Ten contrarian plays for 2019

As well as simply being out of favour with a market focused on 'quality' plays, 'value' strategies have suffered due to disruption within a number of industries where many value plays have turned out to be so-called 'value traps'. Value traps are stocks that command low valuations because something is going seriously wrong. The tendency is for this type of 'cheap' stock to get ever 'cheaper', until finally it reveals itself not to be cheap at any price: think Debenhams.

To be under no illusion, the 15 stocks picked by the Dreman screen last year included a good sprinkling of value traps as the 2018 performance table below shows. But the screen was also able to identify a number of shares that appear to have become too cheap based on excessive market pessimism.

2018 performance

Source: Thomson Datastream

Over the six years I’ve monitored this screen it has had a very bumpy ride. On a cumulative basis, total returns over the period are just above those from the FTSE All-Share at 50.7 per cent versus 46.3 per cent. However, this is before taking into account any costs, which would be an important factor if trying to execute this strategy in the real world (this column presents screens as a source of ideas for further research rather than off-the-shelf portfolios). If I add in a notional 1.5 per cent annual charge, the screen’s total return drops to 37.6 per cent, which is some way below the return from the All-Share.

The starting point for the screen is to look for shares that appear 'cheap' on one or more of a range of valuation metrics. The classic argument in favour of using a 'value' approach to investing is that when times are bad for a company investors believe it will be ever so. The market becomes overly pessimistic and ignores the likelihood that a company’s performance is quite likely to move back up towards the long-term average (revert towards the mean in stats-speak) thereby pushing the share price up too.

Importantly, though, any approach that has valuation as its key criteria faces the risk of piling into value traps; where historical company performance is no longer of any relevance. The Dreman approach uses a series of checks that suggest the value on offer may prove to be genuine and that performance may already be improving. The full criteria for the screen are as follows:

■ Shares must be among the cheapest quarter of FTSE All-Share constituents based on one or more of: dividend yield (DY); price-earnings (PE); forward next-12-month PE (forward NTM PE); price-to-cash-flow (PCF); or price-to-book-value (P/BV). The screen's other criteria differ slightly based on which valuation measure a share qualifies on).

■ Year-on-year EPS growth in the most recent half-year.

■ Forecast EPS growth for each of the next two financial years.

■ A current ratio of more than 1.

■ Above-average dividend yield (excluding cheap P/BV stocks).

■ Dividend cover of 1.5 times or more, or greater than the five-year average (excluding cheap P/BV stocks).

■ Above-average five-year dividend compound annual growth (excluding cheap P/BV stocks).

■ Gearing of less than 75 per cent or net debt/cash profit of less than 2.5 times.

■ Market capitalisation of £200m or more.

This year 10 stocks passed the screen. They are listed in the table below along with some relevant fundamentals and details of the metric against which each share looks 'cheap'. I’ve also taken a closer look at the stock showing the strongest three-month price momentum from this year’s screen: non-prime lender S&U. The stock has cropped up in several recent screens and offers some interesting attractions for contrarians, although any investment comes with some clear risks linked to the credit cycle and its particular lending niche.

*Foreign FX converted to £. Source: S&P CapitalIQ

S&U

S&U (SUS) specialises in risky lending, but in other ways looks conservatively run. These contrasting characteristics provide the potential for mispricing based on investors overestimating the company’s vulnerability to worsening trading conditions. So it should be of interest to contrarians that trading conditions have worsened, but the shares have recently started to rebound after taking a beating earlier this year.

S&U specialises in providing loans to individuals with chequered credit histories (so-called non-prime borrowers) who struggle to borrow from mainstream lenders. The high interest rates it can charge make this very profitable as long as borrowers keep up repayments. What's more, the withdrawal of big banks from riskier lending after the credit crunch has proved a boon.

