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Cash Magic does the trick

My Cash Magic screen has had a storming 12 months, with returns driven by the rampant recovery in the resources sector
June 6, 2017

A key reason for the strong performance of the main UK indices since early 2016 is the rampant recovery by the beaten-up shares of resources companies. Indeed, based on Thomson Datastream data, FTSE All-Share resources stocks (industrial metals, miners, oil and gas producers, and explorers) have on average produced a 52 per cent total return over the past year and almost 60 per cent when weighted according to market capitalisation.

Given that resources companies make up a small proportion of the FTSE All-Share by number (about 6 per cent), but much heftier proportion by market cap (about 14 per cent), I've frequently made reference to the effect of this phenomenon on the overall index in the context of screens that have missed out on the sector's recovery and underperformed the market. However, in the case of the Cash Magic screen, it's a thumping outperformance of the markets over 12 months that needs to be seen in light of these notable market dynamics.

Of particular significance when it comes to contextualising the Cash Magic screen's performance over the past year is Ferrexpo, which chalked up an astronomical 534 per cent total return. However, it wasn't the only runaway resources stock picked by the screen (see table) and, in all, despite being a relatively well diversified screening system based on 30 stocks (more details of the screening process are given below), the Cash Magic share picks managed a 12-month return of 45.8 per cent between them, compared with 25.4 per cent from the FTSE All-Share index. As well as the 30-stock version of the screen, I run another version of the screen that looks for stocks that are attractive based on the main valuation and quality criteria and also show good momentum. This version of the screen actually did best over the past year, with a 52.6 per cent total return.

 

2016 PERFORMANCE

TOP 30 SHARES

NameTIDMTotal return (2 Jun 2016 - 30 May 2017)
FerrexpoFXPO534%
GlencoreGLEN129%
WincantonWIN99%
IndiviorINDV95%
VedantaVED85%
Oxford InstrumentsOXFD80%
EvrazEVR73%
InterContinental HotelsIHG68%
AshteadAHT66%
Morgan SindallMGNS62%
Mirco FocusMCRO52%
RPSRPS50%
Speedy HireSDY47%
NorthgateNTG40%
QinetiqQQ.33%
RMRM.32%
PaypointPAY14%
SercoSERC10%
BerkeleyBKG10%
ComputacenterCCC5.7%
PetropavlovskPOG5.3%
DartyDRTY1.3%
SthreeSTHR-5.0%
Puretech HealthPRTC-5.6%
StagecoachSGC-13%
XaarXAR-20%
Go-AheadGOG-25%
PetrofacPFC-46%
Game DigitalGMD-48%
LonminLMI-56%
FTSE All-Share-25%
Cash Magic-46%

 

MOMENTUM SHARES

NameTIDMTotal return (2 Jun 2016 - 30 May 2017)
FerrexpoFXPO534%
GlencoreGLEN129%
IndiviorINDV95%
VedantaVED85%
EvrazEVR73%
AshteadAHT66%
Morgan SindallMGNS62%
WS AtkinsATK59%
Micro FocusMCRO52%
RPSRPS50%
Speedy HireSDY47%
McColl's RetailMCLS41%
Telecom PlusTEP35%
Hilton FoodHFG32%
HeadlamHEAD31%
De La RueDLAR30%
EuromoneyERM29%
PageGroupPAGE26%
EquinitiEQN15%
PaypointPAY14%
SercoSERC10%
PetropavlovskPOG5.3%
DartyDRTY1.3%
SthreeSTHR-5.0%
ConnectCNCT-15%
Braemar ShippingBMS-26%
LonminLMI-56%
FTSE All-Share-25%
Cash Magic Momentum 20%-53%

Source: Thomson Datasteam

 

The screen has had a good run since I commenced running it four years ago and has outperformed in each 12-month period. The 30-stock screen now boasts a cumulative total return of 134 per cent, or 120 per cent if an annual charge of 1.5 per cent is factored in to account for the notional costs of switching from one portfolio to the next each year. The FTSE All-Share has delivered a 38.0 per cent return over the same period. Meanwhile, the momentum version of the screen has delivered a cumulative total return of 116 per cent, or 103 per cent with costs.

