A stock for 2018

Thursday, 4th January 2018 12:46 - by David Harbage

Well, 2017 came – surprised, delighted, disappointed, brought joy, delivered sadness – and went very quickly. Leaving aside personal experience, most financial commentators would agree that the balance of news had overwhelmingly been market unfriendly: domestic uncertainties surrounding Brexit, the impact President Trump would have, rising geo-political tensions (surrounding North Korea, to name just one country) and below-trend economic growth. However, reminding us that stock market performance will so often be counter intuitive, the FTSE100 index overcame this ‘wall of worry’ to rise 8% in the year to reach a new high of 7,697 on the 31 December.    

In choosing a selection – and, please note, never a recommendation or a ‘tip’ – the writer has been mindful of the following factors:

1. Outlook for the global economy is mixed: the United States can benefit from a more business-friendly regime (evidenced most recently by dramatic cuts in corporation tax), China is still slowing from its supra-normal pace of growth, little is expected from Europe and the UK, with a surprise to economic forecasts expected to be on the upside. In looking at the universe of the FTSE350 index (the 350 highest value UK listed companies, by the worth of their shares), only those expecting to announce an advance in profits in their current trading year were considered eligible. 

2. Equity valuations are becoming stretched, by comparison with historical ratings (for instance by reference to the price to earnings ratio), in particular on Wall Street which appears to have ‘booked’ some of 2018’s anticipated gains (on corporate profit upgrades) already. By contrast, reflecting the impact of sterling’s significant depreciation in 2016, UK listed stocks continue to display an abnormally high dispersion between the valuation of domestic and multinational businesses.

3. Coming up with a single company share, or even a handful of ideas is not a sensible strategy for investment. Putting ‘eggs’ into a variety of ‘baskets’ is more prudent; essentially reducing asset and security-specific risk by creating a diversified portfolio.

Having assumed that the latter is a given and is in place, most investors will be seeking opportunities to introduce – perhaps as dividend income accumulates – a new business activity or add a different company exposure to the portfolio. The prospect of taking advantage of what might appear an oversold situation or buying something particularly unloved might appeal. By all means add to a strong performer if positive momentum – in the form of trading results, news flow and investor appetite – is expected to continue. But the attraction of identifying an out of favour, unfashionable business before the market (or institutional investor) catches on, and re-rates it higher, can give greater satisfaction and may appeal more. 

Certainly, one would only want to buy into a firm where the business model could be understood and the outlook was promising. We have a stock worthy of closer inspection, whose shares are listed on the main market of the London stock exchange and are constituents of the FTSE250 index (the largest 250 companies on the LSE, after the largest 100 which comprise the FTSE100 index). The company builds houses throughout the United Kingdom and is Newcastle based, national volume house builder Bellway.

House builders were one of the prime stock market casualties from the EU referendum vote eighteen months ago, as investors worried about the outlook for the UK economy and a potential end of skilled labour from the continent. Many fund managers, quite correctly, saw the devaluation of the pound as an exceptional one-off opportunity to reposition their portfolios away from domestic businesses to overseas earners. As it turns out, UK consumer confidence has not suffered to the extent predicted by most financial, as well as political, leaders - aided by employment rising to record levels. The cost of borrowing was raised for the first time since the banking crisis of 2009 – if only by 0.25% to a base rate of 0.5% - as the Bank of England, prompted by rising inflation, sought to move interest rates towards more normal levels. House prices, with the notable exception of (stamp duty impacted £1m+ homes in) central London, made further progress in calendar 2017. 

In the year to 31 July 2017, Bellway announced a pre-tax profit of £560.7m on turnover of £2.55bn, a rise of 12.6% and 14.2% respectively. More importantly, looking forward, at the AGM on 13 December management provided further encouragement that the appetite for new homes and land availability remained healthy. Since 1 August, private reservations were 7% higher than last year, and land buying had been resumed (after a pause for a few weeks to assess consumers’ response to Brexit) at prices that are expected to deliver higher margins than historical industry norms. Acquiring 40 new sites and spending £263m on replenishing land, compares to 37 sites and £235m in the comparable previous period, which facilitates future progress - albeit in a relatively conservative way, as net debt is £168m (£136m a year ago) equating to unchanged financial gearing of just 8%.

