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Low valuation, strong momentum winners

James O'Shaughnessy's racier growth screen has produced superior results to his value screen over the last five years, with a 148 per cent total return, but the ride has been bumpier
March 8, 2017

Having reviewed and rerun the James O'Shaughnessy's classic Cornerstone Value Strategy in last week's column, this week I'm turning my attention to its racier cousin, the Cornerstone Growth Strategy. The growth strategy was devised by quant king Mr O'Shaughnessy to deliver superior returns to the value strategy but with the likelihood of a bumpier ride. It's delivering on both counts.

Indeed, while the value screen has delivered outperformance in each of the last five years, the growth screen hasn't but the total return is superior. Last year the growth screen broke a four-year record of outperforming the market, delivering a total return of 8.5 per cent compared with 22.6 per cent from the FTSE All-Share index. While the return is some way off that achieved by the index it is possibly not as dire as it first seems considering the extent to which the wider FTSE All-Share benefited from the stellar recovery of large resources stocks, which troughed out around this time last year.

 

2016 PERFORMANCE

NameTIDMTotal return (29 Feb 2016 - 27 Feb 2017)
TrifastTRI78%
PorvairPVAR69%
RedrowRDW16%
Galliford TryGFRD9.4%
Carr'sCARR3.8%
BritvicBVIC-5.1%
Bovis HomesBVS-15%
easyJetEZJ-34%
LairdLRD-45%
Average-8.5%
FTSE All-Share-23%

Source: Thomson Datastream

 

What's more, the longer-term performance of the screen since I began to run it five years ago remains impressive. The cumulative total return over the half decade (based on switching from one portfolio of results to the next each time a new screen is published) stands at 148 per cent compared with 55.3 per cent from the FTSE All-Share (see graph). If I add in a notional annual charge of 1.25 per cent to account for dealing costs, the return from the screen drops to 133 per cent.

 

O'Shaughnessy growth versus FTSE All-Share index

 

In his seminal 1997 book, What Works on Wall Street, Mr O'Shaughnessy was primarily interested in investigating the question of what stock-picking strategies worked based on his analysis of historic data. He was less interested in the question of why the strategies worked. However, it's not too hard to create a stock-picker's narrative to explain the Growth screen's success. The screen's criteria are:

Value criteria: A price-to-sales (PSR) ratio of 1.5 or less.

Growth criteria: Mr O'Shaughnessy demands earnings growth in each of the last five years.

Momentum criteria: Mr O'Shaughnessy's original screen was based on selecting the 50 stocks with the best one-year momentum. But since first publishing he has said that shorter periods can also work well. I focus on three-month momentum as there are academic studies that suggest this is optimal for a pure momentum strategy. All stocks have to demonstrate superior three-month momentum to the FTSE All-Share.

Shares normally have a low price-to-sales (PSR) ratio when the profitability of sales is low. However, often such companies have the potential to lift margins, especially if sales are growing. Given the market normally values shares based on a multiple of earnings, as margins rise stocks are likely to rerate on a price-to-sales basis. This effect will be magnified if the shares also rerate on a price-to-earnings basis in recognition of the increased profitability and perceived quality of the business.

The screen's test for rising profits can be interpreted as an indicator that sales, or profitability, or both are rising. Meanwhile, the momentum may indicate that the market is regaining faith in the story, pushing the shares' rating up. It's worth noting that in later editions of What Works on Wall Street, Mr O'Shaughnessy changed his approach to identifying 'value' towards using a composite measure (six valuation criteria all rolled up into one), whereas my screen uses his original focus on the PSR.

The growth strategy is meant to be based on 50 stocks, but as with other years I've struggled to find enough stocks that make the grade from the FTSE All-Share. Twelve stocks do qualify, though, and are ordered in the table below from lowest to highest PSR. I've also taken a closer look at three of the stocks taken from the top, middle and bottom of the table.

 

O'SHAUGHNESSY CORNERSTONE GROWTH

NameTIDMMkt capPriceFwd NTM PEDYP/BVPSRFwd EPS grth FY+1Fwd EPS grth FY+23-mth momNet cash/ debt (-)
LookersLOOK£489m123p82.5%1.590.11-0.8%0.8%15.9%-£110m
WincantonWIN£332m269p102.2%-0.2918.8%5.4%21.2%-£32m
Galliford TryGFRD£1.2bn1,516p105.4%2.090.4914.3%11.2%17.6%-£117m
SavillsSVS£1.2bn856p133.1%3.400.872.2%2.6%30.4%£35m
BunzlBNZL£7.4bn2,255p201.9%5.651.006.6%3.4%13.2%-£1.2bn
BritvicBVIC£1.7bn632p133.9%5.901.15-2.5%4.9%17.3%-£517m
RedrowRDW£1.8bn489p82.5%1.611.1613.3%4.8%19.3%-£56m
Barratt DevelopmentsBDEV£5.1bn512p96.3%1.291.230.9%2.2%10.4%£172m
TrifastTRI£243m202p171.4%2.541.3715.9%2.1%8.7%-£14m
Crest NicholsonCRST£1.4bn542p85.1%1.921.3710.9%8.2%24.5%£77m
BellwayBWY£3.2bn2,606p84.1%1.711.438.2%3.1%10.8%£26m
VpVP.£325m832p132.3%2.521.4411.2%6.9%12.1%-£107m

