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Ten Genuine Value shares

Despite a strong performance over the past 12 months (13.1 per cent vs 1.9 per cent from the FTSE All-Share) I'm giving my Genuine Value screen a bit of a tune-up
March 27, 2018

It’s all too easy to be seduced by a strategy that’s been working over the short term but is of significantly less value over the long term. This week I am making a tweak to the criteria of my Genuine Value screen that could risk being a product of such behaviour. Nevertheless, I think one of the purposes of this column is to try to improve the results produced by the screens monitored, which means it is important to try to make sensible changes to screening processes where possible.

The change in question is to make the Genuine Value screen take more account of recent changes to broker forecasts, or specifically to avoid shares that have recently experienced broker downgrades. In fact, the way I am making this change hardly marks an absolute break with the past, as I will also continue to monitor shares that passed the screen based on its old criteria, too. However, to my mind the inclusion of the new tests is very much in keeping with the spirit of a screen that looks to buy growth on the cheap – ie the forecast growth being bought should look like the real thing.

Still, it would be wrong not to acknowledge my thinking on this “improvement” is likely to be influenced by the strong performance of other screens that use the broker forecast trends in their stockpicking process. Indeed, as of the end of last year, my Great Expectations screen, which targets shares experiencing strong forecast upgrades, was the best performing strategy over five years of all those I follow. Over the period the Great Expectations screen delivered a stunning 220 per cent cumulative total return compared with 62 per cent from the index the stocks are selected from, the FTSE 350.

While I may fret that my subconscious is being excessively influenced by the short-term performance of other screens, at least my decision to attempt to give the Genuine Value screening criteria a tune-up is not a knee-jerk reaction to a spell of underperformance. Indeed, the 18 stocks selected by last year’s Genuine Value screen produced a total return of 13.1 per cent, which trounced the 1.9 per cent return from the FTSE All-Share, which is the index they were selected from. That said, only about half the shares selected outperformed the market, but those that did, did so by a handsome margin.

 

2017 performance

NameTIDMTotal return (4 Apr 2017 - 21 Mar 2018)
FennerFENR109%
NMC HealthNMC96%
ForterraFORT58%
Smurfit KappaSKG49%
Jimmy ChooCHOO42%
Morgan SindallMGNS32%
Man GroupEMG27%
AntofagastaANTO17%
Jardine Lloyd ThompsonJLT15%
JD SportsJD.-9.0%
SeverfieldSFR-10%
Crest NicholsonCRST-11%
RandgoldRRS-16%
IWGIWG-24%
Galliford TryGFRD-27%
MearsMER-28%
First GroupFGP-39%
DialightDIA-46%
FTSE All Share-1.9%
Genuine Value-

13%

Source: Thomson Datastream

 

The strong run last year takes the screen’s cumulative total return since its inception five years ago to 84 per cent, or 72.8 per cent after factoring in a notional 1.5 per cent annual charge to account for dealing costs. That compares with 38.3 per cent from the index over the same period.

The key test employed by the screen centres on a version of the price/earnings growth (PEG) ratio that attempts to adjust for a company’s debt levels and dividends. The portentous title I gave the ratio when I started to use it was the Genuine Value (GV) ratio. The ratio uses enterprise value (EV), which represents market capitalisation minus cash and plus debt. Pension deficits and lease liabilities can also sometimes be factored into EV, but that is not the case with this screen.

The ratio compares a valuation based on EV to operating profits with expected earnings growth (Fwd EPS grth) plus dividend yield (DY):

GV = (EV/Operating Profit) / (Fwd EPS grth + DY)

One issue with looking at EV is that it flatters certain types of companies. To take the example of the companies that I look at more closely in the write-ups below, it is sensible for Hays to have healthy finances (and therefore a lower EV) to guard against the extreme sensitivity of its business to the economic climate. What’s more, the lease obligations Hays takes on when it opens new offices can, from a shareholder perspective, be regarded as being very similar to debt, although these liabilities are not included in common EV calculations. Meanwhile, Bovis needs to be in a strong financial position to counter the substantial balance sheet risk that housebuilders necessarily take on due to the huge amounts of working capital needed by their operations. The full criteria for the screen are:

■ A GV ratio among the lowest quarter of stocks screened.

