Big Reliables bounce back

As it would happen, the performance from the Big Reliables screen over the past 12 months gives some credence to the view that it pays to stick with an investment approach that is based on well-founded principles. The six stocks picked by the screen last year delivered a 21 per cent total return over the period, which was well ahead of the 8.1 per cent from the FTSE 350 index.

12-month performance

Source: Thomson Datastream

Over the longer term, the recent strong 12-month performance means this screen is now once again outperforming the index it selects stocks from. Over seven years the screen has produced a cumulative total return of 97 per cent, compared with 74 per cent from the index. If I factor in an annual charge of 1 per cent to reflect the notional need to reshuffle the portfolio each year (in general this column’s assumption is that the screens are primarily helpful as a source of ideas rather than off-the-shelf portfolios) the total return over the period drops to 84 per cent.

Given that the ambition of this screen is to find reliable companies, I feel it is worth keeping tabs on the strategy’s buy-and-hold performance (see table below). One interesting aspect is that the poorly-performing Big Reliables portfolio from 2015 has now, after three years, almost caught up with the performance of the index (30 per cent vs 33 per cent). That compares with last year, when the 2015 stocks buy-and-hold total return stood at just 7.9 per cent total return compared with 24 per cent from the index. That said, the poorly performing 2016 portfolio has yet to make up ground with the FTSE All-Share.

Buy-and-hold performance

Source: Thomson Datastream

The screen itself works by looking at a number of classic indicators of quality while paying no attention to the question of valuation. The view is that quality will out over time. The criteria are:

■ EPS growth in each of the past five years.

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

■ 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.

Five stocks from the FTSE 350 passed all the screen’s tests this year. Details are given in the accompanying table and I’ve also taken a closer look at the two stocks boasting the strongest three-month share price momentum.

Five Big Reliable shares

Source: S&P CapitalIQ

Cranswick

The Big Reliables screen is agnostic about valuation. But while valuation is rarely the catalyst that sparks a share price movement, the potential for a valuation re-rating or de-rating can have significant influence on the extent of a share price movement when a new trend does take hold. This is a consideration with shares in meat-processing company Cranswick (CWK) because after several strong years the company’s shares look very expensive by historic standards.

A period of canny investment and acquisition has seen the group achieve a compound annual earnings growth rate of almost 18 per cent over the past three years. What’s more, over that time the group has moved from having net debt of £22m at the end of March 2015 to £20m net cash by March 2018, which is despite spending heavily on expansion, including a record capex spend of £56m during the last financial year. The company has also established itself as the UK market leader in pork products and has benefited from rising exports helped by sterling’s weakness since the Brexit vote.

The valuation of Cranswick’s shares has marched upwards during this period and now sits at close to an all-time high. While the company has plans for further investments to substantially increase the capacity of its poultry and continental products operation (£80m of investment is earmarked for the current financial year) it will take some time before it starts to generate returns on these new investments and brokers expect growth to slow this year.

This begs the question of whether the high valuation can be sustained during a period of lower growth even if the company remains a class act. Indeed, the shares would face a 20 per cent de-rating to get back to a valuation in the top quarter of the 10-year range (based on a multiple of next-12-month forecast earnings). Meanwhile, to get back to the 10-year mid valuation would take a 41 per cent de-rating. In both cases, such de-ratings far outweigh forecasts of 4 per cent EPS growth for the year plus a sub-2 per cent yield.

But has the underlying quality of the business improved so much that comparisons with the 10-year valuation range are no longer appropriate? The recent strong record of contract wins by the company point to the advantages of its investment in state-of-the-art facilities with high welfare standards and its position as market leader. Meanwhile, as the chart below shows, the debt/cash position has improved, although the shares do still look expensive on valuation metrics that try to take account of this (based on enterprise value/operating profits there is 21 per cent downside to a top-quarter 10-year valuation and 40 per cent downside to the mid point).

The underlying quality of Cranswick’s operations is impressively high as measured by return on capital employed (ROCE) and has been rising in recent years. Unlike the return on equity (RoE) measure of quality used by this screen, ROCE takes into account returns on other sources of finance aside from equity, including debt, to get a whole-company picture of quality rather than the shareholder-centric picture provided by RoE. However, while ROCE is very impressive, based on the 10-year record, the re-rating of the shares has hardly been accompanied by a step change in returns.

The market is often depressingly short-termist and nervy, and while investors live through Cranswick’s relative hiatus in EPS growth, there are potential worries that may set in. Of particular note is the consolidation currently happening in the grocery industry, with Tesco having recently merged with Booker and Sainsbury now looking to merge with Asda. While Cranswick’s focus on the quality of its product and welfare standards may strengthen its negotiating position with its big customers, a noteworthy increase in buying power could see some of the handsome returns it currently enjoys transferred to the big supermarkets, which are currently focused on rebuilding margin.

All in all, there’s a risk that Cranswick’s many attractions have already been baked into the share price, and a bit more besides.

JD Sport

As with Cranswick, if the valuation of JD Sports Fashion’s (JD.) shares were to move back towards the middle of the 10-year range, they too would de-rate substantially (45 per cent). However, in the sportswear retailer’s case, drawing historic comparisons over a decade may miss the point. A lot can happen in 10 years and for JD most of what has gone on has been very good. Profitability has improved markedly (based on Sharepad data the operating margin of 9.3 per cent last year was more than double the 2013 low), exclusive relationships with must-have brands have been forged and strengthened, and the company has established a significant overseas business, which accounts for over half sales following a major US acquisition that has just completed. In fact, having gone from a stock market zero to hero during the past decade, it is easy to regard the shares as cheap following a stumble last year.

Such was the reputation JD had for beating brokers’ forecasts at this time last year that a very minor downgrade to 2017 earnings expectations on the back of a late June trading update saw the shares de-rate from a multiple to forecast earnings of over 20 to a rating in the low teens. While the share price has recovered since, if the shares were to re-rate all the way to the average valuation they commanded during the two years prior to the upset (mid-2015 to mid-2017), there would be another 16 per cent revaluation upside.

In this context, perhaps the best question to ask of the stock is whether sentiment could be repaired to this extent? Arguably, this is not a far-fetched hope.

JD stands out from other high-street retailers thanks to its exclusive relationships with key brands, such as Nike, which makes its stores a genuine draw for young, image-conscious shoppers who are also enthusiastic users of its online shop. And while the UK consumer outlook is not good, JD is benefiting from the so-called 'athleisure' fashion trend, as well as the fact that younger, trend-mad customers are less prone to rein in spending when times are tough. Indeed, JD Sports has re-established a pattern of earnings forecast upgrades since the minor blip a year ago (see chart below).

The real excitement for JD shareholders, though, lies in overseas markets. The company has been growing fast in Europe for some time, but recently completed a $558m (£413m) acquisition that will take it into the US. If the retailer can replicate the success its stores have had elsewhere in the world’s biggest sportswear market, then it would be off to the races for shareholders. JD’s management is certainly excited about the opportunity, describing the deal as “a momentous step in JD's global expansion”. Let’s hope so.