Why we bought Provident Financial
The extraordinary amount of bad news surrounding Provident Financial in recent weeks would have been enough to pique the interest of any contrarian – and that is when the hard work of value investing begins
We do not seek out good news but instead look for where the bad news has been.
So we wrote recently in Why it’s best to stay clear of ‘Peppa Pig’ fund managers – and that instinct to head towards the building from which everyone else is running away screaming is well illustrated by our decision, here on The Value Perspective, to build up a position in Provident Financial in recent weeks.
Look up the definition of ‘bad news’ in a dictionary these days and it would not be surprising to find ‘See Provident Financial’.
As recently as June, the Bradford-based sub-prime lender – or ‘doorstep lender’, as the press prefers to call it – was trading at above £30 a share.
Three months, two crippling profits warnings and one shock chief executive departure later, its share price was nearer £8 and at one point dipped below £6.
That was on 22 August, when Provident Financial announced the second of its profit warnings – a trading update that revealed the company expected to make losses of between £80m and £120m after its debt collection rates fell to 57%, compared with 90% last year.
In a single day, Provident Financial’s shares lost two-thirds of their value and, by the end of the week, chief executive Peter Crook had resigned.
Why was this an attractive investment?
There is more but let’s not labour the point and instead consider why we decided this represented an attractive investment opportunity.
Clearly, on the face of it, it really did not. The point about value investing, however, is it does not matter how a business looks on the face of it – only once we have done our research, analysed its financial strengths and weaknesses and pinpointed whether its shares are worth more than the market believes.
When we looked hard at Provident Financial, there was no denying the wider market’s picture of a 135-year-old sub-prime lender with a whole range of ‘issues’.
A lot of issues
These included a fundamental restructure of the business model of its home-lending arm that resulted in that division’s after-tax profits dropping from £92m in 2016 to an expected loss of some £100m this year.
Certainly the episode has forced Provident Financial to stop selling the Repayment Option Plan (ROP) product responsible for around 30% of its pre-tax profits in 2016 and has potentially put it in line for a chunky fine from the financial regulator.
OK, we are again in danger of labouring the point here, so just one more downside – not only was there the possibility of a fine, there was also the possibility the money being generated by the home-lending division might be prevented from making its way to the overall group, which really needs the cash.
And that division is extremely cash-generative – indeed, historically, that has been one of Provident Financial’s big attractions.
The balance sheet should be fine
Management remains confident that cash will be available and, on our analysis, that means in most scenarios the company’s well-funded balance sheet should be just fine.
We also concluded that – after taking into account the change in the home-lending arm’s business model and the hit from losing that highly profitable ROP product – there was enough profit left in the business to put the shares on a price/earnings (P/E) ratio of 8x. The P/E ratio is used to value a business by dividing the current market price of a company by its earnings per share number.
There may still be more bad news on the way – indeed, experience tells us profit warnings are as likely to come in threes as twos – but our analysis concluded Provident Financial, while not without its risks, represented an attractive investment.
By following our disciplined, value-focused process, here on The Value Perspective, we were able both to tune out the excessive fear surrounding the prospects of Provident Financial and identify an opportunity that, on average and on a five-year view, should make our investors money.
Fund Manager, Equity Value
I joined Schroders in 2001, initially working as part of the Pan European research team providing insight and analysis on a broad range of sectors from Transport and Aerospace to Mining and Chemicals. In 2006, Kevin Murphy and I took over management of a fund that seeks to identify and exploit deeply out of favour investment opportunities. In 2010, Kevin and I also took over management of the team's flagship UK value fund seeking to offer income and capital growth.
Fund Manager, Equity Value
I joined Schroders in 2008 as an analyst in the UK equity team, ultimately analysing the Media, Transport, Leisure, Chemicals and Utility sectors. In 2014 I moved into a fund management role and have had experience managing Global ESG and Pan-European funds. I joined the Value investment team in July 2016 to focus on UK institutional and ethical-value portfolios.
The views and opinions displayed are those of Nick Kirrage, Andrew Lyddon, Kevin Murphy, Andrew Williams, Andrew Evans, Simon Adler, Juan Torres Rodriguez, Liam Nunn, Vera German and Roberta Barr, members of the Schroder Global Value Equity Team (the Value Perspective Team), and other independent commentators where stated.
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