Five stocks for a contrarian

As the second-largest shopping mall operator in the US, the effects of a monster recession were already weighing on the Chicago-headquartered group. To meet fast-approaching debt maturities, the company planned a fire sale of valuable assets. And to top things off, the board had just discovered a $90mn (£74mn) loan from the chief executive’s family trust to the recently ousted CFO.

General Growth’s shares, having dropped more than 90 per cent in a year, were at an all-time low.

Enter Bill Ackman. In early December, the founder-chief of hedge fund Pershing Square (PSH) disclosed a 25 per cent stake in the struggling property firm which he bought on a simple contention.

With capital markets frozen, General Growth’s ability to refinance its borrowings was deemed a non-starter. But its assets, valued conservatively at historic prices, exceeded liabilities by $3bn. If the company could extend its maturities and make good on claims to continue servicing its debts, then its $100mn market value could soon rocket back into the billions of dollars.

In the end, the bet was spectacularly successful. According to a 2011 Bloomberg interview with the hedge fund manager, it helped turn “$60mn into $1.6bn”.

There were elements of the investment that few investors can mirror. For one, the bet was made at a time of acute market stress. Ackman also used his stake to encourage management to file for bankruptcy, a process he then helped steer via $375mn-worth of debtor-in-possession financing.

But the ultimate lesson from Pershing’s foray into General Growth is that the market’s received wisdom isn’t always correct. On occasion, it can massively undervalue stocks.

“There’s a difference between arrogance and confidence,” said Ackman in a conversation that touched on the contrarian bet several years later. “If you’re arrogant in investing, you’re going to get killed. If you’re not confident, you’ll never make an investment. So you have to do a sufficient amount of work to be confident enough to have the conviction to do something that’s contrarian.”

The Investors’ Chronicle’s Contrarian Value screen, which has posted an 11 per cent average annual total return in the 11 years it has been live (versus 6.5 per cent from the FTSE All-Share), adopts an anti-herd approach. But to say it replicates Ackman’s methods would probably be pushing it. Indeed, by automating the process, it circumvents the due diligence Ackman quite reasonably argues is needed to build confidence.

In the sense that the screen carries some conviction, it is in the role that mean reversion plays in the stock market. Eventually, even the most beaten-up share will find a buyer, particularly if there are signs of an operational turnaround.

2021 Stocks

Source: Refinitiv Datastream

Alas, this year’s harvest of contrarian crops has been less than bountiful.

The crash in 2021’s picks – a 25.2 per cent negative return – takes the cumulative total return from the screen's top five stock selection to 230 per cent over the last 11 years, which is based on annual reshuffles. That compares with 108 per cent from its benchmark, the FTSE All-Share. A 20-stock version of the screen, which bucked the long-term trend by outperforming the top five picks this time around, is up 134 per cent total return over the same period.

While the screens in this column are meant as a source of ideas rather than off-the-shelf portfolios, by adding a notional 1 per cent annual charge to reflect dealing costs, the total return from the top five contrarian value stocks drops to 196 per cent, and to a fairly pedestrian 110 per cent from the top 20.

Automated contrarianism

The Contrarian Value screen works by first making 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 5 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 7.5 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.

In 2020 and 2021, the pain inflicted by Covid-19 forced some adjustments to the criteria in order to generate a decent range of results. Torrid trading conditions in both years affected the screen’s historic requirement for a five-year compound annual sales growth rate of at least 7 per cent and a five-year average operating margin of 10 per cent or more.

Last year, we significantly lowered the bar on two metrics to find qualifying stocks, meaning companies only needed to show a compound average sales growth of 1.3 (instead of 7) per cent or more and an average margin of at least 5.9 (instead of 10) per cent. As it turned out, the risks associated with loosening the criteria proved painful, so I have raised the criteria to what feels like a sturdier level: five-year average annual sales growth of 5 per cent, and a 7.5 per cent average operating margin.

With any luck, the long-term fundamentals of the FTSE All-Share’s constituents will have soon improved enough for the screen to return to its original criteria by this time next year.

For some time, we have argued that it is only really the top five results from the screen which are of serious interest, in part because these tend to be the only shares with genuinely low EV/sales ratios. As this is ultimately a value screen, this feels like an important criterion, as it gets to the heart of the asset mispricing idea that contrarian investing seeks to exploit.

This year, each of the ‘top five’ selections has an enterprise value of less than one times’ sales, even though my method for calculating the ratio spits out a higher value for the number one stock, TP ICAP (TCAP), compared to FactSet’s figure.

The interdealer broker was among the weaker performers in 2021’s picks, when it also made the top five. Its apparently cheap valuation, both on the EV/sales metric and other earnings-focused ratios, is partly a function of the thin margins in the corners of the broking market it operates in. But several years of underwhelming operating and share price performance haven’t helped, either.

In fact, until recently it appeared that company executives could not open their mouths without the stock being hammered. The shares dropped by double digits after the 2020 announcement of a plan to acquire trading firm Liquidnet, which presaged a dilutive rights issue. Interim, third quarter and full-year results for 2021 were all met with similar bouts of despondence from the market.

“TP ICAP has not found success under its current governance and ownership structure over a multi-year time horizon,” concluded shareholder Phase 2 Partners in a letter to chairman Richard Berliand in March. The missive decried executive shareholdings and purchases and pressed for a change of ownership. But chief among the complaints was the multi-year deterioration in margins at a business with a global platform and whose assets the investor described as both diversified and high quality.

Might the tide be finally turning? This month, half-year figures revealed a step up in operating margins from 6.1 to 9.2 per cent, despite a spike in overheads. Better-than-expected volumes, productivity, and efficiency savings again moved the shares by double digits, although this time in the right direction. Evidence bodes well for the second half. Such is the promise when thin margins and big revenues combine: trim the fat in the right places, drive sales, and the opportunity to materially boost profits suddenly looks reasonable.

If TP ICAP can continue recent momentum, it could be doubly good news for investors. If profits improve and stay elevated, and what until recently looked like heavy likely impairments to goodwill could soon make way for a sharp upward revision to asset values. We shall soon see.

2022 Contrarian Stocks