For some UK companies, having a large pension deficit is like a proverbial albatross around the neck – unsightly and foreboding.
This can make the shares appear cheap on some measures. But valuing stocks with large schemes is difficult, due to the enhanced complexity of pension accounting. Actuaries and trustees make numerous assumptions regarding future liabilities of schemes, and also the returns that the plans might generate.
In recent years, liabilities have been increasing as scheme members live longer, but returns have been falling with long-term interest rates. Different companies’ schemes make different assumptions – one scheme assuming long-term returns of 4 per cent, for example, is riskier than another of equal size assuming 2 per cent.
The relationship between the company and the plan trustees also needs to be considered. Some trustees may be agitating for an increase in contributions at an upcoming review, whereas others may be more relaxed about the existing level of contributions.
These factors, and others, combine to make pension accounting valuation very complex, prone to large revaluations, and ultimately something that most stock-pickers would simply prefer not to do.
However, if you spend the considerable time required to do the painstakingly detailed work, a contrarian investor might occasionally come to the conclusion that the market consensus is too negative on the stock, and the risk/reward is attractive, even with a large deficit. Of course, it is also possible that you could come to the conclusion that the market is right to steer clear of the stock and the albatross hanging from its neck.
Indeed, BAE Systems is a stock we took the decision to sell out of because we felt the market under-appreciated the risks in the scheme. Elsewhere, however, we have seen sources of contrarian opportunity. In the cases below, we believe the market’s preoccupation with companies’ pension schemes obscures strengths in the underlying operating businesses.
Often referred to as a pension scheme with a telecoms company attached, we estimate that BT’s deficit is equal to around 25 per cent of the company’s market capitalisation. While this is undeniably very high, we believe it is manageable, because BT recently completed an actuarial review, during which the regulator and trustees showed a welcome degree of pragmatism.
Even after high levels of existing cash contributions to the scheme, BT trades at a 9 per cent free cash flow yield. This is a significant anomaly for a company in defensive end markets and with good growth potential.
Imagine you are a broker covering small-cap industrials. You have a relatively large range of companies you could write about and pitch to your clients. You need to shorten the list and focus on those stories you think can generate interest and excitement. Some of your stocks have small pension deficits, but one, Coats, stands out among the pack, with a deficit of 125 per cent of market cap, due to a complicated history.
First, you know that most fund managers you speak to are wary of pension deficits and, second, as a small cap industrials analyst, pension accounting is not necessarily your speciality. It’s quite an easy decision to focus on something else. Maybe you’ll get round to it next week!
So spare a thought for our small cap analyst who has taken the time to go through the unusual situation at Coats, and come to the conclusion that the market is too pessimistic about the prospects of how the deficit will impact Coats’s (otherwise very healthy) cash flows. Should this situation improve, the underlying qualities of the operating business will become more “investable” and the stock should re-rate from its current price-earnings multiple of 8x.
Unlike BT, Royal Mail was able to shift its enormous defined benefit pension scheme into public ownership as part of its transition to private ownership. However, the firm has an ongoing obligation to make contributions to the scheme, and many investors seem to worry that these significant and rather generous (in comparison to peers) payments could impact the company’s ability to grow its dividend.
We think this too pessimistic. In some cases, Royal Mail’s pension contributions are up to 40 per cent higher than other FTSE 100 companies. We think there is a good chance that the company will be able to negotiate a more favourable outcome, and that this will result in investors being able to re-focus on the considerable attractions of the underlying business.