18 genuine value shares

Indeed, investors should be prepared to pay up for high-quality growth stocks even if that means paying what on the surface looks a high valuation. The question is whether the growth on offer is being bought at a bargain price or whether it is too expensive. The genuine value screen is an attempt to square this circle. Last year's performance compared with the FTSE All-Share's was not good, but this screen is poorly suited to identifying the type of recovery stocks (resources plays) we saw drive index returns last year, due to its focus on forecast earnings growth. There was also one real out-and-out dog picked last year in the form of Sepura (see table).

Source: Thomson Datastream

Over the four years I've run the screen the cumulative total return now stands at 62.5 per cent, compared with 36.4 per cent from the FTSE All-Share. Adding in a 1.5 per cent annual charge to account for dealing costs makes the total return fall to 54.5 per cent.

Genuine Value vs FTSE All-Share

The ratio that is central to the screen is somewhat crude. It neither employs the elegant maths of those growth investors that believe they can forecast out to an investment's 'terminal value' and discount the returns all the way back to their present day value, nor does the approach take on the sceptical outlook of the hardened value investor that believes growth is best disregarded as it so often destroys value over the long term by producing returns on capital below the cost of capital.

Indeed, the ratio that this screen is centred around takes the view that there is a value to earnings growth and brokers' forecasts provide a good enough steer on which to base an assessment. The screen also looks at investments on a 'whole company' basis by using the enterprise value (EV) measure of a company's worth. EV in its most basic form, and the way it is used in this screen, simply adds back net debt to market capitalisation. This is done to assess sources of financing other than equity. Other liabilities can be added in, too, for example pension deficits and long-term lease liabilities such as rental commitments on properties.

The purpose of looking at EV is that it provides a more rounded picture of the health and value of a company's entire operation rather than just looking at the equity element of a company, where perspectives can be skewed by financial engineering (eg loading up with debt to enhance the earnings attributable to shareholders but greatly increasing the potential risk should trading deteriorate).

The genuine value (GV) ratio compares a valuation of EV to operating profits with expected earnings growth (Fwd EPS grth) plus dividend yield (DY):

GV = (EV/Operating Profit) / (Fwd EPS grth + DY)

Earnings growth plus dividend yield is sometimes referred to as a stock's 'total return'. Operating profits are used in the valuation ratio with EV because these exclude interest payments, which balances out the fact that debt is factored into EV.

The screen is focused on the cheapest quarter of FTSE All-Share companies based on the GV ratio. These shares must also meet two relatively light tests that suggest the ratio is not based on shoddy data and that the market may be attracted to the value apparently on offer. The extra criteria are:

The screen has highlighted 18 shares this year, which are listed in the table below ordered by lowest to highest GV ratio. I've also taken a closer look at three of the shares from around the top, middle and bottom of the table. I've tried to select shares for the write-ups that highlight some of the considerations investors may want to take into account when using valuations based on EV and expected EPS growth.

18 genuine value shares

Source: S&P CapitalIQ

Unfortunately, there are no perfect one-size-fits-all valuation techniques, and using a ratio based on EV will inevitably benefit some types of company more than others. That's the case with a company like Morgan Sindall (MGNS), which on the surface has a lot of cash and very little debt. However, the thing to appreciate about this business, which is involved in big-money, low-margin construction contracts, is that much of the balance sheet risk it bears is based on the huge amounts of money it has to plough in to the projects it is working on. Indeed, the working capital items on its last balance sheet included £214m of inventories and £333m of receivables (revenues booked on the income statement but not yet collected) and £482m of accrued expenses (costs incurred but not yet put through the income statement).

However, Morgan Sindall's net cash needs to be seen in the context of a capital-hungry business; that's definitely not to say Morgan Sindall's balance-sheet strength is not an attractive quality. And the company's management reckons the business is halfway through a recovery following a jump in profits last year. What's more, the fact that net cash rose by £151m last year should put Morgan in a strong position to bid for, and take on, new work.

Following a number of tough years for construction companies, the outlook may finally be picking up, with the UK's post-referendum government seemingly more committed to infrastructure spending - although lip service is nothing new. Conditions are also favourable for Morgan Sindall's regeneration and affordable housing businesses and encouragement can be taken from the fact that the company's cyclical property fit-out business reported a record £466m order book at the end of 2016.

This backdrop is helping management capitalise on a plan to improve performance, with more selective bidding in order to boost the profitability of the work it takes on. The company is also attempting to make better use of technology to increase returns. And while the shares have had a strong run, at 11 times forecast earnings they cannot be said to be expensive. Indeed, many perceive construction as one of the few pockets of value left following the market's long bull run (last IC view: Buy, 973p, 27 Feb 2017).

