Six Genuine Growth shares

As we enter the final furlong of 2021 with fingers crossed to wind things up with a Santa rally, it looks like growth stocks that are once again capturing many investors’ imaginations. 

Undaunted by Covid or the spectre of rising inflation, UK growth stocks have substantially outperformed over the last six months. The MSCI UK Growth index has returned 10 per cent over that time compared with just under 6 per cent from the main MSCI UK index and a mere 3.4 per cent from the 'value' version of the index. So this year’s Genuine Growth screen is being run at a time when the wind seems to be in the sails of the strategy.

The outperformance of 'growth' over the last half year marks a sharp reversal on the previous six months. Indeed, the choppy conditions over the last 12 months as a whole may be reflected in the fact that the six shares highlighted by last year’s Genuine Growth screen failed to keep pace with a strong market (see table). 

The screen’s cumulative total return since I began to follow it nine years ago now stands at 251 per cent compared with 90 per cent from the FTSE All-Share and 120 per cent from the FTSE Aim 100. While the screens run in this column are meant as a source of ideas rather than off-the-shelf portfolios, if I factor in a notional annual charge of 1.5 per cent to account for real world dealing costs then the cumulative return drops to 207 per cent. 

The screen itself takes a 'growth at a reasonable price' (GARP) approach. It uses a price to earnings/growth (PEG) ratio to try to assess value. All the other tests are focused on both historical and forecast earnings growth. The glaring emission from the criteria is any attempt to assess the actual quality of growth on offer and the results from this screen always need to be seen in this light. 

Indeed, one of the most dangerous things for investors to overlook is the fact that when returns on investment are below the cost of investment growth will actually destroy shareholder value. Still, while the focus of this screen may be a bit myopic, it does often highlight interesting ideas. The full criteria are:

■ Both a three-year EPS compound annual growth rate (CAGR) and a forecast growth rate for the next two reporting years of 15 per cent or more.

■ Forecast EPS growth rate for the next financial year (FY+2) at least half the rate forecast for the current financial year (FY+1), or more than 10 per cent in each year.

■ EPS forecasts higher today than they were three months ago.

■ A PEG ratio among the lowest half of index constituents (either FTSE All-Share or Aim 100).

This year six stocks passed the screen’s tests, four from the FTSE Aim 100 and two from the All-Share. I’ve taken a closer look at the one boasting the most forecast growth for both the next and following 12-month periods. The full list of stocks along with fundamentals can be found at the end of this article.

Watches of Switzerland

In 2014 a new management team was bought in to soup up the performance of luxury watch retailer Watches of Switzerland. The overhaul of the top brass came shortly after Apollo became the latest private-equity owner of the company, which was originally founded in 1924. 

The key opportunity for the new management to exploit centred on making more of the retailer’s symbiotic relationship with suppliers. 

Big brands, such as Rolex, TAG Heuer, and Cartier, are very fussy about who sells their gear and how they shift it. Meticulous manufacturing processes means supply of top-end watches is limited. Generally, it’s lower than demand. That makes the key distribution question one based on the quality of retail partners rather than quantity. First-class sales operations enhance watch makers’ brands and thereby boost the prices at which the limited supply of over-engineered and over-adorned timepieces can be flogged.

This fosters relationships between supplier and retailer based on mutual need and benefit. Top brands only want to sell through top retailers and top retailers need a supply of must-have merchandise to keep posh punters coming through their doors. Case in point, Watches of Switzerland generates over four-fifths of its sales through just eight brands. While that represents a major risk should a relationship sour, it is also a big opportunity. 

The semi-exclusive tie-ups means both the retailer and watchmaker benefit from pricing power. There is also the potential to create ever-deeper relationships at the expense of rivals; something Watches of Switzerland is exploiting with a growing estate of single-brand stores which account for 46 of its 158 shops. Strict control of supply also acts as a barrier to entry, especially against online-only operations given the value brand owners put on having a physical presence in flagship shopping locations.

Watches of Switzerland’s management team was successful in elevating the experience of customers by sprucing up shops, improving customer service, investing in IT systems and bolstering online clout. It achieved this in one of the premier markets for luxury watches, the UK. In the UK we spend more per capita on top-notch watches than anywhere else in the world. 

US gold rush

With business going well in the UK, in the autumn of 2017, Watches of Switzerland decided it was time to export its British know-how Stateside. It did this by acquiring a chain called Mayor. This is where the real growth opportunity now lies.

