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Four growth shares going for a song

For the fourth time in six years, our John Neff-inspired screen has underperformed the market. What has happened?
Four growth shares going for a song

As the manager of Vanguard’s Windsor fund between 1964 and 1995, John Neff presided over some turbulent financial market episodes. But a disciplined approach to stock selection helped the famous US investor return an average of 13.7 per cent a year, versus 10.6 per cent from the S&P 500.

Thanks to the miracle of compounding, that outperformance meant that anyone who stuck with Neff throughout his Windsor career would have made more than double the returns on offer from the world’s premier blue-chip index. In short, Neff’s investment style – which can be summed up as the hunt for growth stocks at fair prices – is worth paying attention to.

This month will mark 10 years since we started running a screen based on Neff’s principles. Though recent form has been middling at best, a brilliantly consistent run in the first half of the decade means the screen is still up since inception, having posted a total return of 172 per cent versus 109 per cent from its benchmark, the FTSE All-Share Index.

Given the screen is intended to generate ideas for further research rather than being an off-the-shelf portfolio, this outperformance is flattered by a lack of frictional costs. Factor in a 1 per cent annual dealing charge and the return drops to 138 per cent. And for that real-world annual outperformance of 1.35 per cent, investors would have had to swallow almost double the volatility while watching the benchmark steadily gain ground on a portfolio that is yet to break above a level first reached more than five years ago. Gulp!

 

 

The poor performance continued over the past 12 months, despite what was broadly a good period for value-oriented stocks.

It didn’t seem this way half-way through the year. Seven months after we ran the screen, our 2021 Neff picks were up 23.6 per cent, compared with a 10.2 per cent return from the benchmark. Each of the stocks were in positive territory for the year, led by Clipper Logistics (CLG) and student accommodation provider GCP Student Living (DIGS), whose board had recently accepted a $1.3bn (£1bn) bid from a consortium led by Blackstone and Dutch pension fund manager APG.

Clipper and GCP ended the year the standout performers, but overall returns stuttered owing to some chunky exposure to derivative trading platforms IG Group (IGG) and CMC Markets (CMCX), the latter of which fell dramatically after a painful profit warning at the start of September.

Another sting in the tail came from B&M European Value Retail (BME), whose shares were badly hit at the end of the period despite another round of forecast earnings upgrades. Investors appear to be laying bets that the low-margin discount retailer will struggle to absorb rising inflation, while a huge recent share sale by SSA Investments, the vehicle owned by chief executive Simon Arora and his family, is unlikely to have helped sentiment.

 

2021 performance
NameTIDMTotal Return (9 Feb 2021 - 20 Jan 2022)
Clipper LogisticsCLG27%
CranswickCWK10%
GCP Student LivingDIGS42%
B&M European Value RetailBME5.4%
IG GroupIGG15%
CMC MarketsCMCX-39%
FTSE All-Share-18%
Neff-10%
Source: Thomson Datastream

 

As we pointed out when we last ran the screen, both IG and CMC are very sensitive to market volatility, given their customers’ trading habits tend to be both sporadic and unpredictable. What our screen interpreted as cheaply priced earnings growth, investors guardedly identified as a cyclical sector in which profit booms are shortly followed by profit busts.

In theory, the Neff method should guard against this approach. First, a focus on reasonable valuations should build in a margin of safety. Second, one of the Neff screen criteria – a five-year earnings per share (EPS) compound annual growth rate (CAGR) of more than 7.5 per cent and less than 20 per cent – should weed out stocks with particularly choppy profits. Then again, short-term earnings volatility is easily disguised by longer-term averages, and always hard to forecast.

The screen’s criteria are:

■ Historic PE ratio below the most expensive quarter of shares and above the cheapest 15 per cent.

■ A lower than median average Neff PE ratio. Neff PE = PE / Average of five-year compound annual EPS growth rate (five-year EPS CAGR) and forecast two-year average growth, plus dividend yield (DY)

■ The aforementioned five-year earnings CAGR of between 7.5 and 20 per cent.

■ Average forecast EPS growth for the next two financial years of more than 7.5 per cent.

■ Rising EPS in each of the past two half-year periods.

■ Five-year turnover CAGR of 5 per cent or more (in the long term, earnings growth needs to be based on rising sales).

■ Positive free cash flow in each of the past three years.

This year, just two stocks passed all of the test – Sirius Real Estate (SRE) and JD Sports (JD) – the first of which I look at in closer detail below. A further two companies, Pets at Home (PETS) and Dunelm (DNLM), are included in the table as they were close to passing the five-year annualised compound EPS growth test. In both cases, they came up just short of the required 7.5 per cent range. Some exception for the past two years’ earnings volatility is probably warranted for both retailers, especially when balanced against strong forecast profit growth for the next 24 months.

TEST FAILEDNameTIDMMkt CapNet Cash / Debt(-)*PriceNeff PEFwd PE (+12mths)Fwd DY (+12mths)FCF yld (+12mths)Fwd EPS grth FY+1Fwd EPS grth FY+23-mth Fwd EPS change%3-mth Mom
N/AJD SportsJD£10,040m-1,160m195p0.57170.1% 81.4%0.8%12.9%-6.3%
N/ASirius Real EstateSRE£1,519m-445m130p0.90182.7%-47.2%7.0%12.2%-3.6%
5Y EPS CAGR > 7.5% < 20%DunelmDNLM£2,698m-165m1,331p1.17177.5%6.2%21.8%3.4%8.5%3.1%
5Y EPS CAGR > 7.5% < 20%Pets At HomePETS£2,087m-332m417p0.72182.3%4.7%55.0%11.9%5.7%-11.3%
Source: FactSet              
*FX converted to £             
**FCF less repayment of lease principle            

 

What the top selections in this year’s screen clearly lack is diversification. JD, Pets at Home and Dunelm all boast strong management teams and track records of defying the travails of physical retail. But they are each susceptible to jittery consumer sentiment and spending patterns, which could be knocked if inflation proves more than transitory.

