FTSE 350: Quality, value and premiums

For a numbers game, investing isn’t all about the figures. In 2016, to coincide with our FTSE 350 Review of that year, we began picking a 'Best' of the index – choosing shares that looked attractive within their sectors on either value or quality ratios. That annual selection came badly unstuck in 2020 as pandemic uncertainty made the basis for judgement spurious. (For posterity, the 2020 shares made an average loss of 13.2 per cent in two years.)

Is it safe to resume in 2022, and write off the bad years as a coronavirus and lockdown induced blip? Initiated when smart beta or ‘factor’ investing was all the rage, it's fair to say the academic exercise has run its course. But there is still plenty to be gleaned by screening the FTSE 350 universe for quality and value before taking ideas to the next level of research.

Factor first, sector second

UK consumer price index (CPI) inflation hit a 30-year high in March, rising 7 per cent year on year, and the accompanying change in monetary policy regime is already clear. As the Bank of England raises interest rates, share valuations are affected and prices often fall. In an environment where there is no longer a rising tide of cheap money lifting every ship, discernment is required.

In other words, it’s going to be more of a stock picker’s market, and quality and value factors are a good place to start looking for ideas. At the overall market level, you'd expect one factor to be a more significant driver of performance – but regardless of which is in the ascendancy, both are a good prism through which to start categorising shares of individual companies. 

We start with value. The most common tool for assessing whether profitable companies are cheap or expensive is the share price to earnings per share (PE) ratio. On top of this, in academic analysis of the value factor, the price-to-book value (PB) ratio has traditionally been used to compare the market value of firms’ equity relative to the values recorded in their latest financial statements.

Quality factors include operating profit margins and shareholders’ return on equity (RoE), although these need to be tempered with an appreciation of the leverage (debt) employed, which inflates the return on equity. Checking the ratio of companies’ net debt to earnings before interest, taxes, depreciation and amortisation (Ebitda), and interest cover (how many times the interest obligations can be paid out of operating profits) are safety ropes.

On their own, screens using these metrics can be applied to suggest a selection of the best-value and highest-quality companies in the FTSE 350, but these lists have serious limitations. Firstly, the appropriate valuation and quality ratios to use can vary sector by sector; the premise of the old 'Best of the FTSE 350' was to compare companies in the same sector to get a best-in-class selection.

Second, we’re ignoring some important facets of good companies. With value, there is a growing body of academic research on how investors should appraise intangible assets, the value of which may be far larger than is accounted for on balance sheets. Furthermore, basic value factors omit consideration of growth, although we will look at this as part of the next stage.

Cutting out the junk

One shortcoming of the old best-in-class approach was that some of those classes were weak in themselves. Arguably, it would be better to just own the good bits of the UK market (assuming we correctly identify what those are) and diversify by buying strong overseas companies in other sectors as well as by owning other asset classes – not just shares – at the portfolio level.

Growth is paramount, too. What shareholders are paying for future profits matters and here it helps to look at the forward PE ratio for a given period, divided by the forecast growth rate in earnings per share (EPS) over that timeframe. This price-to-earnings growth (PEG) ratio is a good way of comparing expanding companies that may seem expensive but actually aren't so pricey, relatively speaking, should their peers have worse prospects.

Of course, not all returns come from growth. For many shares dividends are an important benefit of ownership. Famous investors such as US fund manager John Neff incorporated payouts and dividend growth in their assessment of the genuine value (GV) of stocks when devising their own versions of the PEG ratio.

Peer reviews

Our best value and quality companies still need to be compared versus peers and on industry-specific metrics. This helps when it comes to looking at the quality of earnings and the way assets such as inventory are accounted for, as well as what conventions are followed (or not) in terms of dealing with capitalisation of investments and subsequent depreciation and amortisation.

Earnings quality – the source of profits growth – and its ability to be repeated is also essential. The question of whether a company can only grow by acquisition, or if it is building market share and achieving sources of competitive advantage, is best examined in the context of how it stacks up against others in its industry.

Such analysis can bring companies back into play if they had previously been disregarded by the broad brush of value and quality factor screening. What’s most apparent, however, is the considerable amount of work that still must be done after using a crude ranking system. Such systems do at least give a few pointers on questions to ask when dissecting results, reading the company profiles in this guide, and deciding which shares truly are the best FTSE 350 opportunities. 

What does the quick slice and dice show up?

One of the first problems with trying to screen an entire stock index is that companies report at different times. Consider this alongside the differences in business models and capital structures, and comparisons are never truly fair. That caveat made, the cheapest 20 companies in the FTSE 350 based on their most recent share price as a multiple of book value of equity (as last reported) per share include names like oil services company Wood Group (WG.), retirement income insurer Just Group (JUST), Barclays (BARC) – currently reeling from yet another misdemeanour by its trading arm – and electronics retail group Currys (CURY).

