Six stocks with great expectations

My Great Expectations screen romped home in 2020 delivering another 12 months of substantial outperformance of the market. This further cements its position as the best performing of all the screens I monitor on these pages.

But the screen is not without risk and that was amply demonstrated last year, too. The maximum drawdown (the largest fall experienced from a peak to a trough) during the year was a stomach-churning 60 per cent. That compares with 35 per cent from the FTSE 350. Those numbers hopefully serve as a salient reminder that the 12 months of performance I report for the screens each week only tells part of the story. 

The rollercoaster ride also helps illustrate why the screens are best regarded as a source of ideas for further research rather than off-the-shelf portfolios. It is far easier to make sensible decisions about what to do in falling markets when investments are well understood. When understanding is low, the role of emotion tends to dominate. 

Still, the risks the screen willfully takes on have paid off once again. Indeed, despite the extreme volatility of this screen it has actually outperformed in seven of the nine one-year periods I’ve tracked it. 

Meanwhile, the cumulative total return over that time stands at 485 per cent, dwarfing the 92 per cent from the FTSE 350 (the index the stocks are selected from). If I factor in notional dealing costs of 1 per cent a year, the screen’s cumulative return falls to 435 per cent. 

The screen itself has a fairly straight forward but high-octane approach. It looks for strong forecast earnings growth and significant forecast upgrades accompanied by share price momentum. The idea of pairing share price and upgrade momentum is to try to gauge the significance the market is attaching to a company’s better-than-expected performance as well as to assess the likelihood that there may be more to come. This combination of momentum and growth has very much been the flavour of the past decade. The full screen criteria are:

■ EPS forecasts for the financial year after next upgraded by at least 10 per cent over the preceding 12 months.

■ EPS growth of 10 per cent or more forecast for the next financial year.

■ EPS growth of 10 per cent or more forecast for the financial year after next.

■ Share price momentum at least double that of the market over the past year.

■ Share price momentum better than the market over six months.

■ Share price momentum better than the market over three months. 

■ Share price momentum better than the market over one month.

Given the success of the strategy since inception, it is worth asking if the run can continue. At some point the dominant market themes are likely to run out of steam and even reverse. There are undoubtedly reasons to think there is some froth in this part of the market even if low interest rates do provide some justification for high valuations. 

However, earnings upgrades and strong share price performance is not just the preserve of one specific type of stock. This year's screen picks do offer some out and out growth, but this is mixed in with a number of commodity plays and even shares that would normally be regarded as 'value' investments, such as Royal Mail (RMG).

No stock passes all the screen’s tests this year, so the accompanying list is made up of shares failing one screen test (details included in the table). The table is ranked based on a combination of three-month share price strength and three-month earnings upgrades. I’ve also taken a close look at the top ranking share, AO World.

For more fundamental data and glossary of terms download the excel version of this table:

AO World 

Covid has provided a major boost for AO World (AO.), an online retailer of electrical goods. Lockdown restrictions have caused more people to shop online while more time spent in the house, both at work and play, has bumped up demand for electrical devices. AO’s problem has not been one of attracting customers but one of keeping up with demand. 

The really sweet thing for AO World shareholders about this growth spurt is that the increased scale enforces its competitive position while also improving profitability and underlying cash generation. Indeed, after several years of losses along with lacklustre share price performance since its float in early 2014 at 285p, investors appear to now have seen the light. The shares are up a staggering 740 per cent from their March 2020 low of 50p.

Scale is a key competitive advantage because it allows AO to operate a larger network that better serves customers. This reinforces the group’s focus on customer service. The first half saw warehouse space increase from 740,000 to 1.3m sq ft while delivery capacity rose from 60,000 to 150,000 per week. The company says it is now within 40 minutes of 90 per cent of the UK. What’s more, the group’s focus on customer service has produced a virtuous trend whereby new customers tend to come back, and also recommend the retailer to other. First half customer growth was a massive 41 per cent. The historic sales growth record is also phenomenal (see chart)

While sales growth has not been a problem in the past, before lockdown profits were elusive. But pushing more sales through AO’s infrastructure has caused the retailer to become a lot more profitable. The nature of the business – selling big-ticket white goods – means margins are never going to be high, but rising volumes cause significant gains from what was until recently a lossmaking company. 

As well as benefiting from the proportion of fixed costs in the business (costs that say flat despite increased turnover) the company has also been making its operations more efficient and using its increased scale to negotiate better buying terms with suppliers.

The German business, which made a small first-half loss of £4.6m and accounted for 14 per cent of turnover, has even more to gain from increased scale given it is at an earlier stage of development. Management thinks this business could ultimately be more profitable than the UK. The aim is for Germany to break even in the next full financial year. Growth has been at a rapid clip, with German sales up 82 per cent in the first first half. The market is potentially about twice the size of that in the UK. What’s more, AO has its eye on expanding in other European markets, too. 

The medium-term target is for group cash profit margins of about 8 per cent. That looks ambitious compared with the 4.6 per cent currently achieved by rival Dixons Carphone (DC.), but the efficiencies of the online model and recent progress makes this credible. 

Increased clout with suppliers is also helping improve cash flow as the group negotiates improved payment terms. The company has a cash flow tailwind as it generally receives money from customers before it has to pay suppliers. That said, inventories rose as a proportion of sales during the first half, but this was in anticipation of heavy demand over the festive period. 

The company has been investing in recycling capabilities and has said investment in fleet in the second half will be £3.5m. Generally, though, the business requires very little investment to back growth with much of its asset base secured through leases. Indeed, the capital expenditure supporting the first-half capacity increase was put at just £2m. It finished the half year, at the end of September, with £58m of net cash, ignoring £85.3m of lease liabilities.

Lockdowns mean the current financial year will be a bumper one for AO World. But the group does not expect to give up ground as life returns to a more normal state. So brokers are still forecasting growth in the 12 months to the end of March 2022, albeit at a lower rate. The cyclicality of the business provides some reason for caution. Nevertheless, the success of the company and enthusiasm of new customers means 2022 forecasts have the potential to be upgraded. 

The valuation of the shares could be regarded as toppy based on earnings forecasts. However, if progress continues to be made, the group’s sales have the potential to be far more profitable than is currently the case. The growth on offer also looks tantalising given recent trends. That means it is perhaps more helpful to look at the group’s enterprise value (market capitalisation plus net debt) compared with sales as a potential guide to value. At 1.3 times forecast next 12-month sales, this is not too challenging based on the growth, online market leadership, and margin improvement potential. Still, were sales growth to falter, or future profitability to come into question, there is room for a painful de-rating.