Chemring and the dangers of growth by acquisition

Chemring was one of the very first investments I made as a defensive value investor back in early 2011 and today that lack of experience definitely shows.

Compared to the thoroughly road-tested and comprehensive investment strategy I use today, my strategy back then was basic and untested. But in order to learn, improve and eventually reach your destination you have to take those first few faltering steps, and Chemring was one of mine.

On the face of it, this investment in Chemring has been a complete disaster. More than three-quarters of the capital value has evaporated and the meagre dividend has done almost nothing to offset those losses.

Here are the gory details of what my son would call an “epic fail”:

  • Purchase price and date: 689p on 18th April 2011
  • Sale price and date: 141p on 5th September 2016
  • Holding period: 5 years and 5 months
  • Capital loss: 78.4%
  • Dividend income: 5.5%
  • Annualised loss: 23.5%

However, simply bemoaning this investment’s horrendous returns would almost entirely miss the point.

Yes, Chemring has performed terribly in terms of capital losses and dividend income, but as an educational platform it has provided me with a rich seam of mistakes to learn from and, thanks to the magnitude of the losses, I am unlikely to forget those mistakes anytime soon.

Over the last few years, I have weaved each resulting lesson into my investment strategy and I believe Chemring has already had a significantly positive impact on the model portfolio‘s performance.

Unfortunately, this education does not come for free. It requires holding onto losing investments for long periods of time and that is never going to be fun, as the chart below illustrates:

Chemring share price chart 2016 09
Chemring’s decline highlights the importance of diversification

Buying what I thought was an outstanding growth company at a reasonable price

Back in 2011 Chemring (a leading designer and manufacturer of primarily short life-cycle defence equipment such as flares, chaff, bullets and missiles) was riding high on a huge wave of success.

Over the previous decade, its revenues, earnings and dividends (adjusted for splits) had grown by an incredible 520%, 1,950% and 760% respectively. As a result, the company had a jaw-dropping ten-year annualised growth rate of 34%.

Although I’m not a growth investor, growth was (and still is) an important factor in not only choosing which companies to buy, but also in deciding how much to pay for them, and Chemring certainly had a lot of growth.

Chemring performance 2016 09
Chemring had a track record of explosive growth

At the time I used a now-defunct ratio called PEG10, which I had invented. It was the ratio between a company’s current PE ratio and its ten-year growth rate and my rule was that its value should be below one.

With a PE ratio at the time of just over 16 and a growth rate of 34%, Chemring certainly looked attractively valued according to that metric.

Other factors I looked for were:

  • Consistent growth (a qualitative measure)
  • Growth of more than 50% in book value, earnings and dividends over ten years
  • An expected rate of return of more than 15%/yr based on the sum of the current earnings yield (earnings divided by price) and ten-year earnings growth rate

These are the forerunners to the growth quality, growth rate and valuation ratio metrics I use today, but they were far less battle-tested and I think far weaker.

Time and an evolutionary approach have moved my investment strategy on a great deal and the Chemring of 2011 would fail to pass my current “buy criteria” on a number of fronts.

  • Error #1: Paying too much for growth

There are two big problems with combining the PEG10 ratio with a rule that it should be below one.

  • First, it relies on the current PE ratio and therefore compares price against the company’s current earnings. But current earnings may or may not be representative of what the company can earn across the business cycle.
  • Second, looking at the ratio between PE and ten-year growth rate suggests that almost any PE ratio is acceptable as long as growth has been rapid enough.

In Chemring’s case its ten-year growth rate of 34% meant that even quite lofty PE ratios would look attractive according to PEG10.

I did realise at the time that such a high growth rate was unlikely to be sustained for much longer, but I also thought there was a reasonable chance its growth rate could stay above 16% (although why I thought that I do not know).

Of course with hindsight that was baloney. The company’s growth rate instead turned negative over the next few years which completely undermined any argument for its then near-700p share price.

Had I been using my current approach to valuing companies, which puts a cap on how high a company’s price can be relative to its historic earnings and dividends, then I would never have invested in Chemring at anything like its then near-700p price.

For example, Chemring’s PE10 and PD10 ratios (price to ten-year average earnings and dividends) at the time of purchase were 45 and 142 respectively. Those are way above the maximum values of 30 and 60 that I have used since the start of 2015 and so Chemring would have been excluded on that basis alone.

However, I did purchase Chemring (at too high a price) and it soon became obvious that its future was unlikely to be as rosy as its past.

Holding on (but not panic selling) as Chemring’s world falls apart

Almost from the very first moment Chemring’s share price began to decline. In 2011 the world had only just emerged from the Global Financial Crisis and there were (and still are) concerns about the ability of governments to pay down the debts they’d taken on as they propped up the financial system.

