Sometimes we make mistakes and sometimes we get a second chance. And so it is with Colefax, which readers may remember from the last time I mentioned it, in the December issue. I said then that the luxury wallpaper and fabric designer was a strong and profitable company, but not cheap enough to add to the Thrifty 30 portfolio.

Ironically, I’ve just added Colefax to the portfolio at just under 250p, about 30 per cent more than the price 10 months before.

In deciding how much to pay for Colefax last year I was thinking in terms of book value – the value of its assets according to accountants – less the value of its liabilities. Wallpaper and fabric sounds like a cyclical and pedestrian business and I figured the company was probably not worth much more than book value. Since its market value was higher, I let it go.

I should have looked at Colefax’s record more closely. Maybe because its clientele is wealthy, it has weathered recession well and has a very good record of turning its assets, mostly the fabrics and wallpapers it designs, into profit.

Profit accrues to shareholders, either when it’s paid as a dividend, or when it’s reinvested in the company they own. How effectively a company turns assets into profit is measured by profitability ratios and the ratio that most interests shareholders is return on equity (ROE), which relates profit to the book value of the company, since book value is the value of assets attributable to shareholders, having deducted all liabilities.

Over the past 11 years, Colefax’s ROE has never dropped below 9 per cent. It reached 26 per cent in 2007, and averaged 18 per cent over the whole period. If you could invest in Colefax at a price that equalled its book value per share, you might expect an average return of 18 per cent a year, if the future is anything like the past. That, of course, would be an extraordinary investment.

Colefax is a prosaic business, but it’s not pedestrian, and it follows that because of its earning power, it’s worth paying more than book value for the shares.
So this time I did a different calculation. Comparing Colefax’s market value (nearly £35 million) to its book value (just over £25 million) by dividing the former by the latter, we can see the shares cost 1.4 times book value.

The return investors might expect, known as the earnings yield, will be reduced by a factor of 1.4 to account for the premium they are paying. If we divide the average ROE Colefax achieved in the past (18 per cent) by 1.4, we get 13 per cent.
I look for a minimum of 10 per cent, so coupled with Colefax’s financial strength and consistent profitability, 13 per cent is attractive.

I decided to reject Colefax in December because the portfolio was almost full, and shares were moderately expensive. It felt prudent to hold on to the remaining cash as a buffer.

Come the panic in August when the market crashed 20 per cent, the Thrifty 30 had cash because I’d ejected Mallett, T Clarke, Quadnetics and RM earlier in the year. Coupled with a revised opinion on Colefax, my second chance had arrived.