I thought I'd say a little something about how I decide to buy and sell companies, and what my rationale is behind each trade. There is some discretion involved, but not much, and this is certainly a fair summary of what I do. A simplified version of this is available on the Checklist page. Let's say I start with £1000 in cash. I look for a company where I can pay £1000 for something worth at least £1,500. 'Worth' is a slippery term, but to me it means shareholder equity or book value, and I prefer tangible real assets to intangible assets. I realise that book value isn't always the actual net value of the company assets, what with 'cooking the books' and all. However, I don't have the time or interest in digging out all the details so I imagine that the good and bad net each other out. To be on the safe side I use a wide margin of safety.
So I head out into the market and find some companies where I can buy a pound fifty of book value for a pound. These companies are typically quite sick, often making losses, often unloved by almost everybody. Because they are often losing money they need to be able to weather their current problems. They need a bomb-proof balance sheet, or as near as can be. Typically this means they don't have a lot of debt and have at least fair liquidity.
Debt is often what gets a company killed. If the banks refuse to lend to a company which is dependent on debt it's game over and the companies I buy are not top of many banks lend-to lists. Debt can be measured in many ways, but I tend to use net gearing, which is gearing based on net debt, which is interest bearing debt minus cash and equivalents. What exactly is low debt is debatable and I don't have a hard rule, but certainly less than 100% of tangible equity.
Once I have added a nice cheap strong company to my portfolio I only check on it's market value once a week. Each week I take a quick look to see if the market value has reached the book value. The answer is usually no. It's usually no for many months if not longer. Sometimes there will be a dividend, for which I am truly grateful, but these aren't that common since many of my holdings are loss making. Something has to happen to move the market price, so I sit and wait for something to happen. Alba was a good example of this. They sold the Alba name to Argos and de-listed down to the AIM. They completely restructured the business getting rid of all sorts of non-core bits and that was enough to make Mr Market happy. The share price shot up and I got out.
And talking of getting out, if I can sell a company and turn its book value into cold hard cash then I will. Once the market price equals the book price I see no sense in hanging on. During my holding period the original £1,000 has turned into £1,500, perhaps with some small dividend paid out in the year or three I had to wait. Now I have £1,500 cash in my hands, so I go right back to the market looking for that pound fifty on sale for a pound, or in this case £2,250, at which point it all begins again.
As you can see, the focus is always very much on building up the total book value of my holdings. Of course, it isn't always a happy ending. Sometimes the managers manage to burn a big chunk of my book value up. Sometimes I wake up and the new annual report says my company is worth 30% less than it was yesterday and suddenly the market price is above book value. It might even be worth less than I paid for it. From here there are two courses of action. I can ignore the paper loss, turn a blind eye and say "I will only sell if I have a gain". But this is not logically consistent. It smacks of making up the rules as you go along and one of the keys to investing I think is to make up the rules and then stick to them! So what I should do - and have done so far on the one occasion it's happened - is to sell at a loss, try to work out where it all went wrong, swear at the management and start looking for the next unloved but robust company to back.
This article is for information and discussion purposes only and nothing in it should be construed as a recommendation to invest or otherwise. The value of an investment may fall and an investor may lose all their money. Any investments referred to in this article may not be suitable for all investors. Investors should always seek advice from a qualified investment adviser.