January 2018

Thought For The Month

The most notable of the downward movers in the portfolio over the month was the collapse in Capita. The negative impact of Capita on performance has been especially keenly felt as we only initiated our position in the stock just before the profit warning and consequent share price plunge. This makes us look and feel foolish and a period of reflection has followed. How could we have got it so wrong, so quickly? What can we learn from this deeply unpleasant experience?

When we started buying shares, Capita had already fallen by c. 75% from its 2015 peak and was trading at a low multiple of our estimate of normalised profitability and offered significant (50%+) upside to our appraisal of fair value. In terms of sentiment, after a sustained period of operational and share price underperformance, there were few avowed buyers left in the market. Also, the new chief executive had already further softened-up expectations, by observing that the group had become too complex, was too thinly spread, was overly focused upon short-term targets and was underinvested. So, for us, the cheap valuation and adverse sentiment boxes were very much ticked and, given the same set of circumstances, we would do the same again.

Given the scale and suddenness of the share price fall, this may seem glib, but it is anything but. This has been a painful and ignominious experience for the team and one we have felt deeply. However, the worst thing we could do now would be to impulsively overreact, to extrapolate and thereby infer some deeper meaning from a single adverse data point. We have suffered nothing comparable in terms of size and abruptness of fall after buying a stock in nearly two decades and it would be easy to conclude that a big mistake must have big lessons.

Our investment process is based on the observation that investors recurrently, indeed habitually, overreact to bad news, with this overreaction often providing us with buying opportunities. What has just happened with Capita is, we believe, an exceptionally large overreaction, with the reasons for this readily apprehended. The market rarely responds well to the surprise scrapping of a dividend or an emergency capital raise, while the very recent collapse of (the superficially similar) Carillion has greatly heightened investors’ fear and loathing of Capita. The magnitude of the overreaction can therefore be understood, but the fact of it still surprises.

While we always endeavour to learn something from our errors, it would be rash indeed if we were to similarly overreact and intemperately abandon a process that has served us pretty well over many years. Following the very large fall in the share price, we have subsequently added to the position in Capita, not because we are stubborn or unreflective, but because we believe that it is the right thing to do for our investors.