Bookworm: Legendary fundie exposes mistake in my portfolio
Anthony Bolton delivered incredible long-term returns for investors in the Fidelity Special Situations Fund. What can we learn from his approach?
Welcome to Bookworm, a new weekly column where I’ll explore ideas from books and investor letters.
My aim in this column is to give older ideas new life through modern day examples, apply insights from abroad to Australian examples, and give you food for thought when it comes to your own investing process.
Today’s insight comes from Investing Against The Tide by Anthony Bolton.
Bolton found fame steering Fidelity’s Special Situations Fund to an average annual gain of almost 20% over a period 28 years. His strategy relied on identifying out of favour shares that were cheap against history and, in his team’s opinion, had strong potential to recover.
As this quote from Investing Against The Tide shows, this idea of buying things that are cheap from a historic valuation perspective carried a lot of weight:
“Buying when valuations are low against history substantially increases your chance of making money; while buying when they are high substantially increases your risk of loss. This approach has been at the heart of my approach to investment”.
Today’s insight: Using historical valuations for perspective
Looking at a company’s valuation history from several angles would help Bolton identify potential “valuation anomalies”. He would then apply a multi-faceted research process, helped by a huge team of analysts at Fidelity, to gauge how likely a recovery was.
If Bolton was confident he would buy the shares, wait, and usually look to sell soon after the “valuation anomaly” reversed – usually as part of a portfolio of several dozen positions. Today we’ll look at two important conditions Bolton placed on using historical valuation metrics to find opportunities.
As will be the norm in this column, the methods covered today were just one part of Bolton’s process. They are not something you will be able to use to come to an investment decision in isolation. In Bolton’s case, for example, he met extensively with companies and their management teams.
Also consider that a professional employing a certain strategy across dozens (even hundreds) of positions is very different to you using it on a handful of shares. Nonetheless, I hope this week’s insight adds value to your research process.
Two important caveats
The following two snippets from Investing Against The Tide give us more insight into how Bolton actually went about using historical metrics.
- “I’m often asked what my favourite valuation measure is. My answer is that I don’t have one, but that I like to look at a range of valuation measures. In fact, I believe it is dangerous to dwell on only one measure...”
- “Less than ten-year data I find can be misleading as they will not contain enough variety of business conditions”
Both of those things are worth paying heed to. But I think Bolton’s advice to use as long a valuation history as possible is especially relevant today. So that is where we will focus for the rest of this article.
Let’s look at Nestle’s valuation over time and see how an investor’s perception of cheapness may change as we go further back.
In the interest of brevity, I committed the cardinal sin of looking at the valuation of Nestle (SWX: NESN) using a single metric. I think it still shows my point regarding the timeframe you are comparing valuations across. If you were following Bolton’s advice, you would use several metrics.
Nestle’s free cash flow multiple over time
I refer to free cash flow as cash flow from operations minus capital expenditures and investments in intangibles. This can give you an idea of excess cash generated by a business that be used to reinvest in the business, repay debt, return profits to shareholders or buy other companies.
Nestle’s price to free cash flow multiple (its market value divided by the amount of free cash flow generated in the previous year) was 20.55 times on January 8 2025.
Compare that to its multiple in the last five years and you could say that Nestle looks cheap on a “historical” basis. It has spent much of this time at a thirty times multiple.
Figure 1: Nestle price to free cash flow on Jan 8th of each year. Source: Pitchbook.
Let’s add another five years to our timeframe and bring it to Bolton’s “absolute minimum” of ten years of valuation history. We are starting to see evidence against the idea that Nestle 'belongs' at a high twenties or thirty-something multiple of free cash flow.
Look back another five years and a low-twenties multiple looks a lot less abnormal. Even once you allow for the fact that Nestle has kept a higher percentage of its revenue as profits in recent years than it used to.
Figure 3: Nestle price to free cash flow on Jan 8th of each year. Source: Pitchbook.
In this context, Nestle’s recent free cash flow multiple in the low-twenties doesn’t look much stranger than the fact it ever reached a multiple in the thirties. Or, in other words, exactly the kind of multiple that a shorter view of the past would suggest is normal.
