The Five Universal Rules of Investing

Classical physics is a science governed by universal laws that we can measure with absolute precision and understand rationally. By contrast the investment universe is a tumultuous sea of unpredictability more akin to the realm of quantum physics – where things are not subject to rational behaviour and prediction.

In order to inject a degree of certainty and stability to the field of investing, I have identified five universal rules that have stood the test of time and provided an invaluable guide to my decision making process.

-The first rule states that sentiment is negatively correlated with actual investment returns.  An asset where investors are the most pessimistic will go on to outperform in the future and vice versa.  The table below best illustrates this phenomenon and presents a powerful case for contrarian investing. The winning sectors of the last decade and those where investors were the most optimistic became the worse performing sectors over the next decade.

Another defining piece of evidence was the cover story of Business Week in 1979 – titled ‘The Death of Equities. The opposite actually occurred – 1979 was the beginning of a multi-decade rally. Elsewhere pundits were pushing the peak oil theory in 2008, today the pendulum has swung the other direction and oil has fallen by more than 50%, an unthinkable feat back then. This correlation is exacerbated by recency bias where we try to predict the future by extrapolating recent trends and projecting them into the future. But this cognitive bias ignores the fact that abnormal price levels indicate that something is unsustainable, meaning it cannot continue forever. Markets adapt and revert back to an equilibrium – a sort of reversion to the mean.

As a challenge to this rule – Can you name me an asset where investors have been almost unanimously bullish that went on to outperform over the next decade? I can’t.

-The second universal rule states that the majority of expert forecasts in economics and investing will be proven incorrect. The historical track record of forecasters is nothing short of abysmal. Philip Tetlock, a professor of psychology collected a database of more than 25,000 expert predictions for his book – expert political judgement, published in 2005. His conclusion is that most experts are frequently wrong and their predictions equivalent to random guesses.

This reason for this is a global economy which is increasingly complex and doesn’t operate in clean and measurable ways like classical physics.  While experts treat the investing universe like classical physics, it has a lot more in common with Quantum Physics and ‘Heisenberg’s uncertainty principle’ – were precise measurement is impossible. At the subatomic level the world is fundamentally unpredictable and things will happen that nobody could have seen coming.

Professionals are unable to recognise this because of the incredibly high rewards for making correct predictions. It is the unchanging and universal nature of greed that makes certain the continuation of this rule. Investment professionals ought to spend less time accumulating information to make forecast about the ‘known unknowns’ and instead be content that we know very little.

I want to credit Morgan Housel, Former writer for The Motley Fool for bringing to my attention the very apt physics analogy.

-The third rule demonstrates that the longer a stock is held, the greater the probability of an investor generating a positive return increases. One of my favourite statistics on the stock market  is that the probability of making a positive return increasing from 74% over one year to 94% over 10 years. See table below:

The difficultly with this rule is that few investors have the patience to hold shares for more than 10 years. According to data from the NYSE, the average holding period for stocks is now less than one year; a drop from more than eight years in the 1960’s Short term movements in the stock market are driven by emotion and irrational behaviour. The only way to capture these positive returns is to hold shares over a long-term horizon when the market reflects the underlying value of these businesses.

Another key problem of short-term investing is that if you’d missed the 25 best performing days since 1970 (S&P 500), your returns would go down from 1910% to 371%. These days occurred during periods when volatility was above average making it notoriously difficult for a trader to capture these returns. While it would extremely difficult to miss all the best days, it is certainly possible to miss some of them, highlighting the importance of staying invested. To paraphrase Nick Murray – time in the market; not timing the market would provide investors with their greatest natural advantage.

-The fourth general law states that Equities will outperform corporate bonds, government bonds and real estate over the long-term.

The Barclays equity gilt study 2016 is the UK’s foremost source of data on long-term asset returns. The study has been published every year since 1956 and the consistent takeaway is that equities have delivered superior returns over the long-term than bonds or cash. For example over the last 50 years equities have produced a real return of 5.6%, government bonds 2.9% and cash 1.4%. Data for the US comes to the same conclusion; the S&P 500 produces a real return of approximately 8% every year, outperforming bonds and cash.

