Hunting Genuine Value in market debris

The screen did outperform the market over the past 12 months. At the time of writing this means a painful fall of 10.3 per cent in absolute terms versus 14.4 per cent from the FTSE All-Share – although given the wild market gyrations, all could be much different by the time this article is published. Recent weeks aside, the ups and downs of this screen since I began to follow it in March 2013 coupled with an uninspiring cumulative total return means the results feel quite random (see chart below). 

12-month performance

Source: Thomson Datastream

The cumulative total return over the seven years I’ve run the screen is 41.2 per cent, compared with 26.3 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 add in an annual charge of 1.25 per cent to represent notional dealing costs, the total return falls to a hardly-worth-the-bother 29.3 per cent. 

I’ve decided to give the screen one more chance in its current form. This partly reflects a desire to see what it yields in the current exceptional market environment. However, an accounting rule change that requires companies to put a value on their lease obligations may also help the screen’s key valuation measure do a better job (more explanation below).

However, I also see two potential reasons that may explain why this screen has not done well to date. The first is that the screening criteria is very simple. This design was intentional as I was very keen to road test a valuation ratio that I portentously named the genuine value (GV) ratio. Essentially, this is a price/earnings growth (PEG) ratio that factors in a company’s debt and dividends. Its aim is to identify cheap growth stocks. Details of the ratio and the other criteria are set out below:

■ A GV ratio among the lowest quarter of stocks screened.

The ratio compares enterprise value (EV) to operating profit (Ebit) with the expected return for shareholders based on forecast earnings growth (Fwd EPS grth) plus dividend yield (DY). EV is calculated as market cap plus net debt. Net debt includes pension deficit and for most companies lease liabilities (reflecting the timing of the introduction of new lease-accounting rules). For those who like a formula, that means the Genuine Value (GV) ratio is:

GV = (EV / Ebit) / (Fwd EPS grth + DY)

■ Three-month share price momentum among the top third of all stocks screened.

■ Above-average forecast EPS growth in each of the next two financial years. The average forecast growth rate must be less than 50 per cent – anything above this level is considered to be very likely to be highly unsustainable.

The simplicity of the screen may well amplify its other potential big problem. This is based on the central role played by enterprise value (EV) in calculating the GV ratio. The idea behind EV is compelling and simple, but calculating EV with any serious accuracy can be fiendishly complex. I think I may have been naive in expecting too much from the simple calculation of EV used by this screen, along with limited supporting screen criteria. 

The point of EV is that it reflects the value of all sources of finance used by a company that have a claim on its earnings and assets. This essentially boils down to market capitalisation plus net debt (or minus net cash). This gives investors a whole company value when trying to assess how cheap or expensive the valuation is. The complexity with calculating EV comes down to deciding on the value of net debt. 

Companies’ year ends are often timed to give the most flattering snapshot of net debt possible, making them misrepresentative for the purposes of an EV calculation. For example, it is not coincidence that most clothing retailers have year-ends that coincide with the end of the January sales; a time when stock levels are low and cash is in the bank. Furthermore, when debt levels are fixed and high, the value of debt reported on the balance sheet may not even be a fair reflection of the cost of repayment; lenders would have to be given financial compensation for giving up the right to further high interest payments. 

And then there is the question of the many debt-like obligations companies have, which should be regarded as debt from a shareholder’s perspective even though they do not strictly fit the definition. Accounting rule changes mean one of these debt-like obligations, rental leases, has recently been given a value on balance sheets. This is helpful. 

Shortfalls on defined-benefit pension schemes are another major debt-like obligations. These can be particularly contentious because a series of estimates and assumptions have to be made in calculating these values. What’s more, market movements of the type we have seen over recent weeks have the potential to see such deficits swiftly rise. So even while the GV ratio used by this screen takes account of deficits as reported on balance sheets, the approach can be seen as rough and ready.

In all, the kind of nuances that need to be accounted for in really good estimates of EV are best conducted at an individual company level and are hard to build into off-the-shelf EV calculations. This means my GV screen using EV has been routinely hoodwinked by companies embodying some of the issues mentioned above, although the fact leases can now be factored in for most companies is a big improvement.

That in mind, six stocks pass the screen's tests this year. I’ve taken a closer look at one of them which has a reasonably promising story as a business somewhat marred by a large pension deficit.

