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Six stocks riding upgrade cycles

Even after a poor 2016, my Great Expectations stock screen has performed almost three times better than the FTSE 350 since I started running it five years ago. Six stocks make the grade this year
January 10, 2017

My Great Expectations screen has now been running for five years and over that half-decade has racked up a mighty cumulative total return just shy of 200 per cent, compared with 68 per cent from the FTSE 350 index, which is the universe from which its stocks are selected. However, the past 12 months provided a noteworthy bump in the road for the screen, with the 10 shares picked last year managing a total return of just 2.5 per cent compared with 23.4 per cent for the index over the same period.

The timing of last year's screen can be regarded as a key reason for the underperformance. The screen was conducted as the resources sector went through a savage sell-off before the incredible recovery it staged from February 2016. As this screen is reliant on broker upgrades and share price momentum to make its stock selection, this meant the resources stocks that drove the handsome return of the FTSE 350 index were well off its agenda.

 

2016 Great Expectations performance

NameTIDMTotal return
JD Sports FashionJD.57%
DCCDCC19%
Domino's PizzaDOM11%
CarnivalCCL7.9%
GreggsGREG-3.9%
BellwayBLWY-7.7%
PaddyPower BetfairBET-7.9%
MarshallsMSLH-8.8%
MoneysupermarketMONY-19%
International Consolidated AirlinesIAG-22%
Great Expectations-2.5%
FTSE 350-23%

Source: Thomson Datastream

 

The fact that the screen missed out on the resources rally should not be regarded as too big a disaster when looked at in the round. This is because some of the strong long-term performance of the screen can be put down to the fact that it avoided these stocks during several years when they persistently fell. Importantly, as demonstrated by the strong performance of my quarterly blue-chip momentum screen last year, selecting shares based on the strength of price movements makes it possible to catch on to sustainable trends with relatively good timing even if a momentum strategy will inevitably miss out on the early part of any recovery.

Over five years the results from the screen have been good, with a 197 per cent cumulative total return or, if a 1 per cent annual charge is applied, 183 per cent. That compares with a 68 per cent total return from the FTSE 350 over the same period (see chart below).

 

Great Expectations versus FTSE 350 index

 

To a noteworthy extent, the Great Expectations screen this year is banking on the strong performance of resources stocks to continue, because it has selected two such companies among its six picks. The screen's selection process attempts to exploit the fact that broker forecasts are frequently (and for very understandable reasons) wide of the mark and often there is a clear trend in the direction of the forecasting errors - ie, brokers tend to persistently over- or underestimate future profits during the course of a cycle. Despite this well-established phenomenon, the market tends to price in upgrades as they are made rather than in advance, which means opportunities can exist to profitably exploit established upgrade trends. It is such opportunities that this screen is designed to try to latch on to.

The screen looks to rising share prices (momentum) in conjunction with upgrades as a measure of the credibility of the earnings upgrade story. The screening criteria are:

■ EPS forecasts for each of the next two financial years upgraded by at least 10 per cent over the preceding 12 months.

■ EPS growth of 10 per cent or more forecast for each of the next two financial years.

■ Share price momentum at least double that of the market over the past year and better than the market over the past six months, three months and one month.

Six stocks passed all the screen's tests this year. Details are given in the table below, with the stocks ordered from highest to lowest three-month momentum, along with brief write-ups of the investment cases for the stocks.

 

Six stocks riding upgrade cycles

NameTIDMMkt CapPriceFwd NTM PEDYPEGNet Cash/Debt(-)Fwd EPS FY+1 upgradeFwd EPS FY+2 upgrade1Y price change3M price change
FerrexpoFXPO£758m130p5-1.1-$753m514%618%503%66%
ElectrocomponentsECM£2.1bn475p252.5%3.2-£143m37%40%103%40%
GlencoreGLEN£41bn288p20---$36bn31%103%215%33%
AshteadAHT£7.9bn1,592p141.5%1.1-£2.7bn10%17%43%24%
RPCRPC£3.5bn1,064p161.8%2.0-£867m27%38%38%8.8%
JD Sports FashionJD.£3.1bn316p210.5%1.6£232m42%50%53%6.2%

Source: S&P Capital IQ & Thomson Datastream

 

Ferrexpo (FXPO) has been an ideal recovery play since the commodity market turned. Not only has the price of iron ore risen, but the company has also sold record volumes of iron pellets while focusing production on high-margin, higher-grade mines. At the same time, it has pushed through other efficiency improvements to drive down costs. Currency movements, particularly the weakness of the currency in its native Ukraine, have played to Ferrexpo's advantage, too, and so have falling energy prices.

Importantly, all these favourable factors have allowed the company to generate large amounts of cash. This is particularly significant for Ferrexpo because its balance sheet looked in a dire state when commodity prices bottomed early in 2016. Things look much better now and the company has reported in its fourth-quarter update this week a $110m (£90m) increase in cash on-hand during 2016 to $145m. Meanwhile, $196m of its borrowings have been paid back. At the most recent balance sheet update at the end of June net debt stood at $753m, down from $868m at the end of 2015. Prospects continue to look good for iron ore prices and the premium on the pellets produced by Ferrexpo continues to trend upwards, as do earnings forecasts.

