7 cheap recovery plays

When I updated my Late Bloomers screen last year, I used almost the whole of my column to explain why I was doggedly sticking by my value-focused screens despite the chronically poor performance of the investment style. The palpable desperation so evident in my writing perhaps should have told readers something of much more worth than what I expressed: 'value' shares were set to rocket.

Indeed, since that snivelling apology of a screening column that I penned a year ago, the 19 shares highlighted by my Late Bloomers screen have delivered a 52 per cent total return compared with 24 per cent from the FTSE All-Share. That’s the thing with investment strategies, and often markets too, it’s just when it feels like it's time to throw in the towel that the reverse is most true. The desire to sell at such times is also one of the biggest arguments in favour of diversification to manage risk, as this can help guard against the danger of panic selling.

However, the torrid performance of the screen prior to last year’s strong run means its cumulative total return based on annual reshuffles since inception seven years ago is an uninspiring 47 per cent compared with 40 per cent from the index. While the screen is meant as a source of ideas rather than an off-the-shelf portfolio, if I factor in a notional 1.5 per cent annual charge to represent dealing costs, the total return drops to a below-market return of 33 per cent. 

My Late Bloomers screen’s name comes from the fact that it was originally devised a good few years into the post-credit crunch recovery. The idea was to capture cyclical stocks that were late to enjoy the fruits of the improved economic conditions. Necessarily, this approach means having a 'value' focus.

Specifically, the screen looks for shares that appear cheap against their own long-term valuation range. It assesses this by looking at the valuation of a stock against the ultimate source of its earnings. The reasons to value against the source of a company's earnings rather than earnings themselves is that there is often the most recovery upside at times when profitability has been decimated. In other words, excellent value plays can often look extremely expensive when valued against earnings. That means the source of earnings that could emerge should a company’s fortunes improve can provide a much better valuation yardstick. It measures a company’s future earnings potential rather than its current dire straits. 

The screen assumes the source of earnings for most companies is sales. However, for property companies, housebuilders and financials, it looks to book value. 

A standardised statistical measurement called a Z-score is used to see how cheap or expensive valuation looks compared with the 12-year history (a minimum of six years when the full history does not exist). From this approach, I torture out the acronym of the ZEUS ratio (that being Z-score of earnings’ ultimate source). 

A major weakness in comparing a company’s valuation against its history is that sometimes things can change and a business simply becomes better or worse than it was, therefore justifying a different valuation.

The screen looks for a ZEUS ratio of -1 or less, suggesting the valuation is roughly in the lowest 17 per cent of the historic range. The other tests used by the screen are there to see if the balance sheet looks in a serviceable state and whether the company has indeed been more profitable in the past than it is now. 

The full criteria are:

■ Value: ZEUS ratio of -1 or less. 

■ Recovery potential: Real estate companies get a free pass on this test. For financials, return on equity needs to be at least one-third below its 10-year peak. For other sectors, operating margin at least a third below 10-year peak.

■ Balance sheet: (i) For financials, equity representing at least 5 per cent of assets and return on assets of at least 1 per cent. This is a test suggested by the great Peter Lynch, the former star manager of Fidelity’s flagship Magellan fund. (ii) For utilities, which have very defensive earnings streams well suited to supporting high levels of debt, net debt to book value (gearing) of less than 150 per cent. (iii) For real estate companies, gearing of 75 per cent or less. (iv) For housebuilders, gearing of 25 per cent or less. (v) For all other sectors, net debt of 1.5 times cash profits or less.

■ Growth: Growth in 'earnings' ultimate source' (the EUS in ZEUS over the past 12 months. 

■ Positive free cash flow: Free pass for financials and real estate

(NB investment trusts are excluded from this screen but not Reits)

Even with such limited criteria, only one stock passed all the tests. I’ve therefore allowed stocks to qualify that pass the ZEUS test but fail one other. This boosts the results to seven. Full details of the stocks with some fundamentals can be found at the end of the article. I’ve also taken a closer look at one of the stocks highlighted.