 

CASH MAGIC VS ALL-SHARE

 

The screen itself attempts to substitute cash-based metrics measuring business quality and stock valuation for the earnings-based metrics used in the classic "magic formula" screen developed by hedge fund star Joel Greenblatt and outlined in his very readable bestseller The Little Book That Beats The Market.

 

WHY CASH NOT EARNINGS

While the 'Cash Magic' screen has performed very well in the four years I've run it, there are grounds to think that focusing on cash is likely to make the screen's results more erratic than the classic, earnings-focused Greenblatt screen. The reason for this is that the cash flows reported by companies are by nature often more erratic than the earnings companies report and could prove a less reliable indicator of underlying performance for that reason. For example, a big one-off investment, such as building a new factory, will hit cash flow hard in the year(s) the investment is made but in later years cash flow will benefit as the company generates returns from the new asset. The impact of the cost of the investment on earnings, by contrast, will be spread over what is judged to be the useful economic life of the asset.

However, fans of cash flow analysis will point to the fact that it is far harder to manipulate the cash flow statement than it is the earnings statement (for example by over estimating the useful economic life of an investment leaving the need for writedowns several years later). For this reason many investors regard cash flows as a more reliable guide to performance, especially when analysis is based on long-term trends. And because cash flows can be very changeable from one year to the next, cash has the virtue of often being overlooked by investors, which means companies that have very attractive cash characteristics can become temporarily undervalued.

 

HOW THE SCREEN WORKS

I originally came up with the Cash Magic screen in response to a reader's request for a screen incorporating the cash-return-on-investment (CROCI) measure of company quality. This ratio tells us, in a given year, how much free cash a company is producing as a proportion of the capital that has been invested in its operations (or at least a rough approximation of this from the balance sheet). CROCI can in some ways be regarded as the cash flow equivalent of return on capital employed (ROCE). The ratio is calculated like this:

Free cash flow (adjusted for cash finance costs/income)/capital employed

The screen ranks all FTSE All-Share companies based on CROCI. It also ranks all stocks based on their enterprise-capital-to-free-cash-flow (EV/FCF) ratio. EV/FCF is a cash flow equivalent to a price/earnings ratio, adjusted to factor in the amount of net cash or debt a company has. The idea behind factoring in the amount of net cash or debt a company has is to get a view of valuation based on the entire company rather than just the bit funded by shareholders (the equity). Mr Greenblatt makes similar adjustments to account for a company's net debt/cash position with the price/earnings (PE) ratio he uses in his Magic Formula.

Once every stock has a rank for CROCI and a rank for EV/FCF, the two are combined and a final ranking is based on this. The screen then picks the top 30 ranked stocks. Mr Greenblatt recommends that his earnings-based Magic Formula is used to create a 30-stock portfolio, but also believes 20 stocks should work.

For the Cash Magic screen I also produce a portfolio of stocks that boast a ranking in the top fifth of all stocks screened as well as better than average three-month share price momentum. Details of the stocks in each portfolio are given below.

 

