Eight shares that have it all

The past 12 months saw the 15 stocks selected in early 2017 deliver a 20.5 per cent total return compared with 12.9 per cent from the FTSE All-Share, which is the index the screen selects stocks from. This means the screen has outperformed the market in all but one of the six years I’ve run it, the exception being 2016 when the screen's stock selection was significantly outflanked by a runaway FTSE All-Share fuelled by a recovery in large commodity plays. The cumulative total return from the screen, based on notionally switching from one portfolio of screen results to the next on publication date, now stands at 185 per cent over six years, compared with 87.4 per cent from the index. If I factor in a 1 per cent annual charge to attempt to account for real-world costs of portfolio overhauls, the screen's total return drops to 167 per cent.

2017 performance

While this is a screen that wants shares to display many features that would classically be considered desirable, it is somewhat superficial in its requirements as it does not set very high bars with its criteria. Still, there are quite a few hurdles shares must pass, and once again few FTSE All-Share constituents have proved up to the job. In fact, only advertising behemoth WPP passed all the screen’s tests. I’ve therefore fallen back on my usual technique to increase the screen’s productivity by allowing shares to fail up to two tests as long as they pass both valuation tests (low forward PE and high DY). On this basis eight shares made the grade. The full screening criteria are:

■ Forecast next-12-months price/earnings (PE) ratio among the lowest third of all stocks screened.

■ Historic dividend yield in the highest third of all stocks screened.

■ Average forecast earnings per share (EPS) growth in the next two financial years of 5 per cent or more.

■ Three-year EPS compound average growth rate (CAGR) of 10 per cent or more.

■ Three-year free cash flow CAGR of 10 per cent or more.

■ Three-year dividend CAGR of 5 per cent or more.

■ Return on equity (RoE) of 10 per cent or more.

■ Three-year average RoE of 15 per cent or more.

A screen that asks a lot from shares can tend to turn up shares that look very attractive on the surface, but boast those characteristics for a reason. Often the reason can be because the company concerned is very cyclical. This, for example, helps explain why housebuilders are often popular with this screen. But while these businesses are inherently cyclical, this has not caused them a problem for many years, but the market prudently continues to price in the risk (always less prudently at the top of the cycle than at the bottom, though). Other companies on the list are afflicted by deteriorating prospects, which often show up in the form of recent broker forecast downgrades. To give a flavour of the screen’s results this year, I’ve looked at the share with the lowest forecast price/earnings ratio and the share with the highest historic dividend yield.

Have-it-all shares

Source: S&P CapitalIQ. *Includes special dividends

Norcros (Lowest Fwd PE)

A quick look at some of the key fundamentals (historic and forecast) monitored by this screen is likely to prompt the question of why on earth are shares in kitchen and bathroom products company Norcros trading on such a measly rating. In fact, the impressive chart below doesn’t even fully reflect the attractions, as over the past year brokers have been steadily revising up EPS forecasts – upgrade trends tend to drive shares higher. Based on Bloomberg consensus data, over the past 12 months current-year EPS forecasts are up 6 per cent, while forecasts for next year are up 9 per cent.

Furthermore, aided by a recent £30m placing at 172p to help fund the £60m acquisition of Irish shower tray and enclosure business Merlyn, the balance sheet looks in decent shape with year-end net debt forecast to represent about one times cash profits. The dividend is well covered and, based on numbers from broker Numis, the shares offer a stand-out forecast free-cash-flow yield of about 14 per cent. Does Norcros really “have it all”?

Unfortunately, there are reasons for caution. The company is heavily exposed to the home replacement, maintenance and improvement (RMI) market, which accounted for about three-quarters of sales last year. This economy-sensitive market has been faltering over recent years and the uncertainty created by Brexit could prove a headwind for some time. The company also generates about one-third of its turnover from South Africa. Political and currency instability in the country has been a major issue for investors despite recent solid underlying growth from the business itself. Meanwhile, a large defined-benefit pension scheme with a deficit of £62.7m makes the balance sheet look a bit less healthy than it first appears.

The question is, does all this justify such a measly rating? This seems particularly pertinent following the acquisition of Merlyn, which looks an exciting addition based on its compound annual sales growth rate of 20 per cent between 2015 and 2017. Norcros has past form as an acquirer, so should have the skills to integrate the business well. And while the dilution created by the placing to fund the Merlyn deal means brokers' EPS forecasts only increased marginally on the back of the purchase, the proceeds from the sale of new shares leaves Norcros in a strong position to do another deal(s) which could make a bigger impact on EPS numbers. Numis puts the group’s financial firepower following the placing at about £50m.

Stocks as cheap as Norcros are always likely to come with risks attached and its business is cyclical. Indeed, the shares have given holders a rather bumpy ride over the years. However, there are decent grounds to think the current rating coupled with the recent acquisition means the balance between risk and reward is now skewed some way towards the latter.

Card Factory (Highest DY)

If Norcros has strong fundamentals but a story that doesn’t quite match up, then the reverse is arguably true of Card Factory. The investment case for the company, which designs, makes and sells cards at the 'value' end of the market, sounds compelling: historically demand for cards holds up relatively well during economic downturns; Card Factory’s design-to-sale model provides a potential competitive advantage; the dire state of the high street means the company can negotiate hard on shop leases; and struggling rival Clinton Cards has been closing many shops. What’s more, the structure of the business underpins strong cash generation, which has resulted in frequent special dividend payments – the historic regular dividend yield equates to 4.3 per cent, compared with the 11.3 per cent in our table which includes last year’s special payout.

However, the enticing investment narrative that Card Factory boasts has not translated into enticing numbers recently. Indeed, the company’s post-Christmas update prompted the shares to tank and prompted a slew of broker downgrades to add to a series of smaller downgrades over the past six months (see chart).

While like-for-like sales in the 11 months to the end of December were 2.7 per cent ahead, this implied a slowing rate of growth from 3.1 per cent in the first half to 2.2 per cent in the following five months. Worse still, the growth came from the wrong type of products: lower-margin non-card sales. Added to this pressure on margins, rising staff costs linked to the living wage and the effect of sterling’s weakness on input costs (the company has hedged dollar exposure at $1.34 for 2019 compared with $1.40 for 2018) means profits will be held back next year too.

Investors are faced with two key questions. First, what kind of special dividend, if any, is likely to be forthcoming given the worse than expected trading. Secondly, given the attractive longer-term investment case, is this likely to be as tough as it gets for Card Factory.

On the first point, broker Investec thinks the group can keep net debt to cash profits at the expected year-end level of 1.7 times while paying out a 10p special dividend for the 2019 financial year. While that special payout would represent just two-thirds of the 15p for the current year, coupled with forecasts for a maintained 9.1p regular payment, that still represents a forecast 9 per cent yield. 

What’s more, on the second point, the outlook may start to improve for Card Factory as a new financial year gets under way and the market begins to set its expectations against 2020 forecasts. Savings that the group is pushing through to deal with recent cost issues should start to show up in that year. Importantly, recent currency movement have taken the pound/dollar exchange rate back up towards the $1.40 level, and the weakening of the greenback seems to have considerable momentum. That means it may not be too much to hope currency exposure will be hedged at a much more favourable level for 2020. It could pay for shareholders to tough it out, but any investment demands nerve given the shares’ recent trajectory.