My biggest investment successes have all had one thing in common. They’ve been simple investments in good companies at affordable prices.
I can see many of the qualities I look for in both Next (LSE: NXT) and Prudential (LSE: PRU) following recent news.
A good story gets better
Prudential’s Asian insurance business has been growing strongly for years as the region’s growing middle class has driven surging demand for life insurance.
To maximise the opportunity on offer in Asia, the group has now decided to split itself in two. The firm’s UK business will be spun out into a new company called M&G Prudential. This will include both the Pru’s UK life insurance business and its M&G fund management division.
Which shares should you keep?
When the demerger takes place, existing Prudential shareholders will also receive shares in the new M&G Prudential. Both companies are expected to remain in the FTSE 100, so there’s no danger of being lumped with a stock that’s difficult to sell.
Personally, I’d be tempted to hold on to both companies. Insurance industry analysts say that other successful Asian insurers have higher valuations than Prudential. This suggests the shares could perform strongly over the next few years as growth continues.
Back in the UK, the performance of fund manager M&G seems to be improving. This business suffered nearly £20bn of withdrawals in 2015 and 2016, but generated inflows of £17.3bn last year. With greater independence, I expect this improvement to continue. I also expect the UK business to pay an attractive dividend.
Prudential shares rose by 5% following news of the split, but they still only trade on a 2018 forecast P/E of 12, with a prospective yield of 2.7%. That seems cheap to me given the firm’s record of strong growth.
Unfashionably cheap
Next’s fashion offer is quite reasonably priced. These days, the firm’s shares seem pretty affordable too.
My colleague Alan Oscroft covered the retailer’s full-year results on Friday. Today I’d like to focus on some of the fundamentals which I believe make the shares a compelling buy.
The first is cash generation. The company returned £586m of cash to shareholders through a mix of dividends and buybacks last year.
Although net debt rose from £861m to £1,002m, I see this as quite modest, relative to the group’s net profit of £591.8m. These borrowings are also covered by the £1,117m value of Next’s customer loan book. So net debt could be reduced to zero by selling the customer loan book, if necessary.
I suspect this is unlikely. My calculations suggest that the firm’s 2.49m nextpay credit customers may have paid as much as £250m in interest last year, contributing nearly one third of group profits.
I believe this is one reason why Next is able to maintain an operating margin of 15%, despite the current challenges faced by high street retailers.
Can Next return to growth?
Next’s management says that it made product mistakes last year, but now sees fresh opportunities.
Guidance for the year ahead is for sales and earnings per share to be broadly unchanged. This puts the stock on a forecast P/E of 12 with a yield of 3.2% after Friday’s gains.
Given the group’s track record of generating value for shareholders, I think the stock remains a buy at current levels.