Six zeitgeist stocks

The screening process starts out by measuring the performance of 11 different single-factor strategies over the last three months. This is done by monitoring the performance of the most attractive quarter of FTSE All-Share constituents based on each strategy criterion (see chart).

The message from the last three months may not come as too much of a surprise to close observers of the market. Strategies backing stocks that look 'cheap' have performed poorly. However, strategies that have targeted growth and quality have done well. A reflection of this can be seen in the high valuations currently commanded by many of the stock market’s 'best' companies – as highlighted by the IC’s Phil Oakley (the man who wrote the book on How to Pick Quality Shares) in a number of his recent columns.

After establishing the market’s mood, a screen is created based on the top three strategies. The screen simply looks for stocks that are among the top quarter for each of the three strategy criteria. Few stocks normally pass all the tests (six stocks this year), so the results are bulked out by including shares that qualify based on the top-performing strategy but only meet one of the other two strategy criteria.

Last year’s selection of 28 stocks put in a poor performance compared with the FTSE All-Share index, with a negative total return of 3.3 per cent compared with a positive 4.0 per cent from the index. The five stocks that passed all of the screen’s tests last year managed a 7.4 per cent total return.

2018 performance

Source: Thomson Datastream

This is the second disappointing year in a row for the screen, but strong results in the first four years since its inception means the cumulative six-year total return of 108 per cent is still comfortably above the 50.5 per cent from the index. Taking the important step of factoring in a notional annual dealing charge of 1.25 per cent (the assumption of this column is that the results from screens should chiefly be regarded as ideas for further research rather than off-the-shelf portfolios), the total return drops to 92.7 per cent.

In total, 19 stocks have been highlighted by the screen this year, including six that passed all the tests. The table below provides details of the stocks including whether or not all of the strategy criteria were met. The primary strategy criterion this year was high average forecast growth for the next two financial years. The secondary criteria were high return on equity and forecast upgrades. One of the stocks passing all the tests, Electrocomponents, has also been highlighted by other growth-and-value-orientated screens this year (the Neff and Lynch screens), so I’ve taken a closer look at how it stacks up.

Source: S&P Capital IQ

Electrocomponents

Electrocomponents (ECM) acts as a go-between for about 2,500 suppliers of electronics and industrial products, which it distributes to 1m customers in 80 countries. The business has operations in 32 countries and its distribution network sends out a parcel about every two seconds.

What this means for investors is that demand, and therefore profits, are very dependent on the health of the global economy, especially given the company’s high level of fixed costs. Indeed, angst over the US/China trade war and global economic outlook at the end of 2018 led to a 37 per cent drop in the share price. After a 36 per cent recovery from January lows, the shares have recently experienced a 7 per cent setback as global-trade fears have resurfaced.

Meanwhile, Brexit may also prove a major issue given about 70 per cent of the company’s products are routed through the UK. The company is temporarily boosting fast-moving inventory by £26m to guard against disruption. In the longer term, it believes it will probably need to substantially shift sourcing from UK suppliers to European ones.

Competition is also pretty intense. The fragmented nature of distribution in the vast market for electronics and industrial products should in theory provide the potential for big international players to make significant market share gains. While Electrocomponents has had some success in growing market share and has ambitions to grow at twice the market rate, on the whole small operators have proved pretty resilient. “Smaller companies, if anything, have been more aggressive,” says Peel Hunt analyst Henry Carver. “They’ve had much more competitive fight than had been perceived.”

But while Electrocomponents may not have a very defensible business model, recent years have seen it make good progress and the shares came close to recapturing their highs of the dotcom boom last year.

Following many years of margin attrition (see chart), Electrocomponents began to rebuild its profitability from 2016. While some of this progress is down to favourable trading conditions, the company’s own actions have also been an important factor.

The impact of sales growth has been magnified by improving gross margins (the difference between selling prices and cost of goods sold) and the conversion of a higher proportion of gross profit into operating profit. Gross margins have been helped by: reduced use of discounting to drive sales; efforts to increase the sale of value-added services, such as design and inventory management; focusing on high-growth product lines, such as automation; and increased sales of own-label products.

Meanwhile, conversion of gross profit into operating profit has been helped by cost-cutting, and last year Electrocomponents began a second phase of its performance improvement plan, targeting £12m of savings by March 2021. A high level of fixed operating costs also magnifies the impact of higher gross profits on the bottom line.

Acquisitions are helping to enhance the business and address the changing requirements of clients, as is investment in digital sales. Its acquisition of IESA a year ago, for example, significantly improved its ability to offer maintenance repair and operations (MRO) services, as more companies look to outsource inventory management and sourcing.

So far, the company has increased its conversion of adjusted gross profit to operating profit from 15.3 per cent in 2015 to 25.7 per cent in the first half of its recently completed financial year. The long-term target is 30 per cent. Meanwhile, the adjusted operating profit margin (which excludes acquisition costs and amortisation, and restructuring costs) has grown from 6.7 per cent to 11.4 per cent over the same period, with a long-term mid-teens target.

Progress to date makes the long term-targets look credible, with the scope for many small changes to add up to impressive progress. However, at its heart this is a very cyclical business and the changes being made do not appear to offer much protection against this. That means the group is likely to need a fair wind to realise its ambitions. If it gets this, there should be decent room for further upside.