Should I Buy Marks & Spencer or Next?

Mark

What a very interesting, informed and insightful commentary on the article. You are of course absolutely bang on the money. Jim Slater couldn't make a clearer case for growth investing. That's the easy bit! Identifying and picking these 'sustainable' growth gems and sticking with them is the ultimate challenge.

F1

Fabius - What a kind thing to say, thank you, I'm glad someone found it useful.

Agreed that it can be more difficult in practice than in theory. There's certainly no guarantee that Marks or Next will experience the same patterns in their underlying business over the next 7-10 years.

I think that's why it's all the more crucial to only invest where a reasonable multiplier can be paid relative to normalised earnings. Once we identify the companies with exceptional long term track records with shareholder funds, we can try to avoid paying for any of that future growth by setting a cautious asking price (7-10 times earnings would normally be ideal to avoid paying for any growth, but we can happily pay more, knowing that higher expectations are built in).

One good thing working in the investor's favour though, is that high quality companies generally enjoy a good track record for one reason or another - we can normally make rational evaluations of whether these or temporary, or due to superior economics of the underlying business.

I may be wrong, but I think investors on a whole would do well to limit themselves to companies only with excellent long-term track records with shareholder funds. From there, the most reasonably priced/yielding securities could be chosen, once quality is determined.

At the very least, when comparing companies, I always think it's worthwhile to consider the long-term track record of each enterprise. It can put a company's prospects and yield in a completely different light, and perhaps could've been helpful to investors attracted by high yields in (for example) RSA recently.

Goodlifer - that's a good question, let's examine the record. It's worth saying from the beginning that this is a subjective matter from case to case, two analysts could come up with two differing conclusions on the same issue.

To avoid clogging up this Comments section with the record itself, I'll post a link to the comprehensive discussion of RSA's past record found in the Comments on this Motley Fool article:

http://www.fool.co.uk/news/investing/company-comment/2013/02/04/whats-next-for-rsa-insurance-group-plc.aspx

I hope the points made there are satisfactory in covering the important investment aspects of the record.

On a wider point, when evaluating "straight investments" (where immediate dividend income is the main objective), I think investors benefit from a more bond-like approach in determining the attractiveness of the issue. Logically, more stringent quality measures should be demanded by the investor, owing to dividends only being paid after a company has met its obligations. Again, the track record is really the first place to look in evaluating the likelihood of dividend "default", or income failing to materialise. I've found that the Dividend Aristocrat list is often a useful starting point for identifying straight-income investments, although everyone has their own preference..

Knowing the record of both the underlying business and the dividend history (for both RSA and competitors, AV. for example), an investor might expect the future to play out differently from the past. However, whenever there is an expectation of change in the economics of the industry, an inherently speculative element is involved. That alone might be argued to make the issue intrinsically unattractive for straight investment. The UK insurance industry is exceptionally tough - it would be optimistic for an investor to suggest this is likely to change in the near future.

As in the case of straight investment in bonds, an investor may find it most profitable to exclude any investments where he cannot be certain of income being realised, even at the cost of accepting a lower yield. I may be wrong, but safety and quality would be the two key aspects I'd require personally, if income and capital preservation were my primary goals.

An investor looking to take on more speculative risk than that, might find it more worthwhile to research opportunities where that risk is in turn met with the higher potential for reward. A higher income yield might only be more attractive if an investor is relatively convinced that the promised income will be delivered, through rational and logical analysis of the industry and track record.

Of course, that's just my view, there is probably no right or wrong answer.

Goodlifer - it is true that certain insurance companies on the FTSE sell with relatively attractive earnings yields, or put another way, on relatively low multipliers of their present-year earnings.

That compares with FTSE companies like Intertek, AB Food and Bunzl, which are currently fully recognised (and priced) in the market for favourable developments in their future.

It's interesting you mention those sectors, I would say that Mining and Oil are even more difficult industries, with economics perhaps less attractive than the insurance business. I personally would not normally advocate investment in a company in those sectors, even in the more established enterprises. Further to the discussion above, this aversion is justified in the long-term track record - I can't name a single Oil or Mining company on the London market with an attractive record with shareholder funds.

I think one thing that the oil, mining and insurance businesses have in common is that they effectively operate in commodity-type industries. They are not only at the mercy of prices set by the market (even the big players), but they are subject to heavy regulation, have little pricing power, and (in the case of oil/mining) must suffer extraordinary expenditure to maintain their earning power each year.

One thing in defense of the Oil and Mining companies, their problems are inherent in the nature of their industry, rather than poor management. I would have to question how well UK insurers have been run in the past, a result of (but not an inherent defect of) the economics of the industry. In other words, insurance is particularly prone to mismanagement. It can be intrinsically attractive if:

1) Policies are written sensibly, and underwriting losses are kept low, to the extent that the "cost of funds" arising from the float is kept lower than could be raised via a bond issue.

2) Investments with those funds are made intelligently and effectively over a long period.

Sadly these two aspects do not lend themselves well to human nature. I suspect that most UK insurance operations, RSA included, have made significant mistakes in both underwriting and investment policy in the last 20 years.

On the attractiveness of these companies in terms of price, there are two difficulties in determining whether the low price-to-earnings is sufficient to call these companies inexpensive. Firstly, the unknowable, speculative element. I personally would struggle to advise with any confidence, from the above arguments, whether I believed per-share earnings would be either attractive or predictable over the next 7-10 years in the UK insurance business.

Secondly, even at a lower asking price, I personally would not be attracted by an 8% earnings yield in a difficult-to-predict, historically unattractive proposition. This is made especially true when a 10% earnings yield is available in companies with greater predictability, exceptional underlying economics, and a long term track record of shareholder returns. In that sense, I am more attracted by Tesco at 10.7 times earnings ahead of RSA at 12 times, for example.

However, if an investor believed that RSA's current earnings were particularly depressed, and had rational grounds to believe they would increase consistently in the following years, then an investment might be justified. I would find it very hard to make that argument, but smarter Fools than me perhaps have better insight into the probability of that outcome. Again, this is just my view, other analysts may see things differently.