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Eight genuine growth stocks

The genuine growth screen has served up a 118 per cent total return over the past five years, compared with 61 per cent from the FTSE All-Share, but a bit of tinkering may improve its results.
November 23, 2017

Valuation techniques often suffer from the problem of 'rubbish in, rubbish out'. Compelling but complex methods of valuing stocks, such as discounted cash flow (DCF) models, are often regarded as being particularly susceptible to producing rubbish valuations given the potential to base calculations on rubbish assumptions. In the case of DCF, such assumptions range from judgements about appropriate long-term discount rates through to financial forecasts stretching many years out into an unpredictable future.

Given the vast extent of the uncertainties investors face when trying to value shares, one of the key attractions of the price/earnings growth (PEG) ratio is that it keeps things simple as it attempts to weigh a valuation based on current earnings against prospects for future earnings growth. The basic PEG formula is:

PEG = price/earnings (PE) ratio / EPS growth rate  

Many investors also successfully use a rough-and-ready rule of thumb that a PEG of one or less denotes value.

But despite its simple and succinct nature, 'rubbish in, rubbish out' is still an issue for PEG. For instance, the late, great Jim Slater, who was a noted proponent of the use of PEG to value stocks and wrote extensively on the ratio in his classic book The Zulu Principle, recommended that investors only pay attention to the ratio if its two inputs (PE and EPS growth rate) were within reasonable bands.

My genuine growth screen, which I am re-running this week, uses the PEG ratio as its principal valuation criteria, but I feel it is a bit liberal with its 'rubbish' filters. I’ve therefore made two amendments to the screen this year, which calculates PEGs based on each share’s historic PE ratio divided by the average EPS growth rate forecast for the next two financial years.

The first change I’ve made is to void PEGs if growth rates are expected to more than halve from the current financial year to the next financial year. The second change is that forecast growth in both of the next two financial years must be higher than the median average for all stocks screened. Previously the screen only required average growth over the next two years to be at least half of the company’s long-term average growth rate. The full screening criteria are as follows:

 

Hopefully these changes will improve the screen’s ability to highlight stocks of real interest. That said, the screen has not done too badly in the five years I’ve run it so far. While last year was unspectacular (see table), the cumulative total return from the screen since inception stands at 118 per cent, compared with 61 per cent from the FTSE All-Share (see chart). If I factor in a 1.5 per cent annual charge to account for the notional cost of switching from one portfolio of 'genuine growth' shares to the next each time a new selection of stocks is published, the cumulative total return drops to 109 per cent.

 

2016 performance

NameTIDMTotal return (16 Nov 2016 - 13 Nov 2017)
Berkeley GroupBKG55%
IomartIOM38%
BGEOBGEO25%
IdoxIDOX6.9%
Galliford TryGFRD-2.2%
FresnilloFRES-4.5%
Telit CommunicationsTCM-25%
FTSE All Share-15%
Genuine Growth-13%

 

 

It’s also worth noting that while this screen has a somewhat patchy record of outperformance based on the one-year holding periods that I principally use to assess it (it underperformed the index both last year and more markedly in the year starting November 2015), on a buy-and-hold basis all the older screens currently show noteworthy outperformance of the market. The relative performance shown in the bar chart below is based on compound annual growth rates.

 

 

This year, eight stocks from the FTSE All-Share and FTSE Aim 100 passed all the screen’s tests. They are presented in the accompanying table ordered from lowest to highest PEG. I’ve also taken a closer look at three of the stocks to give a flavour of the screen’s results. For these write-ups I’ve chosen the shares from the top and bottom of the table and one from around the middle.

 

2017 genuine growth picks

NameTIDMSectorMkt capPriceFwd NTM PEPEGDYFwd EPS FY+1Fwd EPS FY+23-mth momentumNet cash/debt (-)3-mth fwd EPS change
S&ULSE:SUSFinancials£267m2,226p110.74.1%20%13%12%-£81m0.4%
SafestoreLSE:SAFEReal Estate£987m471p210.82.5%13%13%12%-£364m1.1%
RedrowLSE:RDWConsumer Discretionary£2.1bn585p80.83.8%11%8.3%1.3%-£73m7.2%
VpLSE:VP.Industrials£340m863p110.92.6%15%14%5.1%-£99m0.6%
MP EvansAIM:MPEConsumer Staples£449m816p341.03.4%43%34%10%$137m7.8%
Clipper LogisticsLSE:CLGIndustrials£396m395p251.21.8%27%19%-6.9%-£56m0.5%
McColl's RetailLSE:MCLSConsumer Staples£334m290p171.33.5%8.1%26%11%-£109m0.1%
PatisserieAIM:CAKEConsumer Discretionary£315m315p181.51.0%17%12%-8.7%£16m0.3%

Source: S&P Capital IQ

 

S&U

During 2017, investors have started to fret about where the UK may be in its current 'credit cycle'. S&U (SUS) has found itself at the forefront of these concerns. As a sub-prime lender the group is likely to be one of the first to feel the chill winds of rising levels of bad debt and the company has seen rolling 12-month impairments to revenue rise over recent years (see chart below).

