- New quality-focused criteria to pep up performance
- Four shares meet the grade
When I ran my Genuine Value screen last year it was on the basis that it would be its last chance in that format should it disappoint again. While it seems harsh to describe the 34 per cent total return over the last 12 months as disappointing, compared with 36 from the FTSE All-Share as it surged back from its March lows, I certainly would not describe the performance as particularly good. So this year change is afoot.
12 MONTH PERFORMANCE
|Name||TIDM||Total return (17 Mar 2020 - 11 Mar 2021)|
|Residential Scr. Inc.||RESI||26%|
Source: Thomson Datastream
The cumulative total return from the screen since inception also makes the case for change. Over eight years it has produced a 46 per cent return or 32 per cent after applying a notional 1.25 per cent charge to represent dealing costs (the screens are not meant as off-the-shelf portfolios but to provide ideas for further research). Both figures are worse than the 52 per cent from the index over the same period.
The main alteration I’m making to the screen is to add in extra criteria. I devised this screen as a very stripped back affair. With the benefit of hindsight, I think it was naive to think it would be able to discern wheat from chaff with so few tests.
So what am I after now that I was not before? Given this screen is focused on finding earnings growth on the cheap, the additions to the criteria can chiefly be regarded as tests to discern the quality of earnings and forecast growth.
Specifically, I am requiring that stocks have seen next-12-month earnings forecasts increase over the last three months. I also now want to see that on average 80 per cent or more of cash profit (that being earnings before interest, tax, depreciation and amortisation, or Ebitda) generated over the last three years have been turned into net (before tax and interest) operating cash flows. Cash conversion is generally a good measure of earnings quality.
The final test I’ve added to try and help get a better quality of stock pick from the screen is to require that all companies have either gearing (net debt as a percentage of net assets) of less than 50 per cent or net debt of less than two times cash profit.
The screen’s existing criteria have also been altered a bit. Now stocks only need to be in the cheapest half of all those screened, based on the genuine value (GV) ratio. The screen used to look for the cheapest quarter of shares. Really cheap shares can often be value traps or the apparent cheapness can be the result of atypical circumstance, such as a single year of unusually high forecast growth in the case of the GV ratio. It’s worth noting that this ratio may be distorted somewhat this year by the fact many companies are expected to recover strongly from a Covid hit and therefore report high-but-fleeting growth.
The full criteria are:
- A GV ratio among the lowest half of stocks screened.
The ratio compares enterprise value (EV) to operating profit (Ebit) with the expected return for shareholders based on forecast earnings growth (Fwd EPS grth) plus dividend yield (DY). EV is calculated as market cap plus net debt.
GV = (EV / Ebit) / (Fwd EPS grth + DY)
- Three-month share price momentum among the top third of all stocks screened.
- Above-average forecast EPS growth in each of the next two financial years. The average forecast growth rate must be less than 50 per cent – anything above this level is considered to be very likely to be highly unsustainable.
- Net debt less than two times cash profit or less than 50 per cent of net assets.
- An earnings upgrade to next-12-month forecasts in the last three months.
- At least 80 per cent of cash profits converted to net operating cash flows over the last three years.
Four shares passed all the screen’s tests. I thought I would take a closer look at the one that also cropped up in last week’s Cornerstone Growth screen: RHI Magnesita. Fundamentals relating to it, as well as the other stocks passing muster, can be found in the accompanying table. The downloadable excel version of the table contains extra fundamental details. Given the screen brought back relatively few results, the downloadable version of the table also contains details of 22 more shares that passed all but one of the screen’s tests.
Four Genuine Value shares
|Name||TIDM||Mkt cap||Net cash / debt (-)*||Price||Fwd PE (+12mths)||Fwd DY (+12mths)||PEG||GV ratio||ROCE||5-yr Sales CAGR||5-yr EPS CAGR||Fwd EPS grth FY+1||Fwd EPS grth FY+2||3-mth mom||3-mth Fwd EPS change%|
RHI Magnesita (RHIM) is a global leader in the refractories (industrial heat-resistant linings) sector. While the history of the firm spans almost 200 years, it is a relative newbie on the London market, having relocated its listing from Vienna in 2017 following the merger of Austrian RHI with Brazilian Magnesita. Almost 30 per cent of the shares are owned by controversial Austrian businessman Martin Schlaff, who is alleged to have had links to the Stasi.
While 2020 was tough for the company, it looks well positioned to benefit from the post-pandemic global recovery as well as a substantial, ongoing self-help program. It’s end markets also look set to ride several long-term mega trends. That said, while the company appears to have many things going for it, it is part of a capital intensive, cyclical and relatively low-margin industry.
RHI operates a cradle-to-grave business model. It mines its own raw minerals (doloma and magnesia) from which it makes its refractory products that are able to protect against temperatures of up to 2,000 degrees. The company delivers, installs and advises on the use of its refractory products and ultimately disposes of them, too, or recycles them when possible.