Why do equities outperform bonds?

The theory states that because equities are inherently riskier and more volatile than bonds, they will offer a higher return (aka risk premium) to compensate investors for holding them. Furthermore by owning a part of a business, you are sharing in the entrepreneurial spirit that is virtually certain to deliver returns in excess of bonds in the years ahead. All told, by buying great companies you are making an optimist investment on the ingenuity of mankind. And what history has taught us is that the ever-present doomsayers have been proven wrong time and time again.

–The fifth rule of investing is a Buffet quote on Isaac Newton’s three laws of motions. Had he not lost a fortune in the ‘South Sea Bubble’, he might have well gone on to discover the fourth law of investing – “that for investors as a whole, returns decrease as motion increases”.

One of the most amusing anecdotes in favour of this law was an internal study by Fidelity to find out which accounts had performed the best.  The results were staggering, the best performing accounts were from people who were dead or had forgotten they even had accounts. With access to more information that ever we are under constant pressure to fidget, to adjust asset weightings or buy the next hot investment.  This increases the odds of making poorly timed, bad investment decisions and heightens transaction costs. I think the father of value investing Benjamin Graham describes it more eloquently than me when he said “The investor’s chief problem—and even his worst enemy—is likely to be himself”.

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Profile of Terry Smith – Financier and businessman

The New Warren Buffet

The former chief executive of Tullett Prebon launched ‘Fundsmith Equity Fund’ in response to excessive fees and poor performance within the investment management industry.

In his own words, he wanted to give “fat and complacent” fund managers a bloody nose. Today the performance of Fundsmith has been exemplary; appreciating by more than 200% since inception (November 2010).

Terry is the UK’s foremost fund manager and one of the few whom I can place in the same league as Buffett and Lynch. He possesses the rare ability of communicating investment ideas in a succinct and user-friendly manner. For example his entire investment philosophy is articulated in three simple principles: “buy good companies, don’t overpay, and do nothing”.

Below is a detailed summary of Terry’s investment philosophy:

He’s a long-term, buy and hold investor. He laments fund managers for being too active, because unnecessary trading damages performance and raises management costs (difference between the bid-offer spread and commission). Renowned investor Warren Buffet eloquently said that “Sir Isaac might well have gone on to discover the Fourth Law of Motion: For investors as a whole, returns decrease as motion increases”.

Avoids over diversification, they highlight research which shows that around 20 to 30 stocks are required for optimal diversification. The more stocks you own, the less you know about each one – its called ‘diworsification’. As Warren Buffett said: ‘Wide diversification is only required when investors do not understand what they are doing’. Terry Smith article on why ‘Too many stocks can spoil a portfolio’.

Invests in resilient businesses; they avoid industries that are subject to technological innovation. New technologies create value for some investors while destroying value for many others. Example: internet destroying the media industry. Moreover he will invest in good quality business only when the valuation is attractive.

Invests in businesses with a sustainable high return on capital employed (this measures the efficiency and profitability of a company’s invested capital). Companies that typically fit this bill are non-cyclical consumer businesses (food and toiletries) with repeat purchases.

Buys companies with ‘intangible assets’ that are difficult to replicate. By this he’s referring to brands, licenses, patents, dominant market shares etc.

Avoids market timing, studies show that the most successful fund managers avoid market timing. Stocks are a ‘giffen good’, this means that demand paradoxically rises as prices increase. Driven by greed and fear, most investors end up buying high and selling low.

Avoid companies that require leverage – They only invest in companies that generate high returns on invested capital on an unleveraged basis. This is why they won’t invest in companies which require borrowed money to function or survive –  such as banks.

Terry and his investment team are ‘global investors’. With a global perspective the fund is able to ‘contrast and compare growth rates and valuations across different geographies’. They also believe that the proliferation of ‘national’ and ‘regional’ funds are anachronisms, this approach leads investors to being overweight in a one market and underweight in another.

You’ll also notice that the name ‘Fundsmith Equity Fund’ doesn’t say whether its a Growth or Income Fund, he regard this distinction as artificial and a marketing ploy.

Interesting read: The Fundsmith Owners Manual.

