Selling Compass Group after recent share price gains

Compass Group joined the model portfolio in February 2018 as the world’s leading food services business.

From its earliest post World War 2 days, when it was known as Factory Canteens, the company has focused primarily on managing canteens for public and private organisations alike.

I added Compass to the model portfolio in early 2018 because it had an extremely impressive track record of smooth and steady growth, combined with good exposure to global growth markets.

And while the initial dividend yield of 2.4% and PE ratio of 20.1 weren’t in traditional bargain territory, the price still seemed to make sense given the company’s steady growth and high rank on my stock screen.

Just over a year later, a handful of factors have turned Compass from a buy into a sell.

First and foremost, its share price has gone up by about 20% in a year, making its shares less attractively valued. At the same time the company’s growth rate, growth quality and profitability have all decreased slightly, while its debts have increased.

This combination of an increasing share price and decreasing fundamentals (i.e. accounting results) are the main reasons why I decided to sell.

Buying the world’s leading food services business

As I’ve tightened up the ‘quality’ side of my investment criteria over the years, I’ve noticed that more and more market leaders make it into the model portfolio, and Compass certainly fit that description.

Following a long spell of large acquisitions, Compass became the world’s largest food services business in 2005 and has retained that position ever since.

However, as is often the case, the company’s acquisition binge left it unfocused, inefficient, overly indebted and in need of a turnaround.

That turnaround began in 2006 as the company sold off non-core acquisitions, using the proceeds to pay down debt and reinvest in its core food services business.

This is a well-proven strategy for companies that have grown by acquisition, and it worked for Compass. In the years after 2006, the company put together a very long and impressive growth streak which was one of the main reasons I chose to invest in 2018.

As you can see from the chart above, Compass’s capital employed, revenues, earnings and dividends had all increased substantially over the ten years to 2017 (with 2017 being the latest annual report at the time of purchase).

Over that ten-year period the company’s growth rate across revenues, capital employed and dividends averaged 8.8%, which is comfortably above the average UK company’s growth rate.

Its growth quality (i.e. consistency) was also above average, with revenues earnings and dividends increasing more than 90% of the time. The only serious blot on the company’s consistency record was a couple of years of declining earnings in 2012 and 2013, which were mostly due to temporary underperformance in Europe.

Compass’s profitability was also quite good, with average returns on capital employed (ROCE) of 14.6%. Net profit margins were a bit thin at 4.3%, but this is normal for a company selling food (and back in 2018 I didn’t look at net profit margins anyway).

The company’s main negative point was its somewhat high debts. In 2017, Compass’s total borrowings came to £4 billion, just over four-times its five-year average earnings. That was more than I’d like, but Compass was a very steady business and I thought its debts were probably not going to be a major problem, so I added it to the model portfolio.

Holding Compass while it continued to churn out steady, solid results

As I’ve said, what attracted me to Compass was its steady track record of above average growth. This steady growth had come about largely as a result of Compass’s exposure to several favourable tailwinds.

1) Compass is a global company with operations in around 50 countries. This geographic diversity opens the company up to global growth trends, rather than being tied solely to the fortunes of one country (although having said that, about 55% of Compass’s revenues are generated in the US, so it is quite dependent on that market).

2) Only about half of the global food service market has been outsourced. This leaves many companies, leisure centres, hospitals, schools, offshore facilities and military bases still managing their own canteens, which is of course a non-core activity for them. Over the years there has been a long shift towards outsourcing, driven by a desire for higher standards and lower costs, and that trend is expected to continue.

3) Food services providers tend to be small regional players, and there are relatively few with Compass’s international footprint. This helps Compass to win contracts where global companies or organisations want a single supplier to manage their canteens and other food outlets worldwide.

4) Compass’s economies of scale also give it a cost advantage in what is, to a large extent, a price-driven low margin business.

Balancing control and autonomy

One interesting feature of Compass is that it’s run as a true ‘group’ company, i.e. a collection of highly focused, relatively autonomous subsidiaries reporting to a lightweight corporate headquarters. When it’s managed well this can be a highly effective structure (as it was with previous holdings Hill & Smith and Senior).

It allows Compass to tailor its offering for a diverse set of customers (a hospital is likely to have a very different set of requirements for its canteen than a Google campus) while still benefiting from economies of scale. The trick seems to be in balancing control and autonomy.

Control is important because you want to run each business unit according to best practice, but if you apply best practice too strictly then you’ll stifle innovation.

