Top Contrarian Value Plays

When I reported on the poor run from the screen last year I made the point that some serious underperformance actually came as something of a relief to me. My reason for this was that the screen had put in such strong results in the preceding four years that I felt some serious 'mean reversion' was a healthy thing, given my belief that screens are never going to provide outperformance year in, year out. Interestingly, a leading quant investor, Rob Arnott of Research Affiliates, has recently been making waves by suggesting that stronger returns could be made from “factor” investing (the vogue industry term for simple screening strategies) by backing proven strategies after periods of poor performance that have made them “cheap relative to their own historical norms”.

Whatever the case, the top five contrarian picks from last year delivered a strong 26.1 per cent total return over the last 12 months compared with 15.9 per cent from the FTSE All-Share.

Last 12-month performance

Source: Thomson Datastream

As well as the version of the screen focused on the top five stocks, I also run a 20 stock alternative which was not very impressive over the 12 months with a 7.2 per cent return. As market-wide valuations have increased in the six years I’ve monitored this strategy, it is my belief that the longer stock list has become of less interest as many of the results do not look very cheap on the screen’s key valuation metric: the enterprise-to-value-to-sales (EV/S) ratio. Indeed, I have a tendency to view EV/S as a ratio that can act as a very useful pointer when it is very low, but of limited interest when it is not.

The performance of the screen since I started to run it six years ago is impressive with the top five picks generating a cumulative total return over the period of 201 per cent compared with 64 per cent from the FTSE All-Share, while the 20 stock version of the screen boasts an 89 per cent return. If I add in an annual 1 per cent charge to account for dealing costs the cumulative returns from the screens drop to 183 per cent for the top five and 78 per cent for the larger screen.

The reason companies priced at a low multiple of their sales are generally felt to be of interest is that such valuations can highlight recovery situations. The logic is a based on the idea that often businesses can encounter temporary problems – both internal and external – that depress profitability and push down earnings. Because the market tends to focus so much on earnings, this can lead to severe share price reactions, even when sales (the ultimate source of profit) remain healthy. And as long as the top line stays healthy and finances are sound, there is a chance that in time margins can be restored. This scenario provides the potential double whammy of a re-rating of the shares based on their earnings multiple at the same time as earnings themselves bounce back upwards.

Personally, I’m a big fan of the kind of contrarian ideas this screen throws up, but there is the constant threat of encountering so-called 'value traps'. While it is often the case that a company with a history of decent profitability will see depressed margins revived, with some company profits can fall permanently. In the write ups below, the fears surrounding Pets at Home and the threat of online competition probably best illustrates such a risk.

The EV/S ratio that is central to the screening approach compares a whole company valuation based on enterprise value (market cap plus net debt) with sales. The rule of thumb is that any rating below one suggests a company may be cheap. The screen then looks to see if sales are doing well, despite whatever other concerns the market may have, and whether historically a company has produced decent returns (if it has done so in the past, it may do so again in the future). The screen also wants an indication that a company is in reasonable financial health, which is important for recovery plays due to the fact that cash may be needed to support a business when it is at a low ebb and to invest in making performance better. The full criteria are:

■ Enterprise value of £25m or more.

■ Five-year compound average annual sales growth rate of 7 per cent or more (5 per cent or more above the 2 per cent target rate of inflation).

■ Forecast sales growth in each of the next two financial years.

■ An average operating profit margin of at least 10 per cent over the past five years.

■ Positive free cash flow.

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

 The top five shares, based on lowest EV/S ratios, are listed in the table below and the other 15, which have EV/S ratios ranging from 1.4 (just about interesting) to 2.3 (getting pricy), are listed separately. I’ve also taken a look at the three lowest EV/S stocks.

Top five

The rest

Source: S&P Capital IQ

Drax

Part of the challenge faced by contrarian investors is the inevitability of buying into situations when uncertainty is high. Power company Drax definitely faces its share of unknowns. However, the future of the business is arguably slowly becoming clearer, and there are some reasons for encouragement.

