Best of the FTSE 350 2019

Our 'Best of the FTSE 350' started out as an experiment in using principles of 'smart beta' strategies to mechanically highlight companies in their sector and see if it is possible to beat the index. The first difficulty here is that within a sector category there is often huge variation between industries. So, straight away in choosing companies, the active decision was made to pick out those that seemed relatively better than their industry peers.

In 2017, the approach worked, but last year the selection of 15 stocks underperformed the FTSE 350 index, on a price and total returns basis. What went wrong? Firstly, there is the possibility that 2017 was just good luck. Part of the explanation may also be that picking stocks largely on backward-looking quality indicators was a less successful strategy as the market had a tougher time, ie the growth/momentum play of the past few years has started to unwind. In other words, beta bit back and looking to turbocharge passive gains by isolating characteristics was a much bigger ask in a period when the parent index dropped nearly 10 per cent.

The good news for investors is that greater volatility will lead to more dispersion in the performance of shares which, as the dust settles on periodic falls, should create opportunities to outperform. The principles of diversifying across different sectors remain sound, so it is still worth analysing on a sector-by-sector basis. The starting point has been to compare companies in the same or similar industries based on expensiveness, using price-to-forward-earnings estimates (forward PE) and quality, using return on capital employed (ROCE). On their own, these two measures are inadequate as a basis for choosing companies, but they are a useful starting point for investigation including measures assessing cash flows, solvency and the pricing of future growth.

The first sector looked at for this year’s sector by sector portfolio (using data from Sharepad) was consumer discretionary, which includes many very different industries. One company that stood out in casinos and gambling was 888 Holdings (888) based on the combination of a forward PE that was lower than most in its direct peer group and a ROCE that is by far the best. Free cash flow (FCF) conversion is over 100 per cent and there is a good cash return on capital employed (CROCI). Furthermore, the business is debt-free and has no pension deficit, meaning there is scope to return cash to investors – with consensus forecasts indicating a 7 per cent yield. The main fly in the ointment is the potential for regulatory issues.

The outlook for retail is incredibly difficult to call, but hobby outlet Games Workshop (GAW) is better characterised as a leisure goods business. The company is expensive, with a rating of 19 times forward earnings, but a well-covered dividend yield of 3.7 per cent and a stellar record of ROCE, makes this company – which is free of debt and pension deficit and has a unique brand and incredibly loyal customers – in some ways a defensive play.

In the internet and direct marketing retail sub-sector, Moneysupermarket.com (MONY) is a business, which delivers very high ROCE (56 per cent) and the high fixed-charge cover and decent cash conversion of 93 per cent means the 3.7 per cent dividend yield looks safe. This business is valued on 17 times, and the high PEG (price to earnings growth ratio) should demonstrate to investors that they are paying for the safe yield rather than strong growth prospects.

Consumer staples is traditionally more of a defensive sector for those who are pessimistic about prospects for the economy. Some companies in the sector (notably supermarkets) could now be characterised as recovery plays, however, and the comparison between PZ Cussons (PZC) and Reckitt Benckiser (RB.) is interesting. Cussons is cheaper but RB. scores better on quality measures such as ROCE, FCF conversion and is expected to grow profits, so despite a disappointing performance last year we include Reckitt once more in our selection for 2019.

A fall in the oil price from over $85 to around $60, places the short-term outlook for energy stocks into doubt and longer term there are questions about the sustainability of their business models. Shell (RDSB) has been the pick in the energy sector over the past two years and again it looks more attractive than BP (BP.). Firstly, on a pure valuation basis, Shell is cheaper according to EV/EBITDA, which takes into account debt. On quality measures, Shell looks better, too, although ROCE is low for both (unsurprising in such a capital-intensive industry). Shell is much better, however, at converting profits to cash.

