Confidence in the UK economy is growing ever stronger with the IMF now forecasting growth of 2.9 per cent for the current year and 2.5 per cent in 2015. Meanwhile, business confidence, according to the Institute of Chartered Accountants, recently hit a record high. While the prices of shares in many cyclical companies primed to benefit from improved economic conditions have already soared, investors late to the party should not feel they have lost out. Indeed, many companies are going to be late to the party too, and buying shares in these ‘late-cyclical’ stocks now still promises the potential for major upside – you just have to know where to look.
It’s true that we have seen the best of the performance from many early-stage cyclical stocks – these are shares in companies that are normally among the first to benefit from improved economic conditions. However, late-stage cyclical stocks still hold significant potential. The construction sector is a prime example. While there are signs that a recovery is beginning to take root in the sector, most analysts still don’t expect to see any major take-off until next year.
How to find late-stage cyclicals
Identifying value in these kinds of recovery situations can be hard if you’re using conventional earnings-based valuation methods. That’s because late-stage cyclical stocks often operate in areas where fierce competition for limited work means profitability is decimated during downturns. This means shares can look very expensive compared with earnings at times when there is the most recovery potential on offer. What’s more, there can be very short lead times on orders, which makes it extremely hard for the analyst community to be confident about forecasting very far into the future.
The market tends to consider low visibility and volatile earnings as ‘low quality’, especially towards the bottom of the cycle. However, as confidence builds, the economic outlook improves and brokers start to regularly upgrade earnings expectations, the market has a remarkable knack for forgetting about its concerns over quality.
The problem for investors, if earnings are depressed and unpredictable, is the pricing in of the potential upside. Looking at the value being put on sales can be a good place to start, and in fact it is the basis of the screen I’ve used to identify 19 cyclical stocks with serious potential upside. A low price-to-sales ratio (PSR) has been demonstrated to be a remarkably good predictor of share price outperformance by investment star James O’Shaughnessy in his book What Works on Wall Street and has also been espoused as a great way to find value by Ken Fisher.
Why sales not profit
The reason for sales being such a good indicator of value is simply that earnings are ultimately derived from sales. That means, while the earnings-obsessed market is looking despondently at a stock’s derisory EPS during a temporary period of depressed profitability, sales can actually tell you much more about how much value is on offer should profit margins recover.
My screen for ‘cyclical-value’ stocks therefore ignores current and forecast earnings when assessing value and instead focuses on PSR, which happens to be one of my favourite ‘value’ metrics. One downside with PSR, though, is that it is fairly rubbish for analysing financial stocks, such as banks, which means I have had to exclude this part of the market from my screen.
My first screening criteria for PSR is that it is below one. While this is an arbitrary level, it is certainly a low PSR valuation, especially following several years of strong stock market performance. That said, the lower the quality of a company’s earnings, the lower the value that one would expect to be attributed to its sales. So I also want to check the PSR commanded by a share is low by the stock’s own historic standards. To test for this, I am insisting the PSR is at least one-third below the peak level achieved over the last 10 years – importantly, this is a time period that covers the peak of the last economic cycle.
A question of quality
Unlike the Ken Fisher-inspired enterprise-value-to-sales-ratio screen that I run every July in my weekly stock screening column, this screen welcomes low-margin businesses. As already mentioned, competition can be tough for late-stage cyclicals, so it would be wrong to expect handsome margins from such businesses, even at the cyclical peak. What I am looking for are companies where profitability is still looking depressed. To try to identify such situations I am screening for companies with an earnings before interest and tax (Ebit) margin that is at least a third below the 10-year peak. (Please note, the Ebit margin data in the accompanying tables from S&P Capital IQ can differ from the ‘adjusted’ operating margins that companies tend to quote and set targets for in their financial statements).
Finding shares in companies where the PSR and margins are a good distance below peak levels is the key criteria of my screen, but there are some other characteristics that I feel late-stage cyclicals should display in order to make a credible investment case. First off, recovery can put a major burden on a company’s finances. This is especially true of late-stage cyclicals, which often need to invest heavily in equipment and working capital to take on the contracts that will allow them to reap the benefit of an economic upturn. This means I want the companies coming through my screen to have solid balance sheets. While net cash is preferable, I am insisting that, as a minimum, companies have net debt of no more than 1.5 times cash profits.
The need to use cash to finance growth is also the reason I have opted to use PSR for this screen rather than the enterprise-value-to-cash-profits ratio, which takes account of a companies finances by taking cash away from a company’s market capitalisation and adding on its debt.
Another supplementary criteria I’ve set is that companies need to demonstrate recent sales growth. If sales are expected to fall in the future, there is a very good reason to put a low value on a company’s current sales (a low PSR). However, I don’t feel I can afford to be too stringent in my screening criteria for sales growth. After all, I am looking for companies that may only now, with the UK and US economic recoveries already looking fairly established, be starting to see a pick-up in business. Therefore my test for sales growth is very light. I simply want to see rising year-on-year sales in the most recently reported six-month trading period.
Finally, I want to see a small indication that a company is generating cash. I’ve screened out any company that has negative free cash flow over the last 12 months. Importantly, this is a measure of cash flow that ignores capital expenditure and therefore shouldn’t rule out companies that have been making major investment commitments to future growth.
The full Cyclical Value screening criteria are:
PSR of less than one
PSR at least one third below 10-year peak
EBIT margin at least a third below 10-year peak
Net debt of 1.5 times cash profits or less
Rising year-on-year sales in the last six months
Positive free cash flow
19 Cyclical Value Stocks
The screen has been conducted on all companies in the FTSE All-Share index except financials.
I’ve focused on the All-Share in order to avoid small-cap cyclicals, which can prove exceptionally risky, although they can also produce bumper profits.
As well as highlighting a number of late-stage cyclical stocks, my screen has also picked some earlier-stage cyclicals that have run into a bit of trouble during their recovery. One may have expected Speedy Hire and Robert Walters to be commanding more aggressive valuations at this point in the cycle, for example.
The 19 stocks selected by the screen have been ranked based on a combination of the PSR discount to the 10-year historic peak rating and the difference between today’s operating margin and the peak. The table on page 29 is ordered by this ranking and I have provided short write-ups of the five highest ranking stocks below.
The IC's top five late-stage value plays
Robert Walters (RWA)
Considering this screen is designed to search for companies that could deliver cyclical upside, it seems fitting that recruiter Robert Walters is among the most attractive stocks based on my ranking system. Recruitment is an incredibly cyclical business, with sales and profits soaring at times of high ‘churn’ in the employment market. Churn – industry jargon for the rate at which workers change jobs – tends to increase with business and employee confidence, so it is good news that confidence has recently been on the rise. But while Walters has reported six quarters of net fee income growth on the trot, investor sentiment has proved jittery due to the company’s high exposure to the finance industry and to the Asia Pacific region. Recruiters have also experienced a number of false dawns since the markets bottomed out, which has made investors somewhat nervous about backing the sector too wholeheartedly.
That said, Walter’s trading in the UK has been very strong recently and the company has been investing in staff (the key ingredient needed for growth when demand is strong) both here and in Japan. Broker Investec Securities is forecasting a rise in sales of 7 per cent this financial year followed by 10 per cent the year after. The broker calculates the company’s underlying operating margin from last year at 5.4 per cent, which is a lot higher than the S&P Capital IQ figure in our table. However, Investec still predicts strong growth in profitability, with margins forecast to increase to 6.4 per cent next year and 7 per cent the year after.
Last IC view: Hold, 358p, 4 March 2014.
