green):

Graph courtesy of Yahoo, click to enlarge.

Is Aberdeen a good long-term investment, and if so, at what price?

Aberdeen is financially in good health and it has a good trading record in recent years:

1. Gross debt declined from 256 million pounds in 2009 to 82 million in 2012. At March 2013, net cash stood at 638 million pounds after a fund-raising of 322 million pounds.

2. Operating cash flow, once share purchases to compensate for employee share awards and capital expenditure are deducted, covered the dividend by 1.8 times these past 5 years. This left 337 million pounds for debt reduction and acquisitions.

3. Earnings per share have increased by a compound 12% since 2005-6, equity per share by 4.5% and the dividend payout by a compound 18%.

4. Return on equity has averaged 9% since 2005.

Using these figures and projecting them for the period 2013-17, with a discount rate of 11.3%, values Aberdeen's shares at 232p. This compares to the current price of 405p, which is on an historical P/E ratio of 23 and a yield of 2.8%.

Aberdeen's business is highly leveraged to the stock market. Costs are fixed while income from fees and commissions are highly variable. A 13% increase in the FTSE All Share between September 2012 and March 2013 translates to an increase of 22% in Aberdeen's earnings per share (H1 2013 compared to H2 2012). Funds flow in and the increase in the value of the funds managed generates higher income. As a result, the present estimate for 2013 earnings is 37% up on 2012. So, at the current price of 405p, the shares are on a prospective P/E ratio of 13 and yield 3.7%. Aberdeen might well be a trading opportunity at 405p.

However, unless we are in for a sustained period of growth in the stock markets, for the long term the present share price is well ahead of fundamentals. Consider:

1. The CEO notes in the 2012 Annual Report, "a battle between active and passive managers is taking place in developed markets". Passive funds (in grey), such as ETFs, are taking market share from managed funds (in orange). And Aberdeen has no passive funds:

Courtesy of Thomas Powers, click to enlarge

2. Asset Managers rely on their performance to gain new customers, and Aberdeen is not currently in the top ten UK asset managers by performance, according to City Wire Global (JP Morgan leads the pack).

3. The UK's recommendations from the Retail Distribution Review, which requires greater transparency of fund charges, are likely to put pressure on the commissions earned by asset managers.

4. Between September 2010 and March 2013 Aberdeen's funds under management have increased by 18%. The FTSE All Share has increased by 13% over the same period and Aberdeen has steadily acquired new businesses. What might be called organic growth is tiny.

5. Two directors have sold 15 million pounds of shares between February and June 2013 at prices between 402p and 466p a share.

6. Aberdeen's shares are trading at 69% above their 12-month low of 241p (in July 2012).

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[NOTE: The next article will be published on 3 July]

 

 

The Use and Misuse of the Price Earnings Ratio

And Interserve PLC

Courtesy Wikipedia

We like to keep things simple. A long time ago, investors settled on the price-earnings ratio (P/E ratio)* as an indicator of how a share was valued by the market. Naturally, the flaws in the denominator of the P/E ratio, earnings per share (EPS), drove investors to look for indicators that are more meaningful. *The P/E ratio = the market price per share X number of shares outstanding/ post-tax profits.

Yet the P/E ratio is not a silly number. As the numerator of EPS is profit after tax, it cannot be ignored. Profit after tax determines, via the balance sheet account of retained earnings, the funds available for distribution to shareholders as dividends. And management often decides the company's dividend based on a fixed percentage of EPS.

The P/E ratio is just one of many measures used to value a company. It is often misused either as a substitute for further analysis or by quoting a figure based on management's 'adjusted' earnings. Management often adjust earnings to exclude amortization, depreciation and impairments to intangible assets and/or non-recurring or exceptional items. This usually inflates EPS and consequently understates the true P/E ratio for the company's shares.

 But the P/E ratio is very useful for measuring aggregates - entire stock markets.

Robert Shiller, a glutton for statistics, showed in 2005 (Irrational Exuberance 2nd Edition)what every investor already took for granted ". . . investors who commit their money to an investment for ten full years did do well when prices were low relative to earnings at the beginning of the ten years." Shiller favours the Cyclically Adjusted Price Earnings (CAPE) ratio as a measure for an entire index, which is a ten-year rolling average P/E ratio.

The following table illustrates the Shiller CAPE for the S & P 500 going back to 1880 (S & P 500 to 1926 and extrapolated backwards) plotted against long-term interest rates. From this graph, one concludes that there is no constant relationship between interest rates and the stock market, except that since the 1980s interest rates have a positive correlation to CAPE but with a lead-time of between 10 and 20 years. According to this measure, the S & P 500 is not far from its long-term mean. (I am not aware of any similar long-term study for the London Stock Market.) 

