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Four cheap growth stocks

My Peter Lynch screen has trounced the FTSE All-Share with a 65 per cent total return over the last 12 months versus 25 per cent, but I'm still not entirely happy
Four cheap growth stocks
  • A great 12-month total return for my Peter Lynch inspired screen of 65 per cent versus 25 per cent from the FTSE All-Share
  • Comfortably ahead of the index over the last nine years at 172 per cent versus 86 per cent
  • But this screen's record is just a bit too erratic
  • Quality is an essential consideration when valuing growth stocks
  • Four new cheap growth picks
  • De La Rue's recovery story under the spotlight

Peter Lynch was a great fund manager. Between 1977 and 1990 the Magellan Fund that he managed for Fidelity averaged annual returns of 29.2 per cent and regularly beat the S&P 500 index by a substantial margin.

Sadly, my screen, which attempts to mimic the process Lynch used to identify stalwart investments, has been far from great. Just to be totally clear, I’m not blaming Lynch for this. I present the screen’s nine-year performance record with my own head hung low. 

I feel it’s probably about time to try switching things up by making some changes to the screening criteria, but two things have stopped me from doing this this year. 

Firstly, while I feel my dissatisfaction with this screen is justified based on its erratic performance since I started to follow it in 2012, last year’s performance actually deserves a hat tip. The seven shares selected by the screen managed to produce a 65.1 per cent total return compared with 24.7 per cent from the FTSE All-Share over the same period. The screen as it stands, may suit the current environment.

 

NameTIDMTotal return (28 Apr 2020 - 28 Apr 2021)
Clipper LogisticsCLG234%
WincantonWIN83%
Sirius Real EstateSRE50%
STVSTVG39%
MotorpointMOTR35%
Impact Healthcare ReitIHR21%
British American TobaccoBATS-7.1%
Lynch-65%
FTSE All-Share-25%

 

The second reason I have been minded to continue with the screen as it is, is that if I do so it will have a 10-year track record with which to judge it by. Giving special significance to 10-year track records is something that is popular in the investment industry, but is also something that I find rather arbitrary. I may well have made a mistake in caving to the sentiment – we’ll see how low my head is bowed next year!

That said, the screen has produced what looks like quite an interesting list of ideas. Whether they deserve to be considered stalwarts is a different matter. 

A standout difference between the screening criteria for my Lynch screen and some of the other more successful 'growth-at-a-reasonable-price' (GARP) screens that I follow in this column is that there is little attention paid to quality beyond a test for debt levels. 

When it comes to valuing growth companies, quality is key. The reason for this is that in order to create shareholder value a company must be producing returns on its investments that are higher than the cost of its investments. In finance jargon: return on invested capital (ROIC) must be greater than weighted average cost of capital (WACC). If costs are higher than the returns, growth actually destroys shareholder value. 

For me, the lack of a quality test to check returns on investment look decent is probably the key reason for the erratic performance of this screen. It has only outperformed the FTSE All-Share on five of its nine outings and has often underperformed badly. 

That said, last year’s good run means the cumulative total return from the screen stands at 172 per cent over nine years which is better than the index at 86 per cent by some way. While the screens tracked by this column are meant as a source of ideas for further research rather than off-the-shelf portfolios, if I factor in a 1.5 per cent annual charge to account for notional dealing costs the total return drops to 137 per cent.

 

 

The full criteria are:

■ A dividend-adjusted PEG ratio of less than one.

Dividend-adjusted PEG = price/earnings (PE) ratio/average forecast EPS growth for the next two financial years + historic dividend yield (DY).

■ Average forecast earnings growth over the next two financial years of between zero and 20 per cent as long as forecast growth in each of the next two financial years is positive, but below 30 per cent – attractive, but not suspiciously high growth.

■ Gearing of less than 75 per cent. Or in the case of financial companies, equity to assets of 5 per cent or more, and a return on assets of more than 1 per cent.

■ Three years of positive earnings.

■ Turnover of over £250m.

This year four shares passed all the screen’s tests. Full details can be found at the bottom of the page along with a downloadable version of the table packed with extra fundamental data.

The stock I’ve taken a closer look at from the four is a turnaround situation that cropped up in another GARP screen last July, De La Rue (DLAR). There are some encouraging signs emerging from the turnaround since I last looked at the company but there is still a long way to go.

 

De La Rue - a race against cash outflows

Banknote and security-label printer De La Rue has been attracting attention as a recovery play since the company was bought back from the brink by a new management team midway through last year. 

