For a second year I find myself tempted to praise my deep-value, David Dreman-inspired screen for not producing quite as ghastly a result as I’d expected it to. Yes, the screen has underperformed the market over 12 months, and yes, the sell-off when it came was unforgiving. But the achievement, if one can call it that, is that the underperformance has not been as cataclysmic as many other value-focused strategies over the last 12 months.
Before going further, I should apologise to any regular readers of this column that are fed up with the seeming fixation on the topic of 'value' investing over the last three weeks. This has not been by design, and the next screen I will be updating – following a break for a week’s holiday – will focus on momentum; so, an escape from value’s clutches is imminent.
But for this week, it’s the approach of famed US contrarian David Dreman that falls due for an update. Mr Dreman was a fan of stocks that looked very cheap based on classic valuation ratios. The key reason for his enthusiasm essentially boils down to a belief that share prices tend to overshoot on the downside. Recently, though, many cheap shares have either stayed cheap or turned out to be value traps. The Covid-19 crisis has been especially cruel to 'value'. That is the context in which the Dreman screen’s modest underperformance over 12 months is arguably not too bad.
|Name||TIDM||Total return (6 Jun 2019 - 22 May 2020)|
|Legal & General||LGEN||-20%|
|Royal Dutch Shell||RDSB||-46%|
Source: Thomson Datastream
The recent torrid showing from value is not a one off. It continues a trend that set in around the time of the credit crunch. It should therefore not come as too much of a surprise that the longer-term record of the Dreman screen is hardly inspiring. Since I began running it seven years ago it has racked up a cumulative total return of 29 per cent compared with 27 per cent from the FTSE All-Share. While the screens run in this column are intended as a source of ideas for further research rather than off-the-shelf portfolios, if I try to inject a sense of reality into the performance number by factoring in a 1.5 per cent annual charge to represent notional dealing costs, the return drops below that of the index to 16 per cent.
The screen criteria are:
■ Shares must be among the cheapest quarter of FTSE All-Share constituents based on one or more of: dividend yield (DY); price/earnings (PE); forward next-12-month PE (forward NTM PE); price-to-cash-flow (PCF); or price-to-book-value (P/BV). The screen's other criteria differ slightly based on which valuation measure a share qualifies on.
■ Year-on-year EPS growth in the most recent half year.
■ Forecast EPS growth for each of the next two financial years.
■ A current ratio of more than 1.
■ Above-average dividend yield (excluding cheap P/BV stocks).
■ Dividend cover of 1.5 times or more, or greater than the five-year average (excluding cheap P/BV stocks).
■ Above-average five-year dividend compound annual growth (excluding cheap P/BV stocks).
■ Gearing of less than 75 per cent or net debt/cash profit of less than 2.5 times.
■ Market capitalisation of £200m or more.
No stocks passed all the screen tests and a key reason is that earnings forecasts have been slashed as a result of lockdown. So to make the screen produce any results I’ve had to can the forecast EPS growth test. That’s a major bit of tinkering and gives grounds to treat the screen results with caution over and above the grounds given by the poor performance in the years to date. I’ve taken a look at one of the stocks on the list that has a rating that suggests it may be a value opportunity rather than a value trap.
Eight deep value shares
|Cheap||Name||TIDM||Mkt Cap||Price||Fwd NTM PE||DY||P/BV||P/CF||Div Cover||FY EPS gr+1||FY EPS gr+2||3mth Fwd EPS chg||3-mth Momentum||Net Cash/Debt (-)||CapIQ DY|
|/ PBV /||Mediclinic International plc||LSE:MDC||£2.0bn||269p||11||2.9%||0.6||4.5||2.14||-6.2%||0.3%||-6.4%||-31%||-£2.5bn||2.9%|
|/ PE /||Taylor Wimpey plc||LSE:TW.||£4.5bn||138p||10||2.8%||1.4||8.9||2.70||-30%||15%||-32%||-40%||£518m||-|
|/ Fwd PE /||C&C Group plc||LSE:CCR||£580m||188p||9||7.4%||1.1||5.7||2.30||-||-||-19%||-50%||-€344m||-|
|/ PE / Fwd PE /||Barratt Developments PLC||LSE:BDEV||£4.9bn||484p||9||4.0%||1.0||12||2.55||-27%||6.0%||-27%||-44%||£375m||-|
|/ DY / PE / Fwd PE /||Babcock International Group PLC||LSE:BAB||£2.0bn||390p||6||7.7%||0.7||6.5||1.78||-18%||-7.8%||-5.7%||-22%||-£2.0bn||7.7%|
|/ PBV /||Aviva plc||LSE:AV.||£9.4bn||239p||5||4.0%||0.5||1.6||2.05||-14%||7.9%||-7.8%||-41%||£10bn||-|
|/ PBV /||Just Group plc||LSE:JUST||£530m||51p||3||-||0.2||1.9||17.8||-12%||-1.7%||22%||-38%||£948m||-|
|/ PBV /||BHP Group||LSE:BHP||£163bn||1,560p||-||6.9%||0.0||9.1||1.39||-0.5%||-20%||-8.9%||-6.1%||-$13bn||-|
Source: S&P Capital IQ
C&C (CCR) makes cider and brews beer under its own brands, such as Magners and Tennants, as well as for third parties. It also has a large business marketing and distributing its brands and those of other drinks companies. The wholesale distribution business got a substantial boost just over two years becoming the UK leader in the hospitality sector following the acquisition of Matthew Clark Bibendum. It paid a nominal £1 for the business and took on its £102m of debt following the collapse of its previous owner, Conviviality.
