A Long Standard Life

I soon found a good example to illustrate my short term vs long term forecasting point. Standard Life reported their 2007 results this week and left many analysts gasping by the strong out performance - EEV operating profit up 43%, new business contribution up 68%, diluted IFRS underlying EPS up 53% were the best indicators with all financial targets being exceeded. Mind you it is a wonder anyone tries to forecast the results for life companies given the complexity and reporting under two separate bases; European Embedded Value (EEV) and traditional accounting (IFRS). In addition results are greatly impacted by assumptions about future investment returns, discount rates, mortality rates, policy lapse rates and so on.

However despite these strong results analysts were then left very perplexed by the meagre 6.5% increase in the cash dividend announced. Yet you didn't have to dig very deep through the presentation slides to find the answer. Management noted that "normalised" IFRS profits (excluding all movements on reserves and provisions) increased by 7%. So whilst management did indeed pull a rabbit out of the hat for 2007 they have clearly shown a desire to set a precedent for dividend increases they regard as sustainable over the longer term. And of course life companies are used to thinking in that way.

It was also encouraging to see how management are focused on improving capital and cash generation (EEV capital and cash generation after tax up 129%) and exceeded all their efficiency targets. All good for Shareholder Value.

Another Piece of Buffettology

This is a summary of the Buffett like thinking which led to my enthusiasm over Drax. For clarity I've written this as a separate post although it underpins my approach to Drax.

In short, my view is that most investors place too much reliance on their ability to forecast and by increasing the perceived, and misplaced future certainty this leads them to place a higher value on the business concerned. But in times of great uncertainty the rug is firmly pulled from under the feet of such investors and pricing becomes very difficult inevitably leading to undervaluation. The trick therefore is to accept the short term uncertainty which is always there, just not recognised and focus instead on the longer term looking for reliability of outcome through sustainable competitive advantage plus value to shareholders via return on capital. Probably no one will fully understand what I am trying to say here since it turns traditional short term thinking on its head.

Postscript: Just came across these words of John Maynard Keynes; "An investor who proposes to ignore near-term market fluctuations needs greater resources for safety". For that reason I never use leverage nor trade on margin.

Simple But Powerful

Increasingly I try and benchmark my new investment ideas against what I would call Buffett Investment Principles. Usually I subsequently find out that each certainly wasn't a Buffett like investment but this process does at least help shape my overall thinking about what makes a good investment.

The inspiration I had today followed the Drax presentation to report on 2007 results. Drax is a very simple business with a single coal fired power station, by far the largest in the UK and which produces 7% of our electricity. These shares have been pushed down by investors spooked by the increased cost of coal (blame bulk shipping rates) and uncertainty about the future cost of carbon under the EU Emissions Trading Scheme. Simple it might be but Drax is affected by the cost of coal, electricity and carbon with oil and gas prices a part of the equation. These are very volatile factors and so there are just too many variables to make an accurate forecast of earnings over the next year, although Drax do hedge many exposures and this reduces the volatility. My interest is driven by some much simpler and more strategic factors:

• Coal has a strong future - management put global proven reserves at 900bnt which, assuming 6.5bnt pa production, suggests a reserve life of 140 years.
  


• In coal fired generation Drax is the low cost producer with the cleanest and most efficient UK plant.



• By being able to burn biomass Drax helps meet our Renewable power objectives



• Long term the UK energy supply market is tightening due to increased demand coupled with plant closures.



• Management put the cost of coal fired new build at £1,000 to £1,100 per kW. Thus the 4,000 mW of Drax would cost over £4bn to replace. This compares to a current EV of around £2.3bn.



• This is a focused business and management are committed to enhancing shareholder value through return of excess cash.

The message therefore is don't try and forecast all the variables but focus on the overall profitability driven by Drax as a highly important and strategic asset with capacity in a market increasingly becoming supply constrained. In the meantime the P/E is under 6.

Supporting Green IT

The past week has been very busy as seven companies I follow very closely reported plus there was the BP Strategy Review and Chairman's Letter from Berkshire Hathaway to digest. I'll come back to all that later.



But exciting news today was that iBase Systems, a small private software business I invested in a couple of years ago, was shortlisted for an award in the European Green IT Awards 2008. Being unquoted I wasn't going to write about iBase in this blog but since I have a close involvement if there is a chance to promote it in some way I should do that. The award category is "Use of IT to support Green process or people change": Our iTRACE product is now used throughout London to promote Green modes of transport use and so I think a well deserved finalist! Update: The other finalists are BP, Lexmark and London Borough of Hillingdon. It's great to be part of such a strong line up.