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Keeping faith with big reliables

My big reliables screen has had its second poor year on the trot, but it's worth sticking with it
July 5, 2017

As an investor, one of the many annoying traits of being human that's been identified by behavioural scientists is that we put excessive emphasis on recent experience, especially when it is extreme. The oft-cited study illustrating this involves spikes in the take-up of insurance cover following a major natural disaster. Ironically, the amount of households with appropriate insurance cover has usually dropped back to normal rates by the time the next event happens.

Such irrationality is often linked to common investment behaviours, for example increasing demand for the latest 'hot' investment fund often shortly before performance drops off, or a willingness to pay very high prices for the latest 'hot' growth stock - the fact that such high valuations may underplay the inherent risk of small 'growth' companies is often given as a contributory factor in explaining the historic underperformance of the Alternative Investment Market (Aim).

However, when it comes to my big reliables screen, the recent event that may give a poor steer is the last two years of poor performance. The two poor years have entirely eroded the screen's strong outperformance of the market in the previous four years.

But while it is always nice to report that a screen has had a good year, the idea behind using a set of rules to highlight stocks is that it provides a sense of emotional detachment when rooting out investment ideas. What's more, as long as there is some commonsense reasoning behind each screen, failures can perhaps offer valuable clues about which approaches work and which don't.

In the case of the big reliables screen, there is one aspect of its approach that is of particular interest. While most of the screens I run try to strike some kind of balance between selecting 'quality' companies and shares offering attractive 'value' (I try to include a broad spread of measures for both quality and value across the many screens run in this column) the big reliables screen ignores the question of 'value'. The use of the term 'reliable' in the screen's title is reference to the reliability of the returns historically generated by the companies highlighted.

As valuations have run away over recent years, aided by the incredibly loose monetary environment, valuation risk has arguably increased, with many 'reliable' stocks commanding such lofty multiples that any disappointments or perceived worsening of circumstance stands to be harshly punished. This may well have been a factor in the underperformance of the big reliables screen over the past two years, especially given growing expectations that monetary conditions are on the road to getting tighter in the west. In addition, the fact that the screen's picks missed out on any of the stellar recovery gains from the resources sector should not be ignored - especially as the resources recovery had a big impact on the overall index performance during the period.

In all, last year's six stock picks produced a total return of zero per cent (or -0.02 per cent to be precise), which is dismal compared with 23.2 per cent from the FTSE All-Share. This has taken the cumulative total return from the screen over the six years I've run it almost exactly level with the index (a 0.002 per cent difference between the two!) at 62.6 per cent. If I add in a 1 per cent charge to account for notional costs of switching between portfolios each time a new screen is published that return drops to 53.1 per cent.

 

2016-17 performance

NameTIDMTotal Return (21 Jun 2016 - 17 Jun 2017)
MoneysupermarketMONY28%
BookerBOK11%
BerendsenBRSN2.4%
WhitbreadWTB-0.9%
EasyJetEZJ-7.3%
DunelmDNLM-33%
FTSE 350-23%
Big Reliables-0.0%

 

Big reliables vs FTSE 350

  

The screening criteria are as follows:

■ EPS growth in each of the past five years.

■ Return on equity of 12 per cent or more in each of the past five years.

■ Forecast earnings growth in the current financial year and the year after.

■ Gearing of less than 50 per cent, or net debt of less than two times cash profit.

■ Cash conversion (cash from operations as a proportion of operating profit) of 90 per cent or more.

 

The strategies pursued by pretty much all the screens I run in this column should be expected to move in and out of favour and, while I personally struggle with excluding considerations of valuation from an investment approach, for many very successful investors it's not the primary focus. I'd therefore regard the selection of six stocks from this year's screen as just as worthwhile a list of ideas as the results from 2015, which were presented following 12 months of strong performance. The share picks are listed in the table below and the provided write-ups take a closer look at three of the stocks.

 

NameTIDMMkt CapPriceFwd NTM PEDYPEGFwd EPS grth FY+1Fwd EPS grth FY+23-mth MomNet Cash/ Debt(-)
DiplomaDPLM£1.2bn1,098p231.8%3.1214.6%5.4%3.8%£15m
Moneysupermarket.comMONY£1.9bn357p212.8%3.117.5%8.9%4.9%£45m
NMC HealthNMC£4.4bn2,170p290.5%1.1438.1%20.5%23.6%-$431m
PersimmonPSN£7.0bn2,274p105.9%1.869.6%2.5%6.6%£913m
WH SmithSMWH£1.9bn1,711p162.6%2.498.6%5.6%-2.2%-£21m
WhitbreadWTB£7.2bn3,963p152.4%2.754.8%7.3%1.2%-£901m

 

There is a lot to like about distribution company Diploma (DPLM). It has targeted three markets (life sciences, controls and seals) that are exposed to different demand cycles and it is creating growth by offering more, higher-margin, value-added services to create closer ties with clients. All this has translated into a track record of high margins, high returns on capital and strong cash generation.

