Being able to put emotions to one side is possibly the most difficult part of investing. Accumulating knowledge and capital is within the reach of most people. However, being entirely logical while also taking subjective stances on companies is tough. It’s all too easy to allow a positive or negative experience with an industry or company to cloud an investment decision. In my experience, this can lead to disappointing investment returns.
One company which I probably wouldn’t invest in if I was allowing my emotions into the mix is Next (LON:NXT). I recently bought a house and am in the process of buying furniture. My experience in dealing with Next was not what I had hoped for but, judging by the company’s past performance, the vast majority of customers have had significantly better experiences.
Alongside the company’s ultra-low valuation, dividend potential and strong cash flow, I think it could be a strong buy. Brexit may cause consumer spending to decline, but for an investor more worried about returns over three years rather than three months, Next could be an opportunistic buy.
I’ve met and worked alongside numerous investors who are unable to let go of their emotions when investing. For instance, a previous colleague invested in Blackberry simply because he loved the product. This was at a time when the company had the business market cornered due to its strong security credentials and the ease of use of its email system. Unfortunately, a poor strategy from Blackberry led to disappointing returns and today the company is a shadow of its former self.
There are many other examples of emotions playing a large part in investment decision-making. Employees who love or loathe the company they work for may or may not choose to take-up their rights to employee share plans. This can lead to sub-optimal investment decision-making in the long run. Similarly, people who have a negative experience with a company they deal with in a professional or personal capacity may choose to forego what proves to be a golden opportunity.
Whatever the situation, it seems clear that there is little place for emotion in investing. Clearly, opinions on the strength of a company’s strategy, business model and other factors are highly subjective and these challenges make investment an art rather than a science. But to allow emotions to sway a decision either way is undesired, but yet difficult to avoid completely.
Despite my disappointment with Next from a customer perspective, I still think it is a sound investment opportunity. Undoubtedly, the risks of declining consumer confidence and lower consumer spending are very real. In fact, inflation is forecast to move to 3% or even 4% this year due to weaker sterling. Given the fact that a General Election is only seven weeks away and the outcome may not be in line with current polls, it would not be a surprise for sterling to weaken yet further as confidence in the UK economic outlook dries up.
If consumer disposable incomes fall in real terms, retailers such as Next could find their sales and/or margins come under severe pressure.
In this situation, inflation is very likely to move above and beyond wage growth. Today, they both stand at 2.3%, but if consumer disposable incomes fall in real terms, retailers such as Next could find their sales and/or margins come under severe pressure. Given Next’s sales are mostly from homewares and clothing, which are probably discretionary rather than staple items, it could suffer to at least some degree.
However, in my view Next may suffer to a lesser extent than many of its retail sector peers. In the financial crisis post-2007, its financial performance has been strong despite its being a mid-price point retailer. While many of its mid-price point peers saw declining profitability as shoppers traded down to budget options, Next was able to remain profitable throughout the recession and grew its earnings for seven consecutive years after they declined in 2009.
In my opinion, this shows the company has an above-average degree of customer loyalty. Its strategy of investing in its buying and design capabilities through improved quality and quicker response times to changing trends could help to reaffirm its relatively high levels of customer loyalty. Further, the changes it is making to its website may also enhance brand loyalty, while the investment it is making in new, key brands such as Lipsy & Co could help to diversify its customer base.
Additionally, Next’s valuation seems to fully factor in the difficulties it faces. It has a prospective P/E of 10.6 using FY2019’s forecast EPS, which I feel undervalues the growth potential of the business. Its debt levels are very manageable, with interest costs covered 22 times by operating profit in the most recent financial year. Its free cash flow has averaged £498 million per annum in the last two years, which has easily covered ordinary and special dividends while allowing for investment in its growth prospects.
While it is unrealistic to think that any investor is able to fully push emotions to one side in every investment-related decision they ever make, aiming to do so can help to improve total returns. It can mean poor investment opportunities are overlooked, while stocks with the best investment potential are not avoided for trivial reasons.
Next faces a difficult future. Possibly the most challenging since the credit crunch. Things may get worse for the business before they improve, as the General Election may lead to an unexpected outcome. Similarly, Brexit negotiations could also weaken sterling, send inflation higher and lead to a decline in consumer spending over the medium term. However, Next’s valuation, cash flow and debt levels are among the most appealing within the retail sector in my opinion.
Therefore, while Next may not have met my expectations from a customer standpoint recently, I remain optimistic about its long-term future as an investment. It is unlikely to be a smooth ride due to the problems it faces, but over a matter of years it could prove to be a stunning buy.