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Fight or flight?

These are the days of worry and losses, the days of inflation and stagnation, the days of pessimism and fear. What’s a poor shareholder to do? Stay and fight or opt for flight? The problem with that metaphor is that, apart from activist investors, shareholders can’t stay and fight. Theirs is a passive role. They serve only to stand and wait. If they don’t like what they see, their sole choice of action is to sell.

Currently, there is plenty not to like. So perhaps what’s remarkable is not the weakness of the equity markets, but their resilience. The FTSE All-Share index tumbled 10 per cent in the three weeks to 8 March, only to recoup two-thirds of those losses by this week.

Among individual stocks, however, there have been scenes of near-carnage. So, let’s address the matter left over from last week’s Bearbull: when shares in a quality company in your portfolio get hammered, how do you decide whether to stay or to go?

●  Check the trading updates.  Focusing on the latest trading update is likely to be the best guide to the direction of trading, especially as it may come with reliable data. Granted, this might be a statement of the obvious, but too often the glaringly obvious is overlooked.

The holding in the Bearbull Income Portfolio that particularly fits the ‘quality’ tag is supplier of consumables to steel makers and foundries Vesuvius (VSVS). Since last week, it has announced a trading update optimistic enough to put some life into its share price. Trading in the first four months of 2022 – helped by pushing up selling prices – has been good enough to raise operating profit 60 per cent from 2021’s depressed first quarter. Even so, the short-term outlook is miserable. The World Steel Association has slashed forecasts for the performance of Vesuvius’s chief end markets. Growth in automotive production for 2022 has been cut from 9 per cent year on year to 4.4 per cent. Production of heavy vehicles is now forecast to drop by 8.4 per cent. The company's bosses say trading is not as bad as the share price has been suggesting, but the near future will be a struggle.

Three of the four shown in Table 1 – each quality companies in their way – have also made recent trading updates. The tone of the message from industrial engineer Spirax Sarco (SPX) was much like Vesuvius’s. For the four months to end April, trading was decent; profit margins are down a bit, although that’s due to extra development spending; the order books are at record levels, but sales growth is odds-on to slow as the year goes by. 

Table 1: Some key ratios
 VesuviusJD WetherspoonDignitySpirax-SarcoGames Workshop
Share price (p)34570947610,3956,975
% change from 52-week high-42-50-51-40-43
Profit margin (%)8.1-40.45.023.838.8
Asset turnover0.80.40.20.71.4
Return on assets (%)4.9-8.40.613.049.9
Sales growth (%)13-39-11331
Net debt/Ebitda1.4na10.40.5-0.2
Debt/capital (%)29.883.6132.731.619.3
Short-term debt/total (%)26532718
Cash flow/profit (%)35na1268497
Source: FactSet

Even at pubs operator JD Wetherspoon (JDW), its often-curmudgeonly chairman, Tim Martin, was almost hopeful. Compared with 2018-19, the most recent ‘normal’ year, sales are still down, but the trend is better and Martin is “cautiously optimistic” about a return to “relative normality” in 2022-23.

Funerals operator Dignity (DTY) can’t be that confident. With a year-on-year 19 per cent drop in the UK’s death rate in 2022’s first quarter, Dignity’s revenues were 22 per cent lower and its operating profit 67 per cent down. Added to this, its business plan is a work in progress, transitioning from ‘squeeze the customer for everything possible’ to ‘cheap and cheerful’ (I caricature). But the trial isn’t finished, so the jury hasn’t even retired yet, which may be why Dignity’s share price is so volatile. Would that Dignity could get away with saying as little about recent trading as Games Workshop (GAW). In March it mouthed monosyllabically that trading was in line with expectations, but may tell us more next month.

●  Look for marginal benefits  When the going gets tough, profit margins become vital. The wider the margin a company makes in normal circumstances, the better (though there are caveats). Wider margins leave more scope for profit to remain even as revenues fall away.

In that context, Games Workshop’s margins are beautiful and Spirax Sarco’s aren’t too bad looking. For the others in Table 1, what you see – the most recent full year’s operating margin – is not that typical. True, Vesuvius’s 8.1 per cent is around its average and Wetherspoon’s should be more like 7.5 per cent, if normality ever returns. As for Dignity, in the halcyon days of the 2010s margins came in at over 30 per cent. Those days are gone. Even so, as a duopoly supplier to a market that, despite annual variability, is assured and comes with good price elasticity, Dignity’s normal margins should surely be in double figures.

