Contrarian shares anyone?
Whilst my overall view of equity markets remains negative I do not want to ignore all shares completely and therefore continue to try and remain flexible in my thinking and try to monitor individual sectors or shares for opportunities.
When it comes to looking for shares my preference is to find value; however these are not so easy to find as (I have previously explained Value Investing – Tough Times Finding Suitable Candidates ) and to find them now its typically necessary to start moving into Small-Cap territory, and whilst I am not averse to this it does bring additional risks.
Therefore over the last week or so I have been looking for shares using a similar strategy to that explained by by David Dreman in the Contrarian Investor – I am a big fan of this book and the ideas in it, not to mention the fact that it should allow investment at any point in a market cycle as well as introducing a strict sell discipline.
The key criteria for the first search are: –
- Share makes up top 30% of shares by market capitalisation
- Shares PE are in the bottom 40% of the index
- Dividend yield is greater than 1.50%
The result of this data mining on the FTSE-350 produces the list below – this is still slim pickings!
The next stage is to have a look at some key criteria such as financial security, favourable ratios and growth when compared to the broader market as well as its own industry. When looking for potentially contrarian shares its also important to consider behavioural factors:
- Avoid investing where EPS forecasts are considerably lower – the turnaround can take years and with analysts typically over optimistic, even slightly negative forecasts can end up falling off a cliff and taking prices with them down further
- Hold the share for two years and remove it if it does not meet expectations
- If the share appreciates and the PE reaches the level of the index sell and replace it with another share
- Dividends should be consistent and sustainable
After this initial search looking at some of these shares I then focused on Next Plc and it was interesting working through each of the relevant indicators.
- Current ratio has declined from 1.8x in previous year to 1.4x
- Interest cover has remained fairly constant in the range of 26-28x
- The same is true of dividend cover at 2.8x and fixed charge cover at 4.4x
- The dividend payout ratio has remained at 35-36% since 2007 showing good discipline – the share price is not being propped up by raising the dividend excessively to attract investment
- Altman Z ratio remains at high levels 6.9 (below 1.8 means there is a risk of insolvency)
- Working capital has declined by almost £260m—the firm is using up its reserves
- Total liabilities/Total assets have remained fairly constant
- Leverage though has been increasing with the debt/equity up to 3.1 compared to 2.3 in 2013
- Capital discipline though has been good with total assets consistently increasing at a reasonable rate rather than at high levels that would lead us to question that EPS growth may be driven by acquisitions
- 2016 saw a deterioration in operating cash flow but a rise in profits; this divergence should be seen as negative as typically cash flow from operations has exceeded earnings by over £200m yet this year the figure has declined to £94.5m
- Cash conversion is also slowing, with debtors outstanding at 81.4 days (the time it takes for customer to pay) and stock days up to 42.5 (days it takes to sell stock) to its highest level since 1999; the financial statements for 2016 FY end also show that inventories have continued to rise. All of this suggests a weakening in sales and the length of time it takes the firm to convert stock to income – a case can of course be made that inventory is high at this time of year (January) for sales but this increase has been year on year.
Overall the firm remains financially secure; however the falling current ratio, declining working capital, rising debt and slowing cash conversion suggests that in the near term conditions are becoming tougher.
Favourable Financial Ratios & Forecasts
Over the last 15 year Next has successfully increased its revenue at a consistent rate of 6.66% per annum; whilst earnings have risen at a rate of over 16% p.a. since 2001. In earlier years a high dividend level that would ultimately prove unsustainable was in place until 2004 when it was cut; therefore the level of dividend growth is lower over 15 years at 2.83% p.a.
The growth in earnings at a faster rate than revenues has been achieved through consistent and growing profit margins (both gross an net); this coupled with effective use of assets has seen a Return on Equity far in excess of peers within the Apparel Retailers sector – however we would note that the rise in leverage has helped ROE growth in 2016.
Comparing Next plc to the median growth levels in the FTSE 350 it has performed well in maintaining a reasonable rate of revenue growth, outperforming compared to EPS Growth and showing DPS growth similar to that of the broader index (we would note the current trend in raising dividends and payout ratios within the FTSE-100 in particular).
Moving into 2017 however the broker consensus is for a dip in EPS – remember analysts are generally over optimistic so a small dip can quickly become a large decline; therefore risk exists that analysts could for next year be incorrect and earnings decline more.
On earnings ratios alone Next is below the long term averages for PE, PE10 and CAPE; but no by that much, whilst Price to Sales and Tobins Q in particular make it appear a little more pricey and closer to fair value. Most ratios are not even close to their most recent lows of 2009 but that period should be considered an extreme case.
