The more I looked at it the less I liked it. The low returns are not just a problem in themselves, but they are slowly declining, making management claims that the pubs being sold are lower quality. If what was being retained were the better businesses, then we should see a rise in returns, but ROCE fell from 6.9% in 2009 to 6.3% in 2012, with similar declines in returns calculated in other ways (using EBITDA, using slightly different asset numbers, etc.).

It is not entirely clear from the accounts, but it looks to me as though:

1. Pubs intended for sale are revalued, almost always downwards. In fact are much of the revaluation (227m of 691m in the last four years) are of “non-current assets held for sale” — i.e. pubs that are up for sale.
2. They are then sold at a little more than the revalued price, generating a small “profit on sale of property, plant, and equipment”.

With £675m of disposals from “non current assets held for sale” over the last four years,  it looks very much as though revaluations are roughly equal to the actual market value of pubs being sold: project that forward (and the trend in returns supports doing that) and that promising 0.5 price/book looks about right.

The calculations above are somewhat “back of an envelope” and the comments on revaluations (the last para above) may well be wrong, but I think it cannot really be improved much of the information available. The market is working nicely and has value Enterprise Inns fairly.

In the long run, the growth that matters is economic growth. Without economic growth organic growth would be a zero-sum game, and negligible at the market level. There would be winners and losers, but the gains would be entirely offset by the losses, so the average investor would gain nothing from this growth.

The question is what drives economic growth? In the long term economic growth comes from improvements in technology. The economy cannot grow past the productive capacity of the economy, and technology enables this. This has not always been what we regard as high technology: the invention  of the horse collar had a tremendous impact on economic growth.

One thing investors forget is that technology often has an impact well beyond the the industry it occurs in. The agricultural revolution made available the pool of labour that enabled in the industrial revolution (not that it would have looked like a good thing to those in the pool!). Computers have allowed the automation of banking (manual processing of cheques is a lot of work) and made logistics more efficient (for example, fewer empty lorries because computers can match loads to journeys better than is practical manually).

I have been arguing for sometime that the last few decades have seen little new invention. I have recently noticed that the message seems to be getting through to the mainstream media (a recent article in The Economist, for example).

We have had economic growth driven by incremental improvements to existing technology. Computers may have ultimately similar designs to those available in 1970, and made using similar processes, but they would not have had the same economic impact if they were still the same size and cost!

The problem with this is that there are limits to incremental improvements. Once we reach the limits of, for example, reducing the size of integrated circuits (that the limits exist is a matter of the laws of physics), advances in computers and electronics will no longer be rapid.

There are also diminishing returns to incremental improvements. It is fairly clear that most of the productivity gains enabled by the automation of clerical work and financial transactions have already occurred, and the impact on productivity of making computers still smaller and cheaper will not be as big.

In the past by the time the impact of the big breakthroughs of one period were running down, the next lot of big breakthroughs were beginning to have an impact. With no big breakthroughs in the last 40 years, once the incremental improvements run out, growth is done.

Of course there are many exceptions to this. The largest lies in emerging markets where existing technology is not anything like fully utilised. The problem is that this is not a replacement growth driver, it is just one driver that is not disappearing with the slowdown in innovation.

Population growth may also help boost demand, at least in some countries, but it will also put pressure on limited resources, particular food and natural resources: slowing technology means that our ability to make more from the same inputs will not grow at the same pace as in the past.

There will also be some growth industries: I am not arguing that all advance will stop, just that it will be a lot slower. There will also be opportunities to consolidate and create economies of scale, and these may be easier to exploit when a lack of disruptive technology makes things more predictable.

None of this is enough to change things very much. Growth in one business will matched by a corresponding decline in another, as low economic growth means aggregate demand will grow slowly. If growth is lower, then returns need to be more immediate. The market as a whole should return far more in the short term: dividend yields need to be much higher than has been typical in the past. IN practice we also need to take into account other ways of returning profits to shareholders such as buybacks.

Although this may seem to be a triumph for value investing, I am not sure this is entirely true. Even growth that comes from wining a zero-sum game is growth nonetheless, and growth stock picking will continue: perhaps with gradual shifts in emphasis.

The problem with valuing the Huffpo (as everyone seems to have taken to calling it) is that we know too little about it. Its fast growing, and has not made the disclosures a listed company would. Perhaps there ought to be a requirement that listed companies’ unlisted takeover targets should make such disclosures.

The fast growth means that valuation (and I am sticking to simple valuation ratios here — nothing too fancy given the limited information) is very uncertain, depending on what growth and margin assumptions you make.

