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Article of faith - Balance sheet and valuation should, most of the time, see investors right

04/03/2013

Andrew Lyddon

Andrew Lyddon

Fund Manager, Equity Value

In articles such as Subtle switch and Missed bargains, we have occasionally visited the corporate strategies of AstraZeneca and GlaxoSmithKline, the two giants of the UK pharmaceutical sector. In the case of Astra, such strategy has involved previous management looking to trim costs, cut back on research and developments (R&D) and use surplus cash flow – which at large pharma businesses with lots of mature patents can be plentiful – to grow the dividend and buy back shares.

Last October saw former Roche boss Pascal Soriot appointed chief executive and one of his first actions, while he assessed his options, was to suspend Astra’s buyback strategy. Soriot then took the opportunity of the publication of the company’s full-year results on 31 January to distance him from some medium-term guidance his predecessor had offered on the sort of financial performance Astra might be expected to deliver as it approaches the drop-off point of some of its leading drugs.

While he has been careful neither to commit to a particular course of action nor to rule anything out, the suspicion is growing that, rather than continue with a strategy of returning cash to shareholders, Soriot is more inclined towards one that requires more investment in the business – whether that involves, say, increased spending on R&D or marketing of current drugs or one or more acquisitions.

This potential change from a company that, while still investing in R&D and new drug development, preferred to return most of its surplus cash flow to shareholders in one form or another to one that thinks a larger proportion of that surplus cash flow might be more profitably reinvested in the business, puts investors in something of a quandary.

After all, without any inside knowledge of Astra’s financial and business position, how is an outside investor supposed to judge which strategy might be the more rewarding? As value investors, we instinctively prefer seeing more cash returned to us as the benefits are more visible and easier to assess – either we receive the money to spend ourselves or our shares hopefully become more valuable.

If that happens at the expense of investing in the on-going franchise, however, then it is doing investors a disservice in the long run. Then again, if the reinvestment strategy goes too far, a company can end up frittering away a fortune on failed R&D projects or big deals at expensive multiples – something Astra has itself been accused of with its 2007 acquisition of Medimmune.

If a new chief executive’s strategy is to say the company needs to invest a lot more in the business, assessing from the outside whether that is a good or bad thing is extremely difficult and really you will have no way of informing that view for what could be a number of years.

Ultimately you are trusting the chief executive, you are trusting the board that appointed and will oversee him and – most importantly from the value perspective – you are trusting the company’s balance sheet and valuation. A healthy balance sheet should provide the chief executive room to waste some money without destroying the company while a cheap valuation should mean, if he does end up frittering away a fortune or making other mistakes, sufficient upside will remain for investors still to make a good, if not exceptional, return.

Nobody can know for sure what AstraZeneca’s previous strategy would have achieved or what Soriot’s eventual plans will do for the business but history suggests very strongly that, perhaps 60 times out of 100, a company’s balance sheet and valuation will see you right. Only time will tell if management and their actions ultimately steer you away from that majority and towards one of the other 40 times.

Author

Andrew Lyddon

Andrew Lyddon

Fund Manager, Equity Value

I joined Schroders as a graduate in 2005 and have spent most of my time in the business as part of the UK equities team. Between 2006 and 2010 I was a research analyst responsible for producing investment research on companies in the UK construction, business services and telecoms sectors. In mid 2010 I joined Kevin Murphy and Nick Kirrage on the UK value team.

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