My genuine-value screen is something of a pet project. The screen came about two years ago from an attempt to crunch as much valuation analysis as seemed reasonable into a single ratio. It's therefore pleasing that, in its second year, the screen has once again outperformed the market. The level of outperformance is hardly awe inspiring and pales by comparison with the bumper returns seen in 2013 but nevertheless, the two-year performance of the screen does look very impressive.
The 16 stocks selected by the screen last year managed a 6.0 per cent total return compared with 5.7 per cent from the FTSE All-Share. Combined with the stellar result from the previous year, that takes the cumulative total return from the screen since its inception to 46.5 per cent compared with 16.7 per cent from the market. Factoring in a 1.25 per cent charge to take account of dealing costs, the cumulative return stands at 42.8 per cent.
| Name | TIDM | Total Return (4 Mar 2014 - 16 Mar 2015) |
|---|---|---|
| Ashtead | AHT | 31.4% |
| Kentz* | KENZ | 28.7% |
| Persimmon | PSN | 28.6% |
| Taylor Wimpey | TW. | 27.2% |
| JD Sports | JD. | 26.9% |
| DS Smith | SMDS | 14.1% |
| Petra Diamonds | PDL | 11.5% |
| Redrow | RDW | 8.2% |
| EasyJet | EZJ | 6.2% |
| Morgan Advanced | MGAM | 5.7% |
| Berkeley | BKG | 4.5% |
| Pace | PIC | -9.4% |
| Gem Diamonds | GEMD | -9.5% |
| Topps Tiles | TPT | -15.6% |
| Findel | FDL | -22.8% |
| Aga Rangemaster | AGA | -39.1% |
| Average | - | 6.0% |
| FTSE All-Share | - | 5.7% |
*Taken over during the period
Source: Thomson Datastream
Genuine value vs FTSE All-Share
The ratio
The 'genuine-value' ratio focuses in on three primary investor concerns: debt, earnings and dividends. In this regard its approach to valuing shares is very mainstream. Indeed, in broad terms the ratio itself bears a lot in common with the popular price-to-earnings-growth (PEG) ratio. But there are nuances to the "genuine-value" ratio that are worth explaining.
Instead of going down the usual route of using price or market cap as a starting point for valuing a share, the ratio looks at enterprise value (EV). EV takes account of a company’s borrowings by adding net debt to its market cap. This means EV takes account of the role lenders as well as shareholders have in financing a company, which is important considering that lenders' claims take precedence over those of shareholders.
Normally EV will be a bigger number than market cap as most companies carry net debt, but when a company has net cash EV will be lower than market cap making the valuation look cheaper. Despite the potential for companies with cash to invest in profit-boosting activities or simply to hand money back to shareholders, commonly used valuation ratios, such as the price-to-earnings (PE) ratio, do not reflect this balance sheet item.
The genuine-value ratio compares EV with operating profit to assess what value is on offer. Because EV is adjusted to take account of net debt, the measure of profit used by the ratio needs to be adjusted for any interest paid out by the company (or received in the case of companies with net cash). For this reason, the formula looks at earnings before interest and tax (EBIT) as its profit measure, which is also often referred to as operating profits.
This enterprise-value-to-operating-profit (EV/EBIT) ratio is then compared with the earnings growth the market expects the company to achieve and the dividend yield shareholders are likely to receive. This is often referred to as the total return from a stock. Other things being equal, a stock with a higher total return will be worth paying a higher price for - based on EV/EBIT - than a stock offering a lower return.
The earnings growth rate the ratio uses is based on the average consensus forecast growth for the next two reporting years. Meanwhile, the dividend yield (DY) is based on historic dividends. So the formula ends up looking like:
| (EV/EBIT) / (Earnings growth rate + DY) |
The screen focuses on the cheapest quarter of stocks based on this ratio in the FTSE All-Share. For this screen that means any stock with a genuine-value ratio of 1.08 or less.
Other factors
My genuine-value screen looks for other supporting factors that suggest the value that the "genuine-value" ratio appears to have found could be the real thing. The two key supplementary factors the screen looks at are share-price momentum and earnings forecast. If share-price momentum is strong, it may suggest the wider market is beginning to appreciate the value in the shares that the genuine-value ratio has highlighted. The earnings-forecast test used by the screen aims to check that companies are expected to produce good growth but nothing so outlandish that it raises serious suspicion about its sustainability. The other tests are:
■ Three-month share price momentum among the top third of all stocks screened (above 14.3 per cent) ■ Forecast EPS growth for the next two financial years of more than the median average (7.8 per cent and 10.3 per cent respectively) and the annualised two-year average growth must be less than 50 per cent. |
Ten genuine value shares
Ten stocks passed the screen's tests. The write ups below are ordered from lowest to highest genuine-value ratio.
