Takeovers dominate momentum plays

The purpose of highlighting the strong three-year returns from backing losers was not to endorse such a strategy. There is a large amount of evidence that strongly suggests that on the whole stock market losers tend to continue to disappoint. Quant investors often like to make a distinction between focusing on the signal and not the noise. In this case, the recent triumph of the losers – albeit a multi-year run – looks like noise as opposed to the signal provided by a mountain of painstaking research into the momentum phenomenon.

But once again anyone that decided to flout the well-founded orthodoxy three months ago and back blue-chip losers, would have done very nicely. The worst performing 10 shares as of 15 December 2017 managed to produce a share price return of 4.4 per cent to 15 March 2018 compared with -4.7 per cent from the index. Much of the strength of the gain can be explained by a single stock out of the 10 blue-chip losers: GKN which received a takeover offer from turnaround specialist Melrose during the period that helped its shares rise 44 per cent.

The good news for anyone looking for evidence of momentum’s veracity is that the FTSE 100’s best-performing shares as of three months ago also outperformed the index (it should be noted momentum is meant to work only as a longer-term phenomenon rather than a consistent cause of outperformance). The 10 blue-chip winners posted a 0.6 per cent share price return compared with the -4.7 per cent from the index.

Three-month performance

Source: S&P Capital IQ

The five-year return from the classic blue-chip momentum screen now stands at 48 per cent for the longs compared with 40 per cent for the shorts, both of which are some way ahead of the FTSE 100, which is up 10 per cent over the same period. The five-year performance of the screen is shown in the chart below and the accompanying table covers a range of other periods over which I have monitored the strategy. It is important to note that unlike the other screens I monitor I do not give numbers that factor in costs and dividends for the momentum screen. Costs are considered a major real-world impediment to the implementation of momentum strategies due to the high turnover involved.

Source: S&P Capital IQ & Thomson Datastream

The picks from this quarter’s momentum screen raise the question of how best to handle takeover situations when assessing the screen’s result. My approach to this is somewhat ad hoc usually, based on how advanced individual takeover processes are. Generally, if a takeover looks like a done deal I tend to regard its relevance to a momentum strategy as limited and therefore best ignored. Three takeover situations crop up in this quarter’s picks and, while if all are included the portfolio seems very skewed, they all seem to be 'live' deals. I’m therefore letting them all be among the 10 picks despite this feeling somewhat uncomfortable to me – it not always easy to follow rules!

The shorts portfolio is based on the 10 worst-performing FTSE 100 shares of the three months to 15 March and represents shares that are considered more likely to underperform in the coming quarter. The longs portfolio comprises the 10 best-performing shares of the three months to 15 March and would conventionally be considered to be more likely to outperform. The shares selected are detailed in the accompanying table and I’ve provided brief write-ups of the 10 blue-chip longs.

New selections:

*includes special dividends

Source: S&P CapitalIQ

GKN

Shares in engineering group GKN (GKN) have taken off over the past three months following a hostile bid from turnaround specialist Melrose. GKN has painted Melrose as something of a short-termist asset stripper. Politicians have also weighed in given GKN’s involvement in the defence sector. Melrose’s recently increased “final” offer stands at 467p a share, which is made up of 81p cash and the rest in new shares. GKN suggests a final dividend should be ignored from the offer price, putting its estimated value of the bid at 460.7p a share. GKN has also laid out plans of how it will seek to realise value should the bid not be approved, which includes the potential sale of its powder metallurgy unit and a return of cash. Meanwhile, GKN’s biggest customer, Airbus, has recently commented that it may struggle to work with the engineering group if ownership changed.

Evraz

Cost cutting combined with rising selling prices has resulted in a surge in cash flows at UK-listed Russian coal and steel company Evraz (EVR). Indeed, recent full-year results reported a doubling of free cash flow to $1.32bn (£960m). Much of this money is coming back to shareholders through dividends. Following a three-year dividend hiatus, there was a bumper 60¢ payout in 2017, equating to a yield of about 10 per cent at the current share price. Evraz is also increasing capital expenditure and cutting debt. The recent steel tariffs introduced by the US could cause problems, but Evraz’s North American operations potentially stand to benefit, and management believes strong alternative markets exist outside America. The shares recently had a bit of a wobble on the back of £720,000-worth of share sales by the company’s chief executive and chairman.

