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Seven genuine growth shares

Should investors start being fussier about the price being paid for 'growth'?
November 17, 2016

By historic standards the FTSE All-Share looks pretty expensive based on its 12-month forward price/earnings (PE) ratio of 14.6, which is comfortably within the top fifth of the 10-year range. There's also a growing feeling that a rise of populism could herald a tightening in monetary policy in developed markets. These circumstances may mean growth investors will need to be on their guard.

The basis of this view is that for many years extremely low 'risk-free' government bond yields have increased the attractiveness of earnings growth, which in turn has pushed up the ratings commanded by growth shares. However, with bond yields rising, investors need to value future earnings against a higher 'risk-free' alternative and will no longer be able to justify putting such a high rating on earnings expected several years out. This creates the potential for a derating of high-priced growth shares.

Indeed, looking at quarterly forward PE data for the FTSE All-Share, the index's top decile PE has fallen by almost a tenth since ratings peaked in mid-2015, whereas the top quartile PE has experienced a more modest 6.5 per cent derating.

 

FTSE ALL-SHARE PE RATING SINCE THE CREDIT-CRUNCH BEAR-MARKET BOTTOM

 

One way 'growth' investors can attempt to protect themselves against the risk of deratings is by being more fussy about the price paid for growth. This is the approach that is at the heart of this week's Genuine Growth screen. The screen is very conventional in the way it tries to identify growth, in so far as the criteria used all focus on the market's dog-whistle number from financial statements: earnings.

The earnings figures reported by companies are probably the most manicured numbers found in financial statements. This means the potential manipulation of earnings numbers is a key weakness of this screen. What's more, cyclical stocks have a habit of looking like cheap growth shares, and there are plenty of reasons to quibble over whether the screen is better at finding 'temporary' growth shares as opposed to 'genuine' growth shares.

Nevertheless, the screen has to date been effective at finding some big winners. Since I started running it for this column four years ago the cumulative total return stands at 92.8 per cent, compared with 41.0 per cent from the FTSE All-Share. If I include a notional 1.5 per cent annual charge to account for dealing costs, the total return drops to 87.7 per cent for the four years.

 

GENUINE GROWTH VS FTSE ALL-SHARE

 

Last year's performance of the screen owes a lot to the strong run by United Arab Emirates healthcare group NMC Health. This balanced out two noteworthy disasters from last year's five stock picks. In another year, the 4.8 per cent total return from the Genuine Growth screen would be a point of consternation when compared with the 10.7 per cent from the FTSE All-Share. However, such has been the woeful run endured by my screens over recent months that this level of underperformance doesn't look that painfully bad.

 

2015-16 Performance

NameTIDMTotal return (8 Nov 2015 - 26 Nov 2016)
NMC HealthNMC57.1%
MondiMNDI10.0%
Galliford TryGFRD-8.1%
Paragon Group of CompaniesPAG-8.9%
PendragonPDG-26.2%
FTSE All-Share-10.7%
Genuine Growth-4.8%

Source: Thomson Datastream

 

The earnings-obsessed screening criteria are as follows:

■ Average EPS growth rate based on the historic three-year compound average growth rate and forecasts for the next two reporting years of 15 per cent or more.

■ Average forecast EPS growth for the next two reporting years of at least half the historic three-year average growth rate.

■ EPS forecasts higher today than they were three months ago.

■ A price/earnings-growth (PEG) ratio among the lowest quarter of index constituents (either FTSE All-Share or Aim 100). PEG ratio is calculated using average next-two-reporting years EPS growth rates.

 

710 stocks from the FTSE All-Share and the FTSE Aim 100 have been screened and the screen has been conducted separately on the two sets of index constituents. Only four stocks passed all the screen's tests and all were from the FTSE All-Share. These stocks are given write-ups below. In addition, the accompanying table contains three stocks from the FTSE Aim 100 which passed all the screening criteria except the market cap test.

 

2016 picks

NameTIDMMarket capPriceFwd NTM PEDYLT PEGEPS grth FY+1EPS grth FY+23-mth momNet cash/ debt (-)
Galliford TryLSE:GFRD£1.1bn1,288p86.4%0.7416.5%10.1%26.3%-£13m
BGEOLSE:BGEO£1.1bn2,885p92.7%0.5124.9%10.3%-4.1%-GEL1.5bn
FresnilloLSE:FRES£10bn1,405p301.0%0.37564.2%-18.6%-28.9%-$96m
BerkeleyLSE:BKG£3.3bn2,427p68.2%0.2847.6%-2.8%-0.9%£107m
iomartAIM:IOM£279m260p151.2%0.7121.6%6.8%-10.4%-£26m
Telit CommsAIM:TCM£301m261p121.5%0.8030.1%8.4%-4.0%-$29m
IdoxAIM:IDOX£218m61p171.4%1.2337.1%7.2%-13.7%-£14m

Source: S&P Capital IQ

 

The housebuilders

Berkeley Group (BKG) and Galliford Try (GFRD)

In 2016 the market has started to act as though housebuilders are living on borrowed time. While they continue to report very impressive profit growth, valuations have pulled back following several years of spectacular sector-wide share price performance. On the face of it, housebuilders' valuations based on ratios such as PEG look low compared with the wider market. However, even after the recent bout of derating, against a long-term historic valuation range, shares are still trading at elevated 'top-of-the-cycle' levels.

The reason housebuilders typically never reach the giddy rating heights commanded by some more pedestrian-seeming sectors is due to the economic sensitivity of the housing market, coupled with the huge amount of financial risk these companies must carry on their balance sheets. The value of land, materials and partly built properties, most of which gets recorded in working capital, represents a ticking time-bomb for housebuilders should the housing market take an unexpected (and it's pretty much always unexpected) turn for the worse. Indeed, the history of the listed housebuilders sector is littered with massive writedowns, value-destroying emergency fundraisings and bankruptcies. However, the counterpoint to this is that when trading is brisk and margins are fat - as seems to continue to be the case for the moment - those swollen balance sheets represent a source of big future profits and cash flows.

High-end London developer Berkeley has been attempting to offset the business's inherent cyclical risk by returning large amounts of capital to shareholders as an alternative to ploughing money back into evermore developments. This has made for an extremely enticing 200p forecast dividend payout on the shares, equivalent to a prospective yield of 8.2 per cent. However, the London market has struggled this year as various hurdles - including a marked increases in stamp duty on very expensive properties - have been put in the way of buyers. Changes have been especially focused on overseas buyers. But despite the added costs, the weakening of sterling has helped spark a pick-up in overseas interest, especially from China where property is so expensive even prime London flats seem something of a bargain! What's more, Berkeley has already sold many of the properties it is now building and the company is in the process of moving its focus to less hot parts of the London market where conditions looks more secure.

Like Berkeley, a standout feature of Galliford Try's investment case is the bumper dividend yield, which is expected to be 7.5 per cent this year based on broker Peel Hunt's forecast of a 97p payout. The company is working on increasing volumes and cutting costs at its Linden Homes housebuilding business as it attempts to drive up returns. Galliford also has a construction business and the outlook for this division is improving. However, the division's performance is being dragged down by a number of low-margin 'legacy' contracts that are depressing overall profitability. The group is trying to exit from these contracts, which, coupled with improving conditions in the end market, could ultimately result in some decent recovery upside (last IC view: Berkeley: Buy, 2,960p, 15 Jun 2016), Galliford Try: Buy, 1,197p, 14 Sep 2016).