The coronavirus lockdown represents a truly massive blow to C&C because about 85 per cent of its sales are to so-called 'on-trade' customers – pubs and restaurants. Lockdown means much of this demand has almost vanished and many of C&C’s customers are small independent operators, which may prove less resilient to the corona hit. On-trade business is also more profitable for C&C than 'off-trade' – off licences, supermarkets and convenience stores.
C&C’s shares are down almost 60 per cent from where they were at the start of the year. Consensus broker forecasts have been downgraded by about 40 per cent over the same period. The key question now is whether C&C can make it through lockdown, what kind of business will emerge on the other side, and are the shares cheap?
Prior to lockdown, C&C had the best part of two years to reduce borrowings from the acquisition of Matthew Clark Bibendum and net debt at the end of August was €255m (£227m). To protect the business, the company has furloughed staff, cut wages, pulled the dividend and reined in non-essential investment. It is also doing what it can to boost off-trade business.
Broker Numis has modelled several scenarios for the company, ranging from a three-month lock down to 12 months. The broker’s best outcome is that net debt makes a modest rise to €275m at the end of the current financial year on 28 February 2021. It views a more likely scenario as a six-month lockdown leading to net debt of €298m. Its worst case leaves C&C with net debt of €464m.
Following a €140m bond issue in March, C&C had liquidity of €570m at the end of last month, which includes €430m cash after it drew down certain credit lines. The company could need a temporary waiver on borrowing terms that require net debt to represent no more than 3.75 times cash profits (Ebitda). However, the liquidity means the group looks pretty well placed to make it through the lockdown hiatus.
That said, there are balance sheet risks that don’t show up in the net debt figures. At the half-year stage, the group was using €160m of financing linked to money owed to it by customers. This is not recognised on the balance sheet because the financing arrangement means C&C transfers all the risks associated with receiving payment. However, given the strain its customers are under, this significant source of cash could become more expensive and harder to access.
C&C also has deals with some customers whereby it provides loans for expansion or refurbishments in exchange for them agreeing to stock its brands. At the half-year stage these advances to customers stood at €48.5m. Covid-19 means there could be a marked increase in bad debts. The group also has a small pension deficit, but the scheme itself is not massive with liabilities of €189m, according to the last annual report.
All about brands
As for C&C’s actual business, the purchase of Matthew Clark Bibendum marked a major strategic move. Firstly, there is the potential to improve profits from the business following neglect by its previous owner. Margins rose to 2 per cent in the first half, from 1.6 per cent the previous year, and the group is targeting a 3 per cent margin. However, more significant is the hope it can use its increased distribution muscle to boost its much-higher-margin branded drink sales. Despite only accounting for about a fifth of net revenues, branded drinks represent about two-thirds of profits.
While there was impressive organic growth from brands in the 2019 financial year, this significantly benefited from the World Cup, warm weather, and the introduction of minimum pricing in Scotland. The longer-term picture is much less rosy , with the group’s drinks brands struggling to fend off competition and the headwind of reduced consumption of alcohol by the younger demographic C&C’s drinks have traditionally appealed to.
The group believes owning a powerful distribution arm will give its brands far better market access and thereby drive growth, and first-half results provided some signs the business may be benefiting. However, there are also reasons to be skeptical about the potential for better distribution to ignite sustained growth. C&C already has significant wholesale businesses in Ireland and Scotland, which have not appeared to have been very effective at driving growth over recent years. Meanwhile, the man who forged the strategy, Stephen Glancey, retired unexpectedly in February, and the top job remains unfilled.
For those with long memories, another sobering thought will be the group’s disastrous $305m (£247m) acquisition of the largest cider maker in the US, Vermont, in 2012 and the eventual $129m impairment in 2017. Still, behind the havoc reaped by lockdown, there is the possibility a promising strategy could be taking hold.
Is it cheap?
So, what does all this mean the group is worth? One way to consider the question is based on C&C’s earning power value based on pre-crisis earnings (this valuation method is explained by Phil Oakley here). The idea of doing this is to assume earnings can get back to pre-crisis levels, but do not go any further.
To calculate what value this level of earnings would imply for the group as a whole I am assuming that cost of capital is 10 per cent. Based on 2019 earnings, this puts an enterprise value (EV) of £927m on the group. Using Numis’s net debt forecasts, that value compares with an EV (market capitalisation plus net debt, plus receivables financing, plus last reported lease liabilities of €88m) of £1.0bn based on the broker’s base case for February 2021 and £1.2bn based on its worst case.
Given the lack of leadership, the vulnerability of the customer base, the historical difficulties growing brand sales, low margins on distribution, and the added balance sheet risks from customer loans and invoice financing, I’m not convinced the shares are that cheap. While C&C looks like it should be a survivor and good news certainly could trigger a sharp share price rise, there is too much risk. Half-year results are due on 3 June, which should shed more light on how the group and its customers are bearing up.