Selecting stocks in the current economic climate feels like fiddling while Rome burns, of throwing good money after bad, or of being just plain daft. Maybe that notion would dissipate by paying more attention to comparatively upbeat US employment data and less to dire warnings from the Bank of England’s monetary policy committee; besides, even the committee acknowledges there is much more uncertainty than usual around its dismal projections. Whichever, sometimes stock selecting just has to be done, like it or not. With 15 per cent of its assets in cash, for the Bearbull Income Portfolio, this looks like one of those times.
Given the amount the Bearbull household spends maintaining its small army of domestic animals, shares in Pets at Home (PETS) might be a ready choice for the Bearbull fund. In truth – and for no particular reason – I have given the pet-foods retailer little attention since its shares came to the market now all of eight years ago.
Of course, the firm’s bosses would object to having their group labelled a ‘pet-foods’ retailer; the point being that an important part of the growth plan is moving beyond foods, tapping into the other streams of spending folk incur when they run domestic animals. Thus management is big on selling so-called subscription services – tying in customers via the likes of loyalty cards and special offers. On the retail scene, this hardly counts as rocket science, but companies do it because it is low cost and it works. Pets at Home claims revenues from subscriptions running at an annualised £135mn, which compares with likely group revenues for 2022-23 of about £1.4bn.
Similarly, management ties in customers with the one-stop-shop thing, which means in-store grooming parlours to keep those cockapoos looking cute and – more important – a veterinary joint venture with over 440 practices. Revenue growth in the vets’ venture, at 8.6 per cent year on year, outpaced the retail operation (up 5.6 per cent) in 2022-23’s first quarter, according to an upbeat trading report last week. The update reiterated that underlying pre-tax profit for the year looks like running out around the average of City forecasts, which is £131mn. That would feed through to about 21p of earnings, about the same as last year.
So, on a price of 338p, a rating of 16 times forecast earnings and an acceptable dividend yield of 3.5 per cent, what’s not to like about the shares? Chiefly, that the group’s growth rate will slow down. That is simply a function of the fact that Pets at Home is now mature, with a claimed 24 per cent of the UK’s pet-care market. Sure, such a big share should provide resilience via profit margins that have averaged 11 per cent in the past 10 years. Yet it will also be tough for Pets at Home to increase it much, especially given the muscle of its supermarket competitors and the ease with which smart new entrants can snap at its heels.
Not that an uneventful slowdown – if there can be such a thing – would be calamitous. In the past 10 years sales growth has averaged 9 per cent a year. If, on average, that drifted off a couple of percentage points in the next few years, it should still provide scope for earnings growth to average 10 per cent-plus.
In turn, it looks acceptable to buy that pace of growth on a 16 times earnings multiple. Granted, that depends on the return an investor seeks. Think of it in these simple terms: assume an 8.5 per cent target return, and a purchase of Pets at Home shares on a 6.3 per cent earnings yield (the reciprocal of a 16 times multiple). If that earnings yield grows at 10 per cent a year, then the break-even point – when the earnings yield exceeds the cost of capital – comes after four years. Beyond that, the investor is in profit (or, at least, the earnings yield is higher than the cost of capital). Obviously, that’s super-simplified, but it is on such back-of-the-envelope sums that sensible investment decisions are made.
Meanwhile, among other companies touched on last week for their combination of acceptable dividend yield plus maybe that extra ‘something’, there is platinum-metals specialist Johnson Matthey (JMAT). What makes Johnson unusual among income-fund candidates is that it is somewhere between a growth stock and a recovery situation. Or it could be a growth stock if it can both harness its expertise in recycling platinum group metals (PGMs) and put to good use the £3bn-plus cash flow it should generate in the coming eight or nine years from its cash cow, its Clean Air division, which provides catalysts for vehicles’ emissions control.
The test will be whether it eventually emerges with as substantial a profits generator as the Clean Air division, which is still going strong. In 2021-22 it made £302mn operating profit (55 per cent of the group total) on revenue of £2.5bn (65 per cent of the group total). The division’s profit margin was only below the group’s average because the other major profits spinner, PGM Services, the world’s biggest recycler of platinum group metals, pushes over 50 per cent of its revenue through to profit. Even so, Clean Air’s 12 per cent margin implies a resilient operation, which is becoming more efficient as production shifts to more modern factories.
