After almost six years BAE Systems, one of the first companies to join the UKVI model portfolio, has been sold.
In terms of raw numbers, the results look like this:
- Purchase price: 308p on 21st June 2011
- Sale price: 643.5p on 8th May 2017
- Holding period: 5 years 10 months
- Capital gain: 106.7%
- Dividend income: 34.9%
- Annualised return: 18.0%
In the rest of this post, I’ll cover why I bought it, what happened during its time in the model portfolio and why I’ve decided to sell.
Overview: Buy on fear, sell on optimism
As one of the world’s largest defence companies, BAE Systems joined the model portfolio in 2011 because it was – and is – exactly the sort of large, successful and relatively defensive company I’m always looking to invest in.
However, as a value investor, I’m also looking to invest when investor sentiment and therefore prices are low, and in 2011 BAE was facing serious headwinds in the form of reduced government budgets as a result of the financial crisis. In the UK and the US in particular (major markets for BAE), defence programs were either being cut, being reviewed in order to decide what to cut, or almost certain to be cut in the near future.
In addition, investors were worried about US and EU governments defaulting on their debts, which could have triggered another financial crisis. With all this negativity in the air, the FTSE 100 stood at 5700, much lower than it is today, and briefly fell as low as 5000.
At the time I thought these headwinds would turn out to be temporary. I thought that when they died down, BAE’s share price would return to more normal levels, and as the chart below shows, that’s exactly what happened.
Buying a high-yield dividend growth company during a period of uncertainty
The first thing I look for in a company is a long and consistent record of dividend payments. In addition, the dividend should preferably have been growing whilst being supported by relatively steady earnings and revenue growth as well.
In 2011 BAE ticked all of those boxes, as you can see in the chart below:
Although the company’s earnings are perhaps surprisingly volatile, the overall picture is one of rapid and reasonably steady growth, which continued right through the financial crisis. Relative to the FTSE 100 average, BAE’s track record over the previous decade had been impressive.
However, thanks to those defence budget cutbacks, BAE was also more attractively valued than the FTSE 100:
As a general rule, the stock market does not offer up companies with double-digit growth rates and 6% dividend yields without good reason. In BAE’s case, there were significant and self-induced internal risks to go along with those external budget cut risks.
One major risk was BAE’s massive defined benefit pension scheme. In the 2010 annual report, the company’s pension liabilities were more than £21 billion with a pension deficit of £3.1 billion. Those are huge liabilities, dwarfing BAE’s then-recent average profits of £1.2 billion.
In order to reduce the deficit, BAE had agreed to pay several hundred million pounds into the scheme each year. That’s a lot of money and is about as much as the company was paying in interest on its £3 billion debt pile.
On their own, those debts of £3 billion gave BAE a debt-to-profit ratio (the debt ratio) of 2.6, which I think is relatively prudent. But viewing the pension deficit as a debt, which is entirely reasonable, increases BAE’s 2010 debt pile to £6.2 billion. That’s 5.3-times the company’s average profits of £1.2 billion, which is above the maximum multiple that I would allow today.
However, in 2011 pension liabilities were not on my radar and so I did not factor them into my analysis of BAE’s debts. As a result, I did buy BAE and, as luck would have it, its pension deficit and the related cash payments have so far failed to cause any serious problems.
Holding on while BAE grew its dividend despite government cutbacks
As a value investor, I’m used to the idea that most of the companies I invest in will be issuing relatively negative updates, especially during the initial phase of an investment. In this regard, BAE was entirely typical. The 2010 annual report neatly summarised the negative outlook for the defence market at the time:
“Pressures continue on the US defence budget. The US Secretary of Defense recently announced a directive aimed at reducing funding for multiple programmes and services. Whilst these funding reductions and expected slowing or ultimate cancellations of new programmes could impact the business, BAE Systems remains well positioned to support its US customers with a balance of products, technologies and services. In recognition of the growing importance of affordability and efficiencies, BAE Systems streamlined the organisation of its US business in 2010 to reduce costs and improve flexibility.”
The picture was similar in the UK, as the Strategic Defence and Security Review looked to cut the UK defence budget back to sustainable levels. For 2011 sales were expected to decline, although the directors were brave enough (or mad enough) to raise the dividend by almost 10%.
