Best of the FTSE 350 2018

Our methodology combined some elements of active management with mechanical ratios. We used stock screens to compare companies in the same industry on various value and quality criteria, before making the choice as to which companies stood out most in their respective industries. 

Buying into every sector at least once gave some benefits of diversification, but inevitably holding just 19 shares out of the wider universe made for a portfolio that was more volatile than the FTSE 350. 

Sizing up the UK market for 2018

Peer comparisons is the main object of the exercise and in equal-weighting the companies that come out of the selection process we aren’t taking account of which sectors should do better at this stage of the economic cycle. Consumer discretionary, for example, should be sensitive to stalling rates of economic growth, rising inflation and tightening monetary policy. 

Within the consumer discretionary sector, one industry where numbers still look enticing is the housebuilders. It is important to consider that high return on capital has in the past signalled that the industry is at a peak in the cycle and the slowing rate of house price expansion should also be taken as a note of caution against loading up on too many companies in the sector. In December 2017, the Nationwide house price index showed prices rose 2.6 per cent year on year, compared with 4.5 per cent in 2016. This matters because it impacts on the value of the land that many housebuilders are sitting on. The home builders still look a better bet than other consumer discretionary shares, though. 

Last year Berkeley Group (BKG) performed well for the portfolio and, trading on a forward PE of around 10, it is still not hugely expensive, although this may be due to lingering fears about its exposure to the London property market. Moreover, with further earnings growth expected, the PEG is appreciably below 1, indicating good value. The dividend yield is not the fattest in the industry, but at over 3 per cent is not to be sniffed at (and is well covered by earnings). The company also has a healthy cash position.

As well as reaffirming our faith in Berkeley Group, we go for a second home builder to fill the consumer discretionary berths in our portfolio. The second company is Countryside Properties (CSP), which focuses more on affordable housing. On the one hand, these are presumably the buyers who will struggle to get mortgage finance in a recession, but on the plus side this end of the market receives most government support. The company also experienced positive movements in its cash position last year. Again, it is rated on about 10 times future earnings by analysts and the high earnings growth rate anticipated gives a compellingly low PEG.

Consumer staples is conventionally a more defensive sector, although the challenging period endured by supermarkets in recent years proves this isn’t always the case. The first pick here is a classic defensive stock: Reckitt Benckiser (RB.). Unsurprisingly this is a play on the quality, rather than prospective growth rate of earnings. That said, positive expected earnings growth is underpinned by management’s record of delivering shareholder value over the previous 12 months. In spite of some challenges last year, return on equity (ROE) – using the S&P Capital IQ last 12 month blended measure – was 27 per cent. 

Britvic (BVC) is another of the star performers from last year (up 43 per cent total returns), but in an expensive sector it still looks relatively attractive. The PEG is relatively high, perhaps because analysts expect earnings growth to be stymied by the impact of the UK sugar tax, but a high past return on equity and a good conversion rate of operating profit to cash are solid quality characteristics.

In the energy sector we stick with Royal Dutch Shell (RDSB). With oil now at its highest level in three years, analysts expect strong earnings growth for Shell next year. On a forward PE of 16, the shares are slightly more expensive than those of BP (BP.), but are still not dear. On the backward measure of enterprise value to Ebitda (earnings before interest, tax, depreciation and amortisation), which is a good way to compare oil companies with different capital structures, Shell is actually similarly valued to BP. The lower proportion of debt in Shell’s capital structure and a good cash conversion ratio are also reasons to believe that in more benign trading circumstances this is a quality company that can continue to make price gains, as well as supporting its generous dividend.

Further down the capitalisation scale, it is more challenging to choose a second energy company to take advantage of recovering oil prices. The weakness of using ratios is that we will probably need another set of financial statements to see who is exiting a tough period in the best shape (ie which companies’ cash positions are improving most) – unless we want to make decisions purely on analysts’ estimates. So with Shell looking attractive, instead of making a speculative call on a smaller producer for this year’s selection we’ll just double up our position in the UK’s largest company.