The group's most recent results were encouraging as its seals and life sciences business turned a corner and reported underlying revenue growth (2 per cent in both cases). Importantly, the growth rate improved markedly in the second quarter for each business. The same was true for the controls business, which reported underlying growth of 16 per cent for the first half. As well as benefiting from comparisons with a soft period in the previous year, the division has benefited from growth initiatives and contract wins. Margin-boosting acquisitions have also helped performance.

Acquisitions are likely to continue to play a noteworthy role in Diploma's growth, especially as the underlying growth rate of the company looks solid but unexciting. To this end, in May Diploma spent £16m on a life sciences business, Abacus. The cash outflow from this deal is not reflected in the net cash figure in the accompanying table. Management has also said it is seeing a number of further good acquisition opportunities.

The only gripe investors are likely to have with Diploma's shares, in common with shares in other quality companies that are trading well, is that the valuation is high by historic standards. Indeed, the graph below shows the unrelenting re-rating the shares have enjoyed over recent years, based on Bloomberg's next-12-month consensus forward earnings multiple. The company also generates about three-quarters of its sales overseas and any serious strengthening in sterling is likely to hurt. The possibility of a sterling recovery looks a bit more likely following recent, somewhat hawkish comments from the Bank of England. Last IC View: Hold, 1,100p, 16 May 2017

 

Diploma's five-year re-rating

 

It seems we are faced with tales of high-street woe wherever we turn in 2017. But perhaps by virtue of selling products that have faced falling demand for many years (newspapers, magazines and books), WH Smith (SMWH) has already done much to adapt to the tough climate. Indeed, about 60 per cent of the group's profit is now generated by its travel business, which operates shops in airports and railway stations. This is a retail environment where demand for WH Smiths' wares is very strong and the group has been using cash generated from its mature high-street shops to grow its travel outlets, both at home and overseas.

The strategy looks as though it could serve WH Smith particularly well this year as passenger numbers are showing strong growth. Indeed, third-quarter like-for-like travel sales to the start of June were up 5 per cent, with overall sales, helped by favourable currency movements, up 8 per cent. The group is expected to add between 20 and 40 travel stores this financial year, with an increased focus on international expansion.

On the high street, third-quarter like-for-likes sales were down 3 per cent, but the group's seemingly endless ability to find operational cost savings will help mitigate this and gross margins are also rising. The company is also opening post offices in its stores to help improve footfall, which should have a knock-on benefit to sales.

Free cash flow is expected to continue to outstrip earnings in coming years and solid growth is forecast. The shares aren't screamingly cheap, but rated at 16 times consensus forecast next-12-month earnings, they are down from a pre-Brexit valuation high of 19 times.

Last IC View: Hold, 1,791p 18 Apr 2017

 

Whitbread's (WTB) first-quarter trading update, released last month, proved something of a relief for shareholders. Costa reported like-for-like sales growth of 1.1 per cent in the three months, Premier Inn experienced 4.7 per cent like-for-like sales growth and the group's restaurants increased sales by 0.7 per cent.

While some comfort can be taken from the most recent quarter, Whitbread faces a number of challenges. Over recent years, the Costa chain, which has long been a growth engine for the group, has shown a worrying decline in like-for-like sales, which had previously been able to hold up strongly while the operation expanded at pace. The bar chart below of like-for-like growth rates at the key Costa and Premier Inn divisions illustrates the trend investors have been fretting over.

 

 

Indeed, shareholders were aghast when like-for-likes actually went negative at Costa in the fourth quarter of the last financial year at -0.8 per cent. This plays to worries that stretched consumer budgets and overexpansion by the eating-out industry may be weighing on coffee shops as well as restaurants. As such, the first-quarter growth was seen as a cause for celebration despite it being poor by historic standards.

And while Premier Inns' first-quarter figures look impressive, there are concerns about the outlook. Some industry watchers think a turn in the UK hotel cycle could be close at hand. Broker Numis has recently pointed out that capacity growth of 3.2 per cent is the highest since 2009, when hotels funded by easy, pre-credit crunch financing were warily opening their doors. Meanwhile, regional revenue per available room (RevPAR) is about one-fifth above the past peak. The reaction to the London terror attacks could also temporarily dampen demand in the capital, although Whitbread has relatively low exposure here.

And even putting trading angst aside, rising costs are likely to prove an issue in the years ahead. Increases in business rates and wages, along with a number of other overheads, mean Numis forecasts a 4.3 per cent rise in costs in 2018. Management is attempting to take this in hand with a five-year £150m saving programme. While Whitbread has a deserved reputation as a quality play, there were clear grounds for the uninspiring contribution its shares made to the 'big reliables' screen last year, and while the recent first-quarter update provides some encouragement, the issues will not necessarily abate all that soon.

The flip side to the problems Whitbread has faced is that the shares' rating looks fairly attractive compared with the high levels of recent years, with a next-12-months consensus earnings multiple of 15.2 just about in the bottom quarter of the five-year range. That said, based on longer-term historic valuations, the rating has not been particularly cheap in any of the past five years.

Last IC View: Buy, 4,007p, 21 Jun 2017