Are retailers valuable or a value-trap? Many of the major retailers have been announcing their Christmas results in the past week so I decided to have a look at Marks & Spencer to see how it stacks up against the alternatives and whether could be a reasonable addition to an "income & growth" value portfolio. The news seems to be constantly bad for retailers at the moment so this may be the time to pick up those that are virtually certain to make it through this recession.
At the completely opposite end of the value spectrum, the 21st Century Net-Net project is moving forward with another retailer in the shape of Home Retail PLC, owner of the Argos and Homebase businesses. I'm very excited about this project because as far as I know it's the only live experiment of low debt, low price to book value investments out there.
For those that are interested, the January issue of the Defensive Value Report is out now and includes the usual array of tools to understand where the market is at the moment and which stocks may be worthy of your attention.
Finally, I must apologise for the changing nature of the emails recently. This new newsletter format will now be published every Friday (barring disaster) and will include all the week's blog posts plus any tweets or other snippets of useful information I come across. I hope you like it and also I hope you have a good start to 2012 and that we all have an 'up' year instead of the 'down' year that most of us saw in 2011!
Yours sincerely,
John Kingham
Contents:
Are Marks & Spencer Shares Good Value? With the Christmas retail results in full swing, now seems like a good time to answer this question. Marks and Spencer is of course a mainstay of many investors’ portfolios, both professional and private alike. It is of course one of the kings of the high street with a long history going back to Michael Marks opening a stall at Leeds Kirkgate Market. Since then it has come a very long way, but is it still a good investment given the current difficulties in the retail sector? In some ways that's a trick question because the difficult environment that retainers face is exactly the sort of environment that often creates the best long term investments. A happy economy rarely creates compelling buying opportunities.
Choosing a valuation system Marks and Spencer is of course not a 'cigar butt', but is instead a market leading company with a long history of dividend payments, so I'll be valuing it using the 'defensive value' strategy. This involves looking at long term earnings growth, the current price relative to those long term earnings and the current dividend yield and its sustainability. Together these make up the drivers of long term equity returns.
So let's start with the share price chart as that's where many investors begin. That's generally a huge mistake as the historic share price has little bearing on the long term future share price which is instead driven by the future fundamental value of the company. 
You can see from the chart that even with a stable, boring old company like Marks and Spencer the shareholders can still have a very exciting time of it. However, in effect, by ignoring the massive spike and crash in the share price between 2005 and 2009, it seems that the shares have gone precisely nowhere in 10 years or so. For many investors this is enough to put them off as they immediately think that the next 10 years are likely to look the same with zero capital gains. Moving on to the fundamentals of the company, those same 10 years or so have produced the following results in revenues, earnings and dividends per share (and it's per share results that matter).
 Are there any signs of growth? The obvious answer is yes. At a glance it looks like revenues are up more than double, as are earnings and almost double for dividends. Assuming these numbers are broadly sustainable it means that the intrinsic value of Marks and Spencer may be twice what it was 10 years ago, and yet the share price is the same. If that were true then the buyer today would be getting twice the value of the buyer from 10 years ago. The revenue growth rate is around 9% while the Graham earnings growth rate is around 7%. The Graham earnings growth rate is calculated like this: take the average of the last 3 year's earnings and the average of the 3 year earnings period from 10 years ago and calculate the growth rate between those two 3 year periods. This helps to smooth out the volatile nature of earnings. These growth rates are both comfortably above inflation which is a decent effort for such a mature business. How much earnings bang are you getting for your hard earned buck? The second piece of the investment puzzle is the current price relative to those past earnings. With a price of 309p when I put these figures together, the PE10 (price relative to 10 year earnings average) was 10.5, which is well below the ceiling of 20 that Ben Graham suggested for large or leading businesses. What will an investor get paid to hold these shares? The current dividend yield is around 5.5% which is some 2% or so above that offered by the FTSE 100. That's a pretty decent yield and is some way north of the historic average which is closer to 4%. Bringing the elements of growth, value and income together So we now know that earnings growth has been around 7%, the price relative to past earnings is about 10.5 and the current yield is about 5.5%. That's all very interesting, but how can that information be used to get a ballpark feel for how attractive M&S may or may not be as an investment? There are a couple of ways. One way is to bring those numbers together into a single ratio called PEGY10. This is simply an extension of the old PEG and PEGY ratios to cover a longer timeframe. The ratio is simply PE10 divided by the sum of G10 (10 year growth rate) and Y (the current yield). In Marks and Spencer's case this is 10.54 / (6.8 + 5.65) which equals 0.85. What does that mean? On its own it means nothing but it does allow the shares to be compared to any other shares that have 10 years of data available, as well as the FTSE 100 index. When I compiled this data the FTSE 100 (at 5,500) had a PE10 of 13.5, a 10 year growth rate of 5% and a dividend yield of 3.6%. That gives a PEGY10 ratio of 1.56, so clearly Marks and spencer is better value by that simple measure. More clearly, Marks seems to have a higher growth rate, a lower price relative to past earnings (and therefore a higher long term earnings yield) AND a higher dividend yield, so it beats the index on all of the key drivers of long term equity returns. Using ranks instead of ratios Another effective way to compare one stock's growth, value and income against another is to rank stocks on each factor and then to combine those ranks. This is the approach used by Joel Greenblatt in his Little Book that Beats the Market. In that book he ranks the entire universe of stocks by 'earnings yield', giving a rank of 1 to the highest, 2 to the next highest and so on. Then he ranks for 'return on capital' and gives a score again starting at 1. The next step is to simply add those ranks together. What you get at the end is a list of all the stocks in the universe, and those with the lowest combined rank have the best combination of earnings yield and return on capital. It's possible to do the same thing for PE10, Graham growth and dividend yield. Simply sort the entire universe of stocks by each of those factors in turn and assign a rank to each stock starting at 1. Then add the ranks together. Using this ranking system the FTSE 100 currently has a combined rank of 583, while Marks and Spencer, with its lower PE10, higher growth rate and higher yield has a combined rank of 387, which puts it in 18th place on my list of FTSE 350 stocks, out of 192 which have enough data for this calculation. Further analysis On a purely quantitative basis Marks and Spencer looks to be exceedingly good value and therefore worthy of further analysis. This doesn't have to be massively exhaustive, but might including, among other things: - Looking for a consistent operating history - are they still doing what they've done in the past?
