Investing with Conviction

By Larissa Fernand |  06-11-18 | 
 
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About the Author
Larissa Fernand is Website Editor for Morningstar.in. She would like to hear from you and welcomes your feedback.

Anthony Bolton earned the stellar reputation as Britain’s Warren Buffett when he managed money at Fidelity in the U.K.

While that must fill him with pride, he did confess to a journalist at The Guardian that he would like to shake off the moniker “The Quiet Assassin”. Here’s how it got coined.

The two largest surviving independent television companies in the U.K., Carlton and Granada were to merge in 2003. Bolton, an investor in both, was in favour of the merger and could see great benefits if structured correctly. Michael Green (chairman at Carlton) was to become chairman of the new entity – ITV, while Charles Allen (chairman at Granada) would be CEO. Bolton thought it imperative that there should be an independent non-executive chairman capable of holding the ring between the two merged partners and led a successful shareholder campaign to that effect. This thrust him into the British media spotlight and bagged the epitaph.

Let’s look at some of the aspects legendary fund manager Anthony Bolton considered when he bought a stock.

Have an Investment Thesis

His first personal investment was when he was working in London for a small merchant bank. It was based on a tip from a friend. He invested in the tin mining company’s shares, an area he knew absolutely nothing about, and within a few days, the share price fell back sharply.

He learnt two valuable lessons.

An experienced colleague asked him how he felt about that experience and told him that it was important for an investor to be comfortable with sometimes losing money. He also learned to never invest in tips as they rarely work out.

Know what you own and why you own it. Each investment should have a clear, explicable investment thesis, and should be sold if that thesis has changed. Pride should not come in the way. If information undermines the original thesis, don’t hang on just to prove the veracity of the original idea. Have conviction, but don’t be pig-headed. You have to be able to change as events dictate.

For instance, Bolton once cited UK-based multinational tobacco company Gallaher as one his best investments in Fidelity Special Values. Here’s why:

  • It had an interest in emerging markets, where cigarette consumption was still growing
  • The company had a stable free cash flow
  • Tobacco companies, at the time Bolton bought these shares, were very lowly valued in the stock market (this changed dramatically as their stable free cash flow became more sought after by investors)
  • The company was a possible takeover target (Japan Tobacco purchased the company)

Another stock that Bolton mentioned with great pride is Securicor, a security company. Ironically, Bolton’s interest in this stock was not straightforward. At the time Bolton analysed the stock, there were only two mobile networks in Britain – Vodafone and Cellnet. Where the latter was concerned, British Telecom had a 60% stake with Securicor holding the rest. Bolton wanted exposure to Cellnet, but was not interested in investing in BT. The reason being he wanted to capitalize on growth in the mobile industry and did not want to put money in the landline business, where BT was big. On the other hand, Cellnet accounted for a much larger proportion of Securicor. And analysts ignored this aspect which led to Securicor being rather undervalued.

Bolton narrowed down on it because he believed at some stage BT would want full control and buy Securicor’s stake. He was right. BT launched a takeover bid in 1999. The value of Securicor's holding in Cellnet had grown from £4 million to about £3 billion. Bolton made a killing.

The business must generate cash over the medium term

Businesses are not created equal. Some have better franchises. Some are managed much better than others. Most businesses vary over time due to factors such as new competition or changes in the environment.

Bolton held on to the view that cash generating businesses are superior to the ones that consume cash. Businesses that can grow without requiring a lot of capital were particularly attractive to him. Cash-on-Cash return is the ultimate measure of attractiveness in terms of valuation. In playing off cash generation against growth, I generally prefer cash.

Evaluate valuation measures over a long-time frame

When it comes to valuation measures, have as long a history as possible. If 20-year charts are not available, at least look at a complete business cycle. Less than 10-year data can be misleading as it will not contain sufficient variety of business conditions.

Look at a range of valuation measures and don’t focus too much on just one measure. The key ones are P/E, P/B, ratio of enterprise value to gross cash flow, free cash flow ratios, cash flow return on capital relative to invested capital, Price or EV to sales, and EV to EBITDA.

There are various aspects to this; how today’s valuation compares with its history – high, average or low. How the company is valued against its industry peer group on a country, region and global basis.

Analyse balance sheet ratios to see how strong the balance sheet is. Consider bank debt, the debt profile and the covenants in place, the company's bonds and other liabilities. Bolton said that his biggest mistakes have nearly always been in companies with poor balance sheets.

Never forget that stock price influences behaviour

The stock price itself influences behaviour - falling prices create uncertainty and concern, rising prices create confidence and conviction. Understanding this is a really important part of investing.

Equally important is realizing that mean reversion is one of the great truisms of capitalism. For most companies, the financial statistics used to evaluate performance – sales growth, margins, return on capital, etc. – all revert to the mean over time. This also applies to valuations.

Most people tend to be excessively influenced by what the crowd is doing. One of the most dramatic examples of this was during the internet bubble in 1999-2000, when the stocks of “old economy” companies were sold off to attractive valuations while the opposite happened to the internet companies.

This extra dimension of the stock market is what Bolton calls sentiment.

It’s important to know whether this is normal or overextended in either direction. Bull markets climb a wall of worry. At the bottom, nearly everyone is cautious and, as the market rises, these bears gradually turn into bulls until, at the top, nearly everyone is optimistic. If at any one moment there are still plenty of cautious investors around, then the bull market probably has some way to go.

The stock market is not about what the future holds; it’s a reflection of what people think the future holds. I prefer thinking in levels of conviction rather than in price targets.

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