Join our community of smart investors

8 big reliable stocks for unreliable markets

The novel nature of the Covid-induced recession presents challenges for my Big Reliable stock screen
July 14, 2020

Giving a stock screen the name 'Big Reliables' is asking for trouble when a crisis strikes. Happily, though, my Big Reliables stock screen has done some credit to its hyperbole with a useful outperformance of the FTSE All-Share index over the past 12 months, even if both index and screen delivered a negative total return. 

But the bigger challenge to the screen than retaining its 'brand integrity' is how to find stocks that fit the bill when the earnings outlook for so many companies has been laid waste by the coronavirus crisis. 

Stock screens tend to sacrifice nuance for process. While the focus on process is the key strength for screens, at times the lack of nuance can be telling. The Big Reliables screen in the current crisis is a good case in point.

The screen’s specific problem is that it looks for forecast earnings growth in each of the next two financial years. This consistency is sought to highlight companies with good reliable businesses. The problem at the moment is that many businesses that are good and reliable will see profits fall over the next 12 months as a result of a very unusual reduction in demand. In some cases the impact of this external event is a reflection of the cyclical nature of a company’s operations. However, for other companies it tells us less about their 'reliability' in more typical recessionary environments. 

Only three stocks pass the screen's tests on the old criteria, which is rather paltry. I’ve therefore made an amendment that gets the screen’s output to eight shares. The change I have made is to allow stocks that fail the five-year EPS growth test if they have experienced a forecast upgrade of 10 per cent or more in the past three months. This can be regarded as exchanging real resilience for Covid resilience.

The criteria and the amendment are:

■ EPS growth in each of the past five years… or a 10 per cent upgrade to forecast EPS over the past three months.

■ Return on equity of 12 per cent or more in each of the past five years.

■ Forecast earnings growth in the current financial year and the year after.

■ Gearing of less than 50 per cent, or net debt of less than two times cash profit.

■ Cash conversion (cash from operations as a proportion of operating profit) of 90 per cent or more.

The focus this screen puts on quality and growth has chimed well with wider market trends over recent years and the cumulative return since I started to monitor this screen continues to look good standing at 116 per cent compared with 53 per cent from the FTSE All-Share. While the screens run in this column are meant as a source of ideas for further research rather than off-the-shelf portfolios, if I take the step of adding in some real world costs with a notional annual dealing charge of 1 per cent, the screen’s total return falls to 97 per cent.

 

12-month Big Reliables performance

NameTIDMTotal return (1 Jul 2019 - 8 Jul 2020)
HomeserveHSV12%
JD Sport FashionJD.10%
DCCDCC-1.4%
MarshallsMSLH-9.3%
Moneysupermarket.comMONY-21%
CompassCPG-40%
FTSE All Share--14%
Big Reliables--8.3%

 

Details of all the stocks are included in the table below, with the three stocks passing on the old criteria listed at the top of the table. A glossary of terms is also now included in the downloadable excel version of the table. I’ve also taken a closer look at one of the stocks passing the old criteria below.

 

EIGHT BIG RELIABLE SHARES

NameTIDMIndustryMkt CapPriceFwd PE (NTM)Fwd DY (NTM)DYPEGFCF Conv.EBIT MarginROCEFwd EPS grth FY+1Fwd EPS grth FY+23-mth Mom3-mth Fwd EPS change%12-mth Fwd EPS change%Net Cash / Debt(-)*
Halma plcHLMAElectronic Equipment/Instruments£8,652m2,279p400.8%0.9%7.8109%18.1%18.6%6.1%0.1%15.7%-1.6%-2.5%£310m
Hilton Food Group plcHFGFood: Meat/Fish/Dairy£983m1,200p232.1%2.0%4.9-108%2.7%11.5%6.1%15.2%10.3%-2.8%11.1%£271m
HomeServe plcHSVMiscellaneous Commercial Services£4,388m1,306p302.0%2.2%12.8162%14.9%14.9%2.9%14.7%13.5%2.6%3.4%£509m
B&M European Value Retail SABMEDepartment Stores£4,337m433p162.3%3.0%0.7131%9.9%16.0%41.3%0.5%44.4%36.0%29.7%£1,640m
Flutter Entertainment PlcFLTRCasinos/Gaming£16,383m10,595p250.5%2.2%2.6293%7.9%3.8%20.8%37.0%35.2%98.1%19.6%£244m
888 Holdings Plc888Casinos/Gaming£693m188p152.8%3.0%1.9156%9.7%29.5%10.6%4.5%41.1%10.8%1.8%-£35m
Fresnillo PLCFRESPrecious Metals£6,927m940p301.6%1.8%6.7-78%8.0%4.5%7.9%61.9%31.6%10.9%-30.1%£360m
Cranswick plcCWKFood: Meat/Fish/Dairy£1,909m3,650p211.7%1.7%3.38%6.1%16.6%7.3%5.1%0.7%10.2%25.3%£43m

