British Bargains: Picking the best value UK stocks

Those of that mindset may view the situation as something akin to the final day of trading at Woolworth’s, or, perhaps a red telephone box repurposed as a storage point for the village defibrillator. In other words, what’s inside might be useful, but the outward appearance is old-fashioned and incongruous in the brave, new tech-driven world.

In this context, it’s no surprise that the UK stock market is cheap relative to its history. What’s different this time is how cheap it is relative to other markets, too. At the start of 2024, the FTSE All-Share price was equivalent to barely 10 times company earnings – almost as low as it was at the end of 2008, in the teeth of the financial crisis. In 2008, however, the S&P 500’s trailing ratio stood at 12 times earnings. At the start of this year, it was a much more expensive 24 times.

This has left many domestic investors more likely to pull funds to send them to the booming market across the Atlantic. The net result is a market where liquidity has been draining away, but which leaves many shares offering massive income yields at some of the cheapest prices in years.

The question is whether investing heavily in the US, while perfectly logical on its terms, makes much sense when it comes to individual stockpicking for value. The associated poser is how can investors find the bargains in a bargain index, and do the same stockpicking rules apply?

Simon Gergel, fund manager for Merchants Trust, says that “structural selling” has become a key feature of the market: “A lot of fund managers are selling down UK equities and companies are becoming the biggest buyers of their own shares. This is why the buybacks launched by the likes of Barclay’s (BARC), which is handing back £10bn of capital over the next three years, moved the shares by more than 10 per cent,” he adds.

But the challenge for investors is to find the ‘deep value’ in the index without falling into a value trap.

Gergel notes that traditional company research, one which emphasises looking at end markets, balance sheet analysis and an emphasis on cash flow performance is more vital than ever for stockpickers. “The problem currently with most valuation measures is that they are just telling us that assets are cheap, but no more,” he notes.

What makes a perfect bargain share?

Establishing the criteria for a decent share search is one way of lessening the workload. Investing’s most over-quoted author, Benjamin Graham (for it is he), has a simple definition that we can use as a starting point: “The most basic definition of a good business is this: it generates more cash than it consumes. Good managers keep finding ways of putting that cash to good use.”

One measure of this is whether a company pays a dividend or reinvests the capital to grow earnings. In recent years, the bias has been that dividends are a sign of a lack of ‘imagination’ on the part of management, for want of a better term.

It tends to be forgotten that Graham, and his protégé Warren Buffett, both like dividends very much. In fact, Graham is quite dismissive of dividend deniers: “the burden of proof is on the company to show that you are better off if it does not pay a dividend.”

One of the key differences between the US and UK markets is that dividend payments are commonly expected of UK companies, supposedly because of their history of mature earnings, stable markets, and lack of profitable growth opportunities. What may be missed in this analysis is that opportunities for profitable growth are far fewer in both scope and volume than 50 years ago, meaning that dividends paid are simply an acknowledgement of this reality.

It also misses the fact that growth can suddenly reappear in what had looked like redundant sectors. For example, anyone wanting to tap into the reality of America’s current economic growth may wish to consider investing in companies that build factories, rather than Alphabet (US:GOOG) or Tesla (US:TSLA), given manufacturing growth is currently at its highest rate in the US since 1979. This would at least give them a better shot at finding an undervalued asset, rather than a high-profile, highly-rated business.

True value

This conveniently brings us to the question of what investors should understand by the idea of true value. In a UK context, the cheapness of the index as a whole can be a hindrance to many forms of screening and analysis because low price/earnings (PE) ratios make it easier to fall into value traps.

It’s perhaps then the right time to resurrect a screening concept that did badly during the value rotation cycle a couple of years ago, but which might help pick out high-quality cheap shares at a time when bargains are hard to define. Essentially, this involves using something akin to a price/earnings growth (PEG) ratio – a PE variant that attempts to factor in future growth prospects – and adapting it further to consider debt and dividends.

The ratio therefore starts by comparing enterprise value (EV) to operating profit (Ebit). EV is calculated as market cap plus net debt – net debt includes pension deficits and lease liabilities where relevant – which can give a better picture of a company’s current state than the share price alone.

It then factors in the expected return for shareholders, as defined by consensus earnings growth forecasts (Fwd EPS grth), as well as the current dividend yield (DY). These metrics all combine to give a ‘Genuine Value’ score, calculated as (EV / Ebit) / (Fwd EPS grth + DY).

What about the ‘F’ factor?

This approach also swerves the problem that book value scores are largely meaningless these days, outside of sectors that invest heavily in land or capital stock machinery. Then again, Joseph Piotroski, whose Piotroski ranking system used price-to-book value as its cornerstone, years ago modified his system to consider a range of other factors. He called these other metrics an ‘F-score’, and investors wanting to add more weight to a genuine value screen may wish to consider something similar. An F-score is a simple 1-9 scale, grading companies on whether or not they pass nine tests, as follows: 

■ Positive profit after tax, excluding exceptional items.

■ Positive cash from operations.

