Great returns from great expectations

Source: S&P CapitalIQ

What's more, while screening strategies like this one can come a cropper at any time, the strong showing from the great expectations screen is not a one off. The screen also produced very impressive outperformance the first time I ran it at the end of 2011. Indeed, the cumulative total return (not accounting for spreads or dealing costs) from the screen is 98.5 per cent over the last two years compared with 35.4 per cent from the FTSE 350 over the same period (see graph). The return from the top five stocks selected by the screen is actually below the performance of the portfolio as a whole, which is largely down to the fact that Anite, the sole underperformer in 2013, was among last year's top picks.

Source: Datastream

It seems likely that a contributory factor to the very strong showing is this screen's bullish character, which looks a good fit with the general mood of the market over the past couple of years. Essentially, the screen looks for stocks which have had large upgrades to earnings forecasts over the preceding 12 months, are forecast to produce good earnings growth, and have also been experiencing strong share price momentum. These factors are largely indicators of strong and improving sentiment towards a stock, which is likely to be aided by improving conditions and sentiment in the wider market. Little surprise then that our top five picks - see below - are dominated by stocks with strong cyclical and structural recovery stories.

Given the nature of the portfolio, it could be painful for this screen if there is a sharp reversal in the economy and the market's mood. Indeed, as with last year, housebuilding remains a significant theme among the picks and consequently a source of major risk.

I've made the screen a bit more stringent this year by looking at forecasts for one and two financial years rather than just one year as I have done previously. But, once again, 16 stocks have passed all the tests. I've provided brief write-ups of the five stocks that have experienced the largest upgrades below, and the rest of the portfolio is included in the accompanying table.

EXPECTING GREAT THINGS

Thomas Cook

Recovery wonder-stock Thomas Cook (TCG) is the great expectations screen's runaway favourite. The shares have rocketed over the past year by a giddying 370 per cent, while broker forecasts have also soared. For a travel agent, the shares hardly look cheap on a forward PE basis, given the low quality nature of earnings due to limited bookings visibility and vulnerability to numerous outside factors - from fuel prices to Icelandic volcanic ash clouds, to political uprisings such as the Arab Spring. But package holidays have proven popular with holidaymakers recently and Cook, under the stewardship of recently appointed chief executive Harriet Green, is proving very adept at pushing through cost savings. The company has also successfully refinanced and almost every trading update seems to bring with it further earnings upgrades.

The prospect of the reinstatement of Cook's dividend could provide the shares with further impetus in 2014. And a second wave of cost savings out to 2018 has recently been put in place which, if achieved, would produce what broker Investec describes as "never-been-seen-before (not even close)" margins. Only time will tell whether this proves an overly-ambitious target for a company in such a notoriously unpredictable sector. For now, though, Cook appears firmly in the ascendant.

Source: S&P CapitalIQ

Last IC View: Buy, 170p, 28 Nov 2013

Ashtead

Equipment hire group Ashtead (AHT) has been in the top five great expectations picks since I began running the screen at the end of 2011. So far it has delivered stunning returns each time. The company operates in an incredibly cyclical industry where sunk costs (investment in fleet) are huge and returns are highly variable and much depended on the health of the construction market. The group is benefiting from the fact that the US construction market, home to 84 per cent of its sales, bottomed out a couple of years ago. Not only has there been a limited cyclical pick-up in demand, but the lack of bank financing has kept competitors at bay and encouraged more construction firms to rent fleet rather than buy their own. This is particularly significant as only around half the US market's fleet is hired compared with about three-quarters in the UK.

The US remains strong and should continue to hold significant cyclical upside. And Ashtead sees plenty of opportunity to expand its presence in the US through both site openings and acquisitions. Meanwhile, Ashtead's management believes the UK market has bottomed out and is about to turn up. This has the potential to provide the group with a second wave of recovery as 16 per cent of sales come from the UK, where it is the country's second biggest player. So it's little wonder the group is investing heavily in new fleet and recently raised capital expenditure guidance for the financial year from £560m to £700m.

Last IC View: Hold, 728p, 10 Dec 2013

The Housebuilders: Redrow and Barratt Developments

Housebuilders were a major theme in last year's portfolio and remain dominant this year, too. While the attributes of individual companies are of importance, this is also an industry story whereby falling land values have allowed builders to buy relatively cheap plots to build on and sell into what is now a rising market. This cyclical time lag between land buying, building and selling is leading to big increases in margins across the industry as well as rising sales. And, while there have been signs that the powers that be are becoming a little wary of the housing market's ascent, notably with the withdrawal of Funding for Lending mortgage support, there are still plenty of state-backed incentives on offer for house buyers.

As far as housebuilders go, Redrow (RDW) is considered by analysts as more amenable to taking on debt to fund growth than most of its rivals. While the use of debt does increase risk, when things are moving in the right direction it has the potential for both increasing growth rates and increasing the proportion of profits attributable to shareholders, as debt financing only demands interest payments rather than a share of profits. Broker Panmure Gordon expects Redrow's revenues to double between 2013 and 2017 and earnings to increase by 150 per cent.

Barratt Developments (BDEV) has been playing a solid hand over recent years to take advantage of the market tailwind. It continues to invest in new land and continues to increase the percentage of houses built on cheaper land acquired near the bottom of the cycle. The company also has a propensity to take on more complex projects than many of its rivals.

Redrow

Last IC View: Redrow, Hold, 236p, 18 Sep 2013

Barratt Developments

Last IC View: Barratt Developments, Hold, 326p, 11 Sep 2013

Dixons Retail

Electrical retailer Dixons (DXNS) is in the process of significantly restructuring the group. The first stage of the process has involved selling underperforming parts of the business such as its PIXmania online business and operations in Turkey and Italy. This has allowed investors to turn their attention to strong sales growth being achieved in the UK and Ireland, which has been helped by the collapse of rivals, notably Comet. The company is still struggling in Southern Europe where sales are falling fast and a second wave of restructuring is expected to address issues with the property portfolio and financing costs.

While profits are expected to grow strongly in the current financial year as the group waves goodbye to legacy problem areas, management is likely to need to give the market some more details on future restructuring plans to keep the share price motoring. There is definitely scope for the group to announce something impressive.

Last IC View: Hold, 43.2p, 20 Jun 2013

The Rest

Source: S&P CapitalIQ