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The segregation myth

In a way, this is a generic idea – that value can be recognised or ignored simply because of where one company sits in relation to others. Take a variation on this theme – that a company can become more valuable if its shares are moved to a stock market sector that is rated higher than the one into which it is currently shunted.

Central to this idea is the assumption that the values of some excellent companies are depressed because they are in the ‘wrong’ sector. They may be the star of a low-growth industry, but that connection with mediocrity deprives them of the recognition they deserve. Put them in a sector where their talents will be acknowledged and their value will bloom.

For instance, label a company a wealth manager rather than a life insurer and it becomes much more interesting. If another can show it’s a technology company rather than a boring property company – obviously I am referencing WeWork (corporate name, The We Company) – there may be no limit to its value. Except the WeWork affair shows it’s not that simple.

So, it would be good to know to what extent company values are restrained by their sector. Because not that many cross over, the obvious way is to make intra-sector comparisons to examine how much share ratings within a sector cluster together regardless of the performance of individual companies. To do this, we need to use sectors that comprise companies that fulfil similar functions, are subject to similar constraints and exploit similar opportunities. I have used three low-tech sectors that meet these criteria better than most – food producers, food retailers and general retailers.

The underlying assumption behind the table is that companies’ performance will drive their share ratings. Performance boils down to use of capital and growth. For these, we use return on capital employed (ROCE) and growth in earnings before interest, taxation, depreciation and amortisation (Ebitda), essentially cash operating profit. To minimise the distortions of lumpy data, we have averaged the figures – the average of the past three years for ROCE and the compound growth over the past five years for Ebitda.

 

Performance gets rewarded
 Food producersFood retailersGeneral retailers
No. of companies11623
Performance
ROCE (%, ave of past 3 years) 
Average7.36.312.8
Median6.95.08.6
High 13.118.340.9
Low2.00.44.5
5-year Ebitda growth (% pa)   
Average8.45.53.5
Median6.98.3-0.8
High 44.817.142.3
Low-10.3-9.7-6.9
Ratings
EV/Ebitda (average of past 3 years)  
Average11.916.210.1
Median10.78.89.5
High 37.555.234.2
Low5.36.93.5
Source: S&P Capital IQ   

 

Share ratings, which have also been averaged, are measured by the ratio of ‘economic value’ (ie, the market value of equity plus net debt) to Ebitda. This makes a better comparator than the ubiquitous price/earnings (PE) ratio because a company’s PE ratio is affected by its capital structure. Focusing on EV/Ebitda, where debt does not affect the multiple, makes the comparison cleaner.

The impression is that neither companies’ performance nor their share ratings are that compressed. True, within the smaller food producers and food retail sectors, the difference between the average and median return on capital employed (ROCE) is limited; and especially among food retailers, the distorting presence of Ocado (OCDO) and its shrinking Ebitda depresses growth and raises ratings.

Nevertheless, it seems that the classy operators get ratings to match and the mediocre performers get the ratings they deserve – and both are well apart. Thus, in food retailers, Greggs (GRG) has the best average ROCE (18.3 per cent), the smoothest growth in Ebitda and – barring Ocado’s outlier – the highest EV/Ebitda rating.

Similarly, in the bigger sample for general retailers, those with rapid Ebitda growth and/or a high ROCE cluster at the top: the likes of Just Eat (JE.) – a bit of an oddball in the sector – JD Sports (JD.) and Next (NXT). Meanwhile, the stragglers struggle at the bottom; for example Marks and Spencer (MKS), whose Ebitda has shrunk at the rate of 1.4 per cent a year for the past five years, earns an EV/Ebitda rating of 5.9 against a sector average of 10.1. Worse, Dixons Carphone (DC.) has shrunk Ebitda by 3.4 per cent a year for a rating of 4.5 times.

General retailers also produce a neat correlation between rising Ebitda growth and higher ratings where the data points are nicely dotted around the regression line. It all adds to the thought that bosses and investors alike should care less about which sector their company shares are grouped in and more about maximising corporate performance – that’s what really adds value.