Fundsmith publishes their annual shareholder meetings on youtube – A very insightful guide to his thinking and process.

Fundsmith Emerging Equities Trust (FEET)

On the back of a successful global equity fund, Terry launched an emerging market fund in June 2014 – raising £192.9 million at launch. The fund was set up as an ‘investment trust’ to address the low liquidity of emerging market stocks.

Fund Characteristics

FEET will use the same strategy of its flagship global fund (Fundsmith equity fund), but have the majority of their operations in and revenue derived from the developing economies. They will invest almost exclusively in consumer stocks and provide direct exposures to the rise of the consumer classes in emerging economies.

More specifically he will identify companies which deliver most of their profits as cash, have predictable revenues, low capital intensity and high returns on capital. He believes this combination will bring compound growth in shareholder return over the long-term.

Investable Universe

Using the same successful investment process as Fundsmith global fund, Smith has identified 139 companies within the FEET’s investable universe. Once fully invested, he anticipates investing in between 35 – 55 of them.

Backtesting the performance of FEET’s investable universe shows a return of 298% over five years to 31 march 2014, compared with 69% for the benchmark MSCI Emerging Markets index. Performance over 10 years is more marked, increasing by 1187% against 188% for the MSCI EM index.

Update: Following the placing and offer, the trust raised £193 million, including £5 million from Terry Smith himself.

Fundsmith Emerging Equities Trust (‘FEET’) website –  http://www.feetplc.co.uk/

And the Fundsmith Emerging Market Equities Trust PLC – Owner’s Manual

All told – Terry Smith is an investment manager of exceptional calibre, a plain-speaking and outspoken maverick. Along with Nick Train and Neil Woodford, he’s one of the few fund managers I hold in high esteem.

Useful sources – Top rated investment funds

I’ve compiled a list of useful sources when selecting the best investment funds. This is aimed at UK based investors.

WhichInvestmentTrust.com

They are a community of investors who’s goal is to help ordinary people who want to manage their own wealth become better informed.

They specialise in investment trusts because independent research demonstrates that investment trusts perform better over both short and long term horizons, than open ended funds (Unit trusts and OEICs).

Investment Trust Intelligence

Investment Trust Intelligence is a “library of high quality investment strategy research, fund analysis and useful guides for private investors, all written in-house by experienced analysts on the investment companies team at Kepler Partners”.

The research produced is entirely independent and they do not write paid-for research.

The Wealth 150 – Hargreaves Lansdown

The Wealth 150+ is their selection of the best funds available to UK investors. They offer a combination of excellent performance potential and low management fees.

In addition, their Wealth 150 is a broader selection of funds with excellent long-term prospects but don’t posses the superior characteristics as the plus selection.

A small caveat – their lists don’t cover investment trusts.

IC – Top 100 funds

The Investor Chronicles Top 100 Funds represents what they believe to be the UK’s best actively managed funds across all the major sectors and asset classes.

Citywire Selection

The financial publisher ‘Citywire selection’ is their independent analysis of the funds with the best established track records.

Citywire is an independent financial publisher that has provided news, investment analysis and research for professional and private investors

Bestinvest Premier Selection

Their list of top-rated funds across all major sectors with the potential to deliver superior returns.

Charles Stanley Foundation Fundlist

This is a list of their preferred funds, carefully selected by the Charles Stanley Collectives Research Team.

Money Observer rated funds

The Money Observer Rated Funds consist of actively managed funds and investment trusts that have consistently outperformed their peer groups over the medium term.

Is The UK Market Overvalued?

P/E ratio

The price-to-earnings ratio compares a company’s share price with its earnings. And in this case, takes an average for the whole stock market.

The FTSE 100 PE ratio presently stands at 15, and the FTSE 350 (an aggregation of the FTSE 100 & FTSE 250) trades on 16 times earnings, matching its long-term average. To put this in perspective, the UK stock market traded at more than 25 times earnings during the dotcom bubble (A speculative bubble in internet-based companies covering 1996–2000).

A more refined version of the PE ratio is the cyclically adjusted price to earnings ratio (CAPE), which smoothes earnings over the course of the business cycle, places the FTSE 100 on 13.5. This is again below its long-term average of 16.

