Shares that have it all

The 27 per cent total return over the past year compares with 15 per cent from the FTSE All-Share, and builds on past gains to take the cumulative total return over the past eight years to 215 per cent versus 102 per cent. While the screens run in this column are principally regarded as a source of ideas for further research, if I inject a bit of reality into the performance numbers by adding in a notional 1 per cent charge to reflect dealing costs, the total return drops to 190 per cent.

2019 Have It All performance

While this screen does ask shares to show a lot of classic, desirable investment characteristics – value, quality and growth – its saving grace is perhaps that it is not too fussy about how strongly they meet the criteria, with most tests being relatively soft. The screen’s full criteria are:

■ Forecast next-12-month price/earnings (PE) ratio among the lowest third of all stocks screened.

■ Historic dividend yield (DY) in the highest third of all stocks screened.

■ Average forecast earnings per share (EPS) growth in the next two financial years of 5 per cent or more.

■ Three-year EPS compound annual growth rate (CAGR) of 10 per cent or more.

■ Three-year free cash flow CAGR of 10 per cent or more.

■ Three-year dividend CAGR of 5 per cent or more.

■ Return on equity (RoE) of 10 per cent or more.

■ Three-year average RoE of 15 per cent or more.

The problem with such a broad list of requirements is that it is hard to find a stock to tick absolutely every box. Indeed, this year no share qualifies on every score. The list below is therefore made up of shares that fail up to two tests – the first four stocks in the list have failed only one. All stocks must pass either the low forward PE test or the DY test. 

Often stocks that look attractive across a broad smorgasbord of fundamentals have risks that are not readily captured by numbers. A standing example from the four shares that pass all but one tests is NMC Health, which has come under fire from short seller Muddy Waters. Meanwhile, with Photo-Me there are grounds to worry that a large chunk of its business (ID photo booths) could become moribund. And the two tobacco stocks in among the stocks failing two tests face considerable regulatory uncertainty.

A more general theme, though, with this year’s Have It All selection is the cyclical nature (sensitive to economic conditions) of many of the companies. After a long bull market and economic recovery, many such companies look both high-quality and cheap on paper because the economic backdrop has allowed them to trade well over an extended period. However, cyclicality remains a very real risk. Indeed, the 'quality' characteristics displayed by cyclicals are only ever transitory. This explains their seemingly low valuations. 

I’ve taken a closer look at the share with the strongest three-month momentum out of the four that pass all but one of the screen’s tests – equipment hire company Ashtead. The company makes a good study of the issues investors face evaluating cyclicals. Interestingly with Ashtead, a strong structural growth story and canny management of the balance sheet mean fears about the level of risk may be a bit overblown.

Shares that Have It All

Source: S&P Capital IQ

Ashtead

The management teams of cyclical businesses need to be aware of cyclical risk to ensure their companies can survive the cycle and prosper despite it. Investors in the shares of cyclical businesses need to be aware of cyclical risks in order to prosper from the cycle by selling before it turns down and buying as it turns up. Arguably, as long as management is not deluded about the inevitability of the cycle, it has an easier job than investors due to the fact it is to take a long-term view. That’s because, knowing when a cycle will turn, and therefore when to bail out or buy in to shares, is incredibly difficult – some would say impossible. The nervousness this induces in investors tends to keep a lid on the valuation of cyclicals even when times are good. 

Cyclical danger is magnified for companies that also carry significant risk on their balance sheets and have profits that are very sensitive to relatively small movements in sales (so-called operational gearing). Equipment hire companies, such as Ashtead (AHT), carry both these risks in addition to being highly cyclical. 

Cyclical risks and more

Hire companies have large balance sheets due to the expensive equipment they invest in, in order to rent it out. These investments are often funded by debt. During downturns, not only are rental assets in less demand, which means they generate less cash to service debt, but their resale value tends to plummet. Hire companies’ profits are also very sensitive to movements in sales because a large proportion of costs are fixed, including the aforementioned cost of buying equipment to rent out, which is reflected in a high depreciation charge. There are also large fixed costs associated with operating a network of hire stores. A breakdown of Ashtead’s 2019 revenue into costs and profit is shown in the chart below with fixed costs depicted in shades of grey (the lighter the shade, the greater the potential flexibility).

Fears in anticipation of last year’s slowdown in the global economy resulted in significant volatility in Ashtead’s share price. The shares hit a high of 2,437p in September 2018 before plummeting 54 per cent by the end of the year. The shares made a wobbly comeback during 2019, and have only just regained the old high. The central question for would-be investors is how vulnerable Ashtead is to a downturn, and consequently whether the shares’ superficially low valuation represents a bargain and recent share price momentum will continue. 

A key thing to realise about Ashtead is that it is essentially a play on the US economy. It generates 85 per cent of sales and 93 per cent of profit in the US through its Sunbelt business, compared with just 11 per cent and 5 per cent in the UK, where it trades as A Plant. It also has a small but fast-growing Sunbelt Canada business.

