Neil Woodford is the 800lb gorilla in the UK fund management world. His style is quite similar to mine and the one covered in UK Value Investor, so any trades that Mr Woodford makes is of interest to me as well as thousands of keen investors.
However, some of his actions of late have left me a bit puzzled, including his sale of Tesco, which he effectively sold to Warren Buffett (and generally you don’t want to be selling what Buffett is buying).
Now that Woodford has sold his Vodafone shares it raises the same question: Is he doing the right thing, or is his outstanding track record beginning to come to an end?
Looking back in time
The first thing I like to do is cast my eyes back over the last decade, to see how well a company has created value for its shares and therefore its shareholders. The results for each of Vodafone’s shares look like this:
It’s easy to see why Vodafone is such a favourite with many fund managers and individual investors.
Over time sales, earnings and dividends have been heading in the right direction – i.e. upwards. In a little more detail, the growth rate has been around 11% a year, while the growth quality (a measure of how reliable that growth has been) is almost 90%.
The market average on the other had (measured by the FTSE 100) can only manage a 4% growth rate with growth quality at 74%.
So in that respect Vodafone is an above average business because it has grown faster and more consistently than average.
Last year was a bit of a shock though, with earnings down considerably. The question is whether this is reversible, and whether it will impact on the dividend.
Thinking about the present
I’m not a big fan of concentrating on the present. To me it seems that 90% of investors look no further than the next 12 months, and I think that’s a big mistake.
They’ll look at Vodafone and see the lower earnings per share, the revenue falls in Europe and the uncertainty over Verizon. They’ll check the news to see if this quarter’s results were better or worse than the “market’s expectations”. Ultimately, I think the vast majority of this time and effort is a waste, and adds little or nothing to investor gains in the long-term.
The point isn’t that there is uncertainty surrounding Vodafone. The point is that the future of all companies is uncertain, whether we like it or not. In fact, the absence of doubt is often a sign that things are about to go badly wrong.
You only have to look back to 1999 when everybody “knew” that dot-com stocks were the place to be, or 2006 when property was a one way ticket to riches beyond our wildest dreams.
So when I’m analysing a company, I’m quite happy for there to be some obvious uncertainty and a lack of consensus about what will happen. That’s often necessary in order to buy companies at attractive prices (think Tesco’s profit warning in 2012).
Instead, what I’m looking for is current problems that might significantly impact the company’s long-term ability to generate returns.
That generally means cyclical issues like recessions are not all that relevant, assuming the company can come out the other side. That’s a big assumption, and in turn means low and easily manageable debt levels are important so the company can survive the rough periods which are an inevitable part of business.
From my research I can see no obvious reason why the events surrounding Vodafone today should have a substantial negative impact on the company’s long-term future. Debt levels are also just three times the earnings of recent years, so I don’t think that Vodafone is going to go bust any time soon.
Having looked at the company’s successful past, and what I consider to be a reasonably benign present, I see no obvious reason to sell Vodafone shares on the basis of the quality of the company.
Gazing into the future
By “the future” I don’t mean next year, or perhaps the year after. I’m talking about five or ten years down the line; the sort of time period over which the changing intrinsic value of the business has more impact on the share price than investor sentiment.
Although my crystal ball is a little cloudy, my very rough and ready estimate is that we will still have a high-tech telecoms industry a decade from now. Although there could be some new technology which completely turns the industry on its head, it certainly isn’t obvious to me what that might be – unlike the very obvious, see-it-coming-a-mile-off demise of HMV and Blockbuster.
So again, I see no obvious reason to sell Vodafone shares based on the idea that the industry in which it operates, or the markets that it sells to, will shrink or vanish in the next few years.
Weighing up the valuation
With the share price at 172p, Vodafone is currently selling for about 12 times last year’s earnings, and also about 12 times the average earnings of the last decade, which I like to call a company’s proven “earnings power”; its ability to generate profit across one or more business cycles.
Those valuations are both lower than average, assuming the FTSE 100, with valuations at 12.1 and 13.7 respectively, represents the average of large businesses.
It’s the same story with dividend yield. The dividend yield on Vodafone’s shares is around 5.5% while the FTSE 100 has a dividend yield close to 3.5%. That’s a 57% increase in starting income for owning Vodafone shares rather than the large-cap index.
As you can probably guess, I see no obvious reason to sell Vodafone shares based on an excessive valuation, as Vodafone’s shares are currently cheaper than average as measured by PE ratios and dividend yields.
Of course there’s more to analysing a company than this, but these simple metrics can help to provide a useful guide to whether or not a company is high quality (high growth rates, high growth quality), and whether its shares are attractively priced (low PE valuation and high yield).
In this case I do still think Vodafone is an above average business with a below average price, so for me, selling today would not be the right decision.
Disclosure: I own shares in Vodafone and Vodafone is also a holding in the UK Value Investor model portfolio.