However the cyclical adjusted price-earnings ratio (also known as Shiller price-earnings ratio) is by no means perfect, according to the financial economist and Reuters journalist Anatole Kaletsky. He correctly highlights that…

“Any comparison of valuations covering long periods is meaningless if it fails to take into account vast changes in technology, economic policies, interest rates, social and political structures, and taxes”.

Anatole explains that investors who followed Shiller’s methodology would have missed out on all of the gains within the last 25 years.

The Shiller price-earning ratio showed the stock market to be overvalued 97 percent of the time during these 25 years. Even during the two brief periods when the Shiller ratio was below its long-term average — in early 1990 and from November 2008 to April 200 — it never sent a clear buy signal. Instead, Shiller’s approach suggested that the valuations in 1990 and 2009 were only just below fair value — implying there was very limited upside at the beginning of two great bull markets that saw prices multiply fivefold from 1990 to 2000, and threefold from 2009 to 2014 (so far).

Therefore I would take this statistic with a pinch of salt.

Monetary Policy and Relative valuation

Monetary Policy remains very accommodative, both in Europe and across the Atlantic.

The Bank of England base rate is 0.5% and the European Central bank base rate stands at 0.05%. The Bank of England governor Mark Carney has suggested that a return of rates to the normal 5% remains unlikely in the medium term. In addition, he said that rate rises would be more limited and gradual than in the past and expects them to reach a new normal of 2.5%.

This translates into negative real interest on cash (where inflation exceeds nominal interest rates) and meagre gains on government and corporate bonds. Therefore on a relative basis, equities look attractive.

Elsewhere, inflation remains subdued and economic growth continues to pick up speed – this is good news for corporate profits. Earnings is one of two key drivers of share prices over the long-term, the other being the attractiveness of alternative asset classes.

Yield Gap

The yield gap is a common yardstick to assess whether a market is over or under valued. It is the average dividend yield in a market compared with the yield of a long-term government bond.

In this case, the FTSE 100 yields 3.4% and the FTSE 350 (aggregation of FTSE 100 and FTSE 200) yields 3.3%. By comparison the 10 year gilt year is 2.64%, this would imply that shares are undervalued. However critics would rightly point out that this method is distorted by quantitative easing and low interest rates.

Market sentiment

Finally, there is the ‘sentiment indicator’. FT investment writer John Auther’s rightly stated, “Bears need to capitulate, journalists need to stop writing articles about corrections and sentiment surveys need to grow unequivocally bullish. This is not happening yet, as this column indicates. This rally continues to be hated and distrusted, and retail investors continue to be heavily in cash”.

It reminds me of the old stockmarket maxim, ‘stockmarkets climb a wall of worry’.

This leads me to the conclusion that while the UK and developed markets are richly valued, they are not a bubble. If anything, I believe there’s a ‘bubble in the prediction of bubbles’ and many journalists make a comfortable living out of it!.

Glossary

CAPE (or Shiller PE): The ‘cyclically adjusted price to earnings’ ratio is calculated by taking an average of earnings per share (EPS) over 10 years and dividing it by the current level of the stock market.

Interesting reads

Anatole Kaletsky – “Time for a ‘melt-up’: the coming global boom” November 14, 2014

Anatole Kaletsky – ‘Here’s what it will take to trigger the next stock market correction’ August 21, 2014

Anatole Kaletsky – ‘Exuberance is not always irrational’ July 25, 2014

Jeremy Siegel – “Don’t put faith in Cape crusaders” August 19, 2013

Key Financial Terms Defined

The business media is awash with financial jargon, perpetuating the myth that the stock market is hideously complex and therefore best left to the professionals.

Instead, successful investing requires a basic understanding of the financial markets and the application of sound investment principles.

Stock Market Terminology

What is a Share? Also known as ‘Equities’ or ‘Stocks’, they represent part-ownership of a company. As a shareholder, you have a right to say in the decision making (through annual meetings) and are entitled to a share of the profits through the payments of dividends.

Board of Directors – A group of elected or appointed members who run the day-to-day affairs of that company. They are elected by the shareholders to represent their interest.

