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Hunting for recovery stocks

I've made a change to my recovery-focused Late Bloomers screen that I hope will rev up performance
May 8, 2018

I’m making a noteworthy change to my Late Bloomers screen this year. Importantly, it is a change that I feel is very much in keeping with the screen’s objectives while offering the prospect of improving its ability to meet those objectives. The idea behind this screen is to find companies that have fallen on tough times but show the potential to improve their performance. When I originally conceived the screen, my idea was to try to identify cyclical companies on the turn (the fact that I started running this screen several years into the current bull market accounts for the name Late Bloomers). However, the characteristics that the screen looks for in stocks means any type of recovery situation is fair game.

The screen tries to embody the idea that a good way to identify value in a recovery situation is to look at what investors are asked be pay for a company compared with the source of its earnings rather than actual earnings themselves. The logic behind this idea is that when a company falls on hard times, due to internal or external factors, its profitability will often fall off a cliff. This means shares in promising recovery situations often look very expensive when compared with their temporarily depressed levels of earnings. But when such setbacks are overcome, a company’s profitability can bounce back strongly, causing earnings to soar and shares to simultaneously re-rate.

So, when trying to identify attractive situations prior to such an earnings recovery, a company’s valuation against its principal source of earnings can offer the best clues to any potential recovery upside. Essentially, the idea is to look for a company’s valuation against its earnings potential rather than earnings themselves. The cyclically-adjusted-price-to-earnings (CAPE) ratio, which assesses valuation against 10-year average earnings and is a popular measure used by many 'value' investors, works on a similar principle.

Broadly speaking, there are two sources of earnings that are of interest to investors: sales and book value (also known as net asset value). Previously this screen has only focused on companies that look cheap compared with sales, but this has meant excluding financials from the screen. Sales are also, arguably, something of a second-rate yardstick with which to measure the earnings potential of other types of businesses, such as housebuilders and real estate companies, which heavily rely on their tangible assets to generate profits. But ignoring the importance of net asset value will no longer be a limitation of this screen due the introduction of the ZEUS ratio as the key valuation measure used by the screen instead of the price-to-sales ratio.

Last year I introduced the ZEUS ratio in this column (heavily-laboured acronym for Z-Score of Earnings Ultimate Source). The ratio simply compares where a company’s current valuation (price-to-sales or price-to-book) sits within its historic range.

In stats speak, the ratio measures the standard deviation of a share’s current valuation from its long-term average (the so-called z-score). For those turned-off by this stats jargon, the main thing to know is that as a rough-and-ready rule, scores of -1 or less point to a stock’s current valuation sitting within the cheapest third of the historic range, while a z-score of -2 or less suggests a valuation in the cheapest 5 per cent of the range. The historic range of data I use to calculate each share’s ZEUS ratio is ideally 12 years (long enough to capture a full business cycle) with a minimum range of three years. The data used is based on end-of-month valuations. For most stocks the ZEUS ratio is based on the price-to-sales ratio (PSR), but price-to-book-value (PBV) is used for financials, real estate companies, and housebuilders.

A great potential advantage of the ZEUS ratio is that every stock can be compared against its own history, meaning stocks that have persistently high ratings due to virtuous business characteristics can appear cheap even when they look expensive compared with the wider market. I would hope this will make the screen less susceptible to latching onto 'value traps' and more prone to include higher-quality stocks in the mix.

As the screen now seeks to cover a broader range of sectors, some of the other supporting criteria it uses now also have sector-specific twists. For example, while the screen looks for potential for margin improvement for companies that look cheap based on PSR, it looks for the potential for return on equity (earnings as a proportion of book value) for stocks appearing cheap based on PBV. The full list of criteria are listed below.

Value: ZEUS ratio of -1 or less (see explanation above)

Recovery potential: Free-pass for real estate companies. For financials, return on equity of at least one third below 10-year peak. For other sectors, operating margin at least a third below 10-year peak.

Balance sheet: For financials, equity representing at least 5 percent of assets and return on assets of at least 1 per cent. This is a test suggested by the great Peter Lynch, the former star manager of Fidelity’s flagship Magellan fund. For utilities, which have very defensive earnings streams well suited to supporting high levels of debt, net debt to book value (gearing) of less than 150 per cent. For real estate companies, gearing of 75 per cent or less. For housebuilders, gearing of 25 per cent or less. For all other sectors, net debt of 1.5 times cash profits or less.

