Buying shares that are trading in deep-value territory is a risky strategy, but it can also be extremely rewarding. Contrarian maestro David Dreman is a man who believes the rewards from deep-value investing are well worth the risks and, over the past three years, the screen I've run based on his approach has borne out this view. That said, the difficult market conditions of the past 12 months have made it tougher for the strategy to outperform the market, with a total return over the period from the screen of negative 6.2 per cent compared with a negative 7.0 per cent from the FTSE All-Share.
On a cumulative basis, over the past three years the screen has now delivered a 62.2 per cent total return, compared with 10.9 per cent from the FTSE All-Share. If I factor in an annual charge of 1.5 per cent to account for the notional cost of switching between the screen's portfolios, the return drops to 55 per cent.
The worst performing of last year's six share picks was a stock that arguably, on the surface, looked the most reliable: former retail darling Next (NXT), which qualified as a Dreman stock thanks to its high yield. This was based on its special dividend payout, which I decided had good potential for being sustained as the company had switched from returning money through buybacks to paying a special dividend due to the price level reached by its shares. But Next's recent share price falls, caused by a deterioration in trading, mean buybacks look like a more likely use of any excess cash in the future.
2015 performance
| Name | TIDM | Total Return (26 May 2015 - 20 May 2016) |
|---|---|---|
| Berendsen | BRSN | 21% |
| LondonMetric Property | LMP | 6.0% |
| Hansteen | HSTN | -6.5% |
| Legal & General | LGEN | -11% |
| U And I | UAI | -23% |
| Next | NXT | -24% |
| Dreman | - | -6.2% |
| FTSE All Share | - | -7.0% |
Source: Thomson Datastream
Last year's screen wasn't helped by its focus on property stocks, either. Mr Dreman is of the view that concentrating bets on individual sectors can be a very good idea for contrarian investors. From this perspective, the share picks for 2016 look a rather more diverse bunch, although property and housebuilding are reasonably well represented. The stocks must be among the cheapest quarter based on one or more of: dividend yield (DY); price/earnings (PE); forward next-12-month price/earnings (Fwd NTM PE); price-to-cash-flow (PCF); or price-to-book-value (PBV). The rest of the screen's criteria vary slightly depending on which value test a stock has passed. The criteria are:
■ Year-on-year EPS growth in the most recent half-year. ■ Forecast EPS growth for each of the next two financial years. ■ A current ratio of more than 1. ■ Above-average dividend yield (excluding cheap P/BV stocks). ■ Dividend cover of 1.5 times or more, or greater than the five-year average (excluding cheap P/BV stocks). ■ Above-average five-year dividend compound annual growth (excluding cheap P/BV stocks). ■ Gearing of less than 75 per cent or net debt/cash profits of less than 2.5 times. ■ Market capitalisation of £200m or more. |
The screen is conducted on the FTSE All-Share. This echoes Mr Dreman's focus on reasonably sized companies were signs of extreme value are less likely to prove to be an indication that a company is in a state of collapse. Nevertheless, this screen remains high-risk. And while the performance I have monitored over the past three years has been strong, it should be noted that an earlier version of the screen came a cropper due to a poorly timed focus on mining stocks. Unfortunately, it is not possible to build the performance of that early screen in with the current version as I originally conducted the screen in several parts over a couple of months, focusing on a different valuation measure each time.
This year, nine stocks have passed the screen's tests. These deep-value share picks are listed in the accompanying table and I've taken a closer look at three of the qualifying shares below.
Deep-value Dreman share picks
| Name | TIDM | Mkt Cap | Price | PE | Fwd NTM PE | DY | Div Cov | PBV | PCF | FY EPS gr+1 | FY EPS gr+2 | 3M Mom | Net Cash/ Debt(-) | Cheap |
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Admiral | ADM | £5.0bn | 1,873p | 17.5 | 17 | 6.1% | 1.1 | 8.1 | 16 | 0.1% | 4.0% | 8.5% | £39m | DY |
| Bovis Homes | BVS | £1.3bn | 990p | 10.4 | 9 | 4.0% | 2.6 | 1.4 | 17 | 16% | 12% | 13% | £30m | PE, Fwd PE |
| Dunelm | DNLM | £1.9bn | 951p | 18.9 | 18 | 5.6% | 2.3 | 14.2 | 12 | 5.3% | 7.6% | -2.0% | -£29m | DY |
| Galliford Try | GFRD | £1.1bn | 1,335p | 11.0 | 10 | 5.4% | 1.8 | 1.9 | 81 | 12% | 18% | -0.8% | -£109m | DY, Fwd PE |
| Kennedy Wilson Europe Real Estate | KWE | £1.5bn | 1,075p | 5.6 | 17 | 3.7% | 5.5 | 0.9 | 12 | 28% | 59% | 1.6% | -£1.1bn | PBV |
| Legal & General | LGEN | £13bn | 225p | 12.5 | 11 | 5.9% | 1.5 | 2.1 | - | 8.7% | 6.7% | 2.8% | £263m | DY, Fwd PE |
| McKay Securities | MCKS | £213m | 229p | 4.0 | 26 | 3.8% | 6.7 | 0.9 | - | 59% | 2.3% | -4.7% | -£144m | PBV |
| Go-Ahead | GOG | £1.1bn | 2,563p | 19.1 | 15 | 3.6% | 1.5 | 16.4 | 4 | 18% | 16% | 8.5% | £315m | PCF |
| Trinity Mirror | TNI | £351m | 126p | 4.2 | 3 | 4.1% | 6.2 | 0.5 | 7 | 7.1% | 0.1% | -15% | -£92m | PBV |
Source: S&P CapitalIQ
