Three not-so-boring cheap growth shares

Overall, the returns from the screen since I started running it in 2012 have been good and the most recent 12-month stint can be classed as a decent year. While the 0.9 per cent total return from the stocks selected in May 2015 was hardly a show stopper in its own right, it compares well with a negative 7.7 per cent return from the FTSE All-Share, which is the index that the screen attempts to pick stalwarts from (see table).

Source: Thomson Datastream

The decent run from the screen in 2015 followed a lousy run in 2014, truly spectacular outperformance in 2013 and a fairly disappointing inaugural year for the strategy in 2012. Overall, the screen has managed a 65 per cent cumulative total return over four years compared with 32.8 per cent from the index. If I factor in a 1.5 per cent annual charge to allow for the costs of reshuffling the portfolio each year, the total return drops to a still credible 55.4 per cent.

Peter Lynch's Stalwarts

But while the screen is fulfilling its objective of outperforming the market, a key question has to be why it is not fulfilling its objective of being boring. I think the answer to this lies in the fact that the screen is primarily focused on buying 'cheap' dividend-adjusted earnings growth (in investment jargon EPS growth plus dividend yield is known as total return, but confusingly is different to the total return used to measure share performance based on share-price-change plus dividends).

The screen’s criteria are:

The dividend-adjusted PEG ratio

While a key objective of Peter Lynch's while managing the Magellan fund was to buy growth on the cheap by focusing on shares in companies that were overlooked because they were boring, there is another type of stock that often offers lowly priced growth: cyclicals.

The growth from cyclical stocks is often ascribed a low value by the market because of its tendency to be fleeting and dependent on economically sensitive end markets - ie these are companies whose growth is likely to be significantly affected by factors largely beyond their control. That means that, regardless of the operational quality of such companies, their EPS growth is intrinsically lower quality and therefore of less value to investors. Mr Lynch is a strong advocate of further research beyond the kind of quantitative hunt done by a stock screen, which could be used to weed out shares deemed too risky.

That's not to say a lot of money can't be made from investing in cyclicals. But a lot can also be lost when the cycle turns, which tends to cause multiples and earnings to collapse in tandem - a case in point was the Lynch screen's poor result in 2013 when a lot of oil services companies were selected ahead of a sharp downturn in oil and gas capex.

The biggest cyclical theme in this year's screen - which was also well represented last year - is the housing market. There is currently some creeping nervousness in the market about the prospects for companies operating in this area. However, apart from the London high-end market, there is not yet much evidence that affordability problems are weighing significantly on the housing market. What's more, the government continues to pursue policies to incentivise buyers that look likely to stoke demand while doing far less to directly address the UK's key problem, which is a lack of supply (giving policies like this names such as 'Help' to buy risks being seen as a laughable misnomer given what's happened with house-price inflation since their introduction). Two of the write-ups below cover companies with exposure to this market and attempt to highlight why they are extremely geared to the cycle.

In all, 13 stocks passed the screen's tests. The qualifying shares, along with fundamentals relating to them, are listed in the table below and I have provided write-ups of three shares: the share boasting the lowest dividend-adjusted PEG ratio, the stock with the highest yield and the pick showing the strongest three-month share price momentum.

Not-so-boring cheap growth shares

Source: S&P CapitalIQ

Ibstock - lowest dividend-adjusted PEG

A key reason for the low adjusted PEG commanded by brick maker Ibstock (IBST) can be explained by the cyclicality of the brick market and the extreme sensitivity of the company's profits to relatively small changes in brick prices. Recently these business characteristics have been working in favour of Ibstock's reported numbers, but against investor sentiment due to anxiety about the economic outlook compounded by a weak spell for the repair maintenance and improvement (RMI) market late last year.

Maiden full-year results from Ibstock, which floated in October last year following its demerger from CRH, showed just how good things can be for the company when the wind is blowing in the right direction. In 2015, on a pro-forma basis, an 11 per cent rise in turnover fed through to a 65 per cent rise in cash profits and a 90 per cent increase in operating profit.

Much of this so-called 'operational gearing' affect - whereby a rise in sales leads to a significantly larger rise in profits - was down to a strong performance from its UK business, which accounts for four-fifths of turnover. As the cost of operating a brick plant and making a brick are largely fixed, rising UK brick prices and increased factory utilisation caused a big jump in profitability. Lower energy prices also helped push margins up.

Brokers were also impressed by the 13 per cent increase in free cash flow from operations, to £69m, despite a significant increase in capital expenditure as well as tax and interest paid. The cash-generation helped bring net debt down by more than expected to £145m. A £60m payment during 2015 also meant the group's £551m defined-benefit pension scheme moved from deficit to surplus.

