In the five years I've been running a screen based on the investment process of fund management legend John Neff, it has delivered excellent returns of 168 per cent on a cumulative basis, compared with 59.7 per cent from the FTSE All-Share. But as the current bull market has got longer in the tooth, the screen has become less and less productive. Indeed, last year just two shares passed all of the screen's tests and this year none have made the grade. So over recent years I've resorted to tweaking the criteria in order to boost the results and it's probably fair to say that the returns from these portfolios have in general looked less impressive than the earlier versions of the screen when stocks that made the grade were plentiful.
Last year the two stocks meeting all the screening criteria managed a very modest 1.9 per cent return, while the larger portfolio based on stocks passing the main valuation test but failing one of the other screening criteria returned 11.3 per cent. Both results look feeble in comparison with the near-30 per cent return from the FTSE All-Share, although the index's return needs to be seen in context of the outsized influence of the turbocharged recovery of large resources stocks.
|Name||TIDM||Total return (8 Feb 2016 - 7 Feb 2017)|
|Primary Health Properties||PHP||8.1%|
|Neff - fully qualifying||-||1.9%|
|Neff - diluted criteria||-||11.3%|
*Shares passing all Neff tests in 2016
Source: Thomson Datastream
John Neff found fame as manager of the Windsor Vanguard mutual fund, where, over 31 years, he returned 13.7 per cent a year versus 10.6 per cent from the S&P 500. His investment approach was based on trying to find steady-as-she-goes growth stocks. He did this by looking at good, but not too good growth rates from stocks trading at low, but not too low, earnings multiples. The criteria used for this screen are:
■ Historic price/earnings ratio (PE) below the most expensive quarter of shares and above the cheapest quarter.
■ A lower than median average Neff PEG ratio (see details below).
■ A five-year EPS compound annual growth rate (CAGR) of more than 7.5 per cent but below 20 per cent (excessive growth can fall off).
■ Average forecast EPS growth for the next two financial years of more than 7.5 per cent.
■ Rising EPS in each of the past two half-year periods.
■ Five-year turnover CAGR of 5 per cent or more (in the long term, earnings growth needs to be based on rising sales).
■ Positive free cash flow in each of the past three years.
Mr Neff's main valuation tool is a version of a price/earnings growth (PEG) ratio that also factors in dividends. In fact, Mr Neff actually liked to express this valuation formula as a yield, but I've flipped the formula on its head to make it look more like a PEG ratio, which I believe is a more familiar format for most UK investors.
The Neff PEG ratio is calculated as follows:
Price/earnings ratio (PE)/earnings growth rate (EPS growth) plus dividend yield (DY)
In the formula I use a historic PE and DY. EPS growth is the average of the five-year compound annual growth rate (CAGR) and the average forecast EPS growth rate for the next two fiscal years.
My screen based on Mr Neff's measured approach to stockpicking has produced excellent results over five years. On a cumulative basis the 168 per cent return drops to 148 per cent if a 1 per cent yearly charge is added in for costs. This compares with 59.7 per cent from the FTSE All-Share, which is the index the screen's constituents are drawn from (see graph).
Source: Thomson Datastream
11 NEFF SHARES
|Name||TIDM||Mkt cap||Price||Fwd NTM PE||Neff PE/TR||DY||Fwd EPS grth FY+1||Fwd EPS grth FY+2||3-mth mom||Net cash/ debt (-)||Test failed|
|Charles Taylor||CTR||£148m||222p||10||0.71||4.5%||6.4%||9.3%||-23.7%||£98m||y-o-y EPS|
|Legal & General||LGEN||£14bn||239p||11||0.94||5.6%||12.9%||2.5%||12.5%||-£1.8bn||FCF|
|James Fisher & Sons||FSJ||£770m||1,540p||19||1.46||1.5%||9.7%||9.7%||-4.8%||-£106m||y-o-y EPS|
Source: S&P Capital IQ
Housebuilders look very cheap on earnings-based valuations at the moment. But another key sector valuation metric, price-to-tangible-book-value (P/TangBV), suggests the opposite. Many investors view P/TangBV as the best metric for valuing the sector because housebuilders are reliant on assets such as land and part-built houses to generate sales and profits. What's more, the industry is highly cyclical, which makes profits erratic. This means investors tend to be understandably averse to paying up for an earnings stream that could prove fleeting. Investors have been particularly concerned about the prospect of worsening performance at Berkeley (BKG) recently due to its exposure to high-end London housing, which has been hard hit by stamp duty changes. Brexit-related uncertainty is also credited as having caused a slowing in the market, although the weakening of the pound that resulted from the vote should be a bonus given the preponderance of foreign buyers.
