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19 recovery and cyclical plays

My Late Bloomers screen has highlighted 19 stocks with recovery potential trading at a low multiple of sales
May 9, 2017

Since I started to track my Late Bloomers strategy three years ago, it's fair to say that it has yet to really come into bloom, and over the past 12 months it has actually underperformed the index. But the principle behind the approach remains worth pursuing. The screen looks for companies that are valued at a low multiple of sales and offer upside based on their historic price-to-sales (PSR) valuation range. On the basis that stocks tend to be priced at low multiples to sales when the profits from those sales are low, the screen also looks for signs that there may be the potential for profit margins to increase.

This is a stock-hunting approach that is arguably best suited to rooting out recovery and cyclical plays. The results from this year's screen seem to bear this out, not least because the IC's Recovery Tip of the Year - RPS - is among the stocks identified. That said, the screen's insistence that companies picked have rising sales meant that last year it missed out on the massive recovery play that was the resources sector. This is one of a few tests thrown into the screen to try to eliminate basket-case stocks. The full criteria are:

 

■ PSR of less than one.

■ PSR at least one-third below 10-year peak.

■ Ebit margin at least a third below 10-year peak.

■ Net debt of 1.5 times cash profits or less.

■ Rising year-on-year sales in the past six months.

■ Positive free cash flow.

nb financials are excluded from this screen

 

In all, the 15 stocks selected 12 months ago delivered a 9.7 per cent total return compared with 21.5 per cent from the market.

 

2016 performance

 

NameTIDMTotal return (16 May 2016 - 1 May 2017)
SeverfieldSFR81%
Robert WaltersRWA42%
Morgan SindallMGNS39%
HaysHAS36%
HeadlamHEAD32%
Bloomsbury PublishingBMY18%
GraftonGFTU14%
LakehouseLAKE1.1%
SThreeSTHR-0.2%
HalfordsHFD-2.6%
StagecoachSGC-13%
CarpetrightCPR-20%
DebenhamsDEB-26%
Go-AheadGOG-28%
FlybeFLYB-29%
FTSE All Share-21%
Late Bloomers-10%

 

Source: Thomson Datastream

 

The poor run relative to the market last year almost erodes the outperformance the screen established previously, taking the cumulative total return to 23.4 per cent compared with 20.6 per cent from the FTSE All-Share over the same period. If I factor in an annual charge of 1.5 per cent to account for the notional cost of reshuffling the portfolio each time a new screen portfolio is published, the total return falls to 17.9 per cent - inferior to the index.

 

Late Bloomers

 

 

 

In all, 19 stocks passed the screen's tests this year. These are listed in the table below, which is ordered from cheapest to most expensive based on PSR. I've also taken a closer look at a stock from the top, middle and bottom of the table.

Thomas Cook

When a company's sales produce a low and erratic level of profit, the market tends to be unwilling to put much of a price on them. That's the basic story behind the low valuations offered by travel companies such as Thomas Cook (TCG). The company is at the mercy of many unpredictable external factors, such as terror attacks, strikes and freak weather events. It is also very sensitive to the general state of the economy, as well as other factors outside its control such as the oil price and currency (hedging is used to help planning). As if all this was not enough of a burden, the industry has the unfortunate habit of overexpanding when trading is good for a decent period, which has the effect of eroding returns and making any subsequent deterioration in fortunes all the worse. And traditional travel agents also face the existential threat of the unbundling of the package holiday as consumers are increasingly putting together their own holidays using online services.

But putting the above caveats aside, the news from Thomas Cook recently has been broadly encouraging, with the company reporting good demand across all its markets. Summer holiday bookings were up by a tenth when it updated the market in late March.

The company is also looking to benefit from increasing its focus on the quality of the service it provides to try to secure more repeat bookings and attract new customers. To do this, the tour operator has been focusing on sending holiday-makers to a smaller number of better monitored hotels, as well as increasing the use of its own-managed hotels. Customer satisfaction ratings suggest these actions may be bearing fruit.

But the business has seen more competition in certain parts of the market (Brits going to Spanish Islands, for example), which could put pressure on margins. The group's German airline operator, Condor, is also seeing margin pressure, although bookings are up. Indeed, there are some grounds to think that rather than having margins that are on the up (the type of situation this screen hopes to identify), the reverse could prove true. Indeed, in two of Cook's divisions (UK and Northern Europe), underlying operating margins were actually at record levels last year (last IC View: Buy, 85p, 9 Feb 2017).

Hays

Regular readers of this column may be aware that I often use company write-ups to highlight weaknesses of key metrics used by screens. From the perspective of the price-to-sales ratio, recruitment companies such as Hays (HAS) certainly highlight a potential flaw. That's because much of the turnover reported by recruiters simply represents wages that are passed directly on to temporary staff placed by the company. This is why the industry encourages investors to focus on net fee income (NFI) rather than turnover, and conversion ratios (operating profit as a proportion of NFI) rather than a conventional operating margin. But I like to keep the screens as 'warts-and-all' as possible and Hays has some merits as an investment at the moment.

