VALUE INVESTING
In the Rut and on a PEG

By Stephen Bland (TMFPyad)
November 12, 1999

A recent trawl through one of my sources threw up a company to which attention has been drawn before on the value board, Rutland Trust.

At 38p it has a historical P/E of about 8, a yield of 5%, book value of 48p and net cash of 33p per share. The book and net cash figures are from the last accounts to 31 December 1998, somewhat out of date of course unfortunately. The cap of £107m is just over my minimum. Eps was 4.5 normalised at the last accounts, forecast to fall somewhat to 3.9 for 31/12/99 rising a little to 4.2 for 31/12/00. Only one broker, Warburg Dillon Read, has published forecasts recently and this was made in May 99. In consequence the forecast is even less reliable than might be the case with several sources.

The four pyad base criteria are there as is the cap requirement. Eps is falling for the immediate year compared with historical and thus it fails on this factor. End of story as far as my wedge goes but I thought it might make an interesting analysis for the value series, if people are interested in following my particular approach.

It is possible to learn strategy from why shares are rejected as well as why they are selected. A bit similar to something I've said before, that one of the earliest steps in successful share investing is not making money but learning how not to lose money. Pyad itself evolved by my immersion, millennia ago, into why most private investors lose money or make only modest returns. Very very few make really high rewards from shares. I never went into shares to make tracker or broad portfolio style returns. Nothing wrong with that, for large numbers of people this is fine, but I personally wanted more, much more. For me it was a shit or bust adventure based on challenging widely held investment assumptions. I wanted to be one of the few.

This series will in general consist of a mixture of articles on value strategy, its application to particular sectors and individual company analysis from the value viewpoint, or at least my particular value viewpoint given that there is room for variations on the theme. In writing about individual companies, I intend to show companies that perhaps come close to being selected but fail at the final hurdle for some reason, as well as those rare few that might pass with flying colours.

I have a bit of a problem with those that pass my tests and into which I may in consequence be willing to sink my immense fortune, because I am conscious that others may follow. And for those that do, if I go wrong so will they. I don't want that responsibility. I have yet to resolve the question of how I can write up such shares without this effect, other than by stressing that I am not advising others to follow me, just writing about my ideas. At the Fool we disclaim, and urge people to make their own decisions and obviously I wholly endorse that, but this point does concern me.

Back to Rutland. We left the story above after it had failed on my tests due to falling eps in the current financial year compared with the last year's actual. I am not interested that the 2000 forecast eps is reckoned by the single broker concerned to be ahead of the forecast 1999 figure. A forecast on a forecast is for dreamers in my view. As I've often said even the current year's forecast is chancy enough, a crude guide at best but I have to use it because rising eps is a major building block of the strategy. But anything further out is worth little, to me at any rate.

But let's assume that it had passed all my tests and we are left with smell. That most elusive of criteria that it is hard to illustrate to others. Look at the business. Rutland does not have a trade in the normal sense of the word, it is one of those companies that is involved in buying other companies and reorganising them to realise hidden profits. In the words of the directors: ".to create value for shareholders from investing in undervalued situations." They are value investors themselves! But instead of just buying a shareholding like me, they buy the whole company.

There are a few listed companies that do this. Another and more well known one is Wassall. These companies tend to be lowly rated because the success rate of many of them in recent years has been poor. And that is why Rutland fell initially into a pyad rating, on the four basic criteria. The market just does not trust such operations. But the hell with the market, I am concerned here with my view, which in any case is nearly always contrary to the market at any point in time.

The question therefore arises whether I would buy such a share if it satisfied the whole range of my filters, bearing in mind that Rutland does not. In other words what does it smell like? I don't like these situations. I don't want to buy into someone else's value operation. I am happy enough with my own. I want to buy into undervalued businesses myself, not trust someone else to do it outstandingly well for me. They may do, who knows, but I am not going to give them the benefit of the doubt, it adds an extra dimension of risk to the shares and thus runs against my dictum of minimising the downside. I am searching for ways to get rid of risk, not add to it, and these corporate acquisition companies in my view are not risk minimisers.

A few more words on eps in general. The ideal situation for me would be a low historical P/E, coupled with an even lower forecast ratio due to rising eps in the current financial year of the company. The deadly combination that one hopes will drive out the value and make some serious money. This is the thing to look for. It comes only rarely.

Of course any share on rising eps will have falling P/E and this is also the growth player's approach. The difference here is that the growth investor is often willing to pay expensive high P/E in the first place for the rising eps. A lot of shares satisfy this. But the value player is not, we are legendarily tight on P/E, we buy cheap only, on low P/E to start with and then look for the share to get even cheaper before the market recognises this and rerates the share. Very few shares satisfy this and the other filters. In that sense our job is far easier than growth investors because we have less choice. Far more shares satisfy the (high P/E + high potential eps growth) approach than the (low P/E + decent eps rise) concept.

I know some readers, perhaps both growth and value types to some extent, favour the PEG ratio as a test of how expensive the share is compared to its potential growth rate. That is really the same thing as what I say above. I don't consciously use it myself in that form, although my insistence on decent rising eps is a similar idea. The value version would insist that the numerator of the PEG, the P/E ratio, is well below the market, in my scheme at least one third less. The growth version would possibly not worry too much about the actual P/E figure. Thus a PEG of say 0.5 is thought by many to be attractive. A growth investor may accept a P/E of 20 with a 40% eps rise forecast. And growth investors may be willing to look further ahead than just the current financial year. But a value player accepting the same PEG would look for a P/E of say 10 giving a required eps growth of 20% for this year.

I know some investors use the PEG ratio as their primary one. But I wouldn't, as a value player, hang my investment approach on PEGs. Only where all filters are satisfied. And the elusive smell is good too.

Comments on this article to the Value Board, please.