Tim du Toit is editor and founder of Eurosharelab. On his website he reveals what more than 20 years of equity investment have taught him – sometimes at considerable cost. To discover how you can avoid costly mistakes and enjoy greater profits, sign up for his free newsletter “Investing that makes sense” at www.eurosharelab.com
Have you ever thought of where and how the highest consistent investment returns are achieved?
The answer is surprisingly simple. You have to buy undervalued companies in good financial shape.
That sounds easy enough you may be thinking. But where do I find them?
Over 20 years of investment experience has taught me, you have to look where others don’t…
either because they are too lazy and do not want to do the analysis, or they simply do not know where to look.
In this article I want to show you some of the unusual places I look for investment ideas, what I turned up and what the result were.
The unloved 9% telecom company
In May 2009 I found a large utility like business with limited or even negative growth.
As with a lot of companies on my watch list I started getting interested after the price fell substantially, against the market.
I first started looking at the company when I saw it on a list of companies with share prices at a 52 week low.
The company also showed in on my “Dogs of Europe” portfolio. A list of the 10 highest dividend yielding companies in Europe and the UK.
The company was Deutsche Telekom AG (“DT”) the large privatised German integrated telecommunications company with a worldwide portfolio of businesses in the areas of telecommunications and information technology.
On 21 April 2009 Deutsche Telekom (DT) issued a profit warning which led to a 10% drop in its share price.
I thought the profit warning was not that bad as the company said earnings before interest, tax, depreciation and amortisation (EBITDA) would be 2% to 4% lower than the previous year.
Remember this was in a recession.
This caused the share price to drop to an all time low, even slightly below the low reached after the bursting of the internet bubble in September 2002.
This decline turned DT into an undervalued defensive investment with an attractive dividend yield of slightly over 9%.
When I asked a few friends and fellow investors about DT it turned out that it was the most hated company in Germany.
This was because just about the whole of Germany bought shares at around €20 in November 1996 when the company was privatised. All these shareholders saw their investment soar to over €100 a share in 2000 during the internet bubble.
Most of then never sold and then watched as the share price declined to €8,50.
No one in Germany had a good word to say about the company.
This was too good an opportunity to ignore, with shareholders hating the company and selling the shares for completely irrational reasons.
I recommended that my subscribers buy at around €8,50
How did it turn out?
One and a half years later they were sitting on a 31,5% profit and holding a share that still pays an attractive 6,7% dividend.
The crash repairer that hit the wall
I discovered this investment idea through my modified version of the Magic Formula stock market screen developed by Joel Greenblatt and explained in his great book called The Little Book that Beats the Market.
The screen identifies companies that earn high returns on assets but at the same time trade at attractive prices.
A high return on assets mean the company does not have to invest large amounts of cash in order to grow. This results in high returns to shareholders in the form of dividends or share buybacks.
The screen simply lists a lot of companies that pass its criteria. This means you still have to weed out junk companies like football clubs and other one hit wonders. You thus have to work through the list to find the proverbial diamond in the rough.
But it’s more than worth it because the screen also finds real gems like this one.
The recommendation I sent to out in November 2009 was for a company that the market marked down substantially because; contrary to what it thought the company’s products were not completely recession resistant.
The company was Nationwide Accident Repair Services plc (“NARS”), the largest provider of automotive accident repair services in the UK.
Its services includes the repair of motor vehicles in its wholly owned sites and the provision of accident claim management services to insurance and auto lease companies throughout the United Kingdom.
At the start of the 2008 recession NARS was viewed positively as analyst thought the number of vehicle accidents was unlikely to decline and thus the profitability of NARS will not be affected.
This however turned out not to be the case as motorists chose not to repair minor damage to their cars because of economic uncertainty.
An unexpected profit decline led to a 20% drop in the share price as investors ran for the hills.
It was exactly at this point where I got interested.
The drop in the share price to 80,5p brought the share price close to its all time low of 77p a long way from its 187p all time high in January 2007.
The company had a rock solid balance sheet with £7,9 million in cash and no debt at the end of June 2009. Thus nearly 25% of the company’s market value was made up of cash.
Based on 2008 results the company was very undervalued, trading at a price to earnings ration of just under seven.
But more importantly at only 5.8 times free cash flow (cash from operations – capital expenditure). This meant that if you bought the whole company at a price of 80,5p per share you could earn a 17,8% cash return on your investment.
Not bad for a small unknown auto repair company based in Oxfordshire in England.
I recommended the investment at around 83p.
Nine months later the company was still a hold with a return of 30,5%
A hobby toymaker at a collectable price
The company I recommended in March 2010 was a small UK toymaker I have been following for quite a few years.
When I find a company with a really attractive business but with a too high share price I put it on a watch list. Twice a year I look over the list to see if any of the companies have not dropped in price or increased profitability making it an attractive investment.