With trading in decline, a tottering tower of debt and pension liabilities, and cash seeping from the business, the company told shareholders there was material uncertainty about its future as a going concern when it published its 2020 annual report. 

Fortunately, management has since bought some time to turn the business around. The price it paid for the life-line was high. Costs associated with a refinancing of £275m of borrowing facilities to the end of March 2023 came in at £3.1m plus an additional 1.5 per cent of interest on borrowings drawn. Meanwhile, the sale of new shares at 110p raised £100m, but £7.1m went in costs.

Still, beggars can’t be choosers, and a 240 per cent surge in the share price in the days following news of the rescue package shows just what a relief it was.

The company had previously raised £42m from the sale of its international identity solutions business in October 2019. 

At the half-year stage net debt was down to just £22m. However, having got borrowings down, the company is now in the process of hiking them back up as it tries to build a viable growth-focused business with a three-year plan running to the end March 2023. Year-end debt (end March) should be £53m. While this is £21m lower than expected, management has said this is chiefly down to the timing of planned spending. 

Indeed, the group’s authentication business (certification labels for things such as cigarettes, alcohol and medicines), which management plans to invest heavily in, suffered delayed orders from governments due to Covid. There is still a target of taking authentication sales from £69m to £100m. 

The company also believes investments per new authentication contract will be less than originally expected. This means it is sticking with plans to invest £80m in growth over three years while also increasing the amount it is ploughing into polymer bank notes – what management regard as the other big opportunity. Investment plans here have increased from £15m to £20m. It is the market leader in this area and sees significant potential for currencies to go polymer, as the UK is doing.

Elsewhere, De La Rue is forking out significant amounts of cash to cut costs. It will spend £16m to reduce costs by £36m at its currency division, which includes a struggling paper banknote division as well as the promising polymer business. The second half of the recently completed financial year is also expected to have seen a £12m cash outflow associated with the winding down of the group’s UK passport contract, which was once a major contract for its discontinued identity business.

Then there is the matter of the pension scheme, which is an ongoing drain on cash. The actuarial pension deficit (the deficit funding decisions are based on as opposed to the one reported on the balance sheet) was estimated to stand at £190m in April 2020. The trustees have agreed to drop top-up payments during the turnaround to £15m a year before ratcheting them back to £24.5m from 1 April 2023 until the end of March 2029. 

If all goes to plan, the company should be in a much better position to face the higher pension bill when it kicks in. It is hoped all the spending on restructuring and investment will create a company capable of producing compound annual revenue growth of 9 per cent, accompanied by a mid-teen adjusted operating margin before central costs (this compares with 11 per cent from De La Rue’s two on-going businesses during the first half).

Broker Numis forecasts net debt will get to £90m by the end of March 2022 before positive free cash flow emerges. Net debt is then forecast to fall to £73m at the end of the following year. Interest costs are estimated at just over £7m in each year.

While there is a lot to do, if it can be pulled off, then shareholders should be able to expect good upside. There are some encouraging signs from the group's order book and brokers have recently nudged up earnings expectations, mainly thanks to faster-than-expected cost-cutting.

If Numis’s forecast turns out to be right, based on expected enterprise value (current market cap plus forecast net debt) and free cash flow to firm (free cash flow before interest expenses), the business's 2023 free cash flow (FCF) yield stands at nearly 7 per cent. Higher pension top-ups would be a headwind the following year, though. Sill, if the three-year targets are achieved, that would represent a bargain. The company would also in a good position to negotiate better borrowing terms as the costly facilities put in place last year mature. Any positives on the pension would also be a boon.

De La Rue is an interesting turnaround story, albeit one with a tight time-frame and noteworthy risk if management can't deliver.

 

FOUR STALWART(?) GROWTH PLAYS
NameTIDMMkt CapNet Cash / Debt(-)*PriceFwd PE (+12mths)Fwd DY (+12mths)FCF yld (+12mths) EBIT MarginROCEFwd EPS grth FY+1Fwd EPS grth FY+23-mth Mom3-mth Fwd EPS change%
Man Group PLCEMG£2,338m£58m161p115.4%- -13.3%24%11%9.4%13.1%
Pearson PLCPSON£6,161m-£536m817p232.5%3.4% 5.7%3.3%18%18%-5.8%-6.5%
St. James's Place PlcSTJ£7,105m-£220m1,319p223.6%- --16%19%10.6%17.8%
De La Rue plcDLAR£349m-£30m179p110.1%-2.4% 8.6%15.7%6%19%17.0%7.0%
Source: FactSet