Blue-chip quality stocks with momentum

The rub is that there have been plenty of ups and downs along the way. What’s more, the regularity with which I run this screen (once every three months) means any real-world application would be beset by dealing costs. This is the only screen run in this column that I present as a purely theoretical exercise without factoring in notional dealing costs or dividends (as with almost all the screens I monitor in this column, the results are regarded as primarily a source of ideas for further research rather than off-the-shelf portfolios). However, the screen’s long-term performance certainly provides a compelling reason to pay attention to momentum as part of any research process.

Over the past three months, both the long and short portfolios – consisting of the 10 best and 10 worst performing shares of the preceding three months – underperformed the FTSE 100. The shorts registered quite spectacular underperformance, with all shares doing worse than the index.

Blue-chip momentum over the past three months

*15 Mar - 7 Jun 2019

Source: S&P CapitalIQ

The longer-term performance can be seen in the charts and tables. The charts cover the screen’s performance since inception and over the past five years when the shorts have been misbehaving by performing better than the market.

Performance ranges

Sources: Thomson Datastream/S&P CapitalIQ

I’ve harped on in recent columns about the significantly superior performance of ‘quality’ screens that pay no attention to the question of valuation, versus ‘value’ screens. I will therefore try to keep my comments on the subject brief, but the extent to which this theme is reflected in the momentum picks for the coming quarter is so striking it deserves some comment.

For those familiar with constituents of the FTSE 100, a lot of quality names stand out in the list of the best performing blue-chip stocks (the longs), such as Spirax-Sarco, Unilever, Rightmove, Intertek, Auto Trader etc. But what is really striking is how expensive these shares are. The 10 longs have a median forward price/earnings (PE) ratio of 26 times and on average yield a fairly meagre 2.1 per cent. The high ticket price has not prevented these shares registering an average gain of 16 per cent over the past three months.

Compare this with the sorry band of 10 worst-performing blue-chip shares that form the shorts, which on average have fallen 19 per cent over the past three months. They boast a median forward PE ratio of just 9 and a bumper average yield of 7.1 per cent. The high yield reflects the market’s disbelief that many of these companies will be able to hold their dividends at historical levels.

Valuations tend to be a truly worthless guide to performance at the moment, and there are grounds to view a number of the shorts as being cheap for very good reasons. However, stock market sentiment can be very quick to change and valuation risk is arguably the stand-out issue with the many great companies that make up this quarter’s top 10 longs.

Details of all the longs and shorts can be found in the table above and I’ve taken a look at one of the longs with a great business but a scarily high forward earnings ratio and one of the shorts with a struggling business and a scarily high dividend yield. Because of delay between writing and publication of this article, the official Longs and Shorts for the next quarter may vary from the lists above depending on performance in the interim. The official monitoring period runs to 15 June.

Longs

Shorts

Source: S&P CapitalIQ

Spirax-Sarco

Engineer Spirax-Sarco (SPX) should be something of a poster child for investors searching for quality stocks. It’s a great company that generates high margins on its sales and high returns on the money it invests in the business. Its steam systems and pumps improve the efficiency of its customers’ operations, which drives demand. 

The products also offer environmental benefits, which means increasing regulation also benefits sales. Meanwhile, its end markets are relatively niche and, coupled with the company’s strong track record for product innovation, this makes it very hard to compete against. The importance of Spirax’s products to its customers’ operations also provides the foundation of strong relationships and a market where more focus is put on quality than price. The company also has a good record for bolstering economic growth with acquisitions. All very nice.

While the company does sell into a cyclical end market, so far the slowdown in industrial activity that began last year has not hit trading. Indeed, during the past three months (the period over which momentum is assessed by this screen) the company released a trading update to say the year had started as strongly as 2018 had ended. This has helped underpin the recent share price ascent. While underlying progress was solid, the trading period was helped by Chinese orders being brought forward to avoid an upcoming VAT change and Brexit-related stockpiling.

The consistency of Spirax’s business has won it a lot of fans, but the consequent rise in valuation may leave the shares vulnerable to even minor disappointments – the worsening industrial backdrop may make 2019 more prone to such events. The consistently high returns on invested capital (ROIC) generated by Spirax over the past 10 years have been accompanied by a consistently rising forward price/earnings (PE) multiple, which recently spiked to a 10-year high. The current forward PE sits more than 50 per cent above the 10-year average. What’s more, the recent inclusion of Spirax’s shares in MSCI’s UK index means there has recently been a wave of buyers at any price in the form of index-tracker funds.

Even for one of the best companies listed on the London markets, which can certainly claim to deserve a valuation premium, the current valuation looks somewhat precarious given no major step change in performance is forecast. Indeed, growth expectations are hardly breathtaking. Broker Peel Hunt, itself a fan of the stock, only expects earnings per share to rise 2.8 per cent this year, followed by 5.6 per cent in 2020 and 3.6 per cent in 2021.

Centrica

Looking at Centrica (CNA), it is perhaps not difficult to see why investors are happy to pay up for the reassurance of quality. The company has tried to slim down its business over recent years, moving away from more capital-intensive operations. But the businesses it has focused on have not been doing well. In particular, its retail business has suffered for years, most recently following the introduction of a new price cap, which pushed up customer churn in March and April. Meanwhile warm weather and natural gas price falls have hit profits and the prospective implications of a more interventionist Corbyn-led Labour government are a source of major uncertainty.

However, the reason for buying any ‘value’ play is the prospect that the future will turn out to be better than the recent past. Indeed, even if Centrica were to halve its dividend, holders would still own a high-yielding share. Current forecasts are for only a 25 per cent cut, but these estimates should be taken with a large pinch of salt.

A poor start to the year means management’s guidance that the company is on course to meet 2019 expectations should also be taken with a pinch of salt. However, the company is cutting costs (a £250m target for the year) and has plans to sell off more assets. Management is due to provide more news on divestments at the end of the month, with expectations of news on nuclear disposal plans.