Looking at financials, we start with the big five banks. This year we stick with Lloyds (LLOY) as a preferred banking stock. It has seen a reduction in the size of its loan book, but the overall health of the bank is good, with a sector-beating net interest margin of 4 per cent – which indicates its lending operations are more profitable than those of rivals. The return on equity of 8 per cent is also best in class. The fall in loans is also reflected in a healthy loan-to-deposit ratio, indicating the bank funds its operations from deposits rather than wholesale funding, which is riskier. The group also has a healthy tier one capital ratio and covers its dividend 1.8 times. This dividend cover is expected to improve to 2.4 times and the dividend yield itself is expected to grow to 5.8 per cent, at the group's current share price.

For our second financial services company, we look to Just Group (JUST). The valuation has been suppressed by a forecast dividend cut, but the shares are still expected to yield 3.5 per cent. Regulatory pressures have eased and the price to net tangible assets is just 0.6 times, marking this out as a potential value play. A healthy return on equity of 9 per cent and FCF margin of 18.4 per cent are also reassuring quality signs. The claims ratio of just 27 per cent, shows that the company does not rely on investment income for its profits.

In healthcare, Smith and Nephew (SN.) scores best on quality in what is an expensive sector. The business has achieved ROCE of 14.9 per cent and has 86 per cent FCF cash flow conversion, which is best in class. Although the forward PE of 19 is high, the company is relatively less expensive when viewed on its EV/EBITDA multiple of 12.

Companies in the pharma sub-sector are a mix of dogs with serious regulatory issues or lumbering giants on stretched valuations. Having picked AstraZeneca (AZN) for the past two years, there is now more value in GlaxoSmithKline (GSK), as the market hasn’t yet formed a strong view on its new strategic direction. GSK is rated on 13 times forward earnings compared to 21 times for AZN, which seems decent value given their respective ROCEs of 18 and 3 per cent.

In industrials, for the third year in a row we plump for BAE Systems (BA.) – the company is valued on 11.5 times forward earnings. Margins are not spectacular at 9 per cent and earnings aren’t forecast to grow but the company covers its fixed charges easily, and while there is a 25 per cent pension deficit to market cap, debt obligations at 27 per cent of capital are not too onerous. The forecast dividend yield of 4.6 per cent looks safe therefore and muted expectations are in the price, so this looks a reasonable stock for the income.

Thermal processing services provider Bodycote (BOY) is another industrial company that stands out. While many industrial companies operate in niches and aren’t directly comparable, its EV/Ebitda is cheaper than peers. There is little debt and no pension deficit to speak of, and ROCE, CROCI and FCF conversion all attest to a quality business.

With more global uncertainty likely, gold is a traditional hedge in either a scenario of inflation or (perhaps more likely) in a deflationary environment. Polymetal International (POLY) looks like the best gold mining stock – versus Centamin (CEY) or Acacia Mining (ACA) – to make an equity play on the long gold trade. True, it is the most expensive of the three on a price to net tangible asset value of 3.7 times, but it’s the only company of the three forecast to grow earnings next year. Furthermore, the 4.1 per cent forecast dividend yield adds a nice additional return.

Our second pick from the materials sector is Elementis (ELM). The speciality chemical producer is on a forward PE of 13 times, with a PEG ratio of 1.3 times (on double digit EPS growth forecasts) – which is better value than many groups in the chemicals industry. Specialist polymer manufacturer Victrex (VCT) is more of a quality play and has the best ROCE and margins in this sub-sector (although again these are very different businesses despite sharing the same classification). Looking for a value share, however, it is Elementis we plump for.  

Debt is something investors should beware of with traditional utility companies. Pennon (PNN), United Utilities (UU.) and Severn Trent (SVT) all have debt levels around 60 per cent of their capitalisation. Pennon shows good solvency characteristics with fixed charges covered 3.1 times, but if more capital expenditure is required this could get worse. The dividend of 5.7 per cent is better than those of direct peers, so despite political risk, we still include it as a defensive position in case of a market downturn. Finally, as I'm not overly confident for 2019, I'm keeping 12.5 per cent in cash as a buffer against periods of market drawdown.