Seven solid growth and income shares

Given the breadth of stock screening possibilities it is perhaps inevitable that some screens will chime with investors more than others and it is probably fair to say the screen based on the investment strategy of legendary US fund manager John Neff became a particular obsession of this column last year. We used the screen, softened up to take account of the markets in question, to select shares in the UK ('Slow-but-steady winners', 31 Jan 2012), Ireland ('Five Irish recovery plays', 10 Jul 2012) and the other so-called PIGS (Portugal, Ireland, Greece and Spain 'Five picks from the PIGS', 4 Dec 2012). In addition, we also used his favoured valuation metric (more of which later) in two other screens.

It is therefore gratifying that the first Neff screen we ran for UK stocks has substantially outperformed the market over the past year. Indeed, even bearing in mind that this has been a very good time for the market, and an exceptional period for many of the screens we ran 12 months ago, the Neff screen results are very impressive. Our Neff stocks have delivered a total return (share price movement plus dividends) of 31.4 per cent, compared with 16.6 per cent from the FTSE All-Share (see table).

Source: Datastream

At the helm of the Vanguard Windsor fund, Mr Neff produced average returns of 13.7 per cent a year over 31 years, compared with an average of 10.6 per cent from the S&P 500. Perhaps the key allure of the approach used by Neff to achieve these results is that, arguably, it is one of the most complete strategies possible to construct a screen around.

Neff's favoured valuation metric, the price-earnings-to-total-return ratio (PE/TR), coupled with the other screening criteria, endeavours to value shares against dividend payments, earnings and solid earnings growth prospects. The screen is also very much focused on a buy-and-hold approach. If everything goes to plan, investors can happily enjoy handsome dividends from Neff stocks and capital growth based on earnings increases, while waiting for the market to wake up to their true attractions and prompt a re-rating.

Mr Neff did not want to buy shares that were so cheap that it suggested they had serious problems, nor did he want to buy shares that were so expensive they risked being priced to fail. The screen therefore starts by eliminating the quarter of stocks that have the lowest PE ratios in the market and the quarter that are most expensive on a PE ratio basis. The stocks are then screened for the following factors, which attempts to discern companies displaying solid long-term growth characteristics from those that are having trouble or those that are growing at a high rate that is likely to prove unsustainable.

Mr Neff's PE/TR ratio is then used to assess which stocks the market is overlooking. For our PE/TR calculation we've taken the historic PE ratio divided by the dividend yield plus an average of the five-year EPS CAGR and forecast underlying EPS growth for the coming 12 months.

Following such a strong run by the market there is a lot less value about than a year ago. Whereas last time we only selected stocks valued at a 50 per cent discount to the median PE/TR valuation, this year we are focusing on stocks that are simply below the median PE/TR of 1.14. The shares that passed the test are listed in order of cheapest first.

SEVEN SOLID GROWTH AND INCOME SHARES

Admiral

Motor insurer Admiral has gone from being a growth stock to a high-yielding slow-growth stock. The big question for investors is whether it is heading towards becoming a no-growth stock, which would put its highly attractive, but barely covered 7 per cent forecast dividend yield under threat. The company is facing a cyclical downturn in its end market and has already showed signs of pricing and volume growth coming under pressure. It has also been hit by the banning of accident injury referral fees and the OFT continues to investigate certain practices of the industry. The big unknown is how fast the slowdown in the industry will develop and how far it will go. Admiral's profits are particularly sensitive to volume slowdowns. While the stock passed our forecast growth test based on consensus predictions for the next 12 months, broker Investec actually expects EPS growth to slow to below 3 per cent both this year and next and puts a 520p sum-of-the-parts valuation on the stock. While our Neff screen rates this as the cheapest share that passes its test, there are clear reasons for the apparent value and the stonking great yield (last IC view: Hold, 1,163p, 30 Aug 2012).

Source: S&P CapitalIQ

Kentz

Sentiment toward specialist resources sector engineer Kentz has been hit by economic uncertainty along with a number of profit warnings from its peers. But there have been few signs of weakness from Kentz itself. A trading update earlier this month confirmed EPS growth expectations for 2012 of 16 per cent, while also reporting further growth in the group's order backlog, which covers 65 per cent of budgeted revenue for 2013. There was also little sign that prospects were worsening with the group's pipeline of new projects rising 32 per cent on a year-on-year basis to $13.2bn. What's more, there could be some excitement coming this year from the expected announcement of the group's medium-term strategy. Given the cash on the group's balance sheet, it has significant ammunition to make earnings-enhancing investments. Stripping out the cash, broker Investec points out that the company trades on a forecast PE ratio equivalent to 7.3 times, which values it on a par with rivals that, unlike Kentz, have warned on profits recently. It's not hard to see the potential for a re-rating here, especially if the global economy gets on to a firmer footing in 2013 (last IC view: Buy, 390p, 30 Aug 2012).