Within financials, Lloyds (LLOY) still looks relatively attractive amongst the banks. Analysts’ expectations for future earnings growth are positive and the shares are trading on a lower multiple of forward earnings than HSBC (HSBA), which is the other steadier UK-listed bank. The improving capital position and expanding net interest income are supportive of the ability to maintain the dividend and, based on the low PEG ratio, there appears more room for upside here. Our second financial pick is life insurer Prudential (PRU), which is attractive based on its positive operating cash flows and cash conversion ratio, which is better than that of last year’s pick Legal & General (LGEN). 

Within healthcare, last year’s pharmaceutical company, Astrazeneca (AZN), performed excellently. The company is now even more expensive and, according to S&P Capital IQ’s consensus forecast data, analysts are not expecting much further earnings growth over the next 12 months. We stick with AZN, however, thanks to the progressive dividend policy and backward indicators of quality, such as free cash flow, which are strong.

Last year’s other healthcare play was UDG Healthcare (UDG), which had a stellar year, making us a 30 per cent gain. For 2018 we shift to a company with even greater momentum: NMC Healthcare (NMC). There is always the fear that jumping on the bandwagon of such a success story you have come too late to the party. According to forward estimates, however, the PEG ratio is still below 1, which shows the high forward PE is based on confidence of future earnings growth from a company that joined the FTSE 100 last year. From a quality perspective, the strong operating cash flow bolsters that optimism.

In industrials, keeping BAE Systems (BA.) wasn’t a tough choice despite a slight loss last year. Profit growth is only expected to be in the single digits, but the price as a multiple of future earnings is still relatively cheap compared with other aerospace and defence companies. Added to this, management has achieved decent return on equity, free cash flow is positive and the dividend has ample cover.

We also go for Ferguson (FERG). Trading at 16 times estimates of its forward earnings, Ferguson isn’t cheap and a PEG above 1 suggests growth is already priced in. The company’s return on equity over the past 12 months and a positive cash position are encouraging, though, and with internationally diverse revenue streams the company looks a decent play on growth outside the UK – especially if 2018 is a tough year for sterling. 

The two companies from the information technology sector last year did not disappoint. We keep Playtech, thanks to an enticingly low PEG ratio, positive free cash flow and a not inconsiderable (and well covered) dividend yield of 3.3 per cent. 

The holding in Rio Tinto (RIO) gave the portfolio exposure to the recovery in mining stocks last year and we keep the same company for this year in the belief that this has further to run. Analysts expect large mining companies to enjoy improved profits next year, but Rio is trading on a lower multiple of forecast earnings than peers such as BHP Billiton (BLT) and Glencore (GLEN). It is relatively more expensive than Anglo American (AAL) but Rio has paid down a higher proportion of its debt, which indicates better quality, as does a superior return on overall capital employed (equity and debt). 

Our other company from the materials sector is very much a value play. Plastics manufacturer RPC Group (RPC) was castigated for its acquisition strategy in 2017, but signs that integrations could bear fruit are not yet priced in, as shown by a PEG below one. Besides, the positive return on equity for the past 12 months suggests that the market was too hard on RPC in the past. Debt to equity is relatively high, but the positive operating cash flows comfortably cover interest expense. Of course, plastic waste is worrying from an environmental perspective, but the trend of increasing demand isn’t abating.

In real estate, there is little that stands out either as especially cheap or with enticing growth prospects. Given that we already have exposure to the UK economy and property through other holdings, we stay out.  

The decision to put Inmarsat (ISAT) in last year was a stinker, but there are better reasons for optimism surrounding this year’s telecommunications selection, Vodafone (VOD). The conversion of profits to cash offers reassurance that the high dividend yield isn’t just a value trap, and with analysts forecasting an impressive growth rate in earnings, Vodafone’s share price has plenty of room to head upwards from the current valuation.

Finally, utilities is a sector which, although historically seen as defensive, needs to be approached with caution thanks to the high multiples, which depend on the ability of these companies to pay good dividends and act as bond proxies in portfolios. This year, however, we stay out of a sector that is not cheap overall and is likely to be weighed down by negative sentiment. 

So, we have a more concentrated portfolio for 2018 in terms of the number of holdings (15 versus 19 last year), but thematically the industries and companies we have chosen should give us a mix of exposures to different economic themes. As well as growth in geographies where economic cycles may be different, currency effects and spreading political risk, there is hopefully a profitable blend of risk-reward factors. 

This year's selection of 15 shares from the FTSE 350 

2017 selection