Deep value hunting

Despite the screen performing poorly in the 12 months to June 2017, as well as turning in a poor return in the past year (see table), it has produced a slight outperformance of the FTSE All-Share based on its cumulative total return since I first ran it in 2013 (54.3 per cent versus 50.7 per cent – see chart). However, due to dealing costs, if a strategy is to earn its keep in the real world, it has to do a lot better than slightly outperforming the index. Indeed, if I factor in an annual 1.5 per cent charge to reflect notional dealing costs, the screen has produced a total return of 43.1 per cent. That’s some way below what one would expect from a low-cost index fund. However, the screen has at least produced some interesting ideas for further research along the way.

2017 performance

The starting point for the screen is to look for shares that appear cheap on one or more of a range of valuation metrics. Any approach that has valuation as its key criteria faces the risk of piling into so-called 'value traps'. These are stocks that command low valuations because something is going seriously wrong for the company they represent a claim on. The tendency is for this type of 'cheap' stock to get ever 'cheaper', until finally they appear to be not worth buying at any price.

The Dreman approach is to use a series of checks that suggest the value on offer may prove the right sort. The full criteria for the screen are as follows:

■ Shares must be among the cheapest quarter of FTSE All-Share constituents based on one or more of: dividend yield (DY); price-earnings (PE); forward next-12-month price-earnings (forward NTM PE); price-to-cash-flow (PCF); or price-to-book-value (PBV). The screen's other criteria other differ slightly based on which valuation measure a share qualifies on).

■ Year-on-year EPS growth in the most recent half-year.

■ Forecast EPS growth for each of the next two financial years.

■ A current ratio of more than 1.

■ Above-average dividend yield (excluding cheap P/BV stocks).

■ Dividend cover of 1.5 times or more, or greater than the five-year average (excluding cheap P/BV stocks).

■ Above-average five-year dividend compound annual growth (excluding cheap P/BV stocks).

■ Gearing of less than 75 per cent or net debt/cash profit of less than 2.5 times.

■ Market capitalisation of £200m or more.

With 15 shares highlighted, the screen has produced more ideas this year than it has for a number of years. Possibly this bodes well for the coming 12 months. However, scanning though the stocks highlighted there is certainly a fair amount of riskiness on display. To give a better taste of the type of situations being highlighted, I’ve taken a closer look at two shares that appear cheap based on more than one of the valuation metrics the screen looks at.

2018 deep value selections

Source: S&P CapitalIQ

RPC

Sentiment towards international plastics company RPC (RPC) has been poor over the past few years, despite the performance of the company itself holding up pretty well. The company has tried to take a lead role in the consolidation of the European plastics sector, which was a strategy that was initially embraced by the market. However, as the list of deals ratcheted up along with rights issues to fund the acquisition programme, nervousness crept in. Cynics are yet to find any smoking gun to show the acquisition strategy has been overly ambitious or that it is masking weakness elsewhere. However, in the meantime, new fears have emerged that the group could be hit by a toughening up of the regulatory stance towards plastic waste.

Against this backdrop, the shares have de-rated markedly (see chart) over the past two years despite rising profits, impressive dividend growth and gradually improving broker forecasts (based on Bloomberg data, consensus EPS expectations are up 5 per cent over the past 12 months for both the recently completed and recently started financial years). Indeed, based on Bloomberg data, the valuation is currently within the most attractive 5 per cent of the five-year range based on price/next-12-month forecast earnings (Fwd NTM PE) and forecast next-12-month dividend yield (Fwd NTM DY).

For its part, RPC is looking to work closely with suppliers and governments to find solutions to the plastic waste problem. Its scale should help its influence on this process and also puts it in a better position than smaller rivals to invest in innovations that may help address the widespread concerns about plastic packaging.

Meanwhile, the company continues to see a big opportunity from industry consolidation and continues to acquire rivals. Most recently, it bought a polythene company called Nordfolien in March for €75m (£66m). It is of note that the deal was funded through debt, and analysts think it is unlikely the company will want to make any cash calls on shareholders to pay for deals while sentiment remains relatively negative.

A pick-up in organic growth in the third and fourth quarter of the group’s recently completed financial year should also help calm the nerves of investors worried about the historic pace and scale of dealmaking. What’s more, management has said the group remains on track to save €105m of costs through business integration by the end of the 2019 financial year.

Dividend growth should also help bolster confidence, with broker Peel Hunt pencilling in 26.5p for the recently completed financial year, rising to 29.2p in the current year and 32p in 2020. That’s equivalent to a prospective yield of 3.4 per cent, rising to 3.8 per cent followed by 4.1 per cent. And while acquisitions have seen debt rise over recent years, the balance sheet still looks reasonable. Broker Numis forecasts that the company should have ended the recent financial year with net debt at about 1.8 times cash profits. What’s more, prior to the March acquisition, Numis forecast net debt would fall to just 1.2 times cash profits by the end of March 2020.

In all, there are inevitably risks associated with integrating several significant acquisitions and noteworthy issues concerning changes to regulation, but the current valuation means there’s the potential for strong upside if the market’s fears are not realised.

Headlam

Flooring distribution company Headlam (HEAD) had a poor start to the year. And while it has not yet warned on profits for 2018, the market seems to be treating a marked downturn in trading as something of a given. When the company reported 2017 full-year results in March, it said like-for-like sales fell in January by 5.9 per cent and that trading had continued in a similar vein in February. The UK, which accounted for 86 per cent of sales last year and 97 per cent of profit, was the key cause of weakness and particularly orders from one large customer.

Still, the start of the year is relatively quiet for Headlam, and when the group reported its gloomy like-for-likes it told investors: “Given the very early stage in the year and our greater focus on profit rather than top-line growth, with organic revenue growth being a lesser contributor to the company achieving its overall plans and expectations, our expectations for 2018 remain unchanged at this stage despite the weaker markets.”

Given widespread concerns about the UK economy and signs of weakness from other companies targeting the residential repair, maintenance and improvement (RMI) market, investors have been quicker than the company to extrapolate the early-year trends. While consensus EPS forecast for this year and next have only been reduced by 2 per cent, the shares are down 12 per cent since the March announcement and are off by about 25 per cent over the past year.

The potential pain for Headlam from a trading downturn is increased by the large level of inventory it holds in order to do business, as well as large amounts of money owing and owed on accounts with suppliers and retailers. However, a net cash position provides some comfort. What’s more, Headlam’s dominance in this fragmented marketplace (it estimates its next largest rival is just one-sixth of its size) means it has been able to hold margins steady despite recent currency and trading pressures.

The company has also recently put a decent part of its cash pile to work by making a trio of small acquisitions for £32m last year and announcing another bolt-on purchase of a Dutch business since the year-end. And from a longer-term perspective, the group stands to benefit from its investment of £24m over the next two years in a new distribution centre in Ipswich.

Headlam is certainly a contrarian play, given worries about the UK economy and residential market. Indeed, it would be foolhardy to rule out the risk of it having to warn on profits. However, the strong balance sheet and the historic record of cash conversion means things would probably need to get considerably worse for the dividend to be put in danger, despite the recent spending on acquisitions and the planned increase in capital expenditure. That makes the shares a tempting prospect for patient investors prepared to bet the outlook for the UK economy is not quite as bleak as the wider market seems to fear.