That said, Berkeley's shareholders should be able to take comfort from reports of strong trading, forward sales of units and the fact that the company's highly respected management has moved its business into less high-end parts of the capital, which look somewhat more insulated from the slowdown in prime London sales. The high dividend yield should also be a source of comfort for investors as well as a source of financial reward, as the bumper payouts are a reflection of the company's determination not to overexpand into the cycle. All the same, the heady level of the return on capital employed (ROCE) being achieved by the group, coupled with the historically high valuation (even after the post-Brexit sector sell-off), means investors have grounds to be asking whether this is simply as good as it gets (see graph).
While the market took the recent government white paper on housing in its stride, there are aspects to the suggestions made that could put sector returns under pressure. The government's desire to encourage new entrants into the sector could put upward pressure on the cost of land and other inputs as well as potentially causing downward pressure on prices. The desire to bring institutional money into the sector could also erode a barrier to entry for the big builders; namely their willingness to take on the balance sheet risk associated with holding large amounts of undeveloped and part-developed land. Regardless of the merits of these arguments, ultimately these are cyclical businesses so when times are very good, as they have been recently, it is more likely on balance that things will get worse rather than better.
Last IC view: Buy, 2,630p, 5 Dec 2016
Babcock's (BAB) shares have come under pressure following a big profit warning from sector peer Capita. Once seen as a sector full of 'defensive growth' stocks, big outsourcing companies have been plagued by profit warnings over recent years, with the likes of G4S, Serco and Mitie all serving up big disappointments before the recent blow from Capita. Babcock stands out as it has avoided providing its shareholders with any really nasty shocks. Indeed, the fact that the company supplies essential services and is regarded as having longer-term more stable contracts provides ground for optimism that it can continue to go against the wider trend. Nevertheless, the market seems nervous.
The impact of the fall in the oil price has caused concern, especially for the helicopter business, Avincis, which was bought at what now appears a fulsome price ahead of the downturn in 2014. Investors have also been worried that the rate at which the group has been winning new work has been falling short and that cash conversion has not been as good as some had expected. And Brexit threw up worries about the company's work in Europe and Scotland, although recent contract wins and project progress should be alleviating these concerns.
Issues associated with the oil and gas industry may also be set to subside based on growing signs that the embattled sector may be ready to step up capital expenditure once again. The company could also prove a beneficiary of increased defence spending (a key market), as Donald Trump steps up pressure on Nato members to put their hands in their pockets. What's more, at the half-year stage £2bn of new work helped the order book hold steady at £20bn.
Debt is expected to get down to 1.4 times cash profit by the year-end based on broker Shore Capital's forecast, which may help calm worries about cash generation. The company is also on an attractive forecast free-cash-flow yield for 2018 of 7.6 per cent. Results scheduled for 28 February could provide some further reassurance and possibly give grounds for a reassessment of the lowly rating (the forward next-12-months PE ratio currently sits in the bottom fifth of the 10-year range).
Last IC view: Buy, 975p, 22 Nov 2016
While investors may have spurned outsourcers as a source of defensive growth, cinemas still cut the mustard on this front. Not only does cinema-going typically hold up well during economic downturns, but the industry plays to the current trend of increased spending on experience-based consumption. In addition to this, Cineworld (CINE) is also enjoying strong growth overseas, where in 2015 it generated just over a third of revenue and just under a third of profit. It has a particularly strong focus on eastern Europe following its 2014 acquisition of Cinema City and growth in the region is expected to benefit from a long-term increase in cinema visits from a low per-person base.
While a year-end trading update reported that growth at the group slowed towards the end of the last financial year (final results are due to be published on 9 March), this came against a very strong release schedule during the same period in 2015. And analysts are excited about the big film releases lined up for 2017. The company should also benefit during the year from the opening of eight new sites last year and the acquisition of the Empire chain of five cinemas, with 64 screens. The group's screen capacity is expected to increase by about 5 per cent this year, which should continue to fuel growth.
Last IC view: Buy, 586p, 11 Aug 2016