■ Three-month share price momentum among the top third of all stocks screened.

■ Above-average forecast EPS growth in each of the next two financial years. The average forecast growth rate must be less than 50 per cent – anything above this level is considered to be very likely to be highly unsustainable.

■ The new criteria: EPS forecast must today be the same or higher than they were both 12 months ago and 3 months ago. For 12-month forecast changes, EPS forecasts are assessed based on the change in predictions for both the current financial year and next financial year and neither can have been downgraded. The three-month test is based on EPS forecasts for the next 12 months. Where data is missing for either the 12 or three-month test, a stock will pass as long as it passes the other test.

The new criteria based on insisting companies have not experienced an earnings downgrade over either the past 12 or three months is tougher than it may first appear. Indeed, slightly more than half of the companies screened have experienced downgrades. Indeed, during years when there is a recession, it is easy to imagine the need to change this rule to make the screen work so it requires companies to have experienced a downgrade of no more than a given amount – a potentially interesting definition of 'growth'.

Ten stocks pass the screen based on both old and new criteria, while an additional six pass based just on the old criteria. The stocks are presented separately in the tables below which are ordered by lowest to highest GV ratio. I’ve also taken a closer look at two of the shares.

 

Tuned-up Genuine Value

NameTIDMMkt CapPGV RatioFwd NTM PEDYPEGFwd EPS grth FY+1Fwd EPS grth FY+23-mth MomentumNet Cash/Debt (-)Fwd EPS Change 12mthFwd EPS Change 3mth
NMC Health NMC£7.1bn3,436p0.97330.4%1.3362%9.5%20%-$1.0bn26%8.7%
MJ Gleeson GLE£406m746p0.86143.2%1.5610%8.9%1.9%£27m7.7%1.0%
Hays HAS£2.7bn189p0.86161.7%1.4817%7.9%2.5%£35m13%-
TUI AGTUI£10bn1,542p0.77---13%9.2%0.5%-874€m5.5%-
Gocompare.com  GOCO£473m113p0.73141.2%1.0228%8.8%12%-£39m14%3.8%
Ashtead  AHT£9.6bn1,958p0.57131.4%0.8426%17%-0.3%-£2.6bn15%-
easyJet EZJ£6.5bn1,639p0.53152.5%0.8830%14%13%£357m26%-
Antofagasta ANTO£9.6bn972p0.51163.7%1.4414%9.1%0.6%-$457m33%18.9%
Beazley BEZ£2.9bn548p0.43172.0%0.7074%7.6%7.6%$64m19%6.3%
Bovis Homes  BVS£1.6bn1,205p0.39133.9%0.7040%7.9%4.0%£145m10%2.8%

 

Old School Genuine Value

NameTIDMMkt CapPGV RatioFwd NTM PEDYPEGFwd EPS grth FY+1Fwd EPS grth FY+23-mth MomentumNet Cash/Debt (-)Fwd EPS Change 12mthFwd EPS Change 3mth
Thomas Cook  TCG£1.8bn119p0.3110.5%9.218%12%0.5%£362m-12%1.3%
STV  STVG£127m324p0.685.2%0.910%12%-0.8%-£36m-1.7%-3.7%
IWG IWG£2.1bn231p0.6152.5%0.926%14%14%-£296m-23%-0.6%
Forterra FORT£605m303p0.9113.1%1.58.5%8.1%4.1%-£61m1.5%0.9%
Findel FDL£193m225p0.910--13%16%8.7%-£238m0.2%-
Clarkson CKN£958m3,185p1.0232.3%2.117%10%12%£168m-1.6%1.0%

Source: S&P CapitalIQ

 

Hays

Recruiters are very cyclical companies. With relatively fixed cost bases – office rents and consultants’ wages – and fees that tend to move in line with the amount of work coming through the door, these companies can yo-yo quickly between periods of feast and famine. These characteristics mean investors tend to put a lower price on growth from such companies than would be the case with defensively positioned businesses. The good news in the case of international recruitment firm Hays (HAS) is that it currently looks more like it is experiencing feast than famine.

