The stock market is filled with individuals who know the price of everything, but the value of nothing’ – A year on

VT Tyndall Unconstrained UK Income Fund

The stock market is filled with individuals who know the price of everything, but the value of nothing’ – A year on

Just over a year ago, 6th May 2020 to be precise, as the COVID-19 pandemic was accelerating globally, we wrote a weekly commentary with the above title. The note focussed on the extreme outperformance of ‘quality’ over ‘value’ in the UK in recent years, using the examples of Rentokil Initial in the quality camp and Imperial Brands in the value camp. We concluded as follows:

‘……..We cannot tell you for sure that Imperial Brands on 6x P/E is a better investment opportunity for the next 5 years than Rentokil Initial on 35x but we have a strong suspicion it will be……….’

One year later we thought it would make sense to see how things are developing.

As a reminder, the chart below illustrates the exceptional relative performance of Rentokil Initial compared to Imperial Brands from the beginning of October 2013, when Andy Ransom was appointed CEO, to the 6th May 2020.

So, how have the businesses fared during the last year or so? Rentokil, perhaps not surprisingly given the strengths of the business model, has adapted well to the challenges of the pandemic. In the year to 31st December 2020 group revenue grew by 6%, operating profit by 5% and EPS by 7%. The star of the show was the hygiene division which, courtesy of exceptional demand for disinfection services, grew revenues by 37% and profits by 81%, more than offsetting the impact of Covid-19 on the other businesses in the group. Given such a resilient performance Rentokil also reinstated the dividend at 5.4p for the year.

Imperial Brands, given the relatively low economic sensitivity of the tobacco market, also held up reasonably well during the year although not as strongly as Rentokil. For the year ended 30th September 2020 (so not quite like for like), net revenues grew by 0.8%, however operating profit fell by -4.8% and EPS by -5.6%. Imperial, under new leadership, also made the difficult decision to cut the full year dividend by -33.3% to 137.7p.

In other developments, both companies changed finance directors which, in Imperial’s case, was part of a broader shake up of the senior management team under the leadership of new CEO Stefan Bomhard. Imperial also sold their premium cigar business for 1,225m Euros as part of a refocusing and debt reduction strategy. Rentokil meanwhile returned to the acquisition trail, following self-imposed suspension earlier in 2020, and ended up buying 23 businesses in the year for just over £200m in total. Finally, the US FDA recently announced their intention to legislate to ban menthol in cigarettes. This is an important market for Imperial and we estimate it alone accounts for c.10-15% of group profits.

Given the respective business and financial performances noted above, it would be perfectly reasonable to expect that Rentokil has continued its long run of outperformance of Imperial in share price terms. That was certainly the case for the first few months after we wrote our note, as the chart below highlights, however over the entire period (6th May 2020 to 21st May 2021) as you can see, Imperial has very modestly outperformed.

It is often difficult to identify the exact reasons for a change in relative performance, particularly when one business appears to be demonstrably outperforming another in financial terms. However, as we have noted numerous times before, starting valuations have a massive impact on subsequent returns in investing and that applies equally at the individual company level as it does at the broader aggregate market level.

When valuations are high, as with Rentokil, almost everything needs to go well for you to make money in the medium term, because eventually the valuation multiple will come down. In contrast, with low valuations you don’t need a lot to go well for your investment to be worth considerably more, if the wider market starts to reappraise the businesses potential more favourably.

To emphasise the point let’s take Rentokil’s starting valuation a year ago of 35x P/E. Let’s assume they grow profits handsomely at 15% a year for our five-year period. If, after this time, the market decides for whatever reason that a more ‘normal’ valuation for the business is 17.5x P/E then, despite all the strong profit growth, the share price will be exactly the same at the end of the period as it was at the start.

Conversely, starting on a P/E of 6x, let’s assume Imperial manage to grow profits at a relatively modest 5% a year over five years. Now suppose the market were to decide that a more appropriate valuation at the end of that time is 10x P/E, as the company isn’t so bad after all. In this scenario the share price will be over 100% higher at the end of the period than at the start.

For what it’s worth, whilst early days, we think this is exactly the process starting to playout with these two particular companies (and most likely in the broader market as well). Rentokil’s valuation to the end of December 2021 has come down somewhat and is currently forecast at approximately 31x P/E. The company continues to perform well financially and operationally but the valuation multiple, in our view, remains too high and will likely continue to compress.

Meanwhile, there are tentative signs that Imperial, under a substantially refreshed leadership team, are refocussing the business sensibly around their core strengths and putting the building blocks in place to deliver considerably improved financial performance over the next few years. Although, on a forecast P/E of 6.5x and a dividend yield (post the dividend cut) of over 8%, the market has not yet, in our view, significantly changed its opinion of the business and its prospects.

So, one year into our five-year period, it is far too early to declare victory for our original assertion that Imperial will be a better investment than Rentokil. However, given what we see as very positive change coming through the Imperial business, we feel even more confident in that assertion now than we did a year ago.

We will be sure to check in again a year from now with another progress report but the good news, as a quick glance at the implied Return on Capital Employed charts above (from Redburn) illustrates, is that if we are right there is still a long way to go in Imperial’s favour.

28th May 2021
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Data source (unless otherwise stated): Bloomberg
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