Initial Public Offering – When a company raises money by issuing shares to the public for the first time. Also referred to as ‘Flotation’ or ‘coming to the market’.

Rights Issue – When a company issues new shares to existing shareholders in order to raise money.

Market Makers – Individuals or stock brokers who guarantee to buy and sell shares in a particular company, in order to maintain liquidity. They create markets in illiquid shares, ensuring there’s always a buyer and seller.

Bid-ask spread – This is the difference between the purchase price and the sales price, it is maintained by the market maker.

Liquidity – The number of buyers and sellers in a particular market. It impacts the degree to which an asset can be sold quickly and easily, with little or no change in asset value. Property is an example of an illiquid asset.

The Big Bang (October 27, 1986) – The day in which the London Stock Market was deregulated. Changes included a shift from open outcry to an electronic system and the abolition of fixed commissions.

Short-Selling – The practise of betting that a share price will decrease. It is the act of selling a borrowed asset with the intention of buying it back at a lower price and returning it back to the owner, pocketing the difference.

Moral Hazard – The incentive to take greater risks, because someone else will bear the costs if things turn badly.

Securities – The general name given to shares, bonds and similar investments that are often traded on the stock exchange

Blue chips – These are large, nationally recognized and well-established businesses. Examples include Royal Dutch Shell and Vodafone Group.

FTSE 100 – An index composed of the 100 largest companies listed on the LSE (London Stock Exchange). It measures the value of the top 100 companies and acts as a barometer of the British economy. Although most of the FTSE 100’s revenue are now derived internationally (more than 70%).

AIM (Alternative Investment Market) – It’s the London Stock Exchange’s market for small, high-growth companies wishing to raise finance without the onerous regulations of the main market.

S & P 500 – The Standard and Poor 500 is a stockmarket index made up of 500 of the largest and most widely held companies on the NYSE (New York Stock Exchange).

Both the FTSE 100 and S & P 500 are weighted by the market capitalization of each stock, meaning larger companies account for a greater portion of the index.

Dividend Aristocrats – A selection of companies in the S&P 500 companies which have increased their dividends for 25 consecutive years. Dividend aristocrats comprise 51 blue-chip companies, predominantly within Consumer staples, industrials, consumer discretionary and healthcare. The S&P 500 Dividend Aristocrats index has a dividend yield of 2.41% (April 28, 2017).

Bear Market – A prolonged period of declining asset prices, fuelled by investor pessimism and lack of confidence. It is characterised by stockmarket declines of 20% or more. Stock market corrections are historical norms, they happen roughly once a year in the 10% range and two to three times a decade within the 20% range.

By contrast, bull markets occur when financial markets have appreciated by at least 20%.

J.P. Morgan table of Bear and Bull markets.

Beta – This measures the sensitivity of a stock’s price relative to the overall market. If a stock has a beta of 1, it indicates a level of volatility equal to the stock market.

Alpha – This is the excess return of an investment relative to the benchmark. A positive alpha means the investment has outperformed its benchmark, and a negative alpha means it’s underperformed the benchmark.

Volatility – Indicates the speed and amount by which an investment changes in value. For example established blue-chip stocks tend to have a stable prices, making them less volatility.

Free Float – Is the portion of shares that are available to the public to trade. Certain exchanges have free float requirements. For example the FTSE (stock market index compiler) requires companies to have publicly available shares of 25%.

Core Tier 1 capital – A measure of a bank’s financial strength. This consists of shareholder equity (capital directly invested by shareholders) and retained earnings (profits not paid out as dividends).

Definitions of A-Shares, B-Shares and H-Shares in China

A-Shares – Shares of mainland China based companies traded on the Shanghai and Shenzhen Stock Exchanges. They are denominated in Renminbi and mainly available for domestic Chinese investors.

B-Shares – Shares of mainland China based companies traded in Shanghai and quoted in US Dollars or traded in Shenzhen and quoted in Honk Kong Dollars (open to foreign ownership).

