Stockwatch: A tuck-away share with limited downside risk

What extent of "premium for quality" is fair? It's a key question in the current stockmarket where sentiment is buoyant and the best businesses are rated highly. Market leaders investing significantly for long-term growth amid firm industry conditions may quite easily beat expectations; so yes, there can be a case for engaging a speculative premium.

I introduced the issue in my last article on upmarket estate agents Savills, noting how the directors were making promising acquisitions - yet adding a note of caution how estate agency is cyclical hence strictly the stock is over-priced.

By way of comparison Young & Co, the AIM-listed pubs group, tilts to rate "long-term capital growth" despite its stock looking pricey on most measures. This is because its investment programme continues to create high-quality assets in a most dependable service industry - affluent British people eating out. The table shows how Young continued to grow through recent recessionary years as its outlets in the south pulled in customers - the British are not going to compromise this kind of social activity, and well-run comfortable pubs are nowadays seen as classy places to chill out. It's a radical change from smoke-filled boozing parlours of the past.

Genuinely strong results for the year to end-March 2015

Young's dependability is shown by my having drawn attention variously to its shares since 600p in July 2012.

Both the business and stock proceeded to do well, affirmed just lately by a strong set of prelims and the market price testing 1,125p. The continued theme I have emphasised has been high levels of investment, e.g. noting the potential in December 2013 which has born out in latest numbers for the year to 30 March 2015: adjusted pre-tax profit up 17.6% to £32.0 million on revenue up 7.7% to £227.0 million, for adjusted earnings per share up 18.1% to 50.6p, the dividend by 6.1% to 16.5p (cover of 3 times) and net assets by 6.9% to 840p a share.

The market had expected £30.3 million profit and 48.4p EPS and the expectation for £31.7 million/50.6p for the current financial year needs upgrading. I also question the normalised earnings and net tangible asset calculations in the table, as under/over-stating respectively.

Young's success is shown by its 6.5% like-for-like revenue growth in managed houses comparing with Wetherspoon reporting 1.7% and Greene King 0.4%. These two are arguably still successful long-term operators, although plenty of British pubs continue to close. It highlights Young's winning formula of location, atmosphere and customer service.

In a currently buoyed stockmarket, all this comes at a price: at about 1,125p Young likely trades at over 20 times forward earnings, although Company REFS shows a high P/E is nothing new: it averaged 16.4 in 2011 rising to 23.4 in 2013 and was 20.4 last year. UK consumer disposable income may now be positioned to rise with wages, a macro factor supporting the rating.

Mind a circa 1.6% dividend yield is insignificant and the stock also trades at a 31% premium to net asset value. Strictly speaking there is no margin of safety in the buying price, but realistically there is security in Young's business having very good defensive aspects. The asset base is also high quality and goodwill only represents 5.1% of net assets; yet Young's reputation for eating-out arguably does have intangible value. If the group was ever acquired, the deal would likely be struck at a good premium to balance sheet value.

So although AIM stocks are generally high-risk, Young's downside is limited unless property values crash. This is why I continue to posit Young as a good tuck-away - especially anyone using AIM stocks to mitigate inheritance tax liability.

Effectively all cash generated, goes on investment

The cash flow statement shows annual purchases of property and equipment rising from £22.8 million to £32.4 million, also acquisitions of businesses from £10.8 million to £18.5 million, i.e. just over the total £50.6 million net cash generated from operations was deployed for investment.

Since about £5 million was required for interest payments and £7.7 million was paid in dividends, this mainly explains a £9.5 million increase in longer-term borrowings and £5.0 million in those short-term - in context of £129 million total net debt relative to £407 million net assets. Cash had run down to £200,000 by end-March, but such is the cash generating profile and considering £175 million debt facilities, that is no eye-popper.

So another reason I remain positive is that Young's current year is set to benefit from eight new acquisitions made during the latest year, and other investments made in its estate. The chief executive says: "These will provide a helpful tailwind as we compete against the strong comparatives we have set ourselves." The new financial year has started fairly well - managed house total revenue up 8.1% or 5.6% like-for-like - and Young reckons to benefit from an improving economy and consumer confidence, the general election uncertainty now gone.

Directors electing to take up their bonuses in shares

With the stock on premium ratings it is therefore a good sign that each of the executive directors is taking up their performance-related bonuses fully in shares, where the scheme initially settles half the bonuses in shares and directors can subscribe for "matching" shares. Furthermore, none of the directors are generally free to sell any such shares before the end of a three-year period. A further condition is 2017/18 adjusted EPS needing to exceed the 2013/14 level, on continuing operations. Altogether, this is a good sign the directors believe risk continues to lie on the upside and are underlining this by way of personal financial exposure.

For more information see youngs.co.uk.