April 2019

Thought For The Month

We can often detect a discernible hint of curiosity from clients when we mention that our list of out-of-favour stocks has grown significantly in size. What new fish are swimming in our pool? There is a sense that they are expecting news of some outrageously high-quality stocks available at bargain prices. Sadly, on seeing the constituents of our ‘naïve’ out-of-favour screen, client curiosity quickly changes to something closer to polite disgust.

Their sentiment is understandable, but in a way completely predictable. The reality is that companies can only be truly out-of-favour if investors have very genuine concerns about their futures. If an investor thinks they have discovered a ‘gimme’ it is often because they have not fully embraced and understood the fears of others.

This visceral reaction to names on the list reflects a natural reaction to overweight the recent past when assessing the future – recency bias at work. And the more vivid the recent past, the harder it probably is to conceive of a vastly different future. For example, what’s your immediate reaction when considering the future of Royal Mail, M&S, ITV, BT, Thomas Cook, Kier and Capita? Unless you are the most bloody-minded of contrarians, the answer is unlikely to be particularly positive.

However, things do change. And one way of illustrating this is to look back at when some of the current underperformers (which thankfully we managed to avoid) were flying high.

For example, when Provident Financial’s share price was peaking at the end of 2015, an investment bank described it as a “safe place to hide” with a forward price earnings ratio of 20x. Similarly, Capita was described as a “relatively safe haven in a stormy market” as it peaked in the autumn of 2015 with a forecast price/earnings (P/E) ratio of almost 17x. Kier at its peak in 2015 was also a place to “shelter from the storm” with a prospective P/E of 15.9x. Even Royal Mail climbed to a forward P/E of 11.5x ratio at its peak in 2016 when there was “improved visibility on wages and regulations”.

These examples are not designed to embarrass anyone – we all have our own catalogue of mistakes – but simply to illustrate how facts (earnings) and views (the valuation put on those earnings) can change. In all these cases (and, yes, we are guilty of picking winners that developed into losers, but that is after all what our screen is designed to highlight) investors discovered they were applying high ratings to high earnings numbers. A very dangerous cocktail.

Obviously, our challenge is to ascertain which companies on our watch list are most likely to have futures significantly different from their recent past and provide investors with the beautiful combination of higher earnings priced at a higher valuation. Often – depressingly often – it is correct to extrapolate current trends, but experience tells us that hidden among the rubbish are some real gems doing their very best to look like rubbish.

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