Five shares to watch
SMITH & NEPHEW
The year 2012 was a flat one, but Smith & Nephew has maintained consistently high levels of profitability, which indicates the company will grow or pay large dividends to shareholders in future.
The company's ambition is to do both. It has increased research and development expenditure and promised to raise it again in 2013. Meanwhile, it has increased the final dividend by 50% and promised a progressive dividend policy.
The medical technology company's new chief executive has reorganised it into two divisions. The biggest is Advanced Surgical Devices, which designs and manufactures replacement hips, knees and shoulders, and develops the minimally invasive surgical techniques and devices associated with these joints.
The other division, Advanced Wound Management, earns about a quarter of turnover but is growing faster than the advanced surgical devices business. Its products promote the healing of chronic ulcers and burns.
These products are in demand among ageing, more sporty populations in the West. But in the developed world, much of the money for medical technology comes from governments operating within tight budgets, and they are putting pressure on suppliers to keep costs down.
At the same time, suppliers' costs have increased. This pressure may have driven Smith & Nephew's strategy of looking to emerging markets for growth and focusing on products that help people heal faster, to reduce time spent in hospital and keep costs down.
Smith & Nephew has strong competitors. The replacement joint market is dominated by five companies, and Smith & Nephew has the fourth largest market share, of 11% in 2011. Its advanced wound management business is in second place in its market and has since been bolstered by the acquisition of Healthpoint.
An unsophisticated reading of the market suggests Smith & Nephew can profit handsomely but can't win outright in the joint replacement market. But it might in the wound management market. At an earnings yield of 8%, it's just about cheap enough to consider investing in, which is unusual for a stalwart company in the current market.
Last year was a step backwards for Morgan Crucible. Turnover and profit were below the record levels achieved in 2011 – hard won after almost a decade of recovery.
The company – which manufactures ceramic and carbon materials, and engineers them into components for industry use – experienced dramatic falls in sales to military and solar customers, reflecting uncertainty in those markets. Recession in Europe, a slowdown in China and uncertainty in the US slowed orders.
The rest of the group, while resilient, was unable to make up for the lost profit.
While it was grappling with these operational challenges, Morgan Crucible planned what may be the final acts in a process of rationalisation that started almost a decade ago: the merging of its ceramics and engineering divi- sions and the announcement of a new name for the group, Morgan Advanced Materials.
The unifying company has, according to chief executive Mark Robertshaw, more opportunities to share customers, costs and knowhow. Morgan Crucible already earns more than a quarter of its revenue outside Europe and north America. A new regional structure could help develop regional capabilities.
Its financial targets are the same for all three regions: a 35% return on capital employed and a 15% profit margin. Where it isn't achieving those goals, it cuts cost and seeks out markets where it can. In 2012 Morgan Crucible closed a body armour production line and a couple of European facilities.
It's not especially cheap on an earnings yield of 8%, but Morgan Crucible may have turned into a stalwart capable of sustained profitability. If so, it's worth the 8% earnings yield.
Staffing company SThree has reached its current value of nearly £500 million without making a single acquisition. It has expanded from its UK origins into a company that does two-thirds of its business abroad, mostly by promoting its own talent.
SThree focuses on niches within niches. It has expanded from information and communications technology recruitment into new sectors, such as pharmaceuticals, biotechnology, engineering, energy, banking and finance.
However, it also targets areas where skills are in short supply, salaries are going up and companies seeking to supply recruits for vacancies are small. It favours sectors seeking staff for particular projects, often involving new technology, where staff churn is high and it earns frequent commission – which increases with wage inflation.
This year, profits fell slightly and the company's cash pile halved. This may be due to the reduced levels of permanent recruitment typical of a recessionary market, which brings in cash. Also a factor is increased levels of contract business, which uses up cash due to the lag between paying a con- tractor and receiving payment from the client.
With 50% of gross profit coming from contract placements and 50% from permanent, it can, within reason, flex with the economy by supplying more contract staff in recessions and extra permanent staff in recoveries. SThree remained profitable through the credit crunch and has recovered during recession, although it has yet to reach the levels of 2007 and 2008.
The company is an obvious shoe-in for the Watchlist, but perhaps because SThree communicates its qualities so well, investors are aware of its virtues and, on an earnings yield at 4%, the market price looks high.