H-Shares – Shares of a companies incorporated in mainland China that are listed on the Hong Kong Stock Exchange

Economics

Opportunity cost – Defined by investopedia as “What a person sacrifices when they choose one option over another”. In other words, it’s the benefits you could have received by taking an alternative action

Example – The opportunity cost of going to university is the money you could have earned from working instead.

Economies of scale – Are the cost advantages that a business can exploit by expanding their scale of production (definition from Tutor2u). As their output increases, they can achieve lower costs per unit.

What is the European Union (EU)?

A political and economic union between 28 European countries.  The EU was created in the aftermath of world war 2 to foster greater economic interdependence and put an end to centuries of warfare. Today, the EU has a population of more than 500 million people.

The EU’s greatest achievement is the creation of the single market (also known as internal market) – this allows the free movement of people, goods, services and capital.

Purpose of EU

The fundamental aims of the European Union are to promote greater social, political and economic harmony among member states.

Eurozone – A monetary union consisting of 19 European Union Countries which have adopted the Euro. Interest rates within the euro area are set by the European Central Bank (ECB), whose principal task is to keep inflation under control.

Financial Conduct Authority (FCA)

The body which regulates the financial services industry within the UK. Their aim is to protect consumers, ensure the industry remains stable and promote healthy competition.

Financial Services Compensation Scheme (FSCS)

The FSCS is the UK’s compensation fund of last resort for customers of authorised financial services firms. They pay compensation if a firm has stopped trading or being declared default.

The scheme protect depositors up to £85,000 per person per firm.

Investments are covered up to £50,000 per person per firm (for claims against firms declared in default from 1 January 2010).

About FSCS: https://www.fscs.org.uk/what-we-cover/compensation-limits/

Peer-To-Peer Lending (also known as Crowd-Funding)

It is the practise of financing a business venture, by raising small amounts of money from a large number of people. This is done through internet platforms such as Zopa, Ratesetter and Funding Circle, which bring together borrowers and lenders. As a caveat, Peer-to-peer lending is not covered by the financial services compensation scheme.

What is Bitcoin?

Bitcoin is a digital currency which allows individuals to buy goods and services, without the need of third parties (i.e. banks). The users can store and send bitcoins via a ‘bitcoin wallet’, which is stored on your mobile or computer device. And details of every single transaction are stored on a ‘block chain’, a public record of all financial transactions.

Drawbacks –

Each transaction is completely anonymous, there are fears this will fuel illegal operations (drugs and firearms).

In addition, the supposedly clever design feature means there will only ever be 21 million bitcoins in circulation. This finite supply has turned bitcoin into a speculative investment, rather than a means of payment.

Ben Dyson from Positive Money on the ‘Three Fatal Flaws of Bitcoin’.

A short Bitcoin video: All the Facts

Financial Statements

Income Statement

Also known as the ‘Profit and Loss’ account, it shows the revenues less expenses over a given period.

Balance Sheet

This summarises the assets and liabilities of a business at a particular point in time – financial year end. Assets could include cash, property or machinery. And liabilities include everything the company owes.

Cash flow

This records the cash entering and leaving the company. A key difference between the income and balance sheet is that it doesn’t include the amount of future incoming and outgoing cash that has been recorded on credit (arrangement to pay later).

Investment Management Terminology

Actively Managed Funds – The investment manager will actively try to beat the market by using his judgement, experience and forecasts in making investment decisions.

Passive Funds – A fund which mimics the market index, rather than trying to beat it.

Closet-Index funds – An investment fund which more or less tracks a benchmark, although it claims to be actively managed. Closet indexing exists because fund managers believe it is safer to track benchmark indices.

Hedge Fund – A pooled investment vehicle available to wealthy and sophisticated investors. They are aggressively managed, and use leverage (borrowed money), derivatives, longs and shorts to generate superior returns.

Exchange Traded Funds – Investment funds traded on stock exchanges, which track the performance of a particular market or index such as the FTSE 100.

Options – A contract which gives the buyer the right, but not the obligation to buy or sell the underlying asset, at a specified price on or before a certain date. This is a type of derivative, and they are used to speculate and hedge risk.

