Questor: We’re still bullish about this FTSE 100 stock despite disappointing returns
Our recommendation to purchase FTSE 100 member Smiths Group has not gone to plan.
Since the time of our initial tip in May 2017, the engineering company’s shares have risen by just 11pc. This is just three percentage points ahead of the large-cap index’s performance over the same period and represents a thoroughly disappointing outcome.
While an 18pc income return on our notional purchase price means the stock’s total return amounts to 29pc, this still equates to an annualised rate of just 3.7pc.
At this point, many investors would be hugely tempted to simply give up on the stock. This is completely understandable, since a plethora of other companies have generated far better returns over the same period. Their superior performance is likely to cause frustration and disappointment among investors in Smiths Group that prompts even the most patient individuals to consider selling their holding.
But as any experienced investor knows, there are inevitably periods of share price underperformance from even the highest-quality companies. Investors must therefore become well-versed in determining which underperformers to stick with and which ones to offload.
Crucially, Smiths Group remains fundamentally sound and still has long-term growth potential. Its latest trading update showed that revenues rose by around 6pc in the third quarter of the year, excluding the impact of acquisitions.
And in the first nine months of the current financial year, it increased by 5pc versus a very strong comparable period in the prior year.
The company remains on track to meet financial guidance for the full year and anticipates further profit margin expansion. This suggests it continues to enjoy a strong competitive position, with return on equity of 13pc in the latest financial year achieved in spite of very low levels of debt.
Indeed the firm’s net debt-to-equity ratio stands at just 23pc. And with net interest cover being in excess of 13 in the first half of the current financial year, the company has a solid financial position through which to ride out potential industry-related challenges and boost its bottom line via mergers and acquisitions.
It made two acquisitions in 2023 and is well placed to engage in further such pursuits. Its four divisions, which encompass a broad range of market segments including aerospace and security, provide a high degree of diversification that reduces overall risk.
And with scope for expansion into new markets, especially those connected with the energy transition, the company’s outlook appears to be upbeat.
Clearly the world economy’s performance will have a significant impact on the firm’s financial prospects.
But with the current era of high inflation and restrictive monetary policy now drawing to a close, the outlook for many of the company’s end markets is likely to improve over the coming years. This could not only boost its top and bottom line growth rate, but also raise demand among investors for its shares.
They currently trade on a price-to-earnings ratio of around 18. While this is relatively high for a FTSE 100 stock, Smiths Group’s 25pc annualised rise in earnings over the past three years suggests it is not overpriced.
With annualised earnings growth in excess of 9pc forecast by the market over the next two financial years, it continues to offer scope for generous capital returns.
The firm plans to raise dividends in line with profit growth over the long run. Although its shares currently yield just 2.4pc, versus 3.7pc for the FTSE 100, a fast-paced rise in dividends coupled with 70 years of uninterrupted shareholder payouts mean its total return potential remains upbeat. An ongoing £100m share buyback programme could also catalyse its market valuation.
With a recently appointed chief executive at the helm, alongside a chairman who has been in the role for less than a year, Questor would be unsurprised if changes to Smiths Group’s strategy lie ahead.
While this presents a modest risk, in reality an internal chief executive appointment coupled with the firm’s solid fundamentals means that its risk/reward opportunity remains favourable.
Certainly the stock has thus far failed to live up to this column’s expectations. But with a sound balance sheet, strong competitive position and an upbeat outlook for the world economy, we anticipate a much improved performance from the company’s shares over the coming years.
Questor says: buy
Ticker: SMIN
Share price at close: £17.51
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