As a defence supplier Chemring’s main customers are the US and UK governments and they are, unsurprisingly, usually willing and able to maintain defence spending regardless of the economic environment; but this time it was different. The magnitude of the financial crisis led many governments to review all of their spending plans, including defence.

The first real signs of trouble came in late 2011 when the company announced that the US Budget Control Act of 2011 was having a significantly disruptive effect on its US business, with delayed and potentially cancelled orders.

Although the company’s 2011 financial results were not particularly bad they did fall far short of the market’s previously lofty expectations, and that alone was enough to cause a major decline in the share price.

The story of government cuts continued through 2012 and by the end of the year the CEO and CFO had been replaced. Unfortunately this brought little in the way of stability and within a few months both the new CEO and new CFO had also departed.

The full 2012 results were pretty dismal and announced the first of many dividend cuts. Since then the story has remained much the same and Chemring’s results have declined in almost every year.

There are of course many reasons why Chemring went from hero to zero in a few short years and why its dividend has been cut in every one of the last four years. There will be all sorts of detailed technical reasons for this or that contract not being won, or for operations not being efficient or competitive and so on.

But from my perspective there are two main problems that Chemring had in early 2011 that are obvious to me now, but about which I had little understanding at the time:

  • Error #2: Buying a company with too much debt

In 2011 I still used the industry standard net debt figure (borrowings minus cash) when looking at how exposed a company was to its lenders. I have long since dropped that metric as being unreliable and instead focus now on a company’s total borrowings compared to its recent earnings (which I call the debt ratio).

At the time Chemring was carrying borrowings of £366m and its post-tax normalised profits had averaged £50.4m over the previous five years.

That gave the company a debt ratio of 7.3 which is a long way above the maximum of five I’ll accept today (and that’s for defensive companies like Chemring; cyclical sector companies are only allowed a maximum ratio of four).

So with the benefit of experience I can now see that Chemring was carrying a dangerously large amount of debt when I bought it in 2011.

The problem with excessive debts is that during the good times they don’t look excessive, as bumper profits can easily cover interest payments and keep lenders happy that they’ll get their money back.

But when things get bumpy, as they did for the defence industry from 2011 onwards, those debts can quickly become about as helpful as concrete shoes in a swimming competition.

In this case, having started out telling investors in 2010 that it had a “strong balance sheet”, Chemring gradually admitted that reducing debt was more and more important.

Eventually in 2015 it announced a rights issue in order to “assist the Group with reducing its indebtedness thereby enabling additional time and resources to be made available for further operational improvement and adequate investment in fully capturing the longer term growth opportunities available to the Group”.

But high debts weren’t Chemring’s only major problem. In fact I would say a bigger problem was the fact that its dramatic growth record had been built on the back of an aggressive acquisition spree.

  • Error #3: Buying a company that had recently made multiple large acquisitions

Over time I have gradually become more wary of large acquisitions for a few reasons:

  • They can be difficult to integrate which may lead a company to ignore or underinvest in its core “cash cow” business
  • They can be used to create the illusion of growth when the acquisitions are made with borrowed money
  • If the acquisitions are large enough you can end up with a company that is built largely from parts (the acquired companies) that you know little or nothing about

In Chemring’s case the company had been pretty much a growth-free zone from 1992 to 2002. In that period there were three years in which the company made large acquisitions (i.e. spent more on acquisitions than it made it profits that year), which is more than I would like but not unacceptably reckless.

However, 2005 brought a new CEO and a new and more acquisitive growth strategy.

In five of the following seven years the company spent more on acquisitions than it made in profits, and sometimes twice as much. During that period more than £450m was spent acquiring other companies compared to total profits generated of £350m.

Avoiding highly acquisitive companies is now a key part of my value trap analysis. If I was looking to invest in a company today and saw an acquisition track record like Chemring’s, I would immediately place it onto my “avoid” list.

That £450m acquisition figure is also considerably more than Chemring’s pre-2005 market cap of just £100m, which comes back to my third bugbear with acquisitions.

The Chemring I was buying in 2011 had an amazing (but somewhat short) track record of explosive growth, but that growth was not the result of a single super-successful business. Instead it was growing simply because the number of businesses within Chemring was growing as it acquired more and more of them each year with more and more borrowed money.

Perhaps a house of cards is a reasonable analogy. The house of cards grows by adding more cards, but as the house grows the risk of collapse becomes ever greater.

At least I understand this now and so I don’t expect to see such an aggressively acquisitive company in the model portfolio ever again.

