The Best of Last Week – Stagecoach

Stagecoach released its interim report last week and was the highest-ranked stock on my shortlist to do so. The question is, at a price of around 250p, what do the shares of this company have to offer the average investor?

HomeServe – A Big Price Equals Big Losses

The stock market can be an unpleasant place. Let’s say, for example, that you own shares in HomeServe, the international home emergency insurance and repair business.

Happy hour or hangover for SABMiller investors?

It’s not easy being picky. I’ve just spent the morning looking at Mothercare and still can’t decide whether I like it or not. It’s either a speculative screaming bargain or a value trap with a UK business that could suck cash out of the good part of the business (the high growth international bit).

Scottish and Southern Energy – A Wolf In Sheep’s Clothing?

Utilities are often seen as boring investments. They’re never going to be sexy, they’re never going to cure cancer or have their products at the top of a teenager’s Christmas wish list. That may well be true, but value investors have a history of liking boring companies and Scottish and Southern Energy (SSE) has a lot to like.

UK Mail – Can A 9% Yield Ever Be Sustainable?

I know I’ve written a lot lately about big cap, solid growth companies like Vodafone, BHP Billiton and MITIE, and I guess some people who read this stuff might think, “What sort of value investing is this? Where are the obscure, the unloved and the unfashionable?”.

More Mega-Cap Value with BHP Billiton

A lot of value investors talk about how you have to look for the unloved, the obscure, the boring and the small. That’s fine if you want to invest in those sorts of companies but personally, I sleep better when I’m invested in big, well-known, highly profitable businesses and fortunately, these can be value investments too.

Tullett Prebon – Terry Smith joins the portfolio

Tullett Prebon is an inter-dealer broker, which basically means they act as a middleman between commercial and investment banks and other parties. If somebody wants to trade in treasury products, interest rate derivatives and fixed income, they go to Tullett Prebon.

Balfour Beatty – The Construction Industry Is Only Sleeping

The model portfolio is filling up nicely (12 out of 20 slots taken) and now it’s time to buy another company.

BAE Systems – It’s Time to Get Defensive

BAE Systems, the giant defence contractor, is another high-quality company with a sustainable income that’s very likely to keep growing through the coming years. The company is financially robust, has a long history, a growing dividend and is internationally diverse. In fact, as I write this it’s currently yielding an incredible 7%.

Better than the FTSE 100

So, what makes this such an attractive proposition? Apart from the fact that there’s a 7% cash payout, it’s a reliable payout. There is no significant risk of it being cut or stopped. Many professional analysts seem to think that the dividend is going to keep growing at 6-7% a year. A 7% yield, growing at 7%, what’s not to like?

Let’s take a look in more detail, using my un-famous technique of comparing any potential investment to an investment in the FTSE 100. That’s a useful thing to do since you can invest in ‘the market’ for low cost and very low effort. Just sit back, re-invest the dividend and get rich slowly.

How does BAE stack up? Here’s a table to go over it all, step by step:

Factor	FTSE 100	BAE Systems
Earnings yield	12%	16%
Dividend yield	4%	7%
Historic earnings growth rate	7%	12%
Return on retained earnings	10%	15%
Possible future growth rate	5%	8%

The numbers in this table are from various sources and are guideline figures. They are also rounded to the nearest whole % point since more accuracy might indicate a degree of knowledge about the future that is not realistic.

In each case, BAE has the upper hand. At the current price, it’s yielding more dividends and earnings. It has historically grown faster (although the fall in the pound in the last few years may have skewed this figure upwards, but currency speculation is just that, speculation). It has been able to generate a higher rate of return on that part of your earnings which are retained within. Finally, using a simple estimate of future growth (simple because more complex models aren’t necessarily more accurate), it looks like BAE may be able to grow faster than the FTSE 100.

The wooly factors

I have Monevator to thank for the term ‘woolly’, which he used to describe the soft factors like: what business are they in? How will their market do in the future? How will they cope with government cuts and the collapse of the west?

