Five contrarian value shares

Some people like to say all investing is value investing. Essentially this is an argument built on semantics, but for me, such a sweeping interpretation of value investing is in danger of missing the point. The “all-investing” position confuses what I would regard as the niche activity of value investing with valuation. 

That’s because my understanding of value investing, and this week's screen's understanding of value investing, centres on the idea of reversion to the mean; a view of value investing that’s by no means novel.

Sometimes companies start to perform badly. The market tends to price shares in these troubled companies as if bad times are here to stay. However, such companies can often recover back towards their past glories. They revert to the mean. When such shares do indeed prove to be mispriced, they are so for a very particular reason: a lack of faith in their ability to regain past form.

Behavioural finance suggests many reasons why the default position of investors is to underestimate recovery potential, but essentially it all boils down to the fact that the human mind struggles to see beyond today’s dominant narratives. My ideas farm column this week on page 44 explores one of the reasons why this is the case.

Whether beaten-up companies are classic cyclical plays (economically-sensitive) or businesses facing idiosyncratic woes, trying to exploit the market’s propensity to underestimate recovery potential lies at the heart of what I regard as value investing. Believing things will get better, or “revert to the mean”, is something of an article of faith for dedicated value investors. That position strikes me as altogether different from buying a quality growth stock, let’s say, which is performing well but looks mispriced based on a discounted cash flow analysis. 

Over the past decade and a half, those who have put faith in reversion to the mean have generally done badly, as much discussed in this magazine and elsewhere. However, the performance of my contrarian value screen provides a reason to keep faith. Over the 10 years I have run it, it has substantially outperformed the market. And last year’s top-five selection produced a knockout 68 per cent total return as vaccine breakthroughs put a rocket under down-trodden value stocks.

2020 PERFORMANCE

Source: Thomson Datastream

The storming result from 2020 – a 68 per cent return – takes the cumulative total return from the the screen's top five stock selection to 344 per cent for the decade, which is based on annual reshuffles. That compares with 93 per cent form the FTSE All-Share. A 20 stock version of the screen, which I’ve grown to have relatively little time for (as discussed below) has managed a 161 per cent total return over the same period. 

While the screens run in this column are meant as a source of ideas rather than off-the-shelf portfolios, if I inject a sense of realism into the numbers with a notional 1 per cent annual charge to reflect dealing costs, the total return from the top five contrarian value stocks drops to 302 per cent and 136 per cent from the top 20. 

More often than not, there are very good reasons for shares looking superficially cheap or expensive. So value investors generally need first of all to understand why their quarry appears cheap. After that, it is important to form an idea of why the shares may re-rate. And finally, a view needs to be taken on the likelihood that the virtuous circumstances needed to trigger a re-rating will occur versus the likelihood of ongoing torment. 

My contrarian value screen tries to find stocks that fit this bill by looking for lowly-rated companies that have historically had decent profitability and appear to be continuing to make enough progress to suggest all is not lost.

Sales is key to the screening criteria. While many investors fixate on profits and cash flow, companies that are in trouble often report very poor earnings, or even losses, with a corresponding impact on cash generation. Forecasts also often get cut back to an extent that suggests little will change. That means recovery plays can look very expensive valued against earnings and cash flow just when the potential for recovery (reversion to the mean) is greatest. Except for in the most extreme cases, sales tend to have more sticking power.

My Contrarian Value screen works by first makes checks on quality that suggests stocks offer reasonable promise based on sales growth, past levels of profitability, debt levels and the ability to generate at least a little cash. For those shares that meet the criteria, the screen then selects the cheapest shares based on enterprise value (market capitalisation plus debt, minus cash) to sales (EV/Sales). 

■ Enterprise value of £25m or more.

■ Five-year compound average annual sales growth rate of 1.3 per cent or more (see below for detail of amendment made this year).

■ Forecast sales growth in each of the next two years.

■ An average operating profit margin of at least 5.9 per cent over the past five years (see below for detail of amendment made this year).

■ Positive free cash flow.

■ 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 one-off nature of Covid-19 meant I had to make some adjustments to the screening criteria last year to get decent results from the screen. I’m having to make adjustments again this year. Specifically, a torrid pandemic trading period means many of the types of duffed-up stocks the screen aims to identify are struggling to hit the tests for a five-year compound annual sales growth rate of 7 per cent plus and a five-year average operating margin of 10 per cent or more. 

The compromise I am making is only ask that companies are in the top two-thirds of those screens based on both metrics. That means compound average sales growth of 1.3 per cent or more and an average margin of 5.9 per cent or more. In normal times this could be regarded as a very low bar, but given the type of stock we’re after should have been hit hard by lockdown, the risks associated with loosening the criteria will hopefully prove worth it.

For several years I have expressed a view that it is really only the top five results from this screen which are of serious interest. That’s because these tend to be the only shares the screen highlights which genuinely seem to have low EV/Sales and this after all is a “value” screen. As a rule  of thumb, an EV/Sales of one or less is often considered very interesting. This year, though, the screen does seem to have found more value on offer in the top 20. The method I've used to weaken the criteria will explain some of this.

One particular thing to be aware of is that because I’ve had to relax the criteria for historical margins, several of the companies in the list have high levels of pass-through costs (cost that flow directly to customers and offer little opportunity for profit-producing mark ups). One case in point is the most lowly-rated stock on the list, Severfield (SFR), which I’ve taken a more detailed look at below. The full list of stocks and fundamentals can be found at the end of this article.