Ideally, Johnson Matthey will build a major profit generator from its Hydrogen Technologies division, which uses platinum to help in the production of so-called ‘green hydrogen’, where an electrical current, powered from a renewable source, is run through water. Although the company already has a presence in hydrogen production and claims contracts and partnerships with “leading hydrogen players”, producing hydrogen via electrolysis of water is much more expensive than deriving it from methane. So it remains unclear whether there is a mass-scale industry to be created.
What Johnson Matthey most wants to avoid is a repeat of the failure of its venture into batteries for electric vehicles, where it designed the battery cathodes. Little more than a year ago, its bosses insisted that its eLNO project remained on track. Yet within months the project was scrapped at a cost of £325mn as it became clear the group was unlikely to generate the scale to sell its battery components at a profit.
Now the group has a new chief executive, Liam Condon, who has spent much of his career at German agri-pharma group Bayer (DE:BAYN). He talks the talk – don’t all chief executives nowadays? – saying that Johnson Matthey must become a more focused, simpler business. Most likely, however, the difference between clear success and the sort of adequate performance that it has typically delivered will be the extent to which the big thing – ie, hydrogen technologies – delivers. To a large extent that will be beyond the chief executive’s control and, at this stage, assessing its chances is mostly guesswork.
Certainly, Johnson Matthey’s prospects divide City analysts. Hence the disparity in their estimates of where the share price – currently £21.55 – should be. For instance, investment bank UBS remains bearish, recommends selling the shares and thinks the fair price should be £17.50. In contrast, broker Panmure Gordon has changed from being a bear in January, and suggesting a price of £22.50, to being a stomping bull with a price target of almost £39.
The group’s steady record – 2021-22 was the first time in more than 10 years that underlying pre-tax profit was below £200mn – means it is fairly routine to find acceptable value in the shares. Assume operating profit at the five-year average plus 8.5 per cent as the cost of equity and there is approaching £27 per share of value. Work via the cashflow statement and the group’s heavy capital spending limits the left-over free cash from which value is built. Yet Johnson Matthey seems to make a healthy return on equity – about 13 per cent – so that implies the capex will also generate future value. Thus tentative value close to Panmure Gordon’s £39 per share can be extracted from the cashflow data.
That may be another way of saying the share price – little more than half its five-year high – should have plenty of upside and limited downside, especially as the group carries net debt that is both modest and close to its five-year average. Last, Johnson Matthey’s share price should respond to a beat that’s different from the remainder of the Bearbull fund. Based on monthly returns over the past 12 years, the correlation of Johnson Matthey’s share price changes with the income fund’s changes is usefully less than the average of changes in the All-Share index with the fund – a correlation of about 0.4 for the shares compared with 0.6 for the All-Share, where 1.0 would mean returns were identical and the ideal is a negative value. In other words, if the future is like the past – big if – the presence of Johnson Matthey's shares in the fund will slightly reduce the volatility of the fund’s returns.
Useful, but hardly a deal maker. The same correlation applies to shares in Morgan Advanced Materials (MGAM) and they won’t be going in the fund. Like Johnson Matthey, Morgan has been around a long time, sometimes exciting high expectations, which it usually failed to live up to. It has changed its shape while retaining core competences; in its case, working in industrial ceramics and carbon materials to supply the likes of firebricks, heat shields, self-lubricating bearings or carbon brushes used in electric motors.
Morgan’s first-half results for 2022 looked fine. The group has been in recovery mode since 2020. Underlying revenues were up 15 per cent on 2021’s first half and operating profit was 23 per cent higher. That fed through to an interim dividend which was two-thirds higher than the previous interim, meaning the annualised payout is now back to its 2018 level and offers an acceptable 3.7 per cent yield with the share price at 296p.
However, a problem with assessing Morgan is that its performance is drowned out by the noise of its virtue signalling. So much so that it is not all that obvious how it actually makes money nowadays. Similarly, a business strategy that, according to the interim results, has three priorities – ‘big positive difference’ (surely a verb missing there), ‘delight the customer’ and ‘innovate to grow’ – struggles to be taken seriously.
Company bosses spend so much communication time telling us how their company will save the planet, while somehow making it more diverse yet inclusive, that they obscure the message about how the company is really performing or even what it does to make a crust. Perhaps that’s the intention and Morgan is hardly alone in this; perhaps the 113 times that it uses ‘sustain’ or ‘sustainable’ in its 2021 annual report isn’t even exceptional. Yet sometimes there are better things to do than wade through the flim-flam. Morgan can stay in the pending file and this search for new income stocks concludes next week.
bearbull@ft.com
