Six Genuine Growth stocks

While a lot of attention has been grabbed by the rotation from 'growth' to 'value' stocks since Pfizer announced positive vaccine news, the fact remains that over the last 12 months growth has been the place to be. My Genuine Growth screen has been a big beneficiary.

Sharp swings in sentiment are hard to ignore and they can often herald the beginning of new long-term trends. But it would be premature to conclude this is the case with value’s sudden surge. Indeed, a spell of significant outperformance was experienced by UK value stocks around this time last year following the outcome of the first phase of Brexit. The moment proved fleeting, though, with a sharp reversal in 2020.

What’s more, many of the oft-cited reasons given for the success of growth investing over the last 10 years remain in place, including low interest rates and rapid technological change. And even if value does enjoy some time in the sun, that does not preclude growth from doing well, too. More prosaically, for most investors the concepts of value and growth are not mutually exclusive. Most good investment processes consider both. That said, there is little denying that over the last few years, high valuations do not seem to have held back stock performance much.  

The Genuine Growth screen does pay some attention to valuation through its focus on the price/earnings to growth (PEG) ratio. A PEG represents a stock’s price/earnings (PE) ratio relative to its earnings growth rate. This represents a fairly crude way of balancing out the concerns of value and growth, yet it can be surprisingly effective when used with other stock selection criteria. 

As already mentioned, a case in point is the performance of the Genuine Growth screen over the last year. Collectively, the eight shares selected 12 months ago delivered a 24 per cent total return compared with negative 10 per cent from the FTSE All-Share and a positive 12 per cent from the Aim 100 (the two indices screened). This is the second storming year in the row for the screen, which have followed a truly terrible performance in 2017. That annus horribilis included one stock – cafe-chain fraud Patisserie Valerie – that went all the way to zero. 

12-MONTH PERFORMANCE

Source: Thomson Datastream

But despite the terrible 2017, the overall performance of the screen since I began to follow it eight years ago is good, with its picks generating a cumulative total return of 211 per cent. That compares with 56 per cent from the FTSE All-Share and 80 per cent from the Aim 100. While the screen results are intended as ideas for further research rather than off-the-shelf portfolios, if I add in an annual 1.5 per cent charge to represent notional dealing costs, the eight-year total return drops to 175 per cent. 

The full screening criteria are:

■ Both a three-year EPS compound annual growth rate (CAGR) and a forecast growth rate for the next two reporting years of 15 per cent or more.

■ Forecast EPS growth rate for the next financial year (FY+2) at least half the rate forecast for the current financial year (FY+1), or more than 10 per cent in each year.

■ EPS forecasts higher today than they were three months ago.

■ A PEG ratio among the lowest half of index constituents (either FTSE All-Share or Aim 100).

This year only four stocks pass all the screen’s tests. The paucity of the result is not too surprising given the impact of lockdown on the growth prospects of many businesses. I’ve managed to bulk the results up to six by softening the PEG test to allow all stocks outside the priciest quarter of those screened. The stocks that qualify on this relaxed criteria are Liontrust (LIO) and Frontier Developments (FDEV). I’ve also taken a closer look at the stock with the lowest PEG. It looks quite an impressive business despite it heralding from a pretty crumby sector. 

SIX GENUINE GROWTH STOCKS

Source: FactSet

Motorpoint

Growth investors have good reasons to turn their noses up at the shares of car dealers. The sector is highly cyclical, margins are wafer thin and significant risks are carried on these companies' balance sheets in the form of the costly inventory parked on their forecourts. Added to that, most companies in the sector have to dance to the tune of the powerful manufacturers whose brands they represent. That means any periodic acceleration in growth is likely to be very low quality. The low valuations shares in such companies trade at are a testament to this.

That said, while nearly-new car specialist Motorpoint (MOTR) is not altogether a thing apart from its peers, the business does demonstrate noteworthy differences that suggests its shares are at least worthy of some consideration by growth investors. 

