Ditch dividends and quality, buy value and momentum

Ditch dividends and quality, buy value and momentum

We've looked at how nine very basic stock-picking strategies have fared over the last three months. We've selected the most attractive 20 per cent of the FTSE All-Share shares based on these valuation metrics as of three months ago (ie, the 20 per cent of shares with the lowest PEG ratios) and have measured how their prices have performed over the three months to the time of writing. Based on this analysis, the strategy most in vogue over the last quarter has been buying low PE stocks (see chart). The momentum strategy we've looked at, based on buying shares in the best-performing stocks of the previous three months, has also done very well. The other key value-based approach we've looked at, buying stocks with low price-to-book-value (PBV) ratios, is also a winner.

Source: S&P Capital IQ

The overall picture presented by the three-month performance looks like something of a dash to trash as strategies based on buying higher-quality stocks, as identified by factors such as a high return on equity, strong EPS track records, and high dividend yields produced lesser gains. In fact, the strategy of buying high dividend yields is the only one of the nine that has actually underperformed the market. Over the three months, a superior performance of 13.3 per cent would have been achieved by buying the 25 per cent of shares with the lowest yields, although that does not take account of any dividends actually paid.

Where now?

We've done some back-testing of five strategies over the last three years to see how good the performance of a strategy over the previous three months is at predicting performance in the coming three months. The rudimentary back-testing we have done is based on performance of the 25 per cent of 'best value' stocks based on our five criteria (high RoE, low PE, high dividend yield, high historic one-year growth and high three-month momentum) in the calendar quarters from the end of 2009. We found that moving into the best-performing strategy of the previous three months at the start of a new period outperformed the index in eight out of 12 quarters tested. It also outperformed the index comfortably over the entire period (see graph).

Source: S&P Capital IQ

That said, switching between strategies was actually inferior to simply sticking with three of the strategies we tested (see table).

Source: S&P Capital IQ

So to try and get a better idea of the potential for strategies that have recently been doing well to endure, we've tested their relative strength compared with the 26-week closing average for the relevant portfolios (see chart) - this is a strategy advocated by US investor Charles Kirkpatrick for picking individual stocks. This test, which has not been applied to our momentum strategy, suggests the market may be beginning to put more emphasis on forecast EPS growth. This is also reflected in the ascendancy of a strategy based on buying low-PEG stocks, a measure that assesses share prices against both earnings and expected EPS growth.

Source: S&P Capital IQ

A screen for our times

Our screen this week attempts to capture the trends identified by our strategy screen. The clear caveat with this approach is that the market's mood can be extremely fickle and the recent result in the Italian election and the upcoming US sequestration negotiations could prompt a change in mood. That said, our screen this week is based on the view that 'the trend is your friend' and consequently looks for FTSE All-Share shares that are:

■ Among the cheapest 20 per cent of the market based on forecast PE;

■ Are among the top performing 20 per cent of shares over the last three months;

■ Have positive forecast EPS growth.

SIX STOCKS OF THE MOMENT

From lowest to highest forecast PE

Trinity Mirror

A torrid outlook for print media, high debts and the matter of a £283m pension deficit are all factors that help make Trinity Mirror the lowest of the low PE stocks on our list. However, Trinity's shares have been rocketing as investors dare to believe the company could prove to be a turnaround situation. Indeed, the shares are up 15 per cent in a month since it was picked out as a 'share with upside' by our recent Charles Kirkpatrick screen. Actions being taken by new chief executive Simon Fox to restructure and bring down debt are helping to foster this optimism and there are some signs that the advertising environment could improve.

Source: S&P Capital IQ

Last IC view: Hold, 38p, 3 Aug 2012

Costain

Costain's impressive performance in a tough UK construction market has vindicated its strategy of diversifying its business. The company has been winning business by offering one-stop-shop solutions that can take projects from the consultancy and planning stage all the way through to completion and maintenance. An update in January reported a strong order book at £2.4bn along with £400m of work that the group is the preferred bidder on. The predictability of earnings is also being aided by the fact that 90 per cent of revenues now represent repeat business. Added to these attractions are an attractive dividend yield and strong balance sheet. Should confidence in the wider construction market grow, the shares look likely to re-rate further.

Last IC view: Buy, 254p, 24 Jan 2013

Synthomer

Chemicals manufacturing group Synthomer, formerly known as Yule Catto, encouraged the market with its recent trading update. Two issues, which contributed to a profit warning in June 2012, have been weighing on the shares but the update provided encouragement on both fronts. First of all, the group appears to be negotiating tough trading conditions in Europe, where it generates about four-fifths of its profits. The recent strengthening of the euro should also help the group. Secondly, fierce competition in Asia does not appear to be intensifying. Yet, despite the encouraging news, Synthomer's shares still trade at a discount to those of rivals, which rate closer to 14 times earnings.

Last IC view: Buy, 198p, 14 Feb 2012

Pace

Share in set-top-box maker Pace have been moving higher as investors have warmed to the potential of the group to deliver growth from its ability to exploit developments in its market towards the use of next generation technology, such as media servers. Indeed, a trading update in January reported stronger than expected growth in North America due to demand for media servers. What's more, a recently installed management team are proving effective at reining in costs and boosting margins while at the same time bringing down net debt. Broker JPMorgan forecasts that Pace will have net cash by 2014, which means there should be plenty of potential for acquisitions after the company missed out on its bid for Motorola's set-top-box business in December. That said, technological change and competition are serious threats that won't be going away any time soon.

Last IC view: Hold, 128p, 24 Jul 2012

Pendragon

Car dealer Pendragon has been re-rating in line with its peers, helped by signs of a nascent recovery in the car market. That said, a high debt burden has kept the shares at a discount to the sector, which trades at around 11.5 times forecast earnings. Debts are coming down with a 12 per cent reduction last year and, excluding car stock financing, it now stands at £109m. Asset sales should help ease this burden further this year. Meanwhile, management believes there is a stable outlook for demand and the group's aftersales business should be supported by strong sales of new cars in 2012.

Last IC view: Buy, 21.25p, 19 Feb 2013

Low & Bonar

Low & Bonar's business is being held back by its loss-making yarns division. Underlying revenues slipped 12 per cent last year, the operation made a £1.8m loss and an £11.2m charge was taken to reduce its carrying value to £17m. Further cost reductions are planned of around £1m but yarns is expected to continue to be loss making. The performance of the rest of the business is much more encouraging. Indeed, underlying profits on a constant-currency basis last year rose nearly 11 per cent, helped by restructuring of the group's textile division. Low & Bonar also stands to benefit from the strengthening of the euro and, if the issues surround yarns can be dealt with, the shares have definite further re-rating potential.

Last IC view: Buy, 60p, 5 Feb 2013