Investing - measuring risk

Investing is often talked about in terms of risk and reward, and as an attempt to balance these two elements. Currently everything feels risky, governments have been putting their economies into hibernation, central banks have turned the money printers up to 11, all to help combat a virus to which we have no medical solutions.

So given the rather frisky nature of the markets of late I decided to look into how investors try to measure risk.

As we’ll see below to a large extent risk is often framed in terms of volatility. To some extent I think this is reasonable. If an investment moved 50% up and down randomly from an average price each day, it would be quite difficult to know when might be a good time to buy or sell. Another investment that only moved 5% would provide some consistency in pricing that might make owning it more palatable.

Perhaps more problematic with using volatility as a measure of risk is that in one direction volatility is surely desirable – a valuation moving rapidly upwards is generally regarded as a good thing. The same degree of volatility going the other way isn’t usually welcome.

I'll look at 3 risk measures:
Beta
Sharpe ratio
Sortino ratio

I’ve set up a googlesheet here to download and play with if you’re so inclined. It shows the measures above, with all the components broken out. It also has a simple scatterplot with regression line, correlation and r², in case these also float your boat.

Beta

Beta is a notion that essentially compares the volatility of an investment against a benchmark (the “market”). The benchmark is given a beta of 1, a beta above 1 indicates that the investment is more volatile than the benchmark, and a beta less than 1 that it is less volatile than the benchmark.

You’ll find it on sites like Yahoo finance – looking at a couple of examples on there, as of mid-May 2020 Diageo has a beta of 0.33 and Lloyds has a beta of 1.1. Booze is less volatile than banking apparently. However, Yahoo don’t state how they have calculated the figure, so a little pinch of salt is required, but it is probably correct to think that a company selling booze will have more stable and consistent returns than a bank which will be tightly aligned to macro-economic conditions.

Beta doesn’t state an absolute degree of volatility but relative to a benchmark. It is a function that for any given input tells us what to expect as an output. In the cases above, if the numbers are to be believed, for every 1% of change in the market, Diageo typically has a change of 0.33%, and Lloyds has a 1.1% change.

Lets take a simple example to understand the principle better, there are plenty of rabbit holes online to disappear into if complexity is what you’re after.

Beta tells us roughly what % change to expect in an asset’s price given a 1% change in the market. Let’s set up a simple pretend business “WidgetX” and see how it performs in good and bad conditions, and how the market also performs:

	Good times	Bad times
WidgetX	30%	-20%
Market	20%	-10%

What we can see here is that the price of an investment in WidgetX tends to be up by around 30% when market conditions are good, but down by 20% when conditions are bad. Whereas the market tends to be up by 20% and down by 10% during these conditions.

If we take the range of scores from WidgetX and the market we get:

WidgetX range = 50

Market range = 30

50/30 = 1.67

So if the market changes by 1%, WidgetX tends to change by 1.67%, which tells us the company is rather sensitive to changes in the underlying market. A bit like Lloyds above which typically moves more than the market, Diageo, on the other hand is insensitive to market conditions, they keep selling booze no matter what’s going on.

To come back to the point above about volatility and direction, this sensitivity will result in a greater movement up and down, so we might expect Lloyds to outperform the market in good years, and to underperform in bad. Diageo, would likely underperform the market in good years and outperform in bad.

Beta is calculated as follows:

Beta = covariance of investment & market / variance of the market

The covariance of both investment & market measures how these two move relative to each other. A positive number indicates that they tend to move in the same direction together. A negative number indicates that they tend to move in opposite directions.

The market variance is simply the amount of variability in the returns from the market from an average - the mean return.

This is all very well, but as discussed more below, not all volatility is created equal.

Sharpe ratio

The Sharpe ratio is next on the list and is described as a way to understand an investment’s “risk-adjusted returns”. In other words the amount of return per unit of risk. As with beta above, the notion of risk is based on volatility – in this case the standard deviation of the investment’s returns. (To save a google for those rusty with stats, standard deviation is a measure of the variability of data, which is established by measuring the distance of each data point from the mean of all of the data)

The “return” in the Sharpe ratio is the return of the investment after taking away the return that a “risk-free” alternative would have generated. What is left after the “risk-free rate” is subtracted is called the “excess return”. The "risk-free rate" is often represented by US Treasuries (debt backed by the US Govt). Given that at the time of writing, mid-May 2020, the 2, 5 and 10yr US Treasuries yield less than 1%, they may not be the best “risk free rate”, the 30 yr only has a yield of 1.42%...