Sports Direct

Sports Direct is the only company qualifying as a Neff stock that is not currently paying a dividend. But this is not a reflection of weak profits. Indeed, 2012 was something of a bumper year for the retailer, which was reflected in the 22 per cent first-half sales growth reported by the group shortly before Christmas. Not only was the company helped by the summer of sport in the UK, but the failure of a big rival, JJB, gave it a market share boost. Sports Direct also bought some JJB assets from the administrator, which should boost its future trading. Underlining the confidence in its ongoing prospects the company has proposed higher targets for a management share-bonus scheme. The really exciting growth potential for the group comes from the prospect of increasing internet sales which, after 54 per cent growth in the first half, account for 12.5 per cent of the total. Brokers think the group may replicate the success of retailers such as Next and Asos by using the internet to generate a growing proportion of revenues from overseas (Last IC view: Buy, 294p, 23 Jul 2012).

Wynnstay

Agricultural supplies and specialist retail business Wynnstay last week reported record full-year results and the good news is that prospects remain bright. The most impressive performance in 2012 came from its agricultural division, which accounts for 45 per cent of profits. Revenues rose 9 per cent while operating profits jumped 23 per cent. A key contributor to the strong performance was the grain division, which was rebranded following an acquisition. The development in this part of Wynnstay's operations reflects a broader strategy to act as a consolidator in the fragmented agriculture market while using acquisitions to diversify its markets, thereby hopefully smoothing performance from year to year and increasing the group's geographic spread. A robust balance sheet means Wynnstay is in a good position to continue on the acquisition trail while also investing in its specialist retail business, which comprises 21 Just for Pets shops and 31 Wynnstay Stores. In the longer term, the group should benefit from structural growth in the agriculture sector caused by demographic changes (last IC view: na).

Dignity

The acquisitive-growth strategy of the UK's only listed funeral home company, Dignity, took a big step forward this month. It is acquiring Northern rival Yew, one of the few remaining UK funeral-home operators of decent scale. The acquisition will increase the size of Dignity's estate by 6 per cent. The deal makes a lot of sense as there is minimal overlap between the location of Yew's 40 funeral homes and two crematoria and those of Dignity. What's more, Yew is considered a well-run business and brokers think it should be fairly easy to integrate. There is also the potential for Dignity to push up the prices Yew charges. Some brokers have quibbled at the price being paid for Yew, though, which is equivalent to 11.2 times cash profits compared with a multiple of about 10 times that is usually paid for smaller operations. Nevertheless, modest EPS forecast upgrades of 1 to 2 per cent are being pencilled in by brokers. Meanwhile, Dignity's investment case continues to be underpinned by demographic changes, the potential to win market share and its pricing power. Broker Numis reckons long-term prospects remain good for earnings growth of about 8 per cent a year and a return of capital equivalent to about 5 per cent a year. Broker Panmure Gordon has a target price of 1,312p on the shares based on a slight valuation discount to Dignity's international rivals (last IC view: Buy, 855p, 31 Jul 2012).

British Sky Broadcasting

The market has been pessimistic about the prospects for British Sky Broadcasting for a while. The main fears centre on increased competition in the pay-TV and free-TV box markets. The increased number of options being offered to consumers could hurt BSkyB's subscriber base, while the cost of securing broadcasting rights to major sporting events is rising with the entry of the likes of BT, which needs to secure must-have content for its new services. But BSkyB's scale provides it with an advantage over rivals when it comes to buying programmes. It also has used its strong cash generation to invest in new services, such as its NOW TV movies-on-demand package. And bundling, whereby pay-TV subscriptions are offered alongside telephone and broadband services, is proving a success for the group. Cash is also being used to fund buybacks with a £500m return planned for this year and broker Investec reckons a £1bn buyback may be affordable in 2014. The shares' rating looks lowly for the media sector and BSkyB's prospects may turn out to be better than the share price currently implies (last IC view: Buy, 720p, 2 Aug 2012).

Whitbread

Whitbread has enjoyed consistently impressive growth over recent years. Like-for-like sales continue to rise at a very impressive clip at its Costa Coffee chain while the group rolls out new stores in the UK and internationally as well as self-service coffee machines. Meanwhile, the restaurant chains and Premier Inn Hotel businesses are benefiting from a solid trading backdrop and ongoing investment in new sites. The group may extend its current growth plans when it reports full-year results, which are expected in April. Broker Shore Capital sees little slowdown in growth in the coming years. It has forecast EPS CAGR of about 8.9 per cent over the next three years, along with annual dividend growth of about 10 per cent. What's more, the broker believes the investment needed to deliver this growth is unlikely to damage the balance sheet. In fact, net debt as a proportion of cash profits is forecast to fall to below one times by 2016 compared with about 1.1 times now (last IC view: Hold, 2515p, 11 Dec 2012).