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Five contrarian value plays

Big rewards are on offer for contrarian investors, but only if they're prepared to take on big risks
July 24, 2019

Contrarians can make huge profits on shares, but only by taking on huge risks. The performance of the top five picks from last year’s Ken Fisher-inspired Contrarian Value screen illustrates this dynamic: 12-month total returns ranged from a knockout 77 per cent to a head-in-hands negative 40 per cent. Overall, the five stocks delivered an average 6.4 per cent total return, which was a bit better than the 2.2 per cent from the FTSE All-Share.

Upsets are to be expected from contrarian investments. After all, contrarians make money by buying shares that hardly anyone else will touch. The hope is that so much bad news has been priced in that the only way is up. If a contrarian investment goes well, the brave investor gets the heady combination of a sharp recovery in earnings and an upward rerating of the share price as a multiple of those earnings. But often with bashed-up shares, the only way for shareholders is actually down. This has been demonstrated by recent high-profile stock market disasters, such as Carillion and Debenhams.  

While my Contrarian Value screen is pretty much guaranteed to pick some howlers, it does use a number of tests to try to reduce the danger of ploughing headlong into value traps. Broadly, these tests involve looking for companies that have been reasonably profitable historically, are not too financially stretched, and have good records of sales growth. 

But key to identifying contrarian situations is identifying shares that the market loathes. A good way to do this is to look for shares with woefully-low valuations. This is trickier than it first sounds. Many measures of value used by investors look at share pricing as a multiple of earnings or cash flow. However, the companies that are of most interest to contrarians are usually those that have seen their earnings and cash flows decimated (hopefully only temporarily). So this screen looks to a valuation measure based on the ultimate source of a company’s earnings and cash flow – sales. Looking at valuation based on sales has another virtue because the top line of a company's accounts is harder to puff up than the other numbers reported. The screen’s full criteria are as follows:

■ Enterprise value of £25m or more.

■ Five-year compound average annual sales growth rate of 7 per cent or more (5 per cent or more above the 2 per cent target rate of inflation).

■ Forecast sales growth in each of the next two financial years.

■ An average operating profit margin of at least 10 per cent over the past five years.

■ Positive free cash flow.

■ Gearing of less than 50 per cent, or net debt of less than two times cash profit.

From the FTSE All-Share constituents that pass all the criteria, the screen focuses on the cheapest five shares based on enterprise value to sales (EV/Sales). I also run a 20-stock version of the screen (the 20 cheapest shares passing all the criteria). For a number of years now I’ve felt the need to stress that many of these 20 shares look too expensive based on EV/Sales to be considered credible contrarian picks. Sadly this continues to be the case this year, with the most expensive of the 20 boasting a valuation of more than three times sales. That hardly looks compelling value based on the lazy rule of thumb that contrarians should look for a EV/Sales valuation of one or less (only two shares on the list make the grade on that score this year).

Fittingly, the performance of the 20-stock version of the screen was pretty rubbish last year, delivering a negative 3.6 per cent total return. Since I started running the screen eight years ago yearly returns from the top five shares have been erratic but overall have been very strong, with a cumulative total return of 215 per cent compared with 81.5 per cent from the FTSE All-Share. While the results from the screens run in this column are considered as ideas for further research rather than off-the-shelf portfolios, it is worth factoring in notional real world charges. If I add a 1 per cent charge, the cumulative total return drops to 188 per cent. For the top 20 the cumulative total return is 91.5 per cent, or 76.7 per cent with the annual charge. 

 

2018 performance

NameTIDMTotal return (23 Jul 18 - 17 Jul 19)
Dunelm DNLM77%-
Pets At Home PETS77%Top 5
Barratt DevelopmentsBDEV32%-
Hiscox HSX19%-
Polypipe PLP15%-
RedrowRDW12%-
GCP Infrastructure Invs.GCP11%Top 5
Taylor WimpeyTW.6.4%-
BellwayBWY5.1%-
Bovis Homes BVS4.0%-
Bloomsbury Pbl.BMY3.9%Top 5
SchrodersSDR-1.3%-
Howden Joinery Gp.HWDN-3.0%-
EssentraESNT-9.2%-
Card FactoryCARD-9.2%-
PlaytechPTEC-10%-
PersimmonPSN-12%-
Drax DRX-19%Top 5
Consort MedicalCSRT-27%-
SeniorSNR-27%-
888 Holdings888-32%-
Mediclinic InternationalMDC-33%-
DialightDIA-40%Top 5
Ted BakerTED-62%-
SuperdrySDRY-67%-
FTSE All Share-2.2%-
Contrarian--3.6%-
Contrarian Top 5-6.4%-

