Thirteen stocks offering growth at the right price

2017 performance

Source: Thomson Datastream

The screen has now produced a cumulative total return over the six years I’ve followed it of 109 per cent, compared with 67.6 per cent from the FTSE All-Share. If I factor in an annual charge of 1.5 per cent to account for notional dealing costs, the return drops to 90.9 per cent.

Mr Lynch is often considered as the investor that popularised the concept of buying 'growth at a reasonable price' (GARP) and was a strong proponent of using the price/earnings growth (PEG) ratio to spot value. Given the somewhat choppy performance of this screen it is interesting to note that the screens I run inspired by the approaches of two other notable GARP investors – Jim Slater and John Neff – have produced more consistent outperformance and stronger cumulative returns. This could be down to the mix of criteria used, but could also have more to do with altogether more random factors such as luck and the timing of screens.

One issue I have pointed out with the Lynch screen in the past is that as the current bull market has got longer in the tooth, the shares highlighted have tended to be quite cyclical in nature, presenting the risk of big losses should market sentiment turn negative. Indeed, the screen experienced a very sharp and deep loss after the UK’s vote to leave the EU, which may in part reflect this. This leaning towards cyclicals seems somewhat at odds with some of the investment wisdom associated with Mr Lynch and explained in his 2000 book One Up on Wall Street. He is strongly associated with the concept of 'buy what you know', even suggesting it presented a clear advantage that private investors have over Wall Street. He is also well known for liking unglamorous, boring companies with simple businesses that are hard to mismanage.

My Lynch screen is based on his approach to identifying “stalwart” stocks and uses the following criteria:

■ A dividend-adjusted PEG ratio of less than one.

Dividend-adjusted PEG = price/earnings (PE) ratio/average forecast EPS growth for the next two financial years + historic dividend yield (DY).

■ Average forecast earnings growth over the next two financial years of between 10 per cent and 20 per cent as long as forecast growth in each of the next two financial years is positive but below 30 per cent – attractive but not suspiciously high growth.

■ Gearing of less than 75 per cent, or, in the case of financial companies, equity to assets of 5 per cent or more, and a return on assets of more than 1 per cent.

■ Three years of positive earnings.

■ Turnover of over £250m.

Thirteen stocks passed the screen’s tests this year and are detailed in the accompanying table. I’ve also taken a closer look at the stock with the highest and the lowest PEG ratios from the results.

2018 Lynch stocks

Source: S&P CapitalIQ

Crest Nicholson

Investors in housebuilders may now feel very familiar with the phrase 'late cycle'. Following several years of excellent volume and margin growth, there are signs conditions may be getting less favourable for these companies. The housing market is showing some signs of slowing, especially in London, price rises are not what they were, and the cost of the land builders are building on (a key determinant of margins) is starting to edge up.

Among the housebuilders, Crest Nicholson (CRST) has been viewed as a particularly good example of the 'late-cycle' phenomenon in action. Indeed, as analysts have factored in a general cooling of strong market conditions, consensus earnings forecasts for both 2018 and 2019 have been reduced by about a tenth from peak levels.

However, while we may be at a later stage of the cycle, the environment for housebuilders can hardly be regarded as terrible. When Crest last updated the market on trading in late March, it described demand for homes as “strong” and its own trading as “generally robust with good sales growth across our areas of operation”. What’s more, forward sales were ahead 15 per cent at £620m. Importantly, forward orders look healthier than they did at the time of the group’s full-year results announcement in early January, so the recent update has shored up confidence in earnings estimates following the series of downgrades. Indeed, as can be seen from the chart above, the shares have bounced noticeably since the late March update even if consensus forecasts have taken a further marginal downward revision.

If we are looking at a situation of prolonged, “robust” late-cycle trading rather than an impending downturn in the cycle, then there are grounds to think Crest’s shares are cheap. While Crest falls short of several of its rivals on some key quality measures, such as operating margin (EBIT Margin) and return on capital employed (ROCE) (see table), its shares are a standout value play in the sector based on both the forward next-12-month price/earnings ratio (Fwd NTM PE) and the price/tangible book value (P/TangBV) ratio – a key valuation yardstick for housebuilders.

Crest comparisons

Source: SharePad. *Market moves between time of screen and construction of this table means Crest's share price in table above varies from main table.

What’s more, while Crest’s high forecast dividend yield (DY) may be slightly lower than that offered by several peers, it is worth noting that the payment is based on a basic dividend payout rather than the basic and special dividends offered by most sector peers. That may indicate Crest sees more potential to stick by its high payout over the long term, although during really tough times housebuilders do tend to have to cut dividends regardless of how they are branded. There are grounds for the fears reflected in the low rating of Crest’s shares, but they could nevertheless prove overblown.

Mears

Social housing and home-care services company Mears (MER) is, from a big-picture perspective, in a very promising position. There is strong and growing demand in both markets it serves. However, a lack of political will to stump up funding, coupled with competition for work, means it has been far from plain sailing for the group over recent years. Indeed, during 2017 revenue dropped (-4 per cent), underlying earnings slumped (-8 per cent) and average net debt rose (£96.4m vs £85m). Meanwhile, brokers have had to take a red pen to forecast earnings. Over two years, EPS expectations for 2018 have gradually sunk by a quarter based on Bloomberg consensus data, while 2019 forecasts are down by almost a fifth.  

Nevertheless, there are grounds to hope sunnier climbs may be in sight. A key issue faced by Mears’ housing business, which accounts for 85 per cent of sales, has been a hiatus in work following the Grenfell tragedy. While the core work from the group’s long-term contracts persists, broker Liberum estimates that about 15 per cent of work each year comes from discretionary spending, and housing providers have been nervous about making new commitments until there is more clarity on health and safety issues. Discretionary work should start to recover this year. What’s more, the increased emphasis local authorities are likely to have to put on health and safety may well work to the benefit of Mears, which is regarded as a high-quality service provider.

Another issue for the housing business last year was that it bid for less work than usual and won a lower proportion of bids than normal (a 16 per cent win rate versus a 33 per cent target). A possible silver lining investors can take from the low win rate is that it may suggest Mears is not taking on contracts when the price is not right, which is to be welcomed given the problems other outsourcers, such as Capita and Serco, which have underbid for long-term contracts, have faced. A more tangible positive for this year, is that the group expects to bid for significantly more work than it did in 2017 (£2.4bn-worth vs £940m). Included in this are two particularly large contracts, which means the prospect of noteworthy forecast upgrades if bids are successful.

The group’s smaller home-care business (15 per cent of 2017 revenue) should also show improvements in 2018 having recently returned to profit. The company has jettisoned lossmaking contracts and has become more selective in the work it bids for. Encouragingly, the company has recently increased its margin guidance for the business from 2-3 per cent to over 3 per cent.

Mears can hardly be described as a dream stock, but there are grounds to think its fortunes could be set to improve this year. Planned cost savings of £5m should also help. There is also an attractive yield on offer that is 2.3 times covered by earnings.