After finding our excess return we then divide this by our volatility – the standard deviation of the investment’s returns. This gives us a measure of return for each unit of volatility.

A quick example, imagine our WidgetX business above generates a return of 25% and we have a risk free rate of 5% then the excess return is 25% - 5% = 20%. If the standard deviation of the WidgetX returns was 15, we would then divide the excess return by this, 20/15 = 1.33. So our Sharpe ratio would be 1.33.

What does a Sharpe ratio of 1.33 mean? On it’s own, not a lot, but using it to compare different investments might help – let’s see how the iThing company measures up to WidgetX

	Return	Risk free rate	Standard deviation	Sharpe ratio
WidgetX	25%	5%	15	1.33
iThing	25%	5%	10	2

Both companies generate the same return, but have quite different Sharpe ratios, telling us that for each unit of risk, WidgetX gives us 1.33 return, whereas iThing gives us a return of 2. Since the return on both investments is the same (25%) it is the denominator in our equation that changes, that the risk, or volatility of iThing is less than WidgetX.

The Sharpe ratio is calculated as:

Sharpe ratio = (Investment return – risk free rate) / standard deviation of investment returns

By using the Sharpe ratio we could try to build a portfolio that generated the highest return for the least amount of volatility.

It does, however, have the same fundamental issue as beta, it assumes that all volatility is the same. A 10% change in the price of an investment has the same amount of volatility whether it is up or down – it’s impact on the likelihood of me achieving my financial goals is not the same however. I want to be exposed to the risk of my investments going up. Risk should have a component that accounts for the detrimental impact of something that makes goals more difficult to achieve. Our final ratio does just that.

Sortino ratio

The Sortino ratio is a modification of the Sharpe ratio. It is calculated in a similar way but rather than using the deviation all all price movements to represent risk, it focuses on the element of volatility most of us find uncomfortable – prices falling.                                          

Before digging into the Sortino ratio lets first revisit the statistical notion of standard deviation as it is this that is modified in the shift from Sharpe to Sortino.

From Wikipedia:

“In statistics, the standard deviation is a measure of the amount of variation or dispersion of a set of values.A low standard deviation indicates that the values tend to be close to the mean (also called the expected value) of the set, while a high standard deviation indicates that the values are spread out over a wider range.”

It is calculated by first establishing the mean of the set of values, and then measuring the distance of each value from the mean. A little more numerical jiggery-pokery gets you to the standard deviation. In most uses this is perfectly reasonable, but as mentioned a few times above, as investors, the direction of the deviation matters. This deviation is regarded as volatility in investing, which is equated, rightly or wrongly with risk. What we really need to do is extract the risky part of the volatility – i.e. an investment losing value.

Downside deviation is what we are looking for. This focusses specifically on downward price movements and uses the volatility of those negative movements – the standard deviation of the losses.

The Sortino ratio calculation is below:

Sortino ratio = (Investment return – risk free rate) / standard deviation of negative investment returns

I’ve highlighted the word “negative” above, as it is the key difference between the Sortino and the Sharpe ratio.

Let’s take our two companies again and apply the Sortino ratio:

	Return	Risk free rate	Standard deviation of negative returns	Sortino ratio
WidgetX	25%	5%	5	4
iThing	25%	5%	10	2

In this case both companies have a return of 25%, from which we subtract the risk free rate of 5%, to leave both with a return of 20%. WidgetX has a lower volatility of downside movements, it’s standard deviation of those movements are 5, whereas iThing has a much more volatile price, with a standard deviation of 10. If we plug these numbers into the denominator of our sortino ratio, we get a score of 4 for WidgetX and 2 for iThing. This indicates that we although we got the same return for both, we had to suffer twice the amount of downside volatility for iThing than WidgetX. As a risk adjusted return, to me this captures much more of the notion of risk, i.e. risk of losing money, than the Sharpe ratio (which includes the risk of making money).

