Jamie Ward takes over this week’s Weekly Market Commentary. Companies covered: SDY & SDRY.
After a prolonged period of unpredictable economic data, most of the big releases last week were either in line with expectations or slightly better. Most of it wasn’t good in an absolute sense but taken as a snapshot, last week’s figures painted a picture of a global economy on muddle-through mode. The one bright spot was the US monthly payrolls that were far better than expected, far better than any other month in the last year and contained upward revisions to previous data. The effect on markets was pretty unremarkable with no major market up by more than 1% on the week. At the other end, only China, which continues to suffer the effects of its real estate-led slowdown, fell significantly.
Early in my career, I worked out the perfect way to invest; one that would ensure high performance and untold wealth. I then grew up a little bit and realised I wasn’t as clever as I thought. Still, what would youth be without a little bit of hubris? The simple idea I thought I’d come up with, although it turned out that lots of people had thought the same, was to buy ‘quality’. To be fair to myself, the term quality wasn’t used much at the time but the principle of investing in better-than-average businesses was known without being ubiquitous. Greenblatt’s book, ‘The Little Book that Beats the Market’ was out around the same time, which espoused a similar sentiment. Its central thesis was that you rank all listed companies into quintiles of quality and eliminate all but the top quintile i.e., keep just those 20% with the highest return on capital (ROCE). You then rank them into quintiles of cheapness and eliminate all but the cheapest quintile i.e., those 20% of shares that are the cheapest. Once done, you invest in any company that appears on both lists, that being the best and cheapest businesses.
There are two slight problems with this approach, which means it has had mixed results as an investment style (‘mixed results’ is a polite term that means disappointing). The first problem is the cheapness part. Markets aren’t truly efficient in the sense that everything known and unknown is already reflected in valuations. It is however sufficiently efficient to mean that simple assumptions about earning-based valuations being a guide to performance are very questionable. Put simply, things often appear ‘cheap’ for a good reason, which means that they aren’t actually cheap after all. That’s one reason why I don’t like to build stock screens that focus entirely on earnings-based valuations.
The second problem with it is the quality part of the equation. The problem with high returns on capital is that they invariably attract additional capital. Really, you are looking for a sustainable competitive advantage but despite what some may think, a sustainable competitive advantage is fiendishly hard to determine ex-ante. We can build all sorts of mental models that say that brand value, or network effect or natural monopolies mean that a business will continue to generate high levels of ROCE. But in reality, many businesses see their competitive advantage decline and along with it, their ROCE.
This second part about declining competitive advantage is crucial. Whilst buying a cheap stock that stays cheap might be frustrating, it at least might not lose you too much money – margin of safety. But, buying a ‘high quality’ company that is in the process of becoming lower quality very well might lose you a lot. I think it takes experience to gain this insight since you have to have witnessed really good businesses become average businesses, and that takes time.
The recently deceased Charlie Munger once said words to the effect that the returns on an investment over very long periods of time cannot exceed the returns on capital of the underlying business. So, it is true to say that truly outstanding investments come from businesses of very high quality, but the subtext is that decent returns can be generated from businesses with decent returns on capital.
By reversing out valuations from the stock market, it is possible to derive a slightly odd concept of weighted average cost of capital or WACC, which is made up of the cost of debt (easy to derive since it is the interest rate a business pays on its debt) and cost of equity (COE), which is a bit weird to be honest. The idea is that the COE is the minimum return you should expect for taking on equity investment risk. It is directly comparable to ROCE in a business and effectively states that a business generating an ROCE greater than its COE is creating value since additional capital employed by the business is being valued higher than its balance sheet value.
Example 1: A ‘great’ business might be generating an ROCE of 40% and the COE, which remember is reversed out of the market valuation, is 8%. Since the ROCE is five times the COE, each additional £1 invested in the business itself is valued at £5 by the market.
Example 2: an ‘average’ business might generate an ROCE of 12% and the COE is again 8%. In this case, the ROCE is 1.5 times the COE and therefore a £1 invested in the business yields a £1.50 increase in the valuation.
At a snapshot moment in time, Example 1 is clearly a better business than Example 2, however, that £1.50 increase that is generated by Example 2 should not be disregarded. It still represents a 50% uplift in investment value, which if done consistently can, over time, yield a tremendous return for patient investors.
The advantage that example 2 has over example 1 is that a 12% ROCE is unlikely to attract a huge amount of competition so, assuming that it is competently managed in an area of modest growth opportunity, its 12% should be pretty safe. You can’t say that of example 2, where competition could be fierce if sufficient competition is attracted to the opportunity.
