Feast on pubs and restaurants in 2018

For many companies the source of earnings is sales, but for others, such as banks, net asset value is more relevant. Generally, investors consider it interesting when a company, sector or market has a low or high valuation against its source of earnings because over time returns tend to revert to mean. For example, if a company is valued at a low multiple of sales compared with the historic norm, margins may have temporarily fallen, but over time are likely to revert back to the long-term average. As returns and earnings rise, the expectation would be that the valuation against the source of those earnings should revert back towards the long-term average too. In the case of a company trading at a low value compared with its net assets (also known as book value or shareholder equity) it may be because returns from those net assets – the so-called return on equity – have temporarily fallen, but over time will return to the historic average.

Comparing unlike with unlike

Different companies and sectors have different characteristics, which means valuations against their ultimate sources of earnings are likely to differ, even based on long-term averages. For example, one would expect the valuation of a high-margin, capital-light business to be higher over an economic cycle than that of a low-margin, capital-intensive one. That said, some investors with a very strict 'value' discipline argue that market forces mean everything returns to the same mean over a long enough time frame, except in a few extremely exceptional cases.

The valuation method used by this screen looks at where each individual company’s current rating sits in comparison to its long-term range (a maximum of 12 years and minimum of four depending on how much data is available). A statistical calculation called a Z-score is then used to get a standardised measure of where the current rating lies within the long-term range (for statos out there, the Z-score measures the number of standard deviations today's valuation is from the long-term mean average). Because Z-scores are standardised, they can be used to make comparisons of how cheap or expensive companies and sectors are against each other regardless of their individual characteristics. Negative Z-scores indicate a valuation is low (the more negative the lower) compared with the historic range and positive scores indicate that a valuation is high.

For individual stocks, a key issue with using this technique is that companies do sometimes change in nature, which can alter long-term returns and therefore long-term valuations. Such profound changes are less likely to occur for whole sectors and less likely still for the market as a whole. That said, certain industries do sometimes undergo massive, long-term, structural changes – many believe this is the case for large parts of the retail sector at the moment, for example. Also, my sector analysis breaks the market down into some quite narrow sub-sectors, making the screen more prone to this flaw. In future years I will try to finesse the screen to provide some broader sector views alongside the detailed sub-sector views highlighted in the table below.

For companies where I consider sales to be the ultimate source of earnings I’ve used a Z-score based on monthly data for enterprise value (EV)/sales. For the other companies, Z-scores are based on monthly data for price/book value.

Built like a Greek god

With the cynicism of an investment banker, I’ve managed to tortuously arrange the words that describe this ratio to create the acronym ZEUS. That being: Z-score of value/ultimate source of earnings… and yes, not so coincidentally, that gives an acronym that is also the name of the daddy of Greek gods (something for readers to get their FAANGS into – sorry ed!).

The screen looks at the average ZEUS ratio of companies in each sector of the FTSE All-Share. As sectors sometimes have some rather spurious members, I’ve spliced and diced the sector classification provided by S&P CapitalIQ into groups of companies I believe to have very similar traits – for example, Capita (CPI) has been taken out of the recruitment sector and transferred into support services, as has Compass (CPG), which was originally housed in the restaurant sector. As mentioned above, I arguably have been too picky in creating some niche sub-sectors that are a bit too small.

As well as looking for long-term value, the screen looks for short-term momentum based on the average price action of each sector constituent over the past three months. All sector data is looked at on an unweighted basis. The idea here is to give a broader view of the sector rather than having some sectors that essentially reflect the fortunes of the largest constituent, which would be the case if using market cap weightings. That said, an alternative argument – albeit one I have not adhered to with this screen – would be that larger companies are more likely to be representative of the sector as a whole. All sectors are ranked separately by average ZEUS ratio and average three-month momentum. These two rankings are then combined to create a final ranking.