The Sharpe ratio penalises an investment for price appreciation which is included in it’s definition of risk. Whereas the Sortino ratio isolates risk from return by focusing only on downwards price movements – the negative volatility that investors would prefer to avoid. 

So as a risk averse investor I should seek out potential investments with a higher Sortino ratio because it means that the investment has earned more return per unit of risk that it takes on.

The Sortino ratio seems closely aligned to the sensible idea of not losing money, which I discuss here.
To save you scrolling back up, the link to the googlesheet with all the above calculations is here.

April 2020 portfolio update

The novelty of lock-down is starting to wear thin. Child1 turning the garden decking into a rainbow is growing on me though.

Adjusting to working from home, and being dragged into a crisis management team at work made for a busy and rather taxing time over the last few weeks. C'est la vie, everything seems to be calming down a little now.

I've had to review my stock market shopping list, given that there were plenty of businesses pulling down the shutters thanks to COVID-19. Even though stock markets were falling I didn't just want to pile in without some consideration as to the impact on each business, and how I felt about investing in them given what is happening.

It has proved difficult to know how to go about judging stock valuations, historical metrics are all very well, but of limited use in the current environment. If a business has no revenue for a while, in a worse case it may not even survive, I think most will, but in what condition? As I point out here, I've decided to only invest in companies that are currently making money. And that I think will be in reasonable shape this time next year. This has had the effect of shuffling a few names on the shopping list. I expect this will all change again as we adapt to our new world.

Some dividends pulled by companies in the portfolio:
AB Dynamics - plenty of cash but prudence required as car makers have taken a beating
Network International - postponed until better clarity on trading
Compass - half the business is shut so needs to preserve cash
Computacenter - permits changes to cash flow from relaxing customer payment terms

The first two are businesses on a sharp growth path so losing the small dividends proposed is of no concern. Compass may take some time to rebuild cash to a point that it can justify a dividend, they effectively have a global duopoly with Sodexo, so I'm confident they'll be a good long term investment. Computacenter's decision is particularly sensible, as helping customers stay solvent is far more useful that getting an invoice paid on time, and the update was quite positive.

Purchases this month included a top up of Sage Group, and adding a small slice of PZ Cussons.

Portfolio performance
The portfolio was up 6.6% in March, ahead of my chosen benchmark the Vanguard FTSE All Share Accumulation which was up 4.4% over the same period.

Best performers this month:
Fulcrum Utilities +64%
AB Dynamics +58%
888 Holdings +16%

Worst performers this month:
Dignity -12%
SAGA -4%
Lancashire Holdings -1%

April share purchase: SGE
A top up of Sage Group was my first April purchase. You'll find Sage in the "Software and Computer Services" sector of the FTSE, but that's where the excitement stops, they provide a range of software to help businesses manage their accounts, people and payments.

They have been moving their business to a subscription model, and were behind the curve in doing so, but seem to be rapidly getting customers across to the new model - at least before the COVID-19 shenanigans. This means that their revenues become increasingly sticky; the cost and disruption of  moving key payment and back office business systems to a different vendor gives Sage a bit of a moat, and the sort of defensive investment that I prefer.

Their revenues and profits have been increasing at around 6%-7%, dividends increasing at a rate just above that. ROCE and margins have both been comfortably into double digits for most of the last 10 years. I'm not convinced historical data is terribly useful at present, but at least they are taking money.

Management are expecting a hit to revenues, and for the second half of the year to look ugly. Businesses can be expected to hold off on contract renewals, and if there are companies succumbing to the lock-down induced economic issues, then there will be some customer churn.

April share purchase: PZC
Second purchase for the month was PZ Cussons, a consumer goods company with brands many will be familiar with - I have some in the bathroom, Carex handwash and Original Source shower gel (love a minty shower 😎). This purchase is a little contrarian as Cussons have been in the doldrums for a while. The share price has reflected the drift in the company's strategy, which has ultimately needed a volte face, and a new CEO. The previous incumbent is also suspected of being naughty - so has had some pension payments cancelled, and the new CEO has spent time at big consumer goods companies, so should know his onions.

