Qualiport

[ August 14, 2000 ]

M&S Revisited

By Bruce Jackson (TMFGoogly)

Marks & Spencer (LSE: MKS) is the most widely held company in Fool portfolios. Just about everyone has an opinion one way or the other about the High Street retailer. Some will say they like the new autumn clothing collection, others will say they hate the new packaging on the Indian food selection. But one thing is for sure. Customers and shareholders alike are quick to let every man and his dog know what they think about M&S -- the great British retailing institution.

I have an opinion about M&S. I first thought they were great. So solid, so predictable, so many growth opportunities, especially internationally. So great that I thought they could do the job of an index tracking fund for the Qualiport, returning 12% per annum over the long-term. I bought the shares for the Qualiport in May 1998 at 554p, when they were trading on a price-to-earnings ratio (P/E) of 20.

As time went on, my opinion about M&S changed. It wasn't because I didn't like their latest clothing collection -- fashion is definitely not my specialist subject -- or that I could see tangible evidence of their deteriorating trading. Instead I concentrated on the numbers coming out of their Baker Street headquarters. They were ugly, and getting uglier. At the same time, my personal education about value and all its different meanings was improving as I read more and more about the subject.

Changing Times

Based on this largely quantitative analysis, the Qualiport sold the shares. That was in May 1999. The shares were sold for 392p, and at the time I wrote:

"They (M&S) are destroying value at the moment, because they are not meeting their cost of capital."

"I calculate Marks & Spencer's cost of capital at 10.6%, and their return on capital at about 7%. They are destroying value, and it will take a long time, if ever, to turn things around. That's why I'm happy to be out of the shares."

These comments caused a flurry of activity on the Qualiport discussion board, started by lazylubby with this post titled "The Meaning of Value..." There ensued thereafter a long debate about life, the universe and the cost of capital -- it is well worth a read. Further into the thread, in this post, I wrote:

"I calculate that it will take them (M&S) at least 5 years of solid growth to get back to anything like their cost of capital. And that also presumes they cut right back on their capital investment programme. Personally, I can't see it happening within 5 years, but I was trying to be a little optimistic with my EVA (Economic Value Added) valuation model, which came out with a 216p price tag on M&S."

In the past few weeks, M&S shares have breached my 216p price tag. When I did my calculation, I was shocked at the result. I mean to say, could you have imagined M&S at 216p when the shares were hovering around 400p, having fallen from over 600p just 12 months prior to that? Although the numbers said one thing, the mind said something different. Ultimately it appears the numbers have won.

Emotional Value

Which brings me onto another point. It's about emotion. When it comes to investing, it's relatively easy to let the heart lead the head. You let the heart tell you that the shares "just can't" fall any further. That's because you're emotionally attached to the company. M&S is a classic example of people being emotionally attached to the company -- remember, we all have an opinion about them, good bad or indifferent. That opinion brings emotion, and emotion often brings investing mistakes.

The Qualiport believes that price ultimately matters. Although it didn't seem possible that M&S could fall to 216p, they did. The heart said no, the head (the numbers) said yes. The head won. You need to be an incredibly skilful investor in order for the heart to be able to consistently pick winners. I'd even go so far as to say you need a lot of luck using this strategy, although Fool US cofounder David Gardner has done a pretty damn good job at it in his Rule Breaker real money portfolio. How the Qualiport would wish for the sort of long-term returns achieved by the Rule Breaker -- gains of 51% per annum over the last 5 years are truly astounding!

Today's M&S

What about M&S today? On Friday, respected retail analyst Nick Bubb of broker SG Securities cut his price target for the beleaguered retailer to 185p per share, apparently saying they could fall to as low as 140p. With a few tweaks of my old EVA spreadsheet I can easily get to a price target something like that -- many of the assumptions are very sensitive, which goes to show just how imprecise the art of valuing shares can be.

Rather than diving into advanced (for me, which isn't really very advanced!) spreadsheet theory in an attempt to come up with a valuation that will undoubtedly be wrong, let's give the good old P/E ratio a run. At a share price of about 210p, M&S shares trade on a March 2001 forecast P/E of almost 16, or an earnings yield of 6.3% (1/16). In this highly competitive retailing environment, with M&S only growing in the single digit range, that still looks a bit pricey.

Don't let the heart lead the head.

Portfolio Update

Independent Insurance (LSE: IIG) reports interim results tomorrow. As of writing, the shares are up over 5% today. Will it be a case of traders buying today on the rumour (of good results) and selling tomorrow on the fact? All will be revealed tomorrow.

Where Next?
• M&S Discussion Board
• How To Value Shares (Fool's School)

Related Links
• Foolish Favourites (Special)
• Destroying Value (Qualiport)
• Buying M&S (Qualiport)
• Selling M&S (Qualiport)