AOL’s CFO expects the Huffington Post to generate revenues of $100mn with a 30% OIBDA margin. On those numbers AOL is paying a modest 10× multiple: even leaving for tax and moderate depreciation (what does a website need to depreciate?) its unlikely the prospective PE is much more than a reasonable 15× 2011 earnings.

Of course there is a caveat: this assumes that growth will continue to be rapid, at least this year. The Huffington Post’s track record and recent growth (Quantcast has the numbers) is encouraging. Unless AOL has been stupid enough to buy just as growth peters out (which AOL is quite capable of doing), then the price is actually quite good.

This does not mean that AOL should buy. Is this deal going to create shareholder value?

Comments in the conference call immediately make me wonder whether AOL know what to expect from their new toy:

Let me clarify that comment, just so we’re all on the same page. In 2010, the Huffington Post was profitable. To a point, you’re correct. This year, we’re expecting a little bit north of $50 million of revenue and $10 million of OIBDA and my comment on the 30% margin range was, we’re on a run rate basis going forward, we expect to manage the business. Obviously, we think going forward, there are some healthy incremental revenue into OIBDA conversion. So, it is more on a go-forward basis after 2011, where we expect to manage the business. And I’ll turn it over to Tim for the sales integration.

That is a clarification!

More worrying is this:

In certainareas we are losing money, and we have told you of our intent to reverse that throughcost cuts, M&A or partnerships with third parties.

Buying your way to profitability is not a strategy that has often worked. What that really means is:

As the management of a declining, but still large business, the best way to justify paying ourselves a lot is to use the shareholder’s money to buying something that is not growing.

From the shareholders point of view, the best thing to do would be to manage AOL as a cash cow. The results show a free cash flow of $460mn in 2010 and $760mn in 2009. This would have been a spectacular return (over 50%) compared to AOL’s current $2.2bn market cap if it had been paid out to shareholders.

It is almost certain that free cash flow would have been even more if the company had been managed to generate cash instead of growth, and there could have been additional income from the disposal of unprofitable businesses.

I have not even considered the costs of integration (to deliver those savings that takeovers always promise to deliver, but which are rarely seen), or the risk that the Huffington Post will not perform as well once taken over by AOL (the usual problems of clashing corporate cultures, etc.).

AOL is not paying a high price, but the purchase is part of a strategy that is bad for shareholders compared to the obvious alternative of just generating as much cash as possible.

There has been a lot of enthusiasm about Demand Media’s growth track record. As always with growth stocks the problem is guessing at what point the growth will stop. Is it likely that Demand Media’s sites will become as ubiquitous in search engine results as Wikipedia, or even more so? Where does the growth stop.

A very high growth rate in needed to justify the high multiple: the company is not profitable, and the IPO price currently being talked about will put it on 6× revenues.

Not only is this high growth uncertain, it is also mostly at the mercy of a single company: Google. I find it hard to believe that Google will allow more and more places in its listing be taken by Demand Media’s sites (such as eHow) and other “content farms”: many users dislike these sites. It is most likely to adjust its algorithm to rank these sorts of sites lower.

I also do note believe that the founder’s track record, impressive though it is, should encourage investors. Yes, he has built very successful businesses, but the buyers did not necessarily do well. I can find no record of iMall’s performance after he sold to Excite, but the dismal record of MySpace after the founders sold to Murdoch is well know. He is smart enough to sell at the top.

The SEC filing is also very vague about what will be done with the cash. We should have more details before the IPO, but it is very hard to imagine what could be done. Generating more content for existing sites will hit diminishing returns somewhere, and increase the risk of a reaction from search engines. More acquisitions are a possibility, but I have never been a fan of acquisitive growth, even from a company that has succeeded with its previous acquisitions.

This company does not strike me as another Amazon. It is not something that will build a loyal customer base. I cannot see it doing anything irreplaceable. Demand Media is brilliant at using SEO (search engine optimisation – getting sites high positions in search engine results) and ownership of well established sites to get cheap content to rank high in search engine results. That is a fragile business model.

I can then use this blog for everything else. The main reason for the change was that many people said that they liked this blog, but were not really interested in the investment stuff, or that they were interested in investment but not my other material. This confirmed by feeling that this blog was not focused enough.

I can now also not worry about posting material here which might put off the people invested in investment.  I suspect I will post more often on each blog than I ever posted on this in the past.

Lots of politics and religion and controversial stuff to come here! For example, I am planning a series of posts comparing Britain to Sri Lanka, which should give me a wonderful opportunity to annoy two groups of people at once…

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 £24m profit in 2005, but the directors paid themselves an almost equally impressive £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 £32m, although its stocks are £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 £32m and debt of another £20m, this implies and EBIT of £9.3m, and a PE ratio of close to 11×. Cheap, but not as dramatically so as Richard’s 7× 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).