Selling because Chemring is by far the least attractive holding in the model portfolio

After a very long and highly educational wait, Chemring has at last become by far the least attractively valued holding in the model portfolio.

As a result, and as part of my regular pattern of alternately buying or selling one holding each month, I have now removed Chemring from that portfolio and from my personal portfolio as well.

As usual I will be reinvesting the proceeds along with other spare cash into a hopefully far superior company next month.

Note: You can read the original pre-purchase review of Chemring in this 2011 blog post.

Author: John Kingham

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

24 thoughts on “Chemring and the dangers of growth by acquisition”

  1. A salutary and very useful lesson: thanks for sharing. We have all had these nightmares in our portfolios and the difficulty, as always, is how long to hang on. I do a quarterly review of my portfolio and before I sell a share I always ask myself ‘would I buy it at this price?’ and apply my own criteria to decide. I am not a believer in setting stop losses, although with a stock such as Chemring that would have been useful. Too many other times, though, I would have been thrown out of a position only to regret it very soon after. ‘Buy and hold’, whilst criteria tests are still passed, remains for me the best strategy, even though the occasional Chemring-type disaster will inevitably slip through. As you say, the thing is for us to learn from these mistakes and tweak our tests accordingly.

    1. Hi Chris, some excellent points you’ve raised there.

      Stop losses: I’m not a fan either. A 20% or even 30% decline tells you essentially nothing about what the future holds and I have also had several stocks go on to produce excellent results even after an initial 20% decline. I think that sort of cut and run strategy is more appropriate to higher risk smaller cap stocks rather than the usually lower risk larger cap stocks that I’m interested in, and even then you would miss out massively on the educational benefits of sticking with losers.

      Regularly asking “would I buy at this price?”: I also do this on a monthly basis, but I know that different investors interpret the answer in different ways. Some will say they wouldn’t hold anything they weren’t willing to buy today, so if the answer was no then they would sell. I’m more in your camp of “buy and then hold for as long as certain criteria are met”. In my case that means going primarily by my stock screen and although Chemring had long since failed several accounting criteria its valuation was good enough that it ranked fairly well on the screen. In recent months that changed and so Chemring was an obvious stock to sell as there was no compelling reason to hang onto it.

  2. The problem with your analysis is that you cannot analise a stock without the market in which it operates. In this case it was an average company which makes standard stuff that could be produced somewhere else (East European allies had massive increase in contracts with the US for the type of stuff this company produces) a lot cheaper. It had a good run based on the contracts for stuff needed in Afganistan, but as the numbers of people sent there decrease, there was less need for their products.

    With my Army background, Defence stocks are my speciality. For example the majority of defence stocks with high intelectual property had a very good run from 2011, one example is Raytheon and Co which tripled in price. But Raytheon makes rockets no other in the word produces.

    Stop loss orders are good also to get you out of trouble, expecially when the investment argument was more of a gamble either because you paid a bit more based on some expectations which did not realise or your analysis was wrong (lost the plot) as it happened to you with this stock.

    Sometimes it saves your skin when in your analysis you lost the plot, it happened to me a few times, once with Rolls Royce. In that case I did not realise that the market for A380 is not that big and there is a lot more demand for medium and short haul planes. I was able to buy RR back a lot cheaper and have now a lower allocation to this stock.

    My view is to set them at 20% but to look at this relative to the index. If a stock loses 20% relative to the market, believe there is something going wrong there and best is to sell and do you analysis after. Bu the time you finsh your analysis, you may be able to buy it a lot cheaper.

    1. Hi Eugen

      I agree that Afghanistan was a major reason why Chemring was able to acquire so many companies and grow so quickly, but I don’t think it’s the key reason for Chemring’s downfall.

      If Chemring had kept debts low and avoided making too many large acquisitions I think it would have had a smaller boom and a significantly (and perhaps virtually non-existent) bust.

      But you’re right though, the environment in which a company operates is of course an important factor which perhaps I should have mentioned (although the article is already 2k words long already).

      On stop losses, I like your idea of having a stop loss relative to a relevant index; I haven’t heard that idea before. I still wouldn’t use one, but having a stop loss of say 20% underperformance relative to the market makes much more sense than an absolute 20% decline, irrespective of what the market’s doing.

  3. John,
    One of today’s headline news reads “Trump calls for military spending increase”. Putting aside your bumpy ride with this company so far, do you think it may be trading at an attractive price right now, assuming Trump wins the elections and does what he says.

    1. Hi Michal,

      I try very hard not to buy or sell based on excessive speculation about the future. Of course all statements about the future are speculative, including that the sun will come up tomorrow; but that’s only very slightly speculative compared to basing an investment decision on what Trump might do, IF he becomes the US president.

