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Sixteen stocks going for growth

The O’Shaughnessy Cornerstone Growth screen has applied the power of the ‘King of Value Factors’ to find its latest 16 growth picks
March 19, 2019

Last week this column looked at a classic screen for investors wanting relatively smooth outperformance, as outlined by Jim O’Shaughnessy in early editions of his seminal book What Works on Wall Street. This week I’m reviewing his racier classic screening option, the Cornerstone Growth screen.

The Cornerstone Growth screen helped to popularise the price-to-sales (P/S) valuation measure, which Mr O’Shaughnessy dubbed “the king of value factors”. His enthusiasm was based less on the way the ratio attempts to identify value, and more on its effectiveness based on the considerable back testing he conducted. While Mr O’Shaughnessy has updated his methods since setting out his original Cornerstone screen, since I’ve run the old-school Cornerstone Growth screen for this column the results have been impressive. That said, consistent with Mr O’Shaughnessy’s findings, the results have been somewhat erratic from year to year.

The past 12 months was a period of modest underperformance. But since early 2012 the screen has delivered a cumulative total return of 161 per cent, or 139 per cent after taking the important step of factoring in a 1.25 per cent annual charge to account for real-world dealing costs. Over the same time, the FTSE All-Share has delivered a total return of 67.8 per cent.

 

Last year's performance

NameTIDMTotal return (6 Mar 2018 – 15 Mar 2019)
JD Sports FashionJD.24%
4ImprintFOUR21%
Legal & GeneralLGEN14%
RedrowRDW13%
GraftonGFTU9.1%
PageGroupPAGE-4.9%
SavillsSVS-5.4%
International Consolidated AirlinesIAG-8.2%
Henry BootBOOT-13%
Babcock InternationalBAB-18%
FTSE All Share-4.1%
O'Shaughnessy Growth-3.2%

 

Cumulative performance

 

While the screens in this column are primarily regarded as a way to highlight interesting ideas for further research, Mr O’Shaughnessy conceived this screen as an end in itself based on a portfolio of 50 stocks. That said, the relatively diminutive nature of the UK market compared with the US means the screen does not produce nearly enough positive results to build a 50-stock portfolio when run on the FTSE All-Share. The screening criteria are:

Value criteria: A price-to-sales (P/S) ratio of 1.5 or less.

Growth criteria: Earnings growth in each of the past five years.

Momentum criteria: Mr O'Shaughnessy's original screen was based on selecting the 50 stocks with the best one-year momentum. But since first publishing he has said that shorter periods can also work well. I focus on three-month.

This year there were 16 positive results. Details of these stocks and some fundamental data can be found in the table below.

 

NameTIDMMkt CapPrice Fwd NTM PEDYP/SalesEV/SalesEV/EBITDAEbit MarginROCEFwd EPS grth FY+1Fwd EPS grth FY+23m Upgrade/Downgrade3-mth MomentumNet Cash/Debt (-)*Net Debt/EBITDA
Robert Walters plcLSE:RWA£422m608p122.4%0.30.364.0%32%10%6.5%3.5%26%£74m-
DCC plcLSE:DCC£6.3bn6,410p171.9%0.40.5152.4%8.9%14%3.1%-0.2%6.3%-£1.0bn2.0
Hays plcLSE:HAS£2.2bn154p125.7%0.40.484.2%37%5.9%8.7%-9.1%£33m-
Clipper Logistics plcLSE:CLG£281m277p153.2%0.70.8124.7%24%13%12%-1.5%9.9%-£44m1.6
Macfarlane Group PLCLSE:MACF£153m97p122.4%0.70.8115.3%13%37%0.7%3.0%32%-£13m0.9
Savills plcLSE:SVS£1.3bn921p123.3%0.80.898.0%21%-0.2%-1.3%0.4%30%-£95m0.7
Henry Boot PLCLSE:BOOT£358m270p103.0%0.90.9615%20%-14%2.6%-1.0%12%-£26m0.4
National Express Group PLCLSE:NEX£2.1bn419p123.5%0.91.388.7%8.8%6.6%4.4%1.2%12%-£971m2.5
4imprint Group plcLSE:FOUR£617m2,200p202.4%1.11.0166.0%75%14%10%2.2%17%£22m-
Redrow plcLSE:RDW£2.2bn621p74.7%1.11.1520%24%5.2%5.0%-0.8%27%£101m-
Barratt Developments PLCLSE:BDEV£6.2bn607p97.4%1.21.2618%17%5.0%2.6%-33%£379m-
JD Sports Fashion plcLSE:JD.£4.5bn466p170.3%1.21.31210%37%--1.4%27%-£85m0.2
Bellway p.l.c.LSE:BWY£3.7bn3,013p74.7%1.31.2522%26%3.1%3.0%-0.8%17%£99m-
Legal & General Group PlcLSE:LGEN£16bn274p96.0%1.30.3219%0.5%12%-4.4%6.3%19%£12bn-
Ted Baker PlcLSE:TED£797m1,789p143.4%1.31.51012%21%-11%19%-8.3%21%-£133m1.4
Taylor Wimpey plcLSE:TW.£5.9bn182p910%1.51.3621%21%-2.2%1.1%-2.2%33%£617m-

Source: S&P CapitalIQ. *All reporting in foreign FX has been converted to £

 

Any screen that looks at a valuation measure based on sales tends to have a bias towards low-margin businesses. Understandably, the market usually puts less value on a company’s sales when they produce little profit because it is a company’s ability to distribute earnings that is key to long-term shareholder returns. What’s more, companies in low-margin industries tend to be in weaker competitive positions and are often more vulnerable to negative changes in their trading environments.

