Industry consolidation - or when longer term returns arrive sooner

Monday, 27th February 2017 10:35 - by David Harbage

Investment in listed company shares should always be undertaken with a full appreciation of the inherent risks and with a long term (of let’s say between 5 and 10 years) perspective. While different individuals or non-personal investors will have very different goals, a sensible expectation of prospective returns from equity is for a total shareholder return (TSR) that matches or slightly exceeds inflation. TSR is often used by companies as a means of assessing and rewarding their directors and is calculated by combining the income return – received typically in the form of dividends - and capital appreciation.

The FTSE100 index produced a remarkable TSR of +19.1% in 2016, compared to its (income included, but not reinvested) average performance over the past decade of 6.4% per annum. Over that ten year period UK inflation, (as measured by the Consumer Price index), averaged 2.5% - reaching a high of 5% in both 2008 & 2011, but flirting with negative inflation (i.e. deflation) throughout 2015. Readers who need to be reminded that the stock market (as well as individual share prices) can go down, as well as up, might be interested to see the TSR for various leading indices of stock exchange fully listed company shares for each of the last ten years:

FTSE100 index (largest 100 companies) 2007 +7.4%, 2008 -28.3%, 2009 +27.3%, 2010 +12.6%, 2011 -2.2%, 2012 +10.0%, 2013 +18.7%, 2014 +0.7%, 2015 -1.3%, 2016 +19.1%

FTSE250 index (next largest 250 companies) 2007 -2.5%, 2008 -38.2%, 2009 +50.6%, 2010 +27.4%, 2011 -10.1%, 2012 +26.1%, 2013 +32.3%, 2014 +3.7%, 2015 +11.2%, 2016 +6.7%

FTSE Small Cap (remaining c.600+ companies) 2007 -10.5%, 2008 -43.9%, 2009 +54.3%, 2010 +19.5%, 2011 -12.5%, 2012 +27.8%, 2013 +32.8%, 2014 +0.9%, 2015 +9.2%, 2016 +14.3%

FTSE All Share (all of the above companies) 2007 +5.3%, 2008 -29.9%, 2009 +30.1%, 2010 +14.5%, 2011 -3.5%, 2012 +12.3%, 2013 +20.8%, 2014 +1.2%, 2015 +1.0%, 2016 +16.8%       

Incidentally, one can also see the dominance of the mega cap constituents within the All Share index – typically the FTSE100 stocks make up, and contribute, in excess of 80% of the All Share index. Accordingly, if the last ten years is any guide, achieving an annual total (dividend income plus capital appreciation) return of say 5% might seem unremarkable, but would comfortably exceed the current rate of both domestic inflation and interest offered on cash deposits. The return on any individual company stock can, of course, vary dramatically from the above mentioned diversified indices and the same applies even within a homogeneous industry grouping or sector. While a stock picker might hope to beat the wider market when selecting a specific company share - perhaps aiming for a TSR of 10% rather than 5% - nevertheless he or she should also have realistic objectives and expectations in terms of shorter term performance.

Research analysts will often attach a ‘fair value’ to an individual company, based on its current financial status and prospects. This may well be pitched ambitiously and calculated using a wide range of criteria, which would almost certainly include the equity valuations (by reference to asset worth or projected profits) of a company’s peer group. Larger businesses naturally attract more broker attention (if only in the hope of earning fees for providing advice on corporate activity, like mergers or acquisitions, known as M&A), as well as institutional investor interest, which combine to mean that the share price is likely to reasonably reflect its true worth. Put another way, the scope for a surprise – be it adverse or pleasing – is reduced, as compared to a smaller less well-monitored business.   

This week has been a busy one in the corporate world, as many firms have announced their trading results for the period to the 31 December 2016. Amongst these, two companies which have been mentioned in previous blogs caught the writer’s eye. The food and household goods giant Unilever captured most headlines earlier in the week, following the news that it had received a hostile takeover approach from the US food giant Kraft Heinz. Shares in the Anglo-Dutch group, which had initially risen on the news of the US$143m bid, retreated on learning of its rejection before recovering again when the CEO announced a comprehensive strategic review of the firm’s operations. Paul Polman has been at the helm since 2009 and has a wide range of other high profile interests; prompting some fund managers to accuse the Dutchman of ‘taking his eye off the ball’ when the most recent trading results exhibited a number of flat spots.

Politically, the proposed bid or merger might not have occurred in the less globally liberal environ that may be emerging post Brexit and Donald Trump’s emergence in the United States. Having said that, it seems that Kraft’s action has prompted a reconsideration of the worth of its European peer by brokers and investors – as well as acting as a catalyst to the company’s own board of directors. It is interesting to peruse the more recent analysis carried out by equity research houses on Unilever. Looking at 20 ‘Sell side’ broking houses prior to last Friday’s statement of a potential merger, 9 had a Buy recommendation, 7 a Hold and 4 were Sellers. The average share price target was £35.50p and speculation on the day took the shares from 3347p to £38. Subsequently, while the stock has moved between 3548p and £38 this week to date, Berenberg Bank’s analyst has reiterated the investment house’s positive stance and raised their assessment of a fair valuation – which was already at the top of the range - from £39 to £41 per share.              

Another even more recent corporate development surrounded the Alternative Investment Market (AIM) listed online gaming company 32Red, who announced a forecast-beating trading update on the 1^st February. Yesterday a larger European peer, Kindred (probably best known for its Stan James brand name in the UK) made an agreed £175m cash bid (of 196p per share), which represented a 32% premium to the 32Red share price that typically prevailed in the month previous. By contrast with the FTSE100, the number of brokers providing research on AIM companies is sparse and, more often than not, getting rarer. In this instance, only two firms proffered a view, the most recent of which (from Numis) was issued in response to the trading announcement. A price target or fair valuation of £2 was put on 32Red’s equity as the broker’s forecasts for earnings in the current year and for calendar year 2018 were raised.

Clearly, two very different industries are represented here: the manufacture of food (in particular) and household products is viewed as low growth – with best future prospects coming from emerging economies being prepared to move upmarket and purchase Western branded products. By contrast, the gaming industry exhibits much higher growth - notably via online and higher levels of mobile device usage. Consolidation is evident in both industries, but M&A in food is often driven by defensive ‘survival’ considerations while amongst online leisure businesses (such as gaming), predators are making complimentary acquisitions to expand their geographic or market share.

In the belief that their market is growing, such businesses are prepared to pay a significant premium to current equity valuations in order to gain the necessary approval from shareholders of their ‘prey’. Such firms are frequently successful themselves, but perhaps in the case of 32Red require more capital in order to fulfil their potential. It will be interesting to see if another ‘player’ in the gaming industry enters the fray and makes a higher bid.

While Unilever stands at a fairly demanding valuation (the stock’s price-to-earnings multiple comfortably exceeds the previously mentioned FTSE All Share index and the dividend yield is no better than average), by contrast with some of its US and European peers the company’s shares are not expensive. However, although Kraft may come back with a renewed attempt (no doubt encouraged by the business appearing more affordable to this US dollar denominated acquirer) the number of other potential acquirers are few.

In 32Red’s case, there may well be more action in coming days – based on the past two years’ experience that several suitors emerge when a business in this industry sector attracts a predator. Even at 200p a share, 32Red does not look expensive based on projected profit growth of 55% in the current year and almost 20% in calendar 2018. The latter would deliver earnings per share (EPS) of 17.4p to put the stock on a PE ratio of 11.5 times which would represent a 15% discount to the wider UK equity market.

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.