Jul 2005

DIVIDEND MATTERS

The combination of some very welcome new mandate wins and the need to reinvest takeover monies has meant that Lindsell Train Limited has been rather more active in UK capital markets than for a while. Mind you, so far in 2005, with the year over half gone, we have yet to sell any UK ordinary equity position, or any part of any UK ordinary equity position, for our biggest account, Finsbury Growth and Income Investment Trust - meaning it would be wrong to assume that we have morphed into wheeler-dealers.

The criteria we set for the stocks we've bought or added to in 2005 are not unusual. We want either good dividend yield, or very strong assurance of future dividend growth, or preferably both.

We have been buying two "super high-yield" assets - a basket of bank preference shares (comprising HBOS, RBOS and Warburg/UBS) and Lloyds Bank ordinary shares, both of which offer net dividend returns double that of the FT All-Share Index and getting on for double that on a Gilt. Our thinking on the appeal of such dividend yields was sharpened recently by a lengthy debate about benchmarks and return requirements with a prospective client. This pension scheme wants us to run UK Equity money, but is uncomfortable about setting the FT All-Share as a benchmark. Their concerns about using the All-Share are, first, they have been burned by other managers' closet-indexing in recent years and worry that by setting that index as the benchmark they encourage us, even unconsciously, to expend our "risk budget" by taking relative risks against it. More to the point, this client is moving away from considering risk in index-relative terms to a focus on meeting or exceeding absolute liabilities. What they told us is - "What we really want you to do is to beat the return our actuary tells us we need for this portion of our assets". And what the actuary wants is index-linked gilt redemption yields, plus 3.0% per annum, or, at today's prices, an absolute return of c4.5%, with an element of inflation-proofing.

Now, as soon as one has been tasked to earn absolute returns of 4.5% per annum and if you assume, as we do, that UK inflation will run at no more than 1.0-3.0% for the foreseeable future, then it is, we think, impossible not to regard those preference shares and Lloyds Bank as anything but extraordinarily attractive, because they already offer starting net dividend yields well in excess of that required rate. Of course, the preference dividends are safer than Lloyd's ordinary dividend and there are a variety of macro circumstances where that bank may have to renege on its recent claim about its sustainability. I must say though, in over 20 years of running UK equity money with an income-seeking remit, I cannot recall such a significant yield premium on such a substantive company as Lloyds Bank, at 2.3x. This is not a clapped-out metal-basher or even an asbestos-tainted insurance company, but one of the most strategically advantaged and profitable banks in the UK. Its control of 21.0% of all UK private current accounts is a wonderful and durable market position, well in excess of its nearest competitor and of keen interest to any international bank that wants a bridgehead into UK retail banking. Santander's purchase of Abbey means that further consolidation of the UK banking sector is a question of "when, not if" and it would be extraordinary, we think, if that future activity did not have positive ramifications for Lloyds. In the meantime, Lloyd's dividend flow alone matches what most equity market strategists regard as a fair total return from UK equities as an asset class during a period of low inflation.

As a nuance, we have switched some of our callable HBOS preference shares into truly irredeemable HBOS paper, in part because higher yields were available on the latter, but also on the principle that if one has exposure to the fixed interest market because one is bullish on the fixed interest market, which is the case with us, then it makes sense to access the longest duration assets available, which means the irredeemables.

Away from these exceptionally high yielding securities, we have been building positions in several other stocks where yields are notably above the market, but where we believe future dividend growth is likely to be in line or better than average. Diageo is a business where we have been happy to exploit the adverse response to the recent trading update and add to holdings. In truth today, at least outside the resource sectors, most industries and companies are finding it hard to deliver nominal revenue growth rates above 5.0%. Those that can get close, with reasonable reliability and Diageo is definitely one, are likely to deliver acceptable total shareholder returns. Regarding Diageo, we think it is important to note that SABMiller's acquisition of South American brewer, Bavaria this month has been concluded at an EV/Revenue multiple of c4.0x. We accept that an emerging market brewer is a different animal to a developed world distiller, but we are intrigued that that transaction multiple fits so neatly with the valuations that have been put on other consumer branded goods businesses in 2005, specifically Gillette and Allied Domecq, at 4.0x revenues or above each. Meanwhile, Diageo trades on an EV/Revenues basis of 3.0x, despite an array of brands quite the equal of those recently acquired companies (don't get me started complaining about why Cadbury only trades on 2.2x this measure). Diageo is celebrating the 200th anniversary of Johnnie Walker this year and has provided some intoxicating statistics about this exceptional property. JW now sells 120 million bottles a year in 200 countries. That is a thought provoking 4 bottles every second (I blinked and missed my dram). In the process JW outsells the world number two blended brand by 2:1 (which I believe is J&B, another Diageo asset). That brand dominance and hence global recognition is very valuable indeed. If JW makes, say, £5.00 per bottle of revenue for Diageo, which is little more than an informed guess, and the strategic value of the brand is 5.0x revenues, which I regard as conservative, then just JW alone could be worth nearly 15.0% of Diageo's market capitalisation, although it contributes less than 7.0% of group sales. In summary, we find it hard to account for Diageo's near 20.0% dividend yield premium above the FT All-Share, because it seems to us that its dividends are safer and likely to grow more over time, than those of the average UK company. A dividend yield relative of 90 - and why not, AG Barr trades there - would mean a share price of close to £10.75 for Diageo, on this year's likely payment, against £7.85 today.

