An early warning sign to help spot struggling UK retailers

Our value investing blog recently ran a series explaining on the various edges value investors can enjoy over their competitors.

We flagged up the importance of having an analytical process that can, on a consistent basis, help you distinguish between companies that deserve to be cheap and ones that don't.

We also touched on seven questions we ask about every company we analyse, which help us distinguish those likely to remain permanently cheap from those whose share prices have the potential to bounce back.

These questions relate to the quality of a business, say, or the strength of its finances but this time we are going to drill down to one particular measure we use when analysing one particular industry – UK retail.

UK retail in decline

With this sector in broad decline, it has become increasingly obvious any operating leases – that is, leases a retailer holds that do not have to be recorded as debt on its balance sheet – will be an essential component to the success of a business and its ability to survive an economic downturn.

The metric we use to assess this aspect of a retail business is called fixed charge cover.

If you felt moved to calculate this yourself, it is a companys EBITDAR (earnings before interest, depreciation, amortisation and rent) divided by total debt service costs (net interest and rental expenses).

At its heart, however, this ratio illustrates the ability of a business to service its debt and rental obligations. Our rule of thumb is that when a fixed charge cover approaches 2x or 2.5x, serious alarms bells start to ring.

Read more:Never base an investment decision on a single month of data

An example

Take a look at the following chart, which ranks a dozen of the UKs household-name retailers by their fixed charge cover and also shows the total returns on their share prices over the last six and 12 months.

As you can see, there is a huge correlation here, with all the companies with a fixed charge cover of less than 2x, seeing their share price falling by a half or more over the last 12, and indeed the last six, months.

Retailer returns versus the fixed cover charge over the last 12 months

Source: Bloomberg to 27 March 2018. Securities mentioned are for illustrative purposes only and are not a recommendation to buy or sell.

One curious twist about this metric is that it appears to be very UK-specific, failing to translate once, say, it crosses the Atlantic.

Nevertheless, the fixed cover charge does produce some strikingly clear results in the British retail sector, with a low ratio very much a warning sign in our eyes – and one that the wider market may well have missed.

• Roberta Barr is an author on The Value Perspective, a blog about value investing.It is a long-term investing approach which focuses on exploiting swings in stock market sentiment, targeting companies which are valued at less than their true worth and waiting for a correction.

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