However, while the numbers from 2015 may look impressive, unfortunately the full-year results also brought news that the group was off to a slow start to 2016. This has been attributed to destocking by Ibstock's customers due to the slow RMI market. This should prove temporary. What's more, the key driver of demand for bricks comes from new building - especially homes - and prospects continue to look good both in the UK and the group,s other market, the US. What's more, the company has already completed its brick price negotiations for 2016 in line with its expectations, which should provide some reassurance.

While the risks associated with Ibstock's cyclicality and operational gearing may be working against the share price at the moment, it also offers significant potential for growth and earnings forecast upgrades if conditions prove robust, which are likely to drive the shares higher if they materialise (last IC view: Buy, 198p, 14 Mar 2016).

Taylor Wimpey - highest yield

Housebuilders make up a major part of this year's Peter Lynch screen results, and the same was true last year, too. It's not hard to see why the screen is so keen on this sector; shares in housebuilders have been a cheap source of earnings growth for several years as companies have benefited from benign land price inflation and soaring demand supported by government incentive schemes and low interest rates. This has led to a surge in the sector's profitability and returns on capital. Taylor Wimpey (TW.) is no exception.

However, the sector's growth is cheap for a reason, and it's a reason that does not sit that comfortably with the slow-and-steady investment philosophy that underpins this screen. The problem investors tend to have with housebuilders is that they have to tie huge amounts of cash up in working capital - chiefly huge land banks at various stages of development, which can prove impossible to build homes on at a profit if markets turn down fast. This means that, in the past, the sector's cyclical retreats have been characterised by huge writedowns, financial difficulties and rescue rights issues.

Given these market dynamics, like other builders Taylor Wimpey has been attempting to pace itself during the current boom by returning some capital to shareholders rather than ploughing all its cash into growth. So part of the high yield reported in the accompanying table reflects a 9.2p special dividend. The company made a 7.7p special payment a year earlier, too, so the 'special' payment can be regarded as something of a regular feature dependent on ongoing trading strength. The 9.2p will be paid in July to anyone buying before the ex-dividend date of 2 June. With net cash on the balance sheet at the end of last year, broker Peel Hunt predicts another special payout in the coming year taking the total forecast payout to 11p for 2016, rising to 12.7p in 2017, representing prospective yields of 6.0 per cent and 6.9 per cent.

While there is good reason to fear the potential consequences for the sector from a turn in the housing market, there are few serious signs of trouble at the moment, despite stretched housing affordability. Nevertheless, share prices in the sector have weakened over concerns that 2016 may not prove quite such easy going as the recent past, due to a potential moderation in house price growth and rising building costs.

For its part, Taylor Wimpey actually pointed to a fall in build-cost inflation in its last update. The group also continues to report a strong order book, although, the pace of order growth has recently tailed off. Nervous investors should be able to take some encouragement from the fact that 70 per cent of private completions were forward sold as of 24 April (last IC view: Buy, 187p, 1 Mar 2016).

BGEO - highest three-month momentum

When BGEO (BGEO) appeared in last year's screen it was called Bank of Georgia and wholly-owned a high-growth business called Georgia Healthcare Group. Since then, the healthcare business has been floated on the main London market, with BGEO retaining a 65 per cent stake, and the bank has changed its name. This means the remaining entity, while still exposed to Georgia's fast-developing healthcare sector, is primarily focused on providing banking services to the growing Georgian economy.

The underlying state of the business looks encouraging. The Georgian economy is expected to grow by about 3 per cent this year, which would be similar to the level achieved in 2015. What's more, the quality of BGEO's loan book continues to look good and the company's balance sheet looks strong. And while corporate loans have slowed recently, the retail business continues to grow at an impressive pace as the banking sector in Georgia develops. Indeed, measured in Georgian Lari, pre-tax profits rose 30 per cent last year while the dividend was hiked by 14 per cent.

The trouble is, the progress of this business is significantly different when seen in sterling terms because during 2015 the Lari devalued by almost two-fifths against the dollar. Currency volatility is not the only major risk factor associated with BGEO. Georgia boarders Russia and was invaded by its neighbour in 2008. Russia's involvement in Ukraine and its annexation of Crimea have brought back uncomfortable memories for investors.

However, what goes down can rebound, and that has been the case with the Lari this year, which has followed the oil price recovery - a key reason for the strong three-month performance of BGEO's shares. Also, as the situation in Ukraine becomes a more established part of the geopolitical landscape, the risks associated with Georgia's neighbour, whether rightly or wrongly, may well start to recede in investors' minds. If investors are prepared to continue putting less stress on these key issues, a valuation argument remains for the shares even after their recent ascent (last IC view: Sell, 1,941p, 14 Oct 2015).