BAE Systems, the giant defence contractor, is another high quality company with a sustainable income that’s very likely to keep growing through the coming years. The company is financially robust, has a long history, a growing dividend and is internationally diverse. In fact, as I write this it’s currently yielding an incredible 7%.
Better than the FTSE 100
So, what makes this such an attractive proposition? Apart from the fact that there’s a 7% cash payout, it’s a reliable payout. There is no significant risk of it being cut or stopped. Many professional analysts seem to think that the divvy’s going to keep growing at 6-7% a year. A 7% yield, growing at 7%, what’s not to like?
Let’s take a look in more detail, using my un-famous technique of comparing any potential investment to an investment in the FTSE 100. That’s a useful thing to do since you can invest in ‘the market’ for low cost and very low effort. Just sit back, re-invest the dividend and get rich slowly.
How does BAE stack up? Here’s a table to go over it all, step by step:
|
Factor
|
FTSE 100
|
BAE Systems
|
|
Earnings yield
|
12%
|
16%
|
|
Dividend yield
|
4%
|
7%
|
|
Historic earnings growth rate
|
7%
|
12%
|
|
Return on retained earnings
|
10%
|
15%
|
|
Possible future growth rate
|
5%
|
8%
|
The numbers in this table are from various sources and are guideline figures. They are also rounded to the nearest whole % point since more accuracy might indicate a degree of knowledge about the future that is not realistic.
In each case, BAE has the upper hand. At the current price it’s yielding more dividends and earnings. It has historically grown faster (although the fall in the pound in the last few years may have skewed this figure upwards, but currency speculation is just that, speculation). It has been able to generate a higher rate of return on that part of your earnings which are retained within. Finally, using a simple estimate of future growth (simple because more complex models aren’t necessarily more accurate), it looks like BAE may be able to grow faster than the FTSE 100.
I have Monevator to thank for the term ‘wooly’, which he used to describe the soft factors like: what business are they in? How will their market do in the future? How will they cope with government cuts and the collapse of the west?
Historically, this area of investing does not have an impressive track record. There have been many studies which show that people who are subject ‘experts’ often have no better forecasting ability than the man in the street. Ask a weather forecaster what the weather will be like in 2 weeks time and your guess is as good as theirs.
That’s why 80%, at the least, of my effort goes into using hard numbers and actual past resultsto determine if an investment is attractive. It pays to take heed of history.
However, there is some work that can be done to sanity check an investment.
Generally you want a company where its business history has been consistent over the long term. This is useful because you are investing in the company’s future and if its past has been unpredictable and varied then the future might be the same. If the company has a history of changing its core business or remodelling itself then what has produced the good results of the past may be restructured or jettisoned in the future, leaving you with a less attractive investment.
In BAE’s case, their history seems fairly steady, with their defence contracting history stretching back many decades. They’ve changed a lot in that time, as have the products and services they supply, but basically they’re doing much the same job they were half a century ago.
Shares are usually attractive for a reason and that reason is typically that no one else wants to own them. This can happen either because of a general market panic about something (sound familiar?), or a real or perceived problem with the economy, the industry or the individual company. The question is, is the factor causing the low price likely to affect the long run returns of the company?
If the answer is yes then perhaps you should look elsewhere for a more trustworthy source of returns.
For BAE it looks like there are a range of factors, with perhaps the largest being the current market panic. This panic is about US and Euro defaults and other things to do with global economy, all of which are really not quantifiable. I take the strategic ignorance approach and guess that the defence industry is likely to still be here in 10 years. With that view the current market panic is an opportunity, not a risk.
Specific to the defence industry is the actual defence cuts that are going through and further possible cuts in the future. Although these cuts are real, BAE seems to think that they can mitigate much, if not all, of the cuts through efficiency and diversification. Another industry factor is the gradual change to fixed price contracts, which could hurt margins going forward.
Specific to BAE, there are a couple of main risks. First is the repeated allegations of misconduct, which may lead to higher legal costs. Then there is the ever present risk of competition, in this case from General Dynamics.
However, I don’t see that any of these risks seriously undermine the case that BAE will still exist in 10 years and will very likely be earning significantly more at that point than it does now.
BAE is exactly what a great dividend growth share looks like. It’s big, stable, pays an amazing dividend which is very likely to keep growing in the years ahead. It is a value investor’s dream, especially one with an addiction to dividends.
– John owns shares in BAE Systems
Hi,
Great blog!
BAE Systems is not a business that I would want to own a part of. On the one hand I don't like their product. On the other our government is in a position where we are spending more than we earn, not growing out of it, and not realistically able to grow out of it. If you include public pension liabilities then debt is 150% of GDP (check out http://www.terrysmithblog.com/straight-talking/2011/08/my-comment-in-the-times.html).