Source: S&P Capital IQ

 

Car dealers' shares tend to trade on low PSRs because their sales of big-ticket items are inherently low margin. What's more, low-margin businesses can be particularly sensitive to negative factors outside their control, something that is always a threat to the cyclical car dealing sector. Unfortunately for Lookers (LOOK) and its rivals, the new car cycle seems to have peaked in the UK with the Society for Motor Manufacturers predicting a 5.5 per cent sales decline this year and February showing the first decline in sales for six years. Things could be made worse by the economic uncertainty created by Brexit. The weakness of sterling has also put upward pressure on car prices while operating costs at dealerships are being pushed up, particularly as a result of labour laws.

Investments made at the top of the cycle rarely deliver good returns. So the headwinds faced by the industry could be of particular concern to Looker's shareholders given the significant step-up in capital expenditure and acquisition spending at the group over recent years. The increased investment has targeted growth as well as satisfying car manufacturers' insistence that their dealers spruce up their showrooms.

That said, it's not all gloom for Lookers or the industry as a whole, and the shares have recently rallied following their post-Brexit malaise. Indeed, the heightened level of new car sales over recent years is good news for higher-margin aftersales work - such as MOT tests and servicing. Liberum expects this market to grow from £21bn in 2015 to £28bn by 2022. Lookers has been winning work in this part of the market. It is also doing well with used-car sales. In revenue terms, used-car sales represent two-thirds of that generated by the new-car business. The used-car market is considered to be fairly robust at the moment, helped by increased availability of financing.

Compared with Looker's shares' own history, the stock is cheap based on both price-to-sales (close to the bottom third of the 10-year range) and price-to-earnings (close to the bottom quartile). But the fact that margins remain relatively high by historic standards means there is room for disappointment should the market's recent fears play out. That said, the balance sheet looks in good shape (broker Numis forecasts that year-end net debt will be £35m, helped by last summer's disposal of a parts business) and capital expenditure should now be topping out.

Last IC View: Buy, 129p, 18 Aug 2016

 

Despite staging something of a bounce back over recent months, shares in drinks group Britvic (BVIC) are lowly rated by historic standards following their torrid performance in 2016. The shares suffered as sentiment soured due to a number of noteworthy uncertainties about 2017 trading. Costs are being pushed up by rising raw material prices and sterling weakness. Meanwhile, worries about consumer sentiment and pressures on the grocery sector means the group will have to fight hard to retain margin, let alone improve it. Added to these problems, the April Budget is expected to contain details of the sugar levy which should come into force next year. That said, Britvic has made impressive strides in reducing the sugar content of its drinks over several years.

Against this tough backdrop the company did report encouraging first-quarter trading, albeit against a weak period a year earlier. However, the fact that the second half of the year tends to be a bigger contributor to overall performance means investors will not be setting too much stall by a strong first three months.

The group is currently undertaking a £240m capital expenditure programme aimed chiefly at improving its UK supply chain. This will push up borrowings, although broker Numis forecasts net debt to peak at a manageable 2.1 times cash profits. The project itself is ultimately expected to produce a 15 per cent return based on cash profits, which should provide a good boost to trading. Unfortunately for investors fretting about the uncertainties in the current year, the benefit is not expected to be seen until 2018. So, while there does seem to be value on offer, nerves may need to settle on a number of fronts before the shares are ready to rerate. But in the meantime, there's a decent forecast dividend yield to stick around for.

Last IC View: Buy, 618p, 31 Jan 2017

 

Shares in specialist equipment hire group Vp (VP.) have had a strong run recently as they've played catch-up after a period of underperforming the peer group. The group has the reputation of one of the safer bets in the highly cyclical equipment hire sector; an industry characterised by huge balance sheet risk, very high sensitivity of profit to changes in sales and economically sensitive end markets.

Vp balances out the inherent risks of the sector by focusing on niche areas, which are less in thrall to the economic cycle. For example, it does a lot work for water companies where there is a reasonably predictable five-year regulatory spending cycle, which is currently just starting to ramp up. It also traditionally makes less use of debt to fund its investment in equipment than many of its peers (this makes returns less racy on the upside as well as the downside). That said, debt has been rising in recent years to fund growth and last year capital investment in the rental fleet increased by 28 per cent to £29.9m, suggesting management is confident about prospects. Indeed, following last year's Autumn Statement the group has expressed optimism about demand from its infrastructure clients.

The group's UK operation drove strong trading in the first half with little impact from Brexit discernable. Vp has been benefiting from strong conditions for housebuilders as well as a pick-up in general construction activity. The international business was bolstered by acquisition last year but has been suffering due to weak demand from the oil and gas sector, where it has noteworthy exposure. On the flipside, that means the pick-up in the oil price should be good news for Vp as clients become emboldened and start investing in their businesses again.

Last IC View: Buy, 759p, 29 Nov 2016