Case Study: Interserve investment returns 117% in 2 years and 4 months

Interserve is a FTSE 250 listed support services and construction business with a current market cap of £651 million.  It’s a steady company in a relatively dependable industry, and it makes profits every year while diligently paying a growing dividend.  To most investors, it probably isn’t that exciting, and it looks no different to so many other companies.

However, by snapping up the shares in early 2011 at 246p, the UKVI model portfolio has profited to the tune of 117% in just over two years, with 96% coming from capital gains and 21% from dividends.

Interserve Chart

The chart is from ShareScope, which is used to track the model portfolio, including dividends and expenses.

How those results were achieved

Step 1 – Find a quality business

To get high returns for relatively little risk, it pays to stick with high-quality businesses.  Quality drives everything else.  Quality companies earn more profits, pay more reliable dividends and are more likely to grow in the years ahead.

Quality is an elusive concept, but Ben Graham summed it up well when he said that defensive investors should stick to large, prominent and conservatively financed companies with long records of dividend payments.  He also said that a growing company, all else being equal, was obviously preferable to others.

So how did Interserve fit that bill?

  • Large – Back in early 2011, Interserve had a market cap of around £330 million.  That’s far from huge, but it’s not what most people would call small, either.
  • Prominent – In its own words, the company is “one of the world’s foremost support services and construction companies” and operates in America, the Far East and Australia, as well as the UK.
  • Conservatively financed – In 2011, the company had debts of £100 million.  That was conservative when compared to its market cap (£330 million) or earnings (in the £60-80 million range).
  • Dividend-paying – Interserve had paid a dividend in every year of the previous decade.
  • Growing – A consistent record of growth has led to revenues, profits and dividends virtually doubling in the last ten years.

In summary, Interserve was a quality company with a good history of growth, profitability and dividend payments.

Step 2 – Buy when the share price is low

If investing were just about finding good businesses to invest in, it would be easy.  The reality is that the price paid is just as important as (and possibly more important than) the quality of the business.

All investors should know that no business is worth an infinite price, and so a good price for a business is somewhere between zero and infinity, and all else being equal, a lower price is better.

The problem is knowing what ‘low’ means.  Low relative to what?

Given that the goal is generally to beat the market, it seems sensible to compare an investment candidate against the market, as well as any other potential investments, and that’s precisely what the stock screen does.

Compared at the time of purchase, Interserve and the FTSE 100 looked like this:

March 2011Interserve at 246pFTSE 100 at 5,990
10-yr growth rate6.8%4.1%
PE10 (using 10-yr earnings)7.715.8
Dividend yield7.3%3.0%

Clearly Interserve has a better growth track record, is much cheaper (measured by PE10) and has a vastly superior yield – in fact, the return from dividends alone is more than twice that on offer from the large-cap index.

Of course, there’s more to an investment decision than just looking at the numbers, but running through the ten or so checks in my investment checklist confirmed that Interserve did indeed match up to Ben Graham’s defensive value ideals.

Step 3 – Earn dividends by being patient

Most investors focus far too much on the short-term, on the day-to-day noise from the market and the day-to-day noise from the media.

In the short term, the market is too efficient for investors or traders to consistently earn market-beating risk-adjusted returns.  However, in the longer term, the market is less efficient because almost nobody looks at the long term.

To make sure I keep my eye on the horizon at least five years into the future, I always imagine how I would feel if I had to hold an investment for five years with no chance to sell.

If I’m happy that I have a quality company and that the price is good, and if I’m also happy to hold the shares for five years with no chance of selling, then I’m happy to buy them.

If I don’t feel comfortable with the idea of holding the shares for at least five years, then I shouldn’t be buying them in the first place.  That doesn’t mean I will hold them for five years; I just have to be happy with the idea that the holding period could be that long.

You would think that doing nothing is easy.  You just buy the shares and sit on them while the company (hopefully) grows and the share price bounces around.  But it isn’t easy.  In fact, it’s one of the hardest things for most investors to do.

My general suggestion is to switch off the news and play golf, go fishing or read a book.  Go and enjoy yourself doing something else.  Just do anything but watch the markets on a daily or even weekly basis.

However, if you cannot tear yourself away from your portfolio, then there is one fun thing that you can do, and that’s watching your dividends pour into your account.

With almost 30 stocks in the model portfolio, dividend payments come in almost weekly, and during its 2-year holding period Interserve has produced an income of 21% on the original investment.

If you’re going to be sitting around doing nothing, then you might as well get paid to do it.

Step 4 – Sell when the share price is high

The final step in the investment process is to sell if the share price moves up “too much”, making a once cheap investment relatively expensive.  When that happens, my policy of Continual Portfolio Improvement kicks in, and the shares are sold and replaced with something more attractive.

In Interserve’s case, the growth rate has dropped slightly from a couple of years ago to 6.2%, but the PE10 valuation has shot up to 17.9 (the FTSE 100 is at 13.6), and the yield is now just 4.1% (the FTSE 100 is at 3.5%).

Although Interserve is still more attractive than most shares, it is no longer at the cutting edge in terms of growth, valuation and income potential.  When it comes to consistently profitable, growing and dividend-paying FTSE All-Share companies, there are better alternatives out there.

The answer is to sell, lock in the 117% profits, feel lucky to have achieved 45% compound returns, and re-invest that capital next month into another potential high-return, low-risk investment.

Important lessons

  • Know beforehand what you want from your investment.  In my case, I’m after relatively low risk but with the potential to generate more income and growth than I would get by investing in a passive market index.
  • Focus on good businesses.  Those that have been profitable for many years and have paid dividends for at least every one of the last ten years.  Also, favour companies that have grown, and consistent growth is better than haphazard growth.
  • Avoid companies with lots of debt.  Although debt can be a good way to lever up a company’s earning potential, it also brings with it a lot of risk and uncertainty.
  • Buy low.  If you were buying an investment property, you would haggle the price down as much as possible.  The same applies to the stock market.   Lower prices equal higher returns.
  • Be patient.  Pretend you are a property investor (or perhaps you are).  They usually have the right mindset, or at least a better one than most stock market investors.  If you bought a buy-to-let property, you would probably see it as a multi-year investment.  In that regard, stocks are no different than property.  Invest with the idea that you could be holding the shares for many years.
  • Sell high.  Sticking with the property investor analogy, if you bought a house for £100,000 (mortgage-free), which yielded a cash-in-hand return of £5,000, you would have a return of 5%.  If another investor offered you £200,000, you would have two options: 1. Refuse to sell because you are a buy-and-hold investor, or 2. take the £200,000 and invest in another property which also yields 5%, which would therefore give you a cash return of £10,000 instead of your existing £5,000.  This sort of thing happens all the time in the stock market, and Interserve is a good example.

Author: John Kingham

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

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