The company, which traditionally generated power from coal, is having to adapt to the UK’s ambition of phasing out coal power by 2025. Drax has already converted three of its six power plants to run off renewable wood pellets imported from the US. However, the going has not been smooth with changes in government financial support making the transition hard going. Meanwhile, recent attempts to find a low-cost way of converting a fourth power station to run on pellets have not yet let to a clear result. The company is also considering re-purposing its remaining three stations to run off gas. Plans for the conversion of the fourth power station are expected to be submitted soon and it’s likely they will take a couple of years to get approval once they’re in. Drax has attempted to underline its commitment to a greener future with the appointment of a high-profile conservationist to its board, David Nussbaum.

As well as the move into renewables, Drax is attempting to shore up its business by moving into energy supply. A major step in this direction was taken last December when it paid £340m to Telecom Plus to acquire Opus, a business-to-business retail operation. It is early days but the business seems to be bedding in okay. After a significant dividend cut, the company has also provided shareholders with more certainty about future payouts. Having refinanced debt in May Drax has announced it expects to distribute about £50m this year (12.25p per share) and it believes this is a level from which it can achieve sustained growth.

While there are signs of progress, half-year results earlier this month did little to inspire the market and the large negative impact of currency hedges and a reduction in the value of coal assets meant the group reported a loss.  Contrarians will hope, though, that the foundations have been put in place for the company to make progress in coming years and that the market may soon see reason to price this in.

Last IC View: Hold, 370p 16 Feb 2017

Pets at Home

One of the pillars of the investment case for specialist retailers is that they can generate higher margins on the product they sell due to the fact that they are not widely stocked elsewhere. However, the internet changes all this by making a huge variety of products easily available at the click of a mouse. What’s more, online retailers are not reliant on high prices to sustain their businesses as they do not have the trappings of such high fixed costs (rent, staff etc) as traditional retailers. Indeed, high-margin niche markets are in many ways ideally suited to online retail as they can substantially undercut incumbents to quickly gain scale while still making a tidy profit.

This potential existential crisis explains the low valuation currently commanded by Pets at Home’s shares. It is already seeing a rise in competition from a number of fast-expanding online stores, such as Zooplus and Ocado’s Fetch. Broker Liberum highlights that Zooplus boasts double-digit growth and undercuts Pets’ prices on food by 20 to 30 per cent, accepts a gross margin that is 28 per cent lower and reports a pre-tax profit margin of 5 per cent compared with 11.6 per cent for Pets. This arguably leaves Pets’ needing to cut prices to compete, which could mean ongoing margin declines. Liberum makes some worrying predictions for an acceleration of recent trends (see graph).

Pets at Home – margin for error?

The fact that the margin squeeze at Pets has the potential to be 'structural' (a long-term trend) rather than 'cyclical' (the result of a temporary issue) increases the chance that the shares represent a value trap. However, the company is not going to give up its market-leading position or its margins without a fight. Pets has been working on schemes promoting customer loyalty and has been investing in services including vets practices and groom rooms. If the retailers can defy the market’s fears there’s definite value on offer, but it’s hard not to see the threat of online rivals as pernicious.

Last IC View:  Sell, 166p, 25 May 2017

Senior

Engineering group Senior (SNR) has served up a series of disappointment results over recent years, but there are hopes 2017 could mark the trough year in the current cycle for the company. Indeed, there already signs emerging that conditions could be on the turn in the aerospace business as orders from new aircraft programmes finally start to tick up, helping to offset falling work on mature programmes. The trend will need to continue for the company to make good on its promise of doing more business in the second half of the year. The aerospace division is also set to benefit from a streamlining programme costing £4m and expected to save the same amount by 2018.

There are less tangible signs of progress at Senior’s Flextronics business which has suffered due to a weak truck market in North America. The company expects the market to turn at the end of 2017. However, given the disappointment of recent years the jury is likely to remain out until there’s some proof of progress.

The links to the North American truck market as well as Senior’s dollar exposure makes it something of a 'Trumpflation' play. While the market is increasingly of the view that the Trump team will fail to come good on many of its campaign promises, the fiscal boost that much of the Trumpflation trade rests on may prove an easier sell given the need to offer a sop to voters ahead of upcoming mid-term elections. Given the difficulties the administration has faced on health reform and travel bans, that feels a contrarian viewpoint.

Last IC View: Buy, 178p, 27 Feb 2017