Over a pint in my local recently, I was telling a long-standing neighbour friend of mine, Dom Crotty, that we were publishing a free 64-page booklet on Sound Investing soon, and that I was looking for an analogy linking sport with investing. He didn’t disappoint. In other words, I cannot take credit for the following, but I was impressed with the analogy and I think readers will be too.
In golf, as with investing, knowing when it is necessary to take (higher) risk, and go for the big tournament winning shot, is important. In winning the 2008 Open, Padraig Harrington’s critical hole was the 17th. As he had a two-shot lead over Ian Poulter (already in the clubhouse) and a 3-shot lead on Greg Norman, he was in an ideal position to take a risk. He took a high-risk 5-wood to the 17th green. It was unlikely that he would score any worse than par (5) on the hole, giving him a 1-shot lead going down the last hole should Norman manage an eagle (3) on the 17th. In investment parlance, we might say that Harrington had a ‘margin of safety’.
Harrington took on the shot and it worked out with the ball coming to rest three to four feet from the hole, and he finished out for an eagle and giving himself a four-shot lead with one hole to play. Gaining that four-shot lead required measured risk, and the result was a Major win.
Contrast this control of risk with Van de Velde, who, at the 18th tee in the 1999 Open in Carnoustie, arrived needing only a double bogey six to become the first Frenchman since 1907 to win the Open Golf Tournament.
Despite a 3-shot lead, Van de Velde took an unnecessary risk and chose to use his driver off the tee. He proceeded to drive the ball to the right of the stream. Rather than laying up and hitting the green with his third shot, Van de Velde decided to go for the green with his second shot. His shot drifted right, ricocheted backwards off the railings of the stands by the side of the green, landed on top of the stone wall of the Barry Burn and then bounced fifty yards backwards into knee-deep rough. He gifted the tournament and Open title to Paul Lawrie.
Grafton Group plc, the Irish builders merchanting group now listed solely on the London Stock Exchange, has seen its share price decline some 40% from a peak of £8.58 in May 2015 to £5.15 recently. The immediate impact of Brexit has been lower volumes and some pricing pressures in the UK builders merchanting market, while the group’s Irish and Netherlands operations are doing well. As a key player in the UK market and with a well-proven track record of managing a growing business, we don’t see the current issue as a structural one. For these reasons, business risks continue to look low.
Financial risks, too, are negligible. Net debt at end June 2016 was £96 million and compares to average annual cash flows generated over the past three years of over £100 million.
Valuation risks also look low. At the time of writing, the group’s share price was £5.15 for a market value of £1,215 million. Add on the £95 million of debt for an enterprise value of £1,311 million i.e. the cost of buying the entire business today. The assets employed in the business amount to £1,211 million so that investors are paying only a little over the historical cost of the assets employed in the business. Some might argue for the exclusion of goodwill, but not me. And in the first half of 2016, the group generated a 12% return on capital employed. Investing some of your zero yielding bank deposits in Grafton shares now makes considerable sense.
Of course there are risks of further earnings disappointments against a weakening residential backdrop in the UK, but the group’s track record is excellent and the risks of a permanent loss of capital for those buying at the current price look low on a 5-year view. The margin of safety in Gratfon’s shares looks good and stepping up to the plate now looks like the right move!