A better balance sheet

According to Refinitiv data, Ashtead is the best performing FTSE 350 share of the past decade. Much of this is due to the fact the share price (as well as profit) was decimated during the credit crunch. But there are reasons to think the company has learned lessons from this harrowing experience. Perhaps most notably, debt as a proportion of total assets has declined significantly since the crunch and gearing (net debt to net assets) is also down (see table). 

In fact, recently Ashtead’s key balance sheet issue has been keeping debt up rather than getting it down. It makes sense for an asset-rich company such as Ashtead to employ a sensible level of debt to improve shareholder returns. This is not only because the company can in theory sell assets to pay off borrowings during tough times, but also because its cash flows have counter-cyclical characteristics. Indeed, while profits have high operational gearing due to the high depreciation charge – as mentioned above – depreciation is not a cash charge. Rather it is a reflection of historical cash investment in assets. Actual year-to-year cash investment into the business is much more flexible and can be reined in when times are tough.

Cash investment into the business last year was £1.6bn, which represented over two-fifths of year-end net debt excluding lease liabilities. Should push come to shove, much of this could be cut, especially as over £1bn of last year’s spending was on expansion projects. What’s more, the company has used strong trading over recent years to make sure that its hire fleet is very young – 32 months at the half-year stage. A young fleet provides not only a competitive advantage against less well-invested rivals, but also provides a cash flow cushion should trading deteriorate because the fleet can be aged. During the credit crunch, the group took fleet age out to 46 months as it cut back on cash spending.

Owning a young fleet, which requires less investment to maintain, is also a reason why the company is keen to stay towards the upper end of its target net debt to cash profit range of 1.5 to 2 times (Ebitda) – this debt ratio stood at 1.9 times at the halfway stage. To keep debt up, as well as making bolt-on acquisitions (£622m last year and £231m in the first half), the company is returning capital through buybacks (£460m last year and £500m planned this year). 

A useful way for investors to think about the benefits of buybacks on returns is to view the capital return as dividends reinvested – the maths is very similar. From this perspective, Ashtead’s so-called 'shareholder yield' (buybacks plus dividend) stands at 6.3 per cent based on payouts made in the past 12 months.

Growth threat and opportunity

But investors have had reason to feel nervous about trading of late. This is reflected in recent forecast EPS downgrades (see chart). Half-year results brought news of a slip in US margins, in part due to less clean-up work related to hurricanes. Management also said it expected US market growth to slow for both this year and next. Meanwhile, in the UK first-half sales were down 2 per cent, but profits plunged by a third, reflecting restructuring, which was recorded as a day-to-day cost rather than an exceptional item.

Clearly this is not great, but there are reasons to be optimistic, too. Indeed, it is of note that Ashtead’s share price was not too shaken by the post-interim results downgrades, which suggests the market is not overly concerned. Importantly, reasons for optimism go beyond cyclical considerations, such as: monetary policy loosening; tentative signs of a pick-up in global growth; US/China trade talks progress; and the incentive to keep the US economy strong during an election year. 

Ashtead’s key long-term growth opportunity relates to structural change in the US hire market. This is because the rental market in the US is relatively immature with about 55 per cent of fleet rented compared with 75 per cent in the UK. But rising equipment costs, along with increased environmental and safety regulation, and fast technological change are all driving a move to rental in the US. 

Meanwhile, the US market is very fragmented. Sunbelt’s relatively small 8 per cent share makes it the number two player, behind United Rentals with 14 per cent. Scale provides advantages in the market from driving down costs to making investment in high-end IT more economic. By buying up smaller players or outcompeting them with new openings, Ashtead thinks it can take its market share to 15 per cent in the medium term and potentially 20 per cent in the long term. Meanwhile, it expects the share of the market commanded by the top 100 hire companies can increase from the current level of 50 per cent to 60 or 70 per cent.

These structural factors help underpin growth expectations while taking some of the edge off the savagely cyclical characteristics of equipment hire. 

Valuation

So there are grounds to think Ashtead is perhaps a less cyclical business than the market is inclined to fear given both the strength of the balance sheet and structural growth potential. Ashtead’s track record also highlights it as a good operator. 

But are there grounds for thinking the shares’ valuation represents a bargain? The price/earnings ratio that this screen uses to gauge value is not necessarily the best way to assess a cyclical company because earnings can swing wildly depending on trading conditions. One alternative is to look at enterprise value compared with sales, as sales tend to be far more stable over the cycle than profits. On this basis, comparing today’s valuation with the range over the past 12 years (a full cycle), the rating is only modestly above the median average (3.3 versus 3.0). 

But the cycle over the past 12 years includes a particularly torrid recession which occurred at a time when the company had a significantly weaker balance sheet than has today. So the fact the shares currently command a near-average rating relative to the period could be seen as pretty attractive. That’s especially true given US recession fears, which were fairly pronounced last year, appear to be fading. This should help support confidence in the strong growth forecasts. What’s more, the structural growth story in the US market has become far better established over the past decade. In all, for those who can bear the cyclical risk, the shares have definite attractions.