Lord John Lee: Making millions from British small-caps

When it comes to investing successfully in UK smaller companies, Lord Lee of Trafford needs little introduction. Famous for being one of Britain’s first ISA millionaires, he invested around £150,000 in tax-free wrappers over the course of 17 years after personal equity plans were first introduced in 1987. His investments took him past the million pound mark in 2003 and his portfolio is now worth considerably more.

Lord Lee credits his success to a patient, common sense approach to investing in smaller companies. He takes positions in attractively valued, good quality, high yielding shares. Many of them he buys and holds for many years, often with no intention of selling.

He’s an evangelist for individual investing and played a role in opening up the predominantly small-cap Alternative Investment Market to ISA investors in 2013. He is also a strong believer that investors should take every opportunity to get face to face with company executives. In 2014, he wrote about his investing successes (and failures) in a book called How to Make a Million - Slowly^[1].

Lord Lee, what do you think it takes to be successful in the stock market?

I believe that the stock market is much more simple than people imagine, and I encourage people to back their own judgement rather than go into funds. There are only two things you need for successful investment, and that’s patience and common sense. Patience I think is number one and it’s something most people don’t have. They see a profit and they want to take it. In a way, modern technology actually encourages more of that short term trading activity. Days before we had instant prices and instant coverage people would invest in a share and almost forget about it for years. Now you can press a button and the prices instantly come up. If you have got patience and common sense and are prepared to put some time to it, you should be able to do reasonably well.

In all my articles I have always tried to simplify the stock market for people. In some ways I suppose the one thing I regret in life is that I never started a fund that people could invest in. But because I focus very much on the small-cap sector I think I have brought to the attention of a lot of private investors companies that they had never heard of before. I have always been very honest in terms of saying when I got things wrong, as well as what was successful.

It sounds like you’re fond not just of investing but of the mechanics of how businesses work, particularly British manufacturing and engineering firms. Would you agree?

Yes, I’m very proud and believe that we have far more good businesses in this country than people imagine. People say we have no manufacturing, and of course we have lost some big sectors, but there are still some excellent businesses in this country.

Is it a source of frustration that these generally aren’t the sorts of companies that you see floating on the stock market these days?

The days of old, when established companies were coming to the market in a traditional form, have almost gone. Now the companies that are coming to the stock market are either near start-ups or in many cases have been in private equity hands. In other words, businesses that have been built up and have a profit record and come to the market with an offer for sale to the general public are very rare these days.

Which means that investors are being presented with heavily indebted companies in frothy priced IPOs?

Exactly, and that’s why I rarely find any of the IPOs attractive. Obviously the private equity people are trying to get the last buck and sadly a lot of these companies are overloaded with debt, which I don’t like anyway, from any point of view. It puts these companies under great pressure, and I don’t like that either.

I like companies that operate conservatively, that are stewarded and have cash or low borrowings rather than being geared up to the hilt. So it’s very much a conservative style of investment and one that is designed to minimise the losses. That is the key - not chasing the profits but minimising the losses. Everyone will have some successes but the key is to avoid the failures.

The parallel I draw in various articles is with golf. Things might be going quite well and, bang, you hit a shot into the river or a shot into the woods and it ruins the round. With a portfolio the key is to avoid those losses and that’s what I think I’ve succeeded in doing with a very conservative approach to investing.

Do you think your passion for investing has made it easier for you to deal with emotional strains and periods of underperformance?

Yes I think so. There is obviously massive human content and input in a business. It is the people who are taking the decisions and running it. So to me it is all about understanding the motivation of those people and assessing them. That’s why I like going out to visit companies and talking to chairmen and chief executives. Not in terms of finding out any inside information, which is obviously illegal anyway, because I’m not worried about the short term, or what the results are going to be in three months time or similar. What I’m interested in, taking very much a long term view, is what the overall strategy is and whether the person stewarding the business is taking a long term view.

