The sophistication – or lack of it – of financial markets in general and equity markets in particular is a never-ending topic for debate. I tend towards the deferential view, which says that the many brains shaping market prices are likely to be smarter than a single, solitary lump of grey matter. So market prices have a better chance of being right than one punter’s stab at valuation. However, the chart for speciality chemicals group Victrex (VCT) might tempt me to revise that opinion.
If financial markets are smart, they should see through the flim-flam and get to the meat of the thing. They should, for instance, be able to distinguish between a company that declares lots of accounting profit but little in the way of free cash (bad) from one that majors on the cash flow and lets the bean counters look after accounting profit (good).
Okay, investment life is rarely that clear-cut, but the chart shows a simplified version of some features of Victrex over the past 10 years and suggests that the market has been a bit thick. As a result, the share price was out of sync with what was happening. It was rising when it might well have been falling; more recently, it was falling when, perhaps, it should have been rising.
The determining factor with Victrex is the relationship between a group’s capital spending and its free cash flow (the cash profit left over for shareholders after all obligations – tax, interest, you name it – have been paid). Ultimately, free cash is what equity investors want because it is theirs and it’s real money, not an accountancy variety. So, yes, in the long run generating free cash will determine a company’s value. But that’s not necessarily so over a shorter timespan, especially if free cash is generated at the cost of investing in the company’s long-term development.
We can’t be so blunt as to suggest that was happening at Victrex. However, it is clear from the chart that, in the past 10 years, its share price was at its strongest – 2016 to 2018 – when capital spending was dropping; put more bluntly, the price was rising the most when the company’s investment in its future was the least.
To smooth the trends, the chart shows the three-year rolling average of Victrex’s capital spending and its free cash flow over its 10 financial years to end September 2022. On a yearly basis, capex peaked at £66mn in 2013-14 and dropped to £10mn in 2017-18. Over the same period, free cash flow rose from £32mn to £119mn and the share price (based on the average end-month prices for the previous 12 months) rose 57 per cent from £17.61 to £27.65.
Why the share price movement was ‘wrong’ is because the market appeared to be tracking the increase in free cash whereas it should have been anticipating it. After all, that’s the point of markets; they are a discounting mechanism, offering the value of the future at a price today. So in this example, markets should have responded earlier in Victrex’s capital-spending cycle. They should have estimated that high capital spending would lead to increased cash flow as new plant began producing income and marked up Victrex’s share price even when free cash was falling.
Next, arguably the market repeated its mistake but in reverse. From 2020 through to 2022, the share price was falling even as capital spending was rising. That trend of rising capex will continue for a while. Victrex’s latest capital spending cycle probably topped out at £46mn in 2021-22, but capex will be close to that amount both this financial year and next. Much of the spend finances expansion in China where new plant, which is close to being commissioned, will raise capacity to about 1,500 tonnes of the group’s PEEK thermoplastic. That’s a significant addition to a group whose annual sales volume runs at about 4,700 tonnes and whose annual sales in China (£40mn in 2021-22) are still less than half the sales in its biggest market, the US, where last year’s revenue was £88mn.
Moving in the right direction?
In fairness, perhaps the market now shows signs of tracking the right relationship between capex and cash flow. At least Victrex’s share price has been moving in the right direction this year. At its current £18.70, the price is up 20 per cent from December’s 12-month low. So there may be momentum in the price, although the shares have still badly underperformed the FTSE All-Share index in the past 15 months. As a result – and concerning the search for new holdings for the Bearbull Income Portfolio – shares in Victrex, for so long rated as a high-class growth stock, now just about qualify for high-yield status with a likely 3.2 per cent dividend yield on offer for the current financial year.
True, when growth stocks show signs of becoming high-yield stocks that can be a concern. For proof, consider pharmaceuticals group GSK (GSK), which, as plain old Glaxo, was for much of the 1980s the London market’s – arguably the western world’s – favourite growth stock. Look at it now with a share price (£14.85) approaching 40 per cent below the level at which it closed the 20th century and offering a yield – 4.1 per cent – that is scant compensation for that decline.
This is not to suggest Victrex is becoming another GSK. The pharma group has never been able to fill the gap caused by the loss of patent protection for its anti-ulcer blockbuster, Zantac. Meanwhile, for many years Victrex has had to cope with competition to produce PEEK, the clever and tough plastic that has a wide range of applications from pistons and pumps to valves and, increasingly, medical implants. Sure, its patents help. Victrex claims more than 200 of them to protect the specifics of production processes. But they are just a building block – albeit an important one – in the barriers to competition that have enabled Victrex to average profit margins of 37 per cent in the past 10 years and return on assets of 17 per cent, a figure that most manufacturing companies would die for. Granted, these ratios are currently at the low end of the range. Even so, 2021-22’s profit margin of 29 per cent provides a thick safety blanket and return on assets of 12 per cent remains clear of the level many manufacturers would dearly love for their company’s return on equity.
Management is playing down expectations for 2022-23, citing the effects of “unprecedented energy and raw material inflation” and suggesting that “the opportunity to improve on last year’s record group volumes is likely to be challenging”. As a result, on average, City analysts reckon that group sales volumes will slightly slip from last year’s 4,727 tonnes. Ever the optimists, however, they also think volumes will bounce by 5 per cent in 2023-24 as sales in Asia are boosted by China’s recovery and the new manufacturing capacity there. They also think underlying pre-tax profits and earnings will follow a similar path, nudging upwards this year and rising by maybe 12 per cent in 2023-24, which would make the respective figures £110mn of profit and 108p of earnings.
Normally I wouldn’t rush to buy a stock that was rated at 17 times earnings for a financial year that does not start for eight months. That said, I don’t place much store by price/earnings ratios anyway. Also, it’s fairly clear that investors who seek to extract their valuation from Victrex’s income statement will search in vain. Even assuming that its record operating profit – £128mn in 2017-18 – could be the basis for a valuation that grosses up net operating profit by the group’s estimated cost of capital then the estimated value per share would still be well short of the share price – about £14 compared with £18.70 in the market.
Focusing on the cash flow statement
It is more productive to focus on the cash flow statement since that shows how Victrex’s heavy capital spending – perhaps twice its depreciation charge over a five-year cycle – generates plenty of value when capitalised at the group’s likely return on investment.
Granted, some brave assumptions go into an estimated valuation using the cash flow model – none more than the rate at which excess investment returns will fade to the cost of capital, for example – and it is still necessary to be generous about the assumptions made for the group’s operating cash flow. Still, it is possible to make the current share price look decent value using as the value drivers a combination of free cash flow and capital spending in excess of depreciation.
It is also encouraging that there is no stock in the Bearbull portfolio that behaves like Victrex. Shares in foundries supplier Vesuvius (VSVS) move to similar global macroeconomic signals, but that’s the only one. Victrex’s idiosyncrasy is backed up by the data. Over the past 10 years, its correlation co-efficient with the Bearbull portfolio – a measure of the extent to which their prices move together – is less than 0.3, where 1.0 would be unison and zero would be the absolute opposite. That’s good. Over the long haul, price movements showing little relation to each other tend to reduce portfolio volatility without harming returns. Sure, past correlation co-efficients won’t necessarily persist. Even so, the combination of intuition and data help persuade me to buy a holding in the stock; just small to start with, maybe more later this year when the acquisition of sausage-skin maker Devro (DVO) will bring in a lump of cash.