With gritted teeth we have been accumulating stock in Pearson through 2005. It is a painful exercise, because we are adding to a holding that has severely disappointed our investors since 2001. The immediate attraction of the shares is the yield, of course, with an income return of c3.9% for 2005, a 25.0% premium to the average. When all is said and done, this is a dividend that has increased by more than inflation for each of the last 13 years and is over 80.0% higher than it was in 1995. However, there are more substantive reasons to buy the shares than yield alone. First, to a degree, we buy management's sob story. The last 4 years have been unusually challenging for Pearson, for reasons in some ways self-inflicted, but in others just bad luck. In 2000, Pearson made operating profits of £378 million on today's continuing operations. Last year that number advanced to £433 million, although earnings per share are no higher than 2000. However, since 2000 the company has had to contend with the loss of £100 million advertising revenue at the FT, the obliteration of £50 million of profit from its technology text book publishing business and at least £50 million of adverse currency swing - with the company making 70.0% of its profits in US Dollars. We wonder, with the Dollar turning, whether the company's bad luck may be too. More important, we are increasingly of the view that Pearson's education business is on the verge of a period of sustained growth, growth that will have the tendency, when fashions change, to be highly valued. The increase in software and Internet content in Pearson's education revenues is marked and should genuinely lead to improved returns on capital. Meanwhile, we were struck by the company's reporting of a British Council forecast that by 2015 2 billion people worldwide will be learning English (or perhaps more accurately, American) as a second language. In that circumstance, being the world's leading publisher of English language text books will be a boon. Finally, we have been struck by how modest analysts' estimates appear to be for a stand- alone valuation of the Financial Times, if that asset were ever for sale, as some have speculated. The FT and FT.com have combined forecast revenues for 2005 of £225 million. Morgan Stanley, for instance, believes a full valuation for the franchise would be £520 million, or 2.4x revenues, which represents c10.0% of Pearson's current market capitalisation. We think this is ridiculous and are not surprised that Pearson management severely dismiss any notion of disposing of this unique franchise in current trading and sentiment circumstances. The FT is already a wonderful property, as Europe's leading business and financial newspaper, with more paying subscribers, 435,000, than at any time in its venerable history. It is inconceivable that anyone could take that position away from it, given how the only viable alternative, Wall Street Journal Europe, has already wasted a lot of money failing to coexist. Advertising will eventually recover, probably doubling divisional revenues by the peak of the next cycle. At that point, investors will almost certainly be ascribing a fair value of 4.0x revenues to those doubled, super-profitable sales, at which point the notional value of the FT will be £1.76 billion, or 34.0% of today's market capitalisation. And that analysis is before thinking conceptually about what the value of FT.com could be in 10 years. Someone is going to make a lot of money establishing a trusted financial portal, that attracts millions of wealthy private investors. Few companies have a better chance of success in creating such a property than the FT. FT.com now has 76,000 subscribers and, for instance, advertising on the site is growing at 20.0% pa rates.

Overall, Pearson has revenues of nearly £4.0 billion in 2005, to which stock market investors accord a value of £5.4 billion. One day that will look much too low.

There is a final stock we have bought recently for dividend yield and growth, which I am not going to expound on in any particular detail, for the very good reason that all our readers know much more about it and the basis of its valuation than we do. The company is Rathbone Brothers and we are attracted to the possibility of participating in the long term fortunes of UK and to a lesser extent global, financial markets, by owning shares in this company, at a time when they offer a yield nearly 15.0% above the market average. What is good for the UK equity market ought to be great for investors in Rathbone. Yet the All-Share is up over 9.0% in 2005, but RAT is down 6.0%. Again, we cannot begin to match your appreciation of the strategic value of such a business, but we believe that if one applies the valuation to RAT that Rensburg implicitly put on Carr Sheppard's discretionary FUM, then the former is distinctly undervalued. Disabuse us of the notion if you must, but gently please.

By the way, my favourite joke in recent days came in an FT article about US NASCAR racing (stock car racing, which is terrifically popular there, the second biggest televised sport, after American football). Anyway, I loved the comment the FT quoted from a Sports Illustrated journalist - "NASCAR fans are tattooed, shirtless, sewer-mouthed drunks, and their husbands." Reminds me of Lords.

Nick Train
Aug 2005