It’s very much a personal assessment and I’ve rarely been let down by individuals. The only problem of course is that by developing those relationships, which I’ve done over the years, if there is ever an occasion where you decide to sell those shares, you feel a bit of a heel cutting down the relationship.

Did your career in business and politics equip you well for spotting a suspect company boss?

Yes, I suppose that’s right but I also tend to be a little bit trusting and therefore I find that when I have been talking I usually come away more enthusiastic about the company. I ask myself: ‘are you being a little bit naive or are you having the wool pulled over your eyes?’ But I suspect the answer, generally speaking, is no. That’s because the process of selecting that particular company has eliminated a lot of the more risky companies and a lot of the more dodgy characters.

So I’m looking for ‘long fuse’ companies where I invest on a modest rating where there is a reasonable dividend yield and a modest P/E ratio. I’m hoping, I’m expecting, that over ‘x’ number of years there will be profits growth and hopefully a re-rating. So you get that double whammy that brings quadruple appreciation.

In addition, in the sectors that I fish in there is a tradition over the years of smaller companies being taken over by larger companies. I have been on the receiving end of about 50 takeovers over the years. I’ll really only invest in a company where the people running it have got good stakes in the business. Where they are professional managers or people starting the business, at some stage they normally want to capitalise on their life’s work. Of course their shares can be placed by a broker with institutions. But a placing would probably only be at the market price or at a slight discount. Whereas a takeover would generally produce a premium over the prevailing price. So those individuals are looking for an exit by way of a takeover. That’s why we get more takeovers, that’s the logic of it.

There has been a re-rating in the share prices of many smaller companies in recent years. Has that led you to rethink your approach of buying shares on single figure multiples and exceptional yields?

That’s quite true. The days have gone when good, small regional PLCs on single figure P/E ratios and yields of 6.5 - 7 percent could be found relatively easily. Also, the days when the stock market really fell in the 2008 period, when yields were up on really good companies to 9 or 10 percent, have also gone. That was a great buying opportunity.

This is where some sense of history comes into it. I remember back in the 1970s when I was running what was then termed a secondary banking operation, the stock market fell. This was when some builders and property firms went down and there were rumours about NatWest. No-one would buy any shares at all in the early 1970s. Top quality blue chips were yielding about 20% but no-one would buy. Soon afterwards the market turned around and the recovery was pretty dramatic.

So apart from those exceptional periods when there were very high yields, and I bought things like Clarkson on a 9-10 percent yield, and Fenner on a good yield as well, you’re right, there has been an overall upward movement in the market. Therefore, now I have to be content with a 3.5-4 percent dividend yield and a P/E of 10 or 11 rather than a yield of 6.5-7 percent and P/E of 6, 7, 8.

So one has to live with that. But even so, the key is getting in at the right price because value always comes through in the end. If you’re investing nearer the ground, it’s safer obviously if things go slightly wrong. I don’t like what I term, ‘investing on the high wire’, where you’re buying at P/Es of 20-plus as it were. Because if things go wrong, it can come down very, very sharply and you can lose a lot of money.

On the subject of market crashes, your portfolio took a serious knock in 2008. How did you manage your emotions at that time?

I don’t spend a lot of time worrying about the macro side of life because you can always talk your way out of investing at any particular time. You could say, ‘well heavens, who would invest now - there are problems with ISIL, China is on the decline, interest rates are about to rise’. You can talk yourself out of investing at any time. What I would say is that broadly, the world will generally become wealthier, the population will expand, people will want a greater quality of life, and the long term trends are encouraging. That’s subject of course to a major armageddon type situation. But if you think that’s coming along, what do you do anyway? Do you hide under the bed with a crate of whisky and a couple of bars of gold?!

So you have to work on the basis that we will get through these difficulties and there will be growth. But I’d preface that by saying that because of what I saw in the 1970s when the market really crashed and no-one was buying, I know that it can happen. I don’t know what will trigger it, but it can happen. Therefore, you don’t want to be caught in a borrowed money situation, and I’ve never borrowed. All I am interested in during the short term is the flow of dividends - and the capital value will hopefully take care of itself over a long period.