The latest is this study , which is nicely summarised by economist Danni Rodrik. What matters most to academics is improving their reputation, on which grants, status and promotions depend. This is most commonly measured by citations of their papers by others, although output in terms of the number of papers they publish also matters.

The problem (for the publishers) is that academics can use the internet to disseminate a paper. This gives it a good chance of being cited, regardless of where it is publsihed. This means that publishing in a top journal matters.

Academics had a strong motive for publishing in the journals with the strongest reputations, because they the most widely read. However they were widely read because they attracted the best papers. A powerful barrier to entry, that gave publishers apparently ever increasing margins.

Now, if it no longer matters so much where papers are published (at least for academics from universities with strong reputations), then it will become easy to established journals, and perhaps journals may disappear altogether. There go the high margins, and probably the revenues as well.

Added 27th July 2007: The importance of this is that it does not require the replacement of existing journals with new channels for the publishers to have serious problems. We can now see and intermediate step, allowing lesser known journals can complete on more equal terms. This will both depress margins in itself and ease the transition to a completely new way of doing things.

Given the academics aim is to disseminate their research as widely as possible, and given their sources of funding, the likely eventual outcome is likely to be that open access will become the norm. I have blogged on the benefits for academics and society before. As for the publishers … bye, bye, it was nice knowing you.

According to John Littlewood (as quoted by Richard), profits increased 20× over a period of fifty year (sending in the late nineties), while share prices increased in value by 75×. The market was rerated by a factor of 3.75!

The reason for the rerating was that companies became better at returning money to shareholders, making shares more valuable to shareholders. Now that companies have gone most of the way they can down this road, we cannot expect much more from this. Just how high could the market PE go?

Does this mean that we should not invest in equities? I would say that we should. Remember that even without the rerating, shareholders would still have had the profit increase of 20× and the dividends paid over the years.

Looking to the future, bonds would only outperform equities if interest was greater than earnings growth plus dividends. This does not seem likely to me.

A rough calculation will show why. Assuming that earnings will growth at the long term trend of economic growth. This is unlikely to fall below productivity growth of around 2% and is currently running at nearly 3%. With the market dividend yield close to 3%, equities are likely achieve a real return of 5% or more, significantly better than on bonds.

Another advantage of equities is often forgotten in these times of low inflation. The real value of bonds can fall sharply after a few years of high inflation: shares offer a hedge.

However, the gap is not dramatic, so there is every reason to have some money in both and diversify.Equities will almost certainly do better in the long term, but do not necessarily expect the dramatic returns of some past decades.

You can have situations, as in Zimbabwe where high returns (as judged by an index measured in a currency that is rapidly losing its value) can in fact be misleading.

On the other hand, the fact that shares are investments in real businesses means that foreign investors should not bother too much about currency risk.

When a currency depreciates, this is usually reflected in higher inflation. The more a country trade relative to the size of its economy the faster depreciation will lead to inflation.

Inflation means higher nominal profits (and revenues), which means higher share prices, which should offset the effect of the depreciating currency.

This should be fairly basic stuff, but I have known institutional investors who should know better to worry about it. Don’t. There are plenty of more significant risks to worry about.

My main reason for optimism is that the largest shareholder is expresing dissatisfaction with the management, which makes it likely that things will change.

It is often useful for investors to ask themselves whether, if they had that kind of money, they would buy the company outright. In the case of Woolworths I would say the answer is yes. On and EV/sales of 0.3× (at 30.75p) and a gross margin that, although it deteriorated a full percentage point, remains reasonable at 25%, this looks like a business that can recover.

The key is to turn around the loss making retail business. It is not difficult to think of strategies that stand a good chance of succeeding:

• Buy a small retailer with overlapping product lines and a format that has been successful, and roll out the better format across the business.
• Keep trying new, internally developed formats.
• Sell stores and shrink the business.
• Break up the group. It should be possible to find trade buyers for both the retail and wholesale businesses.

Of course, the risk is that Woolworths will continue as it is. The problems as:

• It is expensive on a historic PE of 25×.
• The retail business is loss making and badly positioned.
• The wholesale business is is uncertain: it lost a major customer (Tesco) in the course of the year.
• The company has been buying growth through acquisitions.
• The wholesale business is seeing an organic decline (offset by acquisitions) and the retail business a like-for-like decline.
• The management appears to have no convincing new strategy.

Edit: 14th April 2007. I also think the company is a potential takeover target for someone who wants to put in new management and turn it around, or who can integrate it with an existing format. This is, of course, a very speculative bull argument.