Screening for Value: A First-Pass Analysis

In last week’s article, I looked at the value investor’s mindset and introduced one of the most basic value screens: the 52-week low. Given the weak markets, looking for 52-week lows alone yielded far too many results to analyse. Hence, I narrowed down the field with a few additional criteria. Firstly, I only looked at companies with a market cap between £10m and £600m. The lower limit helps ensure the liquidity to invest if I find something interesting. The upper limit is because the academic research on 52-week lows suggests the outperformance is concentrated in the smaller stocks. In addition, I required a Stockopedia Value Rank above 80 and a strong balance sheet, as measured by the current ratio. Finally, I excluded funds, REITs and banks, leaving 26 companies that merited further investigation. Over the next few articles, I will lead readers through a first-pass analysis of the screen results.

The approach investors take when conducting an initial analysis of potential investments matters. This is because we suffer from something called Information Order Bias; when assessing a complex situation, we tend to put more weight on the first piece of information received. Information order bias has been shown to affect how we vote (disproportionately for the first candidate on the ballot paper) and, perhaps even more worryingly, in one study, how accurately air defence operators can identify aircraft as friend or foe.

Many investors start their analysis by reading the management commentary from recent results or, perhaps, a broker’s note. Unfortunately, the management of most companies will be, consciously or unconsciously, biased to think positively about the future of the business they lead. Many CEOs reach the pinnacle of their organisations because they are strong salesmen or adept at getting people to like them. This sales instinct often remains when they take on the top job.

Similarly, the brokers are incentivised to look on the bright side of life and write positively about their clients. You only have to compare the number of ‘buy’ recommendations to the number of ‘sell’ recommendations to see where this incentive system leads. Those who read management commentary or brokers’ notes first are, therefore, likely to be putting on a pair of permanent rose-tinted spectacles.

In contrast, legendary value investor, and 52-week low screener, Irving Kahn, said that investors should:

“…start at the back [of an annual report], where you tend to get the key financial information.”

This is why the Stockopedia StockReport is such a valuable tool. It enables investors to harness the power of information order bias by reading a summary of the key financial information before reading management commentary. I take this approach to an extreme: if I read the Stockopedia StockReport for a company and I don’t like what I see, I won’t even attend a management presentation. I may miss the occasional good investment opportunity, but it saves me from being misled by a great story that never ends up in the financial results.

Very few companies end up trading at 52-week lows when they are trading well, have a positive outlook, great products, growing markets and excellent management. Therefore, when we look at the results of this screen, we are likely to find something wrong with the companies. In these inflationary times, the most likely issue will be a weak outlook. However, the value in a business is rarely in one year’s numbers, and these short-term issues may provide an opportunity for the patient value investor.

However, some issues are of sufficient severity that I will rule out those companies as investments at this stage. These are excessive debt and the risk of earnings manipulation.

Excessive Debt, including Large Pension Liabilities

By requiring a current ratio of 1.5 or above, I have already ruled out companies that may be facing short-term financial difficulties. However, long-term debt still needs to be serviced by the company, and excessive debt may make a company overvalued or too risky to consider investing in. Therefore, when the main attraction of an investment is that it appears cheap on earnings multiples, I will exclude it from further consideration if it no longer looks good value when I debt-adjust those.

The subject of pension deficits, such as the difference between IAS19 and Triennial valuations, can fill an article on its own (and I may inflict this upon readers at a later date!) However, the simple truth is that pension deficit recovery payments have to be met from cash flow and represent real cash leaving the business that cannot be used for dividends or re-investment into growth. Therefore, adjusting any earnings multiples for the pension recovery payments makes sense.

On this basis, I exclude two companies from further analysis.

The first is Carclo (LON:CAR) which has £32.4m of debt compared to a market cap of around £15m and has committed to paying pension deficit recovery payments of about £3.8m, potentially for the next 18 years. Adjusting for this makes the Price Earnings ratio above 20, and the company no longer looks cheaply rated.

The second is De La Rue (LON:DLAR). The presence of £82.5m of net debt compared to a market cap of £143m is not as bad as Carclo. However, annual pension recovery payments of £16.4m last year compare unfavourably to a £24.2m profit before tax, and we cross this one off our list.

Evidence of earnings manipulation

While discovering earnings manipulation can often be a bit of an art as well as a science, the Stockopedia StockReport can tilt the odds in our favour. This contains the Beneish M-score, a metric that looks for earnings manipulation. Suppose a company comes out as high risk for earnings manipulation. In that case, we need strong evidence that the Beneish M-Score is missing something before we include the company for further analysis. If we can’t trust the earnings numbers, then we can’t rely on them to show a company is cheaply-valued.

On this basis, I exclude £OPG.

In this case, the determination is heavily reliant on one factor: the stability of the quality of assets. This may be a quirk of the data. However, given its area of operation and the presence of a significant controlling shareholder, I’m not willing to give this one the benefit of the doubt.

I also exclude Altyngold (LON:ALTN):

Again, the reason why this is flagged up as a company that is at high risk of earning manipulation may be academic. However, given the area of operation and the level of due diligence required, this pushes it beyond my investment comfort zone.

Three additional companies are flagged as high risk of earnings manipulation by the Beneish M-Score:

Gear4music Holdings (LON:G4M) is flagged due to an increase in Days Sales in Receivables, increased SG&A, increased leverage, higher accruals and the potential to be inappropriately capitalising expenses:

While this sounds potentially bad, by looking at their latest results, I believe these can be largely explained by the need to hold higher inventories in the current market and capitalised investment into their IT platform.

Capital (LON:CAPD) is flagged due to an increase in Days Sales in Receivables, increased leverage, higher accruals, very rapid sales growth and the potential to be inappropriately capitalising expenses. However, these don’t look out of place for a company that is growing quickly and requires capital to do so. Although rapid growth itself can be an extra risk factor for earnings manipulation, this growth is not an outlier to their industry competitors. Furthermore, looking at their latest results, the absolute amount of intangible investment is relatively small, so it doesn’t appear to be a risk factor.

Sylvania Platinum (LON:SLP) is flagged for increasing receivables, depreciation and accruals plus rapid sales growth. But, looking at the latest results, there doesn’t look to be anything out of the ordinary for such a business.

Investors would be wise to conduct their own investigation into these potential issues and come to their own conclusions. However, I am prepared to overrule the Beneish M-Score for these three companies and at least look at them in more detail.

With four companies excluded, I am left with 22 companies to analyse further. The remaining companies can be roughly split into five categories: Investment Companies, Resources, Retail, Media and Others.

My next article will examine Investment Companies, Retail and Media. Then the following article will complete the set by looking at the Resources companies and the Others.

[Disclosure: Mark holds shares in Capital (LON:CAPD)]