The stock market.

What a crazy place!

Anyone who read last Monday’s article would have seen that I recently purchased £222 worth of Dignity Plc shares.

Well, these went on to crash and burn 50%.

I must be a genius, right? It takes something special to turn £222 to £111 in just a few days.

Luckily, my portfolio is HEAVILY diversified and the £111 loss I suffered is barely a scratch in my portfolio that’s now approaching £17,000.

Anyone wanting to know exactly what happened to Dignity shares should click here for my live reaction of the 50% drop!

Having just experienced the pain – this seems like the perfect time to talk about falling knives.

The term “catching a falling knife” is when an investor reacts to a declining share price by mistakenly thinking that all the bad news of a stock/sector has been priced in and buying a stock they deemed undervalued expecting a recovery over the longer term.

Last week, I caught a falling knife.

Here’s how I messed up.

Whenever I investigate a company there are two things I generally look at immediately – The market cap and the price to earnings ratio.

These two measurements are related and both hold a clue to how I got burned last week.

Let me show you how.

To illustrate this, let us take a look at two retail competitors, Next Plc and ASOS Plc.

Next currently has a market cap of £7.13B

ASOS, on the other hand, has a market ap of £5.6B

To the newbie investor, it may seem that Next and Asos are of similar scale.

But, if we look at the revenues of both companies we can see that Next is substantially larger.

Next’s 2017 Total Revenue came in at £4,097m with ASOS way behind with Total Revenue of £1,924m.

Here we begin to see how disjointed from reality and business fundementals the stock market can become.

This is why I like to think of the price to earnings ratio of a stock as a indicator of how jointed/disjointed a stock is from the underlying current fundementals of a stock.

Reasonable p/e ratios of 10-18 for the FTSE are my sweet spot. Anything lower may indicate serious underlying problems while anything over may be overvalued.

You see, the key difference between the valuation of Next and ASOS stock comes at their price to earnings ratio.

Next boasts a p/e ratio of a touch over 11 with ASOS trading at close to 89.

That means investors purchasing these stocks today would be paying £11 for every £1 of Next’s earnings and £89 for every £1 of ASOS’s earnings.

But here’s the mistake I made.

The p/e ratio of a stock is based on a stock’s current year’s earnings (ttm – trailing tweleve months).

When I bought Dignity at a 15 p/e I thought I had a bargain!

Here was a solid stock in a recession proff industry trading at historically low valuations.

Sure, competition was heating up but I felt the risk had been priced in to the stock and that it was “worth rolling the dice” regardless of the competition risk.

After all, I was reassured by the words management – they had a statement in November regarding competition and were confident that their pricing stratergy at the time was generally fit for purpose.

BUT – it seems that management really didn’t have a grasp on how much the competiton was heating up, and, in response to falling customer numbers decided to slash their funeral package prices for next year by 25% OUCH!

What? Seriously, in three months things got that much worse?

This folks, is what we call a falling knife.

Just when I thought the bad news was priced in, management dropped a bombshell!

Here, I’ll introduce you to another little phrase – “Value trap”

Let me explain;

Dignity’s 2017 earnings are on track for £1.19 per share and this was the figure used to caluclate the firms p/e raito when I purchased shares, but, next year, after the drastic cuts announced by management Dignity’s earnings per share are forecast to drop to just 88p for 2018/19.

Given these new estimates I purchased Dignity shares at a forward p/e ratio of 21.

21 P/E for a company in an increasingly competitive field?!?!?!

? 

I got hoodwinked by managements smooth talk for sure and should have stayed well clear until the competition dust had settled.

I can’t say I wasn’t warned and will take everything a company’s management says with a massive grain of salt from now on. I should have stuck to the fundementals and sector trends.

DOH!

What lessons can we take from this investment?

In reality, Dignity’s decline has been a pretty cheap lesson in the grand scheme of things.

Here’s a 50% loser amongst triple digit winners that I invested a lot more money into.

MSFT is up 120% since I bought in, MCD 112%, Apple 91%.

These were all £500 buys.

Luckily, one of my investing rules saved my bacon when it comes to Dignity.

Let me explain – my average investment in a single stock is a strict £500.

If I feel really confident and the stock is meets all my ‘Safe buy’ criteria I’ll go in up to £1,000 as is the case with Unilever and Next. (£800 and £900 respectively)

As Dignity was a small cap stock that had significant risk due to debt and competition, a half position was more sensible.

