Cheap recovery plays 2019

I changed this screen last year to incorporate a valuation measure designed to try to root out recovery situations. It’s a metric I’ve termed a ZEUS ratio (heavily-laboured acronym for Z-score of earnings ultimate source). Despite the grandiosity of its name, the ratio simply compares where a company’s current valuation (price-to-sales or price-to-book) sits within its historic range. This is expressed as the number of 'standard deviations' the valuation is from the long-term average. The main thing to know is that as a rough-and-ready rule, scores of -1 or less point to a stock’s current valuation sitting within the cheapest third of the historical range, while a z-score of -2 or less suggests a valuation in the cheapest 5 per cent of the range (perhaps suspiciously cheap!).

The historical range used to construct the ZEUS ratio is 12 years (to reflect the length of the current cycle), but where historic data is limited the ratio is generated from a minimum of a three-year history. For most stocks, the ZEUS ratio is based on price-to-sales ratio (PSR) valuation data, although price-to-book-value (PBV) is used for financials, real estate companies and housebuilders. The central idea behind using these valuation ratios is that returns on sales (margins) and book value (RoE) can fluctuate significantly over an economic cycle, so recovery investors can profit from looking past recently reported earnings and focusing instead on a company’s earnings ultimate source (EUS) - that being sales or book value depending on the sector.

Last year, the revamped screen marginally outperformed the FTSE All Share index (the index from which stocks are selected). But this did little to rectify the relatively poor returns seen from this screen since inception. On a cumulative basis the total return from the screen stands at 32.9 per cent over five years compared with 31.0 per cent from the FTSE All Share. If I take the important step of injecting a bit of reality into the results by including a 1.5 per cent annual charge (it is assumed the screens run in this column are of interest as a source of ideas for further research rather than off-the-shelf portfolios) the cumulative total return drops to 23.3 per cent, which is well below the index.

2018 performance

The difficulty when looking at current valuations compared with historical norms is that historical norms may no longer apply. Arguably, a good example from this year's screen is supermarkets. While some of the supermarket chains have done a good job at clawing back profitability over recent years, in particular Tesco, fundamental changes in the competitive landscape mean historical margins may be history. The traditional supermarket model of offering shoppers huge amounts of choice in massive mega stores has been upended by discounters, such as Aldi and Lidl. These retailers offer far less range in order to focus aggressively on price and quality delivered through smaller stores that are cheaper to run. As such, it is conceivable we may be looking at lower valuations for shares in traditional  supermarkets for some time to come.

The Late Bloomers screen criteria are:

■ Value: ZEUS ratio of -1 or less (see explanation above)

■ Recovery potential: Free pass for real estate companies. For financials and housebuilders, return on equity of at least one third below 10-year peak. For other sectors, operating margin at least a third below 10-year peak.

■ Balance sheet: For financials, equity representing at least 5 per cent of assets and return on assets of at least 1 per cent. This is a test suggested by the great Peter Lynch, the former star manager of Fidelity’s flagship Magellan fund. For utilities, which have very defensive earnings streams well suited to supporting high levels of debt, net debt to book value (gearing) of less than 150 per cent. For real estate companies, gearing of 75 per cent or less. For housebuilders, gearing of 25 per cent or less. For all other sectors, net debt of 1.5 times cash profits or less.

■ Growth: Growth in 'earnings ultimate source' (the EUS in the ZEUS ratio) – either sales or book value – over the past 12 months.

■ Positive free cash flow: Free pass for financials and real estate (NB investment trusts are excluded from this screen but not Reits).

In total, 19 shares passed the screen this year. The results are listed in the table below ordered from lowest to highest ZEUS ratio. I’ve also taken a bit of a closer look at two of the stocks highlighted by the screen to give a flavour of the results.

Source: S&P CapitalIQ

Aggreko

In many ways, equipment hire businesses epitomise the concept of operational gearing, whereby small changes in sales lead to far bigger changes in profits (up or down). Customers use rental companies to effectively outsource a capital-intensive part of their business: the use, management and maintenance of very expensive kit. Hire companies spend huge amounts on this kit and then try to keep it out on hire for as much time as possible for as much money as customers will pay. Operational efficiency is very important, but the biggest factor determining profitability is simple supply and demand. When the industry has not invested heavily enough in past periods to meet current demand, utilisation of rented equipment is high and rates rise. because a large proportion of the costs are fixed as soon as equipment is bought, rising utilisation and rental rates cause profits to surge.