 

 

With impairments coming off a very low level, monetary policy tentatively tightening and levels of UK consumer indebtedness high, it is not hard to understand why many investors think there could be tougher times ahead for lenders, and especially those focused on less creditworthy borrowers.

Furthermore, the fact that S&U does a lot of lending to finance second-hand car purchases through its Advantage business puts it at the sharp end of investors’ worries about the sub-prime lending sector. While the company is not involved in so-called personal contract purchase (PCP) loans (where a resale price is guaranteed on debt-funded purchases of new cars), it could be vulnerable to falling second-hand values should the recent PCP boom result in a glut of second-hand vehicle supply just as demand is weakening. Many fear this may prove the case.

But against this angst, there are also some grounds to think the current rating of S&U’s shares may be overlooking some of the business’s virtues. Management has put recent rises in impairments down to a change in product mix and stresses that the group’s high risk-adjusted yield remains stable. What’s more, the relatively low price of vehicles S&U lends against may help insulate it from the worst of any fallout in the second-hand market created by nearly new, PCP-related sales. And S&U’s loan book continues to grow at an impressive clip, while an increase in gearing from low levels should serve to enhance return on equity (a key metric used to assess the performance of lenders).

Last IC View: Buy, 2,031p, 26 Sep 2017

 

Vp

While hire company Vp (VP.) has a solid record for growth based on its focus on niche tool-hire markets, it is the recently announced acquisition of UK company Brandon Hire that is currently the key reason for excitement. Brandon operates a network of 143 hire shops in the UK that mainly serve small- and medium-sized enterprises (SMEs). The business, which is being bought for £69m including £27m of debt, looks as though it will complement Vp’s Hire Station business extremely well both in terms of geography and customers. Hire Station has performed well for a number of years and the deal will mark a major step change in its operations, which currently span 58 locations.

While the acquisition of Brandon is expected to have limited impact on profits this year, broker N+1 Singer has increased its EPS forecasts for 2019 by 14 per cent. This contributes to a virtuous cycle of upgrades over the past year (see graph). What’s more, if things go well, there could be further upgrades to come based on the scope to cut costs through the combination of the two businesses. Supporting hopes for additional benefits from the integration of Brandon, is Vp’s reputation for prudent management and its experience as an acquirer.

 

 

Meanwhile, Vp has been trading strongly across its end markets, which span infrastructure, construction and housebuilding. Other recent smaller-scale acquisitions have been contributing to growth, as has the company’s push into overseas markets. Growth has been particularly strong in the Asia Pacific region, although international sales only made up 11.5 per cent of the total last year. Vp has half-year results due out between the time of writing and publication of this article.

Last IC View: Buy, 840p, 8 Nov 2017

 

Patisserie

Patisserie operates a national chain of continental-style cafes under the Patisserie Valerie brand. The company looks like something of the growth ideal for its nook of the leisure sector. It has a strong brand with excellent roll-out potential, which is backed up by a strong balance sheet and existing units are generating more than enough cash to finance management’s expansion plans. To cap it all off, Luke Johnson, the entrepreneur that masterminded the phenomenal nationwide expansion of the Pizza Express chain, is executive chairman and owns almost two-fifths of the shares.

That said, all leisure businesses currently live under a cloud of uncertainty due to high levels of new openings in recent years, concerns about the consumer outlook and rising costs – from ingredients to wages. Nevertheless, Patisserie itself has yet to show signs of succumbing to these sector-wide fears.

When the company reports full-year results on 27 November, it should have over 200 stores in operation. At the half-year stage new openings were on average paying back the initial investment in under two years. Meanwhile, cash is building up on the balance sheet at an impressive rate – the cash balance should be seen in the context of rental lease commitments, which SharePad puts an estimated value of £90m on. New accounting rules will require these debt-like liabilities to be reported on the balance sheet from the start of 2019.

All the same, given the robust balance sheet, management has talked about the potential for acquiring other chains to either convert to the Patisserie brand or, if appropriate, run as a separate brand. Given the very limited benefit to the profit-and-loss account of holding cash in an uber-low interest rate environment, a well-chosen acquisition could considerably enhance earnings. What’s more, the tough conditions faced by the sector as a whole means it may prove a buyers’ market.

Last IC View: Hold, 359p, 18 May 2017