I try to cover a broad range of investment approaches with this column but, perhaps inevitably, I find some screens gel more with my own particular investment psyche than others, and this week's screen is a case in point. My Contrarian Value screen, which leans heavily on the investment approach endorsed by US investor Ken Fisher, tries to find shares in companies a low value being put on their sales.
Trying to find value by focusing on a company's sales is less intuitive than focusing on earnings; after all, it is earnings that ultimately determine what a company has available to invest in future growth and to pay out as dividends. But sales are what earnings are ultimately derived from, and if a company's sales are being undervalued, it may well be that its potential to create earnings from those sales is also being undervalued. What's more, when a company that is valued at a low multiple of sales lifts its profitability, shareholders can get a double whammy from a share price rise based on earnings growth as well as a re-rating based on improved sentiment towards the company's earning potential. With this type of value play, relatively small improvements in margin can often cause substantial shifts in profits. In effect, focusing on sales is an attempt to get a step ahead of the earnings-obsessed market by identifying shares in companies that are growing their top line but have temporarily hit a poor patch as far as profitability is concerned.
There are plenty of good reasons for putting a low value on a company's sales. Chief among these are that some companies are in industries where profitability is inherently low, and some operate in highly-cyclical parts of the market where sales growth and profitability are notoriously unstable. In fact, I would suggest one of the reasons for the phenomenal success of this strategy (see graph) over the three years I have been monitoring it, is because the cyclical plays that have been among the screen's stock picks have benefited form the tailwind of improving economic conditions.
That said, this screen actually attempts to avoid companies that have inherently low margins and unreliable or cyclical businesses. The two methods it employs to do this are to focus on companies that have been able to produce a decent average operating margin over the last five years and companies with an impressive track record of average five-year sales growth as well as forecast sales growth (see screening criteria).
A knock-out performance
As already mentioned, the performance of this screen since I began regularly running it in July 2011 has been stunning, and I can't help but think that this must be partly because market conditions over the period have been particularly suited to the strategy. Over the three years the cumulative total return (share price performance with dividends reinvested and ignoring dealing costs) from switching to the new portfolio each time the screen has been published is 68.7 per cent for the 20-stock portfolio compared with 30.7 per cent from the market. Meanwhile, the top five shares have produced a quite incredible 158 per cent. The performance of the 2013 picks is detail in the table below.
| Company | TIDM | Total return (23/07/13 - 21/07/14) |
|---|---|---|
| MDM Engineering (takeover ) | MDM | 32.0% |
| SDL | SDL | 12.0% |
| M&C Saatchi | SAA | 1.7% |
| ACM Shipping | ACMG | 53.7% |
| Drax | DRXG | 11.4% |
| Murgitroyd | MUR | 12.7% |
| Brainjuicer | BJU | 62.1% |
| Griffin Mining | GFM | 17.0% |
| Brightside | BRT | -13.0% |
| Senior | SNR | 3.1% |
| Hunting | HTG | 2.8% |
| Archipelago Resources (takeover) | AR. | 56.6% |
| Ultra Electronics | ULE | -0.7% |
| Gooch & Housego | GHH | 23.4% |
| WPP | WPP | 6.2% |
| Brady | BRY | -0.4% |
| Prezzo | PRZ | 20.7% |
| Pan African Resources | PAF | 18.8% |
| Immunodiagnostic Systems | IDH | 29.7% |
| Gulfsands Petroleum | GPX | -17.7% |
| FTSE All-Share | FTALLSH | 5.6% |
| Top 20 | - | 16.1% |
| Top 5 | - | 22.2% |
Source: Thomson Datastream
The fact that this is the fourth year that I have run this screen gives me the opportunity to also look at the performance of older portfolios on a buy-and-hold basis. Intuitively, I would not regard this as a screen particularly suited to a buy-and-hold approach. However, the buy-and-hold performance of the screens suggests otherwise (see bar chart). Buying and holding the 2011 portfolio produced a far superior result than the switching between portfolios - a massive 168 per cent total return from the top five holdings and 80.6 per cent for the top 20 compared with 'just' 30.7 per cent from the FTSE All-Share index.
Contrarian value buy to hold
The screening criteria are:
■ Enterprise value of £25m or more;
■ Average annual sales growth of 5 per cent or more above the 2 per cent target rate of inflation over the last five years;
■ Forecast sales growth in each of the next two financial years;
■ An average operating profit margin of at least 10 per cent over the last five years;
■ Positive free cash flow;
■ Gearing of less than 50 per cent or net debt of less than two times cash profits.
As with other recent screens, it has been far harder to find really good 'value' this year than it has been in the past. The screen results represent the cheapest 20 shares based on enterprise-value-to-sales (EV/sales) that pass all the screening tests. The use of enterprise value, rather than price/market capitalisation, means the screen takes account of how much debt or cash a company holds. The rule of thumb (a rather unsophisticated one) is that an EV/sales ratio of less than one is cheap. Only one stock is cheap on this basis. The 'cheapest' five stocks are written up below and the rest are presented in the table that follows, ordered from lowest to highest EV/sales.
The best
