Markets have been tanking and at times like these share price falls often don't discriminate between high- and low-quality businesses. With that in mind, we're revisiting a screen we last ran in December, which attempts to identify the type of high-quality companies where value may emerge as markets tumble and offer rich pickings to nimble investors.
The screen focuses on return on equity (ROE). The ratio attempts to measure what return a company can make on each pound given to it. It is often regarded as representing the limits of a company's growth without access to outside capital. The ratio is calculated as profits after tax as a percentage of shareholders' funds.
How it's done
The results from our December screen were reasonable, but not spectacular. The 15 stocks identified by the screen on average delivered a 1.2 per cent return (based on a comparison of ask-to-bid prices and excluding dealing costs and dividends) compared with a 1.3 per cent fall in the FTSE All-Share. However, there were some major extremes hiding behind that rather benign average.
The overall performance was made significantly worse by the woes of the resources sector. The six resources companies selected by the December screen fell by 15 per cent on average, with Gulfsands Petroleum topping the fallers with a 44 per cent drop. But the screen also had some runaway success, such as Rightmove and NCC Group (see table).
| Company | TIDM | Performance (7 Dec 2010 - 3 Aug 2011) | Forecast PE at Dec 2010 |
|---|---|---|---|
| RIGHTMOVE | RMV | 59% | 20 |
| NCC GROUP | NCC | 39% | 14 |
| NICHOLS | NICL | 14% | 17 |
| FRESNILLO | FRES | 13% | 25 |
| HALMA | HLMA | 8.8% | 17 |
| ABCAM | ABC | 8.4% | 30 |
| SMITH & NEPHEW | SN. | 1.2% | 13 |
| RECKITT BENCKISER GROUP | RB. | -2.6% | 15 |
| RIO TINTO | RIO | -7.3% | 9 |
| DOMINO'S PIZZA | DOM | -7.8% | 31 |
| BHP BILLITON | BLT | -11% | 10 |
| DUNELM GROUP | DNLM | -11% | 17 |
| PREMIER OIL | PMO | -19% | 23 |
| VEDANTA RESOURCES | VED | -23% | 6.3 |
| GULFSANDS PETROLEUM | GPX | -44% | 12 |
| Average | 1.2% | ||
| FTSE ALL SHARE | -1.3% |
Source: Datastream/Capital IQ
The screen
As the screen is looking for quality, we consider size to be important and our search has been restricted to the FTSE All-Share and FTSE Aim 100. The criteria used are as follows.
■ A ROE of 17.5 per cent or more over the last 12 months and over the company's last three financial years.
■ Operating margins of 15 per cent or more over the last 12 months and over the company's last three financial years.
■ Operating margins in the company's last financial year above the level of two years earlier.
■ Forecast EPS growth of 10 per cent or more.
■ Gearing of less than 75 per cent.
Here are the companies that made it through the screen.
| Company | TIDM | Sector | Market Cap | Price | Forecast PE* | Dividend yield |
|---|---|---|---|---|---|---|
| AstraZeneca | LSE:AZN | Pharmaceuticals | £37,912m | 2,783p | 7 | 6.0% |
| Jardine Lloyd Thompson | LSE:JLT | Insurance | £1,370m | 631p | 14 | 3.6% |
| Spirax-Sarco Engineering | LSE:SPX | Industrial | £1,408m | 1,815p | 15 | 2.4% |
| Halma | LSE:HLMA | Electronic equipment | £1,435m | 381p | 15 | 2.4% |
| Experian | LSE:EXPN | Research | £7,759m | 773p | 16 | 2.3% |
| James Halstead | AIM:JHD | Building products | £487m | 468p | 17 | 3.0% |
| Rotork | LSE:ROR | Industrial | £1,492m | 1,726p | 19 | 1.1% |
| Hargreaves Lansdown | LSE:HL. | Asset management | £2,341m | 505p | 22 | 1.0% |
| Domino's Pizza UK & Ireland | LSE:DOM | Restaurants | £807m | 500p | 25 | 2.2% |
| Fresnillo | LSE:FRES | Precious metals | £13,676m | 1,907p | 25 | 1.5% |
| Abcam | AIM:ABC | Biotech | £638m | 352p | 26 | 1.3% |
| Rightmove | LSE:RMV | Publishing | £1,281m | 1,209p | 27 | 1.3% |
| Craneware | AIM:CRW | Healthcare tech | £150m | 560p | 37 | 1.3% |
Source: Capital IQ
*Based on EPS forecast for the next 12 months
This is a screen for companies rather than shares, as valuation and price movements are not criteria. However, the stocks highlighted below are those that we consider to have a reasonable forecast PE ratios. Our definition of this is those with forecast PE ratios in the teens - interestingly, such companies are mainly exporters with strong balance sheets.
