Risk and the Asset Allocation Dilemma

And Reckitt Benckiser PLC

Griffin panel Knossos, Crete, courtesy Wikipedia

The ancients created the most marvellous hybrid animals by artistically crossing different species. Wall Streeters and City slickers have created hybrid assets classes that have complicated the asset allocation decisions for individual investors. As has the liberal monetary policy of the central banks since the 2008 financial crisis.

Once upon a time, it seemed to be so simple. Bonds were only issued by governments and the most solid of companies. They paid coupons that gave a return above inflation, didn't default and were senior to unsecured creditors. Equities soaked up speculative funds, rarely paid dividends, and were the first to be hit by any calamity. And cash you held on deposit at the bank, which paid an interest rate that usually covered inflation. These old idealised and simplified categories of assets pervade the thinking on asset allocation. They shouldn't.

The following graph compares the trajectory of the price of UK funds invested in high yield (junk) bonds (in pale blue)to the common shares of Reckitt Benckiser PLC (Reckitt in dark blue).

Courtesy Morningstar, click to enlarge.

The graph covers the period between May 2007, prior to the financial crisis, and today. Reckitt shares withstood the financial crisis months of November 2008 to March 2009 much better than high yield ("Junk") bonds. 44% of Reckitt's business is outside Europe and North America. It is the world leader in cleaning products. Reckitt's earnings per share continued upward, as if there was no financial crisis.

In Margin of Safety (1991), the hedge fund manager Seth Klarman noted that some equities "may demonstrate the stable cash-flow characteristics of high quality bonds." Reckitt is one. And some bonds "more closely resemble options on a future improvement in business results than fixed and secure claims against the current value of a company."

But risk is not a function of an asset class. Risk, as Klarman insists repeatedly, is a function of what you pay for an asset. Consider the present yield on financial assets.

1. Cash. Instant access accounts offer up to 1.7% gross interest. Even for nil rate investors, this is 1.1% below the current rate of inflation of 2.8%. Put it away for one year and the top rate increases to 2%. 5 years and the top rate is 2.55%.

2. Index linked Gilts. At the latest auction (April) they yielded a negative 1.26% p.a.

3. 10-year Gilts yield 1.88% p.a. If inflation continues at the current rate, investors are locking in a loss of 10.4% for the next ten years.

4. Investment grade corporate bonds (SLXX) are on a redemption yield of 3.37%.

5. High Yield Bonds ("Junk bonds") now yield only 5%.

6. Equities (FTSE 100) are on an earnings yield of 7.4% and a dividend yield of 3.4%.

The topsy-turvy relation between inflation and the yield on cash, bonds and equities is the result of the central banks' monetary policy. They aim to bring interest rates, via money market rates approaching zero and 'quantitative easing', to the lowest level possible. Devalued sterling and inflating asset prices contribute to inflation. Asset bubbles have been created and the investor will note:

1. Cash kept in pounds is the one asset that does not decline in nominal terms. It is safe from bubbles, but not its enemy, inflation. Present returns on cash are guaranteed to reduce its value slowly in real terms.

2. All forms of gilts and corporate investment grade and junk (high yield) bonds are firmly in bubble territory. Their prices are at, or near, record highs. If they are safe, they offer no protection against inflation. If they are risky, the margin over inflation does not compensate for their risk.

3. Equities, like other asset classes, have benefited from the largesse of the central banks. But the equity bubble has been suppressed by the major stock market crashes of 2001 and 2008-9 that are still fresh in investors' minds. The FTSE 100, in terms of its price earnings ratio, is not obviously in a bubble:

Courtesy Retirement Investing Today at http://www.retirementinvestingtoday.com/2013/01/the-ftse-100-cyclically-adjusted-pe.html data is from 1993 to April 2013. Click to enlarge.

In the above chart:

The olive line is the Price Earnings Ratio (PE) of the FTSE 100 for the earnings of the year in question.

The blue line is the PE of the FTSE 100 on rolling ten-year average earnings (the Cyclically Adjusted Price Earnings Ratio).

Both show that equities, in terms of PE, are cheap by recent historical standards. It should be noted that the decade prior to 1993 the FTSE PE ratio was much lower, averaging around 12.

