Six cheap stocks in an expensive market

We use three methods to spot rare pockets of value
Thursday 09 Nov 2017 Author: Tom Sieber

Stock markets across the globe are marking new highs as investors continue to focus more on how fast earnings are growing rather than how these earnings are being valued.

‘Growth’ and ‘value’ investing are typically seen as being in opposition to each other and growth is on a winning streak. The US Russell 1000 Value Index has returned 9.7% in 2017 against 24% for the US Russell 1000 Growth Index. That trend is being replicated on this side of the Atlantic too.

Hedge fund manager David Einhorn – a noted value investor – has even questioned if there is a ‘new paradigm for valuing equities’. In a letter to clients of his Greenlight Capital fund, reported by Bloomberg, he wrote: ‘The persistence of this dynamic leads to questions regarding whether value investing is a viable strategy.’

AJ Bell’s investment director Russ Mould says one fund manager recently moaned to him that there is no value in momentum stocks at present – and no momentum in value stocks.

We’re in a difficult time for markets despite the headline indices racing ahead. Nevertheless keep reading as we do have some good news.

How to find value

Value investing may be out of fashion but Shares still believes in considering valuation when it comes to judging an investment.

Just look at the fate of leisure group Merlin Entertainments (MERL) which fell nearly 20% in the wake of a recent profit warning (17 Oct). The news undermined its growth credentials and shined an unfavourable light on its high price-to-earnings (PE) ratio in excess of 20-times.

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Investing in undervalued companies provides what is often described as a ‘margin of safety’ which can help you avoid those kinds of sharp losses.

Expensive markets are making it tricky to find value – but it is not impossible.

Data from Capital Economics suggests the FTSE All-Share is trading at around a 50% premium to its long-run average PE ratio; and the US S&P 500 trades on an earnings multiple of 17.9 against a 10-year average of 14.1.

Buried within the market is a pocket of value stocks. To find them, we’ve decided to look beyond the standard PE figure and use a range of alternative metrics. We’ve accessed three filters offered by Stockopedia’s screening service partly inspired by the processes deployed by legendary investors.

Recognising a stock can be cheap for a reason; we have also applied the knowledge of the Shares team to filter out the bad stuff and arrived at a list of six stocks which we believe offer winning value.

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Contrarian value

This stock screen applies the approach of US fund manager Bill Miller to find companies which are trading below their intrinsic value and which have the potential to rebound.

The process includes looking at the share price relative to free cash flow, sales and earnings growth. Miller had a track record of beating the market for 15 straight years at former employer Legg Mason between 1991 and 2005.

The process includes:

Price to free cash flow of less than 3
Free cash flow greater than a year ago
Sales growth
Price to earnings growth ratio below 1.5

 

Cheap stock #1

Virgin Money (VM.) 288.6p

Virgin Money’s shares are very cheap and we don’t expect them to stay so for long.

The stock was previously weighed down by concerns over its capital – yet the mortgage lender recently reassured the market with guidance that its CET1 ratio (a measure to see if the balance sheet can withstand economic shocks) will be 13.5% at the end of the year. That’s above the 12% level at which management thinks is appropriate for the business.

‘We continue to regard Virgin as a well-managed, low risk bank with strong growth that is not constrained by capital or market size,’ says Investec analyst Ian Gordon.

Virgin’s ratio of cost to income has continually fallen since 2012 thanks to rapid loan growth and operational efficiencies. Further improvement is expected for two reasons. First, there is a plan to launch a digital banking service. This will start in late 2018 and efficiency gains are expected from 2019 onwards.

Analysts also think Virgin will soon announce plans to close more physical branches in light of the incoming digital proposition and the fact that leases are starting to lapse for branches inherited from the Northern Rock acquisition in 2012.

Virgin currently trades on 0.9 times price to 2018’s forecast tangible net asset value per share; and 6.9 times forecast earnings for 2018. Those are very cheap ratios.

It ticks many other boxes on our contrarian value screen including price to earnings growth ratio below 1.5 (it is 1.46 for 2017, according to Stockopedia). Revenue is in a strong rising trend, so too pre-tax profit. (DC)

 

Cheap stock #2

Aviva (AV.) 514p

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After a difficult few years in the wake of the financial crisis, chief executive Mark Wilson has helped steady the ship at this large insurance business.

Summarising last year’s results Wilson said: ‘Aviva’s results are simple and clear cut: more operating profit, more capital, more cash, more dividend. And there is more to come.’

