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Eight cheap growth stocks 2022

After a decade of our Peter Lynch screen, we are tweaking the process
May 3, 2022

To many a British ear, the phrase 'strong and stable' lost most of its power in the run up to the 2017 general election. Unfortunately for Theresa May, the endlessly repeated incantation quickly evolved from assuring soundbite to cliché and then meme.

But for investors, the search for strong and stable companies will always remain a tenet of any diversified stock portfolio. The famed US investor Peter Lynch, who for years ran the Magellan Fund for Fidelity, was a particular fan of such firms. He called them ‘stalwarts’: companies with strong balance sheets, good medium-term growth opportunities and products that are always in demand.

Although he differentiated stalwarts from slow growers (or ‘sluggards’) and the fast growers that are most deserving of investor attention, he was a big advocate of periodically reinvesting in stalwarts by buying their shares when cheap and selling “for a 30 to 50 per cent gain”.

His methodology for finding these shares was outlined in the classic One Up on Wall Street, although Lynch also had the real-world credentials to back this up: between 1977 and 1990, Magellan returned an average of 29.2 per cent per year.

Our Lynch-inspired screen, which has just celebrated its 10th birthday, has fallen some way short of that record. Since my predecessor Algy Hall started to replicate the approach for UK shares in 2012, it has returned 175 per cent, compared with 101 per cent from its benchmark. Last year, its four selections produced a somewhat erratic performance that translated to a stable – if hardly strong – average return of 1 per cent.

The FTSE All-Share, by contrast, posted a total return of 7.7 per cent, meaning it has now outperformed the Lynch screen exactly half of the time.

NameTIDMTotal Return (4 May 2021 - 27 Apr 2022)
Man GroupEMG44.9%
PearsonPSON0.1%
St. James's PlaceSTJ-2.6%
De La RueDLAR-38.3%
Lynch-1.0%
FTSE All-Share-7.7%

Source: Refinitiv Datastream

The compensation for the screen’s jumpy track record has been a few standout years. But factor in a hypothetical annual dealing charge of 1.5 per cent, and the annual average return shrinks from 10.6 to 9 per cent, for a total return of 136 per cent. It’s not quite the compounding miracle Lynch promised.

Of course, any direct comparisons between the FTSE All-Share of the last 10 years and the raging US equity bull market of the 1980s is probably best avoided. But there are a couple of tweaks to the screen which might help to improve its selection success.

For a start – as we flagged last year – the methodology has arguably lacked the kind of ‘quality’ hurdles that are critical for valuing growth companies. One safeguard is provided by the leverage test. But while the screen is looking for cheap stocks, a ‘stalwart’ should not look suspiciously cheap – just as the methodology specifically filters out overly-heady growth expectations.

To do this, I have introduced a crude test of quality, by excluding companies with forward price-to-earnings ratios in the bottom quarter of the market. While this risks missing out on some greater potential re-rating gains, it feels like a market signal worth listening to right now.

A second tweak – and one which I may bring in next year – would be to put a higher lower-bound on the one-year EPS forecast growth than the current level of zero. Lynch specifically talks about stalwarts’ ability to grow earnings by 10 to 12 per cent annually. On reflection, the 6 per cent forward EPS growth forecasted for the one real stinker in last year’s quartet – bank note and authentication specialist De La Rue (DLAR) – might have been a sign that it warranted market doubt.

 

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.

 

Centamin

Even within the notoriously volatile world of mining, gold digger Centamin (CEY) has long been a perennial market disappointment. If downgrades to production expectations in 2018 and 2019 smarted, a warning in the second half of 2020 that the open pit portion of its Sukari mine was not safe to operate all but destroyed investor faith.

While the dollar gold price has swung back to around $1,900 an ounce in the period since, the shares remain 60 per cent down on the level where they traded in September 2020.

In part, this reflects pessimism that guidance for a 4 to 11 per cent jump in production in 2022 can be delivered. The stakes are also higher: efforts to pivot to a multi-asset mining model mean all-in sustaining costs could climb to as much as $1,425 an ounce this year. Even with lots of cash on the balance sheet and no debt, that leaves a lot less on the table for investors’ dividends.

Given the recent history of most listed gold miners – with all their geopolitical and geological complexities – they won't appeal to everybody. Earnings forecasts for all companies in the space, Centamin included, are also derived from analysts’ finger-in-the-air projections for the price of the yellow metal, and hard-to-anticipate shifts in the cost base.