When using multiples that compare an earnings-based valuation with earnings growth, there is always a question of how high or low a valuation or growth should be deemed acceptable. Indeed, if a share has a cheap GV or price/earnings growth (PEG) ratio based on a very low earnings multiple, the valuation could be telling investors that earnings growth expectations are not to be trusted. Similarly, a stock that looks attractive due to a very high growth rate may be a situation where a company is experiencing a temporary strong run that is unlikely to be sustained; something that could lead to the shares actually being overvalued. While the genuine value screen does put a limit on the level of forecast growth it is willing to accept, the limit is a high one. LED lighting company Dialight (DIA) is an example of a share trading on a high earnings multiple and testing the screen's comfort levels for forecast 'growth'.

Indeed, it seems unlikely that Dialight can continue to grow in the long run at the pace brokers expect in coming years. However, the potential to boost profits is significant enough - if everything goes well - to mean the shares may look a lot more reasonably valued based on their earnings multiple by the time the growth rate does slow.

The company's success in more than doubling underlying operating profits last year was largely down to self-help and its constant-currency sales actually made little progress during the 12 months. The group is focusing on re-engineering its products, outsourcing parts of its operations and cutting raw material costs through improved sourcing. It is hoped that this strategy will continue to have impressive results in the years ahead. Broker N+1 Singer forecasts that pre-tax profit margins will rise from 6.9 per cent in 2016 to 12.9 per cent come 2019.

The company has also had success with boosting cash generation by reducing the amount of money it has tied up in working capital. This resulted in a cash flow surge in 2016 and, while such a leap is unlikely to be repeated in the future, the strong cash boost last year is hopefully a precursor to more robust cash-conversion in future periods.

As well as attempting to improve what it is already doing, Dialight is pursuing growth opportunities. It has formed partnerships in the automotive sector, it is investing in product development and it has improved its sales channels. Increased diversity of its end markets should also help to prevent it re-visiting the troubles it had in 2015, which were linked to the travails of the oil and gas sector and its heavy reliance on sales to the industry. Hopes of a pick-up in global GDP growth could also boost the company, as its fortunes are linked to the health of industrial investment (last IC view: Hold, 965p, 27 Feb 2017).

Transport company Firstgroup (FGP) is another potential oddity for ratios using the EV measure of a company's worth. In this case it is due to what EV frequently misses out: lease commitments. Indeed, while equity and debt (the two components used in the basic EV ratio) are two key ways of financing a business, they are not the only way. A company can make long-term lease commitments (such as agreements to rent vehicles or train track) to secure use of assets. In many respects these commitments are similar to debt. This is a particularly pertinent point at the moment because a change in accounting rules means the value of these leases, which are currently 'off-balance-sheet' items, will need to be reported on companies' balance sheets from the start of 2019. The data I use for EV in this screen does not factor in such leases, but other data sources do - notably Sharepad, which very usefully provides many multiples in a lease-adjusted format. In the case of Firstgroup, Sharepad's calculation of EV rises from £3.4bn to £5.3bn when leases are factored in - ie it is a more expensive business when leases are included in the valuation.

That said, as with Morgan Sindall, it could be a bit churlish to quibble too much about the flaws one can encounter using EV-based metrics because the company itself is showing promise. The most notable recent event is news that it has won the South Western rail franchise from Stagecoach as the larger partner in a 70:30 joint venture with a Chinese company. There are some concerns that Firstgroup will be taking charge at a time when the franchise's terminal station, Waterloo, is undergoing a three-week closure. The trials and tribulations experienced by Firstgroup rival GoAhead after taking over the Southern franchise during a similar period of disruption at London Bridge will no doubt be preying on investors' minds. Still, broker Investec increased its sum-of-the-parts valuation of Firstgroup shares by 5 per cent to 142p following news of the win. What's more, what behavioural scientists call recency bias may mean the market is underestimating the potential benefits for Firstgroup from the win because of the recent example of Go-Ahead running into trouble after a rail franchise win that was initially greeted by the market with great glee.

Firstgroup has also recently benefited from a pick-up in its North American operation, which includes the iconic Greyhound buses. Rising petrol prices tend to encourage more people on to buses. Meanwhile, in the UK, while the bus market faces tough conditions, Firstgroup is working on pushing up its margins and like-for-like declines at the division have shown signs of slowing (last IC view: Buy, 112p, 9 Feb 2017).