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:
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.
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
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.