 

This year's top five selection from the screen should raise an eyebrow or two. The picks consist of two retailers and three housebuilders. I would be particularly cautious regarding housebuilders as real contrarian plays. True, there is negative sentiment towards housebuilders. But the sector is highly cyclical and boasts margins and returns on capital that may well represent a cyclical peak. Normally contrarians want to buy shares in companies in a trading trough rather than betting tired cyclicals have more legs than others expect. I’ve taken a closer look at the 'cheapest' share on the list, fashion brand Ted Baker. Details of the other stocks can be found in the accompanying table. 

 

NameTIDMMarket CapPFwd NTM PEEV/SalesDY5-year avg Ebit marginFwd Sales grth FY+1Fwd Sales grth FY+2Fwd EPS grth FY+1Fwd EPS grth FY+23M Fwd EPS change12M Fwd EPS change3-month momentumNet cash/debt(-)
Ted Baker*LSE:TED£373m838p90.87.0%12%3.1%4.9%-21%11%-29%-42%-46%-£124m
RedrowLSE:RDW£1.9bn553p60.95.5%16%6.4%3.8%1.6%2.1%-4.0%--12%£101m
BellwayLSE:BWY£3.5bn2,846p71.15.1%16%5.2%2.7%3.3%0.4%-0.3%-2.6%-11%-£27m
Taylor Wimpey LSE:TW.£5.3bn164p81.23.8%15%2.0%2.9%-3.9%1.7%-1.1%-7.7%-13%£617m
Pets at Home LSE:PETS£1.0bn201p141.23.7%13%4.0%2.6%0.0%3.6%6.5%0.9%39%-£119m
Bovis Homes LSE:BVS£1.4bn1,055p101.25.4%16%3.2%2.9%6.3%11%-0.4%-1.6%-5.9%£127m
VpLSE:VP.£344m869p91.33.5%12%3.1%3.3%7.7%5.1%-0.1%-1.9%2.3%-£168m
Playtech LSE:PTEC£1.4bn454p91.44.8%26%28%1.7%-22%14%2.1%-22%3.3%-€189m
Consort Medical LSE:CSRT£384m782p141.62.7%18%0.8%5.8%-8.1%22%-14%-24%-13%-£97m
MJ GleesonLSE:GLE£423m776p131.74.4%14%17%8.6%8.8%9.7%0.7%1.7%-3.2%£28m
DunelmLSE:DNLM£1.8bn885p181.83.1%16%4.1%5.2%22%4.1%3.2%-1.0%-£73m
Howden Joinery LSE:HWDN£2.9bn491p151.82.4%15%6.2%5.8%5.5%7.9%-0.5%-3.9%-3.2%£231m
ClarksonLSE:CKN£797m2,640p231.92.8%13%5.2%4.5%9.8%11%0.0%-12%11%£166m
Hostelworld LSE:HSW£166m174p341.97.1%14%0.9%5.3%-4.3%18%--52%-22%€26m
Hastings LSE:HSTG£1.3bn199p122.06.8%26%2.6%6.0%-22%11%-17%-35%-15%-£235m
Hiscox LSE:HSX£5.0bn1,741p242.31.9%19%7.4%6.8%118%5.4%-14%-21%5.2%$344m
Polypipe LSE:PLP£837m420p142.32.8%14%8.0%3.9%8.5%6.3%0.0%0.4%-0.4%-£165m
XPS Pensions LSE:XPS£218m108p112.36.1%20%5.8%4.7%-0.1%6.3%-13%-17%-27%-£51m
Hikma Pharmaceuticals LSE:HIK£4.3bn1,795p162.81.7%31%3.0%4.5%-1.0%6.2%0.5%31%6.0%-$340m
Flutter Entertainment LSE:FLTR£6.1bn6,974p-3.12.9%16%6.9%10%-20%14%-2.9%-28%4.4%-£160m

Source: S&P CapitalIQ *Price prior to buyout rumour

 

Ted Baker

If you want to know what happens when a highly regarded business with highly rated shares to match gets into trouble, the experience of Ted Baker (TED) over the past 12 months makes a good case study. With a tough trading backdrop for clothes retailers, the share price had been stuttering for a couple of years, but started to head south in earnest last year. 

