Time to buy British

Once again the screen finds itself being conducted against a backdrop of highly politicised economic fear-mongering. However, the basis for concerns this time around is not comparisons between the UK and another nation, but rather comparisons between the certainties of the past, rooted in EU membership, and the uncertainties of a future outside the bloc.

Often the anxiety created by such uncertainty can present opportunities for investors. Indeed, in an expensive market, shares in UK-focused companies have presented some of the few standout value opportunities of 2017. Anxiety levels tend to be fed by the significant amount of attention given to people prophesising extreme outcomes; be that a free-trade utopia, an isolationist Armageddon or something of a similar ilk.

That said, given that the Best of British screen has its fortunes so firmly pegged to a single country, it can be expected to be more erratic in its performance than most screens. It also tends to have a very tight focus on a few sectors (anyone with an aversion to consumer stocks and housebuilders is likely to gag at the screen results). Indeed, in the six years I’ve monitored this strategy it has underperformed the broader FTSE 350 index in as many years as it has outperformed. The past 12 months have been one of the periods of disappointment (see table).

2016 performance

Source: Thomson Datastream

However, the years of outperformance have been much more extreme than the years of underperformance. That leaves the six-year cumulative total return from the top five Best of British shares standing at 209 per cent, and the broader version of the screen with a return of 138 per cent. That compares with 82 per cent from the FTSE 350 over the same period. If I factor in an annual charge of 1.5 per cent in an attempt to capture dealing costs, the total return of the top five drops to 182 per cent, while the broader screen’s total return falls to 118 per cent.

The screen itself is pretty basic and straightforward aside from the fact it requires all companies passing its tests to be generating at least three-quarters of revenue within the UK. This aside, the screen’s key focus is on price momentum, rising earnings forecasts and a few other broad measures of quality. The full criteria are:

■ At least three-quarters of revenue from the UK.

■ Three-month share price momentum better than the FTSE 350.

■ Return on equity of more than 10 per cent.

■ One-year beta of less than one.

■ Forecast EPS growth in this and the next financial year.

■ Better than average five-year compound annual growth rate (shorter periods used where a full five-year record is unavailable).

■ Net debt of less than 2.5 times cash profit.

None of the FTSE 350 constituents passed all the screen’s test, but 13 passed all the criteria but one. Tellingly, the one test all of these shares failed was the low beta test. Indeed, a high beta (over one) implies a company’s shares are sensitive to the ructions of the wider stock market, and UK-focused companies have certainly been through the mill over the past year. This year’s Best of British shares are listed in the table below ordered from highest to lowest three-month momentum. A write-up is provided of the five shares showing the strongest momentum, which this screen puts a particular focuses on and monitors separately. Unfortunately, none of these five can be regarding as having the 'value' characteristics that have made shares in some UK-focused businesses stand out against the backdrop of a highly rated market this year.

The Best of British

Source: S&P CapitalIQ

WH Smith

Several years ago WH Smith (SMWH) realised its shops on the high street had lost their lustre, but shove one in an airport or train station and paperbacks and mags were flying off the shelves. The group’s recent results for the year to the end of August 2017 have marked a period in which the importance of the travel business, in terms of both sales and profits, has taken over from the high street. Indeed, about 60 per cent of both sales and profits came from this fast expanding part of the business, which now operates 815 units. And while WH Smith may still be a Best of British play due to its UK exposure, revenues are becoming increasingly international, with overseas travel stores now accounting for 273 of the total following 41 openings last year. The future looks bright, too, with more openings planned, margins up and passenger footfall strong.

While travel is the focus for growth, the company has not given up on the high street. True, squeezing costs continues to be a key focus as the company attempts to keep profits and cash flows strong despite declining sales. Indeed, despite a 5 per cent fall in sales last year, the division’s operating profit was flat following £12m of cost savings. A further £18m of savings have already been identified for the next three years. But the high street isn’t only a story of managed decline. Innovations, such as putting post offices in shops to raise footfall and opening local branches, provide some vitality too. And while WH Smith's shares are not cheap priced against earnings, they do offer a decent dividend yield and good earnings growth prospects coupled with an impressive track record for cash generation.

Last IC View: Hold, 2,060p, 13 Oct 2017

Greggs

Baker Greggs (GRG) is benefiting from a period of investment in its supply chain. As well as improvements to its bakeries, the company is developing systems to ensure better availability of products in shops. And despite persistent fears of a weak consumer backdrop in the UK, recent third-quarter results suggested the investment is paying off with like-for-like sales of 5 per cent reported at its own managed stores. The improved supply chain is also underpinning the group’s physical expansion with net openings of 66 shops so far this year and a target of 100 by the year-end. As well as opening shops in what it believes to be promising locations, such as travel hubs, Greggs has been closing shops where footfall is low. It has also refitted 120 stores to help pep up sales.

While the general impression given by Greggs is good, it does face some challenges. A range of costs are on the rise, from ingredients to wages. Meanwhile, broker Investec points to room for fine tuning of the supply chain to bring down higher wastage levels that have resulted from higher availability. As with WH Smiths, Greggs' shares don’t come cheap. However, also like WH Smiths, it boasts a number of attractive qualities based on its impressive cash generation, solid balance sheet and scope to grow profitably.

Last IC View: Hold, 1,113p, 1 Aug 2017

Marshalls

Building materials group Marshalls (MSLH) was one of the stars of last year’s Best of British screen. While the UK construction market is hardly booming, it has been healthy enough to provide the foundations for excellent performance from this business. The group has used its country-wide production and distribution network along with a track record of product innovation to take market share from rivals. Given the sensitivity of profits to increased revenues, due to a large fixed cost base, this has led to margins more than doubling between its 2013 and 2016 financial years to 12 per cent. Broker Panmure Gordon thinks there is further to go with margins of 15 per cent pencilled in for 2020.

As well as rising sales, profitability should be driven by increased sales of higher-margin products and ongoing efficiency improvements. And a strong balance sheet also means there is the possibility Marshalls could boost growth with acquisitions. Once again for a top five Best of British pick, the quality on show comes at a price, with the shares commanding a high earnings multiple.

Last IC View: Buy, 413p, 17 Aug 2017

HOUSEBUILDERS: Persimmon and Barratt Developments

It is fair to say that at some point the housebuilding sector will come a cropper. The sector is highly cyclical and valuations, based on price-to-tangible-book-value (see chart below), are lofty. However, paying up for housebuilders’ shares has proved a very profitable endeavour for a few years. Indeed, while a turn in the market can be expected to bring large drops in share prices and ratings as it has in previous cycles, for now companies such as Barratt Developments (BDEV) and Persimmon (PSN) continue to go from strength to strength while throwing off large amounts of cash to their shareholders.

While there are some signs of house price weakness in the UK, particularly in London, the sector has recently got another bung from the government in the form of a £10bn extension to Help to Buy – a government scheme that supports purchases by financially stretched buyers. Meanwhile, land prices are stable, possibly because there has been little activity since the credit crunch by smaller operators that have traditionally bid up land prices and undermined sector profitability. And despite much talk by politicians about the problems cause by a housing shortage in the UK, the shortage persists. Under these circumstances, housebuilders’ profits and dividends are likely to continue to grow. So the question of what kind of valuation risk current share prices represent may continue to be a side issue.

Last IC View: PSN, Buy, 2,625p, 22 Aug 2017/BDEV, Buy, 604p, 6 Sep 2017