Historically, this area of investing does not have an impressive track record. There have been many studies which show that people who are subject ‘experts’ often have no better forecasting ability than the man in the street. Ask a weather forecaster what the weather will be like in 2 weeks’ time and your guess is as good as theirs.

That’s why 80%, at the least, of my effort goes into using hard numbers and actual past results to determine if an investment is attractive. It pays to take heed of history.

However, there is some work that can be done to sanity-check an investment.

The past

Generally, you want a company where its business history has been consistent over the long term. This is useful because you are investing in the company’s future and if its past has been unpredictable and varied then the future might be the same. If the company has a history of changing its core business or remodelling itself then what has produced the good results of the past may be restructured or jettisoned in the future, leaving you with a less attractive investment.

In BAE’s case, their history seems fairly steady, with their defence contracting history stretching back many decades. They’ve changed a lot in that time, as have the products and services they supply, but basically, they’re doing much the same job they were half a century ago.

The present

Shares are usually attractive for a reason and that reason is typically that no one else wants to own them. This can happen either because of a general market panic about something (sound familiar?), or a real or perceived problem with the economy, the industry or the individual company. The question is, is the factor causing the low price likely to affect the long-run returns of the company?

If the answer is yes then perhaps you should look elsewhere for a more trustworthy source of returns.

For BAE it looks like there are a range of factors, with perhaps the largest being the current market panic. This panic is about US and Euro defaults and other things to do with the global economy, all of which are really not quantifiable. I take the strategic ignorance approach and guess that the defence industry is likely to still be here in 10 years. With that view, the current market panic is an opportunity, not a risk.

Specific to the defence industry are the actual defence cuts that are going through and further possible cuts in the future. Although these cuts are real, BAE seems to think that they can mitigate much, if not all, of the cuts through efficiency and diversification. Another industry factor is the gradual change to fixed-price contracts, which could hurt margins going forward.

Specific to BAE, there are a couple of main risks. First is the repeated allegations of misconduct, which may lead to higher legal costs. Then there is the ever-present risk of competition, in this case from General Dynamics.

However, I don’t see that any of these risks seriously undermine the case that BAE will still exist in 10 years and will very likely be earning significantly more at that point than it does now.

BAE is exactly what a great dividend growth share looks like. It’s big, stable, and pays an amazing dividend which is very likely to keep growing in the years ahead. It is a value investor’s dream, especially one with an addiction to dividends.

– John owns shares in BAE Systems

AstraZeneca versus the FTSE 100 – Which is better?

If you’re going to be a stock picker then one of your goals has to be to beat the market. It must be, otherwise, why would you bother with all the extra work? And if you’re out to beat the market then it makes sense to check each potential investment against the market to see which is best.

The FTSE 100 is a great investment

Just to recap, the FTSE 100 (via an ETF or index fund) is a pretty fantastic investment to start with since it always pays a dividend, the earnings almost always trend upwards over the longer term and it’s virtually certain to be around when you retire so the risk of losing all your money is almost zero. Many studies have shown that for UK investments it’s almost impossible to beat over the long term.

Why pick AstraZeneca?

AstraZeneca has been scoring very well on my screens for a while so it was due a review and I’m also looking to buy something as well. It’s a very large, globally diverse company and it’s in the FTSE 100 anyway, so it’s not like we’re comparing the FTSE 100 with some crazy micro-cap start-up. It’s a big, stable company with tens of thousands of employees earning billions in revenue and profit.

The gap between the FTSE 100 and AstraZeneca is about as small a gap as you’re likely to get between an index and a single company so the comparison is fair I think.

Checking past performance

Both have more than 10 years of positive earnings with no losses and no periods without a dividend, so both have good stable histories.

Over that last decade, the FTSE 100 has grown earnings by about 7% while AstraZeneca has managed about 12%. Dividends have increased for both at sustainable levels with the dividends covered more than 2 times in each case.

