Armour post-mortem

I don't enjoy picking over the bones of a failed trade, but it's important to learn lessons. A 70% loss on consumer electronics company Armour goes back to a rush of blood to the head in February 2010.

It's a story of two statistics, the long-term PE and the F_Score, and a heavy dose of wishful thinking.

When I added Armour to the Thrifty 30 portfolio the shares cost five times average earnings, which, assuming profits in future get close to matching profits in the past is remarkably cheap. The F_Score, a measure of financial strength, was a middling five out of nine.

Taken in isolation that makes Armour look like a reasonable bet. Look at the statistics within the statistics, though, and it begins to look more risky.

Take the PE, in my notes I recognised past profits were a shaky foundation for valuation. As I said:

The big question is whether that mountain of profit, much of it retained by the company to fund future growth and accounted for in shareholders' equity is a one off.

And I based my confidence that it was not on the rather feeble observation that:

If the company is as successful predicting what its customers, 6,000 UK retailers, commercial vehicle manufacturers and house builders, want as it was in last decade, then profits should recover'

That's wishful thought number one.

The company had made much of its money supplying hands-free kits for mobile phones in cars thanks in part to a temporary boom fuelled by legislation banning hands-on use. From 2003 it used that money to put together a home-audio division from acquired brands.

Since much of future profitability (or lack of it) would come from the new home division, I shouldn't have used past earnings as the basis for my calculation. It was a different company by 2009.

Neither was my confidence in an F_Score of five out of nine justified. I tried to justify it, by observing the company was profitable and debt wasn't rising, but that allowed me to skate over the fact that profitability and profit margins had fallen dramatically.

That's wishful thought number two.

I added the shares to the portfolio on the basis of a wishful valuation, and at best mixed signals about Armour's performance. Why?

As I intimated on Friday, I think I was influenced by the fact that I had bags of cash in a bull market. In February 2010 the Thrifty 30 was only five months old and only half invested. I, subconsciously, felt under pressure to populate it before the market ran away.

I used superficially encouraging statistics to justify a decision I was slightly uneasy about, because I was following instinct and not logic. If only I could have expressed it in these terms then, I wouldn't have done it. Things are clearer in hindsight.

The decision to add more shares in January this year was perhaps more forgivable, because the company had staged a minor recovery (the F_Score was seven) and the share price had almost halved, but I was still allowing myself to believe it was cheap on the flimsy basis of past, and largely irrelevant profits.

Maybe I should have seen the placing in January as a harbinger of the profit warning in April and the raising of more debt in July, but it was couched in terms of growth at a time the company was apparently recovering and the subsequent decline in trading seems to have wrong-footed management as much as it wrong-footed me. Armour opened a new factory in China to meet increased demand in January, only to close it in May at a cost of half a million pounds.

If I'd ejected Armour in April (I had the chance), once it was clear the company's recovery had reversed and the company would make a loss, I'd have got just a penny more per share than I did yesterday. The damage was done.

It's uncomfortable 'fessing up, it would be easier to blame the sudden and unexpected loss of consumer confidence (as Armour does). But the reality is, this loss goes back to that day in February 2010 when I evaluated a bundle of facts, and came to the wrong conclusion.

In future I'll be more wary of the biggest risk of them all: The risk I'm kidding myself.