Growth: Growth in 'earnings ultimate source' (the EUS in the ZEUS ratio) – either sales or book value – over the last 12 months. Book value for financials, real estate and housebuilders and sales for all other sectors.

Positive free cash flow: Free pass for financials and real estate

(NB investment trusts are excluded from this screen but not Reits)

While, as already discussed, the reason for making changes to the Late Bloomers screen chiefly comes down to the fact that I think using the ZEUS ratio will help the screen better meet its objectives, in doing so performance will also hopefully be pepped up. Over the last 12 months the screen delivered a total return of 3.1 per cent compared with 7.0 per cent from the FTSE All-Share, which is the index the screen is conducted on. The poor performance was in no small part influenced by one of the screen’s 2017 picks, Carillion, disappearing down the plughole. Since I started running the screen four years ago, it has produced an uninspiring cumulative return of 29.7 per cent compared with 30.7 per cent from the index (see graph). If I factor in a 1.5 per cent annual charge to account for the notional costs associated with switching between portfolios at the time of publication of each new screen, the return drops to an underwhelming 22.1 per cent.

2017 PERFORMANCE

NameTIDMTotal Return (9 May 2017 - 1 May 2018)
Anglo AmericanAAL77%
Robert WaltersRWA61%
Thomas CookTCG31%
Morgan SindallMGNS18%
CapeCIU10%
HalfordsHFD8.2%
HaysHAS8.2%
SthreeSTHR6.5%
RPSRPS5.7%
Bloomsbury PublishingBMY5.3%
SavillsSVS5.1%
AO WorldAO.5.1%
Wm MorrisonMORW2.5%
Speedy HireSDY1.8%
Rolls-RoyceRR.0.0%
GraftonGFTU-1.0%
Dixons CarphoneDC.-34%
DebenhamsDEB-53%
CarillionCLLN-100%
FTSE All-Share-7.0%
Late Bloomers-3.1%

In total, 16 stocks have passed the screen. They are listed in the table below which is ordered from lowest to highest ZEUS ratio. I have taken a closer look at one stock from the top of the table and one from the bottom.

2018 LATE BLOOMERS

NameTIDMPriceMkt capZEUSZEUS rangeEUSEUS GrthFwd NTM PEDYPSRP/BVFwd EPS grth FY+1Fwd EPS grth FY+23-mth momentumNet cash/debt (-)3m fwd EPS change
Empiric Student Property ESP85p£512m-2.43.2yrTang BV18%246.5%9.00.892%19%-0.5%-£246m-18%
GCP Student Living DIGS139p£534m-2.13.6yrTang BV47%424.3%150.9-29%42%-0.1%-£171m-2.9%
Volution  FAN197p£389m-1.73.8yrSales13%142.2%2.02.46.5%8.8%-5.2%-£34m0.3%
Pets at Home  PETS155p£774m-1.64.1yrSales3.7%114.8%0.90.9-10%0.2%-14%-£157m-0.1%
Just Eat JE.766p£5.2bn-1.64.0yrSales45%42-9.57.29.9%32%-4.6%£264m-21%
Target Healthcare REITTHRL110p£373m-1.44.2yrTang BV2.6%195.9%111.119%7.7%-1.3%-£65m-10%
NCC  NCC201p£557m-1.312yrSales12%252.3%2.22.79.1%19%0.2%-£44m-
Travis Perkins TPK1,270p£3.1bn-1.312yrSales3.5%113.6%0.51.11.6%5.0%-13%-£342m-
Wm MorrisonMRW240p£5.6bn-1.112yrSales5.8%192.5%0.31.28.1%7.7%7.9%-£1.0bn-0.5%
BTG BTG685p£2.6bn-1.112yrSales24%22-4.22.729%6.7%-9.0%£227m-1.7%
Anglo-Eastern Plantations AEP757p£300m-1.112yrSales19%-0.4%1.41.1--2.1%$112m-
The Go-Ahead  GOG1,948p£837m-1.112yrSales5.4%115.2%0.23.3-14%-8.4%20%£169m-
William Hill WMH291p£2.5bn-1.112yrSales6.7%114.5%1.52.3-7.1%1.9%-6.6%-£404m-1.3%
SDL SDL400p£329m-1.012yrSales7.9%181.6%1.11.717%12%-16%£23m-13%
Cambian  CMBN170p£314m-1.04.0yrSales7.6%290.3%1.61.061%30%-14%£83m-8.1%
Tritax Big Box REIT BBOX150p£2.2bn-1.03.2yrTang BV36%214.3%171.114%4.9%0.7%-£631m-2.7%