Where I’m from there seems to be a lot of colloquialisms that aren’t well known, but one that I think is well known is ‘where there’s muck there’s brass’. It basically means that you can make a lot of money doing dirty work well. Whilst average ROCE businesses aren’t necessarily involved in dirty work, it is true to say average businesses are rarely glamorous. The history of stock market returns teaches us that there are a lot of fairly ordinary businesses that have been incredibly profitable for investors with patience. Thus, whilst it makes some sense to look at the ’very best’ businesses, don’t discount average because average over long time periods can be very above average indeed.
This week I review the trading update of one such average business that has seen better times; Speedy Hire – might its time in the sun be coming again? The counterpoint to Speedy Hire is the second company I looked at, Superdry, which once generated high returns on capital but is now looking like its story is reaching a sad conclusion.
Speedy Hire, trading update for the end of the third quarter
Speedy Hire is an equipment rental business that was founded in Wigan in the late 70s. It followed a familiar path of a business that was small and well-managed, and that operated in an underserved niche. Thereon it expanded by deploying ever more capital, opening new sites as a roll-out story. It has been listed a long time and, whilst mostly being a fair stock from which to derive an income, capital returns have been lacklustre; putting it mildly.
As a business that services construction, it is unsurprisingly affected by the state of British construction. In the run-up to the Great Financial Crisis (GFC), it had a tremendous run. However, this was more a function of the construction boom generating a pronounced demand/supply imbalance in equipment rental. As is so often the case in economic factors, the supply of construction equipment rental rose to fulfil this demand. Next came the crisis and demand fell off a cliff. What was left was a, by now, supply glut. The performance of the business in the aftermath is reflective of this fact.
When you read a lot of company announcements, you begin to detect a rhythm, which means within a few words you can often tell whether it will be a good one or a bad one. In reality, it is nothing particularly intuitive, but rather, the longer it takes to get to the meat of the announcement, the more likely it is to be a bad one. If a company is going gangbusters, then management can’t wait to you about it. When it is going whatever the opposite of gangbusters is, an update frequently starts by talking about all and sundry nonsense. Sainsbury was always the master of this when it would be at pains to tell you how many mince pies it had sold in the run-up to Christmas, but demurred to inform you on how much money it was making.
Anyhow, the most recent update is very much in the style of the anti-gangbuster. That is to say, not good. But it takes a little bit of reading to work that out. In fact, it takes until the last line of the nine-paragraph update to finally say:
‘Nevertheless, with weakness in some of our end markets and seasonal product lines, and some delays in mobilisation of significant contract wins, the Board expects the full-year profits to be below its previous expectations.’
Rant aside, the style of update, which leaves the nasty until the end is by no means unusual to Speedy Hire. Rather it is probably the norm. Looking through this, the business is doing OK given the well-publicised slow-down in construction owing to the higher interest rate environment. The management probably ought to have exercised more caution in its earlier update so as not to disappoint as, generally, it is better to underpromise and over-deliver than the reverse.
Further out, the strategy looks fine and management seem to have a handle on the way in which its industry is evolving. Net debt is at a seasonally high level owning to working capital requirements but there is confidence that come down into the year end.
Opinion & Valuation
I would categorise Speedy Hire as a class WACC+ business. By which I mean that what they do is not particularly groundbreaking and the main barrier to entry is capital, which means when well managed and in benign economic conditions, they should have the ability to generate returns on capital modestly higher than their cost of capital. This means that they must provide customers with exceptional service. This is achieved by having plenty of locations and plenty of stock that allows them to fulfil customer orders quickly, efficiently and with the minimum of fuss. In some respects, equipment rental businesses are a little bit like distributors. Both types of businesses typically own very little intellectual property, but are afforded the opportunity to generate returns above their cost of capital (i.e., WACC+) since customers value surety of product as and when it is needed.
With this in mind, a through-the-cycle valuation of a business-like Speedy Hire would imply a valuation of perhaps 1.5x the book value. Unfortunately for Speedy Hire and its competitors, the cycle in construction can be very long so there can be long periods where the supply imbalance is such that generating WACC+ returns on capital is unrealistic. Prior to the GFC, the company typically generated returns on capital of 10% in a bad year and 20% in a good year. Since then however, a good year is less than 10% and a bad year is more like 0%.
This fact is reflected in its price-to-book valuation, where in the pre-GFC times, the shares traded at a multiple of its book value but now trades at a fraction. There was a period from 2013 to COVID (which was peak help-to-buy time), where the 1.5x (ish) price to book that it traded at looked about right but the aforementioned fall off in construction has seen it in doldrums.