Last IC view: Sell, 55p, 5 Aug 2016

 

Electronics products distribution company Electrocomponents (ECM) is undergoing something of a transformation. Management has targets to generate sustainable sales growth of 5 to 8 per cent a year and double-digit operating margins, compared with 6.4 per cent last year. Recent progress suggests the company could deliver on these ambitious plans and perhaps even better them. At the half-year stage, the group increased its forecasts for cost savings from £25m by March 2018 to £30m. Margins are also being boosted by growth in own-brand sales, which were 6.6 per cent ahead in the first half and now account for 12.6 per cent of the total. Currency movements have also been helping performance and there are signs of strengthening demand across all the company's international end markets.

What's more, debt is dropping fast and at the end of September had fallen by £29m on the prior year to £141m. This potentially gives Electrocomponents scope to make acquisitions, which could give brokers another reason to rush to upgrade forecasts. For now, though, self-help coupled with solid underlying trading is doing the trick on its own. The shares' earnings multiple (PE ratio) is pricing in some of the potential Electrocomponents has to improve its business. But if all goes to plan, the rating should drop rapidly as earnings increase.

Last IC view: Hold, 387p, 21 Nov 2016

 

Resources group Glencore (GLEN) has been one of the stars of the sector's recovery. It went to shareholders cap in hand for $2.5bn to support its operations in late 2015, following which its shares endured a pummelling as investors continued to fret over its financial viability. However, since February 2016 the shares have staged a mighty comeback. To a large extent this is a reflection of a rebound in commodity prices, which Glencore's profits are very sensitive to.

But the shares have also benefited from efforts to overhaul the balance sheet by cutting capital expenditure and selling off assets to repay debt. The company signalled this stage in its life was largely behind it as 2016 drew to a close by announcing that it will reinstate dividends this year, with a $1bn payout planned. This is set to be the base payment from 2018 onwards, with further payouts linked to the distribution of at least a quarter of free cash flow from the industrial division. With signs that the markets for key metals continue to improve, prospects in Glencore's end markets and for its trading operation look good.

Last IC view: Hold, 183p, 24 Aug 2016

 

Equipment hire group Ashtead (AHT) was a big beneficiary of the surprise election of Donald Trump late last year. The lion's share of the group's revenues (85 per cent) come from the US and Mr Trump's ambitions for $1 trillion of infrastructure spending are expected to provide a huge boost to demand as the construction industry takes up tools. The construction market was already looking healthy in the US before the election, so rising demand should help push hire rates even higher. Ashtead has also been benefiting from a move towards outsourcing in the US and has used its operational panache to keep ahead of the curve.

In a tell-tale sign of the company's confidence, it announced a 20 per cent increase in expected full-year capital expenditure (buying new kit to rent out) plans to between £1bn and £1.2bn when it reported first-half results last month. The strength of the dollar against the Brexit-hit pound is providing another tailwind for the company, which reports in sterling. And back on home shores, Ashtead's A-Plant business also continues to perform well, which has contrasted in recent years with the travails of a number of other UK-listed players, including HSS and Speedy Hire.

Last IC view: Hold, 1,560p, 7 Dec 2016

 

The European packaging sector is consolidating and RPC (RPC) has taken a front and centre role in the process. Indeed, we were so impressed by the potential of the purchases the group had made in 2015 that we made it one of our Tips of the Year for 2016, and it proved to be the star performer, delivering a 40 per cent total return. The acquisition activity has continued apace since then and several brokers have made the stock a key pick for the current year. This is unsurprising based on estimates from Peel Hunt that the group's spending spree has set it up for compound annual earnings growth of 20 per cent a year between 2015 and 2019. Given RPC's strong record for finding extra cost savings from deals, current forecasts could prove an underestimate of the potential of recent acquisitions.

RPC's balance sheet shows the strain of the buying spree, with net debt currently at an elevated level of 3.2 times cash profit, although this is expected to fall quickly to 2.4 times by March 2018. The high debt will also not necessarily put a dampener on further acquisitions given the company's historic willingness to tap shareholders for funds. With the company's market share estimated at a relatively modest 8 per cent, there's plenty of scope for more consolidation, too. The big question for investors, though, is whether RPC can digest all of its purchases. While the company has a very good record for bedding acquisitions in, doing deals at such a pace can often lead even the most sure-footed dealmakers to slip up. For now, though, things look like they are going swimmingly.

Last IC view: Buy, 1,052p, 20 Dec 2016

 

International sports fashion retailer JD Sports (JD.) had a wobbly end to 2016 after a Channel 4 program accused it of poor working practices at a distribution centre. While the group made a response to the incident that was sufficiently conciliatory (a promise to retrain all staff at the centre) to get broad approval from the City, the shares have yet to bounce back. The travails of JD rival Sports Direct, which has also come under attack for bad employment practices, will have made the Channel 4 report resonate all the more with the market.

An upcoming Christmas trading statement this month could prove the catalyst needed to push the shares higher if the group proves to have been trading in its usual expectation-beating form over the festive period. Meanwhile, the group's energetic expansion into Europe has continued to impress investors and there is potential for the group to begin growing more aggressively in more far-flung overseas markets, too. JD has also recently spent £112m buying 58-store retailer Go Outdoors, as a bolt-on for its outdoor activity business, which suggests confidence in this part of its operation.

Last IC view: Buy, 333p, 29 Nov 2016

 

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