Since most investors hate negativity and uncertainty, this negative environment led BAE’s share price down to around 250p on a couple of brief occasions, giving the shares a mouthwatering but short-lived dividend yield of 7.5%.
When the 2011 annual results came out in early 2012 the picture remained virtually unchanged, with little growth expected thanks to ongoing budget cuts in the US and UK. To offset these cuts, BAE’s strategy was revised to include:
- Reducing costs through increased efficiency
- Expanding into growth regions outside the UK and the US
- Focusing on electronics, cybersecurity and intelligence, three markets which were expected to grow.
The board showed their continued confidence (or their reluctance to accept reality) by raising the dividend again.
Despite the board’s confidence it gradually became clear that investors were probably right to be wary of BAE back in 2011. Year after year, government cuts continued to squeeze defence budgets and year after year BAE saw its revenues and earnings decline. However, the tone of the annual reports eventually became less negative.
In the 2014 annual report, the CEO spoke of expected improvements in the US defence budget “in 2016” and the report included a positive outlook for earnings. In 2015 the CEO said that “The overall business environment is now improving”, and that was backed up by revenue and earnings figures which both increased for the first time in years. For 2016, sales increased again and optimism was clearly evident in the CEO’s summary:
“2016 was a good year for BAE Systems. Our strategy is well defined; we have a large order backlog, long-term programme positions, strong programme execution and a well-balanced portfolio. With an improved outlook for defence budgets in a number of our markets, we are well placed to continue to generate attractive returns for shareholders.”
For the last five years then, BAE has been working hard just to stand still against strong external headwinds. The dividend wasn’t cut, but its impressive track record of growth is now just a distant memory:
Selling because the attractive valuation has gone but the risks are still there
Overall I would say that BAE’s story is fairly typical for a defensive value investment.
We have a fundamentally sound business which was trading at an attractive price because it was facing some obvious external problems. Rather than simply taking the impending hit on the chin, the company adapted its strategy in order to reduce the impact and stay on its feet. After several years of underperformance, the external problems began to fade and the company’s underlying strengths and adapted strategy allowed it to aim for growth once again.
So if BAE is such a good company and if its medium-term prospects are now better than they have been at any time since it joined the model portfolio in 2011, why am I selling? The answer is twofold.
First, and as with most successful value investments, price is the most important factor. BAE’s share price has doubled since 2011 and as a result, its valuation ratios have become far less attractive.
This can be seen most clearly in its dividend yield, which has fallen from 6.1% at purchase to 3.3% today. A dividend yield of 3.3% is not bad, but it isn’t anything to get excited about either, especially when the dividend has only been growing at two or three percent in recent years. At the same time, BAE’s excellent track record of growth has turned into an uninspiring track record of stagnation.
This combination of higher valuation ratios and lower growth has driven BAE far down the UKVI stock screen. In fact, it is currently the lowest-ranked holding in the model portfolio and ranks just two places higher than the FTSE 100.
If I want the model portfolio to beat the market then it needs to be filled with stocks that are faster growing and more attractively valued than the market, and BAE no longer fits that description, as the table below shows.
Second, BAE’s pension scheme is still a serious risk and despite ploughing hundreds of millions of pounds into the scheme to reduce the deficit, the pension scheme and its deficit are today larger than they have ever been.
The pension scheme has gone from £21 billion in 2010 to £29 billion today, while the deficit has ballooned from £3.1 billion to £6.1 billion. Add that deficit to the company’s borrowings and you have “debts” of more than £10 billion today, which is about ten-times the company’s recent average profits. That’s way more than the five-times maximum I would prefer.
BAE’s pension scheme is, in my opinion, a huge financial risk and one I would much rather not have in my portfolio. And I am not alone in feeling this way:
“An increasing number of companies face mounting challenges in tackling their pension deficits. In particular, previously nationalised businesses have substantial amounts of unfunded pension liabilities on their balance sheets. At the margin, concerns about their pensions has reduced the level of conviction that we have in stocks such as Royal Mail, BT and BAE Systems. The presence of a substantial pension deficit is therefore a consideration for investors and could put further pressure on the cash available for distribution via dividends.”
– Mitchell Fraser-Jones, Woodford Funds
As a result of these various factors, I have removed BAE Systems from the model portfolio and my personal portfolio. The proceeds will, as usual, be reinvested into a new holding next month.