An acquisitive strategy has been abandoned in favour of one that focuses on a smaller number of key brands. In addition the business has historically generated a decent chunk of revenue from Nigeria but continued instability in the country has led to this drying up. The demographics in Nigeria are promising, the economics, not so much.

PZ Cussons has all the hallmarks of a plodder, a company with limited growth potential - just handing excess cash back to investors (not a bad thing in my view). But it does have a number of positives, not least of which is that it's business is open, and the tills are ringing. A trading update in April stated that two of it's brands had contrasting fortunes from COVID-19, St. Tropez (fake tan product) has seen sales fall away as people presumably won't be prepping the skin ahead of summer hols, but Carex (handwash) is selling like hot cakes. Announcing that earnings were expected to come in at the lower end of guidance left the markets unperturbed. Simply having earnings and not having to explain how the company is planning to survive the next few months makes for a refreshing read.

Watchlist review

It’s been a wild few weeks in the markets. My response has been less wild, and has mainly been an attempt to review the companies on my shopping list to try to ascertain what the impact of COVID-19 might be on these companies. It’s not just a matter of what might happen over the next few weeks, but whenever we get past this virus, what sort of shape these businesses are going to be in.

Assuming we have another year or so before a vaccine is available to make COVID-19 go away, the intervening period could involve various business disruption, social distancing, further lockdown measures, and public testing protocols. So when I’m considering making a purchase, I now need to think about how the business in which I’m investing is going to make it through this? Part of my review over the past few weeks was to look through my preferred list and ask myself some questions:

• how has the company management responded to the crisis?
• are they still making money today?
• will they still be taking in cash throughout this crisis, even if cash flows are disrupted?
• how will multiple waves of infection affect them?
• how will public testing protocols affect them?

As an example, Greggs, the low key tasty pastry seller, has quietly been making investors very happy over the past few years. It’s been churning out great results, keeping a really simple business, just rolling out more of it. They are currently closed and making zero revenue. They went into the crisis with no debt, as of 9^th April had £47m in cash and were taking up the Government offers of support, so will very likely still be operational once we all emerge from our homes. They are likely to serve up tasty grub to millions of punters once again, and the management team have acted and communicated clearly. But what will be the cost of being closed for the length of time that they are required to do so? What is the impact on their finances, staff, suppliers & partners. How would they manage getting customers into their stores after lockdown - if we all have to wear masks, do they think customers would just pop up the mask to take a bite of their sausage roll? Will they test each customer before letting them into the shop? The impact and cost is unknown, so for me it makes investing in such a company very difficult.

Rightmove is (was?) another business on my shortlist. An incredible investment with operating numbers off the charts and a genuine moat. On 18^th March they stated they would defer part of their subscription for up to 6 months for some estate agents, had a strong balance sheet, but were not buying back shares (revealing the flawed logic in shared buybacks – if now wasn’t a good time when would be?). 2 days later another announcement stated that they would reduce their subscription fees by 75% for 4 months, which superseded the deferment offer. 7 days later another statement cancels the dividend. A company that has looked so astute, suddenly looks indecisive, dithering and panicked. The extent to which they make it through this in a position of strength is largely dependent on the survival of the estate agents and their subscriptions – so why ask them to pay anything if the Rightmove balance sheet is so strong. A strange series of statements that do little to endorse the management of the business, just when you need clear heads.

Admiral insurance as a 3rd example – the share price has hardly moved over the past few weeks. Amazingly resilient share price – doesn't seem to give a monkey's about COVID-19.

There are no answers to any of this, markets may get cut in half, or may surge to new highs. It’s difficult to work out if share price falls constitute bargains or not. After all if businesses are making less money, and the share price has dropped by an equivalent amount, the value of the business has arguably stayed the same.

Using Price to Earnings (P/E) values as a short hand for valuation:

Price = 150

Earnings = 10

P/E = 15

With a 20% reduction to price

Price = 120

With a 20% reduction to earnings

Earnings = 8

PE = 15

In other words the valuation is unchanged.