Of course, simply looking at a company's trailing free cash flow multiple in isolation is not enough to say whether a stock is undervalued or expensive. For what it is worth, Nestle recently traded at a discount to Morningstar's Fair Value estimate.
An example from my portfolio
In our team’s New Year’s resolution article, I shared that I want to be more selective with my stock purchases. I wrote this because I feel like a few of my investments in the past few years have been “so-so” opportunities rather than excellent ones.
At the front of my mind here was my investment in Diageo (LON: DGE), one of the world’s biggest alcoholic drink companies Diageo mostly focuses on spirits through brands like Johnnie Walker scotch, Gordons and Tanqueray gin, Smirnoff vodka and Captain Morgans rum. It also owns Guinness and Baileys.
In late 2023, Diageo issued a profit warning due to weakness in its Latin American business and the shares fell. I viewed it as a potential opportunity to take advantage of short-term uncertainty when the longer term outlook still looked fairly good.
I have listed some of the qualities that I seek in an individual share below. Diageo easily met the first three qualities and the fall in price tempted me into thinking that the fourth criteria on valuation might also be in play.
- Fair long-term revenue and profit growth outlook. The growth opportunity in developing markets still looked good, while developed market consumers appeared to be drinking ‘less but better and more expensive’.
- Competitive advantages that I readily understand. I am familiar with its products, many of which are essentially ‘must buys’ for any bar or bottle shop worldwide. Its brand and distribution advantages are daunting.
- A company I’d be comfortable holding forever. After all, overtrading in individual shares had been a big problem of mine since starting out.
- Valuation at time of purchase looks more likely to be a tailwind than a headwind. On several metrics, both backwards and forwards looking, Diageo had fallen to a lower valuation than it had traded at for some time.
Since then, Diageo has netted me a total return (including dividends) of minus 15% or thereabouts. During a time where most stock markets and the index funds tracking them have performed well. In dollar terms, it is comfortably the biggest loser in my portfolio.
I am not writing off the investment yet or considering a sale. But I was interested to see if this insight from Bolton – his preference for as long a history of valuation as possible – may have unearthed a mistake in my judgement on that last point.
Cheap versus history, or just the recent past?
I invested in Diageo in November 2023. Pitchbook data tells me that the price to free cash flow multiple at the time was 21.8.
Looking at historical valuations on that date a decade into the past may have suggested to me that, on this metric, the shares were “cheap versus history”.
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Figure 4: Diageo free cash flow multiple on November 20 each year. Source: Pitchbook
Adding another ten years of context throws some doubt on this. More importantly, it poses some questions. Was the valuation in 2023 actually cheap versus history? Or was the first decade of data I looked at the real anomaly?
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I say this because much of the past decade was very much out of the ordinary. For most of it, interest rates and the yield available on government bonds were near zero. And this absence of ‘risk-free yield’ impacted valuations in several asset classes.
Most relevantly for Diageo and Nestle, this included a group of shares that were dubbed “bond proxies” thanks to their supposed ability to deliver bond-like characteristics in a zero-yield world. Here are some of this group’s defining features:
- Mature blue-chip stature
- Strong competitive position
- Revenue and profits less prone to economic cycles
- Dividends to feed the hunger for yield
Eventually, these stocks showed another quality: they rose to valuations they may never have traded at unless something weird was going on. The ‘something weird’, of course, was that ultra-low interest rates had created this category of stocks in the first place.
Bolton’s advice to use a very long time period if you are studying historical valuations looks especially important today. Especially if you are looking at companies that may have boasted unusually high valuation multiples during the recent era of zero and even negative interest rates.
Using a long timeframe and thinking about the economic and financial conditions that led to different valuation levels could make something that looks like a ‘great buying opportunity’ today look a lot more ordinary.
I am not saying that the multiple I bought Diageo at is the only reason that my investment has performed poorly so far. After all, it has shared a couple more drab profit updates since I invested. I do think, though, that I could have applied more context to my assessment of its historical valuation.
Of course, historical metrics alone are not enough for you to assess the valuation of a company. My colleague Mark LaMonica compiled a checklist for valuing a share here.