●  Making the assets sweat.  Yet profit margins are also a function of what a company does and how efficiently. An operation such as Wetherspoon’s does not necessarily need fat margins because it rapidly turns its stock in trade – booze and food – into cash, and the faster it does that, the better the return on the capital it employs. In that context, a profit margin of, say, 5 per cent can be as good as one of 10 per cent, provided the company making the 5 per cent margin turns over its capital at twice the rate of another making a 10 per cent margin (both end up with the same return on capital).

In that context, the row in Table 1 for profit margins links with those for asset turnover and return on assets; here ratios relating to assets are used rather than ratios using capital because, in company accounts, data for capital – especially its equity component – are so unreliable. But what we deduce from the table is what we should instinctively know – that Games Workshop and Spirax-Sarco are brilliant businesses, that Vesuvius is acceptably good and that Wetherspoon and Dignity are underperforming. Most likely Wetherspoon’s underperformance is temporary, but we can be less confident about Dignity.

●  Making working capital work.  We can dig into the granular level, which is what Table 2 does for three of the five companies. Especially during tough times, it is helpful to have a handle on how quickly a business turns its trading assets into cash. Chiefly, these assets are inventory (its stock in trade) and debtors (or receivables, essentially the value of the invoices dispatched). Using balance-sheet data, the table shows the average number of days, over the past five years, that it takes for stock or debtors to become cash. What’s important is the trend – is it taking more or less time for these assets to become cash? 

Table 2: Turning trading into cash
 Debtor daysInventory daysCash conversion cycle (days)
Vesuvius   
Year 0877299
Year -1906795
Year -2846795
Year -3866599
Year -48963106
Games Workshop   
Year 0278883
Year -1278888
Year -2259386
Year -3248877
Year -4228168
Spirax-Sarco   
Year 07682134
Year -18084140
Year -28078132
Year -38476134
Year -48673137
Source: FactSet

For example, Spirax-Sarco’s debtor days have consistently fallen in the past five years – that’s good. Simultaneously, however, its inventory days, like Vesuvius’s, have lengthened. That might be a concern, although Vesuvius’s bosses have been deliberately building stock levels to counter possible disruption to its supply chain. Meanwhile, the big difference between the debtors days of Games Workshop and the industrial groups isn’t important. It merely illustrates the fact that Games Workshop sells mostly for cash, so doesn’t have many debtors.

That said, it is clear Games Workshop is taking longer to extract cash from its operations. That is shown best in the column for cash conversion. This adds together a group’s debtor days and inventory days then subtracts the average length (in days) of its creditors; roughly speaking, these are the equivalent of debtors on the liabilities side of the balance sheet. The more that a company defers paying its creditors, the more its cash conversion cycle shortens. Games Workshop’s has been going in the opposite direction, adding 15 days in the past five years. Sure, that’s hardly a concern for a business that carries no net debt. If it were happening in a heavily indebted group, it might be another matter.

●  Living with debt.  This tells us that, when share prices fall, assessing debt becomes a priority. Too much? Too expensive? Due for repayment too soon? Those are the familiar issues. Dignity, for example, clearly has too much and is close to breaching some loan agreements. There was a time when it looked as though Dignity could thrive on a business model where equity returns were leveraged by fixed-cost debt. No more. At least the issue of Dignity’ excessive debt seems to be being addressed and, happily, short-term debt is just a small proportion of the total.

Ability service debt is also related to how much profit is cash and how much is of the accounting variety where cash may be incidental. The quick check is to contrast operating profit (income statement profit before interest charges) with operating cash flow (remembering, though, to deduct capital spending, which is shown somewhere within ‘investing activities’ in the cash-flow statement). It might also be necessary to add back interest costs.

The ideal is the sort of result – surprise – offered by Spirax-Sarco and Games Workshop in Table 1’s bottom row, where a big proportion of accounting profit becomes cash. But don’t necessarily be comforted by a high ratio, such as Dignity’s for 2021. It is only high because operating profit is so low.

Sure, these exercises only scratch the surface. Better to scratch the surface, however, than to gloss over the dents. Besides, there is nothing to stop you digging deeper.

bearbull@ft.com