To flip the P/E into the earnings yield (E/P - earnings divided by price) we can show the same as the above:

Price = 150

Earnings = 10

Yield (E/P) = 6.7%

With a 20% reduction:

Price = 120

Earnings = 8

Yield (E/P) = 6.7%

Valuations are unchanged.

The problem is most companies don't know what impact the measures to inhibit the spread of the virus will have on them.

What adds to the madness is not knowing what is supposed to be baked into the share price. If it is supposed to be all future discounted cash flows, losing a quarter or two of earnings shouldn’t make much difference, so why the large moves in share prices?

Taking a simple approach to the Rightmove example above, the reduction in fees will apparently lead to a £65m - £75m cut in revenue for 2019. They made £289m in revenue in the prior year, taking the midpoint of the revenue impact as £70m, leaves us with around a 24% drop in revenue. The share price dropped over 40% from mid February to the low on the 23^rd March, the cancelled 4.4p dividend would only have accounted for a small % of the loss (the share price dropped to around 400p – equating to cancelling a 1% payout). It looks as if the market is pricing in bad news for Rightmove, is it a margin of safety? As noted above the condition in which the business comes through this is predominantly about their customers, it’s not something that Rightmove control. This makes it very hard to invest into.

Banging a few numbers into spreadsheets to get some back of the envelope calculations has helped, but it has also been useful to revisit these companies and try to think through not only will they survive, but in what shape. It’s certainly led to some movement on the shopping list, with a few companies being removed completely. Strange times.

March 2020 portfolio update

Only one thing in the news - COVID-19.

It's not the only problem affecting the markets of course. Oil prices have been smashed by demand dropping off a cliff since nobody is going anywhere, and the Saudi's opening their taps. And until they have achieved whatever they have in mind, any business dependent upon oil is going to suffer.

The collapse in price of a key global commodity, such as oil, and the suspension of the vast majority of consumer spending in a number of economies on the planet is certainly making everyone sit up and take notice. With this happening against the backdrop of expensive markets, it's unsurprising we have seen significant reductions in share prices.

It's going to be interesting to see how far revenues, profits and cashflow have fallen once we start getting earnings reports issued, and whether any businesses are actually priced as bargains. I have a list of companies I'd like to buy into, but I'd like to see a bit of economic data first. Even though some of them are historically very good companies, there is a genuine whiff of existential angst in the air. I'm quite comfortable missing the bottom chunk of the recovery if need be, and I'm equally not fussed about getting in too early. Most quality businesses should recover over the next year or two.

As an investor keen on dividends, it is disappointing to hear of dividend cuts but these are unusual times. The investor community has insisted on spare cash being returned to us via dividends or share buy backs, so we should be not be surprised that an acute cash flow crunch leaves firms a little exposed. Three of my portfolio have so far reported cuts to their dividends, I'm relatively sanguine as this should help reduce the probability of needing to borrow to survive the next few months.:

Somero Enterprises - postponed dividend to 2021 (it's ok guys, you can cut it - we understand 😎)
Nichols - cut dividend as revenues are likely to materially impacted by COVID-19
Fulcrum Utilities - dividend had been postponed whilst asset sale completed, now formally cancelled

Nothing bought or sold during March, waiting for things to stabilise a tad, so keeping the powder dry just a little longer.

Portfolio performance
The portfolio was down -8.9% in March, losing less than my chosen benchmark the Vanguard FTSE All Share Accumulation which was down -15% over the same period.

Best performers this month:
888 Holdings +9%
Reckitt Benckiser +7%
Craneware +1%

Worst performers this month:
Dignity -52%
SAGA -47%
AB Dynamics -33%

Portfolio COVID-19 update

Given the destruction wreaked upon the markets of late, it seemed like a reasonable time to reflect on the status of my investments.

My goals are pretty simple and can be distilled into 2 key points:

• Don’t lose money
• Build a portfolio of dividend paying investments

There is more finesse to these goals detailed here but it boils down to these two things. Since I’m looking to these investments to supplement my pension in a few years, I’m principally looking for income over capital growth.

Many businesses are experiencing disruption to both supply and demand, hardly a recipe for fat cashflows and pristine balance sheets. I’ve been through each of the investments that make up the core of my portfolio and the updates provided by each company over recent weeks, and tried to guess what the likely short-term and long-term impacts are likely to be.

