Steve Scott looks at a cheap share and asks what makes it a 'value' share.
I am, by natural inclination, a value investor. That means I am more likely to be attracted to a bargain; the chance to buy a pound for fifty pence, than chase the latest 'blue sky' killer product or highly rated growth stock.
The problem is how to know when something is a bargain. Value investors use all sorts of financial ratios to analyse companies; price earnings ratios, dividend yields, cashflow analysis and net asset value amongst others. Investors often invoke these and other ratios to prove 'cheapness' as if there is some magic benchmark to compare them against.
Unfortunately companies in different sectors show different financial characteristics and valuations. Property companies, for example, often have relatively high debt levels but trade at a discount to their net asset values. Distribution companies often have low price earnings ratios to reflect their inherently poor cashflow.
Sector analysis
One way to get around this is to compare companies with similar businesses or with the average for their sector as a whole.
One company I have been looking at is May Gurney (LSE: MAYG). The company undertakes maintenance and facility management services to the public and regulated sectors. That means maintaining roads, utility, rail and waterway networks, often under long term contract.
What I like about May Gurney is that its customers are in the public sector and regulated sectors. In the current climate these are likely to be more immune to the economic and payment problems than many other sectors. May Gurney has good sales visibility with an order book of £1.25 billion, equivalent to two and a half times its annual sales. Furthermore it has a solid balance sheet, with no debt, a reasonable dividend and its recent results were generally good, with underlying earnings per share up by 11%. Analysts are forecasting further growth in both earnings per share and dividend. Despite all of this, the share price is a very modest 8.6 times underlying earnings per share.
But is it cheap?
To find out let's compare it with a company in a similar business. Connaught (LSE: CNT) undertakes maintenance and estate management, mainly in the social housing sector. Unlike May Gurney, Connaught has a miniscule dividend, significant borrowings and a pretty weak balance sheet, with net tangible liabilities (after excluding intangible assets and goodwill).
Despite this its profits are valued by the stock market as being worth nearly two and a half times that of May Gurney. Using their last annual accounts, a comparison of the two shows:-
| | May Gurney | Connaught |
|---|
| Share price | 180p | 375p |
| Market cap | £124m | £461m |
| Price earnings ratio | 8.6 | 20.5 |
| Dividend yield | 2.9% | 0.7% |
| Net tangible asset value | 19.5m | - £58.0m |
| Cash/(debt) | £18.6m | - £70.9m |
Looking at this comparison, it might seem hard to understand why any investor would prefer Connaught to May Gurney. However that would be a mistake.
Connaught operates in the more 'sexy' area of social housing, providing property and estate maintenance services to the public and social sectors. Social housing is considered a growing but fragmented sector and Connaught has an even better order book than May Gurney. At £2.7 billion its order book represents nearly five years annual sales, with 99% of 2009 and 92% of 2010 sales forecasts already in the bag.
Connaught's forecast growth is also more impressive, with analysts forecasting 26% growth in earnings per share in 2009 and 20% in 2010. That compares with the more pedestrian forecasts of 8% and 5% for May Gurney.
Nonetheless there is plenty of expectation for Connaught already included in its share price. It would take over six years of Connaught's superior growth for its price earnings ratio to fall to that of May Gurney. That's a long time in business and during this period any disappointment in its performance is likely to cruelly punished by the stock market. May Gurney, on the other hand, is hardly priced for excitement.
The crucial question for investors is whether they are prepared to give up May Gurney's dividend, accept the extra debt and pay the additional amount for the promise of Connaught's extra growth?
As a value investor I wouldn't.
More from Steve Scott:
