Commentators often praise companies with high earnings growth and savage loss-makers despite scant analysis of the context in which profits or losses were made.
A retailer, for example, earns market kudos when profits are strong. But a buoyant economy, strong retail sales growth and healthy consumer sentiment lift the industry.
Equally, a tech firm is criticised when profits fall, even though it suffers from factors beyond its control: a pullback in corporate and government spending on large tech projects, for example. Most business-to-business (B2B) tech firms suffer when project spending falls.
Earnings context has two layers. First, how is the company performing relative to industry conditions? Is it outperforming peers in a slowing sector and taking market share? Or benefiting from tailwinds helping its sector and doing little to add extra value?
Second, how does the firm perform throughout industry cycles? Does it consistently grow profits in up and down markets, which is a sign of good management? Or do earnings tank when industry conditions sour because the company cannot change direction quickly?
My favoured metric for firm performance is Return on Equity (net income divided by shareholder equity). Simply, ROE shows how many dollars of profit a company generates on each dollar of shareholder equity. Companies with high ROE work their equity hard.
Then, I assess the company’s ROE over an industry cycle, typically 7-10 years. I look for companies with high ROE (above 15 per cent, depending on the sector) over long periods.
Companies with consistently high and rising ROE over many years are exceptional. A rising ROE increases a company’s intrinsic (true) value and the share price eventually follows it higher. Conversely, companies with low or falling ROE should be avoided.
I consider many financial metrics beyond ROE. But it’s the first I look at because a high ROE suggests management is doing a good job in up and down markets, and that the company must have an “economic moat” (sustainable competitive advantage) to deliver such returns.
A high and rising ROE, low company debt and strong surplus operating cash flow are traits of exceptional companies. Because they work each dollar of shareholder equity so hard, they use surplus cash flow to grow the business rather than issue more shares or load up on debt.
JB Hi-Fi stands out
Consider electronic-goods retailer JB Hi-Fi. Its ROE for the first half of this decade averaged above 50 per cent – outstanding for a retailer and a return that most high-growth tech stocks would be proud of. The ROE has fallen in recent years to 26 per cent – still high for its sector.
Like most retailers, JB Hi-Fi has many challenges. Australia’s economy is easing, retail sales growth is slowing and consumer sentiment is falling. The fall in national house prices is making consumers feel poorer and less inclined to spend on discretionary consumer goods.
Amazon’s threat to Australian retailing and growth in online sales are other headwinds. Consumers are increasingly buying goods online to save money and expecting larger discounts. That’s crunching sales and profitability in bricks-and-mortar retailers.
Moreover, JB Hi-Fi has faced an army of short-sellers who are betting on a lower share price. It is among the market’s most shorted stocks because the bears believe it will eventually succumb to subdued retail conditions and rising industry competition.
There’s no doubt that JB Hi-Fi has a tough outlook. It’s ROE is expected to fall to around 20 per cent over the next three years – less than half its rate a decade ago. I want companies with rising, not falling ROE, but there’s a good chance JB Hi-Fi’s ROE is stabilising.
The retailer this week reported sales growth of 4.2 per cent to $3.8 billion and 5.5 per cent growth in net profit to $160.1 million for the first half of FY19. Delivering record sales and earnings growth in this tough retail market impressed.
The company’s guidance for FY19 full-year profit was above market consensus; a reason its shares rallied after the result. Nevertheless, management noted challenging retail conditions and greater trading volatility, and modest comparable store sales are a concern.
JB Hi-Fi’s better second-half performance suggests Australia’s housing downturn is not affecting consumer spending as much as critics fear. It was yet another good result from a best-of-breed retailer in its segment.
Longer term, Australians cannot get enough of electronic gadgets and the Internet of Things (connected devices online) will be a growth driver for JB Hi-Fi as consumers upgrade more devices so that they are connected online.
I believe consumers are likelier to buy pricey electronic gadgets instore and seek advice on them, rather than online, although that channel will increase its share of sales. Population growth is another tailwind for JB Hi-Fi with its 300-plus stores.
Ultimately, it comes down to valuation. At $22.92, JB Hi-Fi is on a forecast price-earnings (PE) multiple of about 11 times FY20 earnings, consensus analyst estimates show. That is well below the market average and undemanding for a company of JB Hi-Fi’s quality.
An average share-price target of $25.39, based on the consensus of 12 broking firms that cover the stock, suggests JB Hi-Fi is undervalued at the current price. The consensus looks about right, meaning the stock should offer modest double-digit gains in 2019.
The company’s total return is down 7 per cent over year (including dividends). The market has over-reacted to JB Hi-Fi’s outlook amid the retail gloom. If it can deliver good growth in this retail market, imagine what it will do when conditions eventually improve.
Chart 1: JB Hi-FSource: The Bull
• Tony Featherstone is a former managing editor of BRW, Shares and Personal Investor magazines. The information in this article should not be considered personal advice. It has been prepared without considering your objectives, financial situation or needs. Before acting on information in this article consider its appropriateness and accuracy, regarding your objectives, financial situation and needs. Do further research of your own and/or seek personal financial advice from a licensed adviser before making any financial or investment decisions based on this article. All prices and analysis at February 13, 2019.