Hunting for bargains in the current environment could prove a treacherous business, as well as a potentially profitable one. For many companies that have experienced sharp share price falls, the key question bargain hunters need to ask is whether they are likely to survive the considerable financial strain that will be meted out by the response to the coronavirus.
But one thing’s for sure at the moment, there are a lot of companies trading at valuations that are historically low – for some, as low as they've ever been. This week’s screen is aimed at finding shares that are as cheap as any time since the last financial crisis 12 years ago. Importantly, I’m also using a few well-established screening methods to see which of these cheap companies display characteristics that suggest they are likely to be survivors under severe financial strain.
Valuation is a slippery concept at a time like this. The go-to valuation measures that are most familiar to investors tend to be based on earnings. While the long-term economic repercussions of the coronavirus may still be hard to gauge, it’s odds-on that the near-term impact on the earnings of many companies will be frightful.
This means, in the main, that valuations based on historical earnings are now extremely unreliable. Indeed, for many companies, what’s being seen in the rear-view mirror may well represent the peak of the cycle at a time when earnings are rapidly heading south. The same is true of earnings forecasts, which can also be expected to spend some time playing catch-up to recent events.
So rather than look to earnings, this screen looks to see how cheap companies look against some of their more stable fundamentals: sales and book value, also known as net asset value (NAV). While sales and book value (BV) will undoubtedly be hit at many companies, they provide a more reliable indicator of what is on offer. These measures also ignore the yo-yo nature of the profit margins of many companies and instead focus on the source of companies’ earnings over the cycle.
Specifically the screen is looking for stocks that are close to being as cheap as they have ever been in the past 12 years. For stocks without a 12-year track record a minimum of six years is used. From a stats perspective, 'cheap as ever' is taken to be two standard deviations below the long-term average, which suggests a valuation that is in the bottom 2.5 per cent of the range. The valuation measure used is either enterprise value (EV)/sales or price/tangible BV (TangBV). For most companies the valuation measure used is EV/sales with P/TangBV only used for asset-centric businesses, such as property companies and financials. I term this measure of cheapness a ZEUS, which is the column title used in the tables below (my root to this cheesy acronym is too nerdily tangential to burden readers with here).
One noteworthy weakness of this method of assessing value is that over such a long period many companies can see their long-term prospects deteriorate substantially. This means a low valuation relative to the past can represent long-term troubles that are likely to persist rather than short-term troubles a company may be able to bounce back from.
We’ve yet to see selling get indiscriminate enough to lay many really high-quality stocks very low, although at the time of writing there are signs this may be starting. This means many of the very cheap stocks identified look vulnerable based either on the immediate outlook, a longer-term deterioration, their balance sheets, or all of these factors. This screen uses three key tests to try to highlight potential value traps. Indeed, there will inevitably be many value traps highlighted in the lists below. It should be noted that none of these tests are any good for financial companies. Meanwhile, only the net debt test is of any serious use for real estate, but it sets too high a bar for this sector.
Watching for traps
The first screen test is for stocks to have an F-Score of 7 or more out of 9. The F-Score is a system developed by accounting professor Joseph Piotroski in 2000 to judge whether companies are making self-financed operational improvements. It is particularly focused on trying to identify promising recovery plays.
There is a major caveat with using the F-Score at the moment, though. This is because it is based on historical fundamentals. As already mentioned, for many companies, and especially those that have de-rated significantly, the near future is unlikely to look similar to the near past. Still, a high F-Score may help highlight relatively healthy businesses. And it is better to be looking at businesses that were moving in a positive direction pre-crisis than those that were showing signs of struggle even before the crisis hit.
The second indicator of resilience that this screen looks at is based on the Altman Z-Score. The Altman Z-Score assesses the risk of bankruptcy. It puts different weightings on five different financial ratios that test balance sheet strength and profitability. The maths and the theory boil down to a score that is considered to suggest high bankruptcy risk at 1.8 or below and low risk at 3 or above. This screen looks for an Altman Z-Score of 2.4 or above (half way between the 1.8 and 3 mark).
The third cautionary test used by the screen looks at debt. There is no one-size-fits-all rule when it comes to debt, but given excessive borrowing is almost always a key ingredient in financial calamity, this is something value hunters need to be wary of. The screen looks for companies where net debt, including lease liabilities and any pension deficit, is less than half the company’s market capitalisation. A fairly basic and crude test, but one that has a value for most companies.
An additional element to the debt test is that I require companies not to have a defined-benefit pension deficit. The reason for this is that the unprecedentedly low interest rates we now see have the potential to inflate pension scheme liabilities by reducing the so-called discount rate used to calculate the cost of future payouts to pensioners. Furthermore, the crash in equity values and corporate bond squeeze could have a serious negative impact on the assets of many schemes.
Sadly, one would expect the length of the bull market to have encouraged many schemes to increase exposure to riskier assets such as equities. That said, there has also been a pick-up in liability-matching, which could protect the pension funds of some companies. However, for the purposes of a simple screen, I think it’s best to simply give companies with deficits a thumbs down.
