Monthly Archives: October 2012

I have updated the Obliquity London portfolio page with the current holdings. It’s now fully invested so from now on will only see rebalancing and reinvestment of accumulated dividends or proceeds of capital actions. I’ve not found a good public platform to publish the model portfolio yet, so use the FT’s portfolio tools and re-publish holdings, and in the future performance updates, here.

Unfortunately I wasn’t able to blog twists and turns during construction, it will be easier with rebalancing which should happen one company at a time. In the meantime here are some thoughts about some of the portfolio companies that have been in the news since they’ve been bought in.

Standard Chartered: is the entire banking sector (including regulators) beyond repair?

This is an investment bank, with a focus on Asia and Emerging Market that I like as a way to get proxy exposure without having to buy local stocks; and it seems generally well managed in so far as banks go, and did pretty well throughout the financial crisis. Basically if I have to have any bank it will be one like that.

It was in the news when a US regulator accused it of working around rules about doing business with the Iranians. This was settled after a week’s backhanded negotiations where they agreed to pay a fine for this particular breach with this particular regulator (other US regulators may still find problems) in exchange of an end to proceedings. This is a mockery of due process. It’s not clear whether or not they did something wrong (they didn’t admit to much wrongdoing, just agreed to pay a fine) and we don’t know if the regulator was overzealous and doing a PR coup, or had genuinely found something worth reprimanding. While it’s not glorious you can understand the business rationale — long uncertain reputational procedures are a killer for a financial business, even if they come out clean — the behaviour of the US regulator is harder to justify. This is more akin to what a corrupt third world country would do than what is expected from a supposedly stable and leading developed nation. Cow-boy regulation may work to some extend in so far as it frightens institutions into behaving — if a king randomly beheads someone every so often, remaining subjects may be inclined to behave, if they think the beheading wasn’t random, and don’t get frightened enough to organise themselves to behead the king himself — but it’s not a win for the rule of law.

The price sank on the day, fair enough, and has mostly recovered since, vindicating not selling on the news which is not what I’m supposed to do. The question of whether to keep the company remains open: if they’re genuinely corrupt and have prevalent dodgy practices, it makes enough of my criteria go red to exclude it. Lacking any particularly attractive alternative in the financial sector, I’ve decided to stay put for the time being.

First Group: franchise cockup

This is a well diversified transport operator, unique in the UK stock market in being diversified geographically (they run school buses and Greyhound in the US) and in types of operations (trains, buses).

They won a franchise to operate a segment of the UK train network, which was cancelled after the government found out that the economic modelling they used to support the decision was based on spreadsheets where they forgot to put some numbers in, as far as I understand. The whole idea of awarding public sector contracts based on overly complex and opaque economic models which include highly precise projections of future data that is basically hard to predict is bogus, as shown by nobody noticing when you don’t even put the numbers in. But that’s beyond the point, and beyond the control of one particular bidder.

The stock price sank in response, which this time doesn’t make particular sense. This franchise is but one part of the business, and was controversial to start with, that is whether it would be profitable was not certain. So having to rebid for something which would have brought uncertain future profits, or losses, is not that material a change to the known information on the company. So I consider the price move to be news noise and will keep it in the portfolio because it doesn’t materially change why I included it.

Reckitt Benckiser: dodgy pharma practices

This is a washing up liquid and home products company, with some health and pharmaceutical products. The news was a detail, but it doesn’t reflect well on management. They are publicising a study that allegedly shows a variant of one of their drug-addiction treatment pills was more misused by children of patients than the same in “film” packaging. It might be marginally true (but at what level of significance, 1 in a million vs 2 in a million is double the incidence but not very interesting) but the excuse seems gross: the film delivery method is patented while the pill is about to go generic, and at that very moment they launch a PR campaign that basically pills should be outlawed, and only the more expensive patented alternative be allowed, after having sold them for years while they were under patent protection. Such level of pettiness is shameful, companies should make good products not spend time on playing regulatory tricks while pretending to be angels at the same time.