Wilson took over as CEO in January 2013 and has since divested an interest in Dutch insurer Delta Lloyd, exited markets such as France, Russia, the US and Malaysia and acquired Friends Life in a £5.6bn deal.

The aim has been to build a more streamlined operation which can generate plenty of cash with a focus on offering UK customers a one-stop shop for all their insurance needs (including life, accident and health) alongside asset management. Wilson appears to have gone a long way to achieving this goal.

A shift to managing insurance and savings online could help the company in its efforts to cross-sell products across its customer base going forward.

The company’s presence in our value screen suggests the market is not giving full credit for Aviva’s transformation despite a reasonably strong run for the shares.

Given the strategy of narrowing the focus on the UK, we admit the fate of Brexit negotiations is a potential risk facing the business.

However, the fact that ratings agency Moody’s recently upgraded Aviva’s credit rating is very important. It noted the company had £11.4bn of surplus capital at the end of June based on European Solvency II rules governing how much cash insurers need to hold against the risk of financial shocks.

This surplus capital can be used for shareholder returns, to buy back shares for acquisitions and to re-invest in the business, potentially boosting organic growth.

Investment bank UBS has a ‘buy’ recommendation and 580p price target. It comments: ‘While the transformation strategy is in progress, we believe Aviva can be a sector leading risk-adjusted dividend and capital return story under Solvency II.’ (TS)

 


Deep value checklist

Benjamin Graham was a legendary figure known as the ‘father of value investing’ and was a mentor to Warren Buffett. The following stock screen applies Graham’s 10-point checklist of valuation and financial measures. Devised not long before his death in 1976 this approach was more systematic than his other value investing strategies.

Interestingly this screen threw up several housebuilders. We discussed our reservations on housebuilders in last week’s Editor’s View column and this is an indication of why you need to take other factors into account when determining if a stock is genuinely undervalued.

The three most important ratios according to Graham

Earnings yield =  earnings per share divided by share price

Dividend yield = dividend per share divided by share price

Debt less than book value

 

Cheap stock #3

Centamin (CEY) 140.5p

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All the big spending on mine development has been completed at Centamin’s flagship project, meaning it should now have an attractive stream of cash to help fund handsome dividends.

The gold miner is forecast to pay 10.9c (8.2p) dividend in 2018 which equates to a 5.8% yield on the current share price.

Its Sukari project in Egypt is one of the top-quality gold mines in the world. It benefits from having high grades of gold, so costs are lower than many other miners.

In the third quarter of 2017 Centamin’s all-in costs were $732 per ounce of gold produced. It sold gold for an average price of $1,283 per ounce.

Rather than pay any taxes in Egypt, Centamin instead has a profit share agreement with the government, to whom it currently pays 40% of free cash flow after costs. That figure gradually rises to 50% by 2020.

Gold is produced via an open pit and underground at Sukari. Work is underway to develop a new underground section called Cleopatra which the miner is confident will become another source of production, thereby lifting group gold output and further boosting cash generation.

Analysts think the shares are worth 180p based on the consensus view, implying nearly 30% upside over the next year. Add in the near-6% dividend yield and you’re potentially looking at tasty returns. (DC)

 

Cheap stock #4

Moss Bros (MOSB) 92.6p

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A downwards drift from 120p in the summer to 92.6p presents a buying opportunity at Moss Bros. The retailer’s strong balance sheet and high dividend yield provide a margin of safety and should limit further downside.

Based on the 6.2p dividend forecast by Cantor Fitzgerald for the financial year to January 2018, Moss Bros’ plump 6.7% dividend yield (as well as recent share price weakness) indicates the market is worried about further earnings downgrades.

We believe the progressive payout will be secure given it has a £21.5m net cash position. That cash pile is approximately one fifth of its market value.

Headwinds facing the self-styled ‘first choice for men’s tailoring’ include competition, rising labour and currency costs and the squeeze on consumer incomes.

This year’s hire sales were hit by the later timing of Easter, which traditionally signals the start of the wedding season, and a trend towards lounge suits rather than traditional morning dress.

More grooms are choosing to buy rather than hire their wedding suits, which is at least beneficial for Moss Bros’ retail business and Tailor Me personalisation service.

Nevertheless, Moss Bros’ half year results (28 Sep) were strong with pre-tax profit up by 16% to £4.2m.

Retail like-for-like sales grew 5.1% thanks to investment in staffing, stores and product ranges and this positive momentum carried over into the opening eight weeks of the second half period.

Encouragingly, Moss Bros is making progress with numerous online and store initiatives, while online expansion offers an exciting overseas growth opportunity.