But when profits have been only temporarily depressed, sales can give a much better guide to long-term value than earnings. This means P/S can be regarded as a particularly good valuation measure for recovery plays. By targeting shares with positive momentum, the O’Shaughnessy screen can be regarded as trying to identify situations where the market may have started to anticipate margin improvement. By no means all companies fit the bill, though. For example, some companies tend to look cheap compared with sales because they have high ‘pass-through’ costs to their customers, which is the case with the share from the screen I am taking a more detailed look at below: DCC.

 

DCC

Investors would not usually pay a high multiple of earnings for a company with a capital-hungry, low-margin business. But the punchy valuation of shares in DCC (DCC) of 17 times forecast earnings suggests the company has a better story to tell than may first appear to be the case. Much of the attraction comes down to DCC’s strategy of seeking leadership in niche markets where scale can offer protection from competition. Earnings growth, which has been assisted by significant acquisition activity, is the other noteworthy draw. Indeed, to the end of March 2018, the group boasts a 24-year (since float) operating profit compound annual growth rate of 14.8 per cent, and has grown its dividend every year over the same period.

Meanwhile, to a significant extent, DCC’s high turnover reflects high pass-through costs as many of its contracts with customers allow it to directly pass on supplier price increases. This means that while gross margins are low (9.9 per cent last year) they should be relatively stable.

At its core, DCC is a specialist transport, storage and marketing operation. Essentially, it takes the role of an important go-between for suppliers and a variety of end markets – retail, commercial and domestic. The company also owns and operates a network of petrol stations, healthcare contract manufacturing facilities and consumer-technology service businesses. While the company has been expanding rapidly into North America over the past 12 months, at the end of its last financial year (end-March 2018) the UK was its largest market, accounting for 45 per cent of profit, followed by France at 35 per cent. Its operations are broken down into four divisions: liquefied petroleum gas (LPG) (44 per cent of profits); oil distribution and petrol stations (30 per cent); healthcare products, including nutrition, beauty and pharmaceuticals (14 per cent); and consumer technology (12 per cent).

The nature of the business means that at the operating level the company has a sizeable fixed cost base, including noteworthy lease commitments (rents in the 2018 financial year were £85m). Meanwhile, working capital items reflect the scale of the company’s turnover as opposed to its much smaller profits. For example, at the end of March last year receivables of £1.4bn represented only a tenth of turnover, but a lofty three times cash profits (Ebitda). That said, DCC tends to get paid for sales before it has to pay suppliers, so its negative working capital has actually contributed to a record of strong cash conversion. This is likely to continue to provide a cash flow tailwind as long as growth persists, but could reverse were trading to deteriorate. Meanwhile, some end markets are cyclical, others are very weather-dependent (heating oil and LPG) and climate change regulation and green technology represent existential risks lurking in the background.

However, perhaps the most noteworthy risk with DCC at the moment is actually linked to its biggest opportunity: a massive pick-up in its rate of acquisitions. DCC’s origins can be traced back to an Irish venture capital (VC) firm established in 1976, which later became an operating company in 1990 and floated in London and Dublin in 1994. The VC roots help explain the company’s decentralised management structure and a serious appetite for deals – since floating it has spent over £1.2bn acquiring more than 260 businesses.

The company has been doing a lot of deals since the appointment of Donal Murphy – a DCC employee since 1998 – as chief executive in mid-2017. Indeed, when the company raised £606m by placing new shares at 6,800p late last September, it had spent a heady £900m on acquisitions in the preceding 12 months. That compares with an average annual spend of £260m over the 2015 to 2017 financial years, which was itself a marked pick-up on a yearly spend of £117m in the prior three financial years. Accounting for the recent placing, broker Peel Hunt forecasts year-end net debt to cash profit of about 0.1 times. A previous near-£200m placing happened in May 2015 at 4,700p.

A noteworthy feature of the recent deals is the company’s attempt to expand geographically. While managing the group’s energy business (now separated into LPG, and oil and retail), Mr Murphy was responsible for pushing the business into Europe through acquisitions. Now the key target is the US. In theory, there is a big opportunity, especially in LPG where the market is much more fragmented than in Europe. The company has bought US healthcare and technology businesses too, so it is making its stateside push on several fronts.

However exciting prospects are, some investors are bound to be haunted by thoughts of the litany of UK companies that have come undone trying to break into the US, as well as the bad record of acquisition splurges that occur late in bull markets. That said, DCC does have pedigree as a dealmaker and its strong focus on return on capital employed (ROCE) is a useful discipline.

The adjusted ROCE measure used by the group to monitor its businesses is arguably of less interest to investors than it is internally, because the adjustments used factor out acquisition-related amortisation costs and the large amounts of cash routinely held on the balance sheet (the company has held about £1bn cash for each of the past five years). As acquisitions are a key part of the growth strategy and the company points to the cash levels helping to facilitate deals, it seems worthwhile for shareholders to also consider a ROCE figure that accounts for these items. On that basis, a more run-of-the-mill calculation* gives ROCE of 8.9 per cent for 2018, which is not bad, but not amazing. It is also a lot less impressive than the company’s adjusted figure of 17.5 per cent. The 8.9 per cent ROCE calculation also ignores exceptional items, which are a regular feature in DCC’s accounts and have averaged about 10 per cent of statutory operating profits over the past five years.

The high multiple commanded by the shares suggests the market is currently prepared to take a rosy view, but the rating may underplay the challenges presented by such rapid expansion.

 

*The basic ROCE calculation used expresses operating profit before exceptionals as a percentage of average capital employed from the start and finish of the period. Capital employed is calculated as total assets less current liabilities but adding back short-term debt.