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How our 'Best of the FTSE 350' is performing

There are early signs of encouragement for our makeshift peer-group portfolio, which was constructed by applying financial ratios to companies in the same industries
June 23, 2017

I am wary of waxing lyrical about the virtues of systematic stock selection techniques. This is not to say they don't work - witness the success of Investors Chronicle's benchmark momentum portfolio - but there are bound to be times when strategies underperform, which is disheartening in a period where simply holding a cheap index tracker is more successful than chopping in and out of trades.

The reason investors choose to buy individual stocks, however, is confidence that the market can be beaten and because they are prepared to take on a little more risk in the attempt. Screening rules can be applied to help isolate stocks that are most suitable for individual requirements and, more generally, investors will want to highlight the best value quality companies. With this in mind, back when the IC published its FTSE 350 review at the end of January, we applied ratios on a sector-by-sector basis to select a diverse 'best in class' portfolio. There are a few caveats to be made, the first of which is that just over four months isn't long enough to judge, but the early signs for the 19-stock portfolio are encouraging, with a total return of 13.43 per cent so far, versus 6.82 per cent for the FTSE 350 index.

As noted, when the selection was first published, our equal weightings make for an uneven comparison with the market-capitalisation-weighted FTSE 350. If some of the bigger sectors did exceptionally well our makeshift portfolio would in likelihood do worse than the index. Many investors would also have sectors and industries they would tend to be over- or underweight towards depending on their reading of the macro-environment and the economic cycle. Our portfolio is a simple overview of companies in each major sector that looked attractive relative to industry peers.

 

A mix of mechanical and normative decision-making

There can be enormous differences between companies grouped in the same sector, so comparisons were only made between those in the same industry. A maximum of two companies per sector were chosen, so the first normative judgment was on which industries to ignore on the basis that other companies were more impressive vis-à-vis their direct peers.

In making comparisons, some ubiquitous financial ratios were used, such as price/earnings (PE) and price-to-book value (PB), but these metrics are still more relevant for companies in the same industries. As well as being part-scientific, the pan-industry comparisons also relied on normative judgments based on the opinion of the IC sector writers. Therefore, we are effectively using passive screening techniques as one method of informing an active investment style. Of course, this opens the door to some of the behavioural and cognitive biases that affect investors' returns, but being psychologically comfortable is important. Holding companies you like, having studied their financial health and business models is easier than some mechanical stock selection strategies, which may require you to buy stocks you know very little about - which, of course, runs contrary to the strongly held maxims of successful investors such as Peter Lynch and Warren Buffett.

 

How our picks are doing, sector by sector (27/1/2017 to 16/6/2017):

Consumer discretionary: Berkeley Group (housebuilding) and Compass Group (restaurants)

Berkeley Group (BKG) has made total returns of 17.92 per cent since we ran the screen. It was selected based on its relatively cheap PE compared with other housebuilders and a best-in-industry return on equity (ROE), which measures the profits attributable to ordinary shareholders as a percentage of their equity.

For valuation purposes, as well as looking at PE, we also screened according to the ratio of enterprise value (EV) to earnings before interest, taxation, depreciation and amortisation (Ebitda). Using EV, which represents the entire capital structure of a business - equity and debt - reflects all of the claims on the profits of the business. Using Ebitda as the measure of profit helps neutralise differences in the way companies (even in the same industry) account for items such as depreciation and goodwill. Applying these ratios to the housebuilders in January, Berkeley Group scored well, but has not matched the performacne of others in the industry, some of which have made over 20 per cent since we published our portfolio. The hope is that with its higher ROE and a cheaper valuation than other companies with a higher EV/Ebitda, Berkeley may still have relatively more upside left.

The second industry chosen within the consumer discretionary sector was restaurants and our pick here, Compass Group (CPG) is up 17.97 per cent, one of the best performing stocks in an industry with mixed fortunes. The company was selected for quality characteristics, including robust cash flows as well as the judgments made by our writers in favour of its business model and the quality of management - a factor also attested to by an impressive return on equity.

 

Consumer staples: Britvic (soft drinks) and British American Tobacco (tobacco)

Britvic (BVIC) is up over 16 per cent on total returns as it has seen the value we flagged in January realised. The company was picked on the back of its impressive ROE versus other soft drinks manufacturers and an attractive dividend yield. The choice of British American Tobacco (BATS) over its rival Imperial Brands (IMB), was based on the return on equity and its head-to-head outperformance is particularly edifying, as BATS has made 14.36 per cent versus -2.38 per cent for IMB.