‘Despite the short-term headwinds, we continue to see scope for profits to double from the current base over the medium term’, writes Cantor Fitzgerald, a buyer whose 130p price target suggests 40% potential upside.

For the current year, the broker forecasts pre-tax profit improvement from £6.9m to £7.2m for earnings of 5.6p per share, ahead of £7.3m and 5.7p respectively in 2019.

Moss Bros trades on a mere 5.1 times EV/EBITDA (enterprise value to earnings before interest, tax, depreciation and amortisation) which is too cheap, in our view. It currently boasts 18.4% return on capital employed, according to Stockopedia, which is a very healthy figure. (JC)


Free cash flow cows

Inspired by investment writer Jae Jun, Stockopedia’s ‘free cash flow cows’ stock screen looks for companies which are cheap relative to the amount of free cash flow they generate.

Unlike earnings, cash cannot be manipulated through clever accounting and should therefore offer a true picture of how a company is performing.

What this approach considers:

Enterprise value (market cap plus any liabilities) to free cash flow
Free cash flow to long-term debt
Free cash flow growth

 

Cheap stock #5

Base Resources (BSE:AIM) 19.75p

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An improvement in the price of mineral sands since 2016 has helped miner Base Resources to generate a large amount of cash and dramatically reduce its debt. Some analysts think it could be completely debt free by the end of 2018.

The company owns 100% of the Kwale minerals sands operation in Kenya. It has been producing from a high-grade section since December 2013 and plans to move to a lower-grade section in 2020.

Approximately 80% of the value of its production comes from ilmenite and rutile with zircon accounting for the rest. They are used to help make paint, plastics and ceramic tiles among other applications.

Base’s shares are incredibly cheap, trading on a mere 3.1 times EV/EBITDA (enterprise value to earnings before interest, tax, depreciation and amortisation). That’s at least half the level at which we’d expect someone to pay for a miner of its calibre in a takeover situation.

Broker RFC Ambrian has a A$0.54 price target which equates to 31p at current exchange rates. In comparison, stockbroker Numis has a 30p price target. Both imply you could make at least 50% return in 12 months. (DC)

 

Cheap stock #6

Portmeirion (PMP:AIM) 930p

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Ceramic homewares manufacturer Portmeirion’s shares continue to recover in the wake of a severe 2016 profit warning, triggered by a period of subdued Asian demand in India and South Korea, Portmeirion’s third biggest market.

We see good reason to buy at the current price, particularly as the stock is very cheap based on certain metrics. In fact, it passes all seven of the measures that constitute Stockopedia’s Free Cash Flow Cows screen.

Portmeirion boasts well-invested manufacturing assets and heritage British brands – Portmeirion, Spode, Royal Worcester, Pimpernel – the latter providing a durable competitive advantage.

Geographically diversified, the ceramics maker’s half year results (3 Aug) revealed 18% improvement in pre-tax profit to £1.6m on sales up 16% to £33.1m. The integration of scented candles-to-reed diffusers seller Wax Lyrical is on track, with new collections and co-branded home fragrance products having been successfully launched.

This augurs well with the seasonally important second half underway. A positive trading update in January could provide a catalyst for a re-rating. Sterling weakness also provides a boon for exports to Europe, where Portmeirion remains under-represented.

Prodigiously cash generative, Portmeirion increased the interim dividend by 5.7% to 7.4p, continuing its record of never having cut or withheld the dividend since its 1988 stock market debut, while net debt was reduced by £8m to £1.7m.

Cantor Fitzgerald analyst Mark Photiades has a ‘buy’ rating and £12 price target for Portmeirion, implying potential upside of 29%.

For calendar 2017, the analyst forecasts pre-tax profit recovery to £8.7m (2016: £7.8m), ahead of £9.6m and £10m respectively for fiscal years 2018 and 2019.

Portmeirion is trading on 9.3 times price to free cash flow. On that basis, Stockopedia ranks the company as top out of nine stocks in the household goods sector. (JC)

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Important information:

These articles are provided by Shares magazine which is published by AJ Bell Media, a part of AJ Bell. Shares is not written by AJ Bell Youinvest.

Shares is provided for your general information and use and is not a personal recommendation to invest. It is not intended to be relied upon by you in making or not making any investment decisions. The investments referred to in these articles will not be suitable for all investors. If in doubt please seek appropriate independent financial advice.

Investors acting on the information in these articles do so at their own risk and AJ Bell Media and its staff do not accept liability for losses suffered by investors as a result of their investment decisions.

The Shares team
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