On the other hand, autonomy is important so managers can run their business unit with more creativity and a greater sense of ownership, but too much autonomy can lead to poorly run business units which are not consistently applying best practice.

With the right balance you get a company which operates like a learning machine. There is enough autonomy to innovate and experiment at the coal face, and enough centralised control to learn from successful innovations and apply them (where appropriate) across the rest of the group.

I’ve seen this work well in several different industries and Compass seems to have it down to a fine art. The company continues to make small bolt on acquisitions which bring in new blood and new ways of thinking, and that helps to further improve the company’s collective knowledge and expertise.

A satisfyingly boring investment

Having only owned Compass shares for a little over a year, there hasn’t been much time for anything interesting to happen, and that’s fine by me. When it comes to investing, boring is usually good. There were only really two financial updates of note; the company’s 2018 interim and annual results.

At the 2018 interim results, Compass announced that revenues were up 5%, earnings per share were up 10% and the dividend was to be raised by a healthy 10%. This performance was described as “strong”.

The new CEO also stated his intention to simplify the business and to focus even more on Compass’s core food services business (about 15% of revenues are generated from non-food support services such as cleaning). That was music to my ears and I’m always happy to see a company double-down on its core business.

As for Compass’s 2018 annual results, published in November, they were similarly upbeat with both earnings and dividends per share increasing by 12.5%; an uneventful but welcome result.

Selling Compass because of its increasing price and weakening fundamentals

Having purchased Compass a mere 15 months ago, I was more than happy to settle into a long and fruitful period of ownership. But events have overtaken me.

For reasons we can never really know, the market price of Compass has increased by about 20% in a little over a year.

That on its own wouldn’t usually be enough to turn a company from an attractive buy to a less attractive sell, but in this case there are a few additional reasons. Some of the reasons are to do with Compass while others are to do with how I value companies. I’ll start with some of the changes I’ve made to how I value companies.

One of the biggest changes relates to earnings. When I bought Compass in early 2018 I measured a company’s growth rate across revenues, earnings and dividends. In early 2019 I switched to measuring the growth of capital employed rather than earnings. I did this because earnings can be volatile and that volatility can occasionally mess up the growth rate calculation.

This change reduced Compass’s calculated growth rate because its capital employed growth rate was lower, at 4.5% per year, than its earnings growth rate. Compass’s reduced growth rate implied that, all else being equal, the company needed to trade on a lower valuation and with a higher dividend yield to be attractive.

Another change I made was to stop using adjusted earnings and use reported earnings instead. This was because adjusted earnings are often overly optimistic and, in my opinion, reported earnings usually give a better indication of how a company is actually performing, especially over a number of years.

As the earlier chart showed, Compass’s 2012 and 2013 reported earnings declined. That contributed to a lower growth quality score of 87% compared to its previous adjusted earnings-based growth quality of 96%.

Compass’s thin profit margins also hurt its stock screen rank when I updated the profitability score to take account of net profit margins in addition to net returns on capital employed. The inclusion of net profit margins reduced the company’s profitability score from 15.5% in 2018 to 9.0% today.

One final change which negatively affected Compass’s stock screen rank was the inclusion of the debt ratio into the stock screen’s rank calculation.

Previously, Compass’s relatively high debts didn’t affect its stock screen rank so I had to use judgement as to how those debts would affect its attractiveness. To reduce the need for that sort of judgement, in January I added the debt ratio to the stock screen rank calculation. And as Compass has relatively high debts, this caused its rank on the stock screen to decline.

Having said all that, the 20% increase in Compass’s share price has also had a material affect on its stock screen rank. For example, the company currently has PE10 and PD10 ratios which are above my preferred maximums, and its dividend yield is just 2.2% (although the company does pay the occasional special dividend).

Here’s my concern:

What if Compass grows by 7% per year for the next ten years, which is a reasonable assumption given its historic growth rate?

That would double its dividend, which is good.

But what if investors ten years’ from now think the company will grow more slowly after that?

They may demand a yield of, say, 4.4% (twice the current yield) to offset that lower expected growth.

A doubled dividend and a doubled yield means only one thing: Zero capital growth over those ten years.

I think that’s a very plausible scenario, so although I still like Compass as a company, I don’t like the stock at its current price.

So I’ve removed Compass from the model portfolio and my personal portfolio, and next month I’ll reinvest the proceeds into a different company which has a better combination of income, growth and value and quality.