Stock in Focus - is Dart Group running out of Drivers ?

Dart Group has long been a favourite of Stockopedia subscribers and it’s a stock I currently hold a small position in. A few days ago the company updated the market with some rather positive full year figures. Paul Scott gave his opinion on the headline numbers in his typically timely fashion and I thought, now that the numbers have been digested by the Stockopedia engine perhaps I should give mine.

Taking a NAP…

This year I named Dart (rather reluctantly) as one of my top 10 New Year NAPS. It had had such a good multi-year run already that my biases screamed for me to avoid it. But I took a deep breath and yielded to the will of my selection criteria. It has now stormed to an additional 50% return in less than 7 months.

The move began with a positive trading announcement in March. Dart spiked up a huge 18% on the day to 360p, prompting much dialogue and head scratching between subscribers on the boards about what to do next.

The disagreement prompted me to write a piece in favour of continuing to hold. After all, there is a tendency for stocks to continue to rise after an unexpected earnings announcement. This phenomenon is known as PEAD - the post-earnings-announcement-drift. It is well documented in the academic journals and as a student of the momentum effect, I wanted to remain exposed to this key return driver. If in doubt it’s best to do nothing.

But the stock has not just drifted, it’s surged by another 23% in barely another 4 months, with the latest move maturing on the company’s full year numbers released last week.

Notably though, the moves have become less powerful on each announcement. 18.5% on the March announcement versus 4.5% on the July announcement. Is Dart Group running out of steam ? Or is it running out of something else ?

A quiver full of arrows

Dart Group's numbers have now been properly digested by the Stockopedia engine after last week’s update. Our blended measure of the stock’s Quality, Value and Momentum - the StockRank - has fallen by 13 points almost overnight (down to 83 from 97). Having seen Dart at the top of the ranking charts for such a long time it's gratifying to see the algorithm becoming more discerning in Dart’s case. But let’s take a closer look at why…

Quality - reading between the lines

The new numbers have provoked an especially large drop in Dart’s Quality Rank from 96 to 53. While headline earnings per share rocketed 29%, underlying the figures seems to be a a concerning pullback in profitability and a larger drop in the F-Score - the 9 point checklist of fundamental health and momentum. While a score of 5/9 is no cause for concern, it does flag that Dart is no longer benefiting from the accelerating fundamental improvement it has seen in recent years.

Where has the rest of the dip come from? If we read between the lines we can see that the Quality Rank is dependent on Operating Margin stability. The headline operating profit fell dramatically this year for Dart due to a £17m provision against a Supreme Court ruling on 31st October which went against the company. Stripping out this exceptional provision, operating profit actually increased to around £50m. Much better than is figured into our numbers.

Another factor going against the Quality Rank is the fact the company has only announced preliminary results, and has yet to report its detailed Gross Profits for the year. As a result we can’t calculate Gross Profitability - which Robert Novy Marx found to be the most powerful of all the measures of quality in predicting future stock returns. Dart normally scores extremely well on Gross Profitability so we may expect the Quality Rank to bounce back a little when the fully audited numbers are released in time.

Now I’m not one to second guess the StockRanks as I defer to the Quant. But for stock pickers who like to research fundamentals in detail the above points of note are certainly worth considering when skeptically questioning the Quality Rank.

Value - it’s not such a steal now

What can be less argued with is the fact the stock no longer looks cheap. The ValueRank has fallen to 57, down at least 10 points on this latest update.

Looking at standard valuation multiples the stock is nudging up towards parity with the market. The forecast P/E is 14x, while the Price to Free Cashflow is 16x. Both numbers aren’t far away from the market average. On an Earnings Yield or Price to Sales basis the stock still looks a steal, but from a Dividend Yield or Price to Book basis it doesn’t. Taken as a whole one can understand why the ValueRank is… well… average.

Why is this important ? Well Ben Graham taught us that over time the stock market is a weighing machine. It finds undervalued or overvalued shares and brings their valuations back to normal. This process is driven by a fundamental force of the universe known as ‘mean reversion’ - the tendency for things to return to average. Just as cold winters are often followed by warmer winters, extreme valuations are often followed by average valuations.

