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Nine high-quality large caps

Last year’s high-quality large-cap screen smashed its benchmark, once again proving itself to be an effective stock selector
September 26, 2017

Regular readers may have wondered when they might see our annual high-quality large-caps screen, which since 2011 has been one of the most effective sets of criteria for successful UK stock selection.

Although it arrives a few weeks later than usual this year, the fanfare is still warranted. After a disappointing performance last time around, the screen has returned to its tradition of comfortably beating its benchmark, delivering a total annual return of 28 per cent – a whopping 15 percentage points ahead of the FTSE All-Share.

The screen scours the market for stocks with yield and earnings growth both ahead and behind them, and at a price that looks justifiable against blue-chip peers. As this year’s selections show, such a bias inevitably skews picks towards slightly stodgier business models. Then again, when it comes to investing, quality is not a synonym for exciting, even if the six-year track record for the high-quality large-caps screen has been. After factoring in a 1.25 per cent annual charge, an investor who re-invested their portfolio in the screen’s selections each year would be staring at a 213 per cent total return since 2011. That’s compared with an 87 per cent return from the FTSE All-Share.

A few features worked well for the 2016 screen, which arrived shortly after the Brexit referendum. The short-term sell-off in UK equities sparked by the vote was particularly felt among housebuilders, which were heavily marked down against their book value over fears of an immediate lurch to recession. So despite their recent negative momentum and single-digit price/earnings (PE) ratios, Bellway (BWY) and Taylor Wimpey (TW.) breezed into the screen thanks to their robust balance sheets and earnings growth forecasts. Shares in both housebuilders have now returned to their pre-referendum levels, after spending most of the past year steadily climbing back into investors’ favour.

Equipment rental group Ashtead (AHT) and paper and packaging specialist Mondi (MNDI), both of which entered the year with a higher debt-to-equity ratio, went through cyclical upturns aided by wider margins and earnings upgrades. Even laundry company Berendsen (BRSN), which was hit by two profit warnings in the period, saw its shares gain ground in the period, after succumbing to a £2.2bn takeover bid from French rival Elis. The latter is a neat example of one of the defensive qualities of a high-quality screen: to include the sort of companies that industry peers would quickly move to acquire if the price was right.

 

2016 performance 
NameTIDMTotal Return (9 Aug 2016 - 22 Aug 2017)
BellwayBWY58%
AshteadAHT37%
Taylor WimpeyTW.35%
MondiMNDI35%
BerendsenBRSN5.2%
Howden JoineryHWDN0.5%
FTSE All Share-13%
High-Quality Large Caps-28%
Source: Thomson Datastream

 

Reinvesting the selections 
Year starting AugFTSE ALL-SHARE - TOT RETURN INDHigh Qual Large Caps
201187%173%
201260%73%
201333%58%
201424%50%
201530%27%
201613%28%
Cumulative87%238%
Cumulative with 1.25% pa charge87%213%
Source: Thomson Datastream 

 

This year, the screen’s preference for housebuilders is again apparent. In fact, the top four picks are all big names in the sector, with three of the remaining five stocks drawn from the loosely defined world of leisure and leisure goods.

In selecting them, the screen has scoured for several typical measures of financial health, including interest cover and free cash flow, but its biggest focus is on earnings. To do this, it uses two earnings-derived measures of quality – operating margins and return on equity (ROE) – selecting only stocks with a better-than-average score on these measures and have shown improvement over the past three years.

These tests set a high bar for quality and momentum, and with it the prospect for screening stocks with toppy valuations. To mitigate this, the stock's valuation criteria excludes the market's most expensive shares based on a PE ratio, and avoids stocks that may prove vulnerable to even the slightest disappointment. Equally, the screen also omits the cheapest shares in the market in an attempt to avoid any stocks that are suspiciously cheap and could decline further. The third test of value is for shares with a lower-than-average genuine value (GV) ratio, which the screen's creator Algy Hall defines as price/earnings-growth (PEG) adjusted for cash and dividend yield. This is calculated by dividing enterprise value (a company's market capitalisation plus debt) by operating profits, and dividing again by forecast growth rate plus dividend yield.

When we ran the screen at the end of August, nine stocks ticked at least 10 of the screen’s 11 criteria, which are outlined in full below. A summary of seven of those stocks are included thereafter.

■ PE above bottom fifth and below top fifth of all stocks screened.

■ Lower than median average GV ratio.

■ Earnings growth forecast for each of the next two years.

■ Interest cover of five times or more.

■ Positive free cash flow.

■ Market cap over £2bn.

