Mears Group (MERG.LSE) is a bit of an undercover defensive. It’s not a company that gets much attention among investors (at least those that I know), and yet it has a fantastically successful track record.
After starting life in 1988 as a building contractor, the company grew quickly, partly through acquisitions, and entered the Alternative Investment Market (AIM) in 1996 with a turnover of around £12 million and 83 employees. By 2008 it had moved to the main market having won the AIM “Decade of Excellence” award.
The company continues to grow at around its long-run average growth rate of 15% a year, and shows no signs of slowing down yet. It was added to the UKVI Defensive Value Portfolio back in March 2011; the chart below shows how the investment worked out.
Compared to the ups and downs of owning Aviva (AV.LSE), owning Mears was relatively plain sailing. The only cause for concern was a dramatic 20% decline in November 2011 when the government changed its mind on household subsidies for solar power use (forcing the company to close its solar panel installation business).
However, as if often the case with strong businesses, this was a blip, and Mr Market was wrong to sell. Returns from that low point have been an incredible 140% for investors who were brave enough to get in as so many others were getting out.
The Decision To Buy
Back in early 2011 Mears had exactly the sort of financial history that I like to see. It had an excellent history of very stable and rapid growth, all driven by a business with long-term contracts with its customers (primarily housing associations and local councils) and prudent levels of debt.
Mears joined the model portfolio in late March 2011, shortly after the 2010 annual results had been announced. You can see the company’s results in the years running up to that point below.
As you can see, things had been going well. The growth rate had been around 24% a year, and yet the PE ratio was just 11.4. The dividend yield was nothing to get excited about at just 2.5%, but it was obvious that if dividend growth could be sustained at anything like the past rate, the yield relative to purchase price would soon be better than that of the market.
So given the combination of a leading company (albeit a relatively small one as Mears was in the FTSE Small Cap index at the time of purchase, with a market cap of less than £250 million) with such a strong core business, combined with a relatively low valuation and reasonable yield, it looked like a solid choice as a defensive value investment.
The Decision To Hold
The UKVI investment strategy is resolutely focused on the long-term. It is designed to seek out companies that can prosper over many years and to support, as much as possible, sensible, long-term decision making on the part of the investor.
By default then, my assumption is that each company will be owned for a number of years rather than months. In fact, with 30 holdings and a target of replacing just 6 companies each year, the annual portfolio turnover should end up close to 20%, giving an average ownership period of 5 years per company.
For Mears, this period was just 3 years and it was a relatively easy and enjoyable ownership experience. Other than the 20% decline following that profits warning in November 2011, there was very little – if any – stress.
During those 3 years of ownership, Mears grew its revenues by 71%, adjusted earnings per share by 44% and the dividend by 30%. It added more customers, more staff, and greatly expanded its pipeline of future revenues. In short, it continued to do well as it had in the past, which is what I hope for, and expect, of every investee company.
The Decision To Sell
You may be wondering why I’ve sold this company, given that things have been going so well? It isn’t because I think its future prospects are any less rosy than they were, and it’s not because the company has done badly, because it hasn’t.
Instead, I’m selling Mears because the share price, having gone up by some 80% in those 3 years, has run ahead of the growth of the company’s intrinsic value, making the price to intrinsic value ratio less attractive.
The dividend yield has dropped from 2.5% to 1.7%, while the growth rate has dropped from around 24% down to 15%. While that’s still a healthy growth rate, it isn’t enough to justify such a low yield. Therefore, I will be selling Mears within a few days and reinvesting the money where the combination of growth, income and quality are better.
Please note that this does not mean that I think Mears is a universal “sell”. It depends what else you have in your portfolio.
It currently sits at number 71 on my stock screen of around 250 dividend paying companies, i.e. the second quintile which I would consider “slightly cheap”. So Mears, relative to most other companies and the market, is still “slightly cheap” by my estimations.
However, relative to the 30 companies in the Defensive Value Portfolio (and my personal portfolio which owns basically the same companies) it is one of the least attractively valued, as most of the other companies are either better, cheaper or both.
Disclosure: I have sold my personal investment in Mears
Original Post