As an investor, this is a crucial concept to understand. This force of valuation mean reversion is a massive tail wind in a shareholding’s sails. Some of the best value investors, like David Dreman, will buy shares when they are undervalued and clinically sell them when they return to average valuations.

The following two charts do tell a story around Dart Group’s Valuation. The P/E ratio has risen from under 10x to almost 15x (the market median)…

While the blended Value Rank has fallen from above 90 to its current 57 today….

Yes Dart Group may continue to rise, perhaps even to a premium valuation, but that rise won’t be powered by the Value effect any longer. Make no mistake, if you are buying Dart Group today, the investors selling to you will be investors like David Dreman. Value Investors who have had their fill of the Value opportunity here already and are rotating out of Dart into cheaper opportunities elsewhere.

Momentum - it’s still on target

This stock is now all about Momentum - its Momentum Rank is 100. The brokers keep having to hike their numbers and the stock keeps going up.

Most investors are skeptical of momentum, they just can’t take it seriously. Not for them the idea that you should buy a stock just because it’s hitting new highs or beating broker numbers. They’d much rather use proper investment metrics like valuation ratios and profitability numbers to make their decisions. But they’d be missing a trick.

Would you stand in front of a vehicle blindfolded just because you knew a car had no engine ? I would hope you’d ask whether the car was moving before you did ! Momentum is a force of nature. The tendency for bodies in motion to continue moving. In the stock market it’s an even stronger force than the Value effect.

There’s strong momentum across the board for Dart Group. Not only is the share price moving, but the earnings per share forecasts keep getting hiked. This has the impact of lowering the bottom half of the P/E ratio and keeping the valuation multiples low. The rise in the P/E ratio over the last 2 years can only explain half of Dart Group’s share price doubling, the rest has been driven by a 50% increase in earnings per share.

But the brokers are forecasting far more moderate increases for the future and one has to question whether the momentum can be sustained. Academics agree that the Momentum effect on share prices is most powerful for 6 months to 1 year and tends to revert after three to five years. Dart Group has been a stunning share for the last 5 years… can it really get any better ?

Dart - high flyer or glamour trap ?

One of my more popular posts at Stockopedia has been on what I termed the Taxonomy of Stock Market Winners. In it I described how, as time goes by, stocks move across a spectrum of classifications depending on their exposures to the three big QVM drivers. For context for the following paragraphs I do recommend a refresher.

We’ve certainly had the benefit of hindsight with Dart Group, and there is no doubting that it was a “Super Stock” for a long time. Its high rankings across quality, value and momentum for the last few years gave it a 99+ StockRank for much of that time and the returns have been stellar. It’s been a classic case study.

But as the stock is no longer cheap, its classification has shifted. We’ve seen that we can query the level of the Quality Rank, but the Value Rank being average is incontrovertible. While the ‘taxonomy’ is based on archetypes, it gives us some useful rules of thumb. Personally I like to see my stocks exposed to at least 2 of the 3 Quality, Value and Momentum drivers. Dart is still exposed to Momentum so depending on whether we trust the Quality Rank or not it’s now moving towards High Flyer (sic) or a Glamour Trap status.

Sticking to your investment philosophy

It’s too early to be unduly concerned with Dart Group as it doesn’t seem overpriced, and it seems to be still knocking it out of the park on the earnings front. But investors should be asking themselves whether the stock is still aligned with their investment philosophy. We shouldn’t kid ourselves that we are value investors in holding Dart Group any longer. It’s now becoming a consensus trade, mostly driven by momentum.

There are many different strategies in investing, and all can make money while seeming to be at odds with each other. I’ve often published Venn Diagrams showing the intersection between the QVM drivers and the kinds of investors who invest in the opportunities at those intersections. It’s very notable that all these investors are disciplined and stick very firmly to their preferred domain. Neil Woodford invests in Quality Value stocks, while James O’Shaughnessy is a Value and Momentum investor. The danger in investing is falling in love with the stocks owned, and not having the discipline to let them go when they no longer fit your original criteria.

Value investors should probably be thinking long and hard about whether Dart Group is for them any more, Momentum investors may be willing to wait a while longer.

Disclaimer: At the point of writing Ed Croft holds a position in Dart Group.