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Nine contrarian shares

Is a bear market the perfect moment for our against-the-grain stock-picking screen?
Nine contrarian shares

What does it mean to be a contrarian investor? In simple terms, contrarian investing involves buying or selling assets which go against prevailing market sentiment. And right now, as anyone who has been paying even a bit of attention to markets will know, that prevailing sentiment is very poor.

This sentiment is also generalised. In any given year, a combination of business, consumer or regulatory factors will mean some sectors are struggling or out of favour, even if returns are broadly healthy across the economy. Ordinarily, that can present opportunities for contrarians to spot a rebound in unloved stocks. But currently, long shadows extend across almost everything.

This creates an aversion to risk assets, and something of a bind for contrarians. If the market is pessimistic about the outlook for most sectors, how can the contrarian tell when sentiment toward a sector or company is irrational? Do falling prospects across multiple sectors suggest the herd view might be right? Or is the true contrarian approach now to buy the dip?

There are no straightforward answers to these questions, but Michael Mauboussin gave perhaps the best in an interview in a Columbia Business School newsletter in 2018.

“If you distinguish the great investors from the average investors, it’s not because their cost of capital calculation is more accurate,” the quant investing legend said. “It almost always has to do with the fact that they’re able to make good decisions and be correctly contrarian in adversity.”

This week’s stock screen is loosely based on the methods employed by David Dreman, who staked his investing career on being contrarian – or in Mauboussin’s words, “correctly contrarian”.

Like several other famed investors, including Benjamin Graham and Joel Greenblatt, Dreman’s philosophy starts from the observation that markets are often deeply irrational, and produce disconnects between stock prices and real value. His method for telling when a stock is good value is also rather conventional, and rests on a handful of classic metrics beloved of deep-value investors.

With the FTSE All-Share now 9 per cent off its one-year high, and share prices looking bombed out across a variety of sectors, you might think this is a good time to go deep-value hunting. After all, a cornerstone of the irrational markets thesis is the belief that share prices tend to overshoot when they are falling. It’s hard to find your way in the dark.

Followers of this screen will find little reason for cheer from the results of its 2021 selections.

Instead of finding deep-value shares, the screen ended up clutching at a series of falling knives. For the first time in the screen’s already chequered history, there was not a single positive return from its selections.

NameTIDMTotal Return (1 Jun 2021 - 13 Jun 2022)
KellerKLR-4.5
Morgan Sindall MGNS-9.3
Smurfit KappaSKG-21.1
Domino's PizzaDOM-13.3
MondiMNDI-22.5
Taylor WimpeyTW.-26.3
Dreman--16.2
FTSE All Share-1.8

Source: Thomson Datastream

This annus horribilis – worse than the results of the screen that straddled the Covid-19 crash – amounted to a 16 per cent negative total return, compared wit a 1.8 per cent positive outing for the FTSE All-Share. This has helped push the screen’s long-term returns back below the benchmark: over nine years, our Dreman screen is up by 57 per cent, compared with 62 per cent from the index.

And while the stock screens we run in these pages are meant as a source of ideas for further research rather than off-the-shelf portfolios, a hypothetical annual 1.5 per cent charge to represent dealing costs would reduce the Dreman screen’s cumulative total return to a paltry 36 per cent.

Ironically, Dreman might not have been wholly surprised with the quality of last year’s results. That’s because the pandemic’s damaging effects on recent earnings figures led us to adapt elements of the screen to focus on forecasts rather than historical results. 

Dreman himself was somewhat sceptical of the value of forecasts, and authored a mammoth study on the brokers’ inability to reliably predict earnings. Across 1.5mn forecasts over 33 years, the analysts he found were on average 30 per cent wrong over 12 months. Incidentally, that wasn’t far off the disparity between average earnings forecasts for last year’s selections and what followed, although on average these proved to be under-estimates.  

Normally, you would expect companies with expectation-beating and rapidly improving earnings to do well. The fact last year’s stocks didn’t may simply highlight the recent depth of market pessimism. Or the fact that investors have been quick to discount a recovery when faced with a wall of inflation and fresh economic uncertainty.