There are really two standout features that differentiate Motorpoint from rivals and are the foundations of its superior financial performance. First is the company’s focus on selling nearly-new cars. This means its suppliers do not call the shots. It tends to buy ex-rental and ex-fleet vehicles, as well as sometimes taking stock that manufacturers need to shift fast. Its sound balance sheet and the amazing speed at which it shifts vehicles means supplier relationships are strong.

It is Motorpoint’s vehicle-shifting abilities that are the second major differentiator. It is much quicker at turning its inventory (cars) into sales than rivals. This is partly down to the fact that it is able to focus on buying what it knows it can sell as opposed to having manufacturers push cars onto it. But it also reflects the fact that Motorpoint is a very slick operator and seems to really know what its customers want. And being able to sell stock is key to financial success in an industry where the cost of goods sold is very high and the margin on those sales is slender. 

On average, stock accounts for about half the total assets of UK-listed car dealers. In Motorpoint’s case this is even higher at nearly 60 per cent. What this means is that significant value is created from increasing speed at which that stock is turned into cash. This is reflected in the graph below, which illustrates that the number of days of sales held as stock – a measure of how quickly stock is turned – has a strong inverse relationship with return on capital employed (ROCE) – a key measure of business profitability.

Key to Motorpoint’s industry-leading stock turn is its focus on offering customers value and high levels of no-nonsense service. This is underpinned by standout operational efficiency. The combination of low-prices and operational efficiency is reflected in the fact that while the company has one of the lowest gross margins in the sector – reflecting a low mark-up on each vehicle sold – it nevertheless boasts one of the highest operating margins. 

The company is working to further improve operational efficiency by opening car processing hubs to feed its national network of 13 showrooms; meaning cars can be marketed, shipped and sold more quickly and at less cost. 

Motorpoint already has a formidable logistics operation that is able to get a car to the dealership closest to a prospective buyer for under £100. This expertise has also helped it launch a nationwide delivery service this year, which has helped online orders surge during lockdown. Online sales accounted for 36 per cent of the first-half total.

Other aspects of the business that seem to attract customers includes a no-haggle policy on sales prices. It also offers credit supplied through third parties. Outsourcing financing deals usefully addresses many of the thorny issues associated with FCA regulation. And not only does Motorpoint’s sales growth record suggest it understands its customer (see graph), the strength of its retail proposition is also reflected in its high level of repeat sales. Last year this represented a record 30.4 per cent of the total.

The company has been capitalising on its salesmanship by opening new dealerships. Since floating in 2016, the number of showrooms has risen from nine to 13, with another expected this financial year. The official target is to get to 20 showrooms, but Shore Capital retail analyst Clive Black sees mid 20s as possible. The strain on the industry caused by lockdown may also present the opportunity to acquire sites at attractive prices.

The company tends to sell and lease back properties when it develops them itself. In some ways this is cosmetic as it replaces a financing commitment with a rent commitment, but the practice does support near-term cash generation. High stock turn also underpins strong cash flows. And the use of inventory financing facilities with two lenders frees up cash, too.

All this has allowed the group to both grow the dividend and buy back a tenth of its shares since float. Buybacks, which essentially work in the same way as a tax-free dividend reinvestment programme, have the potential to be a particularly attractive use of cash for Motorpoint because the nature of the industry means the shares’ valuation does not tend to be very punchy.

Motorpoint is due to publish half-year results on 26 November, but has already signalled the numbers will be strong. And while the closure of showrooms during the last lockdown and current one has been financially painful, the crisis may also have benefits. The company’s strong online presence is being rewarded. Its 'value' ethos is also likely to play well at a time when purse strings are tightening. What’s more, an increased fear of public transport is expected to see more people take to the road, which could prop up demand even as cyclical forces work against the industry. 

Indeed, it is quite stunning that despite the crisis, the company has been experiencing noteworthy forecast upgrades. That said, broker coverage is thin and the latest lockdown has caused the company to withdraw guidance. Dividends and buybacks are off the agenda for the time being as the company has taken government support. Half-year results should give more flavour of the current state of play. From a longer-term perspective, Motorpoint looks an impressive business. True, it operates in a difficult sector, but the valuation goes a good way to compensate for this.