Join our community of smart investors

Six deep-value shares

The five shares selected by last year's deep-value David Dreman screen have delivered a 27.8 per cent total return. Six new shares make the grade this year
May 27, 2015

The investment philosophy of acclaimed US investor David Dreman has something of a gut appeal for value investors. That's because he focuses on shares that look very cheap based on some of the most popular and ubiquitous valuation measures used in fundamental stock analysis. And over the two years that I've run a Dreman screen, cheap has certainly proved to be cheerful. The five stocks selected last year produced a cracking 27.8 per cent total return compared with 6.8 per cent from the FTSE All-Share. And on a cumulative basis, over the past two years the screen has returned a stunning 70.6 per cent compared with 19.2 per cent from the index.

 

Dreman vs FTSE All-Share

 

But such rewards do not come without considerable risk. Indeed, while Mr Dreman has a number of methods for avoiding shares that are "cheap for a reason", there is always the possibility that shares trading on very low valuations will prove to be so-called 'value traps'. That's to say, the market is putting a low valuation on a company's shares because that company's performance is likely to deteriorate.

 

NameTIDMTotal return (14 May 2014 - 18 May 2015)
MoneysupermarketMONY70%
MondiMNDI44%
IG GroupIGG24%
Legal & GeneralLGEN22%
Exillon EnergyEXI-22%
Average-28%
FTSE All-Share-6.8%

Source: Thomson Datastream

 

When it comes to value traps, Exillion Energy proved a case in point last year. The shares did look cheap, but only if one assumed the oil price rout was set to quickly abate. That would have been a brave bet at the time and, in the event, the oil price continued to tank. Perhaps an even more pertinent example of Dreman and the value-trap risk occurred when I first ran a Dreman screen in 2012. I ran this screen in three parts over different weeks, relating to the different valuation metrics Mr Dreman focuses on. This means the set of 2012 screens cannot be reconciled with my cumulative performance figures used in the above graph. The screen focused heavily on mining stocks, which at the time had performed terribly, and continued to do so after being selected by the screen.

But big and bold bets are integral to the contrarian approach that has made Mr Dreman so successful. Indeed, in his opinion there is nothing wrong with putting large amounts of cash behind a single sector or theme if the proposition looks correct (property is a big theme in this year's stock picks). The proposition, in the case of my Dreman screen, focuses on stocks that are among the most attractively valued 25 per cent of all those screened based on one or more of the following: price/earnings ratio (PE), dividend yield (DY), price-to-book-value (PBV), or price-to-cash-flow (PCF).

Mr Dreman has several other ways of trying to assess shares' quality (see criteria listed below), which is a key consideration when trying to avoid a value trap. He is also very focused on stocks that pay a good dividend and boast good or improving dividend cover. The focus on dividends has two benefits. On the one hand it fits with Mr Dreman's view that the dividend makes up a very important part of the return an investor can expect from a share. The other benefit of focusing on dividends is that a high and well-covered payout is likely to indicate a company that is not under too much duress. Mr Dreman also focuses on larger companies, which is another important way of limiting risk.

The full list of screening criteria is given below and the criteria vary slightly depending on what 'value' criteria a stock has qualified on.

 

■ Among the lowest quarter of stocks screened based on PE, PBV or PCF, or the highest quarter based on DY.

■ Year-on-year EPS growth in the most recent half-year.

■ Forecast EPS growth for each of the next two financial years.

■ A current ratio of more than 1.

■ Above-average dividend yield (excluding cheap P/BV stocks).

■ Dividend cover of 1.5 times or more, or greater than the five-year average (excluding cheap P/BV stocks).

■ Above-average five-year dividend compound annual growth (excluding cheap P/BV stocks).

■ Gearing of less than 75 per cent or net debt/cash profits of less than 2.5 times.

■ Market capitalisation of £200m or more.

 

Six stocks passed this years screen.

NameTIDMMkt CapPFwd NTM PEPEDYP/BVP/CFPEGFwd FY+1 EPS grthFwd FY+2 EPS grth3-mth MomentumNet Cash/Debt (-)
BerendsenBRSN£1.8bn1,030p17202.9%3.56.04.90.8%7.2%-10%-£392m
Development SecuritiesDSC£313m250p109.35.6%0.94.82.71.5%5.3%7.5%-£145m
HansteenHSTN£808m118p196.94.2%1.2210.522%6.6%2.3%-£422m
Legal & GeneralLGEN£16bn266p14164.2%2.62.91.413%8.0%-1.9%£8,307m
LondonMetricLMP£1.0bn168p237.04.2%1.3740.260%9.2%6.0%-£438m
Next NXT£11bn7,345p17184.1%34153.05.6%5.9%1.1%-£577m

Source: S&P CapitalIQ

 

Berendsen (Low PCF)

Workwear and facilities group Berendsen (BRSN) is due to lose its respected chief executive, Peter Ventress, in July and the shares slumped when this news broke in late April. But, after six years at the company, he leaves the business in good shape for his successor, James Drummond, who is the former chief executive of international helicopter firm Avincis, which was sold to Babcock last year. And despite the recent share price drop, trading at Berendsen does not look problematic.

While the group's first-quarter results, which were announced at the start of the month, took a bit of a hit due to a high level of churn in the company's hotel contracts and negative currency movements, the overall picture was encouraging. The facilities business should benefit from investment in sales people, although this has temporarily hit margins, while the workwear division is continuing to benefit from efficiency improvements despite tough end-market conditions. And importantly, given that Berendsen's shares have been selected as a low PCF stock, the company continues to convert over 100 per cent of its post-tax profits into free cash flow.

