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Investors’ Chronicle: JD Sports, Knights, Games Workshop


BUY: JD Sports Fashion (JD.)

The retailer expects its headline pre-tax profit to come in at £875m as sales in its key Christmas period were up 10 per cent, writes Michael Fahy.

JD Sports Fashion said profit for the year will come in ahead of market expectations after enjoying an upbeat end to 2021.

Sales for the 22 weeks to January 1 were 10 per cent higher than the prior year and its headline pre-tax profit figure will be “at least £875m”, it said, ahead of the consensus forecast of £810m.

The retailer credited fiscal stimulus measures in the US for boosting its performance in the first half of the year, saying this could have added as much as £100m to its result. It also said the positive levels of consumer demand had been sustained throughout the second half of its financial year, which ends on January 29.

Tighter stock levels meant gross margins held up well in what was “a highly impressive end to the year”, broker Peel Hunt said.

Sales growth in Europe was “up in the 20s” in percentage terms, but fell to mid-single digit levels in the US against strong comparables, it added.

Looking ahead to next year, JD Sports expects profits to be in line with the current year, despite facing a number of headwinds including a shortage of stock on offer from some brands. This figure is also ahead of analysts’ expectations of about £858m.

JD Sports has been as well honed in terms of its performance as some of the athletes who promote its brand and it is highly valued as a result. It currently trades at about 19 times forecast earnings, which is well above average for a retailer but in line with its own recent history.

Peel Hunt argued its shares are “still cheap” for a market leader with a record of strong growth. The company’s shares have gained 25 per cent over the past year and Shore Capital has placed its rating under review, but it believes they will “run on again” after its latest profit upgrade.

HOLD: Knights (KGH)

The legal services group is expanding fast, but salary inflation could hit margins, writes Jemma Slingo.

Knights has reintroduced its dividend after a strong six months, in which fee income shot up and cash collection remained speedy.

Acquisitions have long been central to the legal services group’s strategy. With a strong regional focus, Knights is on a mission to consolidate the legal market outside London. Last year was no different, with four acquisitions taking place in 2021 and more planned for 2022.

So far, the approach seems to be paying off. In the first half of financial year 2022, underlying profit before tax rose by 26 per cent to £7.6m. Meanwhile, Knights moved from a statutory loss of £1.1m to a profit of £800,000, suggesting it is in a stronger position to fund its buying spree.

Despite the disruption acquisitions can cause, cash conversion — which the company prides itself on — also remained high at 105 per cent. (Collecting fees became a real problem for some law firms in the midst of the pandemic, when clients were floundering.)

Wage inflation is now the main danger. A battle for legal talent is raging, and Knights will need to offer attractive salaries in order to entice solicitors away from familiar partnership models. So far, the company has kept a tight grip on its profit margins. However, its large city offices could be forced to raise salaries to stay competitive. Junior lawyers are also increasingly expensive.

Management attributed the increase in the interim earnings loss to a change in the tax rate. However, Panmure Gordon predicts earnings per share could rise to 23.5p in 2022, and 28p the following year. Its prediction, combined with the legal sector’s proven resilience, is grounds for optimism.

BUY: Games Workshop (GAW)

Rising costs have hit profits, but licensing fees for SW’s strengthening IP provide encouragement, writes Arthur Sants.

Games Workshop, owner of the extremely popular Warhammer IP, has been walking a valuation tight rope. The success of the franchise, together with regular returns of surplus cash to shareholders, saw the group trading at lofty multiples. However, when supply chain issues kicked in, the market was quick to re-evaluate.

In the second half of last year it lost around 25 per cent of its value, yet there are silver linings evident in solid half-year results that suggest it could recover quickly when commercial disruptions ease.

Revenue was up slightly compared with last year, but the issue is that profit before tax fell 3.7 per cent because of the rising costs of shipping and wage inflation. Input and carriage costs rose £5.6m while staff costs jumped £3m due to an increase in both salaries and headcount. Management was keen to point out that once these costs – plus foreign exchange movement – are stripped out, profits are broadly in line with last year’s record numbers.

While wages rarely do anything other than keep increasing, shipping costs may normalise soon. With these stripped out, gross margin would have fallen just three percentage points to 73 per cent, rather than the reported six percentage point drop.

