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11 growth stocks fighting tough markets

My Genuine Growth screen has experienced a torrid 12 months and tough market conditions means the 11 stocks selected this year have their work cut out
November 20, 2018

Stock screens can be very gullible. While screens provide a great way to scour the market for potential investment ideas, to avoid eliminating too many candidates, they often need to take a rough-and-ready approach. This can mean screens highlight some real howlers. Indeed, this is a key reason this column frequently emphasises that screen results are best regarded as ideas for further research rather than as off-the-shelf portfolios.

As this preamble may suggest, the screen being reviewed this week – my Genuine Growth screen – contained one very noteworthy howler last year: Patisserie Holdings (CAKE). That said, the fraud that the company revealed last month was not easy to see coming for even a diligent student of the company’s reported accounts. Hindsight is a wonderful thing, perhaps a canary in the coal mine existed in the low level of reported interest received by the company on its large cash balances or the uniformly strong showing of Patisserie’s cafes in the face of the troubles being experienced by other eateries. All in all, though, it was a fraud that was hard to see coming, doubly so for a humble stock screen.

However, it was not only Patisserie that disappointed from last year’s selection. Convenience store group McColl’s (MCLS) has been an absolute stinker during the past 12 months with the shares losing nearly half of their value, while Clipper Logistics (CLG) was also battered.

The complication with assessing the torrid performance from last year’s screen is that Patisserie’s shares are currently suspended so I will only be able to factor this woe in once the shares start trading again. For now, what can be said is that the “rose-tinted” (excluding Patisserie) view of last year’s screen is a 9.7 per cent negative total return compared with a negative 2.0 per cent from the FTSE All-Share index and negative 3.9 per cent from the FTSE Aim 100. Yuck!

NameTIDMTotal Return (22 Nov 2017 - 16 Nov 2018)
SafestoreSAFE16%
VPVP.13%
S & USUS0.1%
RedrowRDW-6.5%
MP EvansMPE-11%
Clipper LogisticsCLG-31%
McColl'sMCLS-49%
Patisserie HoldingsCAKESuspended*
Average (ex. CAKE*)--9.7%
FTSE All Share--2.0%
FTSE Aim 100--3.9%

*See text

Source: Thomson Datastream

The poor run takes the cumulative total return from the screen since I began to monitor it six years ago to 94 per cent compared with 59 from the FTSE All-Share and 75 per cent from the FTSE Aim 100. If I add in notional annual costs of 1.5 per cent, the cumulative total return drops to 83 per cent.

Such a torrid run may not make for nice numbers, but it is a good reminder that there’s more to assessing stocks than just a few key fundamentals. What’s more, the poor performance also serves as a reminder that all investment approaches can go through rounds of noteworthy underperformance if they embody a distinct investment style. Indeed, most regard discipline and perseverance as key ingredients needed to generate good long-term returns. When it comes to the Genuine Growth screen, having put in strong numbers in each of the first three years it was run, it has actually underperformed in each of the past three years. Given its focus on growth, this is at odds with prevailing market trends.

Interestingly, given the screen’s difficulty in identifying stocks last year, this year the only way I can find to make the screen produce a worthwhile number of results is to soften some of the criteria used. There is the possibility that by being less stringent on the requirements of the screen, the results from it may actually prove less risky. That said, the changes have been made out of necessity rather than for any other motive.

I have softened the screen’s valuation criteria so that stocks qualify if they have a lower than average price/earnings growth (PEG) ratio, as opposed to the old criteria of needing a bottom quartile PEG. Meanwhile, stocks now need to have either forecast EPS growth of 10 per cent or more in each of the next two financial years (the new criteria) or a change in the forecast growth rate of less than half (the old criteria). The amended screen rules are as follows:

■ Average EPS growth rate based on the historic three-year compound average growth rate and forecasts for the next two reporting years of 15 per cent or more.

■ Forecast EPS growth for each of the next two reporting years greater than the median average.

■ Forecast EPS growth rate next financial year at least half forecast growth for current financial year or more than 10 per cent each year.

■ EPS forecasts higher today than they were three months ago.

■ A PEG ratio among the lowest half of index constituents (either FTSE All-Share or Aim 100).

The screen is run separately on the FTSE All-Share and Aim 100 indices and a total of 11 stocks made the grade. It’s been a tumultuous few months for growth stocks and I’ve decided to take a look at one of the stocks from this year’s screen that continues to show strong growth characteristics but has taken a drubbing. Fundamentals relating to all the shares can be found in the table below and a downloadable version can be accessed via the accompanying link.