But that won’t completely dim the attraction of a leveraged bet on gold’s appeal as a store of value in times of rampant inflation, and the ability to recycle free cash flow back into new projects.

In the case of Centamin, sentiment is already low. Might this change in the coming year? Hitting some targets would help. As Peter Lynch wrote in One Up on Wall Street: “It’s amazing how quickly investor sentiment can be reversed, even when reality hasn’t changed.”

 

Robert Walters

Amid the unprecedented economic disruption of the past two years, the labour market has proved surprisingly robust. This dynamic is clearly spelled out in the long-run share price chart for recruiter Robert Walters (RWA). Having passed through three separate growth cycles between the financial crisis and the pandemic, the stock’s recovery from the depths of the latter event was sharper than at any time in the last two decades.

Extreme job market tightness in many of the geographies and white-collar sectors in which the global HR firm operates turbocharged profits in 2021, and analysts expect more growth this year and next. That optimism stands in contrast to the market backdrop – even as Robert Walters shares have dipped over the last quarter, forward EPS estimates have edged up – resulting in a share price trading at a record 35 per cent discount to the City’s consensus target.

Who is right? As we recently noted, it is often hard to tell whether the recruitment market is a leading or lagging economic indicator, although Robert Walters’ specialisation and broad geographic diversification might mean the market views the shares as more of a bellwether than they are.

Of course, corporate spending plans can turn very quickly, but big spikes in fee income in the first quarter of this year show clients in many sectors are prepared to pay a premium for personnel searches. Robert Walters’ own rising headcount – up 9 per cent in the first three months of 2022 to handle the volume of business – also suggests mandate momentum is yet to be knocked by the macroeconomic and geopolitical backdrop.

The strong implication from our Lynch screen is that investors have underweighted prospects.

 

Segro

On the face of it, shares in logistics landlord Segro (SGRO) do not look cheap. The stock’s trailing return on capital employed sits at less than 2 per cent, while shareholders can expect a 2 per cent dividend yield over the next year. A forward PE ratio of 39 is asking a lot.

Is there a bug with our screen? Having checked the data, I’m confident there isn’t. In practice, the discrepancy between the stock’s forward earnings multiple and its ability to pass the dividend-adjusted PEG ratio comes down to the way the screen looks at profits.

On the one hand, the forward earnings ratio refers only to what analysts expect from rental income over the next 12 months (which, once forecasts for 2022 and 2023 are given proportional weight, comes to around 35p per share).

The PEG ratio, by contrast, uses as its reference point a diluted version of trailing net income for the last completed period. And in 2021, a huge chunk of the company’s post-tax earnings was derived from realised and unrealised gains on its property portfolio. Although net rental income came to just £347mn, Segro’s estate increased in value by a colossal £3.67bn in the period, as soaring demand from warehouse tenants helped the group to mark up its expected future rent roll.

So far this year, there is little sign of a slowdown. In a recent trading update, chief executive David Sleath said that cost inflation and supply chain pressures are only likely to “further tighten the supply-demand imbalance for industrial assets and place further upward pressure on rents”.

Despite market concerns that the share price premium to book value is getting rich, our Lynch screen suggests near-term profits – of the real and paper variety – may have been underestimated.

NameTIDMMkt Cap Net 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%
BodycoteBOY£1,183mn-£117mn618p143.5%8.2%13.0%9.7%21%16%-24.0%-3.4%
CentaminCEY£1,048mn£153mn91p115.5%4.4%25.1%13.8%16%19%2.9%26.8%
CoatsCOA£985mn-£182mn68p102.5%5.1%13.0%25.5%21%15%4.1%16.5%
Moneysupermarket.comMONY£901mn-£77mn168p127.5%8.6%24.3%28.8%8%21%-12.5%-9.0%
PearsonPSON£5,791mn-£461mn774p192.8%5.4%13.6%8.1%16%14%25.7%7.5%
Robert WaltersRWA£497mn£60mn646p123.4%7.5%5.0%20.0%23%12%-15.7%4.8%
SegroSGRO£16,317mn-£3,437mn1,357p392.1%-1.1%-1.8%14%16%5.4%7.5%
Smurfit KappaSKG£8,543mn-£2,422mn3,283p123.5%6.0%10.6%14.1%21%5%-14.9%1.7%
Source: FactSet. *FX converted to £