SIF Folio: Cash keeps me ahead of the market as I consider BAT

This week I want to leave the market meltdown to one side and focus on the latest developments in my rules-based Stock in Focus (SIF) portfolio. I’ll also consider another new buy - 8% yielding FTSE 100 stock British American Tobacco.

Before that, I want to look at how SIF has performed versus the market in recent weeks. I also want to consider how the portfolio’s cash balance is influencing my returns.

Beating the market (so far)

SIF has obviously suffered badly in this market crash. But I’m happy to report that based on its performance since inception in April 2016, SIF is still in positive territory. In contrast, the portfolio’s FTSE All Share benchmark has fallen deep into the red over the same period:

(These figures are complete until 13/3 and don’t include Monday’s sell off)

Even after Monday’s sell-off, SIF is still up by around 5% excluding dividends since April 2016. 

I’d like to claim all the credit for this market-beating performance. But in truth I don’t think it’s down to the stocks I own, so much as the stocks I don’t own. 

In a market crash, an investor who holds a lot of cash will probably outperform the market. That’s the position SIF has been in over the last few weeks. Even after two recent purchases (Morgan Sindall and Ten Entertainment), cash still accounts for around 35% of the portfolio:

(16 March 2020)

Given the scale of the equity sell off, I’m pretty sure SIF’s outsized cash balance has done me a big favour.

Why does SIF have so much cash? In the months before the market crashed, the SIF stock screen was returning fewer and fewer stocks. This meant I couldn’t replace all of the stocks that were sold. The portfolio shrunk to 14 stocks, well below its target size of 20. I had hoped that this would happen when market conditions became uncertain, but I couldn’t be sure if it would work.

My screen has come back to life! Since the market crash started in late February, my screen has come back to life. 

I didn’t expect this to happen so quickly. I thought that my momentum rules would prevent too many new stocks from qualifying. But as I write, my screen results contain 16 stocks, up from just five or six a few weeks ago:

To be honest, I feel like a kid in a candy store. I’m tempted to buy more than one stock at once. But I’m going to stick to the rules and make just one purchase each week. After all, while I’m personally very comfortable buying (some) stocks at their current valuations, I know things could also get worse. 

An important test

I see this new market phase as an important test of my system. 

So far, we’ve seen SIF deliver good results in easy, rising markets from 2016 until 2018. The portfolio then held its ground when market conditions became more uncertain, reducing equity exposure and allowing cash to build through 2018/19.

The SIF rules are now highlighting a growing number of stocks which meet my criteria for buying. The portfolio’s equity exposure is increasing again. I hope this will result in market-beating gains when a recovery does come, but of course this remains an unknown. 

One thing I am happy about is the opportunity to add more defensive stocks to SIF. In the four years since I launched this portfolio, good quality defensive stocks have mostly been too expensive and slow-growing to pass my screening tests. The portfolio has always been underweight defensives, as it is now:

My screen results suggest I may be able to correct this balance at attractive valuations over the coming weeks. I’m going to start today with a look at FTSE 100 firm British American Tobacco.

British American Tobacco (LON: BATS)

Tobacco stocks have been unloved in recent years. But as far as I can see, the reality is that their business models are still working pretty well. Corporate and portfolio consolidation has enabled companies such as BAT to protect their famed margins and free cash flow. 

British American’s 2019 numbers suggest to me that there’s still plenty of life left in this business, even if outright growth prospects are limited:

• Revenue: £25,877m

• Operating profit: £9,016m

• Cigarettes sold: 677bn

From a financial perspective, I think that attractive returns should still be available from this sector. Let’s take a closer look at this business.

A super stock?

Stockopedia’s algorithms certainly like BAT. Over the last year, its StockRank has risen close to 100, as shown below the excellent new charts:

With a StockRank of 96, British American Tobacco is now one of the top-ranked stocks in the FTSE 100:

Why do the shares score so well?

High yields score well for value

BAT’s trailing dividend yield of 7.6% is an obvious attraction. But the stock scores well on a range of other yield and valuation measures, as the ValueRank breakdown shows us:

Is the stock’s 7.6% high dividend yield sustainable? We can test this by inverting the stock’s price/free cash flow ratio to get its free cash flow yield. I estimate this as 13.3%, on a historic basis. This suggests that BAT’s dividend payout was covered comfortably by surplus cash last year.

Another attraction is that BAT’s earnings yield (EBIT/EV) of 8.6% is above my screening threshold of 8%. This suggests to me that investors are paying a reasonable price for their share of the group’s profits.

The elephant in the room is debt. Net debt was £41,726m at the end of 2019. That’s equivalent to leverage of 3.5x EBITDA. I’d normally rule out a stock with this much debt, but in BAT’s case I think the risks are manageable. 

The borrowings are a legacy of the group’s 2017 combination with Reynolds American and are gradually falling. BAT’s debt is investment grade and issued at low interest rates. Less than £5bn is due for repayment in 2020. 

Given the group’s 35% operating margin and consistent profitability, I think problems are unlikely. 

Structural quality

High profit margins are one obvious measure of BAT’s quality. But what lies behind them? One aspect is the group’s portfolio of valuable brands, such as Lucky Strike, Dunhill, Camel and Rothmans. These provide pricing power.

A second attraction is that the firm’s core product - cigarettes - doesn’t require much investment. Stockopedia’s stats suggest that capex has averaged about 13% of operating cash flow in recent years, resulting in excellent free cash flow conversion:

The QualityRank breakdown gives us a broader view of BAT’s quality factors:

The only point I want to highlight here is BAT’s return on capital employed. The long-term average of 16.7% seems pretty attractive. But it hides a mixed picture:

What’s happened since 2017? Broadly speaking, my view is that the average ROCE of 16.7% used in the QualityRank is more representative of BAT’s performance than the 2018/19 figures above. My analysis suggests that these have been disproportionately depressed by the effect of consolidating Reynolds American into BAT’s balance sheet, following the 2017 acquisition. 

On balance, I’m quite comfortable with BAT’s quality score.

Reassuring momentum

Momentum seems an unlikely attribute for a £61bn tobacco company. But BAT appears to possess plenty of it:

There are two main takeaways here, in my opinion. 

The first is that despite the recent market slump, BAT’s positive relative strength shows that it has outperformed the wider market over both six months and one year. That’s generally seen as a positive indicator that outperformance could continue.

The second point is that earnings forecasts have been pretty stable in recent months. At the risk of seeming insensitive, I would guess that tobacco sales are among the areas least likely to be affected by the coronavirus outbreak. I expect earnings to remain fairly stable.

On this basis, the stock’s rolling forecast valuation looks fairly attractive:

It’s not often you can buy a stock with a P/E of 8 and an 8% dividend yield that should be covered by free cash flow. I think it’s fair to say that the shares could offer some value.

My decision

I appreciate that the combination of FTSE 100 membership and dubious ethics will rule out British American Tobacco for some subscribers. But at this stage in time, I welcome the combination of sustainable earnings and dividend income I expect BAT to provide.

Thus I will be buying the shares for the SIF folio and my own real-money replica portfolio this week, after this piece has been published.

Disclosure: Roland owns shares of Morgan Sindall Group and Ten Entertainment