BAE Systems – How to re-value a company you already own

The overall process of investing is simple: Buy – Hold – Sell.  Unless you’re a buy-and-forget investor, it makes sense to periodically check on the difference between the price of your investment and your estimation of its intrinsic value.

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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:

FTSE 100
BAE Systems
Earnings yield
Dividend yield
Historic earnings growth rate
Return on retained earnings
Possible future growth rate

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