While some investments are difficult, others are easy, and my recently ended investment in Homeserve PLC was definitely of the second kind.
As the chart above shows, this was a classic value investment: 1) Buy a good company at a time of difficulty and when other investors are pessimistic; 2) hold while the company and its situation improve and then; 3) sell when other investors become optimistic.
When I looked at Homeserve in 2013 it had a long track record of financial success, but the announcement of an investigation by its regulator in 2011 had unnerved the market and sent the shares crashing by around 50%.
Having investigated the company in some detail I thought the odds were good that it would continue to prosper in the longer-term, so I added it to my defensive value model portfolio and personal portfolio.
As luck would have it I was right, and so after a relatively short three-year holding period I have decided to sell in order to lock in some impressive and largely unexpected gains:
|Purchase price (adjusted)||283p on 07/08/13|
|Sale price||599p on 04/11/16|
|Holding period||3 Years 3 months|
In the rest of this article I’ll outline in more detail why I bought Homeserve in particular, what happened during the three-year ownership period and why I’ve decided to sell now.
Buying Homeserve PLC at a time of uncertainty
Homeserve’s core business is to sell emergency repair insurance to homeowners to cover their boilers, water pipes and wiring.
Rather than simply spamming homeowners with junk mail, the company uses “affinity” relationships with water, gas and electricity utility providers to access their customers; but here’s the clever part:
Homeserve’s direct mail marketing is sent along with utility bills and uses the branding of the utility company (who the potential customer already has a relationship with) rather than Homeserve’s branding (who the potential customer has probably never heard of).
I get these mailings myself, and to me it looks as if “Homeserve” is the name of a service provided by South East Water. Very clever.
This leads to better customer conversion rates than would be the case otherwise, which makes marketing more cost effective and profitable.
A second positive is that the market is relatively under-served (I don’t think I’ve ever seen ads or marketing from any other water pipe insurance), which also leads to better profitability.
These positive points have left Homeserve with a market-leading position in the UK, a strongly growing international business and a long record of above average dividend growth.
Even the financial crisis of 2009 turned out to be nothing more than a minor bump in the road:
Driving its growth was an ever-increasing number of customers and insurance policies, not only from UK customers but more importantly from its rapidly growing international business.
For example, in 2004 the company had 2.9m UK policies and around 0.2m policies from its international operations, but by 2013 those numbers had grown to 5.5m and 4.9m respectively. In less than a decade the international business had come from nowhere to almost match the UK business, and when I analysed the company in 2013 I wrote:
Rapid international growth shows that the company may be able the replicate the UK model in a growing number of countries over time, and so Homeserve may still be a long way from its full potential.
Note: You can find the full pre-purchase analysis in the August 2013 issue of UK Value Investor here (pdf).
But value investments are rarely found in happy situations, and as I’ve mentioned above, that was most definitely the case with Homeserve.
Thanks to some inappropriate approaches to selling, renewals and complaints handling, the company landed in hot water with the FSA (now FCA) and was effectively forced to stop all telephone sales and marketing activities in late 2011.
This was a massive blow, even though the complete ban on sales activities was short-lived.
The company updated its sales processes and “scripts” and re-trained staff as quickly as possible, but the damage was done. The shares fell by 50% and as a result Homeserve’s combination of growth and value left it near the top of my stock screen, driven by the various factors shown in the garishly coloured table below:
Note: You can find out how to calculate those metrics on the free resources page.
Overall I liked the company, I liked the price and so I invested about 1/30th of my portfolios into Homeserve. Now came the tricky job of Doing Nothing.
Holding and waiting for Homeserve to return to growth
Homeserve’s crisis began in October 2011 and I didn’t add the company to the model portfolio until August 2013, so it was almost two years into the recovery phase when I first looked at it, and by that stage several things were clear:
- The UK business had shrunk from around 3m customers to 2m as customers who had not been treated fairly were re-contacted and compensated, and as tighter controls on sales, marketing and complaints handling were brought in
- Although continued growth in the international business was not enough to completely offset declines in the UK, they cushioned the impact of those declines and helped maintain the dividend
- If the international business continued to grow in absolute terms and as a percentage of Homeserve’s revenues and profits, and if the UK stabilised at 2m customers (as management hoped), it seemed likely that Homeserve would return to growth at some point in the next few years
Would the future pan out as I’d hoped?
The first hint came in February 2014 when Homeserve announced that the FSA investigation was over and that it was being fined £30m, which was less than the provisions it had set aside. There were to be no further actions required by the company and so this major source of uncertainty was consigned to history.
Shortly after that the 2014 annual results announced UK customer numbers at 2.1m and international customers up strongly to 3.4m.
It seemed as if the UK business had stabilised and the international business was growing as strongly as ever. The company also announced more marketing investment in the US, clearly seeing that country as its greatest growth opportunity.
In the 2015 annual results the story was the same: UK customers stood at 2.1m again while international customers ballooned to 4.2m, or just over 66% of the total. Normalised profits were down thanks to heavy investment in international marketing, but revenues were up and the dividend was maintained once again. Another welcome surprise was the payment of a 30p special dividend.
This continued flow of good news was driving the share price upwards at a nice pace, but after the publication of very positive annual results in May 2016 the share price took off like a rocket.
But before I get into that, here’s a chart showing Homeserve’s unspectacular but solid financial results during its time in the model portfolio.
Selling because optimistic investors have driven the price towards “fair value”
I am contrarian by nature, but contrarianism for the sake of it can be a mistake.
When it comes to investing, what matters is not whether you disagree with the market’s optimism, but whether you disagree with the share price and valuation that arise because of that optimism.
In this case, when Homeserve joined the model portfolio it had a ten-year growth rate of 12.7% and a dividend yield of 4.2%, giving it a yield-plus-growth value of 16.8%. Today its growth rate and dividend yield have fallen to 5% and 2.1% respectively, lowering that yield-plus-growth figure to just 7.1%.
Although I don’t use the yield-plus-growth metric explicitly, I know which of those two values I find more appealing.
In terms of the valuation metrics that I do use, Homeserve’s PE10 and PD10 ratios have increased from 16 and 36 (slightly more than the market average values of August 2013) to 28 and 57 today (almost twice the current market averages).
As for the company itself, I think it’s in much the same place it was in 2013, minus the ongoing scandal and regulatory investigation.
In short, Homeserve is still a market leading company selling a defensive product, which generates above average rates of profitability and growth, from a strong and relatively low debt balance sheet. And of course it has fast growing international operations in relatively under-served markets.
So I still like the company, but no company is worth an infinite price, and at the moment I don’t find Homeserve’s price appealing. And that, in a nutshell, is why I’ve sold.
The proceeds will, as usual, be reinvested into a more attractively valued alternative next month.
I’ll end this post-sale analysis with a chart showing a stylised view of a typical defensive value investment, which Homeserve came impressively close to matching.
The chart (which originally came from this blog post) shows how common it can be for value investments to struggle for a number of years after purchase.
But, if the core of the company is sound, the odds should be good that a turnaround and share price re-rating will be on the cards at some point, as was the case with Homeserve.