I’m very focused on companies paying dividends and what you can interpret from the announcement of a dividend. The main thing I’m interested in when a company has just reported is what it has done with the dividend. The decision on the dividend tells you three things. Firstly, it’s a reflection of the actual results themselves, the year that is being reported on. Secondly, it tells you what is anticipated for the next year - because only a stupid board would lift its dividend if it can’t at least maintain it next year. And thirdly, it tells you what the cash position of the business is, because they have to be in the position to actually pay the dividend.

In addition, when a company pays a dividend it gives a certain prop to a share price, as well. I don’t want to invest in a company where there is no dividend and it’s all hope and prayer stuff. And of course within an ISA, the reinvestment of the dividend for compounding has a massive impact over a period.

You’ve done very well from long-term buy-and-hold positions. It it the classic case that 20 percent of the holdings made 80 percent of the gains, or is it more evenly distributed?

I think it’s rather more evenly spread than that. I have had some spectacular successes but when I look at the portfolio now - both my ISA and non-ISA portfolio where I have not sold because it would trigger capital gains tax - there are a lot of holdings that are showing five, six, seven, eight, nine times appreciation. There are no real loss makers now, although there have been loss-makers in the past, don’t get me wrong.

What I’ve learnt is to apply a 20 percent stop loss. If you have got it wrong, take it on the chin and get out as quickly as possible. Not only is your loss likely to get worse, but it knocks your confidence. Every time you look in the portfolio, you see that share there showing a 40-50 percent loss and it pricks you and draws blood. So get rid of it.

Stop losses divide opinion among many investors. You discuss the merits of a 20 percent stop loss, but is that a fixed instruction to sell or just personal discipline?

Historically I have never used stop losses and I now realise that had I done so I would have done rather better. Fortunately there have not been too many losses in recent years, so I have come to stop losses relatively recently. But the answer is that I don’t instruct a broker. I would judge each case on its merits, there may be exceptional factors. There may be a general crash in the market, for example, and I wouldn’t want everything to be disposed of. Having incurred costs building up the portfolio, I wouldn’t want that. I think a 10 percent stop loss, which many people have, is too limited. So 20 percent is more realistic, but with discretion.

You have written that on occasion you’ve held on to positions for too long before selling. Have you changed your approach to the way you deal with losing positions?

Yes, at the end of the day no-one is perfect and it’s not a science. Events that one can’t foresee will all of a sudden come along. Who would have thought that the price of oil would have slumped to the level it has done? All logic would have said that the world is growing, industrial demand is increasing, the population is increasing and therefore the price of oil should, over the long term, tend to rise. There isn’t a living economist who forecast that it would slump to anything like this level. So that’s why I operate below the macro and focus on the particular company.

You have also mentioned in the past the frustrations of selling stocks like Clarkson and James Cropper too soon. Do the missed opportunities still sting?

Selling too soon is my biggest mistake. But on the other hand, the monies I got from selling those shares I invested in other things that have done reasonably well. I have never worked it out from a mathematical point of view, but as a generalisation I have sold good stock too soon. So I say to people that if you are into something that is good, stay with it unless that which you are going into is demonstrably better. Value will always come through in the end; it could take years but it will come through.

If you were starting out today, would you change anything in your approach to investing?

If I were to make 10 new investments now, I’d be very disappointed and very angry with myself if more than one was a total failure. I would expect two or three to do exceptionally well, two or three to do reasonably well and two or three to break even and maybe one to be disaster - and even then I’d be angry with myself. That’s after 50 years of endeavouring to hone one’s technique and improve.

The principles of business remain the same. Companies should be cash rich or low on debt, the management should have a big stake in the business, there aren’t frequent board changes, you can understand the business and it has some sort of profits record. But it’s one type of investing. There are obviously people who specialise in investing in the biotech sector or the exploration sector. They can do enormously well if things go right but they accept that a number of their investment will go the other way. But I’m fishing in a different sort of river.