■ Profits after tax excluding exceptional items up on the previous year, which Professor Piotroski highlights as being of particular importance as a signal that a company may be in recovery mode and in the process of re-rating.

■ Cash from operations higher than profit after tax, excluding exceptional items, which indicates an ability to convert accounting profit into actual cash.

■ Gearing (net debt as a percentage of net assets) down on the preceding year, which suggests that the company has not had to look for external sources of finance.

■ Current ratio (current assets divided by current liabilities) up on the preceding year, which suggests that the company’s ability to service upcoming financial obligations is improving.

■ No new shares issued over the past year, which again suggests that the company has not had to look for external sources of finance.

■ Gross margins that have risen in the previous year.

■ Improving capital turn (turnover as a proportion of net assets), which suggests greater productivity.

A score of 8 or more is deemed to be attractive by Piotroski.

The table below does not take into account these metrics, instead including shares only on the basis of their genuine value score. Below, we discuss two of those companies, and we also highlights four other UK shares that, while not included in the table, look attractive in their own right.

Costain is winning back confidence

Costain’s (COST) full-year results last month revealed a reinstated dividend plus full-looking order books. That has reaffirmed the shares’ recent buoyancy, but the company still looks cheap on a range of metrics. The infrastructure specialist has a solid record on cash generation, although profitability can seesaw depending on the timing of projects and the sequencing of funds. In any case, 80 per cent of the 2024 order book is confirmed, with about three times 2023’s revenues lined up overall.

The £100mn rights issue in March 2020 was painful for investors, but it means the balance sheet is now secure enough to support its contracts. The UK will (need to) continue to spend on infrastructure over the next few years and Costain looks well placed to benefit.

Eighteen months ago, we said that while the shares looked cheap on sum-of-the-parts valuations and relative to its free cash flow (two facts which still apply despite the recent share price run-up), it would be profitability that determined the outlook. A 29 per cent rise in pre-tax earnings for 2023 – ahead of estimates – confirms that the company has won back market confidence. Investors might well consider the forward PE ratio of six attractive too.

DFS is all set up for recovery

In contrast to Costain, recent half-year figures at DFS Furniture (DFS) appeared to cast a pall over the business and knocked the share price back. But the company shouldn’t be written off on this basis alone.

If nothing else it is arguably now an even greater bargain, with the share price trading at just above its 99p net asset value (NAV). Then there is the company’s excellent record of earnings growth stretching back more than a decade. While it sells big ticket furniture items, it is also a property company with a warehouse footprint to support its distribution. About half its total assets are made up of intangibles.

Selling big ticket items at a time of higher interest rates means DFS is vulnerable to macroeconomic shocks, although it is doubtful that disruption to trade through the Red Sea would have made it through into many management or shareholder calculations as a significant risk factor prior to the Houthis taking pot shots at passing container ships. This could mean that up to £4mn of profit is shifted into 2025.

While nothing can be done about the lack of footfall, the sign of a good business is how it responds to operational problems as they come up. The first half was forgettable for DFS, but the company still managed to find £22mn of cost savings (management had forecast £16mn), while the next couple of quarters should see some easier comparatives.

Full-year expectations have been lowered, but DFS has continued to grow market share in the meantime (Jefferies analysts note its first-half order volumes fell by 1 per cent compared with the wider market’s 10 per cent drop). A turnaround in the sector as a whole will be required for future progress, but with volumes now roughly a quarter below pre-pandemic levels, the scene is set for that to happen.

It’s worth paying attention to Coats

Thread manufacturer Coats (COA) has some exposure to DFS-style upholstery, but its principle exposure is to clothing: its threads hold together a quarter of the world’s clothes. Despite this, it keeps a relatively low profile. But the FTSE 250 company is worth paying attention to, particularly at its current price.

Coats has just endured a very difficult year as fashion retailers sought to reduce their stock levels. Organic revenues shrank by 14 per cent in 2023, with footwear hit particularly hard. Despite the demand shock, however, it has managed to keep operating profits stable, while cash generation has actively improved.

Its resilience is the result of a variety of self-help measures. Coats has been on a cost-cutting drive, selling businesses, shifting factories from North America to Mexico, consolidating warehouses and cutting staff in some regions. This has caused its adjusted operating margin to widen to 17 per cent – a year ahead of schedule. Before the pandemic, margins sat at 14.3 per cent.

A pension deficit that has sucked in cash for years has also been plugged following a one-off payment of £10mn in December.

When the retail sector does recover, therefore, Coats is likely to rebound with a vengeance and enjoy the full benefit of its internal transformation. Investors might not have to wait too long: the second half of 2023 was better than the first, and management said “there is evidence that customer inventory levels are normalising”.

The group is also tapping into some exciting growth markets. It is the clear leader in sustainable thread, for example, and the sale of entirely recycled products jumped by 44 per cent last year to $172mn (£137mn). This was a key driver of market share gains, with more brands seeking green alternatives to oil-based products.

Coats’ share price has been bouncing around over the last year. However, its forward PEG ratio – which is calculated by taking its PE ratio and dividing by forecast earnings growth – is just 0.9 times. Anything below 1 is usually considered good value. Meanwhile, its forward PE ratio is well below the five-year average at 10.6 times.

