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Evenlode Investment View - December 2010

Elephants Can Run

Year to date, the smaller companies sector has been a resilient place to invest. Although the broader market is up this year there have been three significant sell-offs – the first in February (-9%: Greek crisis), the second from April to June (-18%: worries over a US double dip recession and sovereign debt) and the third in November (-6%: Irish crisis). In a parallel universe, as risk was removed from the table, one might have expected smaller company shares to under-perform their larger peers during these periods. In 2010, the exact opposite has happened.

Specifically, the best performers have generally been small and medium size companies offering a combination of growth and quality (i.e. high returns on equity and strong balance sheets). Given our preference for such companies, we have had our fair share of large price gains in holdings from this area of the market (Domino Printing, Diploma, ITE Group for instance).

The narrative for smaller company growth shares is a simple and compelling one (and very similar to that employed for emerging market/commodity stocks). In a world of sub-par economic growth in the West, growth companies that are not too reliant on the progress of the broader economy deserve to trade at a premium to the overall market. Smaller companies have a much better chance of doing so than larger ones - the bigger a company becomes, the harder for it to escape the shackles of a febrile economic backdrop and the harder each percentage point of growth is to achieve. ‘Elephants can’t run’ as the saying goes.

But this narrative is beginning to look a little hackneyed to us, for two reasons. First, because of the premium valuations that many of these stocks already trade on: when stocks get hot and start to rise by 3-5% a day as a matter of course – as some small caps have started to now - it doesn’t take long for them to get drained dry of value. Second, there is a group of blue chip growth shares that are just as deserving of a premium valuation as their smaller peers, but which have remained largely unappreciated by the market this year (and for far longer too, you might argue). The per share earnings record of the following selection of our blue chip holdings over the last ten years (A decade, we would note, with its fair share of economic problems) is testament to this:

Reckitt Benkiser – 19%
Smith & Nephew – 17%
Sage – 13%
Coca Cola – 13%
Johnson and Johnson – 12%
Astrazeneca – 12%
Reed Elsevier – 11%
Glaxosmithkline – 8%
Unilever – 7%
Diageo – 7%
(All figures are per annum EPS growth rates)

None of the above could in any way be described as smaller companies at the beginning of the decade. We would suggest, therefore, that some elephants actually can run - at quite a decent clip and despite a backdrop of adversity. Furthermore, the aforementioned ‘group of ten’ trade on an average dividend yield of 3.7% (versus a market yield of 3.0%), despite having grown their dividends by 11% per year on average over the last ten years. If they could repeat that performance over the next ten years and end the decade still on a 3.7% yield (i.e. enjoying no upward revaluation at all over the period) they would provide c15% total return per annum. Any revaluation would be icing on the cake.

An Interesting Comparison

Laid out below is a comparison that we think exemplifies the diverging market treatment of high quality blue chips and high quality small caps.

Stock 1

Return on Equity (5 yr av.) = 28.7%
Operating Margin (5 yr av.) = 21.7%
Net Debt/EBITDA = 0.5x
Expected EPS growth (nxt 2 yrs) = 7%, 10%
Price/Earnings Multiple = 12x

Stock 2

Return on Equity (5 yr av.) = 34.1%
Operating Margin (5 yr av.) = 29.8%
Net Debt/EBITDA = -1.5x
Expected EPS growth (nxt 2 yrs) = 15%, 11%
Price/Earnings Multiple = 28x

Both of the stocks in the above illustration are healthcare stocks that sell into niche markets with good growth prospects. Both stocks are franchise businesses: able to generate high returns on equity without the need for debt in their capital structure. The main difference between them is that Stock 2’s forecast earnings growth is a little higher. Other than that, one might think, they appear to be quite similar investment propositions.

So why does Stock 1 trade on a forward Price/Earnings multiple of 12x, while Stock 2 trades on a forward Price/Earnings multiple of 28x? Because Stock 1 is Smith & Nephew, a dreary, dull blue chip, whereas Stock 2 is Abcam - supplier of antibodies to the global scientific community and darling of the AIM market (winner in fact, of the AIM Company of the Year Award 2009).

We have nothing against Abcam – it’s an excellent business that we admire and would be happy to own at a less fancy price. But as Mr Market is busy sucking such companies dry of value we are gradually racheting down exposure to small caps. In their place we are racheting up exposure to the fastest elephants that the stock market has to offer.

Hugh Yarrow
December 2010


Please note, this investment view contains the personal opinions of Hugh Yarrow as at 7th December 2010 and does not constitute investment advice.

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