The FTSE 100 has managed to return almost 10% on retained earnings while AstraZeneca has managed over 20%. Retained earnings are that bit of the earnings that management has kept back (they are your earnings since you are the shareholder and owner) and invested within the company. Since it’s your money you should want it re-invested at the highest rate possible.

In summary, AstraZeneca has had better earnings growth than the FTSE 100 and has produced better rates of return on each pound of shareholder money retained within the company. AstraZeneca wins round 1. Now let’s look at the present.

What return are you getting from day one?

At 5990 (8th July 2011), the FTSE 100 has an earnings yield (inverse of the PE) of 8.8% and a dividend yield of 3.1%. At 3127 (8th July 2011) AstraZeneca has an earnings yield of 11.3% and a dividend yield of 5.3%, higher in both cases.

Yields are the simple bit of investing that most people understand without much effort since they’re used to looking at yields on savings accounts. The higher the yield the more ‘interest’ you’re getting on your money, especially in the case of dividends since the analogy with interest is all the closer as they are both cash payouts.

With the bigger yields, AstraZeneca wins round 2.

Which has a brighter future?

Ahh the future; a land of hopes and dreams or a vast black impenetrable fog, take your pick. To be honest I prefer hopes and dreams but before we get too far into future gazing it’s important to remember that the future will always be highly uncertain. The only thing that changes is how much people are aware of that uncertainty.

Given that the future plays its cards close to its chest, one handy trick to increasing your predictive powers is to predict something predictable. If I say that the Sun will come up tomorrow then I’m almost certain to be right. I could even say that the Sun will come up 200 years from now and I’d still probably be right.

The same sort of idea can be applied to investing. If you take a company with volatile earnings, perhaps some years of loss, it becomes difficult to say anything meaningful about what that company’s future earnings might look like, other than saying they might look like the past, i.e. volatile and therefore unpredictable (or at least less predictable). In fact, there might not be any future earnings if they have too many of those loss-making years.

On the other hand, a company with a long history of relatively stable earnings growth, no losses and no dividend cuts or cancellations may just have a future that also looks like its past, i.e. relatively stable, predictable growth that can be extrapolated into the future with some small degree of confidence.

Both AstraZeneca and the FTSE 100 have relatively predictable earnings and dividend growth and that’s how we can make an educated guess at what their futures might look like.

To infinity and beyond

Using the rates of return on retained earnings and the amount of earnings typically retained, the future growth of earnings can be estimated as about 6% for the FTSE 100 and 12% for AstraZeneca.

By combining estimated future earnings and the average PE of the last few years (14 for the FTSE 100 and 13 for AstraZeneca) and adding in the total amount of dividends paid out, the total return to shareholders over the next 5 years can be estimated as:

56% for the FTSE 100

212% for AstraZeneca

No prizes for guessing which one looks more attractive.

But hold on! Don’t expect those estimates to be accurate, certainly not to a single percentage point. But they may well be a reasonable guide as to what will happen… and so, kapow! AstraZeneca wins round 3.

Pesky Mr Market

There are problems with these sorts of projections. The first problem is they are almost certainly wrong. There’s no way that a buyer of AstraZeneca today will see a 212% return in 5 years. Even if the projections of future earnings are spot on (that’s problem number 2, they won’t be) Mr Market frequently values companies anywhere between half and double (and sometimes much more) what they should be worth.

Even if I am so clever that my earnings projections are right, Mr Market may value the company at half what I expect him to, and so my total returns would be 28% for the FTSE 100 and 106% for AstraZeneca. Or, if Mr Market is very happy in 5 years’ time then the return might just be 112% for the FTSE 100 and 414% for AstraZeneca.

Unless you can live with this level of uncertainty (which in the world of equities is actually quite small) then you might be better off with an index tracking stock/bond portfolio and get used to the 6-8% annual returns.

