Run with me for a second. If you don’t know who Go-Ahead are, don’t look them up, and let me take you on a tour of the company.
We’ll start with the financials. Here is a cash flow profile of the company over the last ten years. The gold bar shows operating cash flow – cash coming into the company in the course of ordinary business. The grey bar shows investing cash flow – cash they’ve invested in growing the business, or at least maintaining the asset base. The black line shows the summation of the two, namely the cash profitability of the business before we start talking about capital structure issues (like interest and dividends):
That’s what we like to see – every year, the company shows a cash inflow. And what’s great is the chart above in combination with the chart below, which shows the increasing revenue the business has generated:
Apparently Go-Ahead manages to pull in more and more cash, more or less every year, whilst also growing the absolute size of the business.
This, by the way, is the practical benefit of having a ‘good return on capital’, a phrase which is thrown around a lot in valuation memos. A good marginal return on capital, when it is really relevant, is such a boon because it allows the company to grow quickly without requiring any more of your cash. The best ones (think Rightmove) are able to grow rapidly while actively returning oodles of it.
Don’t get me wrong: Go-Ahead is not the best company in the world. I calculate the shareholder return since 2000 to be something like 13% – very good, to be sure, but I am not claiming it is a powerful and underestimated hidden champion.
What is unusual is the price. Go-Ahead’s market cap, at just shy of a billion, represents about 10x earnings; much cheaper than the market. We’ve already seen its cash characteristics are superb – much better than the market. And it’s also growing quicker than the market.
A tempting candidate for any portfolio!
On factor investing
But actually, I’m not here to make the investment pitch for Go-Ahead. Instead, I think it is a much more interesting case study on the benefits and dangers of ‘factor-based’ quantitative investing.
Stockopedia have pioneered factor-based investing here in the UK for private investors, but academics have been on the band wagon for a while, and brokerage houses are also increasingly piling into the fray with their own quant-type products. This is no surprise. Investing is like all human nature in that it has fashions, fads and hot flows of money into the trendy new products. As a brief primer, this new sort of ‘factor-based’ investing essentially screens the market for a number of characteristics that historically have been correlated with strong subsequent performance. Good balance sheets, good return on capital, earnings growth and so on.
And one thing you notice if, like me, you read quite a few of these quant-type products, is that Go-Ahead nearly always sits at or near the top of the quantitative ranks. It grows, it throws off cash, it has an excellent return on capital and it possesses an enviable net cash pile of £300m, or nearly a third of the market cap (though most is admittedly restricted, essentially representing government float). What’s not to like? The factoral check boxes are ticked with vigour!
I haven’t actually told you what Go-Ahead do yet, but that’s sort of the point. Quantitative investing doesn’t care. The numbers are the only thing that matter. Stories and annual reports cannot be parsed by algorithms. Besides, we’re probably all the better for it. Stories are windows to human biases, after all, and distractions from the clean beauty of screens.
But call me old-fashioned and indulge me. We’ll move from financial to operational.
The business of Go-Ahead
Go-Ahead has three different operating segments: Regional Bus, London Bus and Rail. The annual report has an excellent description of how these work:
- Regional Bus operates largely on a commercial basis. Revenue comes from fare paying passengers, with the government reimbursing concessionary travel (pensioners with bus passes). There are also some ‘thin’ rural routes which are directly subsidised as a matter of public interest.
- London Bus routes are managed and mapped by TfL, with private operators bidding on individual routes (you can find a fuller description of the tender process here). Supposedly TfL evaluates bids on a holistic basis – while price is an issue, ability to actually provide the service and not embarrass the procurement manager at TfL must be an important concern. There are bonus payments for outperformance vs. service standards, such as punctuality.
- Rail operates three UK rail franchises. The UK rail network, since privatisation, has been split up into smaller route networks, which are tendered out to businesses. Network Rail owns the infrastructure – the operating companies take care of what happens on top of it.
In short: for the most part, it’s a collection of those cutesy private-public partnership affairs you get when you try to privatise services which are essentially, in economic parlance, natural monopolies.
It’s also excellent business for Go-Ahead. Digging a little further into the actual economics makes it obvious why the cash flow characteristics are just so good – and that’s because, contrary to what one might think, it’s actually an incredibly asset light affair. Go-Ahead have £500m of net PP&E on their balance sheet, but are making £1.1bn of annual lease payments for assets on other people’s balance sheets – an absurdly high figure, and almost a third of group revenue. This is debt by another name, but it is debt with an implicit government guarantee. Someone needs to run the trains, after all. On top of that, working capital is tight – the Government, apparently, is a prompt payer. Better than that, though; they actually fund train operating companies with some float at the start of franchise agreements.