As cheap as they have ever been
There are only two companies that are extremely 'cheap' and pass all of the screen’s other tests (IMI and InterContinental Hotels). The tables below show all the shares identified as being very cheap and details what tests they do and don’t pass. There are separate tables for real estate companies and financials, as these have been screened on a much looser criteria for the reasons mentioned above. Given current market volatility I’ve run this screen as close as possible to publication, but share prices may still have altered substantially by the time the screen is published.
I’m highlighting two businesses from the list that have caught my eye. These are all companies that face significant challenges as a result of the coronavirus and could ultimately be affected by permanent changes to consumer behaviour. But what I find interesting about them is that in happier times they are companies I would have considered to have something a bit special.
|Name||TIDM||Sector||Price||Mkt Cap||ZEUS||EV/Sales||F-Score||Altman Z-Score||Net Debt/Mkt Cap||1wk Price Fall||2wk Price Fall||1mth Price Fall||3mth Price Fall||Test failed|
|InterContinental Hotels Group||IHG||Consumer Discretionary||2754p||£4,976m||-2.0||2.7||7||3.0||0.4||-12%||-31%||-48%||-50%|
|Carnival Corporation &||CCL||Consumer Discretionary||886p||£7,964m||-4.7||0.9||7||2.4||1.3||-29%||-52%||-74%||-78%||Debt|
|Fuller, Smith & Turner P.L.C.||FSTA||Consumer Discretionary||660p||£361m||-2.8||1.4||6||2.9||0.4||-5%||-10%||-28%||-32%||F Score|
|Keller Group||KLR||Industrials||446p||£321m||-2.3||0.3||5||2.6||1.0||-26%||-41%||-48%||-43%||F Score|
|Lookers||LOOK||Consumer Discretionary||11p||£43m||-2.1||0.0||5||2.8||6.3||-32%||-64%||-76%||-78%||F Score|
|Marston's||MARS||Consumer Discretionary||28p||£179m||-3.4||1.5||4||0.7||9.3||-10%||-67%||-75%||-79%||F Score,Altman,|
|Mitchells & Butlers||MAB||Consumer Discretionary||121p||£517m||-3.2||1.1||6||1.1||4.0||-22%||-58%||-71%||-74%||F Score,Altman,|
|De La Rue||DLAR||Industrials||50p||£52m||-2.5||0.5||2||1.6||4.3||-33%||-57%||-57%||-63%||F Score,Altman,|
|Mitie Group||MTO||Industrials||86p||£311m||-2.5||0.2||6||2.5||1.1||-14%||-40%||-40%||-44%||F Score,Debt|
|Robert Walters||RWA||Industrials||260p||£187m||-2.4||0.1||5||5.1||-0.1||-34%||-43%||-56%||-55%||F Score,Debt|
|Topps Tiles||TPT||Consumer Discretionary||30p||£58m||-2.2||0.3||5||3.4||0.2||3%||-36%||-65%||-60%||F Score,Debt|
|Devro||DVO||Consumer Staples||131p||£219m||-2.2||1.4||5||1.9||0.9||-4%||-12%||-21%||-25%||F Score,Altman,|
|The Restaurant Group||RTN||Consumer Discretionary||24p||£116m||-2.2||0.4||8||1.8||2.5||-11%||-72%||-82%||-85%||Altman,Debt|
|Morgan Advanced Materials||MGAM||Industrials||209p||£595m||-2.1||0.8||4||2.4||0.6||-16%||-24%||-36%||-40%||F Score,Altman,|
|Dignity||DTY||Consumer Discretionary||330p||£165m||-2.0||1.9||4||0.1||3.2||2%||-39%||-42%||-46%||F Score,Altman,|
|RPS Group||RPS||Industrials||47p||£103m||-3.1||0.4||5||2.4||1.4||-38%||-58%||-68%||-73%||F Score,Altman,Debt|
|Hyve Group||HYVE||Communication Services||23p||£183m||-3.1||1.4||5||1.5||0.6||-27%||-54%||-75%||-78%||F Score,Altman,Debt|
|Rolls-Royce Holdings||RR.||Industrials||359p||£6,918m||-2.9||0.5||5||0.5||0.4||-24%||-43%||-50%||-54%||F Score,Altman,Debt|
|William Hill||WMH||Consumer Discretionary||40p||£348m||-2.5||0.6||4||1.1||1.7||-44%||-71%||-81%||-80%||F Score,Altman,Debt|
|The Weir Group||WEIR||Industrials||742p||£1,922m||-2.5||1.2||5||2.2||0.7||-14%||-37%||-48%||-55%||F Score,Altman,Debt|
|WPP||WPP||Communication Services||492p||£5,958m||-2.3||0.8||6||1.3||0.7||-4%||-29%||-50%||-55%||F Score,Altman,Debt|
|Stock Spirits Group||STCK||Consumer Staples||160p||£318m||-2.0||1.3||6||2.3||0.1||11%||-15%||-32%||-28%||F Score,Altman,Debt|
|Name||TIDM||Price||Mkt Cap||ZEUS||P/TangNAV||NetDebt/Mkt Cap||1wk Price Fall||2wk Price Fall||1mth Price Fall||3mth Price Fall|
|BMO Commercial Property Trust||BCPT||44p||£348m||-6.8||0.32||0.8||-40%||-50%||-58%||-61%|
|Target Healthcare REIT||THRL||96p||£437m||-5.5||0.89||0.2||-9%||-25%||-30%||-26%|
|UK Commercial Property REIT Limited||UKCM||55p||£713m||-5.3||0.59||0.3||-14%||-28%||-37%||-36%|
|BMO Real Estate Investments Limited||BREI||44p||£106m||-5.0||0.42||0.8||-29%||-38%||-46%||-47%|
|Standard Life Investments Property Income Trust Limited||SLI||60p||£244m||-4.7||0.66||0.5||-20%||-31%||-39%||-35%|
