Questions of quality
I like Cranswick as a business. Much like Howden Joinery, it was one I bought back when I started the portfolio because it sort of fitted what I knew I was supposed to be looking for, but didn’t understand that well why. In hindsight, and having looked at quite a few more companies since then, it still strikes me as a company of significantly above average quality. (As a (sort of) economist, I can’t help but add that the previous sentence is home to all sorts of selection bias; I am a value investor, so I am probably more likely than most to be looking at poorer-quality companies and not the ingenious new startups.) Self-chiding aside, quality is all well and good, but it’s the price/quality that we really care about. I guess that’s what stuff like the P/E hopes to give you an indicator of – price vs. quality, in that ratio how much money it’s making. In those simple terms, what we’re really trying to do as investors is refine that ‘E’ so we get a picture of future cashflows far more intuitively and powerfully than just looking at last year’s net profit number.
As I said, it’s a ‘quality’ company. To put numbers or intuition to it, it consistently earns returns above its cost of capital, as a big company, without overleveraging (either on debt or operating leases) and with reasonable consistency. It’s dipped since the recession, as could be anticipated, but still earns returns figures upwards of 20%, having capitalised operating leases. This, to me, is probably the simplest definition of quality. Where it comes from is another, more complex question, but by the simplest yardstick a company able to consistently grow and keep returning more than is required to fund that growth is a sound one. That seems obvious, but that point is sometimes in considerable doubt. I spend a good deal of time trying to decipher whether a company’s returns are just depressed for a idiosyncratic or cyclical reason, or whether it’s simply in terminal decline. Cranswick does not worry me with the same questions.
By the most obvious measure, it’s not hugely expensive, either. It trades on about 12 times forward or historic earnings, having grown consistently for the last 10 years. I’ll paste the same graph, from Cranswick Investor Relations, I’ve used before – just because it illustrates a point:
Note; we don’t know from the graph how much was genuine organic growth and how much was acquisitive – so take it with a pinch of salt. That’s the basic attractive premise, then; it’s not very expensive, it can grow and compound those supernormal returns, and it seems pretty safe – both in financial profile and in operating history and reasonable demand patterns. People aren’t likely to stop eating sausages tomorrow, so it’s not a fad business that seems likely to fade away.
Without getting too carried away, then – I like to be dour after all – the simple fact is that the P/E ratio doesn’t tell us a huge amount about a company. It’s a nice indicator in cases like Cranswick, but we need to sort of drill one level deeper to get any real understanding. The PTBV gives a clue to this – near 4 – in that we are paying 4 times assets in what, at first, strikes me as a reasonably capital intensive business. We’re not getting a huge amount of bang for our buck in that sense. In reality, what we’re paying for is Cranswick – the ethereal entity. Something about Cranswick makes a pound inside Cranswick worth a lot more than its assets are worth. This is, of course, the corollary of previously discussing that the company earned strong returns.
That’s all well and good, of course, but for one little niggling question – where are those excess returns coming from? Sometimes, you can break it down. Red‘s posts are always elucidating on that point. With Cranswick, though, I can’t really figure out what about this company makes them so good at what they do; it’s not a very exciting industry, there’s not a huge amount of space for branding, and it’s essentially one up from a commodity. They’re squeezed by their customers, to which they’re in a rather lopsided relationship (two of the supermarkets account for 52% of their revenue) and tied into an agricultural supplier chain.
I really can’t find any specific reason as to why they avoid those two previous pitfalls and manage to consistently grow and return. I guess the simplest answer is that, generally, they’re just good at what they do. They do things efficiently, management are competent, and they have the requisite structures in place to allow effective decision making. The next thing I have to do is swill with mouthwash, though; the last sentence is essentially nothing more than a list of platitudes you’d expect to hear from a bad boss. It doesn’t really tell us anything.
My opinion on Cranswick’s valuation in a nutshell, then:
If we assume no growth, but a maintenance of the historical level of returns, we’re probably at about fair value – perhaps slightly over*.
If we assume a reasonable continutation of growth coupled with those strong returns, which feels unlikely given the mechanics, Cranswick could still offer great value.
If we assume some sort of tapering of returns – which strikes me as prudent until I find something which explains why they could continue to do so well – we’re overvalued, unless we assume some growth – which, again, seems reasonable. Then you more or less end up where we are today.
I think my assumptions verge on the cautious side, but I’m still erring on the sell. If I find something else to put my money in, I’ll be tempted to hop – the question currently is that I have a lot of potential sells and not too many potential buys.