      As for Chemring’s valuation, according to my stock screen Chemring isn’t trading at an attractive price, which is the main reason why I’ve sold it. Its problems with acquisitions and debts are another reason of course, and also why I wouldn’t re-purchase it at any price, but the main reason I’m selling is that the price isn’t attractive given its very negative results over the past decade.

      1. Agree with John.

        Even if Trump becomes US President, there is no certainty the company will get any contracts for the stuff they make. The same stuff is made a lot cheaper in Poland and Czech Republic but not sure they will get the contract either and probably with an increase of nationalism in the US the contracts will be given to local firms.

        It is also not clear that Trump will have the money to pay for them, expecially that he promissed to halve corporate tax in the US.

        Last, having someone out of his mind in the White House does not mean that the Congress will approve the increase in the Budget.

        To many ifs to base an investment “bet” in my opinion.

  4. Good honest analysis John, and a tacit reminder that the future of any company may not look like the past and it seemingly can turn on a sixpence. I agree with Eugen, it’s also very important to build into your analysis, on all stocks in a portfolio, a clear understanding of competitive threats and threats from technological change.

    I expect BAE and BT will go the same way, for not dissimilar reasons.


    1. Hi LR, actually BAE is my other defence stock and in contrast to Chemring it’s done very well over the past few years.

      In terms of fundamentals it’s done okay, but the capital gain and total return from 2011 have been very good. However, because of those gains the valuation and yield aren’t so interesting anymore and it’s currently on my “might sell soon” list. So hopefully I’ll have gotten out before your negative expectations materialise!

      1. BAE might climb higher, but with a flat revenue for 5 years, negligible cash flow, P/E now double what it was in 2011, and borrowings of £3.75Bn I’d be heading for the exit — had I not done so already.
        Borrowings have risen from £2.6Bn to £3.7bn or 45%, the share price has risen likewise, but the business hasn’t.

        Heh they could win enormous orders and convert them all to cash overnight, but the history doesn’t seem to show that’s ever the case.

        BAE is at a nice price — perhaps there are better companies that are less capital intensive, less dependent on government money, and have a better balance sheet?


      2. “perhaps there are better companies that are less capital intensive, less dependent on government money, and have a better balance sheet?”

        There most certainly are…

  5. Taken some profits recently from BAE and BT, but I will buy again on a weakness.

    BAE is a better company and has long term contracts for F-35 in the consortium with the US companies. F-35 seems to be “the choice” for every NATO country and probably it will also sell well to other US allies as well (Japan, South Korea, Australia) and in the Middle East (Saudi Arabia etc). The expectation is that over 1,300 will be produced and there are a lot of expensive services sold alongside the planes. It is expected that for the first time the services sold over the period the plane will be in service will cost two times the price of the plane.

    I also expect that the UK will renew their nuclear deterrent (Trident) and probably BAE will be the main contractor. With the increase in nationalism (Brexit, Turkey etc) I expect that the expenditure for defence in the NATO countries will increase at least to the 2% of GDP expected from 2017. Myself I am overweight on defense stocks, one name that I bought around 7-8 months was Dassault Systems (French nationalism – they will not purchase F-35) but I also own many US stocks in this sector.

    Probably John will remember me about the defined benefit pension benefit for BAE Systems, Dassault does not have any pension liability – this is a good competitive advantage added to the higher productivity for the French company.

    1. I own a couple of companies that supply parts for the F-35 and they’re looking forward to a long and healthy ramp-up up in their supply of related parts. I have to admit the economics of these long-term service contracts certainly look attractive, but RR shows that it’s not quite as simple as that.

      As for BAE’s pension, yes it’s huge and is another reason why I’m not looking to hold onto the company for longer than necessary.

      1. For RR there is a diferrent story, the A380 is not selling in the numbers expected. Instead medium curriers are selling way better and RR has not paid a lot of atention to this market.

        However at one moment last year in November the RR shares became very cheap i.e. 515p, and knowing the company very well I can see the share price was wrong. The company is now at fair value at 725p so I halved my holding already and not expect too much upside however I believe I stand a better chance to sell higher when the new results for this year are announced as they are going to be good because of GBP devaluation against USD. As a result I believe it still offers an asymmetric risk in terms of possible loss and potential reward.

        It would be the same with BAE Systems, should the orders for F-35 do not pick up in the numbers expected. I am not really expecting that because there is no other alternative/competition, however the Trident replacement, although I believe it will take place, could be postponed if there are Budget constrains resulting from Brexit.