The opportunity is potentially huge. Per capita spend in the US is about two-fifths lower than in the UK market. Watches of Switzerland believe this is down to retailers’ underinvestment in the market. Indeed, while the luxury watch market in the US is only 1.8 times the size of the UK, by comparison the luxury jewelry market is 6.5 times the size. A further reflection of the potential waiting to be unlocked is the fact that while price rises have helped the value of the UK luxury watch market grow at a compound rate of 10 per cent per year between 2012 to 2019, the equivalent growth rate in the US was 2 per cent. What’s more, most of that growth has been achieved since Watches of Switzerland got involved in the market from 2018.

With the help of money raised at IPO in 2019, the company has been growing fast across the pond. From just under a quarter of sales in the first full year of ownership of Mayors (the financial year to the end of April 2019) the US accounted for a third of group revenue in the last financial year. It also accounted for 36 per cent of underlying cash profits. 

As the company squares up to this growth phase based on expansion rather than improvement, new managers are coming in. A new chairman was appointed last November and in August it was announced that a new finance director would be soon be appointed.

Covid Winner

Covid and lockdown did little to slow progress last year. In fact, arguably the opposite. While the company saw sales to air traveller and tourists plummet from 28 per cent of the total to just 5 per cent, it compensated with massive success online. It used one-to-one appointments over both zoom and instore to turn more browsers into buyers. An extra week’s trading from a 53-week financial year helped last year’s reported figures, too, but the 13 per cent rise in sales to £905m was still stunning. So too was a 39 per cent increase in operating profit to £78m.

The first half of the current financial year has also been exceptionally strong, with guidance for full-year sales recently bumped up by £100m to £1.15bn-£1.2bn. And rising sales are pushing up profitability, too, with expectations of a 1 to 1.5 percentage point increase in underlying cash profit margins. The shares have risen higher on a raft of broker upgrades (see chart).

The trend of rising margins reflects the fact that this business benefits from so-called operating gearing; a phrase that describes the benefit to profitability of generating more sales from the same cost base. Indeed, while the group’s mark-up on watches has tended to stay fairly stable over recent years, the effect of selling more watches at higher prices through existing stores has meant margins have marched forward. (see graph)

The group’s own measure of return on capital employed (ROCE) has also marched ahead. It now stands at an impressive 19.7 per cent, having risen from 14.7 per cent in 2019. But this overlooks exceptional charges which have been a noteworthy feature over recent years. Exceptional items relating to share-based payments and impairments connected to Covid and VAT changes totalled £11.9m in 2020 and £9.1m in 2021. Even so, my standardised ROCE calculation of 13.4 per cent is not too bad, albeit not outstanding.

In July, Watches of Switzerland announced plans to put its foot down harder on the growth pedal. Over the next five years it plans £300m-£340m worth of capital expenditure. That compares with £109m of spending over the previous five years. In addition, £150m-£200m has been earmarked for acquisitions. The plans are supported by an increasingly healthy balance sheet. Most of the company’s £343m stated debt is accounted for by its £301m of lease liabilities connected to its stores. High-value inventory of £263m as of the end of April also underpins borrowings.

The group has been quick out of the blocks, announcing the purchase of the properties of three flagship retailers, which takes its store numbers in the country to 36, including 14 single-brand US stores. Meanwhile, Watches of Switzerland purchased a US retailer with a strong online operation last year. There is also a strong pipeline of openings planned based on both multi- and single-brand stores.

The risk with going all out for growth at this point is that there may have been an exceptional bump in demand caused by Covid. Have bored consumers been simply seeking replacements for big-ticket, feel-good treats such as holidays? We’re yet to see much sign of a slowdown, but the world has yet to get back on its feet. A flip-side to such fears is that increased tourism should see a return of demand from this source, which the company is not currently banking on in its issued guidance. Securing sufficient stock to match the growth ambition is also a challenge and the group has recently been focused on boosting inventory levels, particularly of Rolexes.

Based on current investor enthusiasm for growth plays, the valuation does not look so rich as to create a major share price headwind against the successful execution of the US expansion strategy. However, it is rich enough to make any disappointment painful. The weirdness of Covid trading gives cause for uncertainty.

Six Genuine Growth Shares

Source: FactSet