Last IC view: Hold, 1,102p, 3 May 2015

 

Development Securities (Low PBV and high DY)

Shares in property company Development Securities (DSC) could become a more noteworthy income story in coming years. That's because the company recently paid an 8p special dividend and there are good grounds to think this could be a taste of things to come. Indeed, fast-rising development and trading profits mean the group is throwing off cash. Broker Peel Hunt believes that, based on the development pipeline and the company's own guidance, cash-backed profits of £30m to £35m are likely to be generated in each of the next three years. This compares with the cost of the company's base dividend of about £7m. Given that gearing levels at Development Securities are already low at 36 per cent, the question is what management will decide to do with the extra earnings. With UK property getting ever more expensive and the market getting more competitive, there is a good chance that management will decide to continue handing money back to shareholders.

While Peel Hunt is not factoring special dividends into its forecasts, it believes the company may well end up paying out 10p or more a year in this way over the next three years. Such a payment would sit on top of a forecast base dividend of 5.6p for the current year, rising to 6.5p and then 6.8p. Factor in a 10p special dividend and the shares could be paying a near-on 7 per cent yield in the year to the end of February 2018. What's more, prospects for NAV also look good, with growth of 11 per cent pencilled in for the next two years.

Last IC view: Buy, 245p, 29 Apr 2015

 

Hansteen (High DY and low PE)

Like peer Development Securities (see above) Hansteen (HSTN) could be paying out more special dividends in the future. Following a string of property sales last year it bulked up its 5p base dividend payment with a 3p special payout. So, following this month's £64m disposal of a stake in a joint venture unit trust for a £5m profit, there is the potential for management to decide to hand further cash back to shareholders. But Hansteen's European focus means it has more tempting options to reinvest its money than purely UK-focused peers.

Disposals have now reduced the proportion of Hansteen's portfolio that is located in the UK to 27 per cent. Meanwhile, over half of the company's assets are in Germany. Encouragingly, while property prices have been heading upwards in the UK for some time, Hansteen only announced the first increase in the valuation of its German property assets in its last results, so there could be a lot more to play for in the region. The weakness of the euro is a negative, but some of the impact of this will be mitigated by Hansteen's hedging strategies.

While the UK market has started to look more fully priced, the recent £64m unit trust sale does suggest there is still valuation upside. Indeed, the disposal valued the properties sold on a 7.4 per cent gross yield, which broker Peel Hunt points out compares with the 8.1 per cent yield being applied to Hansteen's UK portfolio as a whole at the end of last year.

Last IC view: Buy, 114p, 10 Mar 2015

 

Legal & General (High DY)

Financial services group Legal & General (LGEN) also appeared as a high-dividend-yield Dreman stock in last year's screen. It certainly delivered on the billing by raising its full-year dividend for 2014 by a whopping 21 per cent. The group did face challenges during the year, though. Changes in annuity rules that gave retirees greater choice about what to do with their pension pots did pose something of a challenge, but massive bulk annuity wins vastly overshadowed the damage this did to individual annuity sales.

The shares have fallen back from 295p since the 2014 results were announced in March, in part because profits failed to meet expectations despite a hearty rise. Recent first-quarter results held some cause for concern based on new business wins. But cash generation was at a record level and was in line with expectations. Meanwhile net inflows into the investment business, coupled with strong market conditions, pushed up assets under management. The company should also benefit this year from £80m of planned cost savings.

Last IC view: Hold, 268p, 4 Mar 2015

 

LondonMetric Property (High DY and low PE)

As a high-income Dreman stock, LondonMetric's (LMP) credentials have been improving. Historically, the company's income has not covered the dividends that it has been paying. However, after a period spent repositioning its property portfolio, dividend cover should no longer be an issue and the company is expected to be able to start growing the payout this year. The portfolio, which is focused on retail parks and retail distribution centres, has attractive income characteristics with tenants on long leases and rents often inflation-linked.

LondonMetric's management has dealmaking panache and part of the company's strategy is to sell properties on once they reach maturity. Several recent deals have pointed to the hidden value in the portfolio, such as the £37.2m sale of a Harlow distribution centre on a 4.7 per cent yield compared with the 7.5 per cent yield the property was bought on, and the sale of another centre at 5.5 per cent, which broker Panmure Gordon had been valuing at 7 per cent. Panmure forecasts NAV of 139p for the year to the end of March, which is due to be reported on 2 June, followed by 159p in 2015-16 and 185p for 2016-17. The high prices the group has achieved for recent property sales help to justify the premium to NAV the shares currently command.

Last IC view: Buy, 151p, 26 Nov 2014

 

Next (High DY)

Next's (NXT) high yield comes courtesy of a recent special dividend payment. Returning capital to shareholders is a characteristic of this clothing retailer, but buybacks rather than dividends have been a common way of handing money back in the past. Broker Investec reckons that special dividends are likely to remain the preferred route for capital return, though, as long as the share price remains above 6,800p. That being the case, the broker is pencilling in payouts of 389.5p this year, followed by 394.6p in 2016, equivalent to yields of 5.3 per cent followed by 5.4 per cent.

On the trading front, Next beat expectations with the first-quarter performance it reported at the end of June. This came as a relief, as it provided the market with a weak outlook when it reported full-year results. The company has seen good sales from a new clothing range, but it still faces tough early-year comparatives and, even though the company has made a good start to 2015, management has not raised its guidance for the year.

Last IC view: Hold, 7,345p, 20 Mar 2015