With the Christmas retail results in full swing, now seems like a good time to answer this question.
Marks and Spencer is of course a mainstay of many investors’ portfolios, both professional and private alike. It is of course one of the kings of the high street with a long history going back to Michael Marks opening a stall at Leeds Kirkgate Market. Since then it has come a very long way, but is it still a good investment given the current difficulties in the retail sector?
In some ways that’s a trick question because the difficult environment that retainers face is exactly the sort of environment that often creates the best long term investments. A happy economy rarely creates compelling buying opportunities.
Choosing a valuation system
Marks and Spencer is of course not a ‘cigar butt’, but is instead a market leading company with a long history of dividend payments, so I’ll be valuing it using the ‘defensive value’ strategy. This involves looking at long term earnings growth, the current price relative to those long term earnings and the current dividend yield and its sustainability. Together these make up the drivers of long term equity returns.
So let’s start with the share price chart as that’s where many investors begin. That’s generally a huge mistake as the historic share price has little bearing on the long term future share price which is instead driven by the future fundamental value of the company.
You can see from the chart that even with a stable, boring old company like Marks and Spencer the shareholders can still have a very exciting time of it. However, in effect, by ignoring the massive spike and crash in the share price between 2005 and 2009, it seems that the shares have gone precisely nowhere in 10 years or so. For many investors this is enough to put them off as they immediately think that the next 10 years are likely to look the same with zero capital gains.
Moving on to the fundamentals of the company, those same 10 years or so have produced the following results in revenues, earnings and dividends per share (and it’s per share results that matter).
Are there any signs of growth?
The obvious answer is yes. At a glance it looks like revenues are up more than double, as are earnings and almost double for dividends. Assuming these numbers are broadly sustainable it means that the intrinsic value of Marks and Spencer may be twice what it was 10 years ago, and yet the share price is the same. If that were true then the buyer today would be getting twice the value of the buyer from 10 years ago.
The revenue growth rate is around 9% while the Graham earnings growth rate is around 7%.
The Graham earnings growth rate is calculated like this: take the average of the last 3 year’s earnings and the average of the 3 year earnings period from 10 years ago and calculate the growth rate between those two 3 year periods. This helps to smooth out the volatile nature of earnings.
These growth rates are both comfortably above inflation which is a decent effort for such a mature business.
How much earnings bang are you getting for your hard earned buck?
The second piece of the investment puzzle is the current price relative to those past earnings. With a price of 309p when I put these figures together, the PE10 (price relative to 10 year earnings average) was 10.5, which is well below the ceiling of 20 that Ben Graham suggested for large or leading businesses.
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What will an investor get paid to hold these shares?
The current dividend yield is around 5.5% which is some 2% or so above that offered by the FTSE 100. That’s a pretty decent yield and is some way north of the historic average which is closer to 4%.
Bringing the elements of growth, value and income together
So we now know that earnings growth has been around 7%, the price relative to past earnings is about 10.5 and the current yield is about 5.5%. That’s all very interesting, but how can that information be used to get a ballpark feel for how attractive M&S may or may not be as an investment?
There are a couple of ways. One way is to bring those numbers together into a single ratio called PEGY10. This is simply an extension of the old PEG and PEGY ratios to cover a longer timeframe. The ratio is simply PE10 divided by the sum of G10 (10 year growth rate) and Y (the current yield).
In Marks and Spencer’s case this is 10.54 / (6.8 + 5.65) which equals 0.85. What does that mean? On its own it means nothing but it does allow the shares to be compared to any other shares that have 10 years of data available, as well as the FTSE 100 index. When I compiled this data the FTSE 100 (at 5,500) had a PE10 of 13.5, a 10 year growth rate of 5% and a dividend yield of 3.6%. That gives a PEGY10 ratio of 1.56, so clearly Marks and spencer is better value by that simple measure.
More clearly, Marks seems to have a higher growth rate, a lower price relative to past earnings (and therefore a higher long term earnings yield) AND a higher dividend yield, so it beats the index on all the key drivers of long term equity returns.
Using ranks instead of ratios
Another effective way to compare one stock’s growth, value and income against another is to rank stocks on each factor and then to combine those ranks. This is the approach used by Joel Greenblatt in his Little Book that Beats the Market.
In that book he ranks the entire universe of stocks by ‘earnings yield’, giving a rank of 1 to the highest, 2 to the next highest and so on. Then he ranks for ‘return on capital’ and gives a score again starting at 1. The next step is to simply add those ranks together. What you get at the end is a list of all the stocks in the universe, and those with the lowest combined rank have the best combination of earnings yield and return on capital.
It’s possible to do the same thing for PE10, Graham growth and dividend yield. Simply sort the entire universe of stocks by each of those factors in turn and assign a rank to each stock starting at 1. Then add the ranks together.
Using this ranking system the FTSE 100 currently has a combined rank of 583, while Marks and Spencer, with its lower PE10, higher growth rate and higher yield has a combined rank of 387, which puts it in 18th place on my list of FTSE 350 stocks, out of 192 which have enough data for this calculation.
On a purely quantitative basis Marks and Spencer looks to be exceedingly good value and therefore worthy of further analysis. This doesn’t have to be massively exhaustive, but might include, among other things:
- Looking for a consistent operating history – are they still doing what they’ve done in the past?
- Checking the debt levels. Are total borrowings only a few times operating earnings and interest payments covered many times over?
- Finding out if there are any major problems on the horizon that might impact the company’s long term earnings power.
- Thinking about the future of the industry. Is it doomed or will it be around for many years yet?
But before getting into detailed analysis of a company it’s worth knowing if it has a decent chance of producing good future results and that’s where a focus on long term earnings yield, long term growth and a sustainable income can make a big difference.