Ten Cornerstone Growth Stocks

2017 performance

Source: Thomson Datastream

All the same, the Cornerstone Growth screen still boasts a strong track record over the six years I’ve monitored it. Indeed, last year was only the second time in six years the screen has underperformed the market. The total return over the period stands at 154 per cent, compared with 64 per cent from the FTSE All-Share. If I factor in a 1.25 per cent annual charge to represent the cost of rejigging the portfolio of stocks each year, the cumulative total return drops back to 136 per cent.

The Cornerstone screens are based on extensive backtesting of the US market and the Growth screen employs what Mr O’Shaughnessy named “The King of the Value Factors”: the price to sales (P/S) ratio. The full criteria for this screen are:

Value criteria: A price-to-sales (P/S) ratio of 1.5 or less.

Growth criteria: Earnings growth in each of the past five years.

Momentum criteria: Mr O'Shaughnessy's original screen was based on selecting the 50 stocks with the best one-year momentum. But since first publishing he has said that shorter periods can also work well. I focus on three-month. All stocks have to demonstrate superior three-month momentum to the FTSE All-Share, and nowhere near 50 stocks pass this test as well as the two others.

Having devoted quite a bit of copy to Mr O’Shaughnessy’s approach last week, this week I am going to have a closer look at the stocks highlighted by this Cornerstone screen. Indeed, the Cornerstone Growth screen is more suited to assessing on a stock-by-stock basis when conducted on the UK market because it tends to highlight a relatively limited number of shares. All the stocks picked are detailed in the table below, ordered from lowest to highest P/S ratio. The three shares I’ve take a closer look at are the one with the lowest P/S ratio along with the stocks showing the best and worst three-month momentum.

10 Cornerstone Growth shares

Source: S&P CapitalIQ

Babcock International

On the face of it, shares in outsourcer Babcock International (BAB) are remarkably cheap. On the basis of the shares’ next-12-month forecast price/earnings (PE) ratio, they are about the cheapest they’ve been for the past decade (see chart below). Were the PE to retrace its way to even the bottom quarter of its 10-year range, shareholders would be looking at 37 per cent upside. And were the shares to rerate to midway through the range, the gain would be 53 per cent.

But shares are rarely this cheap without a reason. And the fact that short interest in the shares has shot up since the start of last December from below 2 per cent to almost 7 per cent at the time of writing, suggests many investors are prepared to bet the reason behind the shares’ apparent cheapness is a good one.

There are two key concerns. The first is that the UK government’s focus on cost-cutting will reduce the workload for Babcock, especially given its sizeable exposure to defence. Indeed, the shrinking of the group’s order book since midway through last year has added ballast to these fears, despite commensurate growth in Babcock’s bid pipeline.

The other worry for shareholders is whether Babcock could be destined to go the same way as other outsourcing peers that have issued swingeing profit warnings and been forced into rescue rights issues. However, the parallels between Babcock and woes felt by the rest of the sector could prove misplaced given the specialist nature of its work. By focusing on jobs where expertise rather than price is a key determinant of bidding success, Babcock looks less at risk of taking on long-term contracts on uncommercial terms. That’s important because underbidding is what has proved a bane for other outsourcers. On this front, some comfort can also be taken from the fact that Babcock’s management doesn’t expect any noteworthy impact from a new accounting rule governing the way companies report income from long-term contracts. Other outsourcers have reported damaging negative restatements associated with the new accounting regime.

Recent trading has provided cause for both some concern and some reassurance – on balance, probably more of the latter. In the third quarter of its financial year to the end of March, Babcock reported slightly disappointing turnover but improved margins, meaning the company expects to meet full-year profit expectations. The order book slide has shown some signs of petering out. What’s more, the company expects to meet expectations for cash generation, which represents an important reassurance given poor cash conversion is regarded as a potential canary in the coal mine in a sector that has been plagued by cash crunches.

The current substantial negative sentiment towards the shares may be slow to dissipate, and investor angst may yet be substantiated, resulting in earnings forecast downgrades that would undermine the value argument. However, while there may be clear risks, based on recent trading, the value case currently looks too extreme to ignore. 

JD Sports Fashion

When a stock is priced for perfection, it doesn’t take much in the way of less-than-perfect news for the price to be hammered. Last year, JD Sports (JD.) was a case in point. In the chart below, readers with good eyesight or expensive reading glasses may be able to see the slight downwards blip in 2018 EPS forecasts. But for anyone struggling to spot the minor downward revision, the mid-2017 share price collapse offers an easier-to-distinguish pointer.

The minor downgrade reflected a slightly less-than-perfect trading update at the end of last June, in which management highlighted “anticipated margin pressure in achieving the sales growth”, much of which was related to sterling’s post-referendum weakness.

However, while the update did mark a hiatus in the upgrade cycle, the trend of better than expected trading has re-established itself since June, although the share price is being more coy about following suit. A solid post-Christmas update in the middle of January was the latest trigger for brokers to revise expectations higher, although the mark-up was not all that substantial by historic standards. Meanwhile the group continues to benefit from solid like-for-like growth, increased internet sales and store expansion, especially in Europe where margins should start to push higher as its young store estate matures.

The company’s prospects are being helped by the popularity of sportswear as fashion (the so-called 'athleisure' trend) and the willingness of top sports brands to offer fashionable products exclusively to JD. The international side of the business is also becoming a significant contributor to the group, which could potentially create some excitement as investors start to focus more on the expanded opportunities for growth this brings. A relatively modest price/earnings growth (PEG) ratio of 1.3 suggests the growth potential and the rekindling of the upgrade trend is not fully priced in.

International Consolidated Airlines

BA and Iberia airlines owner International Consolidated Airlines (IAG) has cropped up in several recent screens thanks to a combination of EPS forecast upgrades, solid share price momentum, strong forecast EPS growth and apparent value. To put things into perspective, though, with IAG we’re talking about a company in an industry that is generally regarded to have low-quality, cyclical earnings, reflected in perennially 'low' valuations. Indeed, investors may have been reminded of the fragility of forecasts at the time of IAG’s full-year results last month when earnings came in slightly below some analysts’ expectations.

However, there still seem to be more reasons to feel positive about IAG than negative. Much of the disappointment from the fourth quarter can be laid at the feet of delays associated with negotiations about the closure of the company’s pension scheme. Closure of the scheme should ultimately be a noteworthy benefit to costs, which should give the market cause to continue to focus on the reasons to be optimistic about IAG’s prospects.

As well as cost savings from the pension scheme closure, the company should benefit from a restructuring and efficiency drive. Meanwhile, despite increasing capacity, IAG expects yields (the money got from each aeroplane seat) to hold up this year, and recent revenue growth has been encouraging. Broker Investec also believes IAG may benefit from a slowdown in industry-wide capacity growth on its key London to US east coast routes.

Meanwhile, for investors worried about the cyclical nature of the business, some comfort can be taken from IAG’s balance sheet and the diversity of the business, which straddles both long- and short-haul flights, as well as high-end and budget brands. Indeed, when IAG announced full-year results late last month, management judged the group to be in a strong enough position to launch a fresh €500m share buyback programme and increase the full-year dividend by 15 per cent.