Still, for the sake of objective rigour, we should be prepared to keep the faith with a process with such a strong historic track record. Indeed, if we are on the cusp of a larger shakeout in expensive growth stocks, then the historical parallels augur well. Between January 1999 and December 2002, during which time the bubble in overinflated US tech companies burst, the Windsor fund outperformed the S&P 500 by 8 percentage points a year.

See below for a larger Excel version of this sheet.

Sirius Real Estate
Company DetailsNameTIDMDesriptionPrice
Sirius Real EstateSREReal Estate Development130p
Size/DebtMkt CapNet Cash / Debt(-)*Net Debt / EbitdaOp Cash/ Ebitda
£1,519m-£445m5.8 x123%
ValuationFwd PE (+12mths)Fwd DY (+12mths)FCF yld (+12mths)P/BV
183.2%-1.6
Quality/ GrowthEBIT MarginROCE5yr Sales CAGR5yr EPS CAGR
-5.1%29.2%18.1%
Forecasts/ MomentumFwd EPS grth NTMFwd EPS grth STM3-mth Mom3-mth Fwd EPS change%
13%--3.6%12.2%
Year End 31 MarNet rental revenue*Pre-tax profit*EPS*DPS*
2019£65.9m£42.1m3.95p2.87p
2020£74.8m£48.9m4.79p3.15p
2021£76.4m£77.9m4.76p3.28p
f'cst 2022£89.3m£67.6m7.00p3.59p
f'cst 2023£120.9m£83.1m7.49p4.32p
source: FactSet, adjusted PTP and EPS. *figures converted to £
NTM = Next Twelve Months  
STM = Second Twelve Months (i.e. one year from now) 

 

Whether through management specialism or shareholder demand, UK-listed property funds have evolved to centre on a handful of thematic investments. Right now, the most sought-after (and highly valued) of these themes include warehouses and logistics, self-storage, and doctors’ surgeries. But in a sense, this is just the current iteration of an unchanging constant: the hunt for real estate sectors where supply is limited, demand is strong, tenants are stable, and the prospects for long-term rental growth are good.

Against this backdrop, Sirius Real Estate (SRE) is something of an outlier. Over the past decade, few UK-listed property investments have performed as brightly. And yet it has retained a flexible approach to its large portfolio of branded out-of-town business parks across Germany. As a result, rental income is drawn from a mix of office, storage and industrial leases.

It does this by taking a hands-on approach to its estate, which is managed centrally by a large internal team that works with tenants to understand their immediate demands and re-fit space accordingly.

This has produced a virtuous cycle for rising rents and reinvestment. At last count, around three-fifths of the book value of Sirius’ German properties were tied up in so-called “value-add” assets, meaning there is plenty of reversionary potential in the portfolio. Average capital values of €895 (£749) per sq m are also well below replacement cost, which means tenants are incentivised to stay put and accept long-term rental growth.

Another source of earnings growth comes from expansion of the rent roll. Although Sirius has higher vacancy rates than some of its peers, prospective tenant enquiries recovered very strongly in 2021, and should feed through to higher occupancy levels in the coming months.

This doesn’t mean sacrificing long-term stability for a quick buck, however. Since joining the group in 2010, chief executive Andrew Coombs has injected a granular and long-term approach to tenant diversification and selection. A decade ago, the industrial giant Siemens made up a quarter of Sirius’ rent roll. Now, there isn’t a single industrial sector that accounts for more than 4 per cent of the portfolio. This should act as a buffer to cyclical shocks to the Mittelstand.

Despite the considerable work involved in managing its existing portfolio of 76 business parks, Sirius is keen to grow further.

And while competition for light industrial properties in Germany is rising, the recent acquisition of a €34.5m (£28.9m) business park in the Greater Stuttgart region shows the types of asset the landlord specialises in are available. While the complex is only 80 per cent let, it generates €2.2m in annual rent from two tenants, and management is confident redevelopment work can cheaply add value.

Funding this expansion should not be a problem, given the group’s access to low-cost euro debt, and a 1.36 per cent weighted interest rate. Equity markets are another ready source of funds, as evidenced by the November acquisition of BizSpace – a UK-wide operator of 72 flexible, light-industrial workspace sites – for £245m in cash, of which £137m was raised through a share sale.

While the deal was struck at an excellent price – and should prove accretive to operating cash flows this year – it adds complexity and another country into the bargain. But the weight of institutional investor support for the purchase points to considerable faith in the business model, and a management team whose decision-making is led by the prospects for growing cash flows.

“The way I look at things is it starts with the income statement, then it goes through cash and the balance sheet is the consequence of what you operate,” Coombs told us last year. “As a landlord, your focus has to be on cash generation; when everything else stops, nothing else matters and net asset value is just a paper illusion.” John Neff would likely approve.