Posted by Graeme in Shares at 12:56 pm on Friday, 10 August 2007

Richard Beddard appears to be willing to agree with me that most active investors will under-perform. We still disagree about how investors’ chances of out-performing are. Richard has focused on a particular company , Wogen, as an example of irrational underpricing. Naturally, it is now essential that I poke a few holes in his bullish analysis.

I do realise that the this is becoming rather lengthy conversation, but Richard and I are trying to represent both sides of one of the most constant and crucial arguments in investment. There are also a lot of excellent comments left by our readers, so do read the earlier posts, starting from here.

Richard’s position appears to be that, while accepting that most investors will be what I so tactfully call suckers, he nonetheless thinks that a reasonably intelligent investor, who puts effort into fundamental analysis, has a good chance of out-performing.

I do not have to show that his example company is a bad buy, merely that it is difficult enough to be sure that it is undervalued to make it untenable as an example of an inefficiency that such an investor can be expected to find. I have an easier task than Richard does.

I will start by saying that the very fact that Richard’s example is an AIM listed company that hardly anyone has heard of is evidence for my case that inefficiencies are very hard to find. How many companies do you have to analyse before you find one worth buying?

Now, what is there not to like about this company?

Firstly, the ownership. Three executive directors own 48% of the shares, and other executive directors hold another 10%, giving the them, joint absolute control

This looks even worse when looked at in the context of the directors remuneration. The company may have made a Â£24m profit in 2005, but the directors paid themselves an almost equally impressive Â£10m, and Allan Kerr was the best paid director of an AIM company. This makes one wonder about how the benefits of any dramatic recovery will be split between shareholders and directors.

It is also noteworthy that the company listed (on the AIM) in 2005, and earnings fell sharply the following year. Perhaps the original (when it was private) shareholders (who were largely the directors) were smart enough to sell when the business was at its peak?

I think the idea that the company is cheap because the value of the shares is covered by the value of its stocks of metal is flawed. This does not take into account the company’s debt. Its net assets are Â£32m, although its stocks are Â£37m.

More fundamentally, the stocks are necessary for the business to operate. The profits spring partly from these holding, so valuing the two separately is double counting. Furthermore, I can see no way in which the company can release the value of the assets while remaining in business. It is not like a retailer which can release the value of property it owns, without disrupting its business, by entering into sale and leaseback agreement.

The suspicion that 2005 was an exceptional year, and the extreme volatility of earnings, suggests to me that we should look for another way of estimating what the on-trend PE.

A page on the company site claims an average ROI over a twenty year period. of 18%. Assuming this to be an ROCE, given shareholders funds of Â£32m and debt of another Â£20m, this implies and EBIT of Â£9.3m, and a PE ratio of close to 11Ã—. Cheap, but not as dramatically so as Richard’s 7Ã— based on average earnings over the last five years.

I realise that the calculation above is rough, but I am trying to demonstrate the problems, not carry out a full analysis.

The 9% yield is good, but only if one expects good prospects for increases. If it were to remain at the current level permanently, a 3.25% spread over base rate is not a particualrly good reward for being in as risky a business as commodities trading.

It is unduly pessimistic to assume no growth, but it is also optimistic to take the high yield as a positive signal without considering the risk of a cut if profits fail to recover.

Now that I have run through the negatives, I have to say that I think Richard is looking in the right place for under priced shares. Small cap value stocks do tend to be ignored, as I recently argued myself.

Wogen is interesting, but, given all the above, I am not convinced that it is necessarily an obvious example of a market inefficiency. Richard’s bull case is strong, but I think I have made almost as strong a bear case above. The only positive that I cannot effectively rebut is the yield. You can get exposure to high yield with much less effort and expense, with better diversification, by investing in a high yield index tracker (yes, there are such things).

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