How to build a margin of safety into stock portfolios (Part I)

The UK stock market’s leading indices, the FTSE 100, FTSE 250, FTSE All-Share and (for small-cap fans) FTSE AIM All-Share, have all forged some kind of rally subsequent to the sudden slump of early February.

However, not one of the quartet is showing a gain for the year, as of the time of writing, unlike the headline American benchmarks, the Dow Jones Industrials, the S&P 500 and the NASDAQ Composite, all of which are up in 2018.

The UK’s headline indices are all down so far in 2018

Source: Thomson Reuters Datastream

... regardless of whether they are large or small-cap focused

Source: Thomson Reuters Datastream

It is too early to tell whether February’s flop represents a temporary stumble or the beginning of the end for a 10-year bull market in stocks and a 37-year bull run in bonds, although the combination of lofty valuations (looking at market-cap-to-GDP ratios), lowly volatility and rising interest rates has historically been a tricky one for equities in particular, as anyone who remembers 1994 and 1997-98, let alone 2000-03 and 2007-09, will readily attest.

If nothing else, the stumble is an important reminder that portfolio construction is as much about managing the downside as it is about maximising the upside.

Price must be right

It is tempting to think that a portfolio can be bolstered by slipping in some exposure to so-called ‘defensive’ or ‘quality’ stocks, such as utilities or consumer staples.

Yet it may not be as simple as that, especially now, after an epic bull run.

Fixed-line and mobile telecoms firms are locked in fierce competition for customers and remain under regulatory pressure, while BT also has a big pension deficit to tackle.

Food retail is another purportedly defensive sector where competition is hotter than ever, thanks to the rise of the discounters and online upstarts, and all of that price pressure is feeding down to Food Producers. Utilities and tobacco are also under the regulatory cosh, while the former is now seen as prey to political risk in the UK, thanks to talk of renationalisation from the opposition Labour Party.

The big drug firms are struggling to come up with blockbuster drugs and in Shire’s case it needs to reduce its acquisition-inspired debt pile.

And surely no-one needs reminding of the collapse in the support services sector, which has gone from penthouse to outhouse in the past two to three years, as its fat order backlogs have failed to deliver the sort of earnings visibility (or earnings, full stop) that investors were looking for.

Support services has proved a let-down for investors

Source: Thomson Reuters Datastream

A more refined approach is therefore required, something a little more scientific than buying ‘quality’ or ‘defensives’.

And one of the best ways to avoid, or minimise, short-term losses, and still give yourself an excellent chance of harvesting both capital gains and dividends over the long-term, is to buy good assets cheaply and at levels below their true worth.

This requires analysis of a stock’s valuation and in this and the next edition this column will seek to outline the most useful techniques that can help you decide whether a company’s shares represent good value – or not.

Price to earnings

Benjamin Graham’s 1949 book The Intelligent Investor is still one of the most widely acclaimed tomes on investment ever written.

One of Graham's key tenets was to ensure any portfolio purchase featured what he termed 'a margin of safety’, since the biggest danger to any investor is losing money on a permanent basis. Graham sought to do this by paying low prices for good assets and by not paying top dollar.

One quick way of judging a stock’s valuation is the price/earnings ratio, also known as the PE or PER.

This is calculated as the share price divided by forecast earnings per share (EPS) and expressed as a multiple. If a company’s shares are trading at 100p and it is forecast to make 10p in EPS, then the PE is 10 (100 divided by 10).

A short cut is to divide the market cap by estimated future net earnings and this explains what a PE really represents – the number of years in which it will take a firm to earn, and thus justify, its market valuation.

This ratio therefore really means something and it is worth asking yourself just how confident you are a firm will be trading well, or even in existence, 10, 20 or 30 years down the road.

In theory, the lower the PE the cheaper the stock, but care is still needed. A PE or PEG ratio, which divides the PE by forecast earnings growth, could be low because earnings progress is about to slow or hit a cyclical peak. The stock could therefore be a bad investment as falling EPS figures tend to mean a falling share price.

A PE can also be negative, though this simply means the firm is in loss. Then the investor needs to find out why and there are three possible reasons behind a negative PE:

• The firm could be a start-up company in an area such as technology, biotech or mining, where sales are small and initial investment heavy
• Cyclical stocks such as steelmakers or airlines often fall into loss as the economy goes into recession
• The stated loss can be a ‘paper’ deficit rather than a cash one because a firm may have taken a big one-off restructuring charge or write-downs against the value of assets on its balance sheet. In this case the investor should look beyond the so-called 'exceptional' items and look at the underlying profit

Even stocks with negative PEs can be worth buying – they can be some of the best turnaround candidates – but you will need to then look at other valuation tools to provide a better context for decision making.

We will look at these in the next column but we must finish with the PE first because, like any tool, it is a snapshot which requires a careful interpretation.

A PE can be used in three ways (at the very least):

1. Relative to the broader market. The FTSE 100 trades on a PE of around 15 for 2018, based on consensus analysts’ forecasts, so, in principle any firm trading at a discount could be cheap. Any company trading at a premium must be able to merit such a rating by dint of its earnings growth, cash flow, management quality, track record and overall strength of its business model. This technique is known as the PE relative (to the market).


