Big name stocks for all seasons

Magic squared 

Things are looking up for the stockmarket according to Edmund Ng, an Analyst at Morgan Stanley. In a research note published the day before Halloween, he recommended investors buy shares in quality, stable, growth companies that typically perform well in bull markets.

During the panic culminating last March, investors abandoned companies with weak finances, and poor profitability, worried they might not survive the economic crisis. The really wretched, like Woolworths, didn’t. But with Armageddon averted, or delayed at least, the survivors looked really cheap and investors gobbled them up in a recovery dubbed ‘the dash for trash’.

So far this year, Ng says, ‘value factors’ (explained in this table, published a couple of weeks ago) have beaten ‘growth’ and ‘quality factors’ by 25%, but that spread is narrowing, implying the dash for trash, or as Ng more politely calls it, the “value driven rally”, might be nearing its end.  Also, he says, investors are favouring companies that are genuinely growing sales and profits, over those that are cost cutting.

It sounds like Ng thinks the market is entering the ‘Sweet summer of growth’ in Morgan Stanley’s model of the stockmarket cycle (click to enlarge):

That’s when companies that have grown profits and sales, and are expected to keep growing, do better than companies with low share prices in relation to the value of their earnings, sales, cash flow and assets. Psychologically it means investors are becoming more credulous, and less disciplined.

They’re prepared to pay more for shares because they believe they will do well, as opposed to paying less to ensure they get a good return regardless.

It sounds plausible, but whether the trend will continue is speculative. A quick glance at my own chart comparing the level of the stockmarket to average earnings shows it’s not particularly cheap, or expensive. In other words, the odds of a prolonged period of rising, falling or relatively stable prices looks pretty even to me.

Ng isn’t abandoning value though, he suggests two strategies:

The first, ‘Morgan Stanley Reliable Growth’, sounds a bit dubious as the words ‘reliable’ and ‘growth’ rarely go together when applied to companies. Nevertheless, he says his basket of robust growers like BAE Systems, BAT, Vodafone, Sage, Reckitt Benckiser, Next and Rolls Royce, has beaten the market by an average of 12% in the last decade and it’s currently cheaper than it’s ever been compared to the market.

Twelve per cent sounds good, but shares in general have lost money over the last decade so his second strategy, which made money in the 17 of the last 19 years with an average total return of 13% a year sounds more interesting, particularly for investors who don’t have a strong conviction the market will rise from here.

Strategy two combines Joel Greenblatt’s Magic Formula and Joseph Piotroski’s F_Score. The Magic Formula looks for cheap shares (a high earnings yield) combined with high profitability (a high return on capital) to identify good companies at cheap prices. The F_Score is a measure of financial strength I’ve described before in detail. Ng’s screen requires an F_Score of five or more out of nine.

While it’s easy to test data and discover spurious strategies that appear to work, companies beginning with the letter ‘A’ might also beat the market, the justification for basing a strategy on Greenblatt and Piotroski’s work is compelling. Surely cheap, profitable, financially sound companies are likely to do well in future. Better them than expensive, unprofitable, indebted companies.

The UK companies selected by Ng’s ‘Combo’ strategy are:

• United Business Media
• Tui Travel
• Burberry
• Thomas Cook
• Petrofac
• AstraZeneca
• GlaxoSmithKline
• Smith and Nephew
• Go-Ahead
• BAE Systems
• Smiths Group
• Rentokil Initial
• Intertek
• FirstGroup
• Misys
• BHP Billiton
• Cable&Wireless
• BT
• Centrica

He only screens the biggest, most heavily traded companies, so there are no small company bargains in this list, but in combining a value factor (the earnings yield in the Magic Formula) with a safety factor (the F_Score) it’s similar to my own Thrifty 30 screen.

I reckon Ng is right in his belief that his Combo strategy should make money in bull and bear markets.

Surely that’s the safest approach.

-

Thrifty 30 candidates

Here’s the latest Thrifty 30 screen. As usual, much of the data comes from Sharelockholmes.com. Judging by the numbers the companies at the top are cheapest, and healthiest.

As I said last week, I’m putting the notes explaining the column headings on a special page, but until then, they’re at the bottom of this post.

-

The twelve most significant factors

Talking of growth and value factors, CXO Advisory Blog has found a paper identifying the twelve most significant factors for predicting monthly returns.

Warren Buffett’s made “an all-in wager on the economic future of the United States”. His biggest acquisition ever is a railroad.

The best trades can be the ones not entered, moans Dividend Growth Investor, but nobody wants to hear about them.