Five cheap contrarian plays

But if there is a lesson to be drawn from the disappointing one-year performance of the screen (stocks have on average delivered a negative total return of 3 per cent compared with a positive 16.7 per cent from the FTSE All-Share), it is perhaps to emphasise what an important steer the market itself can give when it comes to distinguishing between stocks that are genuinely cheap and those that are cheap for a reason. The main calamity of our Dreman screens last year (we actually ran three different screens based on dividend yield (DY), price to book value (PBV), and then price to cash flow (PCF) and price to earnings (PE)) was that they picked a number of resources stocks, which have all performed badly. The screen looks for profits growth in the most recently reported half-year period and forecast earnings growth as pointers to prospects. But earnings can quickly slide and brokers are notoriously slow about downgrading their forecasts, which means stocks that are cheap because prospects are rapidly deteriorating can still pass these tests. This has been characterised by the change of sentiment and fundamentals seen in the resources sector over the past year. Three-month momentum would arguably, over the short term at least, provide a better guide than testing fundamentals.

Only one of the 10 stocks that passed the Dreman screens last year actually showed three-month momentum that was better than that of the market before its selection. That stock, Hill & Smith delivered the second best total return over the period, of 36 per cent compared with 16 per cent from the FTSE All-Share. But were we to simply have backed the half of the Dreman portfolio that showed the best three-month momentun at the time of the screens, the total return to date would have been 4 per cent compared with a negative total return of -10 per cent from the half with the worst momentum. That said, the best performer, Computacenter (+ 51 per cent), was also the stock with the worst three-month momentum when it was selected. But the stock with the second worst three-month momentum, Petropavlovsk (-70 per cent), was the worst performing share out of the 10 and more than offset any gains from holding Computacenter.

We wouldn't write off any screen on the basis of a disappointing year, especially a screen that is specifically focused on the long term. And we also wouldn't tamper with the screening criteria advocated by an investor with as august a reputation as that of Mr Dreman, although we have included three-month momentum in our accompanying tables. We're rerunning his screen again on the same basis as last year. The screen starts by selecting the cheapest 25 per cent of stocks with market caps of over £200m on the basis of DY, PE, PCF or PBV. The stocks then have to pass the following tests:

■ EPS growth in the most recent half-year

■ Forecast EPS growth

■ A current ratio of more than 1

■ Above-average dividend yield

■ Dividend cover of 1.5 times or more, or greater than the five-year average

■ Above-average five-year dividend compound annual growth

■ Gearing of less than 75 per cent

Only five 'cheap' stocks passed all the tests.

FIVE CHEAP CONTRARIAN SHARES

Henderson Group (HGG)

The ratios used by Dreman to identify value are fairly broad brush and may not always capture the nuances in particular sectors. Henderson, which comes through the Dreman high-yield screen, does not look very noteworthy on the valuation front when compared with peers on the basis of its enterprise-value-to-cash-profit ratio, which is frequently used to value fund managers. Nevertheless, there could be a potential catalyst for a re-rating later this year. That's because Henderson has experienced net outflows of funds for some time due in part to its significant exposure to Europe and a fund-rationalisation programme following some large acquisitions. But the outflows could be set to reverse in 2013. Analysts at Edison Investment Research think this could happen in the fourth quarter. The final quarter of 2012 showed the lowest level of outflows since the first quarter of 2011. What's more, weighted by size, 73 per cent of funds outperformed in 2012 and 69 per cent where up against their benchmarks over three years. Strong performance is expected to prove a particularly attractive quality for fund managers to boast about following the retail distribution review (RDR), which bans fund managers from enticing advisers with the promise of generous commission (last IC view: Hold, 151p, 27 Feb 2013).

Cheap: DY

Source: S&P CapitalIQ

Legal & General (LGEN)

Legal & General is pursuing a strategy of growth based on making bolt-on acquisitions and expanding into promising overseas markets - currently only 12 per cent of the business is outside the UK. To this end, the group recently spent £131m buying the 75 per cent of fund sales platform Cofunds that it did not already own. Broker Panmure Gordon forecasts that the growth of such platforms is set to double by 2017. Management highlighted at the time of the full-year results that it could spend between £500m and £1bn in its acquisition drive, so there should be more to come. The company is particularly interested in expansion in the US, Gulf states and Asia as a way to diversify earnings away from its highly competitive home market. Dividend cover has recently slipped from the target of two times following a 20 per cent increase in 2012, but still looks comfortable (Last IC view: Hold, 164p, 6 Mar 2013).

Cheap: DY, PCF and PE

Majestic Wine (MJW)

Shares in wine retailer Majestic have ambled downwards while the wider market has rallied. The market reacted badly to the weak trading caused by last year's poor summer weather and low like-for-like growth over Christmas following a strong showing in 2012. Weak consumer demand is a concern and the winding down of the company's wholesale business has caused sales to fall, but it should be good for profits in the long run. However, there are reasons for optimism in 2013. The company faces easier comparatives and wholesale should no longer be such an issue. The group is also trying to broaden its appeal and is expected to increase investment in its online business and in advertising this year. So while the consumer backdrop remains negative, there are grounds to hope that interest in Majestic's long-term growth story could be reignited. Broker Espirito Santo is forecasting strong dividend growth in the coming years with a 16p payment pencilled in for the recently completed financial year, followed by 17.5p then 18.8p giving respective yields of 4 per cent, rising to 4.4 per cent, and then 4.7 per cent (Last IC view: Hold, 466p, 19 Nov 2013).

Cheap: DY

Amec (AMEC)

Demand for the type of oil services provided by Amec has been restrained for a number of years, but it looks as though that may be set to change. The value of demand for oilfield services has recently returned to 2008 levels, which was before the downturn in spending occurred. As well as an anticipated general rise in spending, the company is likely to be a beneficiary of a marked increase in investment in North Sea oil, which has been encouraged as a result of increased certainty in the UK's tax arrangements following an earlier policy gaffe that had the opposite effect (see: 'Tax certainty prompts £100bn North Sea surge'). But the oil price is still a key consideration and, like other commodities, there have been recent jitters in the market. Nonetheless analysts expect Amec's recent robust performance to continue and margin improvements should help EPS advance to management's target of 100p or more by 2015, which compares with 80.4p achieved in 2012. Amec's operations in mining and nuclear face challenges. Still, the company's strong balance sheet, which funded a £400m share buyback last year, should support the attractive dividend yield. And while the buyback has not been continued into the current year, the dividend has been hiked 20 per cent. The shares look reasonable value compared with peers based on their forecast PE and the sector looks cheap by historic standards (see Sector Focus: 'Buy cheap oil services sector ahead of coming boom'). Last IC view: Buy, 1,050p, 28 Feb 2013

Cheap: DY

Prudential (PRU)

Recent 2012 results from insurance company Prudential happily distinguished the company from dividend-cutting peers. As if to rub salt into the wounds of holders of stocks such as Aviva, the Pru hiked its dividend payout by 16 per cent - the second big increase in three years. The company is experiencing particularly strong growth in Asia, and North America is also performing well. In fact, Asia now accounts for about a third of the life business's profits. But the company's conglomerate-like nature is considered to be holding the shares back. Broker Shore Capital predicts this will soon change based on its view that if management cannot convince the market of the advantage of its current structure, it will be pressured into looking at its corporate options. The broker puts a sum-of-the-parts valuation on the company of around 1,250p, suggesting some decent upside from this perspective (Last IC view: Buy, 1,051p, 13 Mar 2013).

Cheap: PE