Four Neff stocks

While a dull or distasteful line of work may not be a very good reason to slap a low valuation on a share, over the past few years my Neff screen has increasingly been latching on to companies that are cheap for a pretty good reason: namely, because their profits are cyclical.

During good times, cyclical shares can produce amazing returns as ratings edge up while profits soar. However, sentiment can be quick to turn. Last year my Neff screen suffered badly due to the fickle nature of market sentiment (see table). The hit was especially pronounced for the stocks that had passed all the Neff criteria because there were only two of them and one (Jupiter Fund Management) got utterly slammed. The other (RPC) looked like going the same way, but its negative performance was reversed by a takeover offer.

2018 performance

Source: Thomson Datastream

Still, the long-term performance of my Neff screen in the seven years I’ve monitored it continues to look impressive, with a cumulative total return of 177 per cent, or 179 per cent based on the weakened criteria I’ve had to use since 2015 to generate a decent number of positive results. This compares with 74 per cent from the FTSE All-Share. If I factor in a notional dealing charge of 1 per cent (the screens run in this column are seen primarily as of interest as a source of ideas for further research rather than off-the-shelf portfolios) then the total return drops to 158 per cent for the full version of the screen and 160 per cent for the weakened version.  

The reason why I’ve possibly not always given enough attention to Mr Neff’s credentials as a 'value' investor, is that 'growth' is an important factor in his take on value – in reality, any separation of the two is something of an artificial exercise. Specifically, Mr Neff’s main valuation tool is a version of the price/earnings growth (PEG) ratio that factors in dividends (he actually expressed this as a 'total return' yield, but I use the more British conventions of the PEG ratio for this screen, which reverses the numerator and denominator used in the yield calculation). 

A PEG compares a share’s price/earnings (PE) ratio with expected EPS growth. In the case of Mr Neff’s PEG, the share’s dividend yield is added to the growth rate to give an estimate of the potential 'total return' (somewhat confusingly, this 'total return' is different from the total return used to measure investment performance, which is based on share price movement plus dividends paid and reinvested). My formula for the Neff PEG uses an average of historical and forecast earnings growth to determine the growth rate as follows:

Neff PEG = PE / Average of 5-year compound annual EPS growth rate (5yr EPS CAGR) and forecast 2-year average growth (Avg Fwd 2yr EPS grth) rate plus dividend yield (DY)

Where my Neff screening criteria can really be regarded as downplaying the 'value' aspect of the Neff approach is the cut-off I apply for PE ratios. The screen rejects very high ratios as too expensive, but also rejects low ratios as too-good-to-be-true. That said, no additional shares would have qualified this year based on the full screening criteria had I relaxed the low PE cut-off rule. The screen’s criteria are:

■ Historic PE ratio below the most expensive quarter of shares and above the cheapest quarter.

■ A lower than median average Neff PEG ratio.

■ A five-year EPS compound annual growth rate (CAGR) of more than 7.5 per cent but below 20 per cent (excessive growth can fall away).

■ Average forecast EPS growth for the next two financial years of more than 7.5 per cent.

■ Rising EPS in each of the past two half-year periods.

■ Five-year turnover CAGR of 5 per cent or more (in the long term, earnings growth needs to be based on rising sales).

■ Positive free cash flow in each of the past three years.

As with previous years, I’ve found it necessary to weaken the screening criteria to generate a decent number of positive results. For the weakened screening criteria, stocks are allowed to fail one test as long as it is not the Neff PEG test. They must also not have experienced an earnings forecast downgrade during the past three months. Four stocks passed the full criteria, while a further eight passed the weakened criteria. Details of the stocks can be found in the table below and I’ve taken a look at one of the shares that passed the screen’s full criteria.

Neff picks

Source: S&P CapitalIQ

Grafton

As a builders’ merchant, Grafton (GFTU) operates in a cyclical industry. This means recent signs of slowing global economic growth and Brexit worries are pertinent issues. But are the foundations on which Grafton has built a strong track record over recent years more resilient than the market is giving it credit for? If there’s a case to think so, there could be real value on offer.

