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The eight survivors

Created:

30 April 2009

Written by:

David Stevenson

We've taken the analysis outlined in part one and part two of this article and built it into a screen (our Survivors for 2009 screen, published online in January) using the following measures. We:

1. Ignored any firm with a valuation below £50m;

2 Looked for a dividend yield that is above the market average. We set this at 6.5 per cent or above, both currently and on a projected, rolling basis;

3. Focused on companies with negative net gearing and gross gearing below 10 per cent. We’ve also looked for companies with interest cover of more than five – that means cash earnings can cover the small loan interest bill more than five times;

4. We excluded any company where there’s been a sudden drastic profits warning that could indicate much bigger long-term trading problems that could affect the whole viability of the company.

Eight companies passed this screen – they're all listed in the table below. It's a fairly mixed list with an average forecast yield of just under 10 per cent, plenty of cash and positive cash flow at the operating level.

SocGen's analysis of successful screens

Leading French investment bank Sociétié Générale (SocGen) has also been carefully monitoring what it calls investing "styles" over the past year. These investing styles are various stock-picking strategies that make use of fundamentals-based measures. Their quantitative investing team led by analyst Andrew Lapthorne has crunched the data on a number of key stock-picking strategies and the results tend to back up our own conclusions – the full list of screens used by the SocGen team is detailed in the table below.

■ Simple value strategies failed. According to Lapthorne's team, buying low PE ratio stocks was the worst-performing investment style during 2008 as "collapsing confidence in both historical and forward profit measures undermined the meaning of most valuation measures". Simple dividend strategies also started off badly – too many financials and banks emerged in the screens – but by the second half dividends began to be cut at the weaker companies. According to SocGen the high dividend-yielding companies that remained on its list "were more representative of genuine income stocks than simply being firms who had seen their share prices collapse".

■ Traditional growth-based screens that look at earnings growth were also a dismal failure as earnings projections turned out to be largely a mirage – analysts had systematically over-inflated future earnings growth, and these estimates have since been brutally pared back.

■ Momentum styles also had a difficult year. In the first half this strategy worked brilliantly and identified lots of fast rising commodity shares but when the reversal came it was sudden and brutal. One momentum-based strategy used by SocGen identified companies with a strong share price over the previous three months relative to the market. By June it was up 13 per cent but then proceeded to lose 20 per cent in the following two months. One momentum strategy did seem to work consistently, though: identifying those companies with strong earnings momentum, especially those that produced earnings surprises. A strategy that focused on buying stocks being upgraded (against those being downgraded) by analysts based on earnings estimates would have delivered an annual gain of 14 per cent.

Is Japan the way forward?

So, what's next? Which screens and strategies should investors use over the next few years? One way of finding out what may work in the future is to focus on the one country that's already been through a grinding bear market: Japan. If we're to believe the sirens of gloom, we're now entering a period of rampant deflation, with intense pressure on margins and subdued or even non-existent earnings growth, all of which will combine to produce a deadly decade or two of stop-start bull rallies punctured by bear market falls.

So, if we're about to follow the Japanese into a multi-decade bear market, what are the lessons to be learnt? Luckily Mr Lapthorne's quantitative team has again been crunching the numbers. They compared the pre- and post-bubble stock markets of Japan, starting in the 1980s and finishing in this decade – and their key findings are consistent with their analysis of different stock screens in 2008.

■ In an economy suffering from "anaemic growth and a deflationary environment, value performance actually improved, especially when the metric used did not incorporate a measure of earnings". Put simply: forget earnings as a measure. Mr Lapthorne's team found it difficult to isolate the effect of debt on Japanese share price returns but buying stocks with high dividend yields and strong balance sheets did produce strong returns. In particular, picking stocks with a low price-to-book ratio versus their history proved to be a winning strategy.

■ Price momentum didn't work. But buying the losers and selling the winners became increasingly profitable after the bust in the late 1980s.

■ Other factors such as size, profit margins, return on equity and such like produced inconclusive results.

■ Mr Lapthorne's bottom line is: "The evidence from Japan suggests that most growth plays will eventually disappoint anyway and better protection against anaemic growth and ensuing deflation is to buy the cheap stuff. A value strategy – especially those based on profit-related measures such as price to book or dividend yield, or where profits are cyclically adjusted such as the Graham & Dodd PE ratio – makes sense. Finally, dividend yield coupled with balance sheet strength – a strategy that we continue to recommend – also outperformed."

How the screens compare*

Eight survivors for 2009

SocGen's analysis of successful stock-screening

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