I’ve a feeling there is a challenging period ahead for my screens that search for growth at a reasonable price, as well as those hunting down stocks with positive price momentum. This is because the lockdowns across the globe caused by Coronavirus mean both growth and momentum are currently in very short supply. This week’s screen, which attempts to mimic the approach of famed Fidelity manager Peter Lynch, is a case in point.
While finding shares that fit the screen’s criteria may be a challenge, the market reset could prove to have some longer-term advantages. For a number of years, I’ve expressed some exasperation that my Lynch screen has had a tendency to highlight many cyclical companies – companies with profits that are sensitive to the economic cycle. These are not the kind of steady-and-boring growth stalwarts Mr Lynch was famous for backing.
The problem for the screen, in my view, has been that the long bull market and economic recovery has made cyclicals look like solid growth plays based on a glib look at the numbers – screens tend to be glib by nature. This is simply because when economic conditions are improving, cyclical companies tend to be able to grow profits. This is particularly true of companies with high fixed costs, as a large proportion of any increase in sales shows up as profits. In financial jargon, this is known as a company having high operational gearing. When sales go into reverse things get painful, fast.
Lockdown and recession should help flush out cyclicals from the screen’s stock picks. Unfortunately, so great is the economic shock from lockdowns that a lot of companies that have relatively robust longer-term growth prospects are also likely to be flushed out.
In order to address this great flush-out, I’m tweaking my Lynch screen’s criteria. Specifically, this year I’ve decided to lower the forecast growth test used by the screen. Rather than looking for shares expected to grow earnings on average by 10 to 20 per cent a year over the next two financial years, I’ve widened the range to zero to 20 per cent. A word of warning here: forecasts are always to be treated with a pinch of salt, but at the moment investors should be particularly wary given the havoc being cause by the coronavirus crisis. Still, in this column the show must go on. Here’s the screen’s full criteria:
■ A dividend-adjusted PEG ratio of less than one.
Dividend-adjusted PEG = price/earnings (PE) ratio/average forecast EPS growth for the next two financial years + historic dividend yield (DY).
■ Average forecast earnings growth over the next two financial years of between zero and 20 per cent as long as forecast growth in each of the next two financial years is positive, but below 30 per cent – attractive, but not suspiciously high growth.
■ Gearing of less than 75 per cent. Or in the case of financial companies, equity to assets of 5 per cent or more, and a return on assets of more than 1 per cent.
■ Three years of positive earnings.
■ Turnover of over £250m.
Over the years the results from this screen have been extremely erratic. The performance of last year’s screen picks suggests my frustrations about the cyclical nature of the selection has some foundations.
Last year's performance
|FTSE All Share||-||-17%|
|source: Thomson Datastream|
Over the recent weeks in lockdown, I have not been able to access performance data to update the long-term numbers for my screens, but the good people at Refinitiv have found a way to allow me to access the data now.
Since I began running the Lynch screen in 2012 the cumulative total return stands at 59 per cent compared with 46 per cent from the FTSE All-Share. However, this does not consider real-world costs. While the screens run in this column are considered as a source of ideas for further research rather than off-the-shelf portfolios, if I add in a charge of 1.5 per cent a year to represent dealing costs, the total return falls to 41 per cent. That is pretty feeble, really, given it is less than the index. It also is certainly poor compared with Mr Lynch’s track record.
Two shares pass all the screen’s tests. These appear at the top of the table below, with the rest of the results ordered from lowest to highest dividend-adjusted PEG. The other shares in the table have passed the valuation and forecast growth test, but failed one of the others. The forecasts associated with the smaller companies in this list should be viewed with significant skepticism as brokers can be very slow to update their forecasts for tiddlers and some have withdrawn guidance due to the uncertainties associated with the current crisis. I’ve also taken a look at a share that surprised me in passing the screen’s full criteria: Wincanton.
|Name||TIDM||Sector||Mkt cap||p||Fwd NTM PE||DY||PE/TR||Fwd EPS grth FY+1||Fwd EPS grth FY+2||3-mth momentum||3M Fwd EPS change||Net cash/debt (-)||Test failed|
|British American Tobacco||BATS||Consumer Staples||£66,134m||2,893p||9||7.0%||0.9||3.9%||7.0%||-14%||-1.3%||-£43bn||none|
|Sirius Real Estate||SRE||Real Estate||£713m||69p||15||4.5%||0.4||8.3%||12%||-25%||0.2%||-€278m||turnover|
|Impact Healthcare REIT||IHR||Real Estate||£308m||97p||18||6.4%||0.6||7.8%||12%||-12%||1.9%||£24m||turnover|
|source: S&P CapitalIQ|
The UK’s largest third-party logistics company, Wincanton (WIN), is so far looking surprisingly resilient in the face of Covid-19. Some of the reasons for surprise include: the company’s high costs relative to sales (low margins), its asset-intensive operations (warehouses and lorries), its historically stretched balance sheet, its shares' terrible performance during the last recession, and the cyclical nature of many of its customers’ businesses.
