Hunting for deep-value contrarian stocks

To do this, the screen first looks for companies with semi-decent operating records, manageable balance sheets and the potential for earnings growth, before highlighting those trading in deep value territory.

It is triply contrarian. For a start, by looking for extremely cheap shares, it is going against prevailing sentiment; if a stock were trading in line with the rest of the market, it wouldn’t be cheap. In this sense, the screen is banking on mean reversion. This is the idea that stock valuations and company fortunes can only stay depressed relative to their historic average for so long. At a certain point, the logic goes, buyers will return.

Faith that mean reversion still works, I would argue, is a second source of contrarianism. One convincing explanation for why the world’s most valuable and profitable listed companies keep on getting bigger is that investors increasingly accept the wealth-generating power of a narrow band of exceptional performers.

It is hard to shake the notion that consistent above-average performance merits more investor attention than near-term operating rebounds. While the Contrarian Value screen puts a spin on this by annually reshuffling its selections, it is nonetheless fishing for stocks whose beaten-up valuations and choppy track records are unlikely to mean a sudden flip to a premium rating.

The third reason I argue the screen is contrarian is that in concentrating on five stocks, it does away with the normal rules of diversification. Although this can work to its advantage (as the 2020 version of the screen showed), such concentration increases risks. And as the performance of last year’s selections highlight, it only takes one or two bad eggs to stink the place out.

The performance of 2022’s picks – a 4.7 per cent negative total return – takes the cumulative total return from the screen's top five stocks to 215 per cent over the past 12 years, based on annual reshuffles. That compares with 117 per cent from the FTSE All-Share. A 20-stock version of the screen, which again bucked the long-term trend by outperforming the top five picks this time around, is up 138 per cent 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 179 per cent, and to an index-lagging 111 per cent from the top 20.

The methodology

The Contrarian Value screen works by first making checks on quality that suggest 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). The quality checks are:

■ Enterprise value of £25mn or more.

■ Five-year compound average annual sales growth rate of 7 per cent or more (back up to historic level from post-pandemic dip).

■ Forecast sales growth in each of the next two years.

■ An average operating profit margin of at least 10 per cent over the past five years (back up to historic level from post-pandemic dip).

■ 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, the effects of the pandemic hammered companies’ ability to meet the five-year compound annual sales growth and five-year average operating margin tests, leading us to dilute the requirements for both. After raising the bar slightly last year (following a particularly rum outing for the screen’s 2021 picks), there are now enough stocks with decent trailing operating metrics to reinstate the full historic criteria.

That doesn’t mean the screen is working entirely as intended.

For some time, we have argued that it is only really the top five results from the screen that are of serious interest, in part because these tend to be the only shares with genuinely low EV/sales ratios. And 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.

However, just two of this year’s selections – trading platform CMC Markets (CMCX) and housebuilder Vistry (VTY), both of which were in 2022’s cohort – currently boast an EV/sales ratio below one, highlighting the difficulty of finding companies that strike a balance between reassuring historic growth and profitability, positive near-term forecasts and truly beaten-up valuations.

However, two columns in the table below suggest that this year’s selections may be more contrarian than their trading multiples currently imply. On average, the share prices of the 20-constituent portfolio have declined by 2.2 per cent over the past three months, during which time their average forward earnings per share (EPS) forecasts have climbed 0.3 per cent. While the top five stocks have seen a larger average consensus downgrade of 1.5 per cent, an average price fall of 12.8 per cent could be interpreted as investor capitulation.

The most badly hit member of this group, CMC Markets, has had an even worse year. Its shares are down 44 per cent down since the beginning of January, 52 per cent since last November’s one-year peak, and three-quarters down on their 2021 all-time peak.

That high water mark baked in some heady assumptions about the provider of spread betting and contracts for difference: namely, that the huge cohort of users who started using the site amid the highly unusual market conditions of 2020 and 2021 would stick around and keep trading in high volumes.

But as experience has repeatedly shown – not only in the case of CMC, but with FTSE 250 constituent Plus500 (PLUS) and fellow 2023 Contrarian Value stock IG Group (IGG) – the sector’s ability to both retain active users and reliably forecast their trading habits is extremely bumpy. While this hasn’t led to investors abandoning leveraged platforms entirely – Plus500’s 600 per cent total return since CMC’s IPO in early 2016, for example, is among the best in the FTSE All-Share – it has raised understandable doubts around the way risk is priced.  

In the past year, this lack of clarity on CMC’s near-term profitability has intensified. First, hopes that the board might split its more volatile trading division from its investment platform were dashed after a review concluded last November that the two businesses were better together. Then came an industry-wide drop in trading volumes, a trend that analysts at Numis believe has been exacerbated at CMC, given its historic retention and client income levels and approach to risk management.

Recent noises have been more positive. Although the company expects trading and investing activity to decline by 15 to 20 per cent this year, net operating income has been propped up by strong returns on cash. Though merely maintaining a top line is a distant second to actual growth, it is one potential signal that a trough may be approaching. Should the coming 12 months witness a spike in market volatility – a reliable lead indicator for CMC’s client activity levels – then we may look back on this moment as a nadir in the share price, too.