Ted makes a significant amount of its sales through department store concessions and, as the travails of the sector became more apparent during 2018 and House of Fraser spiralled into administration in August, sentiment towards the shares began to darken. 

A lacklustre December trading update added to the market’s dour mood, as did the surfacing of accusations that the company’s founder and then-chief executive, Ray Kelvin, had enforced a “hugging” culture at the company among other behaviour deemed inappropriate. But it wasn’t until after Mr Kelvin had resigned that full-blown profit warnings started to arrive. This year, Ted told shareholders it would miss expectations in both February and June. 

The share price fall on the back of this torrent of negative news represents both falling forecast earnings and a steep drop in the share price multiple applied to those forecasts. Indeed, at one point Ted’s shares were valued at over 30 times forecast earnings, but are now rated at less than 10 times. The shares have lost around three-quarters of their value from their 2018 high.

 

 

What grounds are there to think this is a contrarian situation as opposed to a value trap? For the sake of prudence, it is first worth considering the reasons to be wary. 

One thing that really stands out from Ted’s accounts is that over the past 10 years inventories as a percentage of sales have risen sharply. This ratio appears to have gone from the reasonable (just over 20 per cent) to the astronomical (nearly 37 per cent). 

 

In part, the climbing inventories-to-sales ratio is a reflection of the group’s push into wholesale and increased licensing activity, but both of the group’s warnings this year have given cause for concern about inventory levels; February's warning included a £5m inventory writedown. Meanwhile, in June the company warned it had been forced to resort to a high level of promotional activity to shift stock, with first-half gross margins dropping from 61.0 per cent to 58.3 per cent. 

Shareholders have few indications that the company has turned the corner, but management has said it is taking action. Indeed, it is often said profit warnings come in threes, and it is hard to rule this out with Ted Baker given that the combination of high inventory levels and poor trading conditions is a classic recipe for retail woe.

A further big unknown for shareholders is whether the loss of Mr Kelvin, who was a driving force behind the business, has taken the wind out of the brand’s sails. In the meantime, it should be a concern that the most recent warning was accompanied by the news that Ted had “experienced some challenges with our Spring/Summer collections”. Since originally running this screen, Mr Kelvin, who owns 35 per cent of the shares, caused a share price fillip by saying he would back a buyout.

But for contrarians, the time to buy is when there is blood on the streets. And, from a contrarian perspective, Ted Baker’s business model can offer some reassurances. A key plus is that it does not operate too many actual stores. The long-term, upward-only rent commitment associated with shops has been a key factor in the downfall of a number of retailers. The company instead operates a lot of concessions where rents tend to be linked to turnover. Of the £96m in lease payments recorded last year, about 45 per cent were contracted on variable terms, which makes Ted’s cost base more flexible than a classic clothes retailer. 

What’s more, retail is only one part of what the company does. Ted has used its brand strength to generate profits from a number of different sources and geographies. Online sales accounted for over a quarter of retail sales last year.  Meanwhile, the company’s biggest profit generator is wholesale, which accounts for 46 per cent of the total, and it makes a further 15 per cent of profit from licensing its brand. The business also offers international diversity, with about half of sales coming from outside the UK and Europe. 

So despite few definitive signs that trading has bottomed, there are some grounds to see Ted Baker as well positioned to negotiate its current sticky patch. That said, there are also reasons to fear another warning and high stock levels raise the potential for a real 'kitchen sink' job. Indeed, were it not for the stock trends, there would be grounds to feel a lot more positive about the value on offer – as Mr Kelvin clearly seems to.