Stockwatch: This highly-rated share offers defensive growth

With the business cycle already extended and warnings creeping in, be alert for dependable performers. A proven theme from the last recession was well-managed pubs in South East England, benefiting from people's resolve not to compromise social life - eating and drinking out.

Years ago, I pointed out that, despite negativity about the smoking ban from the Wetherspoon chairman, it was a major positive change for pubs - creating winners and losers according to quality of food and service. They have largely transformed from the traditional male-oriented smoke-filled local towards restaurant/hotel situations regularly reviewed by customers online.

The winners have broadly divided into those like Wetherspoon with a good reputation for basic value, and the more gastro pubs such as within Young & Co's Brewery  - located where professionals' incomes mean resilient demand for good food and drink, and where high and sticky prices are good for margins and earnings quality. Employment is late-stage in the cycle, but it's interesting to note a 16% rise in UK finance and accounting jobs year-on-year, as professional vacancies grow.

So long as mortgage costs do not impact disposable income as house price rises continue, the affluent middle classes will continue to spend. Big national pub chains are possibly more exposed to cyclical downturn, already facing the challenge of the National Living Wage when operating on relatively tight margins; whereas smaller pubs groups on higher margins may cope with it better.

Double-digit advances, top and bottom line

In this macro-thematic context it's interesting to note the latest interim results from Fuller, Smith & Turner in the FTSE SmallCap index. Normalised pre-tax profit rose 10% to £21.6 million on turnover up 10% to £177.7 million, giving a 13.8% operating margin - compared with 7.4% for Wetherspoon.

The second half-year has started well, with some London pubs especially benefiting from the Rugby World Cup. Fullers has diversified logically from brewing and pubs (as tax on beer has risen) such that it now operates 189 managed pubs and hotels - containing 651 "boutique bedrooms" - also 203 tenanted pubs. Last year, it bought 51% of a craft cider and gourmet pizza restaurant business.

The traditional sense of brewers as defensive stocks is being progressively transformed into a lifestyle group capitalising on demand for something special, from an evening dinner, to weekends away, to selling a variety of drinks such as wines, craft beers/ciders and premium soft drinks.

Value benchmarks unlikely to get cheap

At about 1,150p, the stock looks dear on key measures: a forward price/earnings (PE) multiple twice the underlying growth rate; a scant yield of 1.5% despite moderate earnings cover of three times; and a 51% premium to net tangible assets.

However, this significantly reflects a less liquid market for a family-controlled business, accentuating the premium for a dependable grower: Company REFS shows the annual average PE at 17.4, rising progressively to 21 times in the last five years, while the chart shows the stock doubling from 590p in 2011 to 1,233p last summer.

The situation is very similar to Young & Co, to which I drew attention at 600p in July 2012 along a similar rationale: the stock likewise doubled despite a high PE, and now trades on exact same PE/yield as Fuller. Young does, however, offer a 7.7% discount to net tangible assets, so if you prefer that comfort then look more closely at Young.

Asset price inflation may become a hurdle

To some extent the share price progress of both groups reflects wider asset price inflation besides commercial properties being successfully developed. This is also potentially a risk to expansion if pubs/hotels get significantly more costly to acquire, given they represent over 80% of group profits.

Fuller's interims cite £53.4 million capital expenditure over six months, buying two new pubs, three freehold properties and spending on the existing estate. It required net debt to increase by £28.6 million to £191.2 million or net gearing of 65.6%, despite strong cash generation (which the table shows consistently ahead of earnings).

Capital expenditure (capex) per share figures are lumpy, albeit with a definite re-rating in 2013/14 - as if partly reflecting asset inflation in the quest for growth. It presents a risk of earnings becoming costlier to grow - indeed, a point where they might not be value generating, if asset inflation increases as we are seeing with homes currently.

Higher commercial property prices - including pubs and hotels - tend to be a "late-cycle" feature, this time boosted by years of quantitative easing (QE) and very low interest rates contributing to asset price inflation. This may finally be checked by an interest rate rise, when it happens. Also, new sites (where available) can more easily enhance earnings than buying out freeholds like Fuller has also been doing. So it may not prove too much of an issue.

Service standards are winning formula

Barring a stockmarket crash, it's hard to see this stock retreating while the group delivers what relatively affluent Brits want, and service standards continue to be enhanced. Training has more than doubled in the last three years, with new pay rates for employees on any of six development programmes.

Fuller's Chef's Guild programme has three levels and a general aim of training is to increase internal promotions - which should mean consistency in the various pubs and hotels, versus a typical risk of chefs moving on and it taking bad reviews until new ones can cope.

All Fuller staff are now offered a full and structured career path. This is good "defensive" practice managerially as, come the next recession, customers will be less willing to tolerate disappointing food/service and prioritise those outlets which do deliver.

So, while this stock doesn't shout "value" in its financial yardsticks, its underlying progress is a reminder it can still be a valuable portfolio constituent. Pub groups can now be genuinely defensive stocks - if the quality of food, drink and service is up to Fuller's and Young's standard.

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This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.