Refractories are an essential part of many industrial processes including steel making, which accounts for 70 per cent of RHI’s sales. Steel is a particularly interesting refractory market because, unlike other industrial processes, heat-resistant linings need replacing very quickly – between 20 minutes and two months. This means refractories are part of steel companies’ operating budgets as opposed to easy-to-delay capital spending. This characteristic means RHI should be very quick to benefit from a post-pandemic recovery in steel production, which there are already encouraging early signs of.
What’s more, while refractory products usually account for only 2 to 3 per cent of steel-making costs, the quality and application of refractory products has a major impact on overall efficiency of operations. Purchasing decisions are therefore based more on quality than price.
RHI’s other markets cover a range of industries from concrete to glass making. Most of the areas served by the company stand to benefit from increased demand from mega trends such as urbanisation, automation, the emerging middle class in the developing world and investment in infrastructure.
RHI is the global refractory market leader with a share of 15 per cent – or 30 per cent excluding China. Scale not only brings cost advantages, it also puts RHI in a very good position to invest in the quality of its products to secure an edge over competitors. Spending on research and development (R&D), and technical marketing has stood at about €60m a year for the last three years. It is hoped that this investment, which includes developing digital monitoring and optimisation tools, will contribute to a goal of achieving a €40m to €60m uplift in sales by 2022. The company also wants to grow the proportion of sales from its solutions business from 27 per cent to 40 per cent by 2025. Boosting these revenues has the added advantage of potentially creating more 'sticky' customer relationships which should improve pricing power.
The company is also looking to increase its profitability through a massive post-merger cost-cutting programme. It expects to achieve savings of €100m by 2022 (and €75m this year). The change is not cheap and there have been regular 'exceptional' items relating to the cost of the restructuring. But the capital expenditure bill is expected to peak this year at €260m, including €80m of maintenance spending. This is expected to drop to €165m in 2022 and continue falling through to 2024 to €125m.
The cost-cutting drive was key to keeping the group’s underlying refractory margin moving forward in 2020 despite a substantial 23 per cent, Covid-induced reduction in sales. The margin nudged up from 9.0 to 9.1 per cent. However, this progress was made harder to spot by the fact that the company has its own raw material mining operation. Owning mines helps ensure security of supply, product quality and makes the group more profitable. However, profits from the operation are very volatile due to fluctuations in commodity prices.
In 2017, a major shortfall in industry-wide raw material supply led to a profit surge from mining. This has been correcting for two years, which caused top-level margins to drop from 14.0 to 11.5 per cent last year, despite improvements in refractory margins; the thing the company has real control over (see chart).
Importantly, it now looks like raw material prices have stabilised near the long-term average. They could even show a sustained improvement as a recovery kicks in. At the very least, there is a good chance efficiency gains will now be able to shine through along with margin benefit from a post-pandemic recovery. A potential counter to this is the sensitivity of RHI’s profits to the dollar (about €2m per cent) which has recently been showing some weakness.
Despite significant capital needs, the company also made a decent return on invested capital (operating profits after tax as a percentage of capital employed) last year of 11.5 per cent – within its 10 to 15 per cent target range.
As well as growing with its customers, RHI is looking to get a larger share of the huge Chinese market. It has had success establishing local sales teams and acquisitions could be an option. Indeed, globally, growth through acquisition is one of the company’s aims.
The balance sheet looks like it should be able to support acquisitive ambitions. Year end net debt of €589m (excluding €57m of lease liabilities) does not look too high, although the fact Covid shrunk 2020 cash profits by a third means RHI finished the year at the top of its 0.5 to 1.5 times target range for net debt to cash profits. The maturity of borrowings also looks reassuring. There is also a pension deficit of just over €300m.
There are some balance sheet features that may raise eyebrows, but in context of the firm have some explanations. For example, the company uses supply-chain financing to get cash early from unpaid invoices and also to speed up payments to suppliers – this totalled €222m at the end of 2020. This kind of financing is often seen as a sign of a company struggling to find cash and has recently once again been brought into the spotlight by the demise of Greensill bank and its associations with the Gupta industrial empire. However, this kind of financing can be a totally legitimate way to oil the financial wheels for companies, and RHI has set limits on its usage at €320m.
Another point of note is that a €400m chunk of the company’s borrowings are through Schuldschein loans. This is a form of German financing that companies can obtain without a credit rating and which gained infamy with UK investors due to its use by Carillion prior to its collapse. On the flip side, this is a well established and popular debt market with companies in Germany and Austria. So while the use of such borrowing by a Wolverhampton-based company, as Carillion was, may seem peculiar, it does not seem so unusual for a company headquartered in Vienna, such as RHI.
Importantly, RHI’s cash generation has generally been strong. This was helped last year by the release of working capital from reduced turnover and the group’s own efforts to get spending down. Management was confident enough to announce a €50m share buyback programme at the time of the full-year results and debt should fall as the company moves beyond its peak capital expenditure plans this year.
On many measures the shares are not expensive, the market leadership and R&D is a big plus, and there are many potential catalysts for broker upgrades (recovery, raw material prices, self-help, a China breakthrough, acquisitions). If progress starts to shine through, investors may start to look past some of the elements of the investment case that look less attractive.