In particular, Hays is benefiting from its international reach. While the UK jobs market has been slow since the Brexit vote and is unlikely to be helped by uncertainty ahead of the general election, this only accounts for a quarter of the group's NFI. Indeed, strong growth in Europe and the Asia Pacific region meant recently reported third-quarter underlying like-for-like NFI growth for the group as a whole came in at an impressive 8 per cent. What's more, while like-for-like NFI was down 4 per cent in the UK, the rate of decline is slowing, suggesting a recovery may not be too far off.

While the company is continuing to invest in growing its headcount, particularly in Europe, its coffers are swelling, with net cash reaching £45.7m at the end of the third quarter. Brokers think net cash could reach £100m by the year-end. Given Hays' policy of returning any net cash over £50m to shareholders, a special dividend looks likely. Brokers have also been persistently upgrading earnings per share (EPS) forecasts since the Brexit vote (the referendum outcome itself caused downgrades) and the growing optimism has helped push the shares higher.

While forecast upgrades are encouraging, there is arguably less scope for margin improvements than this screen would typically be hoping for. Indeed, Hays already boasts a sector-leading conversion ratio and this measure of profitability actually fell marginally during the third quarter. Still, while Hays does not fit the screen's brief brilliantly due to the nature of its top-line numbers, there are good grounds to be positive about its prospects (last IC View: Buy, 170p, 20 Apr 2017).

Rolls Royce

The past three years haves seen aerospace and defence giant Rolls-Royce (RR.) succumb to a string of profit warnings, followed by a management overhaul, a dividend cut and significant ongoing restructuring. Many problems have contributed to the dismal state of affairs at Rolls, but a key concern for investors has been the disconnect between the company's reported profits and its much more meagre cash flows.

The issue Rolls has had with cash generation centres around its heavy investment in developing new products and selling them at a cash loss in the expectation of securing valuable 'aftersales' work further down the track. Recording a portion of the expected profit from future aftersales work upfront has been a key cause of the cash-conversion conundrum. Indeed, the introduction of a new accounting standard relating to revenue recognition (set to become effective at the start of 2018) has meant brokers have had to scale back sales and profit forecasts, and there could be a marked fall in book value.

Problems at Rolls have also been exacerbated by the early retirement of some plane engines, which hit existing aftersales work. The low oil price has also had a very damaging effect on the marine division. Meanwhile, a £671m fine from UK, US and Brazilian bribery and corruption investigators has hit sentiment, as did a massive writedown last year relating to currency hedges.

But there are hopes that the worm could turn in the years ahead. As well as the action taken by new chief executive Warren East to cut costs and stabilise the business, the company is now expected to start benefiting from the heavy investment it has made in the civil aviation operation. Indeed, there are hopes that free cash flow could exceed £1bn by the end of the decade. Increased US military spending also bodes well and, as a big dollar earner, currency movements have benefited reported numbers - albeit with the dollar more recently going into reverse against sterling. And a wobbly but higher oil price means there are grounds to hope trading could improve at the marine business, too (last IC View: Hold, 698p, 14 Feb 2017).

 

19 late bloomers

 

NameTIDMMkt CapPricePSRFwd NTM PEDYEPS grth FY+1EPS grth FY+23-mth MomNet Cash/ Debt(-)
Morgan SindallMGNS£466m1,060p0.18123.3%12%13%29%£208m
Thomas CookTCG£1.5bn96p0.19100.5%17%19%6.4%£195m
CarillionCLLN£957m223p0.2278.3%-4.7%3.2%4.6%-£219m
DebenhamsDEB£629m51p0.2786.7%-16%-11%-3.2%-£217m
Robert WaltersRWA£324m454p0.33161.9%13%12%25%£23m
CapeCIU£290m241p0.3482.9%6.2%-0.1%27%-£78m
Wm Morrison SupermarketsMRW£5.6bn240p0.34202.3%--2.1%-£1.2bn
Dixons CarphoneDC.£3.9bn336p0.38112.9%5.9%4.6%6.8%-£285m
SThreeSTHR£416m325p0.43154.3%5.1%14%2.6%£10m
HaysHAS£2.5bn171p0.53171.7%13%6.5%13%£48m
HalfordsHFD£733m374p0.69134.5%-8.4%-2.2%3.3%-£65m
Grafton GroupGFTU£1.8bn746p0.70151.8%3.9%8.3%28%-£96m
Speedy HireSDY£287m55p0.82251.3%175%4.1%10%-£86m
Anglo AmericanAAL£15bn1,107p0.826-32%-25%-22%-$7.1bn
AO WorldAO.£619m135p0.86-----14%£21m
SavillsSVS£1.2bn929p0.88143.1%-5.7%5.3%20%£188m
RPSRPS£552m254p0.95153.8%0.9%10%2.2%-£83m
Bloomsbury PublishingBMY£128m171p0.96153.8%-23%-3.6%1.0%£9m
Rolls-RoyceRR.£15bn812p0.99241.4%11%3.7%22%-£617m

 

Source: S&P CapitalIQ