NameTIDMMkt CapPriceFwd NTM PEDYPEGFwd EPS grth FY+1Fwd EPS grth FY+23mth Fwd EPS chng12mth Fwd EPS chng3-mth MomentumNet Cash/Debt(-)
Diversified Gas & OilAIM:DGOC£601m111p94.9%0.32104%15%43%-9.3%-$132m
Countryside PropertiesLSE:CSP£1,265m281p83.6%0.4730%13%0.1%5.0%-12.0%£14m
Energean Oil & GasLSE:ENOG£966m632p41-0.6846%75%--19.6%$176m
CYBGLSE:CYBG£3,753m263p90.4%0.8620%12%7.9%--25.9%-£567m
SpectrisLSE:SXS£2,482m2,149p132.6%1.265.8%11%0.1%--6.4%-£232m
4imprintLSE:FOUR£536m1,910p202.4%1.3024%12%0.6%9.3%-0.8%$27m
JoulesAIM:JOUL£218m249p180.8%1.4014%19%0.5%-1.4%-12.7%£0m
IG DesignAIM:IGR£466m595p231.0%1.4019%18%3.8%14.1%12.9%£4m
Gamma CommunicationsAIM:GAMA£685m730p251.1%1.6718%16%2.3%13.3%-5.7%£31m
Brewin DolphinLSE:BRW£943m345p154.4%1.6712%11%0.9%0.6%-2.6%£143m
JD Sports FashionLSE:JD.£3,943m405p140.4%1.688.7%9.2%1.1%9.7%-14.9%-£85m

Source: S&P Capital IQ

Gamma Communications

Until about a month ago, growth had been very good for shareholders of Gamma Communications (GAMA). However, since the shares peaked at 944p in early October, Gamma has received a double slap down leaving it 23 per cent off those highs.

The company provides internet-delivered communication services, which include a broad gamut of products from cloud-hosted exchanges to video conferencing and many things in between. The nature of Gamma’s business has meant its shares have suffered during recent market turmoil, which has been harshest for highly-rated tech stocks. More recently, the shares have taken a knock as Brexit angst has added to negative sentiment with fears that an economic slowdown caused by a no-deal would be bad news for Gammas many business customers.

Looking at the rating of Gamma’s shares, it’s not surprising they have proved vulnerable. While investors have been willing to overlook valuation risk for much of this year and chase momentum in hot growth stocks, the mood has abruptly changed. Indeed, even after recent falls, Gamma’s shares look expensive on most measures and don’t even look great value against their own five-year history (see graph).

The PEG ratio that this screen looks at offers one of the most favourable perspectives on the value on offer. Even here, though, the attractions are not altogether standout with a PEG of 1.7 some way above the rule-of-thumb “cheap” zone of 1 or less. But where Gamma does impress is growth, and the record of broker earnings upgrades over the past two years is certainly eye catching.

The company’s new chief executive, Andrew Taylor, will be reviewing the group’s strategy over the coming months, but the focus is expected to remain firmly on growth. Key to Gamma’s success over recent years has been its investment in research and development, aimed at making it market leader in terms of both products and its level of service. The group also seeks to increase sales  by providing training and marketing support to a network of resellers – it had 1,149 channel partners in the UK at the end of the first half. Gamma is also developing its own direct sales with a focus on the public sector. Direct sales accounted for almost a quarter of last year’s gross profit.

Overseas expansion is now on the cards, too. Early last month Gamma announced the acquisition of a small Dutch business called Dean One, which also services predominantly sells through channel partners. Mr Taylor has experience of international markets and the deal is regarded as providing a potential springboard into Europe, particularly France and Germany; the countries neighbouring Dean One’s domestic market.

Gamma’s markets are competitive, which means capital expenditure on innovation can in part be regarded as a necessity rather than just a choice. That said, Gamma is a reflectively capital light model for a telecoms play because it does not own much infrastructure and instead bases its advantage on its investment in software and systems. Moreover, its investments in growth areas have historically generated strong returns. Despite managing declining traditional business lines (just shy of one tenth of first-half gross profit), operating margins have risen over recent years and return on capital employed has been over 20 per cent in each of the past five years and was a bumper 28 per cent in 2017. Still, investment has made for patchy cash conversion. 

The really big question as far as Gamma’s shares go is whether the market can rekindle its pre-October spirits. Much of this could depend on whether recent jitters are a fair reflection of future challenges to growth prospects. The shares would need to fall further before it was easy to regard them as cheap, but the growth record is such that they could probably reclaim a very lofty valuation if the mood was right.