Message from the gods

The sectors are listed below from top to bottom ranking and hopefully will provide food for thought as we approach the start of the new investing year. I’ve also taken a closer look at the top-ranking sector, as well as the cheapest sector based on the ZEUS ratio and the sector showing the strongest momentum.

Source: S&P CapitalIQ

TOP RANKING: Pubs and restaurants

The pubs and restaurants sector has found itself at the centre of a host of worries. Brexit is possibly the most salient. The drop in the value of sterling is pushing up the costs of much of the food and drink pubs sell, but of more concern is uncertainty about the economic outlook as the UK splits from the EU. These fears have surfaced at a time when the outlook was already looking rather worrying.

Rising costs related to staff – from the minimum wage to the apprenticeship levy – and business rates are expected to squeeze margins. What’s more, pubs have been increasing food sales aggressively for several years at the same time as the restaurant sector has been opening lots of new outlets. It now looks as though oversupply in the eating-out sector is starting to have a negative impact on individual companies’ sales, and there could be tougher times ahead.

However, given the high yields and low ratings being put on shares of companies in the sector, it is worth considering if investors have got ahead of themselves in pricing in turmoil. Indeed, recent results from the likes of Greene King (GKN) and Marston's (MARS) have suggested a trend of earnings downgrades could be starting to grind to a halt. And while investors who followed the sector during the credit crunch may have traumatic memories of pulled dividends and, in some cases, rescue rights issues, it does not feel as though we’re near such a point now.

CHEAP: Car dealers

During 2017, car dealers have gone from flavour of the month to an investment pariah. The sector had benefited from surging new car sales over several years, but the cycle turned during 2017. Previously, many analysts had argued that second-hand sales and higher-margin after-sales work would fill the breach as new car sales fell away. However, now it seems the market is not so sure. Halfords, a bit of an oddity in this sub-sector as it has a broader retail base but also operates Kwik Fit garages, faces some similar themes.

A key issue for car dealers has been the surge over recent years in personal contract purchase (PCP) sales. This is when customers are offered loans on new car purchases with a guaranteed resale price. Stories of sharp practices by car dealers eager to sell more cars have caused alarm and fears of sector-wide repercussions. Some are even likening recent activity to the sub-prime mortgage industry before the credit crunch. Furthermore, there are fears that the second-hand market could be flooded with supply as PCP contracts come to an end and cars are handed back to loan providers (usually manufacturers and not actual car dealers) and sold on. This could result in falling second-hand prices and possibly losses for lenders, which could have serious ramifications for the car industry as a whole.

What’s more, these worries are being played out against the backdrop of economic uncertainty created by Brexit. Should all these negative factors come to a head together as some fear, it could indeed be ugly for the car dealing sector, which has the added vulnerability of generating low margins and requiring large amounts of working capital due to the high price tags associated with its stock. The best value opportunities in the market often look very much like value traps and normally either come very close to being value traps or do indeed turn out to be value traps. Car dealers at the moment seem to fit that bill.

SOARING: Capital-light tech

There are clear grounds to fear that after a long bull market most stocks have become overvalued. This is particularly the case for capital-light technology businesses. However, the same could have been said at the beginning of 2017, yet these companies have remained the flavour of the day. The huge excitement about these businesses focuses both on their growth potential and structural changes that make the industry more enticing.

Indeed, the ability to use 'the cloud' to provide software as a service (Saas) is allowing companies to generate regular payments for software use (as opposed to selling a one-off licence), which considerably improves the reliability and attractions of revenues and earnings. What’s more, the ability to offer cloud-based services provides software companies with scope to better service and retain customers. Other exciting developments such as machine learning and big data have also really captured investors’ imaginations, even though it may be some time before anyone is properly placed to understand such innovations’ true commercial significance.

So could the momentum continue in 2018? Naturally it could, but it is also rare for the top-performing sector from one year to remain a high flyer. What’s more, if fears of a market rout, held by many prominent investors, are substantiated, it seems likely that tech shares will be among the first in the firing line.