 

Graph courtesy of Robert Shiller at his Yale website, click to enlarge.

Goldman Sachs has also produced results, based on CAPE and the forecast P/E ratio for 2013, for 17 major stock markets as of February 2013. The UK stock market was then at a lower valuation than the average for the last 38 years. This is a most useful measure for investors interested in foreign markets, where they plan to invest via a fund.

Table courtesy of Goldman Sachs website, click to enlarge

And this week's Buttonwood column in the Economist uses comparative P/E ratios to show that emerging-market equities are at a 25% discount to developed-world equities. Buttonwood comments, "They [emerging-market equities] have been cheaper in the past, but a further period of underperformance will make them very attractive to long-term investors."

To conclude, the P/E ratio is a useful measure for stock indices, given the few alternatives (dividend yield, price to net assets ratio) available. But given the large amount of financial and non-financial information available for individual companies, the P/E ratio is a really poor measure of that company's value.

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Interserve PLC

Courtesy Wikipedia

Interserve is in an unfashionable business (support services to the public sector mainly) and relies for two-thirds of its profit on the stagnant UK economy. The shares stand on a current P/E ratio of 10, half the level of the FTSE 250 (of which Interserve, with a market cap of 610 million, is a component). They yield 4.4% compared to the FTSE 250's average of 2.6%. Interserve's share price has underperformed the FTSE 250 these past 5 years:

Graph courtesy of Yahoo, click to enlarge

Yet Interserve is financially strong and has a good trading record. Consider:

1. After the sale of its interests in PFI (Private Finance Initiative), the company has a net cash position of 27 million pounds at the end of 2012.

2. Interserve's ordinary free cash flow for the past five years, after capital expenditure and paying the dividend to shareholders, left 30 million pounds for acquisitions and reducing debt.

3. Interserve's dividend is twice covered by earnings and has grown by 4% p.a since 2003.

4. Return on equity averages 19% and, on retained earnings these past 10 years, 27%.

5. Ordinary earnings per share have grown by 11% annually and equity per share by 15% annually since the period 2003-5.

6. Business in hand, at 6.3 billion pounds, is the equivalent of 3 years' revenues.

Interserve has a stable management team with the CEO in office since 2003, the Chairman since 2006 and the CFO since 2010. Management has pursued a strategy of:

1. Moving away from construction to support services (over a wide range of activities), where longer contract periods guarantee more stable revenues. However, business in hand at the end of 2012 was no greater than in 2008.

2. Moving into new areas that promise more growth. However, the business sectors served by Interserve are not substantially different from 2004:

                               Sector                                  % Revenues 2012            %Revenues 2004

                               Commerce                                   21%                                     23%

                               Defence                                        20%                                     13%

                               Infrastructure                              16%                                     17%

                               Health                                           13%                                     11%

                               Education                                     10%                                       6%

                               Other                                             20%                                     30% 

3. Increasing the share of international business, dominated by the Middle East, where margins are triple those in the UK. Interserve has increased its international revenues from 8% of the total in 2004 to 33% in 2012. However, operating margins have hovered between 4 and 5% for the past 5 years. 

4. Doubling earnings per share between 2011 and 2015, to about 80p a share. 

To achieve this objective, in 2012 Interserve sold its substantial PFI business and bought a number of companies to extend its business in welfare-to-work (for the UK government), home healthcare and oil and gas services to the Middle East. 

On conservative assumptions*, my valuation model values Interserve at 486p a share, or about the present market price of 470p. *For the years 2013-17: 11% p.a. increase in EPS, 10% p.a. increase in equity per share, 19% return on equity, and an average P/E ratio of 9. Discounted by 12.3% to allow for the execution risk associated with these assumptions. 

Interserve, at its current share price, offers a superior and well-covered dividend that in the past has more than kept pace with inflation. 

The cautious investor will note: 

1. Interserve has made a significant move from its profitable business in PFI to increasing its business elsewhere. This is not guaranteed to succeed. 

2. The company relies on UK public spending/outsourcing for a large share of its business. 

3. The shares have been as low as 292p in the last 12 months (20 June 2012). 

4. Four directors have made large sales of their shares in April at 475p a share. 

5. Although the company closed its defined benefit pension scheme to new entrants in 2009, its liability is growing. In the latest year, the company handed over 55-million pounds of PFI projects to its pension fund to fund a part of the deficit. This is equivalent to 70% of its 'headline' profits for 2012. Future payments have been agreed at an 'indexed' 11 million pounds a year. This will prove to be a drag on profits and dividends.