Company	Business activity	COVID-19 update	Likely short-term impact	Likely long-term impact
Abcam	Provider of biological ingredients, kits and information to life sciences	9th March Chinese impact to operations quantified. Further impact outside of China unknown.	Reduced turnover and potential supply chain disruption. Possible increase in demand for products if relevant for COVID-19 research.	Little impact. Potential for increased funding for life sciences as a reaction to global pandemic which might benefit Abcam.
AG Barr	Soft drinks	23rd March Delayed annual results. Contained update on COVID-19.	Not material so far. No immediate interruption to production, hit to demand, balance sheet ok.	Little impact.
Compass	Contract catering	17th March Severe impact from March onwards.	Severe impact. Possible breach of debt covenants if impact continues.	Assuming customers remain trading, long-term impact should be positive. Compass should have scale to take market share from smaller businesses or to acquire these at lower prices.
Computacenter	Tech services	12th March	Increased demand for remote working. Potential for decreased technology infrastructure.	Likely to see increased spending in ecommerce and ensuring resilient remote working.
Foresight Solar	Solar energy provider	9th March FSFL Statement: No impact	Minimal impact.	Minimal impact.
Glaxosmithkline	Pharmaceuticals and consumer health products	5th February GSK Statement: Impact unknown	Reduced turnover and potential supply chain disruption. Potential increase in demand for any respiratory medicines.	Potential for increased funding for research and respiratory medicines.
National Grid	Energy infrastructure	None	Minimal impact.	Minimal impact.
Nextenergy Solar	Solar energy provider	20th March No significant impact. Cancellation of scrip dividend.	Minimal impact.	Minimal impact.
Nichols	Soft drinks	None	Reduced turnover and potential supply chain disruption	Little impact.
Reckitt Benckiser	Consumer goods	27th February Some disruption to Chinese supply chain	RB’s portfolio contains a number of household cleaning products which should benefit. Potential supply chain disruption.	Little impact.
Telecom Plus	Utilities and telecoms reseller	None	Little impact.	Little impact.
Tritax Big Box	Distribution centre property REIT	17th March Vague risk around global recession.	BBOX customers include retailers that could become distressed, e.g. M&S. These could look for rent reviews, or even potentially fail.	Potential for increased demand for online sales during COVID-19 outbreak. If ecommerce gets even more ingrained into consumer habits it could benefit BBOX.
Unilever	Consumer goods	30th January Statement: impact unknown	Little impact.	Little impact.

The true extent of the disruption is unknown, and fortunately for most of my investments is it unlikely to be crippling. The one exception is Compass. Compass is a catering company, providing catering services to business, governments, events, and have the market essentially split with Sodexho.

By my calculations if the current levels of disruption continue for too long, they may breach their debt covenants. Exactly what this means is unclear, if the loan defines covenant breaches as ‘potential’ or ‘actual’ events of default. The lenders may either have the right to demand immediate loan repayment – which with a cashflow crunch may not be ideal. Watch this space (from behind the sofa)

Compass update and back of the envelope calculations below:

"Compass' organic revenue growth for the five months ending 29 February 2020 was 6% as measures to contain the virus in our Asia Pacific region did not materially impact our business. Our operating margin during that five month period increased by around 10bps with the benefits from the restructuring programme in Europe coming through strongly. 

However, the acceleration of containment measures adopted by governments and clients in Continental Europe and North America have affected our expectations for the Half Year. The vast majority of our Sports & Leisure and Education business in these regions has been closed, and our Business & Industry volumes are being severely impacted.  Our current expectations are that Half Year 2020 organic revenue growth should be between 0-2%.  We are implementing significant mitigation plans to manage our costs, and at this stage expect the drop-through impact of the lost revenue to be between 25%-30% across the business.  As a result, our operating profit for Half Year 2020 will be £125 million - £225 million² lower than expected.

We are working to protect our cash flow and are pro-actively managing our capital expenditure and working capital.  We have significant headroom against a 4x net debt/ EBITDA covenant in our US Private Placement Agreements and we have substantial liquidity with a £2 billion committed Revolving Credit Facility³ maturing in 2024.  Stable outlooks have recently been reconfirmed on our A/A3 credit ratings."