While financial engineers might view Bellway’s management of its balance sheet as being overly cautious, the board’s track record of managing in a cyclical industry is commendable and compliments its operational risk-reward profile – featuring a focus on providing family homes (rather than apartments) on a national (rather than say a London or regional) basis. Within the industry, the group has been perceived as being focused on organic growth – rather than being merger or takeover-led – avoiding the temptation to become financially stretched. By contrast, back in 2007 at a peak in the housing cycle, such industry consolidation - involving the likes of Barratt Developments buying Wilson Bowden, and Taylor Wimpey emerging from George Wimpey & Taylor Woodrow being put together – resulted in precarious levels of debt and made the builders ill-equipped to manage their businesses when the banking crisis came along soon after. Incidentally, just before that broke, Bellway held preliminary talks with Redrow in May 2008 with a view to merging their businesses.  

The prospect of another shock to the UK economy – of perhaps a Brexit-induced downturn (leading to higher unemployment, low job security, forced sellers, loss of confidence to borrow, higher interest rates being required to support sterling, tougher regulation on mortgages) – continues to weigh on investor sentiment. Despite the wider UK equity market overcoming a number of shocks in 2017 to reach new highs, and reassuring reports from the builders themselves, the equity ratings (share price valuations compared to the wider market) of the listed companies remain depressed. Almost without exception, brokers have revised and upgraded earnings expectations for 2017 and 2018 - in Bellway’s case by more than 20%, while the shares have risen by 44% in 2017 - but investor sentiment remains mixed. Some fund managers have used the sector as a ‘source of funds’ to reinvest into non-sterling earning sectors in the knowledge that protracted Brexit negotiations will ‘cast a cloud’ over domestic industries for the foreseeable future.

The current valuation of Bellway equity, based on 31 December’s close of business price of 3563p, company data and consensus of broker opinion, suggests that in the year to 31 July 2018 earnings per share (EPS) is forecast to be 414.2p. This equates to a price-to-earnings  (PE) ratio of 8.6x – which represents a 35% discount to the overall UK equity market’s one year forward looking PE multiple - and the company is expected to pay a dividend of 136.7 p (therefore covered more than 3 times) which equates to an income yield of 4.4%. On the Sell-side, the writer noted 17 research houses that monitor the stock and have input into those estimates; their collective recommendations show 13 Buys, 3 Holds and there is 1 with a Sell. The most recent price targets (for what they are worth) issued in December on the stock have ranged between 2780p (made by Canaccord Genuity) and 3745p (HSBC).     

Incidentally, this time last year the same City broking community predicted EPS of 329.3p for the year to 31 July 2017, and Bellway comfortably exceeded analysts’ expectations by delivering 370.6p. Such a ‘beat’ should not be expected this year, as trading conditions have become predictable – as evidenced by slowing house price inflation (Nationwide published house price survey today, suggesting overall UK home prices rose 0.6% in December 2017, by 2.6% over the past year as a whole). The same survey indicated a 4.5% rise in house prices in 2016but, critically, HM Government’s Help to Buy scheme means that demand – and therefore prices – for new homes is undoubtedly much stronger.   

Like share prices, house prices can go down as well as up and are likely to be impacted by any future shock to the system. However, the current supply-demand imbalance (most obviously emanating from population growth and secular demographic trends towards smaller family units) has underpinned recent forecasts - from the Royal Institute of Chartered Surveyors, to mortgage providers Halifax and Nationwide - of further growth in UK, ex-central London, house prices in 2017. While much of the demand from the domestic, private buy-to-let investor has eased, other new landlords might be emerging in the form of institutional asset managers (contracting to buy residential developers, such as Telford Homes, ‘build to rent’ schemes). 

