Screening for genuine value

Some gripes

Despite the strong performance, the formula we've arrived at is not without some disappointments given our aim to find a holistic measure of value. And for reasons we will explain later, the performance figures, while very encouraging, should not be over-hyped.

Probably the most frustrating omission from our 'genuine value' formula is that we've been unable to find a means of factoring a decent measure of book value or return on assets without making a nonsense of the results. What we have ended up with is a ratio that owes much to the influence of John Neff's PE/total return ratio and Jim Slater's PEG ratio (PE/EPS growth rate). We've also taken a cue from Joel Greenblatt's 'magic formula', and the aforementioned reader comment, by using an enterprise value (market capitalisation plus debt and minus cash)-to-operating-profit (EV/Ebit) ratio rather than the ubiquitous price-to-earnings ratio in our calculations.

The EV/Ebit ratio takes account of a company's net cash or debt position and adjusts earnings for the interest paid or earned as a consequence. This can give a far better impression of underlying value than PE, but a key weakness of EV/Ebit is that it does not take account of the potential value of productive assets that high debt levels may be funding.

Still, not bad

Gripes aside, the 'genuine value' formula we've come up has produced impressive results when back-tested based on the formula:

(EV/Ebit)/(three-year compound average EPS growth + dividend yield)

As the graph below shows, a portfolio based on the quarter cheapest 'genuine value' FTSE All-Share, held for the calendar year and then refreshed, produced a very strong 475 per cent gain from 2003 to 2013. That compares with just 63 per cent from the wider index over the same period. All the portfolios were only selected from FTSE All-Share stocks that had a 'genuine value' ratio that could be calculated and was positive. In most years, less than half the stocks had a ratio that we could calculate and that was positive.

Source: S&P Capital IQ

It should be pointed out that our back-testing comes with some significant drawbacks. Firstly, we have only looked at 10 periods, which is by no means thorough. Also, we have only been able to test present FTSE All-Share constituents, which give the results a bias towards companies that have avoided crashing out of the index over the period and those companies that have been successful enough to gain admission. But while comparisons against the index may be questionable, it is very encouraging that over the 10 years the cheapest quarter of stocks comfortably outperformed more expensive stocks - as represented by the cheapest half and the most-expensive quarter.

The screen

While it was not possible to back-test the formula using forecast EPS growth figures, we feel this is likely to give a better indicator of likely total return. So for our stock screen this week we are looking for the cheapest quarter of FTSE All-Share stocks based on:

(EV/Ebit)/(Forecast EPS growth in the next 12 months + historic dividend yield)

In order to focus on stocks where the market may be starting to recognise value and to eliminate extremes, we have also screened for:

■ Three-month share price momentum in the top third of all FTSE All-Share constituents;

■ Forecast EPS growth above the median average of 5.75 per cent;

■ Forecast EPS growth below 50 per cent.

To give a taster of the results, we take a closer look at the five cheapest stocks that passed our screen below, followed by a table of the other 19 qualifying stocks.

Table notes: EV=enterprise value; Ebit = earnings before interest and taxes; TR = total return; P/BV = price/book value; P/TangBV = price/tangible book value.

24 genuine value stocks

The Berkeley Group

Berkeley is widely considered the quality play among the housebuilders and its business certainly seems to be where the action is presently at in the housing market. The group specialises in buying brownfield sites in London and the south east of England and building high-end flats on them. The current trend for foreign buyers to snap up such properties before they are built is helping to add to the group's allure and lift sale prices. Berkeley has also pledged to return £13 a share by September 2021, with the money expected to really start to flow to shareholders from 2015.

Source: S&P Capital IQ

Last IC view: Buy, 1,691p, 13 Dec 2012

Costain

Costain was one of the stocks that was highlighted by our screen last week, which attempted to pick up on market trends. A key trend we identified was the outperformance of low PE ratio stocks. The construction group's high levels of cash and forecast growth based on its strategy of offering a one-stop-shop for clients means it also looks good based on the 'genuine value' screen.

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

Mondi

It proved to be a year of two distinct halves in 2012 for paper and packaging group Mondi in 2012. The good news is that the good half was the latter one and the improved performance is expected to continue into 2013. The company is benefiting from higher than expected cost savings from recent large acquisitions as well as its move into faster-growing and higher-value parts of the market. The yield also looks attractive and, based on a multiple of forecast earnings, it currently trades at a discount to the sector average of around 13.

Last IC view: Buy, 838p, 21 Feb 2013

Speedy Hire

The sensitivity of profits to relatively small changes in sales and costs means the fortunes of equipment-hire companies can move quickly. At the moment, it looks as though the movement is in the right direction for Speedy Hire. Following a torrid period after the credit crunch, the company has focused on its core, large customers and this appears to be paying off despite the construction sector's ongoing troubles. Speedy is also trying to boost margins by offering more value-added services and catering more to specific sector needs. Management has also cut costs and the business is growing in overseas markets. So, while the stock does not look cheap on a conventional PE ratio measure, the growth potential means there could be genuine value here.

Last IC view: Buy, 34p, 15 Nov 2012

Pace

As with Costain, Pace was a stock featured in last week's screen. Prospects have recently begun to improve for the company, thanks to the increased take up of its technology for next generation set-top boxes. There are also hopes that growth could be boosted through acquisition after Pace missed out on a big move for Motorola's set-top-box business last year. Still, this is a highly competitive area and the evolution of technology and consumers' video-viewing habits could present serious long-term challenges.

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

Source: S&P Capital IQ