Quality is trickier to discern, given the pandemic's impact on margins and RoE over the past two years. Still, we look at whether companies have performed at a level above the median for the index on both counts over the past three years. We then rank on operating profit margin for the last 12 months.

The top 20 companies according to these quality measures don’t really include any surprises. However, having not initially filtered for other factors such as leverage, the group does include some more cyclical stocks that are having a good run. Miners Rio Tinto (RIO) and Anglo American (AAL) fall into that category. Iron ore pellet manufacturer Ferrexpo (FXPO) also operates in an industry with large peaks and troughs and, with its main mines and production facilities located in Ukraine, it certainly isn’t a share for most retail investors at the moment.

With their low fixed costs and cheap costs of sales, internet platform companies always do well in limited scope quality tests, but Rightmove (RMV) and Autotrader (AUTO) which top the list, have vulnerabilities. Tailwinds in the housing and used car markets, respectively, could soon subside, and higher interest rates may start to restrict financing options for buyers.

Steady companies with strong brands, such as drinks business Diageo (DGE), industrial equipment manufacturer Spirax-Sarco Engineering (SPX), and fantasy game and intellectual property business Games Workshop (GAW) have strong competitive positions and/or a unique proposition for customers. Spirax-Sarco's earnings can be expected to be reasonably recession proof, but the question mark is whether it is still too expensively valued, even if it were to suffer relatively mildly compared with other companies in any wider downturn. In the case of Games Workshop, a worsening economic outlook and the effect of inflation eating into people’s disposable income will be a test of gamers’ devotion.

Macro views and micro details...but size matters

Sometimes ideas come down to an appreciation of prevailing narratives. Companies such as cyber security business Avast (AVST), which stands up well to the most basic quality examination, benefit from popular fears about hostile state actors which certainly aren’t irrational given Russian aggression and the rivalry between China and the US.

Other FTSE 350 listed companies that aren’t flagged by basic value or quality screening are beneficiaries of major trends, too. Notably, the UK’s two oil majors, Shell (SHEL) and BP (BP.), are important in the context of a short-term crunch (or even crisis) and a long-term transition in energy supply. But oil companies' travails in the first year of the pandemic meant they would never pass our basic quality filters. As far as value is concerned, the opportunity in UK-listed energy companies was seized on months ago and both companies now have mid-ranking PB ratios.

Large companies can’t be ignored, however. For professional investors they are a source of benchmark risk; their prominence in indices means that, if the large caps do well and fund managers are underweight, those managers will underperform. Private investors aren’t worried about achieving bonus targets – but to make the costs of picking stocks worthwhile they want to beat the market, otherwise they might as well buy tracker funds.

Therefore, it’s worth thinking about prospects for big oil companies, miners, banks and pharmaceutical businesses, even if you plan to ignore some of them. Paying attention to the historical co-efficient of price returns between individual shares and the market, known as the beta of stocks, is useful. It gives an idea of how much a portfolio that deviates from the market weightings will over- or underperform.

Beta can also be thought of as the proportion of a stock’s risk and return that comes from being dragged around by market moves. Any excess in price changes beyond the historical beta represents the reward or punishment for judgments made about the idiosyncratic risks and opportunities companies face; otherwise known as a stock’s alpha.  

Setting course for the likelihood of overall positive alpha is the portfolio manager’s goal. Choosing sectors to be overweight versus market capitalisation proportions, and then the best companies within those sectors, can improve the odds of achieving returns in excess of the benchmark.

Ask questions, especially 'What am I being offered?'

Going through our FTSE 350 guide, the fundamental questions to ask are: What is this share offering? What is the likelihood it will make good on the promise of upside? What could send things belly up? What is the margin of safety that indicates how far the shares might fall if the outlook did sour?

These are questions that can’t be answered without a detailed analysis of individual companies. The approach of investing by numbers alone can come up short, especially in an environment of greater beta risk – ie, market volatility. Still, there are numbers to try and get at from the examination of businesses. One of the best is an estimate of the level of free cash flow (cash after capital expenditure (capex) and interest payments) that will be reinvested in the business or returned to shareholders. The anticipated growth rate in free cash flow and today’s share price can be used to extrapolate a cost of equity to the firm, and an investor’s implied rate of return.

How this stacks up versus the expensiveness of shares relative to close peers and the wider market, plus the premium implied over the yield to redemption on government bonds, is a simple yardstick – albeit the result of much hard work to get good inputs for computation. Once risk premiums are estimated, the analysis ratios can tell us whether they might be realised by earnings growth (quality) or re-rating (value). But the hard yards are in analysing the individual stories behind the numbers to assess the chances of upside or downside risks materialising.