Porvair had a record 2012, but that should not be the end of the run for the company, which provides filters for metal casting, industrial and commercial equipment.
Although growth is likely to moderate, Porvair believes it will increase its market share as it invests in Chinese production for the Asian market and continues developing better filters for a wider range of applications.
Filters are used to protect expensive components in foundries that cast aluminium, copper, steel and superalloys, while micro-filters are used in energy, aviation and bioscience industry equipment. Porvair says its filters are specified on ‘almost all commercial airframes' as part of hydraulic, fuel, lubrication and air systems.
The business has many of the qualities of a hidden champion: a company that provides vital products or services invisible to the final consumer.
Eighty% of Porvair's sales are consumables and replacement parts for machines. These often have a long life cycle, which means a long stream of earnings for the company.
Technical knowhow and patents developed over at least three decades in filtration may give it a competitive advantage in the US, where it earns 40% of its revenues, and the UK, Europe and Asia, where it earns between 15 and 20% of its revenues.
Like SThree, though, the earnings yield at 6% means it looks like a good business at a fair price, rather than a cheap one.
AstraZeneca is the opposite to Porvair: a challenged business at a tempting earnings yield at 13%.
The increased competition that follows when drug patents expire has long been a recognised threat to the profitability of giant drug companies.
In 2012 at least four AstraZeneca blockbuster drugs came off patent, most damagingly Seroquel, a treatment for depression. Turnover fell 17% and profit 21%, and the company expects it to fall again in 2013.
More recently, government legislation to regulate prices and contain the burgeoning cost of healthcare has emerged as another big threat.
So far, AstraZeneca has focused its attempts to improve its profitability on raising productivity. It has shed tens of thousands of jobs in research and development since it started restructuring in 2007. Recently, restructuring has extended to the sales and administrative functions.
Some of the money saved has been invested in building commercial infra- structure serving emerging markets and in new drug development.
However, cost-cutting may have only exacerbated a destructive craving for profitability over the short term. An emphasis on marketing, which can give a quick return, rather than research, from which profits increasingly flow much later, leaves drug companies short of new blockbuster drugs to replace ageing ones.
When the company's full-year results were announced in January, Pascal Soriot, AstraZeneca's new chief executive, talked of achieving scientific leadership while maintaining strong financial discipline, which sounds like a value-creating long- term aspiration. As his plans become clearer, so might the case for buying AstraZeneca shares.
But at the moment, there are too many unanswered questions about AstraZeneca's business.
This feature was written for our sister publication Money Observer
The general term for the rate of income from an investment expressed as an annual percentage and based on its current market value. For example, if a corporate bond or gilt originally sold at £100 par value with a coupon of 10% is bought for £100 then the coupon and the yield are the same at 10%, or £10. But if an investor buys the bond for £125, its coupon is still 10% (or £10) and the investor receives £10 but as the investor bought the bond for £125 (not £100) the yield on the investment is 8%.
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).
If you own shares in a company, you’re entitled to a slice of the profits and these are paid as dividends on top of any capital growth in the shares’ value. The amount of the dividend is down to the board of directors (who can decide not to pay a dividend and reinvest any profits in the company) and they will be paid twice yearly (announced at the AGM and six months later as an interim). Dividends are always declared as a sum of money rather than a percentage of the share’s price. Although dividends automatically receive a 10% tax credit from HM Revenue & Customs (HMRC), which takes the company having already paid corporation tax on its profits into account. Dividends are classed as income and, as such, are liable for personal taxation and so shareholders have to declare them to HMRC.
In a financial context, churn refers to the frequency at which a share portfolio or investment fund sells the securities in the portfolio to realise cash in order to buy more securities. It’s also a way unethical brokerage firms “churn” clients’ accounts by trading securities very actively in order to increase brokerage commissions rather than customer profits, as brokers’ income is directly related to the volume of trading they undertake on customers’ behalf.
Generic, loosely-defined term for markets in a newly industrialised or Third World country that is in the process of moving from a closed economy to an open market economy while building accountability within the system. The World Bank recognises 28 countries as emerging markets, including Argentina, Brazil, China, Czech Republic, Egypt, India, Israel, Morocco, Russia and Venezuela. Because these countries carry additional political, economic and currency risks, investors in emerging markets should accept volatile returns. There is potential to make large profit at the risk of large losses.