However, the main point still stands in that since we cannot know what Mr Market will do in the future, we have to effectively ignore him! That in turn means we look back to the original, very probably wrong, projections, which means that…

AstraZeneca wins!

If you think you have the stomach for stock market investing and can handle large amounts of uncertainty (the antidote to which is good old blind faith… no seriously, it is), then AstraZeneca in this case should appear to be the better investment.

10 Beefy stocks to chew over

The companies in this month’s shortlist are sorted and selected based on their growth, both past and estimated future, as well as their current dividend and earnings yields. They all have steady histories over the past decade and I’d go so far as to describe them as good companies at good prices.

Company	Index	Industry	Rolling PE	Dividend (%)
ASTRAZENECA	FTSE100	PHARMACEUTICALS	7.2	5.4
JD SPORTS FASHION	FTSE250	APPAREL RETAILERS	7.7	2.7
CHEMRING GROUP	FTSE250	DEFENCE	11.6	2.7
BAE SYSTEMS	FTSE100	DEFENCE	7.6	5.8
CLARKSON	SMALLCAP	TRANSPORTATION SERVICES	10.2	4.0
RECKITT BENCKISER	FTSE100	NONDURABLE HOUSEHOLD PRODUCTS	14.4	3.5
BALFOUR BEATTY	FTSE250	HEAVY CONSTRUCTION	8.5	4.4
INTERSERVE	SMALLCAP	BUSINESS SUPPORT SERVICES	7.6	6.0
MITIE GROUP	FTSE250	BUSINESS SUPPORT SERVICES	10.9	3.8
CARILLION	FTSE250	BUSINESS SUPPORT SERVICES	9.0	4.4

Generally, I start at the top of this list and if I find something that fits my criteria I’ll buy it, assuming I have any cash to deploy. Otherwise, it’s still worth reviewing a company or two in greater depth just in case some cash magically appears (I wish!), since most of the leg work will have already been done.

I’m pretty sure that out of this list of companies there’s something that I’d be happy to put into my pension fund, in fact I already own four of them. I’m looking for something where I’d be happy to go to sleep for five years and trust that the investment has one hell of a good change of returning a fair profit in that time. Or in the words of a rather clever chap,

“Only buy something that you’d be perfectly happy to hold if the market shut down for ten years” – Warren Buffett

That might be a bit of a stretch for most people, but it should get you in the right mindset for picking great companies. Picking great companies is important because by buying any company’s shares you are putting your money at risk and just as importantly, you are tying your economic future to their economic future.

How you live when you retire is going to be affected in a massive way by the value of your pension fund. Pick the wrong companies and the consequences can be huge. Pick the right companies at the right prices and your retirement might look a whole lot different.

May 2011 Value Investing Portfolio Update

Valuing the market – A first step beyond passive investing

“Investments may be soundly made with either of two alternative intentions: (a) to carry them determinedly through the fluctuations that are reasonably to be expected in the future; or (b) to take advantage of such fluctuations by buying when confidence and prices are low and by selling when both are high” – Ben Graham

Chemring Group – Leveraging global leadership

Chemring is primarily a defence group that currently focuses on countermeasures, counter IED, pyrotechnics and munitions.

What do Durex, Cillit Bang and Nurofen have in common?

In 1999 Reckitt & Coleman merged with Benckiser to form Reckitt Benckiser (RB). At the time Reckitt & Coleman were a leading global household products company with most of their turnover generated by brands with number one or two market positions. Benckiser was in a similar position with household cleaning products, especially their dishwasher brands including Finish, and the water softener Calgon.

Predictability, growth and price

One of the interesting things about investing is the almost infinite number of ways that you can tackle it. From indexing to stock picking, bottom-up and top-down, technical and fundamental analysis, scuttlebutt and quantitative formulas, you’ve got enough options to keep you happy for a thousand years. That’s why I’m going to try out a new approach to value investing for a while. The eagle-eyed among you may spot its origins.