In terms of risk, it can be argued that:

Currently, cash and equities are the lowest risk asset classes, depending on the period they are to be held. Gilts, corporate bonds of all natures and sovereign debt are the highest risk asset classes at the moment. (But see http://thejoyfulinvestor.blogspot.co.uk/2013_01_13_archive.html and http://thejoyfulinvestor.blogspot.co.uk/2013_01_20_archive.html for further comments.)

------------------------------------------------------------------------------------------------------------

Reckitt Benckiser PLC

Sunshine Cleaning poster courtesy Wikipedia

Reckitt Benckiser (Reckitt) has built a successful, cash generating, recession resistant business on the sale of cleaning products. 19 'power' brands in health, hygiene and home cleaning products account for 70% of revenues. According to the company, these are all ranked one or number two in their respective world markets. They include Strepsils, Durex, Nurofen, Scholl, Dettol, Lysos, Harpic, Veet, Finish, Clearasil, Air Wick, Vanish, Calgon, Woolite and Cherry Blossom shoe polish.

56% of Reckitt's revenues derive from North America and Europe and 44% from the rest of the world. Shares in Reckitt (blue) have comfortably outperformed the FTSE 100 (green) these past 5 years.

Graph courtesy of Yahoo, click to enlarge

The company is highly profitable, growing and cash generating:

1. Reckitt's net operating margin is steadily in the 25-26% range, and the historical return on equity (ROE) is 30%. ROE on retained earnings is 21%.

2. The company's growth in earnings per share has slowed from 20% (2004-9) to 10% pa. (2009-2012). Equity per share and dividends per share have followed a similar pattern.

3. Between 2009 and 2012, Reckitt has generated 7.1 billion pounds in operating cash flow. After paying out 3.9 billion in capital expenditure and dividends, it still had a surplus of 3.2 billion. It has used these funds to buy new businesses and to buy back shares. The company is in the fortunate position of having negative working capital. So the more it sells, the less capital it requires.

Reckitt's balance sheet is strong, with net debt at 40% of equity and a mere 7% of the company's 34 billion-market capitalization. It could pay off its entire debt with one year's earnings. The defined pension scheme deficit is low (0.4 billion) and Moody's rates its unsubordinated debt A1.

Reckitt's current share price of 4828p puts the company on an historic PE ratio of 18 and it pays out a dividend yield of 2.8%. The only large director transaction occurred on 3 May, when the outgoing CEO realised 1.3 million pounds from the sale of shares at 4642p.

Reckitt is a good addition to an investor's long-term portfolio. But at what price?

It is easy to overvalue a company with the growth characteristics of Reckitt. But a too cautious approach can lead to undervaluing a growth company. I have used the following assumptions:

1. Earnings per share (EPS) growth. From 2004 to 2009 Reckitt's EPS grew by 20% p.a., and from 2009-2012 it grew by  10% p.a. Assuming a continuing decline in growth, I have used 8% p.a. for the period 2013 to 2017.

2. Return on Equity (ROE). Based on its historical cost of assets, Reckitt's ROE is 31%. But on retained earnings, from 2004 to 2012, it has averaged 21%. I have used 20% for the period 2013 to 2017.

3. Equity per share (EqPS). From 2004 to 2009, Reckitt grew its EqPS by 18% p.a. This declined to 14% p.a. between 2009 and 2012. I have used 10% p.a. for the period 2013 to 2017.

4. My discount rate of 10.3% is based on the return on investment grade corporate bonds (3.3%) plus 2% for operational risk plus 5% for a margin of safety.

5. The dividend payout ratio is based on the company's policy of paying out 50% of EPS as dividends. And the PE ratio for the last 5 years has averaged 19.

On this basis, Reckitt is valued at 4454p compared to a present price of 4828p. More optimistic assumptions (EPS growth of 10% p.a., EqPS growth of 14% p.a.) would value the shares at 5448p. This illustrates the sensitivity of growth assumptions.

The prudent investor will note:

1. Reckitt will have a new CEO, and this introduces a new level of unpredictability.

2. If growth falls further, the PE ratio might well fall, with the consequence that the shares would lose twice over. Lower earnings on a lower PE.

3. Reckitt's competitors include some of the strongest marketing companies in the world (Unilever, Colgate-Palmolive, Procter & Gamble, SC Johnson and Henkel).

4. Reckitt's share price has increased by 47% since June last year, well ahead of the FTSE 100's 29%.