This is exactly why I arrange my portfolio into a house.

Foundations, Walls, Auxillary.

As Dignity was in my Auxillary it was always going to be a riskier play.

As for Dignity’s future – I’m going to hold and see how things go.

In summary, here are the key lessons I learnt from this investment and my adjustments from here on.

1. Take EVERYTHING management says with a HUGE grain of salt.
   
2. Fundementals and industry trends don’t lie.
   
3. I should continue to organise my stocks under the ‘dividend house’ model as this saved me from a material loss.
4. I should look for companies with wider and more secure economic moats and be wary of a company that’s considering moderate price cuts – this may be a sign of harsher price cuts in the future (as was the case here).

Before going, I have a small favor to ask of you.

At Frugal Student, I hope that you enjoy tracking my portfolio and appreciate the fact that I don’t shy away from any investing mistakes or hide anything from you as a follower.

I’m a full-time student and running this blog isn’t easy.

I don’t earn a penny from this blog and will never run ads on this site – it’s lame and kills the browsing experience.

So, I ask you, if you enjoy my content if you could introduce just one friend to my blog it would mean a lot!

Happy investing.
Lewys

PS: Any questions just drop a comment or E-mail me at – Lewys@frugalstudent.co.uk

Hello, and welcome to week 2 of my new year’s resolution to bring consistency to this blog by posting every Monday.

Just 50 weeks to go!

I’ve been very active on the stock market as of late and as such I’m very pleased to present you with my latest buy.

I recently purchased a small position in UK Funeral and Crematoria operator Dignity PLC.

I bought 12 shares of Dignity Plc for a total of £222.00 – meaning one share cost me £18.50 or 1,850p including fees.

Dignity PLC slots nicely into the ‘auxillary’ or ‘roof’ of my dividend growth portfolio – This represents the relatively high risk of this addition.

Links;

1. Business Overview
2. Share History
3. Why I Invested
4. The Dividend
5. The Industry
6. The Risks
7. Valuation
8. Summary

Overview[sta_anchor id=”overview” unsan=”Overview” /]

Dignity PLC is a UK-based funeral operator that operates in three main segments;

1. Funeral Services

2. Crematoria

3. Pre-arranged funeral plans

Funeral services

Funeral services represent 63 percent of the Group’s revenues and relate to the provision of funerals and ancillary items such as memorials and floral tributes. Dignity operates a network of more than 792 funeral locations throughout the UK trading under established local trading names.

Crematoria

Crematoria represent 30 percent of the Group’s revenues and arise from cremation services and the sale of memorials and burial plots at crematoria and cemeteries.

Funeral plans

Pre-arranged funeral plans represent 7 percent of the Group’s revenues. Income represents amounts to cover the costs of marketing and administering the sale of plans. Pre-arranged funeral plans allow people to plan and pay for their funeral in advance.

A brief history of Dignity shares & Why did Dignity shares drop so much?[sta_anchor id=”history” unsan=”History” /]

Since Dignity debuted on the stock market in 2004 it has earned a reputation as a recession-proof cash machine.

The company has easily grown revenue through acquisitions and yearly price hikes of 6-8%.

But what was seen as a recession-proof machine is now somewhat out of favour.

Dignity’s success and high rate of return on capital has enticed competition and as a result, in November, Dignity slumped over 20% to a low of a touch under 1,600p a share after their Chief Executive warned of intense competition in the funeral sector due to an increase in local start-ups.

As most of Dignity’s profit and revenue growth has come from yearly 6-8% price hikes, the market is now spooked that intense competition will strangle margins and lead to slowing or, worse still, declining earnings momentum in the coming years.

There’s no doubt, any need to cut prices and aggressively compete for market share will put significant pressure on the stock.

Regardless of these fears, I swooped in at 1,850p a share.

Dignity’s fall from grace.

So, why did I invest?[sta_anchor id=”why” unsan=”Why” /]

Dignity has been on the periphery of my stock radar for a while now but has always been trading at a pretty rich valuation.

But the huge November drop presented me with the opportunity to buy this still growing stock at just 15 times earnings.

Although the funeral care industry is set to become very competitive I am confident Dignity can leverage its scale and its strong cash generation to come out on top when the dust settles and that the current collapse in share price is an over-reaction.