I’ve downgraded the “executives” criteria but it still passes enough of the others, and it’s arguably a small issue for the company as a whole, so it’s on watch but stays in for the time being.


A common problem when looking at the market valuation of companies is that we’re looking at numbers which are net of leverage.

In simple terms, ignoring some marginal sideshows, the balance sheet of a company is formed of asset and liabilities where:

  • Liabilities = debt + equity
  • Assets = cash + stuff (inventory, equipment) + intellectual property (aka intangible assets)

By construction of double entry accounting, liabilities = assets, that is equity = assets – liabilities (aka net assets). What the shareholders own is what is left over if the components of a business were to be sold separately (the accounts are an estimate of this resale value).

Accounts don’t formally include as an asset the value of the business as the whole of its parts, unless a third party business is bought in, which gives a price for this, known as “goodwill”. The goodwill of the whole business is the difference between the balance sheet valuation and the market’s, which for well run businesses is higher (the business is worth more than the sum of its parts, e.g. a tire manufacturer is worth more than tires in stock and the building in which they’re made).

Accounting for goodwill as an asset of the acquiring business allows it to track whether it made a mistake when buying another business. This is useful for the acquiring business but muddles the accounts for the outside observer wishing to compare a business which grew by acquiring smaller competitors vs. one which grew organically. This particular problem is relatively easy to solve by looking at valuations less the goodwill element of the balance sheet (with an equal amount deduced from accounting equity).

At the whole company level we still have the problem we compare the market valuation to the accounting valuation (aka equity) net of debt. For two identical companies with different level of debts the numbers will look different while the reality isn’t necessarily. For example if company A has a balance sheet value of 100 formed of 80 of debt and 20 of equity, a market cap of 60 is 3 times equity. If we assume the value of the debt in the accounts is fair value, the total value of the company to debt and equity holders combined is 140 (80 + 60). An otherwise identical company with no debt also valued the same would have 100 of equity and a market cap of 140, 1.4 times book value, very different but for the same thing net of leverage.

While leverage must be accounted for at some point — the equity holder of the leveraged company has really more up/downside for each unit of investment — it makes numbers less comparable when trying to see what the market price of a business is and how the total valuations compare when companies have different structures.

Simply deducting the book value of the debt in the accounts, as is sometimes done, is not necessarily accurate, because debt is accounted for at discounted face value, which is fair from the point of view of the company — it must repay face value when debt matures — but may differ from what the market thinks they will get back. As chance would have it, there is a secondary market for debt, at least for large companies whose debt consists mostly of corporate bonds or notes.

So an interesting number would be the market cap of a company obtained by unfolding all classes of publicly listed debt and equity, and use that number with the correspondingly unfolded balance sheet numbers. This would indicate at how much collectively all public stakeholders of a company value it, and should produce more comparable numbers than the usual numbers people look at (even though some class of liabilities lacking a public price will unavoidable be excluded).

It would be interesting to see what happens to beta in those case. Beta is an approximative measure to how much an individual stock price is sensitive to whole-of-market prices. Raw beta thus include both leverage effect, and the effect of all other reasons that make a company more or less sensitive to market moves. A deleveraged beta could be calculated, for all companies whose debt is public enough.

It may have been done although I know of no easily accessible source of such numbers (as in with the calculation done, I believe all the input data necessary is public, it’s just not trivial to unfold). If available it may allow to answer some interesting questions:

– are there material differences between deleveraging the beta using the market value of debt and that obtained using its book value?

– does the low volatility anomaly persist in deleveraged beta space? (I suspect it does)

– is there a “money illusion” type of effect where looking at the equity beta obscures facts that would be obvious to a deleveraged beta observer? (I suspect there is)

– and surely many more…

Update (12/2012): the wheel I was reinventing here is called Enterprise Value, a metric that deserves higher visibility.