Revenue for 2019 was £25.2 billion, the update indicates a 25% - 30% loss of revenue but it is not clear over what time period. Assuming the whole year that would put the 2020 revenue around £17.6 billion, similar to 2015 revenues, roughly where the share price is at the moment.

Based on the update, most of the impact has occurred in March, as for 5 months ending in Feb, revenue was up. For 1 month losses were material enough to result in projection of operating profit being £125m - £225m lower than expectations. EBIT consensus projections on the Compass website for 2020 are £1950bn, which breaks down roughly as a £163m per month. That's not going to leave a lot of spare change if the bad end of the losses plays out.

Net debt was last reported as £3.3bn, the update states that they need to keep net debt/EBITDA to 4x, which implies EBITDA needs to be greater than £800m to keep out of trouble with the bank. 2019 EBITDA was £2.5bn

Coronavirus March Meltdown

February and the first week of March have seen a sizeable slice of value taken off of the stock markets, thanks mainly to the COVID-19. Oil prices are taking a hammering and the recent failure of OPEC to come to an agreement to cut oil production is only likely to exacerbate the decline in oil prices. Add in a bit of hard Brexit and there's a pretty potent mix, for the UK markets in particular.

China seems to be slowly coming back online, but we are seeing increasing numbers of infections reported across other regions. In the UK the FTSE has seen a couple of days of selling that appear to be particularly panicked, so I thought it would be interesting to see what has sold off, and by how much. There is a googlesheet here with the data and charts.

The FTSE100 has lost around 13.5% over the last month or so, the red line on the chart below shows the index performance.

Perhaps unsurprisingly travel, miners, retailers and financials are all taking a hit, losing more than the index. Utilities and supermarkets all holding up. I find it interesting to see which businesses have more resilient share prices, and wonder which are getting caught up in the selling, and are unlikely to see much impact from the virus when the dust has settled. Smith & Nephew for example is a healthcare company selling medical devices and wound dressings, and is down 10%.

I also wonder whether those more resilient share prices are actually the companies in which I want to invest. After all if a global pandemic, oil price crash and resurrections of a hard Brexit don't make a dent in the prices, they are probably the sorts of companies I'm after.

February 2020 portfolio update

COVID-19. Cheeky little feller, causing a bit of a nuisance.

The markets are thrashing around trying to work out how to price it in, and have gone from exuberance to despair in a few days. A somewhat predictable reaction, with apparently indiscriminate selling. I imagine we will see selling continue for at least a couple more weeks, with some small relief rallies in between, until the headlines get more positive, or stocks all go to zero. Fingers crossed for a vaccine being developed quickly (preferably by Glaxo 😎).

Anyway nothing bought or sold during Feb, and as there's a whiff of panic in the air I'll keep my cash in my wallet and hope to pick up some bargains once the selling eases up.

Portfolio performance
The portfolio was down -8.3% in February, losing less than my chosen benchmark the Vanguard FTSE All Share Accumulation which was down -8.9% over the same period.

Best performers this month:
Dignity +1%
Craneware -0.3%
Next Energy Solar -1%

Worst performers this month:
AB Dynamics -23%
SAGA -23%
Abcam -17%

Rule number 1: don't lose money

With the markets having a few wobbles I thought it a good opportunity to ponder what happens to investments when share prices drop.

A certain Mr Buffett with his folksy wisdom often wraps deep insights into absurdly simple language. He insists that the first rule of investing is to not lose money. And that the second rule is not to forget rule one. Clearly losing money is never fun, but we can recover this fairly quickly if the price picks up, can’t we?

The table below illustrates why Buffett’s words are key:

Loss	Gain required to breakeven
-10%	11%
-20%	25%
-30%	43%
-40%	67%
-50%	100%
-60%	150%
-70%	233%
-80%	400%
-90%	900%

It shows us that a loss of 10%, needs an 11% uplift to get back to where we started. No problem. But a 50% loss requires a 100% gain to recover the loss. Percentages can be a little slippery, so to put it into more concrete terms:

Starting investment value = £100

10% loss = £10

New investment value = £90

A 10% increase of the new value of £90 only takes us to £99, not the original £100. For this we need an 11% uplift.

