Last Updated September 30, 2012
The stock market can be an unpleasant place. Let’s say, for example, that you own shares in HomeServe, the international home emergency insurance and repair business.
For years they’ve been good to you by increasing the dividend from 3p to 10p over the last decade and in that time you’ve seen the share price move from 100p to 500p.
Those are results worth shouting about.
Throughout this time HomeServe has been a relatively steady business, providing insurance and emergency repair services to homes across the UK, the USA, Spain and France and growth looked set to continue with further international expansion.
On the face of it then, it seemed to have just what I’m looking for in a company, a consistently high growth rate and a robust business.
And then, out of the blue, a statement at the end of October hits you with this:
“Over the past month, HomeServe has been undertaking a comprehensive review of its UK telephone sales operations and procedures including commissioning an independent report from Deloitte. This review showed that there were cases where its sales processes did not meet the Company’s required standards.
Following this review, the Company has therefore decided to suspend all telephone sales and marketing activity.”
That must have scared the life out of a lot of shareholders. In fact it did, because the share price then fell from close to 500p down to less than 250p. Bye bye half of your investment.
The company is now retraining staff and restarting their sales operations but it will incur one-off costs of around £10m and estimated on-going costs of around £10m per year to support the higher standards.
On top of that those renewing customers who slipped through the net while the sales force was shut down is estimated to cost the company £15m in sales in 2013. Analysts are much more gloomy though.
Looking back at past results, HomeServe seemed to be a decent business which, at the right price, may have been a good, defensive investment. Such is the nature of investing and these kinds of events can happen even to good companies; remember ‘New Coke’?
But was 500p the right price?
At that level the dividend yield was about 2.5% which is a little bit below average (the average of my short-list of about 150 companies is 4%).
The price was also over 30 times the 10 year earnings average. That’s more than 30 times the proven earnings power of the company. Ben Graham often mentioned a sensible limit of 20 times and the average of the companies on my short-list is right around that level at 19.5 times.
To be worth more than 30 times the 10 year earnings average, the next 10 years would have to be almost certainly far better than the previous 10 years… as much as 3 times as good. Of course, that may be possible because there are some companies that can triple their earnings decade on decade, but is HomeServe one of them? Mr Market did think so, and now he doesn’t.
And that’s the problem with overpaying
Even when the underlying company is good, if something even slightly scary turns up the share price can plummet faster than you log into your broker and issue the sell order.
At 500p my defensive value screen would have HomeServe ranked at number 97, while the FTSE 100 comes in at number 51. Anything ranked below the FTSE 100 would be on the sell list as it’s going to have a hard time competing with the FTSE 100 given that the index is such a relatively risk free investment.
At 500p HomeServe was a high risk investment
Not because the underlying company was shaky, because unless you were an insider or a very astute investigator, you probably wouldn’t have known about the impending miss-selling crisis.
It was high risk because the share price was dependent on the continued good growth of the company and the continued confidence of the market, which in turn requires the continued absence of bad news.
However, now that the shares are priced at 235p HomeServe comes in at number 37 on my screen, which is getting close to the ‘buy’ zone.
If I had bought HomeServe at something under 230p (assuming it had been available at that price in the last year) then at the moment, it wouldn’t have lost any money.
That’s not to say that I would be looking to buy now because generally I try to avoid buying into turnaround or crisis situations, but:
By avoiding overpaying in the first place you at least have a chance of avoiding the massive share price drops that can occur when Mr Market loses confidence.
Remember, the market has sharp teeth, so be careful!