Last Updated September 5, 2013
Whether or not a company’s shares are a good investment will depend on what you’re looking for. In my case I want my investments (which match those in the UKVI Model Portfolio) to produce higher total returns than the general market (i.e. the FTSE All Share), primarily through:
- Having a higher dividend yield at all times
- Growing the dividend income faster than inflation and faster than the market
- Growing the capital value in line with the growth of the dividend
To achieve this I focus on buying shares from a diverse group of large, high quality businesses. Each of those businesses should have a long history of increasing profits and dividends, and the share price should be low relative to the earnings and dividend payments of the company. You can find out a bit more about this strategy here.
This review will show whether or not BG Group’s shares are up to those standards, whether they’ll only be considered at a lower price, or if they would never be considered because the company just isn’t good enough.
Overview of BG Group
BG Group is effectively one half of what used to be British Gas; the other half is Centrica. BG Group kept the ‘upstream’ business involved in the exploration and production of gas, while Centrica took the ‘downstream’ activities of supplying gas and electricity to retail customers.
BG is a large company, with a market cap of more than £36 billion. That puts squarely at the top end of the FTSE 100. It has over 6,000 employees working in more than 20 countries, and describes itself as a ‘world leader in natural gas’.
From an initial glance this is clearly the sort of large, diverse and market leading company that I like.
Starting with the company’s accounts
As usual I’ll start this review with the company’s accounts. Ultimately it doesn’t matter how much you like a company, or how well it’s positioned within its market – if it isn’t producing a steady stream of growing sales, profits and dividends, it isn’t doing a good job for shareholders.
You can see the results that BG Group has achieved for shareholders during the last decade using the key metrics of revenue, earnings and dividends per share.
I think the best way to find companies that have a good chance of producing growing earnings and dividends in the future is to look back at what the company has done in the past. In this case, BG has definitely produced the goods, with a long and consistent record of growing revenues, earnings and dividends per share.
While this doesn’t mean the historic growth rate is guaranteed going forwards, it does show that the company has been able to grow – and not just once or twice, but repeatedly over many years.
Converting past results into useful numbers
Although the chart looks nice, I prefer to have numbers which are directly comparable between one company and another, or one company and the relevant market index.
Long-term growth rate
The first number I use is the annual growth per share over the past decade. For BG Group that number 15.1%. That means that, according to the financials, BG Group has managed to grow at around 15.1% per year.
To put that into context, the companies that make up the wider market (i.e. the FTSE 100 or FTSE All Share) generally grow, in aggregate, at around 4%-5% a year.
So it’s safe to say that BG Group has, in the past at least, been a high growth business.
Long-term growth quality
It’s nice to find a company with a high growth rate. However, if the results are erratic, or if the company occasionally makes a loss or cancels the dividend, that historic growth may not be a good indicator of what might happen in the future.
Common sense and academic studies suggest that companies which can produce consistent growth of profits and dividends over long periods of time will tend to be able to maintain that consistent growth into the future. More importantly, they may be able to maintain consistent growth better than more average companies.
I call this consistent growth of profits and dividends the “quality” of the company’s growth.
As the chart above shows, BG Group has made fairly steady progress over the years, resulting in a growth quality score of 83%.
This compares to the FTSE 100 which has achieved a growth quality score of 74%.
These numbers confirm what the chart suggests; that BG Group is a company which has produced consistent, high quality growth at high rates over many years.
From a purely accounting point of view, I would call it a high quality business.
If you’d like to know how to calculate the growth rate and growth quality numbers, see the strategy guide and related worksheets.
Looking at the numbers is just the start. Now that BG Group has shown itself to be a consistent producer of growing profits and dividends, the next step is to dig a little deeper and see what the company actually does, and how it fits in with the rest of your portfolio.
Emphasising diversity over stock picking
Diversification is hugely important. It’s far more important than the individual stock picks you make. I believe that for the most part the stock market is pretty efficient, and that means it’s very hard to pick winners, or to know how things are going to work out in the future.
Your best defence again uncertainty is to spread your bets and focus on maintaining a diverse portfolio rather than a concentrated one.