There are some reasons to feel positive. Grafton has 14 brands spread over the UK, Ireland, Netherlands and Belgium, including Selco, Plumbase and Leyland. Its key focus is on professional builders doing repair, maintenance and improvement (RMI) work. While RMI activity is strongly linked to the level of housing transactions and general economic conditions, it is considered less cyclical than new-build.

In Grafton’s largest geographic market – the UK, accounting for 70 per cent of last year’s sales – RMI demand has been turgid for a number of years due to both a lack of skilled tradesmen to undertake jobs and subdued housing transactions. Despite this, Grafton’s progress has been impressive, and in January the company said full-year results, due at the end of this month, would be ahead of expectations. And while like-for-like sales growth slowed towards the end of the fourth quarter, this was seen as a natural moderation after very strong trading in September and October.

Scale has the potential to provide Grafton with a degree of competitive advantage and possible resilience in the face of any downturn. The company can boast leading positions in ironmongery in the Netherlands (5 per cent of sales) and both merchanting and DIY in Ireland (22 per cent). Its dominance seems to be reflected in strong margins, with the respective geographies achieving first-half underlying operating margins of 10.5 per cent and 7.9 per cent. Meanwhile, a leading position in mortar manufacture (2 per cent of sales) in the UK, coupled with strong demand from the new-build market, underpinned bumper first-half margins of 23.5 per cent.

That said, in its key UK market, the group’s position isn’t as strong. It is the third-biggest builders’ merchant and fourth in plumbing. It does claim some leading regional positions, though, and its Selco and Leyland chains have a significant presence in London. The company has also been improving UK profitability with the rapid expansion of its retail-style Selco trade outlets. The mix of products sold at Selco generates higher gross margins. All the same, as well as weak RMI spending, competition is tough in the UK. What’s more, general price inflation has been the main cause of recent like-for-like growth, which suggests less underlying market strength was volume driving growth. UK merchanting first-half margins came in at 5.5 per cent.

The reality is, whatever the quality of their business, builders’ merchants are limited in what they can hope to do to protect themselves from the ups and downs of an economic cycle. However, Grafton’s management does appear to have made some smart investments over recent years judged by the advance in lease-adjusted return on capital employed (ROCE) and group margins (see chart below).

There is a medium-term target to get underlying ROCE to 15 per cent and underlying operating margins to 7 per cent. At the half-year stage these measures of profitability respectively should be 14 per cent and 6.1 per cent. Back in 2011 ROCE stood at just 4.6 per cent and margins at 2.7 per cent.

As well as a recovery in trading conditions since the depths of the financial crisis, performance has been helped by acquisitions and organic expansion. Of the £370m invested since 2015, a little over 60 per cent has been spent on acquisitions, which have played a key role in the group’s ongoing overseas expansion strategy, as well as boosting the UK businesses – including the £82m purchase of Leyland a year ago. The company says three-quarters of its investments have been in businesses with double-digit margins.

Despite this spending on growth, cash generation has kept net debt comfortably in check. A recent €160m 2.5 per cent bond placement with 10- to 12-year maturities has also helped bolster the group’s finances. True, net debt does not tell the whole story as the company has a pension scheme with liabilities of £254m, which showed a £15.3m deficit on the interim balance sheet. Grafton has also put an estimated value of between £500m and £600m on its lease liabilities (debt-like rent obligations that new accounting rules require to be reported on the balance sheet from this year).

Against its five-year history, Grafton’s shares look cheap and the valuation offers decent upside were it even to re-rate to the bottom quarter of the range (see table). Neff PEG also certainly looks attractive, especially in light of the fact earnings forecasts have recently been subject to modest upgrades.

Grafton valuation

Source: Bloomberg. NTM = next 12 months.

However, the key question is whether the five-year history and valuation against forecast growth are reliable guides to the future. While Grafton’s progress in improving profitability over recent years looks commendable, the real test will come if the economy turns south, and forecasts are likely to be quickly downgraded if this happens. It is the uncertainty about the outlook that is reflected in the share’s valuation. If the day of reckoning is further away than the market seems to be anticipating, then the value on offer does look attractive. For anyone speculating on the possibility of a Brexit bounce, Grafton could make a good candidate.