It might also suggest the screen ended up hunting for the wrong signals when we switched its criteria around. Had we taken the inference from last year’s original screen – that there were no genuine contrarian shares on offer at the end of May 2021 – and stuck with its 2020 selections, then the past year’s negative total return would have narrowed to 2.9 per cent.

The alternative, given none of the 2020 picks re-qualified as 2021 contrarian shares, might have been to move the screen to cash. That wouldn’t have made for a particularly interesting set of results, but at least the returns would be neutral. After all, it doesn’t make sense to change the rules of engagement if your contrarian method is telling you there’s nothing to be contrarian about.

This year, then, we have reverted to the pre-Covid criteria, which are as follows:

■ Shares must be among the cheapest quarter of FTSE All-Share constituents based on one or more of: dividend yield (DY); price/earnings (PE); forward next-12-month PE (forward NTM PE); price-to-cash-flow (PCF); or price-to-book-value (P/BV). The screen's other criteria differ slightly based on which valuation measure a share qualifies on.

■ Year-on-year EPS growth in the most recent half year.

■ Forecast EPS growth for each of the next two financial years.

■ A current ratio of more than 1.

■ Above-average dividend yield (excluding cheap P/BV stocks).

■ Dividend cover of 1.5 times or more, or greater than the five-year average (excluding cheap P/BV stocks).

■ Above-average five-year dividend compound annual growth (excluding cheap P/BV stocks).

■ Gearing of less than 75 per cent or net debt/cash profit of less than 2.5 times.

■ Market capitalisation of £200mn or more.

After failing to find any qualifying stocks a year ago, the original screen criteria have proven much more successful in June 2022. A total of nine stocks meet a requisite number of tests and are in the cheapest quarter for each of the value factors.

Interestingly three stocks – the housebuilder Taylor Wimpey (TW), and construction groups Keller (KLR) and Morgan Sindall (MGNS) – make returning appearances. That might suggest there is more continuity with last year’s forecast-heavy version of the screen than perhaps I have given credit for.

The trio is joined by no fewer than three more housebuilders, each of which trades at a discount to book value. Regular listeners to our Companies and Markets podcast will by now be sick of me highlighting the cheapness of this sector, particularly as its share prices have drifted ever lower in recent months. But at least the signals from our contrarian screen now back that view up.

The full list of stocks can be found in the table below, as well as a downloadable screen with plenty more data points and valuation metrics.

CheapNameTIDMMkt CapNet Cash / Debt(-)*PriceFwd PE (+12mths)Fwd DY (+12mths)FCF yld (+12mths)P/BVNet Debt / EbitdaOp Cash/ EbitdaROCEFwd EPS grth NTMFwd EPS grth STM3-mth Mom3-mth Fwd EPS change%
/ PBV /Crest Nicholson CRST£729mn£249mn284p75.9%3.2%0.8-128%12.1%12%10%-4.1%0.4%
/ Fwd PE / PCF /Hochschild MiningHOC£558mn£61mn109p83.5%-6.6%1.1-98%22.3%21%19%-16.4%58.6%
/ PBV /InvestecINVP£3,208mn-£1,815mn461p85.5%-0.7---6%14%4.6%10.0%
/ DY / Fwd PE / PCF /KellerKLR£539mn-£193mn741p75.3%11.3%1.21.1 x84%12.6%10%6%-8.3%2.7%
/ DY /Morgan SindallMGNS£898mn£305mn1,912p95.2%-1.8-87%21.3%3%7%-15.6%1.5%
/ DY / PE / Fwd PE /RedrowRDW£1,833mn-£96mn521p66.0%7.4%0.90.4 x113%15.0%2%0%-8.1%-0.1%
/ DY / Fwd PE /Taylor WimpeyTW£4,429mn£810mn125p67.5%8.6%1.1-70%19.0%6%6%-10.7%2.9%
/ DY / Fwd PE /VesuviusVSVS£936mn-£275mn345p86.2%9.2%0.91.4 x42%9.1%15%10%-12.6%1.5%
/ DY / Fwd PE / PCF / PBV /VistryVTY£1,983mn£201mn897p68.4%9.0%0.8-129%10.0%8%4%-11.6%1.6%

Source: FactSet. NTM = Next 12 months; STM = Second 12 months (ie, one year from now)