I've stealthily been re-categorising the Share Sleuth spreadsheet to indicate the status of each share, whether the shares I follow are buys, holds, or sells.
In the process, I've realised holds are an uneasy combination of two different situations:
- The shares are in a good business, but the valuation is not obviously low and there may be better candidates for investment.
- I used to think the company was a good company, but something's worrying me, and I may need to change my mind.
In the first case, the price may be dubious. In the second, the business may be. The danger of branding these situations 'holds' is that it feels like a decision, that I'm confident the shares are worth holding.
In fact, that's only true for the first kind of hold on a variable and sliding scale. Typically, the higher the valuation, the less confident I am. The second kind of hold exists because of the absence of a decision. These are investments I'm not confident about at all.
To ensure I recognise these situations, I've divided the shares I follow into four categories: 'add', 'watch', 'review' and 'replace'. 'Watch' and 'review' are the two different kinds of hold. Watch tells me to keep an eye on the company's valuation. Review tells me I need reconsider the investment, probably next time it publishes its annual report and maybe sooner.
Before I explain the categories in more detail, some notes on the spreadsheet:
Here is a snapshot of the 'add' category today (click to enlarge):
The spreadsheet contains data on portfolio candidates as well as portfolio members. This is so that I can easily weigh up the shares I want against the shares I have.
EV stands for enterprise value, a measure of the size of the businesses (its market capitalisation plus net debt, or minus net cash).
'folio% is the value of the holding of a particular share as a percentage of the overall value of the portfolio. The 'folio% for portfolio candidates is 0 per cent.
EY is short for earnings yield, the company's adjusted profit in its most recent financial year as a percentage of enterprise value, the market value of the company including its net debt (or less its net cash). It's a crude way of estimating the return on an investment in a business at its current share price.
A high earnings yield is good, if profits are sustainable in future. To justify a low earnings yield a company must grow. In practice I often use an earnings yield based on average profitability over many years, but the spreadsheet value is calculated using the most recent year only.
The spreadsheet highlights shares on an earnings yield of 8 per cent or more, which I consider to be a reasonable rate of return for a good company, one that is generally profitable and capable of remaining so.
It also highlights shares which account for more than 5 per cent of the portfolio's total value. To maintain diversification, I do not add shares above that level.
All of the shares in the add category are, in my opinion, good companies at cheap prices. I may be prepared to add more shares in these companies if the portfolio's holding is no more than 5 per cent of its total value.
The fact that there isn't a queue of candidates at attractive valuations waiting to join Share Sleuth right now could mean one of three things:
- There aren't many good companies available at low valuations;
- I'm setting my standards too high;
- I'm not working hard enough.
I do consider all three possibilities!
These are good companies that I would add if the share price was lower. If the shares are already in the portfolio, I might reluctantly replace them if the market valuation rises to a level that requires unlikely levels of growth to support it.
When an earnings yield drops below 5 per cent, which means the market value is about twenty times current earnings, I may liquidate part, or all, of a holding, depending on how confident I am in its prospects.
The portfolio still has an interest in Sprue Aegis, though, which is on an earnings yield of 3 per cent, about 35 times adjusted profit. Sprue is growing and its profit will be significantly higher than it was in 2013 when it announces its full-year results for 2014 very soon.
Nevertheless, it's testing my limits, and is in danger of joining the replace list.
The review category is a temporary place for shares in businesses that I'm questioning.
Either they are candidates that I'm still getting to know, or they are already members of the portfolio, but I've discovered something worrying.
My doubts might arise from terrible shocks, a fraud, say, or act of God, but it's more likely they are due to a lack of foresight. I thought the company was a good company, capable of sustained profitability, but I missed something worrying and now I'm trying to establish how significant it is.
While I'm pondering, the share remains under review, reminding me not to add more shares no matter how cheap they appear to be.
ITE is a case in point.
Any companies that don't fall into the first three categories fall into this one. If I think the businesses are too weak, or they're outrageously overvalued they will be removed from the portfolio when I need the funds.
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