With the FTSE 100 hitting new all-time highs and global stock markets in the ascendency since the Autumn it has arguably become more difficult to find stocks which offer good value.

This article delves into the unloved parts of the UK stock market to search for opportunities which investors may have missed. A problem with looking at cheaper stocks is they may be cheap for good reason and they are often of lower quality.

This could be problematic if the economy falls into recession because lower quality companies tend to be the most vulnerable. To avert this
risk Shares has applied a quality filter to the stock search.

WHAT CRITERIA DID WE USE?

Using the Stockopedia data platform we created a screen based on enterprise value to trailing free cash flow, setting the threshold at 10 times. Cash flow metrics are more reliable than earnings-based measures, which can be manipulated.

Enterprise value or EV for short is the total value of a business including its debt. Turn the ratio of EV to cash flow on its head and its reveals a free cash flow yield.

For example, oil and gas explorer Gulf Keystone Petroleum (GKP) has an EV to Free cash flow of 1.9 times which means the yield is (1 divided by 1.9 times 100) 53%.

This implies the company could generate cash equivalent to its enterprise value in two years which seems incredulous. This appears a case of investors not believing the free cash is sustainable.

In the case of Gulf Keystone, it operates in the politically sensitive and war-torn area of the Kurdistan region of Iraq which probably explains investor scepticism.

While it is not possible to eliminate all value traps, or situations where shares could stay cheap indefinitely, we have tried to reduce this risk by stipulating companies must have positive free cash flow growth over the prior five years.

To reduce the risk of inadvertently including low quality companies we have screened out stocks with a Stockopedia quality and value rank below 90.

In other words, the stocks which make the final list are the top 10% in terms of quality and value. This adds another level of diversification because the ranks are comprised of several metrics.

The value rank is a composite score ranked across six metrics including price to earnings ratio while the quality score is a composite score ranked across five metrics including long-term average return on capital employed and long-term operating margin stability.

BARGAIN BASEMENT STOCKS

The list of qualifying stocks is an eclectic bunch of names operating across diverse industries.

There are several metals and mining companies and a few oil and gas companies including Shell (SHEL) which has been throwing off lots of cash as energy prices have spiked due to the war in Ukraine.

How sustainable those cash flows will prove to be is questionable and it is also worth being mindful that resource and mining companies tend to look cheap around earnings peaks.

It is surprising to see managed hosting and cloud services company Iomart (IOM:AIM) on the list. However, profit hasn’t increased for several years and the growth in free cash flow is nothing to write home about.

Likewise, retailer Marks & Spencer (MKS) has an uninspiring earnings record and analysts expect a declining trend in the next couple of years. Speciality retailers N Brown (BWNG:AIM) and Card Factory (CARD) have had terrific runs in the last few months with the latter’s shares doubling and the former up over 40%.

N Brown finds itself in an interesting position after Mike Ashley’s Frasers Group (FRAS) swooped in to take a 12.6% stake while leading shareholder Lord David Alliance has also been increasing his 43% stake in the company.

SHARES’ TWO TOP PICKS

SHOE ZONE. Price: 245p

One share we believe is undeservedly cheap with good prospects not just in the current environment but long term is discount footwear retailer Shoe Zone (SHOE:AIM).

The free cash flow yield of 18% looks very attractive against a five-year compound annual growth rate of 33% a year. The business doesn’t need to offer loads of growth if it is throwing off cash and paying it out to shareholders.

The company delivered strong results for the year to 31 October with adjusted pre-tax profit up 18% to £11.2 million. The board announced a special dividend of 8.2p per share in addition to a final dividend of 3.3p per share.

Including two interim payments of 5.5p the 2022 payout equates to 17p, giving a dividend yield of 7% In addition, the firm purchased nearly one million shares reducing the share count and boosting earnings per share.

The balance sheet is solid with a net cash position of £24.4 million, representing 21% of the market capitalisation.

Shoe Zone is benefiting
from the cost-of-living squeeze as consumers look to trade down within their non-discretionary budgets.

The firm can be competitive on price due to the high volumes it orders direct from factories. It sells a wide range of brands including Skechers, Kickers, Lilley & Skinner and Heavenly Feet.

SOMERO ENTERPRISES. Price: 405p

Laser assisted concrete levelling equipment maker Somero Enterprises (SOM:AIM) is a quality business with strong barriers to entry which emanate from its intellectual property.

The 10% free cash flow yield looks attractive against a 20% five-year compound annual growth rate. In September 2022 Shares discussed the possibility of Somero being a value trap.

The shares do not appear to be a trap mainly because investors have already priced in the risks and probability of a recession. The cyclicality of the construction industry means profits can quickly turn into losses.

But it is important to look beyond the cycle and over the long term the company has grown profit by a compound annual growth rate of 15% a year.

If investors are prepared to accept greater share price volatility due to the cyclicality of the business the future rewards look attractive relative to the low rating.

At a recent trading update (31 January) Somero said it expected 2023 revenues to around the same record levels as 2022 ($134 million) and a lower EBITDA (earnings before interest, taxes, depreciation, and amortisation) margin as the company invests to add ‘strategic resources for future growth’.

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