Keep it simple stupid!

A phrase not to be forgotten….

One of my favourite books is James Montiers Value Investing and the title of Chapter 19 is “Keep it Simple, Stupid”; the introduction to the chapter tells us

Too much time is spent trying to find out more and more about less and less, until we know everything about nothing. Rarely, if ever, do we stop and ask what actually need to know!

I have been reading a lot lately about organisation and how to prevent information overload that ultimately leads to poor or no decisions being made; its an important concept to consider when you are investing as in the current technological age it has become easy to obtain more an more data that will apparently help you make your mind up. However more data does not always lead to better outcomes just more things for an already overloaded brain to process, so why not apply a little common sense and keep it simple stupid?

Anyway this I thought makes sense so lets trim down the data and think about what matters, whats effective and whats important to making my investment decision; I have used GKN as a real life example.


GKN PLC

What has made me interested in this share? 

The share has appeared in my initial filter for the following reasons

  • Cyclically Adjusted PE (CAPE) of under 16
  • Earnings Yield 6.4%
  • Seven year EPS growth of 28.3%
  • Current ratio 1.3
  • Interest cover 6.1
  • Dividend cover 2.1
  • Net current assets of £563m
  • Total borrowing to equity 57%

Plenty to like in the above when it comes to financial security.

The share price has also fallen by over 30% from the 2014 high which is something worth considering; what is the reason that a firm with the above positive attributes has taken such a dive? Does an opportunity exist?

A bit more analysis 

Looking at some key ratios GKN may not actually be that cheap with most well above their long term average (bottom row), with the exception of PS (Price to Sales)

GKN Summary

This can also be demonstrated with some graphical interpretations of key data over history.

Fair Value Estimate 

This estimate excludes some data I would normally use such as Tobins Q and Yield but because there are some major outliers that affect the data I have removed them; you still get the idea though…..

  • 1994-1996 the price was clearly below fair value
  • This changed in 1999-2000 (as it did for most shares!) and the price was above the fair value estimate
  • Undervaluation occurred again in 2003 and most dramatically in 2009
  • Overvaluation peaked in 2014 and gave a significant warning that the share looked pricey
  • Despite the 30% declines in price it remains well above the fair value estimate

Fair Value

Reversion to Mean

This graph uses the long term average of a price ratio compared to its current level to create an implied return for the next 5 years per annum; put simply if the current PE is below its average a return to the mean will give positive returns, if its above the average it will be negative. The use of a number of ratios helps limit the chance of being mislead or focusing on a single piece of information.

Actual returns in red bear more than a passing resemblance to the implied returns, in fact other than the period between 2002-2006* the PE10, CAPE and PS have provided a fairly accurate range of potential returns for GKN for the coming years – currently this could be anything from 5% to -10%.

* (In 2004 GKN restructured significantly becoming a much smaller company following the sale of its stake in AugustaWestland – this goes some way to explaining the deviation during the period) 

reversion

Implied Returns 

Looking further at the historic ratios to create a statistical model for GKN it is clear that there have been better times to purchase the share and implied returns for the coming 5 years are around 0%; the extreme undervaluation in 1994/1995 and again in 2009/2010 is clearly visible as is the overvaluation of 99/00 and 2014. Again the 2003-2006 period is the only major deviation from the model.

predicted returns

 

Conclusion 

There are lots of positives in terms of financial security and the fall in price possibly creating the chance of value existing; however some analysis based on historically accurate facts suggests that I would need a lower price from hear to start considering a more detailed look at the financials and possible purchase so until that point I will forget it and move on to the next share……..remember “keep it simple stupid!”

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