For me that means:
- Having 20 – 30 companies in the Model Portfolio
- Spreading investments across many different FTSE Sectors
- Building a globally diverse portfolio, with revenues coming from around the world.
A deliberate policy of diversification across these various fronts, combined with focusing on large, market leading, highly profitable and growing companies, will in most cases massively reduce the risks associated with investing in individual shares.
In this case, BG Group is in the Oil & Gas Producers sector, and the Model Portfolio only holds one other Oil & Gas company, so adding BG would not make the portfolio overly concentrated in that area.
BG also generates revenues primarily from outside the UK, which should help to keep the portfolio from becoming overly reliant on a single country.
Looking for companies that are diverse in their own right
Some companies are dependent on single customer or supplier. This is generally a bad idea as it gives power to those outside parties, and puts the company at risk if the relationship breaks off.
In the same way, some companies are reliant on just a few resources (a small group of employees, patents or natural resource), without which the company would struggle. Again, this is a risk that you might not your companies to take.
I prefer to stick with companies where the customers and suppliers do not have power, and where no single resource (whether a patent, copper mine or group of brokers) generates most of the company’s profits.
Looking at BG, it has a wide range of exploration and production projects spread across the globe. It also has a sizable and varied gas shipping and marketing business.
I would say that perhaps the biggest lack of diversity is the reliance on oil and gas prices. Both can be volatile, although the spike and subsequent collapse of oil prices around 2008 only show up on the company’s results as a minor blip. It may be that diversification away from exploration and production into gas shipping and marketing has helped to smooth things out.
Focus on successful, market leading companies
Once a company gets into a relatively dominant position within an industry, it is often hard for smaller competitors to compete. Economies of scale, purchasing power and other factors often mean that past success can more easily be replicated in the future if a company is at the top of its industry.
As the chart above showed, BG is a very successful business, with above average growth rates produced with above average consistency.
It’s also a market leader, shipping, for example, about 50% off all the gas transported into the Pacific basin from the Atlantic basin.
Avoid companies that are having major problems today
When you’re looking for shares that are cheap relative to the dividends and profits of the company, you have to expect some unpleasantness. If everything was rosy and all news surrounding the company was positive, the shares wouldn’t be cheap.
Instead, they’d look more like Diageo’s shares, which have almost doubled since 2010, while the company has grown by perhaps 20%. A big increase in the share price may sound attractive, but the dividend yield is now just 2.2%, while the PE is 27. No matter how good the company (and Diageo is a very good company), it cannot be worth an infinite price.
So, some bad news should be expected, although it’s important to differentiate between trivial bad news and significant bad news.
For BG the bad news came back in November 2012, when the company issued a statement which amounted to a profits warning, stating that 2013 production would be in line with 2012, rather than the 10%-20% growth that some analysts had expected.
The shares dropped from around £13 to £10, although they have since recovered to £10.76 as at today.
This is a good example of how hard it is to see into the future. The professional analysts couldn’t, and BG’s directors couldn’t either. That’s because nobody can see into the future which is why it’s important to:
- Stay diversified and
- Buy shares on bad news (at low prices) and sell on good news (and high prices)
All companies will have both good and bad news, even the very best companies. It makes sense to pick companies that are strong, and buy them when trivial bad news has pushed the share price down to an attractive level.
Then, hold those companies and collect the dividends until some good news (and high share prices) comes their way; as it eventually does in most cases.
As for BG’s profits warning, I don’t think it can be classed as a significant problem. To me it looks like the sort of thing that all companies go through from time to time, whether they be Tesco, Apple or Vodafone.
In time, and in most cases, the tide will turn and other investors will pile in and push the share price back up on good news.
Only buy companies which are virtually certain to be bigger 10 years from now
If your investments aren’t growing they will be eaten by inflation. An obvious response to the threat of inflation is to stick with companies that are virtually certain to be larger a decade from now.