S&U chiefly lends to people buying second-hand cars through its Advantage Finance brand. Typically loans cover three years, are for up to £15,000 and are secured against the car. In 2017, S&U also set up a property bridging loan business called Aspen, which is small but growing rapidly. This lends up to £2m (average loans are £375,000) secured against the property. The money is usually repaid on sale or on arrangement of a conventional mortgage.

Investors were spooked in March by results covering the year to the end of January, which reported a drop in the risk-adjusted yield from 26.7 per cent to 24.6 per cent as a result of increased impairments (costs associated with loans that are not expected to be repaid). Sensibly, the company has tightened its lending criteria to improve loan quality. However, it faces the challenge of doing this against a backdrop of increasing competition, which could put a longer-term squeeze on returns.

It’s not hard to see why rivals want a bigger slice of the market. S&U is very profitable and bad debt levels have been very low across the UK for several years, encouraging others into riskier parts of the lending market. Despite a recent share price rebound, based on a forward PE ratio of 9 the shares are comfortably in the cheapest third of their five-year range and offer about 16 per cent upside were they to rerate to their five-year average (median) rating.  So it looks as though the market is pricing in the possibility of more competitive pressure as well as the potential for a more severe turn in the credit cycle (rising bad debt). Brexit uncertainty is also not helping sentiment. Do these concerns justify the shares' current rating?

Some comfort can be taken from a recent trading update for the first four months of the year. The recent tightening in lending practices helped nudge the risk-adjusted yield up from 24.6 per cent to 25.0 per cent. What’s more, despite the current mood of economic doom and gloom and falling new car sales, the used car market remains healthy and demand for loans from Advantage has been at record levels. That meant car loan receivables rose to a record £263m. To facilitate its lending, S&U increased its own borrowings from £108m to £114m, but remains well inside agreed debt facilities of £160m. What’s more, despite Brexit angst and the perilous finances of many households, unemployment remains low and the minimum wage looks set to continue rising, which should help the ability of S&U’s customers to keep up payments.

There’s also been some encouraging regulatory news. For a company like S&U, regulation poses both a potential threat and a potential source of competitive advantage; especially given concerns over sharp practice in parts of the car finance market. From this perspective, the results from the Financial Conduct Authority’s (FCA) motor finance sector survey in March were heartening. The practices recommended by the FCA were all already well established at S&U. The type of long-term thinking that should help the company stay ahead of regulatory changes and benefit from tougher rules should be encouraged by the founding family’s high level of ownership and management. The Coombs family founded S&U as a retail business in 1934. The long tenure of staff should also support long-term thinking.

The general state of the balance sheet also suggests a conservative long-term approach, as well as reflecting the inherent risks of lending to people with poor credit histories. S&U does not have a banking licence and also differs from most lenders in basing its attractive return on tangible equity (17 per cent last year) chiefly on a high return on tangible assets (10 per cent) thanks to its ability to charge a high price for the money it lends. This means it does not have to significantly leverage its balance sheet (lending many multiples of tangible equity) to generate decent returns for shareholders.

Based on S&P CapitalIQ data, S&U’s so-called leverage ratio, which represents tangible equity to tangible assets, stands at just 1.7 times compared with 4.9 times and 6.1 times for non-standard lenders Provident Financial and Non Standard Finance. Leverage ratios for mainstream banks are substantially higher, with Lloyds, for example, on 19 times. The higher the leverage, the more rapidly bad debts can erode a lender’s capital base. So lower leverage means problems associated with impairments should be better contained. Naturally, though, when a lender chooses to have lower leverage it is normally because it is more likely to run into bad debt problems, as is the case with S&U.

The potential for impairments to continue to rise should not be underestimated. S&U is a cyclical business and after a prolonged period of benign credit conditions we may be starting to see a turn in the credit cycle. A severe turn would undoubtedly be bad news for shareholders. Increased competition could also undermine returns. However, Brexit angst notwithstanding, encouragement can be taken from the strength of the second-hand car market. Meanwhile the company looks conservatively run and well placed within its niche. As such, the shares look an interesting value play for those prepared to take on the not inconsiderable risk.