What do we do about Churchill China (see June’s Share Watch). The company has ramped up return on capital every year since 2010, putting it in a special category of growth stock. Not only has Churchill made more money, it’s got better at making more money.
This may explain why traders are currently paying 22 times adjusted profit in the year to 2016 for the shares. The earnings yield is less than 5 per cent, which is, in theory, the return an investor can expect on an investment at the current share price and level of profit. It’s not a particularly attractive rate of return, so long-term investors must believe Churchill will make substantially more profit in future.
Since profit must grow to justify the share price, we must establish the reasons for Churchill China’s growth, and form an opinion about whether it is likely to continue. I visited the company in June for its annual general meeting, and saw for myself the investment and innovation that has increased demand for its tableware among restaurateurs, hoteliers and commercial kitchens. The plates are gorgeous and hard-wearing, the factory modern and efficient, but that’s only partly responsible for Churchill’s performance.
Churchill China has also been a beneficiary of our membership of the European Union. While the UK is its biggest market, growth has mostly come from other parts of Europe where it has benefited from protectionist EU duties and a free internal market. After the UK exits the EU, it’s possible Churchill China will find it harder to grow.
Standard valuation metrics only compare profit in a single year to the price of the investment. When I consider a share for the Share Sleuth portfolio I also compare the price to the profit the company would have made had it earned its average return (profit) on capital. The average is taken over a representative number of years to prevent particularly good years, or bad years, having undue influence on the valuation.
There’s a risk that exporters like Churchill are experiencing a goldilocks period: exports are worth more because of the low pound, but they still benefit from membership of the EU.
Churchill’s average return on capital over the past nine years is 10 per cent, compared to 16 per cent in the year to December 2016. A lower return on capital means less profit, which makes the shares look more expensive. So normalised, Churchill China’s price/earnings ratio (p/e) is 37, and its earnings yield is 3 per cent.
This valuation gives me a different perspective. Churchill China must not only do better than it did in 2016 to justify its share price, it must perform much better than it did on average over the past nine years. It’s a well-managed business with an improved product range, so it may excel, but I’m not confident enough to make that assessment.
You may ask, why go to the trouble of normalising profit? There’s lots of evidence that simple valuation ratios such as p/e work.
There are two reasons. The first is intellectual; the other is all about results. When you relate valuation to the performance of a company over many years, you’re thinking about the long term, how it has performed and how it might perform in future, through thick and thin. You’re thinking about what drives profitability, what’s changing, and what’s staying the same.
That is the essence of investing, and it leads nicely to the second reason. Although, over long periods of time and across large portfolios of shares, investors will do better if they buy shares on low p/es (or high earnings yields), they’ll typically only grind out an extra percentage point or two of returns a year compared to an investment in an index-tracking fund that simulates the whole market. To do better, perhaps we have to work a bit harder.
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