That means companies where:
- The products are unlikely to be replaced or disrupted by technology
- The company is unlikely to suffer from changes in cultural tastes and demands
- The company’s competitive position is strong enough so that it can, at the very least, maintain its share of the pie
- The market is growing rather than shrinking
With BG I think all these boxes are ticked. The company is a market leader, has a proven history of growing market share, and sells and distributes a product which is in demand and where demand is unlikely to go down for a long time yet.
Gas is a finite resource, but I think any significant move away from it is likely to be several decades away. In the medium-term there may even be a shift towards gas.
I would be very surprised if BG didn’t at least keep up with inflation over the next decade, although of course, anything can happen.
BG Group is a company that I would be happy to own, but only at the right price
The price of an asset is just as important as the asset itself. Whether it’s a classic car, a house or a company, at one price it will be a good investment and at another it will be a poor investment.
In the stock market there is never an obviously ‘correct’ price for shares, and so the price is set simply on the supply and demand for those shares on any given day. Most of the time, for most companies, this gives a share price which is reasonable.
However, on any given day there will always be some shares that are expensive and some that are cheap, and of course it’s the quality assets at cheap prices that I’m looking to add to the UKVI Model Portfolio.
Two ways of comparing price and value
Given that returns come from dividend income and capital gains from the growth of the company and changes to valuation ratios, it’s a good idea to start by looking for shares that have a high dividend yield.
For BG Group’s shares the yield today is just 1.55%, which is far below the yield of 3.2% that you can get from a FTSE All Share index tracker. In addition, the index tracker is a lower risk investment than BG.
Price relative to cyclically adjusted earnings
I’m not a fan of the standard PE approach to valuing shares, as the E part (current earnings) is too volatile from year to year to be of much use.
Instead I prefer to use the price to cyclically adjusted earnings ratio, or PE10, which uses a 10 year average of earnings in order to smooth things out across the ups and downs of the business cycle.
Using that measure, BG group has a PE10 ratio of 15.7, while the FTSE 100 has a PE10 ratio of 14, making BG shares somewhat more expensive than the average of large companies.
It’s clear that from a simple valuation point of view, BG Group’s shares are far from cheap as they have a higher valuation ratio and a lower dividend yield than the average large-cap company.
Combining the quality of the company with the price of the shares
Many investors are led astray by looking just at dividend yields or PE ratios, or by looking for companies that are surrounded by good news. Usually this is a mistake.
A much better approach is to look at both the long-term quality of the company, as well as the price that you’re being asked to pay for it.
It’s relatively simple to compare BG against the wider market (perhaps the FTSE 100) to see if it has a reasonable change of outperforming the market over the next 5 years or more.
If there is no obvious reason why the shares could beat the market, then it may be worth putting them onto a watch list with a lower target price to buy at.
In terms of the four factors that I have looked at here:
- Growth rate – BG has a long-term growth rate of 15.1%, while the FTSE 100 manages just 4%.
- Growth quality – BG has a consistent record of growth and a quality score of 83%. The FTSE 100, with its lower growth rate, only has a growth quality score of 74%.
- Dividend yield – BG falls behind the market here, with a yield of just 1.55% compared to 3.2% for the market index.
- Share price to cyclically adjusted earnings – BG is currently priced at 15.7 times its cyclically adjusted earnings, while the market index is cheaper at just 14 times.
You can see from the above four points, and from the rest of the analysis, that BG Group is an above average company (with growth that is both faster and of higher quality than average), but the shares are not attractively valued (with a lower dividend yield and higher PE10 than average).
BG is a high quality company, but the shares at 1,076p are not cheap enough – It’s one for the watchlist
I’m happy to invest in BG, but not at these prices. I think that if the share price fell to below £9 them I might start to be interested in adding it to the UKVI Model Portfolio, but realistically I think the share price would need to be closer to £8 for BG to be a real contender.
At that price the yield would still be low at just 2.1%, but the PE10 ratio would be better than the market average at 11.6, and at that price you would also have the high growth rates and high historic consistency and quality.
This is confirmed by the fact that currently, on the UKVI Stock Screen, BG currently has a rank of 84, just slightly better than the FTSE 100, which comes in at number 90 out of 165.
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