Financial Instability Hypothesis – American economist Hyman Minksy believed that ‘Stability begets instability’. This is because long periods of economic stability encourages financial institutions and firms to become complacent. As a result they take on greater risks and more leverage – sowing the seeds of the next crisis.

Minksy Moment – The moment when the financial system moves from stability to instability. Over-indebted borrowers begin to sell assets in order to meet debt repayments, triggering sharp falls in asset values and a loss of confidence. At this point, the whole house of cards falls down.

Capital Employed – The capital investment required for a business to function.  Equation = Total Assets – Current Liabilities.

This is used to calculate ‘Return on Capital‘ – which is the operating profit (excluding taxes and debt interest) of a business divided by the capital employed, expressed as a percentage.

http://www.investopedia.com/terms/c/capitalemployed.asp

Tobins Q ratio – A measure of firm assets in relation to its market value.

The formula for Tobin’s Q: Total market value of firm / Total asset value of firm

Tobin’s premise is that a firm’s market value should be equal to their total asset value.

A low Tobin Q ratio (between 0 and 1) means that the cost to replace a firm’s assets is greater than the value of its stock. This implies that the stock is undervalued. Conversely, a high Q (greater than 1) implies that a firm’s stock is more expensive than the replacement cost of its assets, which implies that the stock is overvalued.

Most of these terms are articulated through Investopedia’s short animated videos – http://www.investopedia.com/video/

Investment Education – Financial Metrics

What is Earnings Per Share?

Equation: net profit divided by the number of ordinary shares in issue.

It represents the portion of profit allocated to each outstanding share.

It allows investors to observe the growth in profits for each share held.

Diluted EPS expands on basic EPS by including the shares of convertibles or warrants in the number of shares outstanding.

What is Price to Earnings Ratio?

Equation: share price divided by the earnings per share.

The P/E ratio represents the number of years it will take for the earnings of a company to cover its share price. Essentially, it is how much investors are willing to pay for £1 of earnings.

A high PE ratio means the investors are bullish on the company prospects and expect it to perform well.

Conversely a low ratio means that investors aren’t expecting much growth, it might indicate an undervalued company.

It’s not an absolute measure and is best used when comparing companies within the same sector.

Investopedia’s animated video explaining what a P/E ratio is.

The Cyclically adjusted price to earnings ratio (CAPE)

Whereas a PE ratio is the share price compared to one year’s earnings, the CAPE (or Shiller PE) is an average of ten years earnings compared with the latest price.

The purpose is to smooth out fluctuations within the business cycle rather than base it on a snapshot, which is what the conventional PE multiple does.

What is the PEG (Price to Earnings Growth) ratio?

Equation for PEG ratio: price to earnings divided by the growth rate of a company.

It’s the price earnings to growth ratio. It is used to gauge to relative value of a stock versus the company’s growth rate.

It is P/E ratio in the context of the company’s growth rate for the year ahead. Because it takes into account growth rate; it is favored by many over the P/E ratio.

A PEG of 1 indicates the company is fairly valued, a PEG of below 1 means a company is priced below its expected growth rate and indicates an undervalued company, above 1 indicates an overvalued company.

With PEG ratio, the numbers are projected and can be less accurate.

Investopedia’s animated video on the PEG ratio.

Price to Book ratio

Equation: Current stock price / (Assets – Liabilities).

It compares a stock’s market value to its book value.

It shows what shareholders will get after the company is sold and all its debts are paid off.

Low P/B Ratio could mean stock is undervalued.

Investopedia’s animated video on the P/B ratio.

Price to Sales

Equation: Current share price / Sales revenue per share (trailing 12months)

The lower the P/S the better the value, its more useful when comparing similar companies.  Advantages being that sales is harder to manipulate than earnings.

However this valuation metric is less useful for service companies like banks/insurers which don’t really have sales.

This ratio should not be used in isolation.

Free Cash Flow

Equation: FCF = Operating Cash Flow – Capital Expenditures

FCF is a measure of how much cash a business generates, after accounting for capital expenditures (money spent to maintain or acquire land, buildings or equipment). This cash can be used for dividends, expansion or reducing debt.

Operating cash flow is EBIT (earnings before interest and taxes) + Depreciation – Taxes. EBIT is also known as operating income.

