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High-yield market leaders

The James O'Shaughnessy Cornerstone Value approach continues to do an impressive job at delivering outperformance with similar risk to the index.
February 24, 2016

Over the five years I've run a UK version of the James O'Shaughnessy Cornerstone Value strategy, the screen has done a very impressive job of achieving Mr O'Shaughnessy's key objective of outperforming the market while taking on a similar level of risk (see graph). This strategy was set out by the US quant king in his investment classic What Works on Wall Street and was not aimed at producing knock-out returns but rather offering a better alternative to index funds for investors who were nervous about making bigger losses than the market during down years.

O'Shaughnessy Value vs FTSE 350

 

NameTIDMTotal Return (23 Feb 2015 - 15 Feb 2016)
Amlin*AML39%
BeazleyBEZ26%
InformaINF24%
AdmiralADM21%
Imperial BrandsIMB21%
HiscoxHSX19%
Direct LineDLG15%
InmarsatISAT13%
Catlin*CGL5.7%
British American TobaccoBATS5.5%
Greene KingGNK3.2%
KingfisherKGF-0.8%
DiageoDGE-2.5%
GlaxoSmithKlineGSK-4.3%
AstrazenecaAZN-6.2%
Britvic BVIC-8.5%
HendersonHGG-13%
HammersonHMSO-14%
Jardine Lloyd ThomsonJLT-14%
BPBP.-20%
CarillionCLLN-26%
AntofagastaANTO-39%
Aberdeen Asset ManagementADN-48%
BHP BillitonBLT-49%
Amec Foster WheelerAMFW-53%
Average--4.2%
FTSE 350--12%

*Taken over

Source: Thomson Datastream

 

Once again the screen has produced some solid outperformance of the FTSE 350 index during the past 12 months with a negative total return of 4.2 per cent compared with a negative 11.7 per cent for the index. And while the O'Shaughnessy screen did underperform the market over a 12-month period when I first ran it in 2011, on a buy-and-hold basis all five of the screens I've run since 2011 have produced solid annualised outperformance. In fact, the buy-and-hold records of the screens are superior to the returns generated from rebalancing the portfolio every year, especially after accounting for dealing costs (see table).

YearAnn. OutperformanceFTSE 350O'Shaughnessy Value
20114.5%20.0%49.7%
20128.5%23.6%71.5%
20136.2%4.9%25.7%
20148.2%-6.4%9.6%
20158.5%-11.6%-4.2%
5yr cumulative4.0%20.0%45.9%
5yr cumulative with 1% charge3.0%20.0%38.8%

Source: Thomson Datastream

 

Mr O'Shaughnessy's value strategy is based on his extensive study of historic data. Rather than basing his approach on established stock-picking ideas, he based it on the factors that seemed to have been the best historic predictors of share price performance. At the heart of the cornerstone value strategy is the targeting of "market leading" shares. This essentially means shares in large companies with high liquidity and decent cash generation. Market leaders need to have:

■ A market value of over $1bn. I've set the market value minimum at £500m.

■ More shares outstanding than the average.

■ Higher than average cash flow per share.

■ Turnover of 1.5 times the average or more.

The O'Shaughnessy cornerstone value shares are made up of the 25 highest-yielding "market leaders" from the main market and Aim 100. The original O'Shaughnessy strategy looked at the top 50 shares, so my version of the screen can be considered to be riskier than his as it offers less diversification.

The screen is based on historic dividend yields and a number of the dividends listed in the table of results seem unlikely to be sustained. Indeed, at the time of writing, BHP Billiton has just announced a much-anticipated substantial cut to its payout. Meanwhile Rio Tinto has already announced that falling commodity prices means it will move from a progressive payout policy to a more "flexible" approach. Indeed, an investing rule of thumb is to view any yield of 7 per cent or more with suspicion. That said, these "suspiciously" high historic yields may prove an indicator of contrarian value even if the actual payment is not sustained. The recent ascent of shares in WM Morrisons, despite the fact a dividend cut is forecast, is arguably a case in point (see write up below).