Source: FactSet

 

Hilton Food

A quick glance at Hilton Food’s (HFG) paltry margins may make it puzzling to see it included in a screen looking for reliable companies. Wafer-thin margins are usually a sign of a weak business that is struggling to make money. However, as suggested by the healthy valuation that Hilton’s shares command, there is more to like here than may first seem the case.

Hilton is a meat and fish packaging company that operates in seven European countries and Australia. The low-margin nature of its business is explained by the fact that many of its multi-year contracts operate on a 'cost plus' or 'packaging rate' basis. What this means is that much of its turnover is based on the cost of the meat it sources and processes, which is a cost that is passed straight on to its customers – big supermarkets. Stripping out these raw material costs shows the packaging operation makes good money; an operating margin of nearly 12 per cent last year if the cost of raw materials is ignored.

Looking past these costs casts another aspect of Hilton’s business in a different light – its capital requirements look high. Often high capital requirements are viewed negatively because it means growth is costly and high fixed costs may be associated with operating assets that can make profits more vulnerable to swings in demand. In Hilton’s case, though, its capital investments (£435m in the 15 years to 2019) also represent a real source of competitive advantage. 

Grocery retail is a cut-throat business and over many years supermarkets consolidated supply chains to focus on the most efficient suppliers. Efficiency is not only about costs but also about food quality and welfare standards. Hilton has used its scale advantage to invest in state-of-the-art facilities and processes while developing deep relationships along the supply chain. This has helped it win big-name customers while creating barriers to entry. A number of contracts last year underlined its credentials, including a deal to start supplying Tesco with all its red meat in the UK and an agreement with Delhaize to supply its red meat in Belgium, where Hilton will open a new facility in September.

The past two years have seen heavy spending on expansion, and capital spending of £99m in 2019 fed through to an increase in net debt excluding lease liabilities from £23m to £88m. Still, Hilton’s financial position looks solid, with £110m cash and £116m of undrawn facilities at the end of last year. What’s more, the risks associated with its investments are reduced by the fact that facilities are normally expanded or built in order to support contracts in place with a large customer. 

Hilton’s reliance on relatively few large customers is a risk should one of them get into trouble or relationships sour. For example, the group’s business in central Europe is expected to see some disruption due to Tesco’s decision to sell its Polish business. On the whole, though, Hilton’s customer base has been beneficial in helping it expand into new geographies and extend its product ranges. Indeed, the strength of customer relationships, coupled with the structural move towards fewer, higher-quality suppliers, has resulted in a very impressive track record. Over the past 10 years the company has achieved a compound annual revenue growth rate of 8.2 per cent and 7.3 per cent for EPS.

One issue associated with big customers is that they can put pressure on margins and payment terms. While expansion clouds the issue, it's worth noting that receivables (money owed) as a percentage of sales have steadily climbed from 8.3 per cent to 11.3 per cent over the past five years. Reduced demand for meat is a potential risk, but the company has made acquisitions over recent years that have given it exposure to fish and vegetarian food. 

All in all, with little impact expected from Covid-19 and continuation of a strategy that has underpinned impressive growth, Hilton looks deserving of the “big reliable” label. That said, the shares are fairly pricey.