By way of background, Bellway’s equity is currently capitalised at just over £4.5bn, and the shares are held by institutional fund managers like Standard Life Aberdeen (who own 9.9%), Strategic Equity Capital (5.5%) with Fidelity, Dimensional, Blackrock, MFS, JP Morgan Chase, AXA Framlington and Credit Suisse also owning 3%+ stakes. This stock is liquid, enjoying a free float - with the directors owning just 0.5% of the company. The shares performed very well from January 2012 to December 2015, rising from 700p to 2836p, before market makers used Brexit to induce a collapse to 1689p. The trading record throughout the period has remained impressive and the shares have doubled since their summer 2016 low.

On the basis of the housing market remaining stable (via likely house price inflation of 1%, and 5 year interest rates to rise by no more than 1%) in 2018, and forecast profits for 2018 -2019 remaining close to the current level, Bellway stock appears undervalued. If an earnings multiple of 10 times (implying a re-rating of sorts, but still a 25% discount to the wider UK equity market) were placed on the current forecast EPS, the shares would be valued at 4142p – 16% higher than their current worth. On the same presumption of a steady new housing market over the next 3–5 years leading to a conservative prediction of an unchanged earnings stream, the board would almost certainly seek to increase the pay-out ratio (from being 3 times covered by profits to 2 times). This could lead to a 50% increase in the dividend to 207p, which would equate to an income yield of 5.75% - and still allow the distribution to be twice covered by earnings.   

Perhaps encouraged by Christmas spirit, management could also reconsider that prospective merger with peer Redrow, or perhaps Crest Nicholson, with a view to improving its buying power insofar as build materials is concerned and boosting its availability to bigger (especially passive) investors. Currently, Bellway is the 100^th largest listed company on the London stock exchange (has to get to number 90 in order to oust and replace an existing FTSE100 index constituent) and a merged group would become members of the FTSE100 club. Redrow is half and Crest Nicholson just one-third of Bellway’s size in market capitalisation worth – enterprise value is a minor consideration given each of these firms’ relatively low debt – and Bellway could afford to offer some cash to ‘sweeten’ the deal.

However, an ideal would be a largely ‘paper’ merger of their equity: with both peers looking unloved – and therefore vulnerable to takeover – for instance Crest Nicholson is on an earnings multiple of 7.5 times the profits forecast for their accounting year to 31 October 2018. Trading across the new residential build industry has been robust (although retirement home provider McCarthy & Stone – relying on down-sizing – and Berkeley Group, with its exposure to higher priced London, exceptions). A good example would be Redrow in the year to 30 June 2017, Redrow announced a pre-tax profit of £315m on turnover of £1.66bn, a rise of 26% and 20% respectively, and November’s AGM provided further encouragement: via private reservations (+2%) and selling prices (+5.4%) up, along with a record order book of £1.2bn and debt down to a negligible £25m. The next update from this company, which builds homes in England & Wales, will be on 7 February when they are due to announce results for the second half of 2017.

Investors have to decide whether house builders look fairly valued – appreciating that these businesses are significantly operationally, if not financially by contrast with the past, leveraged. (A fall of 10% in the number of houses sold and a 10% fall in the average price of each unit would have a marked impact on profits). Prospective investors in the sector have to ask themselves if they believe profits are set to halve from current levels – in order to take a stock like Bellway to a market average earnings rating - or be maintained and potentially even grow, which would imply that the current share price is significantly undervalued. While the ‘jury may be out’ on the impact of Brexit on the domestic economy, the prospect of owning a cash generative business paying high dividends has appeal. A raft of trading updates will emerge from the builders with calendar year-ends over the next few weeks and it is their forward-looking outlook comments that will be scrutinised most closely. As far as assessing Bellway’s particular trading performance is concerned, the company’s next pronouncement will come on February 7^th when it announces a trading update for the six months to 31 January 2018.

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.