Sixteen 'big and reliable' stocks

Active managers, while less restricted by questions of stock weighting, have a habit of thinking in terms of company size, too. Even if there is no explicit reference to size in an investment trust or fund’s name, managers are often marketed for their credentials as large-cap or small-cap specialists.

There are some good reasons for all of this. Because the ability to easily move in and out of portfolio positions can have a bearing on fund performance, and because the market size of a listed company tends to be correlated to its shares’ liquidity, large caps can be a benefit in and of themselves. Larger stocks are also often associated with lower volatility, and a wider breadth of analyst research.

Historically, company size has also been seen as an important driver of share price returns. From the dawn of quantitative investing, size was shown to be a style factor worth paying attention to, following the discovery that small-cap stocks tend to outperform their large-cap peers even after adjusting for risk.

Some academics dispute the evidence for this dynamic, which was made famous in a 1993 paper by University of Chicago professors Eugene Fama and Kenneth French. One recent study found that the size factor showed “weak robustness” as a driver of investor profits; another, also published in 2018, suggested there is “no evidence of a pure size effect” in more than 90 years of US stock market data, and that the factor “may not have existed in the first place”.

To certain investors, the mere notion of isolating size as a meaningful attribute to stock returns seems a bit barmy.

Pat Dorsey, a fund manager and one-time head of Morningstar’s equity research team, believes a company’s size is immaterial when compared to the nature of its business, industry and market position. “Being a big fish in a small pond is much better than being a bigger fish in a bigger pond,” he writes in The Little Book that Builds Wealth. “Focus on the pond-to-fish ratio, not the absolute size of the fish.”

As we explore in this week’s cover feature on the UK alternatives to slow-moving FTSE 100 stalwarts, size matters much less than structural business advantages and economic moats.

I would add a couple of caveats to this. The first – to extend Dorsey’s metaphor – is that a growing pond is something to look for, too. Another is that while size alone cannot halt competition, margin compression or technological disruption, it can improve access to cheaper finance, and a business’s capacity to redeploy capital into higher-growth projects and products where an economic moat can be built.

All of which is to say, in a roundabout fashion, that I count myself a fence-sitter on the relationship between company size and returns. I also include it as a hopefully useful preamble to this week’s stock screen, which looks for companies that are first and foremost big (by UK standards, at least), but whose combination of earnings growth, returns on equity and solid cash conversion suggest there may be enough for us to believe in the presence of that other ephemeral investing factor: quality.

Now in its 13th year of service, the Big Reliables screen has had a decent run of late. In the year and a bit to 13 July, its 2022 selections produced an average total return of 9.6 per cent. That was 4 percentage points ahead of the benchmark from which its 14 picks were drawn, the FTSE 350.

Those returns were produced by some heavy lifting by several stocks, including five that returned at least 20 per cent in the period. Of these, just Centamin (CEY) lacks what I would describe as a strong economic moat within its sector – despite the obvious challenge of building a mid-tier gold mine anywhere in the world.

Also among the five is Centrica (CNA), which following a period of sector chaos and consolidation has seen rising barriers to entry in the domestic electricity market, and growing investor acknowledgement of the utility’s role as a key player in the UK’s drive for national energy security. Burberry (BRBY), despite experiencing some wobbly investor sentiment in the year, has once again demonstrated the demand for its mid-tier luxury products, while Diploma (DPLM) has continued its march towards FTSE 100 membership thanks to solid demand from customers in the healthcare and industrial sectors for its niche technical products and services.

Results and methodology

Since we began to monitor it in 2011, the screen has returned 152 per cent, compared with 103 per cent from the FTSE 350. While the principal idea behind the screen is to generate ideas rather than off-the-shelf portfolios, once a 1 per cent annual charge for notional dealing costs is added, the Big Reliables total return is closer to 120 per cent.

Once again, the screen struggled to find companies with an unbroken record of consistent earnings per share (EPS) growth over five years, which is one of its tests. That was to be expected, given the big dent Covid-19 put in almost every income statement in 2020 and 2021, and means we may need to wait until 2026 before the playing field has been levelled. As such – and though both Oxford Instruments (OXIG) and Watches of Switzerland (WOSG) passed the long-run EPS test – we have again waived it to boost the range of results and let diversification remove some of the risk of a two-stock portfolio.

I have also kept last year’s tweaked criteria to accommodate shares that experienced a Covid-19 blip in growth but appear to be making a strong recovery based on recent forecast upgrades. This ended up throwing a larger than usual array of stocks, so to narrow the pool to a more manageable number – while raising the hurdle to reflect the reality that capital now costs more than it ever has done in the screen’s history – I have upped the requirement on the return on equity from 12 to 15 per cent.

The full criteria, screening all stocks in the FTSE 350, are as follows: 

■ EPS growth in each of the past five years… or a Covid-blip, but also 10 per cent upgrade to forecast next financial year* EPS over the past three months. 

(*The upgrades in the accompanying table related to the next 12-month periods rather than the next financial year.)

■ Return on equity of 15 per cent or more in each of the past five years, up from 12 per cent.

■ Forecast earnings growth in the current financial year and the year after.

■ Gearing of less than 50 per cent, or net debt of less than two times cash profit.

■ Cash conversion (cash from operations as a proportion of operating profit) of 90 per cent or more.

Applying these tests produces 16 Big Reliable stocks for 2023. Despite an agnostic approach to valuation, just two stocks – credit data analytics outfit Experian (EXPN) and multi-utility Telecom Plus (TEP) – are returnees, suggesting that the UK market may lack consistently high-return companies.

Then again, it’s also debatable whether a market cap of £725mn should be considered ‘big’. We’ll find out if this mixture of biggish, semi-reliable stocks can capitalise on this year’s outperformance in 12 months’ time.