Five contrarian value shares

The reason why I don't feel more consternation about such a ghastly 12-month performance is that I believe a number of my screens have enjoyed an unusually good run and have been due to come off the boil; something I've previously raised in my yearly screen review and commented on when I ran this screen last year. Indeed, while my hope is that the screens I run mimic investment approaches that will outperform over time, my expectation has always been that outperformance is unlikely to be consistent, as different investment styles wax and wane with changing market conditions. Part of the fascination with tracking these strategies is developing an understanding of how, when and why they underperform or outperform. And following four spectacular years for this screen, a bit of serious mean reversion comes as a reminder of the risks of chasing contrarian value.

Year-by-year total return

2015 performance

Source: Thomson Datastream

The cumulative five-year performance of the contrarian value screen remains outstanding, with the top five shares boasting a 139 per cent total return over five years, compared with 41.5 per cent from the FTSE All-Share. Factoring in a 1 per cent annual charge for costs, the return from the top five drops to 127 per cent. The focus on the top five results from the screen reflects the fact that these are the stocks that tend to show real value on this screen's key valuation metric: enterprise-value-to-sales (EV/S). The general rule of thumb is that an EV/S valuation of around 1 or less is interesting. The cumulative five-year total return from the 20-stock version of the screen stands at 73.6 per cent or 65.1 per cent with the charge.

Contrarian value vs FTSE All-Share

The fact that this screen performed very poorly last year may reflect where we are in the current market and economic cycle. The key aim of the contrarian value strategy is to find companies that have seen a slide in profitability that has depressed the valuation but will only prove temporary. Arguably, such a strategy has a better chance of success earlier in the cycle when there are more likely to be tailwinds to a recovery in profitability, such as improving trading conditions and low-hanging-fruit 'self-help' options.

The purpose of looking for a low EV/S ratio is based on the idea that the market's obsession with short-term earnings momentum means the inherent earnings power of sales becomes undervalued when margins are temporarily depressed. To try to home in on such situations, the screen looks for stocks that have generated decent average operating margins over the past five years and where sales have been growing and are forecast to continue to do so. The full criteria are:

The screen looks for the 20 FTSE All-Share stocks with the lowest EV/S ratio that pass all the tests. Some of these stocks actually have quite high EV/S ratio, which somewhat undermines the logic of the approach, and I put a special emphasis on the 'cheapest' five stocks. These top five contrarian value picks are all given short write-ups below, with all 20 stocks listed in the table.

TOP 5 CONTRARIAN VALUE SHARES

Charles Taylor

In general, it's a very encouraging sign for long-term investors in cyclical businesses when a company invests even when trading is poor, which can supercharge performance when the cycle turns. This is the strategy being pursued by shipping insurance specialist Charles Taylor (CTR) for its adjusting business. It has been pushing ahead with office openings despite a torrid end market caused by a dearth of big natural disasters over recent years.

Fortunately, Charles Taylor has also been investing in areas where trading is altogether more promising. Results in March provided some encouraging signs from its investment in insurance technology. Meanwhile, the company's recently established Lloyds Insurance 'turnkey' operation has also launched its first syndicate. Charles Taylor's insurance buying clubs have also been performing well. So, in all the company continues to make progress despite some tough trading conditions and the shares offer an impressive yield to keep investors interested while waiting for a pick-up in the adjusting market (last IC view: Buy, 245p, 11 Mar 2016).

Restaurant Group

This time last year, Restaurant Group (RTN), the owner of chains including Garfunkel's and Frankie & Benny's, was a leisure sector darling. Three profit warnings later and it's being viewed as something of a basket case, suffering due to increased competition and declining footfall at the retail parks where many of its units are located. However, it may be foolhardy to forget past glories altogether. The group has a strong track record for cash generation and, while analysts now expect the dividend to be cut, the shares are still expected to produce a yield some way north of 5 per cent.

The group is undertaking a strategic review and in June brought in a cost-cutting and turnaround expert, Barry Nightingale, as finance director. The City is not expecting a quick fix to the problems that have emerged and a high level of relatively fixed costs in the form of rent and staff means margins could feel a severe squeeze. However, the rating now looks undemanding and the group's past glories still give grounds for hope of a revival (last IC view: Buy, 292p, 3 May 2016).

LSL Property Services

It's been a terrible year for shares in estate agents. While the first quarter saw a spike in housing market activity, this was largely down to buy-to-let purchases ahead of the introduction of a stamp duty surcharge in April, the full impact of which will become clearer as the year goes on. The buy-to-let tax hike hasn't been the only cause of angst. There have been reports of a slower market in the run-up to the Brexit vote and since then surveyors have reported a noteworthy decline in activity and expectations of house price falls. The gloomy sentiment was added to by a recent profit warning from Foxtons.

While LSL (LSL) is far from immune to housing market weakness, shareholders can at least take some solace in the fact that its business is relatively well diversified, with exposure to financial services and surveying. The company's extensive letting business is viewed as relatively defensive given the housing shortage the country is suffering. Acquisitions and attempts to boost the efficiency of its operations may also help shore up the group's performance. What's more, the shares look cheap on several measures aside from EV/S and offer a high yield. Still, given the market's current anxieties, LSL certainly fits with the contrarian theme and was a disappointing performer from last year's top five screen picks (last IC view: Hold, 262p, 4 Mar 2016).

Dialight

The rapid growth of industrial LED lighting company Dialight (DIA) saw it come horribly unstuck in 2015 when poor planning and overexpansion caused underlying profit before tax to plummet from £17.8m to £5.6m. A new chief executive, Michael Sutsko, has set about a costly reorganisation. His job has been made all the more difficult by a tough market backdrop and recent disappointing industrial output data suggests the company is unlikely to see any let-up soon. Dialight has also already warned shareholders that it expects the best of the year to occur during its second half. This reliance on a second half pick-up increases the chances of disappointment, so investors are likely to be waiting with bated breath for any news on the outlook at the time of the half-year results announcement early next month.

However, those willing to take a contrarian view should be able to find comfort in the long-term growth prospects for industrial LED lighting and the fact that necessary operational changes are now under way, which should boost efficiency. In fact, broker N+1 Singer believes underlying EPS could be 41.5p by 2018, compared with the 13.3p delivered last year (last IC view: Hold, 495p, 9 Mar 2016).

Senior

High-tech components maker Senior (SNR) is experiencing a margin squeeze across its operations. In the aerospace business, where trading conditions are actually good, start-up costs associated with new production programmes are weighing on profitability. Increased working capital needs associated with these programmes are also likely to hold back cash generation this year. Meanwhile, sales are falling at the company's Flexonics division due to poor conditions in key end markets in trucks and oil and gas. While management is focused on cutting costs to help mitigate the sales decline, margins are still expected to drop.

Senior has dealt with tough market conditions in the past and has seen its shares bounce back when the environment has improved. However, there is clear potential for things to get worse before they get better. Indeed, the company was among the disappointing selection made by the screen last year when the apparent value on offer turned out to represent justified concern. Nevertheless, a bit of daring and a bit of patience could yet pay off for contrarians (last IC view: Hold, 210p, 1 Mar 2016).

*Excludes special dividends at ITV and SuperGroup

Source: S&P Capital IQ