At a price above the £2,00 the toymaker was too expensive and at £0,70, at the peak of the financial crisis in March 2009, I simply did not have the courage to buy.
In February 2010 I got very interested in the company when, in spite of a really positive trading statement, its share price declined over 29% to £1,20 for no apparent reason.
The company was called Hornby PLC (“Hornby”) and its principal business is the development, production and supply of hobby and toy products which is distributed through specialist and other retailers throughout the UK and overseas.
The share price declined in spite of the company saying:
“In mainland Europe, demand continued to be strong prior to Christmas and with a good pipeline of new introductions, we expect to finish the financial year with sales and profits significantly ahead of the previous year.”
in its 25 January 2010 trading statement.
Over the last few years the company’s profitability had been impacted by two factors that have largely been dealt with. Another reason I thought the company was an attractive investment.
The price decline, in spite of this positive trading statement, led me to recommend the shares.
At a price of 124p the company was trading at 11 times March 2009 earnings and 9 times the average earnings over the last seven years.
With improved earnings the company was also very likely to resume dividend payments that were stopped to preserve cash and pay off debt in the recession.
With average dividend payments of 7,8p between the 2005 and 2008 financial years Hornby, should dividend payments be resumed at a similar level, will at 124p trade at an attractive 6.3% dividend yield.
Seven months later, after posting excellent results and resuming dividend payments, subscribers were sitting on an attractive 47,8% gain.
The adult media company at a stripped down price – that did not work out
I am of course not right every time.
Here is an investment that did not work out as planned.
It was not an investment for everyone as it was a company that produces and distributes adult entertainment products in the USA.
I thought long and hard before recommending the company, but as I promise my subscribers to only recommend the most undervalued companies I found I decided to go ahead.
It was also a company I found while sifting through the results of the Magic Formula screener mentioned above.
The company was New Frontier Media Inc. (“NFM”) and was on sale at an extremely low price.
The company was so undervalued that it was trading on just over three times the average earnings before interest and taxes (“EBIT”) over the last seven years.
Furthermore if you average the free cash flow (cash from operations minus capital expenditure) the company generated over the last 7 years it was trading at only 4,4 times free cash flow.
That meant that the company could have paid out a dividend of 23% per year over the last seven years as it generated enough cash to do so.
Another positive was the company’s rock solid balance sheet with negligible debt of $3,5 million and $17,3 million in cash. The cash made up just under half of its $35,8 million market value.
Profitability at the time, in the recession, was also not bad with expected earnings equal to 19c. This translated to a price to earnings ratio of 10,9.
The company was also trading at a just 73% of book value. Inexpensive for a company with an already asset light business model.
Six months later, after the share price decreased 20% from the price I recommended it I immediately sent an email to subscribers to sell the position.
As with all my recommendations, to limit losses, I follow a strict stop-loss strategy, immediately informing subscribers to sell an investment that has lost more than 20%.
A mobile telephone company with a catalyst
I don’t just look at 52 week low lists and the output of numerous stock screens to get ideas.
Over the years through the exchanging of ideas I have built up a network and gotten on the mailing list of a lot of outstanding fund and hedge fund managers.
Some have also become close friends.
I carefully study their letters to investors for ideas to research further.
In one newsletter, hidden at the end of page three, there was a short reference to a very well known mobile phone company where an interesting development was taking place.
The company was Vodafone PLC the UK based mobile telephone operator with more than 300 million subscribers and a market value of £73 billion.
And the event was that its 45% holding of Verizon Wireless in the USA will soon start paying a substantial dividend to Vodafone as a large inter-company loan it was repaying will soon be paid off.
The opportunity was that the other 55% owner of Verizon Wireless, Verizon Communications could not allow Verizon Wireless to pay a dividend to Vodafone as it needed the cash to continue paying its own dividend.
This would result in Verizon Communications either buying Verizon Wireless completely or suggesting another transaction that will ensure it continues to receive the cash.
Vodafone’s share price will get a boost either way because the value of this holding in Verizon Wireless was not reflected in its share price.
I did the research to see if the idea was feasible.
Only after I confirmed all the facts did I recommend the idea to subscribers.
All we had to do was buy some Vodafone shares and patiently wait for the market to wake up to what was going to happen.
And, eight months later, as the market caught on we were sitting on a 25% profit.
As you can see I do not always get it right. But if I am not I cut my losses quickly and I let my winners run.
I also do not have a unique strategy.
I just have a boring, old fashioned approach where I look in places most investors don’t and I thus find profit opportunities they miss.
And I apply what 24 years of continuous study and experience has taught me about the difference between profit and loss in investment.
But most of all I give simple, easy to carry out suggestions – that take less than 5 minutes to understand and follow.
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Eurosharelab Alert Service
Your gem digging analyst.
Tim du Toit