Last Updated September 5, 2013
Smith & Nephew (a FTSE 100 medical equipment maker) recently released its annual results and managed to please Mr Market. It did this by increasing revenues, margins and adjusted earnings, which was better than many had expected.
Suitably impressed, Mr Market responded with a four percent plus rise in the share price.
AstraZeneca on the other hand (a FTSE 100 drug maker and a stock I have reviewed before) met with a much harsher fate by merely matching expectations, which are generally pretty glum anyway.
Overall, the market expects one company to do well in the next few years and the other to have a very tough time.
Massive Valuation Differences
These differences of opinion have caused a massive difference between the valuations of the two companies. Whether these differences are justified or not will only become clear in the years ahead, but at the moment they are striking.
Let’s start with the Smith & Nephew chart:
That’s a pretty good looking chart which will probably please long-term shareholders. It’s up by something like 60% in 10 years, which gives a compound growth rate of about 5% and of course there would be dividend income too.
So if you jumped on board yesterday or today, what exactly are you getting for your money?
Good, solid and consistent long-term growth
Smith & Nephew is a world class company, there’s little doubt about that. It has produced good results for many years, with long-term earnings per share growth of around 11%. You can see the per share results in the table below:
Companies don’t produce results like that unless they have a solid competitive advantage in a growing industry. So the underlying company is good and perhaps excellent, which is always a nice place to start.
But what about the price? It may be a good company, but buying good companies is only half the story in our efforts to beat the market.
A high price relative to historic earnings
The price today is about 21 times the 10 year average earnings. This isn’t horrendously high (Ben Graham suggested a maximum of 20 times) and some companies can carry off this premium price if earnings can continue to grow for long periods of time.
In fact this stock was more expensive (relative to earnings) back in 2002, and look at the share price since then. But still, a high valuation is a risk because any drop off in growth can result in the shares falling a long way, leaving investors with a capital loss for many years.
A weak dividend yield
How much you care about dividends may depend on what kind of investor you are. But regardless of personal opinions, dividends are a very handy source of additional reliable returns.
In this case, the company has paid a dividend very consistently and has increased it in just about every year of the last decade. Both of these are very good signs and what I’d expect of an excellent company.
The problem though, is size.
The current yield is less than 2% which does not stand up very well to many other companies of similar quality, and it also fails to match the yield of the FTSE 100. It provides little downside protection if growth falters.
If the yield was closer to 6%, as it is for AstraZeneca, then it’s doubtful that the share price would fall much further, assuming the dividend was maintained. Even if the share price did fall, you’d have a yield of over 6% as compensation in the short and medium term.
No stock is an island
There is no point in analysing a stock in isolation. Each stock has value only in relation to what else is available, whether that’s bonds, other stocks, index tracking funds or perhaps even actively managed funds.
Compared to the FTSE 100 and AstraZeneca, Smith & Nephew stacks up like this:
Taking the simpleton’s route to total return estimates by just adding long term growth to current dividend yields (which is of course naïve, simplistic and probably just as good as anything else) then we get estimated total returns of 12.4% for Smith & Nephew, 19.9% for AstraZeneca and 8.5% for the FTSE 100.
If you want to get clever with it then you can double count dividends as there is a general rule of thumb which says that cash in the hand (the dividend) is worth twice as much as the promise of future cash (earnings growth). However that still doesn’t help Smith & Nephew as dividends are the weakest part of its investment case.
Only spend time on obvious bargains
Life is short enough as it is without wasting time analysing investments that are not obviously cheap.
In this case, although there is much more to do in a full analysis of Smith & Nephew, from the numbers above I don’t think it would be worth it.
With a ballpark total return figure only 3.9% better than the FTSE 100, and yet with all the additional risk that comes with owning a single stock rather than a basket of 100 large-caps, I don’t think the recent good results are anything to shout about for new investors.
For owners the recent good news is indeed good news as it increases their net worth and provides a possible selling opportunity.
Prospective buyers on the other hand may be better off waiting for the company to miss estimates and fall in value before considering a purchase.