 

Energy: Royal Dutch Shell (integrated oil & gas) and Cairn Energy (oil & gas exploration)

Following a stellar recovery in the latter part of 2016, performance in the energy sector has been muted so far this year. The share price of Shell (RDSB) has fallen back slightly and in the small-cap space, the value we identified at Cairn (CNE), on the back of its low ratio of EV to proven reserves, has not yet been realised. Still, in a diversified portfolio, this is one riskier stock we are happy to hang on to, although with heavier reliance on the normative judgments of our reporters. With good news on projects under way, this remains one to watch.

 

Financials: Lloyds (diversified banks) and Legal & General (life and health insurance)

Of the banks, Lloyds (LLOY) was selected because it had a healthy dividend yield and subsequently it has been one of the better performers. The other financial pick was Legal & General (LGEN), which also had a high dividend yield that crucially was well covered and, as its payout ratio was not high by the standard of other insurers, it appeared sustainable. The company has been another solid performer, generating a total return of 8 per cent. This has been less impressive than peers, but with only a third of a year gone since it was picked, there is scope for it to re-rate higher.

 

Healthcare: AstraZeneca (pharmaceuticals) and UDG Healthcare (healthcare services)

Healthcare is a sector that was already trading on high multiples thanks to the rush for bond proxy income stocks and dollar earners after the EU referendum in the UK. With valuations stretched, choices were made largely on the analysis of our pharma correspondent. With dollar earners likely to be beneficiaries from further sterling weakness, there has been further upside for AstraZeneca (AZN) and UDG Healthcare (UDG) since January, with the stocks making total returns of almost 29 per cent and 35 per cent, respectively. These are two of the strongest performers in a solid sector.

 

Industrials: BAE Systems (aerospace and defence) and Bodycote (industrial machinery)

Industrials is another big sector with many different industries that can't really be compared with one another. The normative judgment of which industries to choose contained an element of heuristics - the companies that looked relatively better versus their sub-sector peers based on the easiest to understand metrics. A more intricate knowledge of the individual industries can actually help you choose the best ratios to apply, but we focused on an application of EV/Ebitda to compare profitability with capital valuation; return on capital employed, to show how successfully the business has put that capital to use; and dividend yield and cover. Two companies that stood out in their respective industry sub-sets were BAE Systems (BA.) and Bodycote (BOY), both of which have since made total returns of around 16 per cent. There have been companies in other industries that have done better, but we can be happy with these holdings.

 

Information technology: Playtech (home entertainment software) and Moneysupermarket.com (internet software and services)

When one thinks of IT and tech stocks, the image of disruptive industries with growth potential springs to mind. In the 21st century, however, some of these companies are now long established (in the US, the top five companies by market cap are now technology companies) and we went for companies that were hardly new kids on the block. In the case of Moneysupermarket.com (MONY) we were impressed by its quality characteristics, including impressive return on equity and operational cash flow. The shares have since made total returns just shy of 10 per cent. Gaming software company Playtech (PTEC) has done even better, making 23 per cent.

 

Materials: Rio Tinto (diversified metals and mining) and Synthomer (speciality chemicals)

A loss of 12 per cent does not usually give cause for feeling vindicated, but this was a best-in-class selection, so losses by Rio Tinto (RIO) have to be viewed in the context of more severe weakness for BHP Billiton (BLT) and Anglo American (AAL). Flagging that it had a better ROE and showed more commitment to its dividend than rivals, Rio was our mining pick. The other materials selection was Synthomer (SYNT) from the chemicals industry. This has performed better, with a total return of 16 per cent. The case over other chemical manufacturers that have actually delivered even more stellar returns was that Synthomer looked cheaper on a PE and EV/Ebitda basis - this still holds true and there could be more upside for a company with momentum and more value to be realised.

 

Real estate: Savills (real estate services)

As we already had a housebuilder, we decided to limit real estate to one company. This was Savills (SVS), which has delivered a creditable 17.5 per cent. It still has a solid cash position and strong balance sheet to support a decent 3.25 per cent dividend.

 

Telecommunications: Inmarsat (alternative carriers)

Thanks to takeover rumours, Inmarsat (ISAT) has made a stunning 32 per cent in four months, although without knowing this was in the offing the stock was selected on the basis of its ROE and a positive cash flow, which offered hope that it could manage a large amount of debt.

