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Investors’ Chronicle: Pets at Home, AO World, De la Rue

BUY: Pets at Home (PETS)

Revenue growth looks encouraging, after the shares were hit by news of the chief executive stepping down, writes Christopher Akers.

Pets at Home’s third-quarter trading update revealed continuing momentum. The petcare company, which has benefited from a pandemic-induced boom, shows few signs of slowing in the short term as it posted robust sales growth on both a one- and two-year basis.

Revenue for the 12 weeks to December 30 were up by 9 per cent and 28 per cent compared with 2021 and 2020 respectively, with total group sales jumping 6 per cent to £319m for the quarter. Like-for-like revenues for the nine-month period were up 28 per cent on 2020.

Retail sales growth of 28 per cent was helped by online and in-store sales, plus monthly flea and worm treatment subscriptions – climbing by almost a fifth from last year and doubling against the 2020 comparative.

Vet group revenues were up 23 per cent, meanwhile, helped by a jump in practice registrations. This gave an average weekly sign-up at practices of 9,200 for the period, against 9,000 in the third quarter of 2021.

Interest in the company’s loyalty schemes grew significantly, suggesting that branding and marketing is paying off. Active members of the discount-offering VIP club were up to 7m, growth of a third on the same period in 2019 and 13 per cent on 2020. Puppy and kitten club members, who tend to spend around a third more than those outside the fold, were up by 60 per cent.

Peel Hunt analysts said that there is “good visibility on future earnings and a strong balance sheet” at the company, with net cash of £77m. The broker forecasts adjusted profit before tax and earnings per share of £162m and 25p for its 2023 financial year, rising to £182m and 27p for 2024.

The shares have fallen back since November when it was announced that chief executive Peter Pritchard, who has overseen significant growth, would step down in the summer. They were up by more than 4 per cent on the back of the update, however, and trade on a consensus 12-month forward price/earnings ratio of 18 times. The company looks undervalued as things stand, given growth prospects, but investors should consider the potential of a future slowdown in pet ownership rates as certain pandemic trends recede.

SELL: AO World (AO.)

The retailer’s European arm faces stiffer competition as online buying demand falters, writes Michael Fahy.

AO World is putting its German business under review, saying it had been “significantly impacted by a number of recent material changes” in the local market.

The online electrical equipment retailer said competition in Germany had intensified at the same time as online penetration rates slipped back to pre-pandemic levels. Digital marketing costs also increased.

Given that it expects these trends to continue “for the foreseeable future”, it is weighing up a range of options for the German business, whose revenue for the three months to December 31 fell 24 per cent year-on-year. UK revenue in the period was also 12 per cent lower.

The company’s shares were trading 2 per cent lower at 105p per share, having lost almost two-thirds of its value over the past 12-months. AO World has struggled with supply chain challenges and driver shortages, which have hit sales.

Peel Hunt suggests cash remains its biggest challenge, though, given that the earnings margin it is generating is below 3 per cent.

“AO needs to focus on its strategic priorities, in our view, with the wider European expansion now in question,” the broker said.

Things certainly don’t look pretty for the company at the moment and, with economies reopening across Europe, it’s difficult to see how it is going to generate significant growth.

HOLD: De La Rue (DLR)

The banknote printer faces an even harder road back due to the pandemic, writes Mark Robinson.

One step forward, two steps back. Not for the first time in its history, De La Rue delivered a negative trading update, this time just over halfway along its turnround plan.

Shares in the Hampshire-based group lost nearly a third of their value in early trading after it guided for adjusted operating profit of £36m-£40m for the year to March 26. The range is in line with its previous financial year but below the market consensus of £45m-£47m.

De La Rue, which specialises in polymer banknote production and authentication products, also announced that ongoing supply chain issues would result in a 12-month delay to its turnround plan.

Matters seemed to be progressing well enough given that the group registered an increase in statutory profits at the half-year mark. But the plan was initiated just before Covid-19 took hold in the UK and the subsequent commercial disruption wrought by the virus has stalled progress.

Despite the improved interim showing, profitability is still being constrained by external issues, not least of which is the dearth of semiconductors and an accompanying increase in raw material prices. Management also had to contend with a marked increase in absenteeism. The residual impact of the problems is forecast to stretch into the following financial year.

