Stock in Focus portfolio: double dipping with GlaxoSmithKline and Somero Enterprises

It’s too soon to say how the Stock in Focus portfolio will perform, but one thing that’s clear at the moment is that the stocks which qualify for my screen are disproportionately weighted in a few sectors.

As I write, 16 of the 20 shares which qualify for my screen are either consumer cyclicals or industrials. There are also two financial stocks, one of which is actually a housebuilder. Finally there’s one basic materials stock (last week’s pick, Pan African Resources) plus one healthcare share.

Luckily, the industrial and consumer cyclical sectors contain a fair variety of sub-sectors, many of which are not obviously correlated. For example both recruitment firms and bus operators are listed within the industrial category. Despite this, it’s clear that I will have to choose stocks carefully if I’m to avoid creating a portfolio that’s a direct proxy for the UK housing market!

An ultra-defensive pick?

My stock screen doesn’t use StockRanks for screening, but the results are ordered by StockRank. The idea is that I’ll add the next highest-ranked stock that meets my diversification criteria. For the final time I’m going to add two new stocks this week.

The first of these is GlaxoSmithKline, a stock I looked at in detail back in February. This article attracted a record number of detailed and perceptive comments, so it’s probably worth taking a look if you missed it the first time round.

As I explained then, in the five years since 2011, Glaxo has provided a dividend return of nearly 40%, plus capital gains. That compares favourably to many big caps, and certainly to the index. In my view, Glaxo’s asset swap deal with Novartis and its improved financial condition have left it well positioned for a new phase of growth.

Although Glaxo’s StockRank of 79 puts it relatively low down my list of potential buys, it is a genuine defensive stock. I believe this pharma giant should add useful income and diversity to the portfolio, along with decent long-term growth potential.

Smooth operator could beat expectations

My second choice is also a company I’ve written about in the past.

Somero Enterprises is the dominant player in the market for using laser-guided screeding machines to produce perfectly flat concrete floors for industrial buildings.

The firm last featured in this column in December, when I raised concerns about the cyclical risks of investing at what might be a relatively late stage in the cycle. Ironically, I’m less concerned about this now than I was then.

There are several reasons for this. Firstly, I’m trying to break out of the classic value investing trap of buying too soon on the way down, and selling too soon on the way up. A second reason for my confidence in Somero is that the firm produced a stonking set of 2015 results along with very confident guidance for the year ahead:

“We see 2016 as an exciting year full of opportunity. We believe we are well positioned to capitalize on expected growth in our core US and other existing markets, extend our global footprint and grow revenues from new products. Most importantly, we look forward to delivering another year of superior results for our shareholders.”

I also gained confidence after reading the transcript of Small Cap Editor Paul Scott’s interview with Somero’s CEO and CFO, which took place in January. This really provides a lot more detail and colour on the firm’s competitive advantage and on how management sees the market opportunity in the US and overseas. It’s well worth a few minutes of your time (as of course is all of Paul’s small cap coverage).

A fine set of figures

Stockopedia continue to rank Somero highly, with a StockRank of 98. Last year’s figures have now been assimilated into the firm’s StockReport. Rather than analyse them from scratch, I’ve decided to compare them to the StockReport I used back in December. What’s changed?

Back in December, Somero traded on a rolling forecast P/E of 8.9. Although the shares have risen by 22% since then, rising earnings guidance means that today’s forecast P/E is almost unchanged at 9.3. Forecast yield is also unchanged, at 3.4%.

Somero’s earnings per share dipped in 2015, but it’s worth noting that operating profit rose strongly. The fall in net profit appears mainly to be the result of Somero spending around $4.2m on new building facilities. These are being funded out of free cash flow, which is currently very strong. Net cash doubled from $6m to $12.6m last year, despite this investment.

Last year’s rise in capex is nothing to worry about.

Somero’s ValueRank has fallen from 78 to 71 since I last looked at the firm, but I’m not concerned by this small change. The fundamentals remain solid and very appealing, in my view.

Solid quality

Somero’s QualityRank today is 96, a fall of just two points since December. Very little seems to have changed. The operating margin rose from 21.2% to 25.0% in 2015. Return on capital edged up from 42.5% to 44.7%.

Other metrics have also improved. As Somero’s 2009 results have dropped out of the QualityRank calculation period, Somero’s five-year average net margin has risen from 3.7% to 9.1%. The long-term average return on capital has risen from 0.4% to 17%. These numbers show the severity of Somero’s previous debt problems, and the strength of its recovery since then.

As management are keen to explain, a repeat of this calamity should be unlikely. The company’s policy is now to maintain a net cash buffer of $10m at all times, so that when the next recession does come, Somero will be able to ride out the storm in safety.

If you’re wondering why Somero’s QualityRank has fallen at all, I suspect the reason is that the stock’s Piotroski F-Score has fallen from 8 to 7. The reason for this is that last year’s lower post-tax profits resulted in a lower return on assets last year. This is simply the result of the money being spent on new buildings and is absolutely not a concern, in my view.

Big momentum gains

Perhaps the biggest difference between now and December is that Somero’s momentum has improved significantly. The stock’s MomentumRank has risen from 70 to 87.

Broker forecasts for 2016 earnings have risen and the outlook for 2017 suggests further progress is expected. Somero’s cash-backed dividend is also expected to rise and the forecast yield is 3.3% for 2016, rising to 3.6% for 2017. That’s quite high for a small cap.

Somero’s 2015 results made it clear that the firm should be able to deliver material ongoing growth from the US market. Growth elsewhere will be a bonus. In the case of China, it’s a long-term goal where the potential rewards are vast.

I’m happy to add the stock to the portfolio at this time, and look forward to the next trading update in the summer.

Roland owns shares of GlaxoSmithKline.