Starting investment value = £100

50% loss = £50

New investment value = £50

A 50% increase of the new value of £50 only gives a return of £25 so only takes us back to £75. To get back to the original £100 we need a 100% increase.

A chart shows these nasty consequences clearly:

We can use the same arithmetic to get another perspective on gains and losses:

Starting investment value = £100

Gain of 100% = £100
New investment value = £200

A loss of 50% = £100

Taking the value back to £100

A more dramatic example in my view is the 233% gain in the chart above, which needs only a 70% drop to wipe out all of the gain.

A google sheet is available here with this chart and some sample calculations.

A significant loss recorded against an investment could therefore take a while to get back into positive territory. But also a significant gain could be wiped out with what appears to be a much smaller loss.

Based on the above, losses can have a disproportionate impact on gains, and a portfolio. And it should be evident that a see-saw of gains and losses would end up with an investment losing money. The extent to which this could happen is modelled in the chart below. This shows the result of a successive gains and losses of 10% iterated 100 times.

The values start at 100 and drift slowly down to 60.5, despite the percentage gain being the same 10% gain or loss each time.

The trend is clearly downward. This is simply because the loss is always calculated from a larger number than the gain. This would be the same for any consistent repetitive gain/loss over time.

Of course the stock market doesn’t behave like this and the impacts are not played out like this. However, it is hopefully enough to give pause to also focus on avoiding losses in addition to making gains.

January 2020 portfolio update

The UK markets were drifting sideways during the start of January, and US markets predictably continuing their upwards march. Then everything went a bit George Romero with the appearance of  Coronavirus. Shares started getting sold off in what appeared to be a rather indiscriminate way, but with Asia exposed equities bearing the brunt.

If the news media are to be believed, we have an impending apocalypse, so share prices are the least of our worries. Perhaps a more likely scenario is a short-term health scare that is resolved over the next few months. If a few bargains present themselves I might as well indulge, after all if we return to normal, I'll have bought some shares at a discount. If the end is nigh, it won't matter anyway, checking my portfolio is likely to drift down the to-do list in favour of barricading the windows and hunkering down over my last tin of beans.

Portfolio performance 
The portfolio was down -0.6% in January, losing less than my chosen benchmark the Vanguard FTSE All Share Accumulation which was down -2.8% over the same period.

Best performers this month:
National Grid +7%
Fulcrum Utilities +7%
AB Dynamics +5%

Worst performers this month:
Craneware -26%
SAGA -21%
888 Holdings -18%

January share purchase: NICL
AIM listed soft drinks company Nichols (NICL) joined the portfolio this month. Nichols have a portfolio of products, the most iconic of which is Vimto. They have sat on the watchlist for a while, and my interest began to perk up when the share price started drifting downwards after bumping against a previous high point. Then just before Christmas the company released an update stating that in one of their markets, the Middle East, Saudi Arabia and UAE were applying a 50% tax to soft drinks. The share price predictably tanked by around 20%. Given that this region generated just under 7% of revenues in 2018/19, it seemed a typical market over-reaction.

Nichols have some great operating numbers: ROCE over 20% in each of the last 10 years, along with double digit net margins, no debt, plus a dividend well covered by free cash flow that has increased by an annualised 13% over the same time. They have been able to generate these sorts of returns by outsourcing the production of their main brand - Vimto - and by doing so greatly reduce the capital requirements of the business. Vimto is also licensed for production in other confectionery products, again with minimal capital.

Revenues and profits have been ticking upwards over recent years, while the share price has remained fairly flat, possibly due to it getting an excessive premium which it needed to justify. The Middle East taxation issue shouldn't put too large a dent in either top or bottom line, even with a bit of additional marketing in the region. 

The business was founded in 1908 and was listed on the AIM market in 2004. John Nichols, the grandson of the founder of the company remains on the board as Chairman, and owns 2m shares which amounts to a 5.5% stake in the company, worth around £27m as at the time of writing. Other members of the family also own shares and are employed by Nichols, so they have an interest in ensuring the ongoing success of the business.