Source: S&P Capital IQ

 

SDL

Translation and localisation specialist SDL (SDL) is undergoing a multi-year business overhaul that the top brass hopes will deliver growth that is stronger, more consistent and more predictable. In theory, the opportunity to do this is clear. As businesses become more global and offer more services online, there is an ever-greater requirement for online content to not only be well translated but also to be culturally in tune with the market it is attempting to target. These are the kind of customers SDL wants as their more sophisticated needs provide an opportunity to build closer relationships that should result in more repeat business and higher value sales.

So much for the theory. Last year, trading was very uninspiring. The group’s first half was marred by a cost spike at the translation services business which hit margins. This was followed in the second half by the failure of the software business to get deals signed before the all-important year-end. So, even after squirreling £2.5m of research and development spending away onto the balance sheet (none was capitalised the previous year), underlying pre-tax profit still fell from £27m to £22m.

But the poor financial result does not necessarily need to be seen as a reflection on the transformation programme – that’s certainly the line management are sticking to. Indeed, there are encouraging signs of progress with some key elements of the strategy.

At SDL’s language services division, which accounts for about two-thirds of sales, the company is starting to roll out a translation automation system called Helix, which is expected to begin to lift margins in the second half. Meanwhile, good progress is being made with the application of artificial intelligence. And several product launches are also expected during the current year.

What’s more, there were positive elements to the 2017 financial year even if the overall result was bad. Of particular note was very strong growth (a 78 per cent revenue increase to £40.1m) for premium services. These services embody more industry and company-specific solutions as well as secure translation, which is becoming more of a regulatory necessity for some businesses. Operational changes have also been pushed through aimed at cutting costs and improving the effectiveness of marketing. The company has also completed the disposal of operations regarded as non-core. And in a brief trading update at the end of April, the company said the deals that had missed the financial-year-end deadline had now been signed.

Following a disappointing 2017, SDL certainly has a few things to prove if its shares are to re-rate. However, for those prepared to show patience, there is a modest dividend on offer (not always a given for tech companies) supported by a healthy balance sheet. And while the company says it sees little advantage in acquisitions to simply build scale, it could use its strong financial position to do a deal if a strategically attractive opportunity was identified.

 

Empiric

Empiric (ESP) is a real estate investment trust (Reit) investing in student property that last year went from being something of a sector darling, to an ugly duckling. The attraction of Empiric’s property niche is that students make relatively reliable tenants and there is a lack of quality accommodation available for them. Many property developers and investors have rushed in to take advantage of these attractive fundamentals. Empiric is one of them, but in its rush to grow its portfolio, it came a cropper.

Last year, several operational issues resulted in a severe drop in margin as well as dividend cover and a scaling back of the dividend payout. Sentiment was not helped by the fact that the problems surfaced not long after the company had raised £108m through the sale of new shares at 109p in July.

In November, the company announced a full strategic review and in December it bid goodbye to its chief executive. Results for 2017 saw occupancy come in at 92 per cent and net operating income margins fall to 57 per cent compared with targets of 97 per cent and 70 per cent, respectively. Meanwhile, earnings only covered the 5.5p dividend by about one-third. The company’s response has involved reviewing external contracts, bringing facilities management in-house, selling off non-core assets (about a tenth of the portfolio), improving management systems for monitoring the performance of properties and cutting costs.

While trust in Empiric understandably remains limited, there are actually some encouraging signs from the remedial action that’s been taken. Late last month, management updated the market that bookings for the coming year stood at 57 per cent compared with 45 per cent at the same time in 2017. Meanwhile, good progress has been made bringing facilities management in-house and in switching all properties to its 'Hello Student' management platform. Furthermore, plans to cut administration expenses by 26 per cent, or £10m, are on track. All in all, this is underpinning management confidence that margins and occupancy will move back to target levels and the company expects its 5p dividend for the current year to be two-thirds covered, with full cover predicted the following year.

With 9,158 beds in 29 cities as of the end of 2017, Empiric has a strong asset base from which to produce profits and its end market has promising characteristics. On that basis, while it may be hard to get behind a company that has disappointed so spectacularly, there are grounds to think the green shoots that have emerged could prove to be the real thing. That said, Brexit-related worries and the possibility of rising interest rates are potential sentiment dampeners.