2. Relative to growth. Dividing a PE by the forecast earnings growth figure gives the Price to Earnings Growth ratio, or PEG. Any ratio below 1.00 is generally seen to be attractive, anything above 1.5 times a bit toppy.


3. Relative to history. PE relatives, PEGs and even absolute PEs can be compared to the ratios and multiples seen across a company's trading history. This is particularly useful for cyclical firms which often lose money at the trough of the cycle but make stacks at the peak. Here, using an average EPS figure across a cycle might help reveal the shares are oversold at the trough, when the firm is in the red (and a normal PE would not really work) or overbought at the peak.

Calculating returns

A PE is also useful because it helps you to assess two of the three contributors to what is know as the Total Shareholder Return (TSR) from a stock.

• The annual earnings and the profit growth that can be expected. This is the ‘E’ in the PE. If the ‘P’ stays the same and the earnings grow, the share price should broadly track the increase in profits over time (albeit with some large potential variations higher or lower in the near term). The economic cycle will have a big say in how the earnings (or ‘E’) develop, but so will strategy and how the firm is run.
• The multiple the market is willing to pay for those profits. This is the P in the PE. A re-rating will see the share price rise faster than profits, a de-rating will see it rise slower or even fall quicker, depending on the circumstances. Management acumen, financial strength, corporate strategy and issues such as governance, investor communication and the quality of the accounting will all help to shape the ‘P,’ too, alongside the business model and whether it is seen as reliable or defensive or volatile or capable of generating rapid growth. Faster growth and more reliable or higher quality earnings will attract a higher multiple, or ‘P’, than cyclical, unpredictable earnings streams, for example. Firms with less debt will often get a higher rating than ones with lots of borrowing, as the former are seen as safer and the latter as more risky.
• The dividend paid. These valuable distributions form a telling part of TSR, especially once they are reinvested and the power of compounding is allowed to do its work.

A working example

Over the past 12 months Reckitt Benckiser has provided a good current example of investors who have been able to use the PE ratio to judge a firm’s merits and whether its shares were expensive or not.

Reckitt Benckiser has suffered a de-rating over the past 12 months

Source: Thomson Reuters Datastream

In June 2017, Reckitt’s shares reached £80.89 and analysts were forecasting EPS of 336p for 2017 and 351.1p for 2018.

That put the stock on a forward PE of 24.1x for 2017 and 23.0x for 2018.

The FTSE 100 household goods giant subsequently lowered its sales growth target for the year on two occasions, completed the acquisition of Mead Johnson, sold its food business, jiggled with the way in which its accounts were presented and (earlier this month) revealed some nascent signs of margin pressure alongside its full-year 2017 numbers.

As a result, the company achieved EPS of 316.9p for 2017 (on an adjusted basis) and analysts’ forecasts have dipped to 349.8p for 2018.

Applying a share price of £59.05 puts the stock on a historic PE of 18.6x for 2017 and a prospective one of 16.9x for 2018.

In sum, earnings estimates have fallen and the stock has suffered a de-rating, owing to disappointment with the firm’s organic growth profile and the higher risk associated with the Mead deal, which came with a lot of debt, has taken up management time and resource to integrate it and has shown some signs of margin pressure.

This de-rating explains how a small change in earnings forecasts has changed into a much bigger share price drop.

For Reckitt’s shares to recover, organic growth needs to improve, margins need to stabilise (or improve) and the company needs to wean itself off big acquisitions as a tool for stoking growth (although its rumoured interest in Pfizer’s consumer healthcare business is an issue here). All of this could help profits and also forge a recovery in the rating given to the stock.

Falling profit estimates and rising risk have prompted the de-rating at Reckitt

Source: Digital Look, analysts’ consensus estimates. *2017 EPS figure is accurate as of February 2018.

Conclusion

There is no one, or 'right', way to value a stock and it is probably more of an art than it is a science. Nor will valuation alone be a catalyst for share price performance.

Yet careful research into the multiples of sales, profits, cashflow or assets upon which a stock trades will dictate your entry and exit points and it is a mistake to ignore them and buy in to a firm regardless of its rating.

If a company increases profits at a rate faster than the broader market on a consistent basis, regardless of the economic backdrop, then investors will look to pay a premium for the shares – the 'P' in the PE will expand as the earnings do likewise, creating a virtuous circle.

If things go wrong, earnings disappoint, management proves incompetent, an acquisition proves to be a dud, the balance sheet falls apart or the firm's competitive position is eroded or demolished by a rival, then a stock can suffer the double-whammy of falling earnings growth estimates (lower ‘E’) and a derating (lower ‘P’), as Reckitt has unwittingly shown us over the past year.

Value investing aims to benefit from the virtuous cycle and defend against the vicious one and thus reduce risk in portfolios.

In his 1984 article The Superinvestors of Graham and Doddsville, Benjamin Graham’s disciple, Warren Buffett encapsulated this perfectly when he wrote:

'If you buy a dollar bill for 60 cents, it's riskier than if you buy a dollar bill for 40 cents, but the expectation of reward is greater in the latter case. The greater potential for reward in the value of a portfolio, the less risk there is.'

But it may be best to let Benjamin Graham have the final word on the importance of doing your homework on valuation as a tool in downside protection and risk management:

‘An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.’

Russ Mould, AJ Bell Investment Director