Another issue to note about the dividend yields presented in the table is that some of the payouts reflect a contribution from special dividends. These have been included when the special dividend looks likely to be sustained. Dunelm, for example, has a track record of paying special dividends and while these can be lumpy they are likely to persist, with broker Peel Hunt suggesting the recently announced 31.5p special payment would be sustainable on an annual basis. Elementis's net cash position means it also is expected to continue to pay special dividends. Meanwhile 3i has a stated policy of paying out a proportion of the proceeds from asset sales as special dividends. And the non-life insurers in the table are operating in an industry that is currently awash with capital, which means shareholder returns should remain firmly on the cards in the absence of a major claims event in the sector.

All this year's cornerstone value stocks are listed in the table that follows and the three stocks showing the strongest three-month momentum get write ups below as a taster.

 

WM Morrisons

Shares in supermarket group WM Morrisons (MRW) have been on a run since the group reported Christmas trading well ahead of expectations. A 0.2 per cent increase in like-for-like sales compared well with a negative 2 per cent pencilled in by analysts. Like-for-like volumes were up by 1.3 per cent in the period, too, suggesting the group has been winning back shoppers to its stores. This looks a very encouraging performance against a backdrop of food-price deflation and the ongoing assault on the sector's big players by discounters - Aldi and Lidl.

The strong festive sales numbers are being seen as a possible early vindication of the strategy adopted by the retailer's new chief executive, David Potts. Mr Potts has sought to refocus the group on its main stores while attempting to shore up profitability with cost cutting. The company has been selling its convenience stores and could also off-load its manufacturing assets. Combined with the group's cash flows, proceeds from the disposals are helping to give Morrisons more lee-way to invest in its products and stores as it attempts to fend off the challenge from the sector's upstarts and stabilise margins.

Unfortunately, any improvement in trading may well come too late for the dividend given the scant cover. While cash flows have been improving under the new management and free cash flow is expected to balloon to £450m this year helped by property sales and a cut in capital expenditure, broker JPMorgan expects free cash generation to drop back to about £250m a year in the longer term. On this basis, the broker forecasts a drop in the dividend to 5.46p, which represents a 3.1 per cent yield. The company is expected to give an update on its dividend policy in March.

From a valuation perspective it's of note that the shares trade at close to book value which includes around £8bn of property assets. The high-teens forecast price-to-earnings ratio meanwhile points to hopes that earnings will recover over time. Earnings for the year to the end of January 2016 are expected to be less-than-half that achieved in 2014.

Last IC view: Hold, 168p, 10 September 2015

 

Persimmon

House builder Persimmon (PSN) is trying not to get carried away during a boom period for its industry. In order to stop itself overspending on land and pushing prices up, the company has committed to returning excess capital to shareholders. Conditions are so good, that the company this week has increased its capital return plans saying shareholders will get 110p for each of the next five years.

The company looks in an exceedingly strong position to make this promise and several analysts even think Persimmon is being too conservative. A combination of tight housing supply and government policies that are stoking demand have put the housing industry in a sweet spot, which helped Persimmon raise revenue by 13 per cent last year. Operating margins are also screeching ahead and hit 23 per cent in the second half of the last financial year leading to a 34 per cent increase in operating profits. All this is helping to substantially boost cash generation. The group ended the year with net cash of £570m and a very well invested land bank which should be enough to cover 6.5 years of output.

While nervousness about the housing market persists, Persimmon is not exposed to the high-end London market where there are signs of a slowdown. What's more, supply problems look unlikely to be resolved any time soon and while curbs on buy-to-let may dampen one source of demand for new homes other government policies, such as help to buy, continue to stoke the already hot market with operationally-geared house builders as key beneficiaries.

Last IC view: Buy, 2,067p, 23 February 2016