Price to Free Cash Flow

Equation: Market capitalization divided by free cash flow.

A valuation metric which compares a company’s market price to its level of annual free cash flow.

Profitability Ratios

Return on Capital Employed (ROCE)

Equation: Earnings Before Interest and Tax (EBIT) / Capital Employed (Total Assets – Current Liabilities).

ROCE is defined as the profit made by a company divided by the total amount of money (capital) which has been invested in the business. This ratio indicates the efficiency and profitability of a company’s capital investments.

A higher ROCE indicates an efficient use of capital. It should always be higher than the cost of borrowing, otherwise the company won’t be generating shareholder value.

Investopedia’s short animated video on – ‘Return On Capital Employed’ – http://www.investopedia.com/video/play/return-capital-employed-roce/

Interesting Reads:

One of best explanations of ROCE that I can find is from Charlie Huggins, fund manager at HL – ROCE – What is it and why do we like it?

Return on Equity (ROE)

Return on Equity = Net Income/Shareholder’s Equity (Total assets – Total Liabilities)

ROE measures how much profit a company generates with the money shareholders have invested.

Essentially, as a shareholder how much bang for the buck are you getting?

Net Profit Margin

Profit Margin = Net Profit/Total Revenue

It represents the percentage of total revenue that a company keeps as profit. The higher the profit accrued from the sales of products or services, the greater its efficiency and profitability.

A Profile of Neil Woodford

Neil Woodford is one of Britain’s most successful and well-known fund managers. As former ‘head of equities’ at Invesco Perpetual he ran the ‘Invesco perpetual income’ and ‘Invesco perpetual High Income’ fund, collectively managing over £25bn in assets.

Performance

His long-term track record is nothing short of outstanding. Had you invested £10,000 in ‘Invesco Perpetual High Income’ fund at launch (in 1988), it will have grown to £250,000 today (total return).

For those choosing to receive dividends, they will have collected £38,943 in income, while their capital will have appreciated to £88,150.

This is an averaged annualised return of 13.2%.

Investment Approach

Neil Woodfords approach is succinctly summed up by Mark Dampier, Head of Research at Hargreaves Lansdown:

“I have known and invested with Neil Woodford for over 20 years. He has remained consistent and true to his long-term investment philosophy, refusing to follow the herd and investing in unwanted, unfashionable and unloved sectors and companies. I believe him to be the finest fund manager of his generation and look forward to investing in his new fund at launch.”

Woodford typically holds shares for more than 10 years, he is the antithesis of short-term city culture.

For example in the 1960’s the typical investor through the London Stock Exchange held shares for eight years, today it is seven months.

CF Woodford Equity Income

Neil left Invesco perpetual in April to set up his own investment management business – Woodford Investment Management LLP

He subsequently launched a new equity income fund ‘CF Woodford Equity Income’, it became available to the public on June 19.

The fund will aim to generate an income of 10% higher than the dividend yield of the FTSE All-Share Index*.

It is predicted to yield 4.0% at launch, with income distributions paid quarterly and may invest up to 20% in international companies.

His aim – To deliver an attractive long-term return and growing income stream.

Patient Long-term capital

Neil Woodford also expressed an interest in early-stage science based businesses and highlighted Britain’s poor track record at turning great ideas into long-term commercial success. Neil believes the scarcity of capital and short-termism has created an compelling investment opportunity, he will devote between 5-7% of his fund to this area.

Woodford Patient Capital Trust plc

Elsewhere, Woodford has also announced his intention to launch the ‘Woodford Patient Capital Trust plc’, an investment vehicle which would give him the opportunity to build a greater exposure to early-stage and early-growth companies. He’s looking to raise £200m at launch.

The portfolio will represent a mix of their highest conviction blue-chip ideas together with exposure to early-stage and early-growth businesses. The fund will use an innovative fee structure, it won’t charge a management fee but will instead receive a fee based on performance.

Aim: Their aim is to deliver a return in excess of 10 per cent per annum over the longer term.

*The FTSE All-Share Index is an aggregation of the FTSE 100, FTSE 250 and FTSE Small Cap Indices