The recent declines have made the share interesting but not a bargain, a few shorthand calculations confirm this: –
PE = Price / Earnings so Price = PE x Earnings
Price based on mean PE = Mean PE x Current EPS = 15.33 x 4.4632 =£68.42
Price based on mean PE10 = Mean PE10 x Current EPS10 = 20.91 x 2.6473 = £55.35
Price based on mean CAPE = Mean CAPE x Current CA EPS = 19.54 x = £55.35
If we were to have a two year holding period a the share reverted to its mean the gain from the current price of £54.87 would be anything from 0.87% to 24.69%; which coupled with a fairly secure dividend of 2.85% would provide a total return range of 6.65% to 30.47%.
With the current EPS at 1.7x the EPS10 and other ratios still above average the share may be priced to return the lower end of this range unless we see further price declines or an improvement in EPS forecast.
Business & Economic Conditions
The UK Consumer continues to spend and take on credit and this has now increased to levels beyond that of pre the financial crisis; the low interest rate environment and wealth effect of rising house prices has given many individual the confidence to make purchases and push retail sales forwards at over 4% year on year.
My next question from this is can this spending continue indefinitely?
Ultra low interest rates have discouraged savings and the UK household savings ratio is lower than in 2008. The consumer has also been helped by low inflation and more recently lower Oil prices – a shock to the system in the form of rising inflation or interest rates could see the consumer, with little savings in reserve, need to reign in spending quickly to cover borrowing and/or rising costs leaving much less disposable income.
The recent Next trading statement from mid May see guidance for the year moving downwards to the lower end of the range and an identification of falling consumer spending. Next is a well know UK Brand and certainly enjoys considerable loyalty from its customers, with support for the online Next Directory service particularly strong; the bias towards the UK means that the effects of Britain possibly leaving the EU may have less of an effect. However there does appear to be risk to UK retailers from a slowdown in consumer spending and falling revenues.
Within this statement the lower end of estimates would see an EPS 6.6% lower than present and push the PE ratio up to 13.16x based on the current price—effectively this would mean that reversion to mean PE may be driven more by EPS decline than price rises.
- Next is a well known UK brand that enjoys considerable consumer loyalty
- This loyalty has been reflected in growth in revenues, earnings, dividends and share price over the last ten years through efficient use of assets and profit margins of close to 15%
- The declines in price from the high of over £80 per share in August 2015 to £54.4 today have made it an interesting share to consider possibly for a contrarian purchase.
- Long term financial ratios appear strong, however near term there may be a sign of deterioration with rising cash conversion, declining cash from operations and the use of significant amounts of working capital year on year.
- Long term EPS has grown consistently but the uninterrupted increases of the last few years may now be at risk with a negative trading update and broker forecasts that suggest a modest deterioration (however this can easily become something much more severe).
- Falling EPS means that any potential value from the PE reverting to mean may not come from price appreciation; the long term PE10 and CAPE may be more indicative of the price and suggest the share is somewhere near fair value.
- From an economic/business view the UK consumer may again be over leveraged and overspending; the trading statement alludes to weakening demand.
Overall this has been an interesting exercise and many of the criteria for a contrarian purchase are in place, as well a Next being an attractive Company to own ; however the risk of falling EPS and the possible deterioration in fundamentals and short term financial security would lead me to the conclusion that the share would need to be purchased at a much lower price.
I started this exercise, trying to keep in check any biases that I have and hopeful that I would be telling you of an addition to the model portfolio; however this was not to be simply because as I worked through the analysis the evidence told me something different and raised a few red flags that made me question my initial positivity!
Ultimately I may be wrong and the price will return quickly to previous highs and I will have missed an opportunity, but there will be others; the beauty of investing is that there is always something around the corner.
That said Next is a Company I would like to have in my portfolio and I have set a price alarm for a review if it falls to £45 as well looking out for any news and broker ratings changes.
Model Portfolio Update
With no new shares to report things have remained pretty boring here……just how investing should be!
Since inception the Portfolio continues to stay ahead of the FTSE-100 Total Return Index – it only owns five shares at the moment making up around 10% of the portfolio with nearly 80% in index linked gilts and the rest in cash. There are many who would perhaps consider this heresy that so little was in equities however thats just my view of the Investment World! I would love to be fully invested in equities but the value or opportunities in my view are just not there at present, so until the time comes when you can invest in shares with a high probability of success I am staying put and looking for a reasonable return net of costs and taxes.