About that cash flow….

One of the main reasons I like Dignity is its ability to generate large amounts of cash.

£58m in 2016 and £73m in 2015.

Such strong cash generation has meant that Dignity has been able to continually expand its operations through purchasing of crematoria (June 2016: 39, June 2017: 45) and acquiring new locations for its Funeral services segment (June 2016: 777, June 2017: 811).

This strong cash flow will enable Dignity to continue acquiring new funeral locations and crematoria to grow its revenue in the short and medium term even if new-entrants succeed in eroding company margins in the short term.

Better than this, such strong cash flow has meant that shareholders have been rewarded handsomely via dividends.

The Dividend[sta_anchor id=”dividend” unsan=”Dividend” /]

As a dividend investor, a company’s dividend is of utmost importance. This is because a regular dividend helps reduce risk through instant returns and allows me to compound my wealth.

So, what does Dignity’s dividend look like, and is it safe?

Dignity has paid a dividend since 2006 and has increased the dividend by an impressive and inflation smashing 10% a year ever since.

Dignity’s dividend growth.

But is this kind of growth sustainable?

Taking a look at the company’s cash flow for 2016 we can see that the £58m generated in free cash easily covered the £11m paid out in dividends. This results in a FCF payout ratio of just 19%! (11/58 x 100).

As a result of this very low FCF payout ratio – I am very confident that Dignity can continue to grow its dividend at an above-inflation pace for the foreseeable future even if the company faces adversity as a result of competition.

But, a downside to this low payout ratio is that the stock is sitting at a dividend yield of just 1.36%, as a result, investors will need to rely on continued double-digit dividend growth in the far future.

The industry[sta_anchor id=”industry” unsan=”Industry” /]

Funeral services and crematoria are highly specialized industries and one would think that this would provide dignity with a medium, economic moat.

It has spooked investors, therefore, that management is becoming increasingly bearish given the emergence of competition.

I’d even go as far as to say that management took their eye off the ball and took eye-watering price hikes for granted.

But…

As Benjamin Franklin said – ‘In this world, nothing can be said to be certain, except death and taxes.”

thus, the inevitability of death provides Dignity with a somewhat steady flow of business and ensures that the company’s offering isn’t going out of fashion anytime soon!

Better still, the UK’s population is booming and the ONS doesn’t expect that to slow down, projecting continued growth.

It doesn’t look like the services that Dignity offer are going out of fashion anytime soon and such a predicatble and steady flow of business makes Dignity a solid recession-proof play.

The Risks[sta_anchor id=”risks” unsan=”Risks” /]

Having gone so heavily into Card Factory and Next after significant drops in their stock price, readers will be forgiven for wondering why I have invested a mere £222 into these shares.

Well, the answer is that I consider Dignity as a much riskier investment, mostly due to its high debt leverage and the tiny dividend yield.

Dignity’s debt is probably my largest worry.

Dignity is currently holding total debt of £590m with assets standing at just £715m.

This gives a debt to asset ratio of 83% meaning that Dignity is highly leveraged and may find it difficult to access cash if the debt to asset ratio continues to head northwards.

Dignity’s debt pile.

With such strong cash generation, this isn’t a worry, that’s until one considers the direction that Dingity’s management is moving the company.

As competition in the high-margin funeral services sector heats up, Dignity’s management has indicated that it will increase its focus on the acquisition and ramping up of thinner-margin operations in order to fuel revenue growth in future. But – if margins in funeral services get cut significantly due to competition (as management is predicting), the company may become reliant on debt in order to fund these acquisitions.

In the worst case scenario Dignity may face a perfect storm of declining FCF due to tighter margins and the inability to raise revenue through acquisitions due to being highly leveraged although the sheer scale of current cash generation leads me to think that this would be unlikely.

More likely though is that this squeezing of FCF could cause a slowing in the company’s dividend growth leaving me with a low yielding dud!

Valuation[sta_anchor id=”valuation” unsan=”Valuation” /]

Over the past five years, Dignity has been able to achieve EPS growth (5years) of 9.29%.

BUT – the years of ‘lazy’ growth is over and it’s very unclear as to what EPS growth we could see in the future.

It is therefore VERY difficult to accurately analyze what shares in Dignity are worth today.