Sales growth is likely to be modest in the near term. However, Coats is an established operator with a mind-boggling market share and has taken many successful steps to boost its efficiency. Not one to leave on the shelf. JS

Redde Northgate’s recovery is under way

Redde Northgate (REDD) shares are valued at seven times forward consensus earnings, putting them firmly in bargain territory given resilient demand and a chunky dividend yield at the motoring company. After a tough few years when the company first emerged via the 2020 merger between motor insurance services business Redde and fleet hire specialist Northgate, there are signs a recovery is under way.

In the latest results for the six months to 31 October, underlying operating profits rose by almost a fifth to £115mn despite ongoing challenges with light commercial vehicle (LCV) supply in the domestic rental market, where the average number of vehicles on hire fell 7 per cent. Management guided for full-year earnings to come in ahead of market consensus after claims and services revenue rose 27 per cent and vehicle sales surged from £68.7mn to £178mn. The performance in Spain, which had previously faced a particular struggle with vehicle shortages, was a standout, with underlying profits there rising 44 per cent and the margin hitting 33 per cent.

Borrowings have increased of late, but the balance sheet position is manageable. Net debt (including lease liabilities) came in at just under 75 per cent at the last count, with leverage of 1.6 times sitting in the middle of the company’s target range. Around 40 per cent of facilities are fixed at an attractive 1.3 per cent rate and mature between 2027 and 2031. Peel Hunt analyst Andrew Nussey argued on the back of the interim results that there is “potential for medium-term upgrades, given the strategic and operational positioning in structurally attractive markets”.

Something to watch is the movement in the residual value of the company’s vehicles as supply eases. But with a dividend yield of 7 per cent and nicely diversified revenue streams, we remain bullish.

Workspace’s flexibility is an advantage

There are a lot of cheap British real estate investment trusts (Reits) out there. After all, since interest rates started rising and property values started sinking in 2022, most have been trading at a discount to net asset value (NAV). For some, these price are fair, reflecting the likelihood that their valuations will sink further. Other valuation gaps look like an overreaction, particularly now interest rates look to have peaked.

Workspace (WKP) is one such example. It trades on one of the steepest discounts to NAV among all UK Reits, likely because it is an office landlord in the era of uncertainty around the need for those offices post-pandemic.

But Workspace’s flexibility is an advantage. Because companies are unsure about their office requirements, business at Workspace is booming. It offers smaller offices on flexible terms for months at a time, as opposed to the multi-year or sometimes even multi-decade long leases for large floor plans offered by traditional office landlords. Small companies renting their first office and big companies looking to downsize their estates are Workspace’s bread and butter.

The numbers reflect this. EPRA earnings per share, which focuses on rental income minus the costs of running the assets but before valuation changes, leapt 17.2 per cent in the six months to 30 September to 30.7p, covering the not ungenerous 9p interim dividend more than three times over.

Nor is the high-profile collapse of peer WeWork a worrying sign for Workspace. The lease-and-sublease model favoured by the likes of WeWork makes it overly leveraged and unprofitable. By contrast, Workspace owns the offices it lets out flexibly and is thriving. Investors should consider this alternative on price, not least because there are now signs of the wider economy picking up. ML

RHI Magnesita’s resilience is being ignored

Refractory materials are renowned for their stability in extreme conditions. It’s therefore tempting to draw a parallel between refractory specialist RHI Magnesita (RHIM) – which has been on an acquisition spree despite a bleak demand landscape – and the products it sells. But the metaphor won’t stretch far, as the group’s shares and sales volumes have proved undeniably volatile in the post-pandemic period.

Global production slowdowns in various heavy industries are at the root of RHI’s present challenges. Almost 70 per cent of its sales are to steelmakers, and production of the metal either declined or remained flat in all regions bar India last year.

Put together, these factors make a re-rating due to resurgent demand look extremely unlikely for RHI, at least in the immediate future. But does this mean the company is fairly priced at a lowly eight times consensus earnings for FY2024?

We’d argue that the present valuation fails to account for the company’s resilient performance in difficult market conditions. While sales volumes were down 5 per cent overall last year, this was partly offset by six acquisitions, which ultimately contributed €56mn (£48mn) to its adjusted Ebitda. That’s significantly more than the €40mn management originally guided for when the transactions closed.

Even with the buyouts, net debt to Ebitda was flat at 2.3 times last year. Although this level of leverage might be enough to make some investors uncomfortable, it should only become an issue if profitability declines. Looking ahead, management expects Ebitda to be “at least in line” with analyst consensus of €410mn, with acquisitions made last year adding around €40mn to the bottom line.

“The focus on M&A is not always well received by the market, but there are evidently no signs of slowing, and this continues to be the key driver of upgrades,” said Jefferies analysts last month. While a timely steel recovery would be nice, RHI can keep growing regardless. Its latest purchase, of US-based alumina and refractory producer Resco Group, confirms this: the acquisition will increase the company’s US-based production (increasingly important for its US customers), and help diversify it away from steelmakers. JJ