True, there are some difficulties in the UK with Brexit uncertainty still seeming to weigh on the job market. What’s more, Hays’ noteworthy exposure to the public sector has also held back its UK and Ireland division, which accounted for 27 per cent of last year’s net fee income (NFI). That said, the operation is made more defensive by its focus on temporary recruitment, which provides a more constant stream of fees than the big one-off payments associated with permanent placements. What’s more, first-half results in February suggested the UK market may be stabilising, with like-for-like NFI up 1 per cent. And the small rise in fees, coupled with tight cost controls and a drop-off in depreciation charges, made for a 24 per cent first-half jump in operating profits in the UK and Ireland.

Elsewhere, Hays’ prospects look a lot more promising. Germany, which accounts for 24 per cent of NFI, is a particular focus for growth given recent labour law changes that are expected to provide the foundations for long-term structural growth. Indeed, Hays has put in place targets that could see it more than double cash profits from the country by 2022. However, heavy investment in office openings and hiring is pushing down profitability at the moment, but first half like-for-like NFI growth of 17 per cent in the country was encouraging.

With other regions also performing well, the overall first-half performance was strong, with like-for-like NFI growth across the group of 12 per cent and an improvement in the conversion ratio – the industry’s key measure of profitability – from 21.7 per cent to 22.2 per cent. The group’s cash pile has also been building and there’s a decent chance that investors could get a special dividend this year given Hays’ track record for shareholder returns.

 

Bovis Homes

For some time Bovis (BVS) has had trouble trying to match the returns achieved by rivals. Following a cathartic profit warning in 2016, the company has spent a year under new management readying itself to make up ground. The group’s target is to raise return on capital employed (ROCE) to 25 per cent by 2020.

ROCE is a key measure of the quality of a company’s operation. ROCE is dependent on two key factors: the rate at which sales are generated from a company’s capital (so-called capital turnover) and the amount of profit before tax and interest it makes on those sales (operating margins). Trends in capital turnover and operating margins can be analysed separately to gauge business prospects, which is a process known as Du Pont analysis. The table below uses this break down, and shows just how much scope Bovis has for improvement when compared with peers.

 

Bovis misses the Du Pont

NameTIDMCapital turnover*EBIT margin*ROCE
Berkeley GroupBKG1.230%36%
PersimmonPSN1.028%28%
Bellway BWY1.222%27%
Countryside Properties CSP1.119%21%
Redrow RDW1.120%21%
Crest NicholsonCRST1.021%21%
Taylor Wimpey TW.1.118%20%
Barratt Developments BDEV0.918%16%
Bovis HomesBVS0.912%11%

Source: *SharePad

 

Historically capital turnover was regarded as Bovis’s key problem in matching sector returns. However, as management attempted to improve the sales rate, Bovis ran into some headline-grabbing issues regarding the quality of the houses it was building. Following a savaging in 2016, new management decided to press the reset button. Profits fell by over a quarter last year as the company slowed down production and gave the business an operational overhaul. The land bank has been slimmed down with the sale sites and a slowdown in land purchases. The leaner capital base should benefit capital turnover in the future. Meanwhile, housing specifications, pricing strategy and the building process have all been reassessed with the aim of boosting margins.

There are already some encouraging signs, with Bovis’s homes registering higher levels of customer satisfaction. The sales rate has also picked up a bit. Management plans to mark its delivery on its goals by returning cash to shareholders and has pencilled in 134p-worth of special dividends over the next three years, including an initial 45p earmarked for the end of this year. That has broker Numis pencilling in a total payout for 2018 of 102p, rising to 105p in 2019. That’s equivalent to a yield of 8.5 per cent rising to 8.7 per cent.

The combination of a high-yield back-up by the significant potential for earnings growth based on self-help could prove of interest to investors given signs of slowing growth at some of the sector's highest-flying companies. London-focused Berkeley, for instance, recently disappointed the market with its production increase plans. On the flipside, Bovis’s decision to slim down the land bank could have consequences for its growth potential further down the track.