- Checking the debt levels. Are total borrowings only a few times operating earnings and interest payments covered many times over?
- Finding out if there are any major problems on the horizon that might impact the company's long term earnings power.
- Thinking about the future of the industry. Is it doomed or will it be around for many years yet?
But before getting into detailed analysis of a company it's worth knowing if it has a decent chance of producing good future results and that's where a focus on long term earnings yield, long term growth and a sustainable income can make a big difference.
Further reading:
1. Scottish and Southern Energy
2. Reckitt Benckiser
Does Size Matter? Having written about the need for sufficient diversification, I’ve been thinking about what a company’s market cap means in terms of how sophisticated an investor should probably be before buying the company’s shares. I realise this isn’t a new idea, but there is very probably an inverse relationship between the size of the company and the minimum sophistication of the investor. In other words, the bigger the market cap the less the investor needs to know about the company and the small the market cap the more they should know. In some ways this may be counterintuitive because a company like BP is massively more complex than something like AGA Rangemaster. That’s not just because BP is bigger, it’s because it does many more things in many more places around the world. Just compare the annual reports. But, somewhat like the QE2 luxury liner compared to a speed boat, the QE2 is hugely more complex but also hugely more stable when faced with storms and worse. When travelling across the Atlantic most people would be better off on the big boat. This also ties in with the idea that fundamental investing, of which value investing is a part, is about investing in real companies and not just a wiggly stock-price chart or a number on a ticker. An analogy that I sometimes use is that investing in shares can be like investing in property, where there is a real asset generating a real income and potential capital gain. From that point of view it’s much easier to think about where Marks & Spencer might be in 5 or 10 years time than a micro-cap company that doesn’t have access to the best brains in the business. For the ultimate in stability (at least in terms of equities) you just have to look at a market index like the FTSE 100. Not only is it full of the biggest 100 companies but it’s cap weighted, so the biggest of those companies make up a disproportionate amount of the index. The average market cap is about £15 billion, which is big enough, but the weighted average market cap is over £40 billion, which is bigger than all but 10 of the constituents (i.e. BP makes up about 6% of the index at £90 billion while Hargreaves Lansdown makes up 0.1% at £2 billion so the weighted average is slanted towards the biggest of the big). I’m not sure I’d call myself a big-cap investor just yet, but for my ‘defensive value’ portfolio I’ll be concentrating on FTSE 350 companies from now. Not that there aren’t many great small cap companies out there, it’s just that I think it’s much easier to find good, big companies than good, small companies. 21st Century Net-Net #2 – Home Retail The doom and gloom that surrounds retailers continues and it’s thrown Argos and Homebase into my sights. As things currently stand the FTSE 250 listed company has a price to book ratio of 0.27 and price to tangible book of 0.76, so it’s cheap by book value. For those that like to look at liquidity the headline figures are net cash of £200m (at the last interim report), quick ratio of 0.72 and current ratio of 1.63. The market cap is over £700m so it’s quite big for a net-net, even a 21st century one. In terms of the original net-net ratio, it does have a positive number which on its own is a stretch for most companies, but at more than 2 it’s well past Ben Graham’s old limit of 0.66. However, that’s the whole point of using an updated set of ratios, so that the pool of available stocks is wider in order to allow greater diversification in a smaller market like the UK. Looking at the most recent reports, it’s obvious and completely expected that times are tough. You aren’t going to get many net-net type companies that aren’t having lots of trouble, but that’s exactly why the requirement is that they have net cash, i.e. enough ‘cash’ assets to pay off all borrowings. Home Retail passes my 10-minute sanity check, which just includes a quick glance at the most recent reports and statements and any news about the company. I didn’t find any obvious signs that the company was about to collapse in the next few weeks or months so I will be adding Home Retail Group PLC to the 21st Century Net-Net model portfolio is due course. You can see below the top 10 stocks by this screen, sorted by price to book. All else being equal I’ll be adding AGA next week.  Further reading: - 21st Century Net-Nets
- 21st Century Net-Net #1 – PV Crystalox Solar
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