A late March trading update countered many of the prejudices investors may harbour against the company and its shares. Firstly, the nature of the current crisis means increased demand from some sectors, such as grocery, has offset weakness in other areas, such as general merchandise. How long this can continue is open to debate, but it is encouraging the company has so far proved adept at shifting underemployed resources to areas where they are needed.
Comfort can also be taken from the fact that 64 per cent of contracts are so-called 'open book', including 80 per cent in retail. An open-book contract involves a customer paying for the costs incurred in providing an agreed service plus a margin. This type of agreement transfers much of the risk of volume volatility from Wincanton to the customer.
Likewise, most of the warehouses Wincanton operates are customer owned or customer dedicated, with costs passed straight on. And the three warehouses it operates on a shared basis are currently busy. There’s added security, too, from the fact that most of the company's large contracts are billed in advance.
There is also more flexibility in the cost base than one might assume. In order to be able to quickly respond to changes in demand, a proportion of the fleet is made up of short-term hire vehicles, while the company also uses subcontractors and agencies.
The pleasant surprises don’t end here. Indeed, the most significant difference between Wincanton entering the current crisis and the company during the credit crunch is that a huge effort has gone into repairing the balance sheet, including its once substantial pension deficit. At the time of the credit crunch, the company had spent spent 10 years building up debt as it made acquisitions; many of which were later massively written down in value and sold off.
Things are different now. When Wincanton publishes results for its year to the end of March, net debt is expected to be between £10m and £15m. That compares with £176m at the peak in 2009. Meanwhile, interest cover stands at about 15 times, the company is well inside its loan covenants and agreed borrowing facilities stand at nearly £190m (including overdraft and an accordion facility) compared with £54m total debt at the half-year stage.
Years of big cash payments into the defined-benefit pension finally pushed the mammoth scheme into an £8m surplus at the half-year stage. This compares with a funding shortfall of £172m 10 years ago. Importantly, too, the scheme’s massive £1.26bn liability is fully hedged against the impact of falling interest rates – falling interest rates push up pension liabilities because of changing assumptions about the future value of cash.
Don't get carried away
While there are several reasons to feel relatively positive about Wincanton’s resilience in the wake of the coronavirus crisis, the company is still no safe haven.
Already there are signs that demand for groceries has started to get back to more normal levels and customers from hard-hit sectors could feel the pain of lockdown for some time to come. That means there is the potential for the forecast earnings growth this screen monitors to be downgraded as the picture becomes clearer.
Cash flow is likely to suffer any serious downturn in trading more acutely than reported profit due to the company's 'negative working capital' – Wincanton tends to get paid by its customers earlier than it has to pay money out. Last year, its negative working capital (creditors less debtors and inventory) was more than twice its operating profit.
And while much work has been done to 'de-risk' the pension scheme, the amounts involved are so massive that it wouldn’t take a big negative movement to have a major adverse impact on Wincanton’s balance sheet. What’s more, the size of the scheme means despite the improvement in its funding, the company remains scheduled to make inflation-linked top-up payments of £24.3m a year out until 31 March 2027.
Wincanton also has substantial lease commitments, with an associated liability at the half-year stage of £124m, which is in addition to its net debt.
Scope to improve perceptions
Nevertheless, Wincanton has emerged from the early stages of the current crisis looking like a company that is well aware of its vulnerabilities and which has taken many sensible actions to address them. What’s more, while things definitely could change, so far demand appears to have held up well overall. In fact, the underlying, core business showed signs of being relatively resilient during the last recession. The company has even said it is still considering paying dividends.
Wincanton’s shares tend to trade at a low valuation because investors perceive the business to have inherent weaknesses and historically the balance sheet has added to concerns. While the shares are never likely to command a premium rating, there is the chance that a robust performance during the current crisis will prompt a reassessment of the investment case and an improvement in the valuation. Further down the line, and more speculatively, the need for companies to invest in more secure supply chains and hold higher levels of inventory could improve growth prospects.