Eight Deep Value recovery plays

In a year when 'value' took a beating, it’s curious to see my value-focused Piotroski screen beating the market by a large margin.

Rather than telling us something about 'value' investing, this juxtaposition may tell us more about what a funny measure of value price-to-book (P/BV) has become in the two decades since accounting professor Joseph Piotroski published his famous paper about using fundamentals to spot recovery plays. 

The P/BV ratio values a company against the value of its net assets per share. There’s a good central idea behind this approach. A company's assets are utilised by it to produce sales and profits. If the price of a company is low compared with its net asset value, it may be that investors are underestimating how profitable those assets will be in the future. This is especially true when companies have fallen on hard times and the market is yet to appreciate the steps that have been taken to turn performance around.

The problem for P/BV is that companies' balance sheets have progressively captured less and less of their profit-generating assets  over time. That’s because companies increasingly focus on investing in intangible assets, such as brand and research and development (R&D). Generally, rather than being recorded as an asset on the balance sheet, these investments are treated as an expense to be offset against profit in the year they are incurred. This effectively means the productive assets of firms that invest mostly in intangibles are underreported. Some companies also carry a lot of goodwill from past takeovers, which bolsters the balance sheet but is simply waiting to be impaired .

Still, there are still some companies that require lots of tangible assets to generate sales and profits, such as property, resources and investment companies, along with many industrials. The P/BV measure can still be useful in these hunting grounds. This is particularly true of smaller companies, as is amply demonstrated by Simon Thompson’s annual Bargain Shares Portfolios. 

However, in general, I’m not too convinced about P/BV as a means of assessing value for the market as a whole. While three runaway small-cap picks from last year’s screen meant it did very well overall, the longer-term picture has been very bumpy.

Still, following last year’s run the screen is comfortably ahead of the market since inception in early 2012. The market in this case is taken to be an even split between the three indices screened: FTSE 350, FTSE All Small and FTSE Aim All-Share. The nine-year cumulative total return stands at 222 per cent compared with 113 per cent. While this screen is considered as a source of ideas for further research rather than an off-the-shelf portfolio, if I add in a notional 2 per cent annual dealing cost (the cost of dealing small caps can be high) the total return falls to 169 per cent.

While I have some issues with P/BV, I have far fewer reservations about the F Score devised by Mr Piotroski in his 2000 paper. This involves an interplay of nine different fundamental factors to test whether a company is making operational improvements without drawing on outside factors. The nine tests are:

■ Positive profit after tax, excluding exceptional items.

■ Positive cash from operations.

■ Profits after tax, excluding exceptional items, are up on last year, which Professor Piotroski highlights as being of particular importance as a signal that a company may be in recovery mode and in the process of rerating.

■ Cash from operations is higher than profit after tax, excluding exceptional items, which indicates an ability to convert accounting profit into actual cash.

■ Gearing (net debt as a percentage of net assets) is down on the preceding year, which suggests that the company has not had to look for external sources of finance.

■ The current ratio (current assets divided by current liabilities) is up on the preceding year, which suggests that the company's ability to service upcoming financial obligations is improving.

■ No new shares issued over the past year, which again suggests the company has not had to look for external sources of finance.

■ Gross margins have risen in the past year.

■ Improving capital turn (turnover as a proportion of net assets), which suggests greater productivity.

Mr Piotroski classified F Scores of eight or more as high. He found stocks with high F-Scores and low price-to-book ratios (bottom quarter) outperformed. He backtested a long-short strategy based on this method and found it would have achieved an average annual return of 23 per cent in the 20 years to 1996, almost double that of the S&P 500.

This year eight stocks have been identified by the screen. I’ve taken a look at the largest on the list, Premier Foods, which is a really interesting example of the massive gains that can be made when a heavily indebted company gets on top of its balance sheet issues.

Premier Foods

Groceries and baked goods company Premier Foods (PFD) has been a major lockdown winner. And while there are reasons to think some of its lockdown trading gains will reverse, the biggest long-term prize for investors may have already been won: getting on top of  the company’s debt and pension problems.

