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Why we passed on Dignity well ahead of its latest price fall

Last autumn, funeral provider Dignity became cheap enough to show up on our radar – but an integral part of being a value investor is distinguishing whether a company is cheap temporarily or for a good reason

06/02/2018

Ian Kelly

Ian Kelly

Fund Manager, Equity Value

Death and taxes may rank among the only certainties facing humanity but that has proved of little support to funeral provider Dignity of late.

Most dramatically, the UK’s second-largest undertaker saw its share price halve on 19 January after announcing it was cutting its prices in a bid to preserve market share.

Dignity’s share price had already come under pressure towards the end of last year, which brought it onto the radar of The Value Perspective team.

An integral part of being a value investor, however, is doing the work to distinguish if a business is cheap temporarily or permanently, as buying into the latter variety – companies that are cheap for good reason are known as ‘value traps’ – can be very bad for a portfolio’s health. 

For us, the most interesting Dignity headlines in the latter part of 2017 focused on increased competition in the funeral services market, which analysts suggested stemmed from regular price increases by Dignity and its biggest competitor, The Co-operative Group.

Here on The Value Perspective, we are no experts on the funeral sector but we would argue over-profitability of established companies in any industry will act as a spur to new entrants.

Success attracts attention 

When an industry is visibly overearning, it attracts the attention of enterprising souls. The new entrants typically offer a lower-priced service than the incumbents (established companies) in order to win new customers.

The incumbents and entrants then tend to wage some sort of price war until the consumer has a better deal – and all the providers are making substantially lower returns than the industry used to enjoy.

Dignity's profit margin looked good 

Returning to the funeral sector, as the first chart below shows, Dignity’s operating profit margin of 30%  – around 10x the normal margin of a supermarket – would clearly have piqued the attention of new entrants.

 

Dignity operating profit margin

 

 Source: Bloomberg, 7th February 2018

 

Furthermore, when looked at on a return-on-capital basis, as the below chart shows, Dignity has averaged a very stable after-tax return of 12% to 14% on capital supplied either by its shareholders or the debt markets.

Dignity return on investment capital

 Source: Bloomberg, 7th February 2018

Alongside the risk of competition, another very important question for investors to consider is the level of profitability assumed by a company’s share price – and this is where things get really interesting.

Forgive us while we cut a few corners here to avoid becoming too entangled in some highly technical considerations – the main points still hold true.

Enterprise value 

For anyone looking to judge the expectations the market has for a company, a key ratio is the relationship between the ‘enterprise value’ (EV) of a business – that is, how much is being paid for invested capital – and how much actual capital has been invested in the business (IC).

In a normal competitive industry, the return on invested capital will be roughly the same as the market demands for the investment it has made.

A business earning the type of return Dignity has been should trade at around 1x EV/IC and indeed, for a long period, as the following chart shows, the company’s shares used to trade at around 1.8x, suggesting it enjoyed some sustainable competitive advantage.

When we crunched our numbers last autumn, however, the shares were trading on roughly 3x EV/IC, which suggested the market believed the company would make roughly 3x more than its cost of capital – into perpetuity.

That seemed unlikely, to put it mildly, so we passed on the shares.

Author

Ian Kelly

Ian Kelly

Fund Manager, Equity Value

I joined Schroders European equity research team in 2007 as an analyst specialising in automobiles. After two years I added the insurance sector to my coverage. In early 2010 I moved into a fund management role, and then took over management of two offshore funds investing in European and Global companies seeking to offer income and capital growth. 

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The views and opinions displayed are those of Ian Kelly, Nick Kirrage, Andrew Lyddon, Kevin Murphy, Andrew Williams, Andrew Evans and Simon Adler, members of the Schroder Global Value Equity Team (the Value Perspective Team), and other independent commentators where stated. They do not necessarily represent views expressed or reflected in other Schroders' communications, strategies or funds. The Team has expressed its own views and opinions on this website and these may change.

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