The logic behind the valuation yardstick is that a sub-teen PE ratio for a supposedly high-quality company is telling us that all may not be quite as it seems. Indeed, AstraZeneca may have made it through the forecast EPS growth test for this year, but earnings are expected to drop off in the longer term. From our previous screen, stocks with a sub-teen forecast PE ratio on average made a 21 per cent loss.
Any company with a forecast PE ratio above 20 we've considered potentially expensive. Although expensive stocks delivered the best average return from our last screen (10.7 per cent compared with 8.2 per cent for stocks with teen ratings) the returns were a lot more erratic, varying from Rightmove's 59 per cent gain to Premier Oil's 19 per cent loss.
The companies
Insurance broker Jardine Lloyd Thompson has had a number of obstacles to overcome recently. Insurance premium rates are weak and trading in Europe is sluggish, its market is also crowded which limits growth potential. However, the group's heavy exposure to emerging markets has offset these issues and it has also been using acquisitions to bolster growth. In the longer term, recent catastrophes, such as the earthquake and tsunami in Japan, should help push up premiums and aid the performance of the business. The company also expects to benefit from recent investment in staff. The shares are lowly rated relative to US peers.
Steam-engineering specialist Spirax-Sarco has a solid record of growth, a history of returning excess capital to shareholders and retains a strong balance sheet, with £33m net cash at the end of April. The equipment the company makes and sells globally saves energy and therefore becomes more attractive when commodity prices are high, as they still are despite recent falls. Spirax also has good exposure to emerging markets and has been benefiting from strong demand from these regions.
Health and safety equipment maker Halma is seeing growth across its markets aided by global regulatory pressures, which puts it in a reasonably defensive spot. Its 32-year record of growing the dividend by 5 per cent or more each year illustrates the consistency of the business. Over the past year the company has also been fairly acquisitive, but still retains a strong balance sheet - so further acquisitions remain on the cards.
Credit checking is a fast-growing business in developing markets and Experian has been riding this wave while its more mature businesses in Europe and the US struggle with the sluggish recovery. The company has a particularly attractive position in Latin America, which it has bolstered this year through acquisition, and growth in the region was running at 19 per cent in the second quarter. However, the group showed how cyclical it was during the credit crunch, which is a reason for caution based on current economic uncertainties.
Given the questionable health of the commercial and residential property markets and rising raw material prices, you may think of flooring as a bad business to be in. However, James Halstead is showing little sign of breaking its record of 35 years of dividend increases. The group recently said turnover was up 15 per cent in its full-year pre-close trading update. And while trading in the UK and some other hard-hit markets is tough, the group's products are in hot demand from exporters. Further reassurance comes from a balance sheet boasting £30m net cash at the half-year stage.
Valve specialist Rotork earlier this month stunned the market with a set of bumper record results, which sent the shares racing ahead 12 per cent. While they have been giving back those gains since then, the company continues to look in great shape. It boasts a record order book and has been reinforcing growth with acquisitions. The business is also generating cash quicker than it can spend it, which means it is paying an 11.4p a share special dividend. What's more, with a strong balance sheet and continued strong trading, more impromptu payments could be on the cards.