If we can't grow we either cut or become insolvent and then are forced to cut. So what is going to give? Well I imagine a bit of everything and a lot of defense. Defense of the nation is important but recent foreign policy defies cost benefit analysis or far more importantly common sense.
Best regards
Alan
Hi Alan. Good points there, we are in a sticky situation aren't we? But alas, I have little faith in anybody's ability to predict the future in any usable fashion. Terry may well be right, but exactly how that affects the stock market on a day to day and even year to year basis is impossible to tell.
As for BAE, they may face cuts from the UK, but what about the US? Will they cut by much? What about the company's exposure to India? They are going to grow their military spending. How much? Who knows. It might be a lot, or not, or there might be another war or three in a few years.
There are just so many unknowns I simply try to stick to companies where it seems highly likely that they are going to do okay in the medium to long term. Like you say, BAE faces some tough headwinds, but then all companies do.
If you only invest in things when everything looks rosy then you pay a high price as somebody once said.
Anyway, good luck with whatever you do invest in.
One last point. I'm not a fan of BAE's product either. I'd rather see the world full of happy people hugging each other a singing 'tie a yellow ribbon round the old oak tree', but that's just isn't going to happen.
As we've seen recently in the UK, many people are serious idiots and want to smash and kill, so no matter how unpleasant they may be, the tools of military defence are need by even the nicest of people.
Good write-up, John.
Depending how the defence cuts pan out in the USA, UK and elsewehere, and their impact on the bottom line (and, future dividend growth prospects), BAE remains one of our core picks as we believe that it is currently undervalued on the basis of our investment methodology – buying dividend paying shares when they are historically undervalued.
Steven Dotsch
Managing editor
Dividend Income Investor.com
Hi Steven, thanks. I know we have a lot of overlap in our investment styles now that I've moved to focusing on dividend growth. I'm finding it a happier place to be as the companies tend to have fewer troubles than recovery or turnaround situations.
I think BAE is really being clobbered by worries about US defence spending cuts to come later this year, if that committee Obama has set up gets its act in gear.
You might want to look into the impact of cuts on the likes of Lockheed Martin in previous cycles. (I'm not an expert on BAE, I stress! 🙂 I try to avoid bombs, which lost me Chemring at £3 a few years ago. Grr! )
Thanks for the hat tip.
The US cuts are definitely the elephant in the room. We'll just have to see what management can do to offset these problems, but the fact that there are problems doesn't bother me. I wouldn't be a value investor if I only bought when everything was rosy!
Someone once said you pay a high price for a cheery consensus and he was right.
An interesting comment I heard by Marc Faber the other day: when economies break down, they often wage war.
I’ve done my own maths and think the company is under-valued by almost 20% to true value at current market prices, and invested fairly significantly a few weeks ago. This comment, though, is about this article and the photograph at the top. Great photo of potentially one of the greatest all-round fighters of modern times. It is an F/A-18E, made by Boeing, BAE’s biggest competitor. So what is it doing in this article? It makes me wonder as to the depth of research the author has gone to.
Hi Konrad, thanks for your comment. Interesting point about the photo, to which I have two reasons/excuses.
1. The UK Value Investor is run with a keen eye on costs, i.e. a shoestring budget. Those images cost money (if I pinch them from the BAE web site I’d get sued for copyright infringement in no time) so I have some for various industries and the picture of the plane falls into the aerospace/defence/anything-else-where-a-plane-might-be-appropriate category. At the time I didn’t know it was a Boeing plane and even if I did I would have still used the image because otherwise I’d have to go and buy a BAE related image. More important though is reason/excuses number 2.
2. I don’t really think it matters what plane BAE do or do not make. At least it probably won’t matter to my investment performance. I can hear the roar of disapproval from some readers but my methods are far more quantitative than qualitative, and I have some good company.
James Montier has written extensively on the folly of forecasting, the dangers of overconfidence and information overload. In The Little Book Of Behavioural Investing, James covers the problems with too much information in a chapter called Information Overload.
In that chapter he cites numerous studies which found that humans make poor analysts when given more than a relatively small number of factors to interpret. The more data we are given the more confident we become in our estimations but sadly, we don’t tend to make better decisions.
This problem is magnified in the investment world because the problems we are trying to solve (valuing companies) are complex, ambiguous and often ill defined, while at the same time the investor is operating under stress and with high stakes at risk. These are exactly the situations that make people decide on emotion rather than logic, and so add emotional decision making into the mix with too much complex ill defined data and you have the makings of a disaster.
That’s a big part of why investing is so hard and why it’s usually done quite badly.
However, if an investor wants to dig into the fine details of a company’s product range then of course they’re free to do so and if they have the requisite skills they may even profit from doing so.
For me though, I have a set of 20 or so factors which I weigh up before investing and I’m comfortable with those factors alone. Those factors tend to focus on the long term financial success of the company, rather than what products they currently sell.
PS – Next time I’ll try to use a more appropriate picture but I can’t promise anything.