If you look for cheap shares with low p/e ratios or low price to book valuesthen the chances are that a lot of pub stocks start to look interesting. But are pubs good investments or should you steer clear? Let's take a look.
A trip to the pub
One of the best ways to find out if a company or industry is a good investment is to be its customer. If you like what it sells then the chances are others will too and you may be on to something. A few weeks ago, my neighbour and I passed on our normal 25-mile bike ride and decided to walk a few miles to a village pub instead.
We arrived around lunchtime to find a few regulars propping up the bar. After ordering a couple of pints we started chatting to the landlord. Several hours later we left having been given a fascinating lecture on the economics of a sleepy village pub. The pub, despite being located in a desirable Essex village was losing bucketloads of money. A few more months of dire trading and closure looks likely.
Subscribe to MoneyWeek
Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE
UK Pub Companies P/E Ratios
Contrast this scenario with last weekend when my wife and I met some friends for a meal at a pub restaurant a few miles away from the sleepy local. The car park was packed and we had to wait over an hour for a table. The wait was well worth it as we enjoyed great quality food for a reasonable price. Why such contrasting fortunes?
Pubs face a lot of problems
Pubs are being hit by taxes and supermarkets. Just as motorists have faced the pain of the fuel duty accelerator on petrol and diesel, pubs have borne the brunt of the beer duty accelerator. This piece of government legislation increases the duty on beer by 2% more than inflation every year. According to pub group Fullers, the duty on beer has increased by 35% since March 2008. This has not only led to people drinking less beer but has led to more beer being bought in supermarkets and less in pubs.
Then there's the issue of VAT. Pubs pay 20% VAT on food whilst supermarkets pay a lot less. Again this shifts more trade to the supermarkets and away from pubs. The end result? Lots of pubs are closing.
According to CAMRA, 16 pubs a week were closing in 2011. These were the sleepy village pubs referred to above but also a lot of backstreet pubs in towns. Why is this?
People who rented them from the big tenanted pub companies (pubcos) such as Enterprise Inns and Punch Taverns ran a large proportion of these pubs. (Marstons and Greene King also have lots of tenanted pubs). They pay rent and buy their beer from the pubco but then have to cover the costs of running the pub. With the rising cost of beer driving customers away, many of these tenants can no longer make ends meet. Others simply do not have enough cash to keep the pubs in good order or reinvest to attract new customers.
This trend looks set to continue with further beer duty increases expected in this month's budget. Add in the fact that both Enterprise Inns and Punch Taverns have enormous amounts of debt, then their shares are best avoided. Don't be tempted by their low p/e ratios as their large debt piles make them expensive.Staying in business looks challenging for these companies.
It's not all bad news
Tough times are forcing people to look for more value. One area where this seems true is 'eating out'. Companies such as Greene King and JD Wetherspoon, Marstons and Fuller Smith & Turner are investing in food as families trade down from expensive restaurants. This strategy seems to be working as their food sales are growing. We think that this could be a good investment theme.
Our top picks are JD Wetherspoon and Greene King. JD Wetherspoon has a simple business model based on selling good food and drink at reasonable prices. Its pubs are generally well looked after whilst it makes the highest returns on capital in the sector with lower levels of debt. At 10.8 times 2012 forecast earnings with a 3.2% dividend yield covered nearly three times, this looks like a conservative investment.
We like Greene King for its dividend and its exposure to the more affluent south east (55% of pubs). Its strategy of growing food sales is bearing fruit. The stock offers a 5% dividend yield that is covered twice by profits. These dividends should keep growing.
Marstons has a similar business model to Greene King whilst offering a prospective dividend yield of 6.3% - albeit it suffers from lower returns and higher debt.
Finally, Fullers. It has some great locations in London, but the shares look a bit pricey just now.
Phil spent 13 years as an investment analyst for both stockbroking and fund management companies.
After graduating with a MSc in International Banking, Economics & Finance from Liverpool Business School in 1996, Phil went to work for BWD Rensburg, a Liverpool based investment manager. In 2001, he joined ABN AMRO as a transport analyst. After a brief spell as a food retail analyst, he spent five years with ABN's very successful UK Smaller Companies team where he covered engineering, transport and support services stocks.
In 2007, Phil joined Halbis Capital Management as a European equities analyst. He began writing for Moneyweek in 2010.
Follow Phil on Google+.
Act now: First Direct’s £175 switching bonus ending soon
First Direct has launched a £12,500 prize draw on top of its £175 cash bonus - but they both finish soon, so you’ll need to be quick
By Vaishali Varu Published
Credit card providers slash 0% balance transfer deals
Customers face a double whammy of rising interest rates and shorter 0% balance transfer periods. We look at what’s going on in the credit card market and why you’ll need to act fast to get the top 0% balance transfer deal
By Ruth Emery Published