David Harbage Blog

High levels of macro-economic noise, confusion surrounding the financial system, and unexpected ‘banana skins’ amongst a plethora of trading announcements, suggest investors need to be increasingly selective at both the business sector and individual stock selection level.

Having looked at most of the major industry sectors represented on the UK equity market (which are not necessarily the largest industries or business activities within the domestic economy), this week’s blog progresses the review by looking at the first of two ‘catch all’ segments: industrials and consumer services.

Industrials – from dull defence to exciting IT

Featuring manufacturing and engineering of products across a wide range of industries, investors should focus on the applications – both of end products and geography of customer – and demographic or other pertinent drivers before considering each individual company on its own merits. Such companies will often produce high specification, niche market products that command global leadership, as compared to the often erroneously-perceived, non-differentiated, lower margin widget producer or ‘metal bashing’ engineer. These businesses will often be exporters - although some will manufacture overseas under licence - and the extent to which they can maintain or improve profit margins will depend upon the industry and their competitive position within it. Examples of very different industries, currently experiencing rather different paces of growth, are civil & military aerospace and technology hardware & equipment. Within those business sectors, BAE Systems is one of the UK’s biggest employers amongst manufacturers, best known for its military hardware (jet fighters and armoured vehicles), while ARM Holdings designs and produces microprocessor chips used to power personal computers and mobile phones.

Aerospace: BAE Systems, Rolls Royce...

BAE Systems will typically work on long term contracts for the Ministry of Defence or equivalent international government agency. As such, unlike most industrial manufacturers, the company’s business is not particularly sensitive to the current economic climate; other factors such as a medium term estimate of likely geo-political tension or military activity come into play. Clearly many governments are introducing austerity measures which will impact defence budgets, but other developing nations are not so financially constrained. Another FTSE100 index constituent in the aerospace industry, Rolls Royce, is more cyclical but it has a greater bias to civil aircraft – via its Trent engine - with its prospects being impacted by global demand for air travel and new airliners. Tougher environmental legislation (governing sound and emissions) could be beneficial, as older fleets are retired, but otherwise Rolls Royce benefits from increased demand for servicing (in itself a higher margin business activity) on more mature aircraft. As one might anticipate in the current political clime, as both administrations in the US and UK plan to reduce defence spending, BAE Systems stock appears neglected (on a price/earnings multiple of 7.7 times analysts’ consensual forecasts for 2013, and a current dividend yield of 6.2%), while Rolls Royce shares appear more fully valued (based on a PE ratio of 13.2x projected earnings in 2013, and current dividend yield of 2.3%).  

...or look beyond the biggest

Beyond these two big FTSE100 companies, other industrials with manufacturing interests in aero and defence include Cobham and Meggitt, who reported results on Tuesday and Wednesday respectively this week (as did the maintenance business BBA Aviation), and Smiths Group. But taking a closer look at smaller specialist defence companies could prove worthwhile, as sentiment has depressed share valuations of a number of interesting military or aero-industry businesses – perhaps to the point of attracting the attention of cash-rich predators. One such example is the FTSE250 index constituent Chemring, a world leader in its particular proposition: the company produces the flares and chaff counter-measures jet fighters and warships deploy against missile attack. Smaller, more product focused businesses like this are more likely to be exposed to up or down swings in the industry than bigger more diversified industry peers, with recent fears of more governmental cut backs resulting in the share price more than halving in the past 18 months. As a consequence, Chemring stock is currently valued at 5.6 times analysts’ consensus of projected profits in 2013 and currently yield 6.0% (three times covered by earnings).