SEVERFIELD

Source: FactSet

Severfield’s shares have never been very highly rated. There are good reasons for this, as outlined below. However, there are also a number of reasons for thinking they may represent good value at the moment.

The company is the UK’s leading steel fabricator. It designs, manufactures and installs everything from high-end bespoke steelwork to modular systems. Through its five facilities across the UK can process up to 300,000 tonnes of steel a year.

But the industry itself is competitive, low-margin, and cyclical (sensitive to the demand cycle in its end markets). The company also has a high level of fixed costs which can make profits sensitive to changes in demand (so-called operational gearing). Trading and profits are also vulnerable to disruptions in the steel supply chain. 

What’s more, the large, multi-year contracts that the group operates means a lot of its reported sales and profits each year necessarily have to be based on estimates of work done and profit earned. For example, in its last financial year management said there were eight contracts that required significant accounting estimates that represented £155m of sales and nearly £12m of profit. That was about half the group totals in each case. 

For many construction and outsourcing companies, this kind of contract accounting has been a recipe for significant disappointment and exceptional charges. Investors therefore naturally tend to put less value on such earnings. Reducing contract risk has been a key focus for Severfield since the group spiralled into loss in 2013 due to poor bidding and contract management.

Getting steelier

But while the nature of the industry helps explain the relatively lowly valuation, the performance of Severfield during the pandemic and since its annus horribilis in 2013 provides some grounds for optimism. So too does the potential outlook for demand.

Given the backdrop of the pandemic, Severfield came through its last financial year to the end of March strongly. With the help of acquisitions, sales rose 11 per cent. Meanwhile, underlying profits before tax were down a relatively modest 15 per cent due to Covid-related costs. 

This suggests some operational savvy. So too does the fact that the company has so far managed supply chain challenges caused by lockdown well. Long-standing and well-monitored relationships with multiple suppliers have helped. Severfield has also effectively passed on substantial steel-price increases to clients. Raw material prices are usually a pass-through cost as long as agreed terms with suppliers hold up, although higher prices do cause more cash to get tied up in inventory.  

The company's ability to create operational efficiencies is helped by the scale advantages that come with being the market leader. Severfield’s size helps it: attract and retain skilled staff; run high-capacity, fast-turnaround facilities; and invest in state-of-the-art production lines, with £50m of capital expenditure over the past seven years. 

There should be potential for the group to further capitalise on its scale through its focus on sustainability and carbon reduction. The growing requirements of its clients to deliver low-carbon, ESG-friendly projects means Severfield could build a competitive advantage here. And sustainability is a key component in the company’s ongoing SSS (smarter, safer, more sustainable) efficiency programme.

The operational resilience shown by the group recently is reflected in the fact that the group’s underlying operating margin only slipped slightly below the target 8 to 10 per cent range last year, coming in at 7.0 per cent. The current margin target was established after several years focused on rebuilding profitability.

Another indicator that management has a decent grip on the tiller is that despite the high level of estimates that have to be made when totting up the year-end scorecard, there have been no painful “exceptional items" since 2015. The £6m hit in 2015 related to a contract from 2013. The only adjustments the group tends to make to its profits are justifiable ones to reflect the peculiarities of acquisition accounting and movements in the value of financial derivatives. 

In demand

The cyclical (boom and bust) nature of Severfield’s business is another issue which may not currently be as concerning as has often been the case. For one thing, the company has been working hard to diversify the business. Of particular note was the fact that commercial offices represented only a quarter of the year-end order book in March compared with 60 per cent four years ago. Other end markets include: stadia and leisure (such as its project at the Tottenham Hotspur Stadium, pictured); industrial and distribution, transport and infrastructure, and nuclear. Two acquisitions over the last two years – Harry Peer and DAM – have also helped take the group into new markets. 

And the general outlook for demand seems strong. Management sees signs that the commercial office market has hit its nadir. There should also be significant work from the UK’s £640bn National Infrastructure Strategy as well as a strong anticipated economic recovery. 

The year-end order book was up from £287m to £301m. While the growth was achieved due to £18m of work acquired with DAM in April, management described tendering and pipeline activity as “very encouraged”. 

Prospects for the Severfield’s Indian joint venture also look like they are on the up. The operation slipped into loss during the pandemic but broke even in the second half. It also finished the year with a record £140m order book.

Should buoyant demand materialise, the group should benefit from having a more efficient balance sheet than it has for a number of years. Investment, cash returns and acquisitions have taken the company from a net cash position of £33m in 2018 to £4m at the end of March. The cash figure ignores £11m of lease liabilities and a £22m pension deficit. The balance sheet still looks solid, and having more of its capital at work rather than sitting as cash in the bank should make the company better able to exploit stronger end markets. 

Cheap for what reason?

The current EV/forecast next-12-month sales ratio does not seem to be pricing in anything too special. It is currently exactly at the mid-way point in the five-year range. While ongoing, issues in the steel supply chain generally are a risk, the current valuation of the shares may well prove to underestimate the ability of profits to pick up. Brokers have been upgrading forecasts since last November’s vaccine breakthroughs, which was recently aided by the acquisition of DAM. The trend could continue. An earlier fillip came in April when the group said it would comfortably beat expectations for the 12 months to the end of March 2021.

There is always going to be a risk that a company in Severfield’s line of work could serve up a nasty disappointment and steel supply is a concern. But the stock looks a good fit for the kind of unloved situation with improving prospects that this screen is designed to find.

FIVE AND 20 CONTRARIAN VALUE PLAYS