Such conditions normally coincide with strong second-hand markets, which means hire companies can make good profits when selling old equipment. All this applies in reverse when demand turns down, especially if it comes after a lengthy period of industry expansion.

With temporary power hire company Aggreko (AGK), it is tempting to hope the company is at an inflexion point. After seeing hire rates and margins drop over the last five years, signs of pricing stability have finally started to emerge. The company now also has credible plans to rebuild the margins and take its adjusted return on capital employed from 11 per cent to the mid-teens.

That’s all well and good, but there are grounds to feel a bit uncomfortable about the route Aggreko plans to take to achieve the objective. In order to improve returns the company is relying on cost-cutting and has also reduced investment in fleet in order to boost utilisation (see table). Profits and cash flow could also benefit from Aggreko selling more of its heavily depreciated kit.

But while reducing the capital base of a hire business during bad periods can be advantageous, doing so when economic conditions are still strong is altogether riskier. A well-invested fleet is a key source of short-term competitive advantage in good times. True, as the dominant player in a specialist market Aggreko to some extent can dance to its own tune. But this argument only goes so far. The pressure on Aggreko to keep the fleet fresh is increased by: changing emissions standards; the threat of rival green technology; increased customer sophistication driving demand for longer-term and more efficient contracts; and the encroachment on parts of the temporary power rental market by generalist hire companies, such as Ashtead and United Rentals, which have superior branch networks.

Sentiment towards Aggreko’s shares could be helped by positive moves towards the ROCE target, and progress should be aided by a recent contract for the Tokyo 2020 Olympics. Strong recent share price performance suggests this may already be happening. Debt also does not look like a problem and the shares offer reasonable income. But while the valuation is low by historical standards, changes in the industry mean the company may struggle to repeat past glories and it does not look cheap compared with less-specialist peers. What’s more, given that Aggreko’s improvement plan relies on cutting back on capex and cost, any gains run the risk of proving only temporary.

Topps Tiles

There are reasons to think Topps Tiles (TPT) could be a beneficiary of a benign-for-business Brexit outcome. A slowing housing market and subdued consumer confidence have both created a challenging trading environment. Against this backdrop, the tile retailer has done a good job at generating modest like-for-like sales growth.

However, the company faces the question of what can be done to pep up growth whilst protecting margins from operating cost pressures. While operating costs are expected to continue to rise this year, a focus on exploiting the group's buying scale and sourcing lifted the gross margin in the first half and the company should be able to continue to take advantage of the short average lease length on its stores to close less profitable units. Average store  numbers during the first half stood at 362 stores compared with an average of 372 during the previous financial year.

A longer-term solution could come from ambitions to rapidly grow the commercial business. While commercial sales currently account for a tiny portion of the total, moving into this area roughly doubles Topps’ addressable market. The company has noteworthy ambitions, too, believing it can use synergies with its retail business and its buying power to disrupt this fragmented part of the market. In April, Topps announced the £3.3m purchase of commercial tile company Stata following an initial foray into the commercial sector with the purchase of Parkside in August 2017.

This looks like a good plan on paper, but the job of becoming a market disruptor will not necessarily be cheap or easy and could end up making the business more cyclical.

Floorings  group Headlam - a company with a strong balance sheet, first-rate national distribution network and relationships with large numbers of independent retailers - acquired Domus, the largest player in the commercial tile market, at the end of 2017. Given Headlam’s expertise in distribution – albeit chiefly carpet distribution – Topps looks far from the only credible, would-be disruptor.

Meanwhile, long lead times on sales means Topps’ commercial operation is expected to make a loss of £1.5m this year - up on earlier estimates of £1.1m – this is around a tenth of forecast profits but the company excludes these losses from its headline adjusted profits. If the commercial business does manage to achieve scale, its cash flow characteristics are likely to be less attractive than retail because commercial clients take longer to pay bills which adds to cyclical risks (when Headlam bought Domus, Domus’ debtors totalled about 14 per cent of sales compared with Topps’ trim 4 per cent debtors to sales ratio).

On something of an aside, sentiment towards Topps’ shares could be negatively affected by a new accounting rule that changes how companies report lease expenses and requires debt-like lease liabilities and assets to be included on the balance sheet. Topps’ shops are mainly leasehold. 

Topps appears to be doing a decent job of handling tough market conditions and offers a worthwhile dividend yield. The commercial push, while coming from a low base, could attract new investors as it has the potential to produce good growth, but trying to break the commercial market has risks. The possibility of a market-rousing Brexit outcome looks the most likely cause for any near-term rerating.