Why Smith & Nephew’s Good Results Could Be Bad News

Smith & Nephew (a FTSE 100 medical equipment maker) recently released its annual results and managed to please Mr Market.  It did this by increasing revenues, margins and adjusted earnings, which was better than many had expected.

Suitably impressed, Mr Market responded with a four percent rise in the share price.

AstraZeneca, on the other hand (a FTSE 100 drug maker and a stock I have reviewed before), met with a much harsher fate by merely matching expectations, which are generally pretty glum anyway.

Overall, the market expects one company to do well in the next few years and the other to have a very tough time.

Massive Valuation Differences

These differences of opinion have caused a massive difference between the valuations of the two companies.  Whether these differences are justified or not will only become clear in the years ahead, but at the moment, they are striking.

Let’s start with the Smith & Nephew chart:

smith and nephew chart

That’s a pretty good-looking chart which will probably please long-term shareholders.  It’s up by something like 60% in 10 years, which gives a compound growth rate of about 5%, and of course, there would be dividend income too.

So if you jumped on board yesterday or today, what exactly are you getting for your money?

Good, solid and consistent long-term growth

Smith & Nephew is a world-class company, there’s little doubt about that.  It has produced good results for many years, with long-term earnings per share growth of around 11%.  You can see the per-share results in the table below:

smith and nephew table

Companies don’t produce results like that unless they have a solid competitive advantage in a growing industry.  So the underlying company is good and perhaps excellent, which is always a nice place to start.

But what about the price?  It may be a good company, but buying good companies is only half the story in our efforts to beat the market.

A high price relative to historic earnings

The price today is about 21 times the 10-year average earnings.  This isn’t horrendously high (Ben Graham suggested a maximum of 20 times), and some companies can carry off this premium price if earnings can continue to grow for long periods of time.

In fact, this stock was more expensive (relative to earnings) back in 2002 and look at the share price since then.  But still, a high valuation is a risk because any drop in growth can result in the shares falling a long way, leaving investors with a capital loss for many years.

A weak dividend yield

How much you care about dividends may depend on what kind of investor you are.  But regardless of personal opinions, dividends are a very handy source of additional reliable returns.

In this case, the company has paid a dividend very consistently and has increased it in just about every year of the last decade.  Both of these are very good signs and what I’d expect of an excellent company.

The problem, though, is size.

The current yield is less than 2% which does not stand up very well to many other companies of similar quality, and it also fails to match the yield of the FTSE 100.  It provides little downside protection if growth falters.

If the yield was closer to 6%, as it is for AstraZeneca, then it’s doubtful that the share price would fall much further, assuming the dividend was maintained.  Even if the share price did fall, you’d have a yield of over 6% as compensation in the short and medium term.

No stock is an island

There is no point in analysing a stock in isolation.  Each stock has value only in relation to what else is available, whether that’s bonds, other stocks, index tracking funds or perhaps even actively managed funds.

Compared to the FTSE 100 and AstraZeneca, Smith & Nephew stacks up like this:

smith and nephew comparison

Taking the simpleton’s route to total return estimates by just adding long-term growth to current dividend yields (which is, of course, naïve, simplistic and probably just as good as anything else), then we get estimated total returns of 12.4% for Smith & Nephew, 19.9% for AstraZeneca and 8.5% for the FTSE 100.

If you want to get clever with it, then you can double count dividends, as there is a general rule of thumb which says that cash in the hand (the dividend) is worth twice as much as the promise of future cash (earnings growth).  However, that still doesn’t help Smith & Nephew, as dividends are the weakest part of its investment case.

Only spend time on obvious bargains

Life is short enough as it is without wasting time analysing investments that are not obviously cheap.

In this case, although there is much more to do in a full analysis of Smith & Nephew, from the numbers above, I don’t think it would be worth it.

With a ballpark total return figure only 3.9% better than the FTSE 100, and yet with all the additional risk that comes with owning a single stock rather than a basket of 100 large-caps, I don’t think the recent good results are anything to shout about for new investors.

For owners, the recent good news is indeed good news as it increases their net worth and provides a possible selling opportunity.

Prospective buyers, on the other hand, may be better off waiting for the company to miss estimates and fall in value before considering a purchase.

Author: John Kingham

I cover both the theory and practice of investing in high-quality UK dividend stocks for long-term income and growth.

5 thoughts on “Why Smith & Nephew’s Good Results Could Be Bad News”

  1. Ha, I really regret not buying S&N under £6, as I’ve had it on my radar for ages but had nothing I wanted to sell to buy it! 😉 There are other things that may be supporting the price here, principally a takeover. One might also consider looking at the US rivals (Zimmer, Striker, et al) as a better comparator than AZN as I think the business models / challenges are different, although the sector is the same.

    Still, you’ve made me feel a bit less like one got away.

    Like the new site design, btw.

    1. Hi Monevator, thanks re the design. I thought the other one was a bit harsh and authoritarian.

      AZN was mentioned for comparison mostly because it got a hard time in several of the same press articles that were praising S&N, so that’s really the point of the article. It’s the old ‘buy on bad news sell on good’ thing that seems to be eternally true.

      And you never know, the CEO might sneeze or something and cause a 20% drop in the price at which point you could get in (although I think I’d need nearer a 50% drop before getting excited).

      I’d still rather have Tesco any day of the week.

  2. John

    I owe both stocks, although S&N is a bit too expensive and AZN probably a bit too cheap. Myself, I am not a dividend chaser, I am happy to let the company reinvest is CROCI is well above the cost of capital so your dividend comments are of little importance to me.

    The reason I hold both is that they are in one of my favorite sector, healthcare. In my oppinion there is space for growth here, even space for a little bubble and why not.

    Why we should have bubbles only for tulips, dot.coms, banks & property prices. Why not for some saving life (eternal life) remedy?

    Only an oppinion. Thanks

    1. Eugen, totally agree that health is likely to be a growth industry for a long while yet. Not sure about the bubble thing, but even though I said S&N is a bit pricey for me that doesn’t mean it won’t be a good investment as there’s perhaps 10% growth plus 2% dividend. It just needs to maintain the premium rating otherwise a downward revaluation might take away all the gains from dividends and earnings growth.

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