The turnround plan was designed to help the group overcome the highly-publicised loss of its UK passport contract to the Franco-Dutch firm Gemalto, somewhat ironic given its post-Brexit significance.

De La Rue has also been subject to the attention of Crystal Amber since 2018. The activist investor holds an 11.4 per cent stake in De La Rue, according to FactSet data, but it could be forced to dispose of all of its strategic stakes due to the intervention of Saba Capital, which acquired a 26.2 per cent share in the fund and voted against its continuation last month.

We can’t be sure that De La Rue’s valuation won’t come under further pressure due to an enforced sale on the part of Crystal Amber, but the group’s fixed cost base has been pared back significantly since the dark days of 2019 when a break-up of the assets might have seemed a realistic proposition.

Management points that despite the downward revision, we can expect an increase in adjusted operating profit across both divisions. However, shareholders would be well advised to determine whether the group records a commensurate increase in cash flows at the operating level.

Chris Dillow: When diversification fails

Your UK equity holdings are probably not as diversified as you think, because shares rise and fall together to a greater extent than is generally realised.

To see this, let’s consider the correlations of monthly returns between the main 25 FTSE sectors since 2003. Each of these 300 paired correlations is positive. This means that if you take any two sectors, they are more likely than not to rise and fall together in the same month. In fact, the average of these 300 correlations is 0.43, implying a high likelihood of any two sectors moving in the same direction.

Even shares in apparently very different industries tend strongly to rise and fall together. For example, the correlation between banks and engineering is 0.57; that between construction and media stocks is 0.65; and that between IT and chemicals is 0.58.

Correlations are especially high among and between financials and cyclical stocks. That between banks and life insurers for example is 0.78, as is that between chemicals and engineers, suggesting that these pairs move almost in lockstep with each other from month to month.

By comparison, correlations tend to be lower between defensive sectors such as tobacco or pharmaceuticals and others. Even these, however, are positive, implying that these sectors have a greater than 50-50 chance of falling if (say) banks or oil stocks fall.

Correlations, however, change. There’s nothing immutable about them. For one thing, they tend to be higher in bad times. If the All-Share falls only 1 per cent there’s a high chance that some sectors will move in opposite directions. If it falls 10 per cent, however, almost all will fall.

It’s for this reason that correlations between sectors have generally been higher in the volatile times of last three years than they were in the previous three; the average correlation has been 0.45 compared with 0.32 in 2016-2018.

In particular, the recession caused by the pandemic has caused huge co-movement between cyclical stocks. In the past three years, construction stocks have had a correlation coefficient of 0.77 with transport and 0.82 with retailers and support services.

Such heightened cyclical risk (both downside and upside) has also caused previously lightly correlated sectors to move together — such as retailers and travel stocks or transport and general finance. This happened because a factor that causes co-movement between stocks (cyclicality) has increased in importance relative to things that might drive shares in opposite directions such as perceptions of management quality or valuations.

You might think that if correlations can rise they can also fall. True — and this is especially likely if the market remains reasonably stable. Which brings us to a paradox. Equity diversification is most likely to work in quiet markets — but that is when we least need it. On the other hand, when we most need diversification — when prices are tumbling — it works less well.

The times we’ve most needed diversification in recent years have been September-October 2008 and February-March 2020 when equities fell sharply around the world. But on these occasions all the main FTSE sectors fell sharply. Diversification across equities thus failed. Time diversification — simply holding on in the hope of better returns later — worked better.

It’s easy to think that if we are investing in different businesses we are diversifying well. We’re not. In bad times, almost all stocks tend to fall simply because all are sensitive to market risk and fears of recession. In such circumstances the best that equity diversification can do is simply lose you slightly less money, which isn’t much of an achievement.

Now there is a massive caveat to all this. Although sectors rise and fall together in the short term this is not the case in the long term. In the past 10 years, for example, some sectors such as IT or beverages have tripled in price, while others such as oil, banks and tobacco have fallen. This tells us that diversification across stocks works better in the long run than in the short.

Whether you have the mindset that allows you to see through months in which all your holdings do badly and focus only on the long term is, however, another matter. If you want to diversify short-term risks you must hold non-equity assets such as bonds, gold, foreign currency and, of course, cash. Yes, these offer lower likely returns than equities — but insurance comes at a price.

Chris Dillow is an economics commentator for Investors’ Chronicle

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