If things turn out as I think they will (remember – I have no crystal ball), Dignity will struggle to grow EPS in the short term as competition heats up but will succeed in overcoming the competition and return to higher growth in the medium term.

In order to reflect this scenario, I used the Discounted Cash Flow fair value calculation model to try to put a value on Dignity shares.

I factored in 8 years of EPS growth at 3% and 5% EPS growth thereafter.

This gave me a fair value of 2119p a share.

Summary[sta_anchor id=”summary” unsan=”Summary” /]

Dignity’s management has their work cut out. They can no longer sit back and raise prices by 6-8% a year to smoothly grow earnings.

Increased competition now means they’ll have to work for growth in the future.

The uncertainty in management’s ability to successfully compete and thrive has created a buying opportunity but significant risks remain.

I’m rolling the dice on this one.

Dignity PLC: Speculative auxiliary buy.

Blogging Update

To skip the blog/life update to go straight to the stock analysis click here.

Having been pretty inactive on the stock market as of late, I finally picked up some shares in National Grid.

For followers of this blog, this article has been a long time coming as I haven’t posted in what feels like forever!

In September of this year I started a PGCE (teacher training) course with the hope of fulfilling my long term  aspiration of becoming a teacher, after all, this was the whole reason I started my university journey to begin with.

But – it’s been far tougher and time-constraining than I ever anticipated.

It’s safe to say that the hours are longer and the work a lot more demanding than my wildest imagination  – naivety perhaps.

The sheer demand on my time has meant that I have barely had time to meet and socialise with friends, let alone upkeep my beloved blog.

Despite this, I have managed to keep my portfolio in order and my dividend income for this tax year has just peaked above £300 for the first time (with 3 months of dividends to go!)

Not to bore you with negativity, I do have once piece of exciting news – Starting September 2018 I will be taking my first step in a new career direction.

When I started investing I was just frustrated with the terrible savings rates on offer and wanted to earn extra cash.

I wasn’t really that interested in business, enterprise or the stock market as such, this was simply my vehicle to achieving some decent return on my savings.

But, what started as a hobby and some painful investment losses has turned into my core passion.

I now spend hours upon hours (albeit much less since beginning my PGCE course) researching stocks and acquiring investment knowledge.

I now feel like it’s the time to take that leap into getting some accreditation for this acquired knowledge and to learn much more about stocks – more precisely the underlying businesses that these stocks represent.

I’m therefore HUGELY excited to have been accepted to study a MSc in Finance and Business Analytics starting in September 2018.

It’s safe to say that I have been routinely humbled by many of my peers who have completed such a qualification and it is through being humbled that I have aquired most of my stock market knowledge – turning from a sheep following the investment advice of other bloggers to taking independent stock purchasing decisions.

Here’s hoping to acquire some serious knowledge come September – knowledge that will no doubt improve my investment decisions and the value of this blog to readers.

In short – I look forward to being humbled further.

Some essential news to readers is that I will now be posting an article every Monday – a new year’s resolution I expect to stick to – This early article being the first in my string of 52 posts for the year. [sta_anchor id=”stock” unsan=”Stock” /]

Anyhow – it’s time I stop rambling, let’s take a look at my most recent purchase – 59 shares in National Grid!

I purchased these shares of National Grid (NG.) for an average price of close to 880p a share with these shares adding £27 to my yearly dividend income.

National Grid is currently trading close to a 52-week low of around 850p and to me, this represents a ‘good’ price for a very predictable company that has a great track record of consistently raising its dividend.

National Grid plc is an electricity and gas utility company focused on transmission and distribution activities in electricity and gas in both the United Kingdom and the United States. The Company’s segments include UK Electricity Transmission, UK Gas Transmission, United Kingdom liquefied natural gas (LNG) storage activities;, and US Regulated activities.

In short – National Grid makes sure you can turn your lights on and fire up your gas stove!

At a 5.2% yield – I’m a buyer of this great utility company, but, I don’t expect much capital appreciation from here with shares only marginally undervalued at a 18.24 p/e or a more generous 15.11 p/e if we use the manipulated ‘adjusted EPS’ figure that management is touting – this is compared to an industry average p/e of a touch over 19.2 p/e.

So why are National Grid shares trading at a discount vs the industry?

Utility stocks have been HAMMERED as of late and I feel that there are two people driving this sentiment.

Mr Corbyn and Mrs May.