30 CASH MAGIC SHARES

NameTIDMMkt capPriceFwd NTM PEDYEV/ FCFCROCI3-mth momRank
Morgan Sindall  MGNS£545m1,240p132.8%2.149%23%1
Interserve IRV£327m225p43.6%3.026%-7.8%2
Costain  COST£507m484p142.6%5.334%22%3
Ferrexpo FXPO£1.0bn172p31.5%5.532%7.8%4
Indivior INDV£2.3bn326p13-6.4135%-8.2%5
Northgate NTG£699m531p113.0%4.925%-6.1%6
UDG Healthcare UDG£2.0bn817p271.2%6.228%18%7
Vedanta Resources VED£1.7bn612p57.0%4.119%-33%8
Savills SVS£1.2bn865p133.4%6.628%-1.3%9
Hochschild Mining HOC£1.5bn286p270.7%6.221%12%10
Euromoney Institutional Investor ERM£1.2bn1,150p152.0%8.237%1.2%11
Entertainment OneETO£1.0bn244p110.5%6.220%1.2%12
Galliford Try GFRD£1.0bn1,250p86.6%6.620%-20%13
KCOM  KCOM£486m94p186.3%9.131%2.2%14
St Ives SIV£69m48p416%4.215%-14%15
Speedy Hire SDY£304m59p181.7%7.618%16%16
Lamprell LAM£365m107p--1.813%9.4%17
Cape CIU£290m240p82.9%5.813%39%18
ITV ITV£7.8bn196p126.2%1231%-9.5%19
UBM UBM£2.8bn723p143.0%9.518%-3.5%20
Gocompare.com  GOCO£391m94p1619%15515%-5.3%21
ITE  ITE£418m157p192.9%1222%0.2%22
4imprint  FOUR£481m1,716p212.4%1659%1.0%23
Hays HAS£2.4bn167p171.7%1427%1.7%24
Wincanton WIN£380m308p113.0%1762%14%25
Avon Rubber AVON£333m1,100p170.9%1423%13%25
GVC  GVC£2.4bn804p16-10.017%14%27
Kainos  KNOS£275m232p242.6%1846%8.2%28
Communisis CMS£112m54p94.5%5.311%1.5%28
Persimmon PSN£7.6bn2,455p115.5%1218%13%30

 

CASH MAGIC MOMENTUM SHARES

NameTIDMMkt capPriceFwd NTM PEDYEV/ FCFCROCI3-mth momRank
Morgan Sindall  MGNS£545m1,240p132.8%2.149%23%1
Costain  COST£507m484p142.6%5.334%22%3
Ferrexpo FXPO£1.0bn172p31.5%5.532%7.8%4
UDG Healthcare UDG£2.0bn817p271.2%6.228%18%7
Hochschild Mining HOC£1.5bn286p270.7%6.221%12%10
Speedy Hire SDY£304m59p181.7%7.618%16%16
Lamprell LAM£365m107p--1.813%9.4%17
Cape CIU£290m240p82.9%5.813%39%18
Wincanton WIN£380m308p113.0%1762%14%25
Avon RubberAVON£333m1,100p170.9%1423%13%25
GVCGVC£2.4bn804p16-1017%14%27
Kainos  KNOS£275m232p242.6%1846%8.2%28
Persimmon PSN£7.6bn2,455p115.5%1218%13%30
Thomas Cook  TCG£1.4bn92p90.5%8.013%4.0%32
Forterra FORT£535m267p122.8%1519%34%35
Capita CPI£3.9bn583p115.4%1115%4.2%36
Telecom Plus TEP£1.1bn1,321p233.6%1924%7.9%37
Howden Joinery  HWDN£2.8bn453p162.4%1926%5.6%38
Crest NicholsonCRST£1.6bn632p94.4%1114%9.5%39
LSL Property Services LSL£238m232p104.4%1114%13%40
Moss Bros  MOSB£121m120p214.9%1515%9.5%43
Lookers LOOK£510m129p82.8%1213%6.5%46
Sophos  SOPH£2.1bn452p711.1%1918%66%47
Severfield SFR£249m83p152.4%1112%7.2%48
John Laing  JLG£1.1bn299p72.7%1011%7.3%49
AG BarrBAG£762m659p212.2%2017%22%51
Tarsus  TRS£324m288p113.2%1513%5.0%53
Next NXT£6.2bn4,360p113.6%2318%10%57
Moneysupermarket.com  MONY£1.9bn349p212.8%2933%4.2%57
Dixons Carphone DC.£3.8bn329p103.0%9.210%5.6%59
MJ Gleeson GLE£346m642p142.3%1613%9.6%60
RELX REL£34bn1,663p212.2%2519%10%62

Source: S&P Capital IQ