  6. Everyone suffer from big losses John, but is how we bounce back that counts. I remember investing in MBL Group and saw a similar loss because of its juicy 10% dividend yield, instead should have focused on its reliance on one customer, W Morrison for 80% of its sales. Once that plug got pulled the stock cratered.

    Then again you come across winners like MCB Finance which gave me a return of 500%+.

    So, losses and profits come with the investment territory.

    However, reading your article, I can think of one metric which is total military spending growth rate from 2000-2011 in the UK and US and compare it with Chemring growth.

    Or, the coming maturity of Chemring means slower growth in the future.

    BTW, thanks for sharing.

    1. Bouncing back wiser is the most important thing, as Howard Marks would probably say.

      As for MBL Group, I invested in that one as well, back in 2010/2011. I think it was the last “deep value” stock I bought. Its demise made me say “never again” and hastened my conversion to defensive value investing.

  7. Hi John

    Great article, thanks

    The stop-loss & when to sell discussion is interesting, and is an opportunity to learn from you & the other commenters. Although I don’t use stop losses myself, I do watch for falls and when found I take this as a cue to review my original reasons for buying to see what has changed if anything (I also review all holdings at semi-regular intervals). Also to limit churn I still don’t sell if only one or two points on my check-list are missed, depending on how important those points are (not all points on my check-list are equally important). This means I might sell more than one share in a month (although normally I don’t sell anything for months at a go).

    So this brings me to a question. You are famous for your regular pattern of alternately buying or selling one holding each month; so would you have sold Chemring any sooner if you did not have this policy in place? Do you regret not selling Chemring before it achieved the lowest ranking position in your screen? I ask because like many, my formula for when to trade is based on criteria rather than time, and I’ve often wondered if I should follow your example and try to make it more driven by time.

    Cheers, Ric

    1. Hi Ric, good question.

      Chemring has been the lowest ranked stock almost every month since February, so I certainly haven’t rushed into selling it even with my time-based selling rules.

      Despite Chemring being ranked lower, I chose instead to sell Hill & Smith in March and Reckitt Benckiser in July (I also sold Tesco in May but that had failed to pay a dividend for a whole year which made it an automatic sell).

      I sold HS and RB before Chemring because I wanted to lock in good returns on those stocks. I think that’s fair enough, but I do admit there is some irrationality in there as well and I certainly wasn’t looking forward to locking in Chemring’s losses.

      With no restrictions on when I can buy or sell I think I might have offloaded Chemring a bit sooner, and probably at a higher price. And I do regret not selling Chemring sooner, but only in the same way that I regret not picking last week’s winning lottery ticket (i.e. not very much).

      In my decision to sell Chemring when I did and my decision not to play the lottery last week, I think I made the best decision I could, given the information available at the time.

      As for my regular buying and selling regime, I like it. I like its metronomic nature and I find that there are significant psychological benefits to always knowing what I’m supposed to be doing and when. Given a world in which I know what season is coming next or one where I don’t know, I’d pick the former every time.

  8. An interesting insight John, thanks!

    It is interesting you’d rather sell to lock in profits than sell a loser. My natural tendency is probably slightly tilted towards the opposite, and I still hold RB even although I know it is over priced and fails some other criteria such as the poor current ratio.

    I’ve never yet played the lottery, and like you I’ve no regrets there!

    On reflection, I’m not sure I’ve got the right psychological disposition to cope with your ridged rules, I think I’d rather live with a little uncertainty than feel obligated to do something each month. Your way is probably better in theory, but knowing one’s own biases and styles and working with them is probably important too, therefore I’ll probably stick with my current style for now. Thanks anyway 🙂

    Cheers, Ric

    1. An important point Ric. Adapting to your own preferences is critical:

      “If a man does not keep pace with his companions, perhaps it is because he hears a different drummer. Let him step to the music which he hears, however measured or far away.” – Henry David Thoreau

  9. A wealth of thought provoking comments and responses!
    Surely it is the more difficult decision, when to sell, or more correctly at what price level to sell?

    Am always fascinated by investors of old, and recently read :-

    “I have done only what other people wanted me to. When they were determined to sell their stocks in a falling market at whatever prices they could get and clamored for buyers, I accomodated them by buying. When they were equally anxious to buy stocks at high prices, I agreeably permitted them to buy mine”

    A “famous speculator” quoted in ‘Why you Win or Lose’.
    Fred C Kelly 1930

  10. Yes, Magneto, there’s a lot to be said for contrarian investing ‘Buy the Fear and Sell the Greed’. There only remains the conundrum of at what degree of fear or greed?!

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