Ramping up the business, hence, is relatively simple. Win a new contract, lease some more trains/busses, march off to the races.
You knew the ‘but’ was coming. Here is my problem.
Of the three networks that Go-Ahead Rail runs, one of them has been in the news a lot recently. GTR – Govia Thameslink railway, runs the Southern route – a service so woefully poor it has received more or less constant coverage for the last year. Here are the punctuality stats from Southern’s own website:
Sub-50% implies peak time performance is off the charts bad, given off-peak services (which are less frequent, less busy and easier to schedule) are blended in there.
Normal market economics – and common sense – would dictate that a business providing a service this dismal – regardless of who is to blame – would be bleeding money to rectify the issue. But Go-Ahead’s RNS contains the following statement:
As previously reported, the additional resources being invested in GTR to support service delivery continue to impact margins in the short term. Our margin expectations for the life of the franchise remain unchanged.
And now we arrive at the crux of the issue, and the battle between quantitative and qualitiative investing. It can be summed up in one simple question:
Do I think Go-Ahead is a sustainable business? Will it be functioning in ten years’ time in much the same way it is today, and with the same or a better level of profitability?
Algorithmic and factor based investing does not care, per se. It is strictly a numbers game. Go-Ahead could’ve been a pork pickling company in Portishead, for all my nice Excel screening tools know. But ‘care’ is a vague word – more precisely, factor based investing relies on the generally correct rule that the market tends to underprice quality of earnings, cash generation, consistent growth and so on. Go-Ahead benefits from falling into a bucket of stocks that have historically outperformed.
By overruling the algorithms, I have to have a reason why I think the past won’t look like the future. Or, at least, for there to be enough uncertainty to make it not worth the attractive price. I think that is the case.
I worry that Go-Ahead have benefitted from an excellent political atmosphere over the last 15 years. New Labour, the Coalition and now the Tories have all pushed forward successive waves of privatisation. I worry the political tide may shift at some point. More specifically, I worry about contract risk. I think about G4S and the prison service, the tagging scandal, and Atos and the disability tests.
These were all examples of highly profitable contracts which went disastrously wrong. Highly profitable companies which went disastrously wrong.
They’re also symptomatic of the other issues with Government procurement, namely the degree to which the government gets woefully, hideously outclassed when it comes to contract negotiations. Go-Ahead has made a 10% operating margin effectively every single year on its bus contracts. Its rail contract will continue to be profitable despite arguably the worst conditions we have seen on a route in decades. And, what’s more, as far as I can calculate they are running this contract with negative capital. The float the Government gives them, and the implicit guarantee allowing them to lever up to the hilt through leases, means they are running a consistently profitable business with less capital than I have in my savings account.
It’s easy to forget, in the throes of a bull market, that even a modest 10x P/E ratio is making a bold statement about the way in which the future will unfold. In Go-Ahead’s case, it’s the statement that the future will look like the past. That the government will continue to underwrite exceptionally profitable contracts with essentially no risk to the operating company. That the public will not kick up enough of a fuss to end it or, worse, seek some sort of retribution. I’m not sure I’m comfortable making that statement.
The battle between quantitative and qualitative writ small
I have to battle my own biases – my own biases as a taxpayer, as a user of Go-Ahead’s rail services, and as an investor. The stock is hence almost a perfect example of the new, quantitative model of investing vs. the human-driven investing of old. The financials are great. Yet I choose to overrule the numbers based on a softer, qualitative assessment of the business.
Am I being that typical, fallible investor? Am I ignoring the obvious signs of cheapness in front of me? I’m open to those accusations. In fact, I can think of a few obvious accusations myself:
- Maybe I’m committing the crime of eternal optimism. I’m arguing operating margins this strong aren’t sustainable. But maybe that’s just wishful thinking as a taxpayer – maybe my sin is not seeing that government is a structurally poor negotiator. What will ever change that?
- Maybe I’m biased as a user of the service. Maybe my own experience clouds me against the company and gives me an overly negative opinion. Maybe Go-Ahead are actually excellent operators, running a business which is a net positive for the country due to their exceptional operational efficiency, and maybe we are all richer for it.
The funny thing is, for most people Go-Ahead should either be a bargepole stock or a real purchase consideration. If you think the business is sustainable, it is an absolute steal. If you do not, it’s very difficult to make a case even at very low valuations.
Where do you sit?