Smurfit Kappa

Earlier this month, after a bout of trading weakness aggravated by unfavourable raw material price moves, Dublin-based paper company Smurfit Kappa (SKG) received a bid from US rival International Paper. The bid values each Smurfit share at €36.46 (3,220p) made up of €22.00 in cash and 0.3028 new International Paper shares. The bid followed full-year results from Smurfit that set out several new operating targets and showed signs that performance had picked up in the fourth quarter. Smurfit has rejected the offer as being too low and opportunistic. However, now a bid has been tabled, there is the potential for more would-be suitors to emerge.

Sky

The long-running bid saga for Sky (SKY) took yet another intriguing twist during the past three months. For some time, 21st Century Fox has been looking to buy the Sky shares it does not already own, but has faced regulatory scrutiny due to concerns about UK media plurality. Meanwhile, Disney has snuck in with a bid for Fox’s media assets, including the Sky stake. Most recently, Comcast entered the fray last month looking to trump Fox’s 1,075p bid for Sky with a 1,250p offer of its own. What happens next? The momentum portfolio will be staying tuned to find out.

Anglo American

Rising output, rising selling prices and falling costs have proved an excellent mix for shareholders in miner Anglo American (AAL). There are hopes for more to come, too, with the company pointing to the potential for cost savings of between $3bn and $4bn by 2020 to add to the $4.2bn savings racked up in the past five years. The company’s sizeable South African operations may also benefit from increased stability in the country following recent political upheavals, although the consequent appreciation to the rand raises costs.

Old Mutual

Like Anglo, improved sentiment towards the South African economy has helped financial services group Old Mutual (OML) during the past three months given a lot of its business is based in the country. The market also seems to have been encouraged by the progress being made with the group’s separation, which it is hoped will be complete by the end of the year. The company is looking to split itself in four, and in the process reduce costs and debt. While the reorganisation made for some confusing full-year numbers when Old Mutual reported results earlier this month, the company did report a doubling of profit at continuing operations.

NMC Health

Middle-East focused healthcare group NMC (NMC) has a phenomenal track record of growth. It is exploiting the roll-out of mandatory health insurance by countries in the region and growing demand for more complex medical treatments. The company has significant capacity at its specialist hospitals, which gives it room to grow, and it has also been making acquisitions to enable it to provide new services and move into new geographies. Results earlier this month reported a 31 per cent rise in sales and a 44 per cent increase in cash profits. While net debt at 2.9 times cash profits is significant, solid cash generation and rising profits mean analysts believe there is still plenty of room for growth through acquisition, as well as investment in organic expansion.

Royal Mail

During the past three months, the threat of costly industrial action at Royal Mail (RMG) lifted as the company reached an agreement over pay and pensions with its workers’ union. What’s more, productivity improvements should offset the cost of the settlement. This leaves the company better able to focus on developing the business and investing in improved services. The shares should also have benefited during the period from the company’s promotion into the FTSE 100, which is likely to have attracted buying from index funds.

EasyJet

EasyJet (EZJ) operates in a capital-intensive industry where the supply of seats is always a key determinant of profitability. Consequently, a series of problems for rivals have proved beneficial for the budget carrier. Air Berlin, Alitalia and Monarch have all gone under, while rival Ryanair has run into well-publicised operational difficulties. This has resulted in improved trading for easyJet and a series of broker forecast upgrades. The company has also been able to take on assets from Air Berlin. Given solid demand for flights, a key issue is whether the industry will be able to hold back on its expansion or whether it will all too quickly replace the lost supply again.

Next

Shares in clothing retailer Next (NXT) have had a good three-month run following news of stronger-than-expected Christmas trading. While it used to be de rigeur for the group to beat City expectations, torrid conditions on the high street have made this a rarity. Indeed, the high street still looks grim and it was the group’s online Directory business that did the running over the festive period, with 13.6 per cent sales growth.