■ Higher than median average RoE in each of the past three years.

■ Higher than median average operating margin in each of the past three years.

■ RoE growth over the past three years.

■ Operating margin growth over the past three years.

■ Operating profit growth over the past three years.

 

2017 selections: three themes

Cyclical concerns?

Why are investors currently underestimating the fortunes of the housebuilding sector? As our resident economist Chris Dillow recently pointed out, it’s not as though they’ve proved poor investments in recent years. In fact, the biggest names in the sector have quite reliably beaten the FTSE All-Share index for much of the past three decades, even if those gains have come at the price of much higher volatility and cyclical risk. So while earnings at Crest Nicholson (CRST), Persimmon (PSN), Taylor Wimpey (TW.) and Redrow (RDW) are expected to grow in each of the next two years, investors are increasingly concerned that the good run is coming to an end.

Since we ran the screen, these fears have started to mount. As property is all about calling peaks and troughs, the market was unnerved by Redrow chairman Steve Morgan’s decision to sell a £153m stake in the company earlier this month. Was Mr Morgan signalling that we are at the top of the cycle? Higher inflation, modest growth expectations from peers, the possible withdrawal of Help to Buy, weakness in London house prices and a bearish report from the Royal Institute of Chartered Surveyors have all played their part. The Bank of England’s hint that it will raise interest rates earlier than expected could also conceivably hit demand.

The dominance of housebuilders in the screen therefore looks like a contrarian call, but one that our resident property expert Jonas Crosland is confident of, having put all four stocks on a ‘buy’ rating. As recent results for each group have either promised huge dividend returns or strong profit momentum it’s not hard to see why, although the potential threats to working capital may call into question the reliability of earnings.

 

A question of size

This year’s picks are propped up by three companies which fall into the London Stock Exchange’s loosely defined ‘leisure’ sector, even if enthusiasts of one of those stocks – Games Workshop (GAW) – might see their fondness for miniature figurines in more strident terms. The retailer has benefited from favourable currency movements in the past year, although profit upgrades, strong trading and a focus on shareholder returns has also made it one of the top-performing shares in 2017.

A love of miniature worlds is also proving lucrative for Merlin Entertainments (MERL), whose results for the six months to June were buoyed by an excellent contribution from Legoland parks. Constant currency sales from the resorts jumped 20 per cent to £267m, while operating profit surged 13.2 per cent to £67m in the period, and full-year results should be buoyed by the recently opened Legoland Japan. Potential expansion in China and a new location in New York might help plaster over concerns about domestic demand, and account for the significant hike in expected earnings growth in two years’ time.

Miniaturisation – at least in photographic terms – has been a boon for booth operator Photo-Me International (PHTM), although its four-year track record of double-digit annual earnings growth has been increasingly driven by the expansion of its laundry business across Europe and Japan. The kiosk group is aiming to triple its self-service laundry units to 6,000 by 2020, and can take significant confidence from the roll-out since launching the business in 2012. And with net cash on the balance sheet, the group is in a strong position to expand both its network and shareholder distributions.    

In a peculiarity of this screen, both Games Workshop and Photo-Me passed all the criteria bar the requirement for a market capitalisation of at least £2bn. Consequently, both stocks also made it on to Algy’s high-quality small-cap screen, published last month.

 

2017 high-quality large caps

NameTIDMMkt CapPriceFwd NTM PEDY*PEGGV RatioFY EPS gr+1FY EPS gr+23-mth MomentumNet Cash/Debt(-)
Crest Nicholson HoldingsCRST£1.4bn533p75.2%0.80.49.5%12%-16%-£35m
RedrowRDW£2.2bn603p92.0%0.70.522%6.1%4.2%-£56m
Taylor WimpeyTW.£6.4bn196p106.1%1.50.86.3%7.9%-2.6%£429m
PersimmonPSN£8.0bn2,601p115.2%1.30.920%0.7%4.3%£1.1bn
Smiths GroupSMIN£6.2bn1,577p162.7%3.31.512%2.6%-0.3%-£635m
Photo-Me InternationalPHTM£609m162p174.3%3.11.25.4%5.5%-3.5%£37m
Games WorkshopGAW£534m1,662p176.0%3.51.25.0%4.7%72%£18m
Moneysupermarket.comMONY£1.7bn323p193.1%3.01.75.9%9.4%-4.9%£18m
Merlin EntertainmentsMERL£4.8bn466p201.5%2.21.63.7%16%-10%-£1.2bn
            
* includes special dividends          
source: S&P CapitalIQ