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Style counsel

Created:

3 June 2008

Written by:

Mr Bearbull

You've heard of lifestyle investing - it's the notion that, at various times, has made shares in the likes of Diageo, Next and Whitbread wonderfully fashionable. Now think about decline of lifestyle investing - betting on life's events that can be postponed but never cancelled. Buy shares in companies that aim to defer the inevitable, or deal with it when it happens, and you buy bits of companies whose markets, at worst, are deeply reliable or, at best, have an insatiable demand propelling them.

Healthcare group Smith & Nephew operates in the best parts of these markets - the areas where customers demand to defer the effects of ageing so they can once more shop at Next or (sort of) work out in the health clubs that Whitbread, until recently, owned. This is really what Smith's biggest division - reconstruction (eg, hip and knee implants) - is about. Smith also operates in the harrowing parts of these markets - where customers may already be doing business with another Bearbull decline-of-lifestyle favourite, nursing homes operator Southern Cross Healthcare (see last week's column); or, in the case of funerals provider Dignity, may be before long. For example, Smith's wound-management division supplies the dressings that make life a little less unpleasant for the bed-ridden and immobile for whom leg ulcers and pressure sores are as much a part of life as catheters and bed baths.

It's depressing, it may as well be treated with humour as not, but there is nothing immoral about seeking to make investment profits out of it. And the hope is that Smith's shares provide a good opportunity because their price has been hit by the botched £460m acquisition of Swiss-based Plus Orthopedics. At least it was botched to the extent that Smith's bosses did not know what they were getting until they had bought the business and found that its sales practices were... well, Smith is resolutely not saying, but the implication is that Plus's sales were fuelled by back handers. As a result, Smith will lose about $100m-worth of revenue in 2008 but, more to the point, its share price, now 542p, is 22 per cent off its 2008 high.

In one clear way this signals that Smith's shares are, indeed, cheap. Their multiple of 2008's forecast earnings is about 18 times. That's well below their average earnings multiple of the past five years, which is close to 24 times. Indeed, if we apply Bearbull's upside/downside ratio, which assumes that future share prices will be driven by the range of earnings multiples of the previous five years, then there is 3.2 times more upside than downside at their current price. That's just the sort of sensible yet appealing ratio that I look for when applying this little model - a lower ratio and there is not enough upside; higher and it starts to look silly.

The trouble is that, if we focus on other valuation yardsticks, then Smith's shares don't look so good. The basic reason is that the group's financial performance has not been anything to shout about for some years. Sure, earnings have increased at an acceptable pace - 10 per cent a year since 1999, for example - but nothing truly exceptional. And to achieve that, Smith's bosses have had to pour lots of capital into the business. As a result, its return on equity is ordinary - about 12 per cent in 2007. If future projects generate that scale of return, it would be difficult for management to justify capital spending that, on average, sucks up half of free cash flow. As it is, it is difficult to value Smith's shares at anything like their current price.

At least it would be if we removed takeover speculation from the share price. But we can't - Smith is a perennial takeover candidate, and this presents us with a paradox. On the one hand, Smith makes ordinary investment returns because, with the exception of arthroscopy, it does not command dominant positions in its markets - and that should depress its share price. On the other, the very fact of Smith's nearly-but-not-quite share of several attractive business segments means that one day, the group will be takeover fodder for Zimmer, Stryker, Johnson & Johnson or whomever - and that supports its share price.

So, if I bought the shares - even at their slightly depressed price - essentially I forget about upside from earnings growth and focus on takeover potential. Yet that's not enough. Either Smith does something to its business to justify a share price above £5 - unlikely anytime soon - or I wait for another gaffe to bring the price to £4 or below, at which level the shares become a different prospect. And the possibility isn't that remote - the shares were trading at that level less than two years ago.

All this does mean that this decline-in-lifestyle investing isn't coming that easily. Smith's shares are too high. Shares in Dignity - now 728p - refuse to drop to my price target (670p). And Southern Cross's shares have bounced to 422p against a target of 400p, despite growing worries about the debt levels carried by the private-equity industry's ventures into nursing homes.

Still, if patience is a virtue that comes with age, then I should be able to demonstrate it. Let's just hope I don't have to wait until I'm gaga. But at least by then I won't be worrying about investment performance.

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