Six Genuine Value stocks

Source: S&P CapitalIQ

STV

Scottish broadcaster STV (STVG) seems an odd stock to be showing some decent momentum (one of the screen’s criteria) relative to a crashing market. It is a company heavily dependent on cyclical advertising revenues. The prospect of advertisers cutting spending sharply in response to coronavirus fears is a major threat. Indeed, the company said earlier this month that while total ad revenue should be up during the first quarter, it expects to see a 5 per cent fall in April. This is better than the 10 per cent April drop forecast by ITV, yet there is clear scope for things to get worse as the country goes into lockdown. Also, the fixed nature of a high proportion of broadcasters’ costs means a slide in sales can be very painfully felt by profits – operational gearing in the jargon.

Nevertheless, the relative resilience of STV shares suggests there are things going for the company. One of those things is that STV is very well watched in Scotland. This includes the hard-to-reach 16-to-34-year-old demographic, over 90 per cent of which tune in to its programmes. This age group also continues to be exposed to just over 60 per cent of on-screen advertising through traditional TV broadcasters, including their playback and online streaming services.   

And last year STV was Scotland’s best watched peaktime channel, beating BBC1 for the first time since 2013. It also produces the country’s most popular news programme – STV News at Six.

Full-year results this month helped inspire confidence in a strategy established by a new management team a few years ago. The company is aiming to counter a weak and erratic outlook for traditional TV advertising by growing regional and digital ad sales. Digital growth has been particularly impressive and was responsible for £2.1m of a £2.5m increase in underlying operating profits in 2019 to £22.6m.

Digital revenues, which mainly come from advertising, are increasing as the company’s video on demand (VoD) STV Player is made available through more platforms. The player has recently been added to Sky and Apple TV. Sky in particular has caused a marked pick-up in revenue, which should be fully felt this year. The service has also benefited from an increase in exclusive content. What’s more, digital sales are extremely profitable, with the division contributing 27 per cent to group operating profit on only 11 per cent of sales. 

Meanwhile, regional advertising growth is helping to counter falling national advertising. Last year the company set up its STV Growth Fund to recruit small business advertisers. As well as helping with campaigns, the fund offers regional advertisers free airtime, double-matched airtime, and airtime sold on revenue-share agreements. The 11 per cent growth in regional advertising in 2019 helped limit the fall in traditional advertising sales to 2 per cent, despite a 4 per cent decline in national advertising. Adding in the contribution from digital, overall ad sales rose 2 per cent. 

And while the group’s production business saw revenue fall 16 per cent to £13.7m last year, and went from making a small profit to a small loss. This reflected a management shake-up, which it is hoped will lead to improved output and growth in the years ahead. Acquisitions have been used to strengthen this side of the business and the division is trying to become more international. That said, the small scale of this business and lumpy nature of commissions means the contributions from the business are likely to be rather erratic unless it can scale up.

All in all, there seems to be a decent self-help story at work. But there are question-marks over the long-term future of traditional broadcast advertising and considerable worries about near-term prospects. Meanwhile, STV has some work to do if it is to convince investors it can produce sustainable sales growth. The chart of the past five years shows the faltering progress.

The company also has a £64m pension deficit, which has been seriously eating into cash flows over recent years. The good news is the deficit was down from £79m at the end of 2018; the bad news is the existential question of whether the current market crash will see the deficit blow out.

Based on the current agreement with trustees, top-up payments rise 2 per cent a year for 11 years to 2028, and extra recovery payments are required if cash flows are strong. Last year top-up payments absorbed £10.3m of cash. Along with buybacks and dividends, the top-up payments have contributed to a steady rise in net debt over the past five years. 

There is also a big disconnect between free cash flow and profit after tax. Unsurprising given reported profits do not include top-up payments. Money owed by the group’s lottery venture has also locked up cash, although the company is looking to divest this operation. In all, the attractive dividend yield, which is comfortably covered by earnings, looks far less secure when compared with free cash flows.

STV is a company that appears to be doing well with what it’s got. However, given the pension deficit and uninspiring outlook for traditional TV advertising, what it’s got is not that alluring, despite the strong position of the STV brand. For these reasons I don’t think the value on offer is as great as it may first seem even with management moving the business in a sensible direction.