In Labour’s recent election manifesto Mr Corbyn promised to;

“Take energy back into public ownership to deliver renewable energy, affordability for consumers, and democratic control”.

If this were to happen – National Grid could likely be bought out by the government at it’s Net Asset Value of 497p a share thus meaning investors would lose close to 50% of their initial investment.

Yup – that’s spooky!.

This wasn’t really a possibility – I mean Corbyn was unelectable right?

That’s until May limped to victory and now has to rely on support from the Democratic Unionist Party to govern.

As we can clearly see from the below chart – the share price has declined steadily following the political earthquake following its prior large drop in May due to the stock going ex-dividend on its 87p special dividend.

Surprisingly May is seemingly keen to abandon the neo-liberalist principles of the modern Conservative party by introducing an energy price cap which I argue would have a knock-on effect on National Grid shares due to lower industry profits.

On top of this ‘market noise’ – there are also more concerning fundamental factors behind the current drop – 2017 was down 2.30 pence on the year prior (although adjusted EPS jumped 8.9 pence to  after weak results in 2016 – adjusted EPS now sits at levels similar to 2015).

The current half-year results are also slightly disappointing with operating profit and EPS taking continued significant hits when compared with 2016.

So why buy?

1. National Grid is currently in transition.

After selling two-thirds of its UK gas supply business National Grid is now looking towards the states.

I believe this transition has thrown of earnings in the last few years making National Grid shares appear weaker than reality.

2. National Grid has committed to buying back £835 MILLION pounds worth of its own stock with proceeds of the sale of most of its gas division which will boost EPS over the long term and provide a little more room to grow the dividend.

3. National Grid is that it’s a defensive dividend stock that operates in an industry where demand isn’t going to disappear overnight. We’re always going to want to turn the lights on! – Expect National Grid shares to hold generally firm during a recession.

4. Regulation, regulation, regulation! National Grid operates in a highly regulated industry which provides a high barrier to entry to competition.

The dividend

Any long-term reader of this blog will know by now that I love nothing more than a big fat juicy dividend and with a 5%+ yield I’m a happy investor.

But is this a growing dividend?

You betcha!

National Grid’s dividend policy is to growth the dividend by at least the rate of inflation. This has resulted in a very reliable yet very uninspiring 2% 5-year dividend growth rate and a recent 2.1% increase to the interim dividend.

The dividend is currently covered by earnings at a rate of 1.3 times which would be a close shave for most businesses but this is a highly predictable, wide-moat, recession-proof business with a long history of dividend raises bar a disappointing 3 pence cut in 2011.

But, by taking a close look at National Grid’s Free Cash Flow we can see that the company’s regulatory obligations to invest significantly in its infrastructure leaves it with little room for maneuver in 2016.

2017 FCF came in at 1725m with 1463m of this being paid as a dividend.

Conversely

2016 FCF came in at a healthier 2699m with 1337m of this being paid as a dividend.

Bearish points

This neatly brings me on to the bearish points;

• National Grid is aggressively investing in North America and infrastructure is expensive and as such, I can’t see the squeezing of National Grid’s FCF going away anytime soon. As such, it is likely that National Grid will have to issue new debt in order to both maintain the dividend (of which I’m confident they will do) and to fund capital expenditure.

• National Grid’s share price is sensitive to interest rates as it is most generally held for income –  any rise in UK interest rates will likely lead to a short-term decline.
  
•  National Grid’s North American operations are thus far proving less profitable than its UK   operations which is worrying given management’s tilt to the States. (Return on invested capital in the states is 2-3% lower than in the UK currently).

Valuation

Morningstar currently has a 990p price target for National Grid shares.

Using the bottom end of management’s 5-7% long-term EPS growth target and a 10% discount rate – a dividend discount valuation models gives me a fair value estimate of 1092p.

Given the attractiveness of the current yield and the slight discount to fair value – I rate National Grid shares an INCOME BUY as a stock that fits nicely into the ‘core holdings’ of my portfolio.

But investors need be patient. Don’t expect much capital appreciation over the short to medium term, this is an income play.

Today, I bought shares in the highstreet and online card retailer Card Factory following 18.53% share price drop after announcing ‘disappointing’ half-year results.

If you’ve checked out this scary share price graph, you’re probably wondering what the hell happened?

Keep reading to find out.