Were construction spending to increase meaningfully in the next few years, we might well see Speedy Hire move much closer to the old 1.5x price to book value, which would imply a doubling of the share price. Additionally, the dividend, according to Sharepad forecasts is likely to be 2p this year, which implies a yield of c. 6.5%. You can argue that you are being paid to wait for a turnaround in construction spending but personally, I would rather wait and see, and perhaps open a position if the UK house builders become much more positive.
I’m not good at technical analysis but I have a very good friend who I know reads this; for Speedy Hire, the use of technical analysis might aid in timing the turnaround and is something I’m keen to monitor.
Superdry, Press Speculation and Share Price Rise
Following the previous week’s lacklustre Half Year figures, Superdry released a statement about some recent press speculation regarding significant cost savings.
Superdry was founded by Julian Dunkerton and James Holder in 2003 as a sort of quasi-Japanese/American style clothing brand. It grew through the 2000s via a typical store rollout strategy. Dunkerton ran the business through to the listing in 2010. After which the shares yoyoed on the fortunes of the group. In 2015, he resigned – not on a high, but certainly with the shares at a level some way above the list price. He was replaced by Euan Sutherland. Under whom, the business appeared to be doing OK for a while. The wheels began to fall off in 2017 and by 2019, Julian Dunkerton regained control of the business. Since then, it has got worse. As for Mr Sutherland, Saga was the next business to benefit from his stewardship until a sudden ouster in November last year. On February 1st it was announced he would become CEO of AG Barr – third time lucky?
Half Year Results
Bruce briefly mentioned the update in passing last week on a theme of the catching of falling knives. Revenue was down 14% in the previous 12 weeks. Technically, the company reported a profit but that was only possible by selling an intellectual property joint venture in South Asia. Without that fillip, the loss before tax would have been £25.3m. Furthermore, the outlook statement was poor, stating that the full-year figures would reflect the more difficult environment seen recently.
The same morning the CFO announced his resignation. As is usual, the announcement was very genial, with the CEO thanking the CFO and the CFO talking about his fondness for the company – blah blah blah. It doesn’t look like a resignation to me. Best guess is that Julian Dunkerton needed someone more radical in their approach given the dire straits of the firm and the outgoing CFO, wasn’t it? This is not a slight on either individual but just the reality that difficult times require hard choices.
Overall, the adjusted losses were more than the then-current market cap but the shares are so close to worthless, the update didn’t change much.
On Monday 29th of January, management released a statement about press speculation. There had been conjecture that there could be several store closures and job losses to help save the necessary costs to keep the business afloat. One wonders where the press’s speculation came from. Some of it was very complimentary of Mr Dunkerton. Anyhow, the announcement stated that the company ‘is working with advisors to explore the feasibility of various material cost-saving options.’ Frankly, it added little as we already knew that there were significant savings being targeted and they have to come from somewhere.
Ultimately the business is in trouble. Something big needs to happen and Mr Dunkerton knows that. The large cost cuts have been well communicated in advance so it shouldn’t be of a huge shock what comes next. The problem is whether it will be enough. The share price suggests that there is little more than option value in the company at this point. The thing with options is that if they come off as hoped, the owners can make bucket loads of cash, but mostly they expire worthless. The caveat of course is whether Mr Dunkerton, who is considerably wealthier than the market capitalisation of the business could be motivated to step in. Money might be made by the canny but he is no fool, he’s not going to bid the shares up to very high levels.
Ten years ago, Superdry was already the brand worn by middle-aged dads trying to look younger but actually looking tragic. I don’t think things have improved since then. My worry about Superdry as a brand is that it has a very specific aesthetic and it is painfully uncool. As a 41 (nearly 42) year-old man with less hair and more tummy than I would prefer, I know all about painfully uncool. At this point, my bet would be it will end up like Joule, French Connection and Ted Baker – a sad end to what was a decent enough business once upon a time.
As a final point, in my Christmas article for Sharepad, I suggested that there is value in monitoring Google Trends as a way of gauging the likely fortune of a business. For Superdry, the trends are not your friend.
*I wrote this on Wednesday 31st January. In the following two days, it emerged that Mr Dunkerton was in fact looking to take the company private. This has prompted a more than doubling of the shares at the time of writing this (late Friday afternoon). Where it goes from here is anybody’s guess.
Jamie doesn’t own any shares in the companies mentioned.
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This article is for educational purposes only. It is not a recommendation to buy or sell shares or other investments. Do your own research before buying or selling any investment or seek professional financial advice.