Two cheap fast-growing shares

While the numbers are flashy, Mr Neff’s style of investment was not. He is often regarded as a contrarian and value investor, although his approach has many of the hallmarks of a strategy of 'growth at a reasonable price' (Garp). In particular, he favoured a valuation metric that is very similar to the price/earnings-growth (PEG) ratio made popular in the UK by growth-focused investor Jim Slater, author of the classic investment book The Zulu Principle.

Where Mr Neff does fit the 'value' and 'contrarian' bill is that he liked high dividend yields and was not scared to buy stocks on low price/earnings (PE) ratios. Low PEs can often be a warning sign of trouble ahead (so-called value traps). He also thought a great place to look for value was in the shares of dull and undesirable businesses that make good money, as these types of companies are easily overlooked by investors. 

Following a poor run in 2018, my Neff-inspired stock screen had a decent run in 2019, returning 16.2 per cent compared with 9 per cent from the FTSE All-Share. The four stocks from last year that qualified on the screen’s full criteria managed a total return of 16.7 per cent. On a cumulative basis, the screen has produced a total return of 225 per cent since I started running it eight years ago, compared with 90 per cent from the index. While the screens in this column are meant to provide ideas for further research rather than off-the-shelf portfolios, if I apply a 1 per cent annual charge to represent notional dealing costs, the screen’s cumulative return drops to 200 per cent. 

2019 performance

A key valuation criteria used by Mr Neff was his 'total return yield'. For this screen, I present the metric as a PEG ratio rather than a yield, which provides exactly the same valuation information but in a format that tends to be more familiar to UK investors. A PEG ratio simply compares a PE ratio with a company’s earnings growth rate. The lower the ratio, the more value it implies could be on offer. In the case of the Neff PEG ratio, a share's dividend yield is also factored in. The formula I use is:

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

The screen’s criteria are:

■ Historic PE ratio below the most expensive quarter of shares and above the cheapest 15 per cent. 

■ 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.

In recent years it has not been possible to find many shares that meet all the screen’s criteria and its results have become increasingly focused on cyclical companies. This year is no exception and the screen only found two fully-qualifying shares. In order to get more results the table below includes seven shares that fail one of the screen’s tests as long as it is not the Neff PEG test. It is worth noting that one of the shares passing on the weakened criteria is currently the subject of a high-profile short attack and should consequently be considered very risky (NMC Health). 

I’ve taken a closer look at one of the two companies that passed all the tests below and which was also a good contributor to last year’s screen results. The company fits the bill of being dull but good at making money and growing.

Cheap growth shares

Source: S&P CapitalIQ

Macfarlane

Macfarlane (MACF) is the UK’s leading protective packaging distributor, as well as a manufacturer of bespoke packaging and sticky labels. This line of work would definitely seem to fit with John Neff’s fondness for dull and easy-to-overlook companies.

Protective packaging distribution is by far the biggest contributor to sales and profits, accounting for 86 per cent and 93 per cent of the respective 2018 totals. This is not the type of business where it is easy to establish a really strong competitive edge, which is reflected in mid single-digit operating margins. But Macfarlane's specialist focus and position as market leader does provide some advantages over rivals.

The division commands a market share of about 22 per cent and reckons international, generalist distributors account for a similar amount of sales, with the rest made up by small local and regional businesses. 

The fact that Macfarlane is a specialist gives it the potential to offer a better service than generalists. This is based on its product knowledge and range, as well as efforts to get closer to customers by helping them to develop packaging solutions. Strong client relationships are also being used to take the business into European markets through the recently instigated 'follow the customer' strategy. Providing more value-added services is one of two key planks of the group’s growth strategy.

When it comes to competing against smaller regional and local players, Macfarlane’s scale also gives it an advantage. The protective packaging division distributes the products of about 1,000 different suppliers to more than 20,000 customers through a national network of 24 regional distribution centres and three satellite centres. This national network is difficult for smaller players to replicate and provides Macfarlane with operational efficiencies, as well as giving it the ability to service large national accounts. 

Meanwhile, the fragmented nature of competition provides a fertile hunting ground for acquisitions, which is the second key plank of the group’s growth strategy. Ten businesses have been bought since 2014, which has resulted in regular forecast upgrades as well as making a major contribution to the packaging division’s growth record (see charts).

Shareholders have been asked to help out in funding the acquisition strategy, with a total of about £17m raised through placings in 2014, 2016 and 2017 at prices of 37.5p, 58p and 66p. The fact the company has been able to place shares at steadily rising prices, points to the success of the acquisition strategy, with Macfarlane able to cut costs by integrating new businesses into the rest of the group, as well as moving into new product areas and geographies. 

Another indicator that acquisitions have been well judged is that the company has reported rising operating margins and return on capital employed (ROCE) over the past five years. Forecasts are for the trend to have continued in the recently completed 2019 financial year, which is due to be reported on later this month. 

House broker Arden Partners predicts an increase in adjusted operating margin from 6.6 per cent in 2018 to 7.5 per cent in 2019, followed by 7.8 per cent in the current year. 

Macfarlane actually had a bit of a tricky year in 2019 due to weak demand from existing customers, but new business wins and impressive growth at its small manufacturing businesses helped support progress. In a trading update in November, the group said that assuming a typical year-end pick-up in business, results would be in line with expectations.

The seasonality of the business is a reflection of the group’s exposure to retail customers. The growth in internet retail is a long-term trend that should benefit the group and this sub sector now represents more than a fifth of protective packaging sales. However, this business is cyclical (sensitive to the health of the economy). 

Macfarlane also has a lot of customers in the industrial sector, which is also cyclical, although the group does tend to supply packaging for the shipment of parts, which are generally less sensitive to economic conditions than big equipment orders. Still cyclicality is a risk, especially given the high level of fixed costs associated with running a national distribution network, which makes profits sensitive to movements in sales.

As well as fluctuations in demand, Macfarlane also has to deal with volatile input costs. These are passed on to customers, but typically with a lag. Given this, and the fact paper prices have fallen significantly recently, the consistency of gross margins over recent years (see chart) is impressive and suggests management has a good handle on operations.

Raising money with equity means the balance sheet has not become overstretched. The £45m net debt in the above table includes lease liabilities of £30m, but not the company’s £9.0m pension deficit. Top-up payments are something of a drain on cash, with scheduled payments of £2.9m a year until April 2024, although a new triennial pension review will be undertaken in May. 

All in all, the growth being generated by Macfarlane is perhaps not of the highest quality and the acquisition strategy requires financing from shareholders. Still, the group is achieving a decent return on money invested in the business (return on capital employed or ROCE) of 12.4 per cent, based on the 12 months to end-June 2019. And growth is impressive, with a compound EPS growth rate of 14 per cent over five years and 11.4 per cent over 10 years. Meanwhile, the valuation of the shares, at 13 times forecast earnings, while not a serious bargain, is also not very challenging. A downturn in the cycle, or fear of one, would be bad news for the share price. But if that does not happen, the combination of organic growth and possible forecast upgrades from acquisitions has the potential to keep the share price moving ahead nicely.