 

Utilities: United Utilities

With a decent and well-covered dividend yield, plus a less toppy PE than others in its sector, United Utilities (UU.) was the final selection for the portfolio. The 7 per cent total return is less than Pennon (PNN) delivered, but UU's dividend was slightly better covered when the choice was made back in January.

 

Going forward

As we've acknowledged, this selection of 19 companies may have beaten the FTSE 350 so far simply because of its equal weighting. Large companies in banking, mining and oil & gas make up a larger proportion of the market-capitalisation-weighted FTSE 350. These industries have been relatively weaker performers, so our equal-weighted portfolio is more exposed to the strongest industries even before stock selection decisions are taken.

Some of the companies selected have not delivered the most impressive returns in their industry, but of those which have lost value - the likes of Rio Tinto and Cairn Energy - the quality filters we have applied have helped us avoid the very worst falls.

Given that some of our companies in other sectors were bought on value criteria, we should not be surprised that, in just four months, shares with more momentum in January have outperformed. As we are up overall, we perhaps shouldn't concern ourselves overly, there is plenty of time for the value cases to be realised and hopefully it is just a sign that there is more potential upside to be had.

 

BOX: Some of the ratios used

This screening exercise has been somewhat cursory and based on just a few core metrics. Where we tried to add a bit more focus is on looking just at companies in the same industries. This hasn't necessarily led to selecting the very best-in-class performers over a few months, but hopefully it can add perspective to selecting quality companies that might do well over the longer term. There are, in fact, even more useful and industry-specific metrics that we can apply, although gathering the correct inputs can involve access to specialist industry data. For now, though, using data easily available through our S&P Capital IQ market intelligence terminal, we were able to use a cross-section of the following ratios to choose our companies:

Price/earnings ratio: Share price-to-earnings per share

Price-to-book ratio: Share price-to-book value per share. PB is a common value indicator, but for some industries, like technology - where much of the value is intangible intellectual property - it isn't as useful.

EV/Ebitda: An alternative to the basic PE ratio, using enterprise value (EV) reflects the value of the entire capital structure of a business – debt and equity. Dividing this figure by Ebitda (earnings before interest, tax, depreciation and amortisation) gives the ratio of claims by all capital owners to profits.

Return on equity (ROE): This is the profits attributable to ordinary shareholders as a percentage of the value of their equity. It is an indicator of how much of a return management has made on shareholders' capital.

Levered cash flow: This is the free cash flow that a company has after meeting its operational expenses and interest payment obligations - this was looked at as a quality measure to check companies had money available to invest in the business or reward shareholders.

Dividend yield: Dividend per share/share price

Dividend cover: Earnings per Share/dividend per share. Dividend cover shows how well the dividend is covered by company profits and is therefore a measure of the sustainability of payouts.

 

Table: The companies selected on 27 January and how they have fared

 

SectorIndustryCompanyTotal returns 27.1.2017 to 16.6.2017 (%)
Consumer DiscretionaryHousebuildersBerkeley Group (BKG)17.98
Consumer DiscretionaryRestaurantsCompass Group (CPG)17.97
Consumer StaplesSoft DrinksBritvic (BVIC)21.09
Consumer StaplesTobaccoBritish American Tobacco (BATS)14.36
EnergyIntegrated oil & gasRoyal Dutch Shell (RDSB)- 2.68
EnergyOil and gas explorationCairn Energy (CNE)- 21.18
FinancialsDiversified banksLloyds (LLOY)7.67
FinancialsLife insuranceLegal & General (LGEN)10.79
HealthcarePharmaceuticalsAstraZeneca (AZN)28.78
HealthcareHealthcare servicesUDG Healthcare (UDG)34.75
IndustrialsAerospace & defenceBAE System (BA.)15.92
IndustrialsIndustrial machineryBodycote (BOY)16.93
Information technologyHome entertainment softwarePlaytech (PTEC)22.73
Information technologyInternet software and servicesMoneysupermarket.com (MONY)9.64
MaterialsMetals and miningRio Tinto (RIO)- 12.22
MaterialsChemicalsSynthomer (SYNT)16.11
Real estateReal-estate servicesSavills (SVS)17.49
TelecommunicationsAlternative carriersInmarsat (ISAT)31.66
UtilitiesWater utilitiesUnited Utilities (UU.)7.34
    
  Portfolio Average TR13.43
  FTSE 350 TR6.82

 

Source: S&P Capital IQ, Bloomberg and Investors Chronicle