Sometimes companies build up debt and pension liabilities that become an insurmountable burden. The cash drained from such a company simply to pay interest and pension top-ups leaves little left over to fix the problem by paying down borrowings. While Premier Foods has been chipping away at its debt millstone for several years, prior to lockdown, investors still viewed the company as going nowhere fast. This was reflected in the valuation, which at the start of 2020 stood at 5.2 times enterprise value to forecast cash profit (forward EV/Ebitda).

However, with UK consumers confined to their homes, they have swarmed to Premier’s brands; the three biggest sellers being Mr Kipling, Batchelors and Bisto. 

The trading boost has caused cash flows to surge, which has radically altered Premier’s balance sheet to shareholders’ favour. How profound the impact on debt and profits has been is reflected in the fact that a year ago the company was still talking about its long-standing target of getting its net debt to cash profits ratio to 3 times. Now, having rapidly shot below that level, it is aiming for 1.5 times.

At the same time as lockdown has boosted the company’s coffers through improved trading, a new management team, installed in late 2019, has undertaken a strategic review. This has included securing an agreement with pension trustees to significantly reduce the cost of servicing the company’s two substantial pension schemes, which together have liabilities of £5bn. 

The two schemes, one with a big surplus and one with a big deficit, are being merged. This will reduce the combined funding requirements as well as wiping £4m from servicing costs. The amount of cash needed to service the pension should fall by between £8m and £21m starting in the year to the end March 2024. That compares with £38m of payments had nothing been done. That’s a big win for free cash flow (FCF).

FCF is also benefiting from the fact that a lot of the debt that is being paid back takes the form of expensive bonds. The company has redeemed £120m-worth of its senior floating rate notes that pay a painful 5 per cent above Libor. This saves about £6m in annual interest payments. The cost of its revolving credit facility has also dropped from 3.5 per cent over Libor to 2.75 per cent as rating agencies have lifted their assessments of its creditworthiness.

There’s scope for further cost-of-borrowing benefits to come from the company’s sturdier balance sheet, too. Premier is now in a much stronger position to refinance its remaining expensive debt (£90m more of the floating notes and £300m of fixed senior notes at 6.35 per cent). Shore Capital reckons this may get under way in mid 2022 when costs of repayment would be substantially lower than is currently the case.

So Premier is forecast to become a much more cash-generative business, which means it is a much more valuable business for its shareholders. The graph below shows the massive jump in FCF in 2020, which owed much to a one-off boost due to a huge Covid-related stock outflow, is forecast to be close to the new normal.

A good debt pay down story can be a wonderful thing as the value that previously sat with debt holders gets transferred to shareholders. Indeed, while Premier’s market capitalisation has shot up 157 per cent over the last year, its enterprise value (EV) is up only 50 per cent. This reflects the fact that much of the share price gain can be directly attributed to lower debt, which puts more of the company’s economic value in the hands of shareholders; EV tries to express a company’s full value by adding net debt to market capitalisation. 

However, Premier potentially offers something more than just debt pay down. There are signs that a decent brand-focused business may exist behind all the borrowing. True, once UK consumers can dine out again it seems highly likely that demand for Premier’s products will pull back. However, the real long-term allure for investors is that the value of the brands can now shine through and lockdown may have boosted the potential for this. Importantly in this regard, the majority of sales (80 per cent) are branded products.

Focused advertising has helped the company win market share during lockdown. Meanwhile, product innovation has seen the percentage of new products that make up branded sales gradually rise from 2.5 per cent in 2015 to 6.5 per cent in the year to the end of March 2020. Online sales growth has also been very strong. Meanwhile, the underlying trading margin of the company is decent at 15.7 per cent last year.

While balance sheet improvements have started to be reflected in the share price, the financial flexibility the company now has will potentially allow it to further develop the business as well as allowing it to make further inroads into its borrowings. That means, even after the shares' very strong run, there could be good further upside in the years ahead. 

Reinstatement of the dividend could provide a trigger, which a recent capital reduction makes legally possible. And while tough comparisons with lockdown trading could be a hindrance once people can go out again, priced at 10 times next 12 month forecast earnings and offering a 7 per cent forecast FCF yield, the valuation does not seem to anticipate anything special.