Shaftesbury

Real-estate investment trust (Reit) Shaftesbury (SHB) owns 16 acres of incredibly desirable real estate in prime West End shopping and leisure destinations such as Carnaby Street, Covent Garden and Soho. The company has spent nearly 35 years amassing its portfolio of around 600 buildings and creating an estate that would be impossible to replicate. 

The trouble is, the things that made the West End so attractive to landlords prior to Covid have become major problems as a result of lockdown. In normal times, Shaftesbury’s properties benefit from extremely high footfall due to both tourism and large numbers of local workers. 

Covid has torpedoed this. Few people have wanted to venture into crowded areas, while international tourists have been told to stay away for much of a year.

Footfall in the West End cratered as soon as lockdown hit and has lagged the recovery of high streets during periods of reopening. What’s more, the focus of Shaftesbury’s portfolio on eating (37 per cent of rent), drinking and shops (30 per cent) many of which were classed as ‘non-essential’ has meant its tenants have been slower to benefit from the easing of restrictions. Many tenants will be cash-strapped for some time to come, especially given shops were only open for three of the usual 10-week bumper festive trading period.

The company has said it expects tourism to start picking up late next year but is not expecting a return to pre-pandemic levels until 2025 or 2026. Meanwhile, there is uncertainty about demand for offices and central London apartments (the two other parts of the portfolio) in the post-lockdown world.

As one may expect, the numbers Shaftesbury has been reporting during this torrid period have been terrible, and the red ink is expected to continue to flow in the current financial year to the end of September. 

Vacancy rates stood at 10.8 per cent in February, which compares with a 10-year average of 2.9 per cent. The company had only collected 45 per cent of rent due for the final quarter of 2020. Meanwhile, the 2020 financial year saw a drop in property valuations along with a painful like-for-like fall in estimated rental values (ERV) of 6.6 per cent. The last previous fall in ERV was a 3.9 per cent drop at the height of the great financial crisis. 

The bottom line was that for 2020 Shaftesbury reported a drop in net asset value (NAV) per share of almost a quarter from 982p to 743p. Broker Liberum forecasts further big NAV falls, with an estimate for the end of September this year at 570p recovering to 599p by 2023. That forecast includes a dilution from the sale of 77m new shares (about a quarter of those previously in issue) at 400p last November.  

So trading is horrible. But in the longer term there are grounds to think Shaftesbury’s assets are still very lovely. It is already seeing interest in new letting as retailers start to look ahead to the end of lockdown. It’s focus on relatively small and affordable units is also in its favour. The fundraising last year also puts it on a sound financial footing with a loan to value ratio estimated at 24 per cent and £358m of cash and undrawn bank facilities available. It also has waivers on key loan covenants out to 2022. Indeed, management has felt confident enough in the financial position to continue to snaffle up the odd few hard-to-get properties when they come free.

Expectations for a recovery in NAV currently look fairly pessimistic, with expectations of just 599p a share by 2023. This reflects the huge levels of uncertainty about exactly how smooth a transition the world will make back towards normality – the Indian variant of Covid-19 being a pertinent case in point. Against this, the share price suggests investors perhaps see more value than brokers' forecasts imply. 

The portfolio is extremely attractive and the special attractions of the West End and spread of tenants means the normal concerns about online retail competition are much less relevant to Shafestbury than other landlords. The long-term history of rental growth is also very impressive.

2019 may feel like a distant memory, but adjusting for the fundraising NAV in that year was equivalent to about 860p and growing. It’s the kind of return to form that this rear-view-mirror view suggests that the screen is focused on as the ZEUS ratio does not factor in forecasts. Still, for anyone prepared to put their faith in a return to normality, and buy and forget, given the very special nature of the portfolio, the current share price has attractions despite the premium to forecast NAV.