Reckitt Benckiser is a fantastic company. Every day it sells millions of pounds worth of products like Dettol, French’s Mustard and Nurofen to customers worldwide. In financial terms it has a perfect record of consistent dividend and earnings growth over the last decade – so why would I want to sell it?
The answer certainly isn’t because the shares have done badly.
I made the decision to add Reckitt Benckiser to my own portfolio and the UK Value Investor Model Portfolio back in April 2011, exactly two years ago. At the time they were selling for £32.82. Since then the shares have paid out dividends of £2.59 each. The share price has also appreciated significantly, reaching £46.28 on the day that I sold.
Total returns from this two year investment were 47.2%. That’s 7.9% from dividends and 39.3% from capital gains. In annualised terms that’s 20.8% a year, which is well clear of my target return of 15% a year.
Buying a quality company
I buy shares after working through both a quantitative and qualitative analysis. The first step is to look at how the shares rank on the UK Value Investor Stock Screen. This screen ranks shares on two key factors – The quality of the underlying business and the value for money that the shares represent at their current price.
Taking the quality aspect first, Reckitt Benckiser really is hard to beat. When the shares were bought in 2011, the company had increased revenue per share in every year of the previous decade. It had also increased earnings in every one of those years – and it had also increased the dividend in every single year. That’ a 100% record of consistent growth in sales, profits and dividends.
If you’re looking for companies that can grow earnings and dividends consistently in the future, then looking for a proven track record is a sensible place to start. You can see Reckitt Benckiser’s financial results in the chart below.
Of course, the point of buying a high quality business is that you hope it will continue to produce high quality results once you have bought the shares. In this regard Reckitt Benckiser did not disappoint. There are two obvious ways in which a company can produce returns for shareholders:
- Dividends – In the two years that Reckitt Benckiser has been in the Model Portfolio, dividends worth 259p have been paid or become due. This is a return of around 7.9% on the original investment.
- Growth – By growth I mean growth of the company. If a company is able to sell more stuff to more people at higher prices each year, and in the process generate more profits, cash and dividends each year, then shareholders gain as they each own a fixed fraction of that growing company.
There are various ways of measuring a company’s growth, none of which are totally accurate. My preference is to look at the growth of the company’s average earnings per share over the last decade. Using average earnings helps to smooth out the yearly ups and downs which most companies suffer from. This in turn creates a more stable estimate of ‘value’, whereas looking at just the latest earnings might lead you to assume that a 10% fall in profits this year should result in a 10% drop in the value of the business. In most cases, it shouldn’t.
In Reckitt Benckiser’s case, the average earnings were 122.5p when I bought the shares. Today that number stands at 163.4p. That’s an increase of 33.4% in the company’s historic average earnings in just two years. Although that’s probably overstating the true level of growth somewhat, the company has definitely grown by a considerable, double digit amount in that time. So by buying a high quality dividend paying company, the return was 7.9% from dividends, and 33.4% from the growth of the business.
At an attractive price
In April 2011, at £32.82, the dividend yield was 3.5% and the price to earnings ratio was 17. Neither of these is especially attractive, but that’s because PE ratios and dividend yields are overly simple ways of valuing shares.
The approach I use looks at cyclically adjusted earnings, dividends, growth and consistency, in order to get a far more detailed picture of what a company is worth, rather than just looking at the most recent earnings or dividend numbers. Even though by conventional measures Reckitt Benckiser’s shares looked somewhat expensive at £32.82, when long-term earnings, dividends, growth and consistency were taken into account, they didn’t. And that view seems to have been right.
With the price at £46.28 in April 2013, the value of the shares had increased faster than the value of the company. Even though value of the company (according to its average earnings) had grown by 33.4%, the shares had gone up by an additional 5.9%. This additional 5.9% return is the boost that you can get from buying companies at low valuations.
If you give Mr Market enough time his mood will often improve, and he will happily pay a higher price to earnings ratio than you did.
After looking purely at ‘the numbers’, I always like to look at what the company actually does. I have a series of questions, in checklist form, that I ask of every company I look at, covering:
- The past – I always look back over the company’s past, to make sure the company has a stable and competitive history within its industry.
- The present – I also like to look at the present situation, to make sure the company isn’t facing any significant threats to its ability to make profits in the future (after all, the shares are cheap so there is often bad news surrounding these investments. However, you have to separate significant bad news from minor bad news).
- The future – Finally, I like to think about the future, and whether there is any major risk that the company’s industry or core products and services could become obsolete in the next decade.
Reckitt Benckiser sailed through all these tests, and that’s why I bought at £32.82. So in summary, Reckitt Benckiser is a high quality company, capable of consistently high earnings and dividend growth. In 2 years, the UK Value Investor Model Portfolio received a dividend return of 7.9%, capital gains from the growth of the company of 33.4%, and an additional capital gain of 5.9% as the shares were re-rated upwards.
Why sell Reckitt Benckiser?
Reckitt Benckiser is still a fantastic company. It is still exactly the sort of company that belongs in the Model Portfolio, and it’s still exactly the sort of company that defensive and income focused investors like to own. However, the quality and value of the company is only one side of the investment equation. The other side is price, and how much cash you need to part with to buy the company, how much you can get if you sell, and what else you could buy with that cash instead.
At its current level, Reckitt Benckiser is it one of the least attractively valued stocks in the Model Portfolio, when quality, growth, value for money and dividend yield are taken into account. Just as importantly, the UK Value Investor Stock Screen tells me there are shares in other high quality, dividend paying companies that are more attractively valued.
This doesn’t mean Reckitt Benckiser is a ‘sell’. I don’t think that kind of blanket labelling is of much use. What matters is how one company’s shares compare to the others that you already own, and what else is out there in the market.
In Reckitt Benckiser’s case, it is still quite attractively valued, and is much more attractive than the average company, with a Stock Screen rank of just 37 out of over 160 companies. If your portfolio is full of average companies at average prices, then Reckitt Benckiser could be the best thing that you own, in which case you might be better off selling something else. But to beat the market you have to focus on owning shares with the lowest valuations and highest yields from the best companies, and for me, at £46.28 Reckitt Benckiser’s shares no longer meet all those criteria.