|Raven Property Group Limited||RAV||31p||£153m||-3.2||0.42||6.3||-10%||-25%||-36%||-38%|
|U and I Group||UAI||93p||£116m||-3.1||0.33||1.2||-30%||-44%||-53%||-51%|
|Capital & Regional||CAL||77p||£80m||-2.8||0.21||4.8||-8%||-58%||-60%||-69%|
|Schroder Real Estate Investment Trust Limited||SREI||37p||£190m||-2.7||0.54||0.6||-14%||-25%||-33%||-34%|
|Town Centre Securities||TOWN||137p||£73m||-2.6||0.41||2.5||-22%||-32%||-43%||-41%|
|British Land Company||BLND||361p||£3,345m||-2.5||0.43||1.0||-6%||-20%||-36%||-43%|
|Land Securities Group||LAND||612p||£4,530m||-2.4||0.47||0.8||-9%||-22%||-39%||-39%|
|Capital & Counties Properties||CAPC||143p||£1,216m||-2.2||0.49||0.3||-16%||-26%||-43%||-45%|
|Name||TIDM||Price||Mkt Cap||ZEUS||P/TangNAV||1wk Price Fall||2wk Price Fall||1mth Price Fall||3mth Price Fall|
|RSA Insurance Group||RSA||354p||£3,660m||-3.0||1.14||-16%||-29%||-41%||-41%|
|Close Brothers Group||CBG||941p||£1,403m||-2.5||1.17||-11%||-19%||-36%||-43%|
|Standard Life Aberdeen||SLA||189p||£4,300m||-2.5||0.88||-8%||-24%||-44%||-45%|
|The Royal Bank of Scotland Group||RBS||114p||£13,744m||-2.2||0.37||-13%||-22%||-46%||-54%|
|Legal & General Group||LGEN||157p||£9,320m||-2.1||1.00||-16%||-33%||-54%||-53%|
Source: S&P CapitalIQ
Intercontinental Hotels (IHG) serves an industry that is being incredibly badly hit by the coronavirus. The hotel business is cyclical and the financial pain felt by hotel companies is made all the more severe by owning large, expensive-to-run assets. On this latter point, Intercontinental has reduced risk over many years by selling off its hotels in favour of generating revenue from providing its brands and services to the owners of the bricks and mortar. This is a great business model, but it can go only so far in protecting shareholder returns.
Demand has fallen off a cliff, with management expecting revenue per available room to be down about 60 per cent in March. A little encouragement can be taken from signs of a recovery in demand in China. Plans to build new hotels will also be put on hold, significantly denting growth prospects. Meanwhile, having been forced to change travel habits, there is a question over whether businesses and individuals may reassess their need to travel in the future, including hotel stays.
Crystal-ball-gazing aside, these are now hugely trying times for the company. The company’s bosses have cut their own pay as part of a $150m cost-saving drive, while capital expenditure is being cut by $100m and another $150m is being retained by pulling the final dividend payment. Some reassurance can be taken from the group’s debt maturity profile, with the next major repayment not due until 2022, and the company has access to significant funding facilities. So through all the causes of anxiety, it is worth remembering that in normal times there are many things to like about Intercontinental, which means the extreme valuation lows, while understandable, are also interesting.
Fuller Smith & Turner
London-focused pub group Fuller, Smith & Turner (FSTA) comes into this crisis after a turbulent year. Having sold its brewing business to Ashanti for a great price, arrangements for cost sharing during the transfer of the business led to a profit warning. Now the company faces the prospect of shuttered pubs.
This is a horrible situation for the company to be in. But for investors the attraction of the company has always been that it owns some of the best pubs in the UK in the most affluent parts of the country. The fact that nearly 90 per cent of its pubs are freehold means rent is less of a concern. Across the leisure sector tenants are calling for a six-month rent moratorium, but Fuller has already said its tenanted pub operators will not be expected to pay it rent for the time being. The government’s unprecedented action to pay 80 per cent of wages should also be another major help.
The sale of the beer business also means the balance sheet has been shored up. At the end of September net debt stood at £23m (or £119m including lease liabilities) compared with £245m six months earlier. While there could well be a drawn-out recession ahead, which would not be good for demand when pubs do reopen, Fuller is a company with tangible assets that should prove capable of earning good returns once again at some point.