A Rather different ‘Manufacturer’

By contrast with many engineers and industrial businesses, ARM Holdings only began life in 1990 and its business model is very different. Designing the processors which are then manufactured under license by its partners (primarily semiconductor manufacturers), usually in low-cost locations, results in royalty income. The need to retain technological edge and pricing power is paramount, with the increasing pace of new product developments (in mobile phones, digital television, mobile computer tablets) offering high risk-reward potential. This is reflected in ARM Holdings stock’s heady rating: an earnings-based valuation of 32.5x forecast profits in 2013 and dividend yield of just 0.7%. Clearly, by contrast with BAE Systems, this is a business which is focusing on reinvesting its revenues into the business. However, any disappointment in revenue or earnings – relative to the market’s expectation, rather than in absolute terms – or perceived competitive threat, or change in consumer appetite for a specific product, could prompt a sharp correction in the share price. Most technology-related stocks should probably carry a ‘not for widows & orphans’ label but, if equity investment is ultimately about owning the most successful (and therefore growing) businesses, then IT cannot be excluded from a portfolio. Conservative investors might feel more comfortable with the likes of FTSE100 accountancy software business, Sage, whose shares – reflecting more stable prospects - offer a more supportive valuation; or otherwise prefer to capture technology’s higher growth potential via a specialist collective vehicle.

IT: Departees and Newcomers

The UK equity market, particularly by reference to the FTSE100 index, has a relatively light technology weighting, but looking beyond the biggest companies there are a number of small IT companies – primarily in services and software – notwithstanding a number of acquisitions or takeovers from overseas, which has seen the likes of one-time FTSE100 members Autonomy, Logica and Misys delist. While seasoned stock market investors have not forgotten the technology bubble at the turn of the millennium (when valuations rose dramatically, before subsiding), development within the industry itself has continued apace. There are many smaller businesses, who have sought to deliver a particular technological edge or solution in the rapidly developing and global application of new products such as android mobile phones and handheld multimedia computers; companies such as Imagination Technologies or Monitise are worthy of a closer look.

Spotting the next ‘big thing’

As in any business sector, investors look at new developments – secular, structural, in demographic or lifestyle terms or in products, locally or worldwide - and seek to establish who the potential listed market beneficiaries could be. The Olympic Games represent an example of a short term event, which the market knew was occurring, but may yet provide investment opportunity as surprises (pleasant or adverse) inevitably arise – perhaps Halfords Group could enjoy a much overdue improvement in bicycle sales, following Team GB’s success in the sport. Looking across an entirely different industry, the rapid appearance of a plethora of electronic devices suggests a number of smaller and medium sized companies who facilitate such developments – beyond the bigger well-known names, such as Apple, Microsoft or Samsung – can be major beneficiaries.

Potential British winners....

Hertfordshire-based Imagination Technologies is a £1.4 billion market capitalised global leader in multimedia and communication technology; not unlike ARM, it creates and licenses hi-technology processors required in applications as diverse as digital radio to motor car sat-nav electronics, HD & 3D television to cameras. The company is profitable (projected to make £34 million in the current trading year, and £48 million in the year to end April 2014) and, currently monitored by 16 brokers, has a significant following amongst City institutions. A lesser known but more product-specific technological application, reflecting the increasing use of the mobile telephone for an ever widening range of applications, could prompt interest in AIM-listed Monitise which claims to be a global leader in providing the capability to access bank information, action financial transactions and shop via the handy-sized phone. Growing via joint ventures (notably with Visa), serving UK listed banks HSBC, Lloyds, Royal Bank of Scotland, Standard Chartered), the group expanded its global aspirations via the acquisition of Clairmail in June to take a 30% share of the US market. Increasing interest on the part of the big institutions (Goldman Sachs began coverage of Monitise this week, with a Conviction Buy recommendation and a 60 pence price target) will help publicise the business.

...but undoubtedly higher risk-reward investments

By contrast with Imagination Technologies, the much younger Monitise (which began life in 2003) is unlikely to become profitable until 2014 and neither company is expected to pay a dividend to shareholders in the foreseeable future. The threats to ongoing progress for each business are very real, but perhaps the greatest hurdle to shareholders’ achieving satisfactory returns surrounds the high expectant valuation. For equity investors requiring greater comfort, in terms of asset backing or immediate income, other businesses – typically in more mature and visible industries – will probably offer greater appeal. In the absence of a more compelling financial story, we will conclude our review of business activities reflected within the UK listed sectors next week by considering consumer related activities.

The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.