These issues are largely operational problems beyond the control of management. The real value for Games Workshop is in the popularity of its Warhammer IP and there are lots of metrics to suggest this is doing just fine. users were up 15 per cent across all territories, while The Age of Sigmar launch in July was “the best fantasy launch to date by a considerable margin”.

Royalties received on its IP more than doubled in the period to £20.1m and a number of major video games are due to be released in 2022. The pandemic has accelerated demand for gaming and if the 2022 releases are successful, then it should lead to a further increase in royalties. It has also increased its licensing team with additional personnel in North America, Japan and China.

FactSet consensus is for free cash flow to rise to £161.5m by 2023, giving it an impressive 2023 free cash flow yield of 5 per cent.

Any retail business that can continue to generate record sales despite a global pandemic deserves our attention, particularly given the regular capital returns. This dip is a good time to buy.

Chris Dillow: Protect your portfolio against the unpredictable

Something unusual has happened in the past few months: interest rates have been higher than investors had expected.

There’s a simple way of assessing this from the basic maths of the gilt market. The expected returns on a two-year gilt should be equal to the expected return on a one-year gilt which we reinvest on maturity for another year. From this starting point we can infer the market’s expectations for the one-year in a year’s time from the level of one and two-year yields today.

A year ago the one-year yield was minus 0.15 per cent and the two-year yield was minus 0.14 per cent. That meant the market was forecasting that the one-year yield today would be minus 0.12 per cent. In fact, as I write, it is 0.6 per cent. That’s 0.72 percentage points more than expected.

Interest rates have been lower than expected. Since the Bank of England was given operational independence in May 1997 one-year yields have on average been 0.46 percentage points lower than the market expected 12 months previously. Granted, some of this was because the 2008-09 crisis caused rates to plummet. But that’s not the whole story. Even since 2011, one-year yields have on average been 0.27 percentage points lower than forecast 12 months earlier.

For years, investors have expected interest rates to rise and been consistently surprised by them not doing so – until the past few months. The forces of secular stagnation, which cause low growth and low “natural” interest rates, have been stronger than investors have realised.

In fact, though, this tendency to over-predict interest rates is an old one. From 1973 to 1997 interest rates were on average lower than expected, because investors were surprised by the recessions of the early 1980s and early 1990s and by the fall in inflation in between.

It’s in this context that we should read the market’s current forecast, which is for one-year yields to rise from 0.6 per cent now to 0.9 per cent by December. It thinks rises in the Bank rate in response to inflation will push up yields. History warns us that such forecasts have in the past had an upside bias.

It’s easy to tell a story of how history will repeat itself. Real incomes will be squeezed by higher gas prices, a public sector pay squeeze and increased national insurance contributions in April. That will hit consumer demand and hence retailers’ ability to raise prices. With China’s weak monetary growth predicting falls in raw materials prices, and price increases last year dropping out of the inflation data from the spring onwards, inflation should fall. That could cause interest rates to surprise us on the downside, as has happened so often in the last 50 years.

But we must guard against the narrative fallacy: we attach too much credence to stories, and therefore trust forecasts too much. Having realised that they’ve been very often wrong in the past to expect rising rates, investors should now be more cautious. If so, the history of over-predicting rates doesn’t tell us much about the market’s next error.

There is, however, another important fact about interest rate forecasts. It’s not just that they have been biased, but that the mistakes have been large. Since May 1997 the average error regardless of direction has been 0.8 percentage points. Even if we ignore the 2008-09 period (which we should not!) and look only at the post-2011 period the average error has been 0.4 percentage points.

One interpretation of this is that, given the market’s forecast of a one-year yield of 0.9 per cent in December, there’s a two-thirds chance of yields being between 0.5 and 1.3 per cent; a one-in-six chance of yields being under 0.5 per cent; and a one-in-six chance of them being over 1.3 per cent. And this perhaps understates the uncertainty because it is based on an average error taken from a period that under-samples big surprises.

The point, then, is that interest rate forecasts are unreliable, even when made by people who have plenty of skin in the game. We must be prepared for surprises. As investors, our job should not be to predict moves in yields – which is impossible – but rather to ensure that our portfolios are resilient to surprise moves.

Chris Dillow is an economics commentator for Investors’ Chronicle

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