This week, Paul Hill, one of Britain’s most successful private investors, identifies two overvalued blue chips to sell
The art of successful investing is not only identifying which shares to buy, but also knowing when to sell. Many times I hear that the ‘trend is your friend’. But if there’s a buying frenzy and a share price rockets, then holding on in the hope that it will go higher is pure gambling. Unless the rise is supported by a corresponding increase in the business’s underlying value, investors who hold on are setting themselves up for a big disappointment.
Discipline is the key. I typically sell if a share price becomes more than 30% overvalued. The profits are then recycled into more attractive opportunities. This week, as a one-off special, I alert you to two FTSE 100 firms that I believe are both substantially overvalued.
1. Reuters Group (RTR), 362p
Merchant banks, hedge funds and commodity and foreign exchange traders have all recently benefited from historically low interest rates, booming mergers and acquisitions activity, increased volatility and soaring stockmarkets. Profits and bonuses at many finance houses have been nothing short of staggering. Clearly, the City is mostly in excellent shape
and, since 2003, it has recruited thousands of new employees to cope with this growth.
If you’re an information provider, providing accurate, up-to-date and insightful information to this buoyant sector, then you’d expect to be enjoying a mini gold-rush.
Reuters is such a firm, but strangely its sales are not rocketing. In fact, in 2006, like-for-like revenues are forecast to increase by only 3%-4%, which is similar to last year. So why the pedestrian growth?
Put simply, much of the information that Reuters provides is now freely available on the internet, or supplied cheaper elsewhere. I expect this trend to continue. Although Reuters is one of the world’s largest electronic publishers, with turnover of £2.4bn and a 27% share of the £6bn finance information market (level with Bloomberg), I believe it will struggle to grow. Indeed, if it can’t ‘make hay while the sun shines’, then when will it make money?
Worse still, Reuters is also being forced to invest heavily in new technologies in order to boost its top line, particularly in electronic trading.
The only way it could maintain existing operating margins of 10% would be to cut costs rapidly, which, to its credit, the board is already doing. However, Reuters now looks very much like a mature utility, increasing its cash distributions to shareholders, rather than a high-growth stock. Consequently, I would expect it to be valued on a price/earnings ratio of around ten to 13 times. Instead, at 359p, the shares are trading on p/e multiples of more than 20 and 15 times for 2006 and 2007 respectively. Frankly, this is far too rich for a company that is only achieving 4% organic revenue growth and slashing costs in order to boost earnings per share.
What will happen when there is a downturn in the finance sector? Merchant banking is notoriously cyclical, and when markets tank, so too do profits – inevitably leading to a severe round of cost-cutting. In fact, this happened between 2001 and 2003, when Reuters’ revenues fell by a total of 16%. Don’t be fooled into thinking that Reuters would remain unaffected this time round. Interim results are due out on Wednesday 26 July.
Recommendation: SELL at 362p
2. Reckitt Benckiser (RB), £20.69
Reckitt Benckiser is a slightly different animal to Reuters as its brands are enjoying faster organic growth at 6% a year. But I still believe its shares are similarly overvalued. Let me explain.
Reckitt Benckiser is the world leader in household cleaning (excluding laundry) and has a major presence in health and personal care. Its leading brands include Vanish, Harpic, Airwick, Dettol, Gaviscon and Lemsip. Additionally, in January 2006, it acquired Boots’ Healthcare (BH) business for £1.93bn, which brought three more heavyweight brands (Nurofen, Clearasil and Strepsils) into the fold. Moreover, the management team has continually delivered or exceeded City forecasts and so has built up a great deal of trust with investors. So far so good.
However, the problem I have with the company is not over whether or not it is a solid business – it’s over whether the shares are overvalued or not. I think they are. I attribute this largely to their attractiveness as defensive plays in times of market turbulence and to their consistent track record.
Moreover, I believe investor complacency has now seeped into the share price, and there are some pretty strong headwinds around the corner. Raw material and energy prices are soaring, for example, and powerful retailers, such as Wal-Mart and Tesco, are increasingly demanding bigger discounts, while at the same time introducing their own much cheaper competing brands – consumers in developed countries are being squeezed as higher utility bills, petrol prices and mortgage payments all start to bite into disposable incomes.
Finally, Reckitt Benckiser paid top dollar for Boots’ Healthcare. Even though Boots’ Healthcare’s sales growth is only around 4% a year, the price tag was a whopping 19.6 times operating profits. At £20.76, Reckitt Benckiser’s shares are trading on lofty price/earnings multiples of 20 and 18 times respectively for 2006 and 2007.
Moreover, the future earnings per share estimates assume that Reckitt Benckiser can also improve its already-rich operating margins from 20% to 22%. In the long term, these profit margins look unsustainable to me, especially as more than 80% of Reckitt Benckiser’s turnover is generated from mature Western markets.
I think now is a good time to take profits and reinvest the proceeds in something less expensive. Interim results are due on Monday 24 July.
Recommendation: SELL at £20.69
Paul Hill’s personal portfolio has gone up by 483% over the last five years.
To find out more about his own specialist share-tipping service, ‘Precision Guided Investments’, click on the link below: