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18 June 2019

AlphaScreens: the quest for Quality

The holy grail for buy-and-hold investors is to fi nd a business that is capable of generating a high return on its capital and sustaining it while reinvesting profi ts. This screen looks for shares that demonstrate these ‘quality’ characteristics and can deliver signifi cant compounded returns over time

High-quality small-caps Screen criteria: vs FTSE Small-Cap/Aim ur Alpha Quality screen uses two key measures of quality: 260 High-quality small-caps 240 FTSE Small-Cap/Aim Ooperating margins and return on equity. We are mindful 220 200 that debt can fl atter a company’s return on equity, so we aim 180 to reduce this risk from the screening results by introducing 160 Total return 140 interest cover tests, to eliminate companies that are 120 aggressively gearing up their balance sheet. 100 80 2013 2014 2015 2016 2017 Source: Thomson Datastream n Consistency is a hallmark of quality and many of the High-quality large-caps highest-ranking companies in our FTSE All-Share quality vs FTSE All-Share screen have been scoring full marks month after month. Some companies such as Games Workshop (GAW) have 260 High-quality large-caps 240 FTSE All-Share been on a tear – the specialist retailer has seen its share 220 price rise over 60 per cent in the past three months. 200 180 Total return 160 n Other regular screen-toppers include Unilever (ULVR), 140 Diageo (DGE) and Moneysupermarket.com (MONY). 120 100 2013 2014 2015 2016 2017 n Alternative Investment Market (Aim)-listed companies Source: Thomson Datastream that get full marks include Fevertree Drinks (FEVR) and sheep antibody manufacturer Bioventix (BVXP), although share prices for both companies are below recent highs. There are other companies, however, that enjoy recent share price momentum, as well as demon- Analyst: Algy Hall strating underlying quality. These include cloud service [email protected] provider Gamma Communications (GAMA) and protec- Alpha Production Editor: Sameera Hai Baig tive textile specialists Johnson Service Group (JSG). JN

www.investorschronicle.co.uk telephone: +44 (0)20 7873 3000 email: [email protected] © The Financial Times Limited 2019. Investors Chronicle is a of The Financial Times Limited. Registered offi ce: Bracken House, 1 Friday Street, , EC4M 9BT

1 The dream company The holy grail for buy-and-hold investors is to find a business that is capable of generating high returns on its capital and is able to reinvest all its profits for decades to come, while maintaining those returns. The compound- ing effect of such an investment is what every long-term investor’s dreams should be made of. A company making a consistent 15 per cent post-tax return on its equity and reinvesting all its profits would experience a near-30-fold (28.6 to be precise) growth in its equity base over 25 years, and after 50 years it would be a mind-boggling 1,084 times bigger than when it started. For a patient investor con- vinced that they have found such a situation, valuation should not act as a major impediment to a purchase. Unfortunately, this kind of dream company is extremely rare and stock screens are too crude to provide the depth of analysis needed to provide confidence that a business may be the real deal. In particular, it is inevitable that some of the shares highlighted by our Alpha Quality screen will be cyclical companies that are enjoying a good run rather than companies that are well placed to sustain high returns through many business cycles to come. What our screen does do, however, is attempt to find pointers for companies that may have the potential to go some way to filling the dream brief. What’s more, buying shares in companies that look attractive based on quality metrics can often prove a profitable strategy, even if many of the shares picked fall short of the buy-and-hold ideal.

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2 Alpha Quality screening criteria The screen uses two key measures of quality, which are operating margins and return on equity (RoE). The advantage of using RoE to measure the quality of a company is that it focuses on the returns that are ultimately of most significance to shareholders – after-tax earnings. However, RoE can be boosted by a company if it increases the amount of debt it car- ries. That means a high and rising RoE can sometimes simply reflect a reduction in the quality of the company’s balance sheet and little improvement, or even a deterioration, in the quality of its operations. The screen attempts to counter this with its interest cover test, which should help it avoid compa- nies with very aggressively ‘geared’ balance sheets. Focusing on operating margins also provides an assessment of quality at the operating level – ie before the impact of debt. n An operating margin higher than the median average (mid-ranking) stock in each of the past three years (ie quality that shows some signs of persistence). n A return on equity (RoE) higher than the median average (mid-ranking) stock in each of the past three years (ie again, quality that shows some signs of persistence). n RoE higher than it was two years ago (ie quality is improving as well as persistent). n Operating margin higher than it was two years ago (ie quality is improving as well as persistent). n A dividend-and-debt adjusted price/earnings growth (PEG) ratio below the top fifth of stocks screened (ie stocks must not be too egregiously expensive for the growth on offer). n A price/earnings (PE) ratio above the bottom 10 per cent of stocks screened and below the top 10 per cent (ie not a suspi- ciously cheap or dangerously expensive valuation). n Interest cover of more than five (ie high RoE is not overly dependent on the use of debt). n Forecast earnings growth for each of the next two financial years. n Positive forecast free cash flow. The Alpha Quality screen is conducted separately on constituents of the FTSE All-Share, FTSE All-Small and FTSE Aim All-Share indices, with the results from each screen reported in separate tables. Not many stocks pass such a stringent list of criteria. The ones that pass all the tests are listed at the top of the table, followed by those failing one test, then those failing two tests as detailed in the ‘Tests passed’ column. All stocks must pass the test for three-year, higher-than-average RoE and margin to feature in the table. While the primary ranking of the stocks is based on the number of tests they pass, inside each of these groupings stocks are ordered according to their attractiveness based on operating margin and three-month share price momentum. Stock screen methodology formulated and explained by Algy Hall www.investorschronicle.co.uk telephone: +44 (0)20 7873 3000 email: [email protected] © The Financial Times Limited 2019. Investors Chronicle is a trademark of The Financial Times Limited. Registered office: Bracken House, 1 Friday Street, London, EC4M 9BT

3 Alpha Quality screen: large-cap results

Market Fwd NTM Fwd EPS grth Fwd EPS grth 3-mth Net Cash/ Tests passed Test Name TIDM cap Price PE DY FY+1 FY+2 momentum Debt(-) Cur (out of 9) failed Games Workshop LSE:GAW £1,628m 5,010p 25 2.6% 8.0% 4.7% 64.1% 25m GBP 9 na Spirax-Sarco Engineering LSE:SPX £6,420m 8,720p 33 1.1% 4.6% 7.2% 24.9% -236m GBP 9 na PayPoint LSE:PAY £723m 1,070p 16 6.5% 5.3% 6.0% 22.5% 37m GBP 9 na RELX LSE:REL £37,399m 1,926p 21 2.2% 8.2% 6.5% 16.2% -6,267m GBP 9 na Unilever LSE:ULVR £129,753m 4,967p 21 2.7% 7.6% 8.5% 17.2% -20,688m EUR 9 na Diageo LSE:DGE £80,576m 3,401p 25 1.9% 9.5% 6.6% 11.1% -10,577m GBP 9 na Moneysupermarket.com LSE:MONY £2,112m 394p 21 2.8% 6.1% 8.2% 9.1% 30m GBP 9 na Diploma LSE:DPLM £1,802m 1,592p 25 1.6% 9.8% 5.0% 10.5% 22m GBP 9 na Ashtead LSE:AHT £9,112m 1,962p 10 1.7% 14.8% 7.3% 4.4% -3,745m GBP 9 na Domino’s Pizza LSE:DOM £1,159m 252p 15 3.8% 3.5% 8.1% 6.6% -203m GBP 9 na Polypipe LSE:PLP £874m 439p 14 2.6% 8.5% 6.3% 2.6% -165m GBP 9 na MJ Gleeson LSE:GLE £422m 774p 13 4.1% 8.8% 9.7% -2.3% 28m GBP 9 na Burberry LSE:BRBY £7,185m 1,753p 21 2.4% 1.5% 10.5% -5.0% 837m GBP 9 na Imperial Brands LSE:IMB £18,505m 1,951p 7 9.6% 3.7% 3.2% -26.4% -12,807m GBP 9 na LSE:CSP £1,307m 293p 7 3.7% 12.6% 10.4% -14.5% -40m GBP 9 na Rightmove LSE:RMV £5,141m 580p 29 1.1% 9.9% 9.0% 16.8% 7m GBP 8 /RoE grth/ Experian LSE:EXPN £21,830m 2,420p 29 1.5% 9.4% 9.6% 18.7% -3,318m USD 8 /RoE grth/ Holdings LSE:SAFE £1,375m 654p 23 2.5% 5.5% 7.0% 9.2% -426m GBP 8 /RoE grth/ Smith & Nephew LSE:SN. £15,029m 1,722p 21 1.7% 0.1% 7.1% 16.6% -1,103m USD 8 /RoE grth/ Halma LSE:HLMA £7,552m 1,993p 36 0.8% 5.0% 7.5% 19.8% -182m GBP 8 /PE/ LSE:HSV £4,196m 1,262p 31 1.7% 8.6% 8.8% 25.4% -305m GBP 8 /RoE grth/ Intertek Group LSE:ITRK £8,955m 5,564p 27 1.8% 5.2% 6.9% 16.0% -778m GBP 8 /RoE grth/ A.G. BARR LSE:BAG £1,042m 922p 28 1.8% 4.3% 4.0% 13.2% 22m GBP 8 /RoE grth/ Croda International LSE:CRDA £6,680m 5,235p 26 1.7% 4.6% 7.0% 6.1% -426m GBP 8 /RoE grth/ Reckitt Benckiser LSE:RB. £46,406m 6,547p 19 2.6% 1.3% 5.8% 4.9% -10,421m GBP 8 /RoE grth/ Polymetal International LSE:POLY £4,208m 895p 10 4.3% 10.3% 5.8% 4.1% -1,520m USD 8 /RoE grth/ Photo-Me International LSE:PHTM £353m 94p 10 9.0% -4.7% 10.7% 5.6% 31m GBP 8 /Fwd EPS grth/ Limited LSE:SRE £663m 65p 15 4.5% 5.3% 2.5% 2.4% -295m EUR 8 /FCF/ On the Beach Group LSE:OTB £609m 464p 18 0.8% 10.5% 18.7% 3.7% -1m GBP 8 /FCF/ Ten Entertainment Group LSE:TEG £150m 230p 11 4.8% 26.1% 11.9% 3.5% -11m GBP 8 /RoE grth/ FDM Group (Holdings) LSE:FDM £998m 915p 24 3.4% 6.4% 7.3% 1.8% 34m GBP 8 /Int Cov/ Medica Group LSE:MGP £159m 143p 17 1.6% 8.3% 10.9% 0.8% 1m GBP 8 /RoE grth/ Smiths Group LSE:SMIN £5,872m 1,483p 15 3.0% 6.4% 9.6% 2.3% -938m GBP 8 /RoE grth/ Mondi LSE:MNDI £8,276m 1,709p 10 4.0% -3.5% 2.9% -2.0% -2,218m EUR 8 /Fwd EPS grth/ XP Power Limited LSE:XPP £423m 2,210p 13 3.8% 1.2% 7.6% -6.6% -52m GBP 8 /FCF/ Barratt Developments LSE:BDEV £5,725m 565p 8 7.9% 5.2% -0.9% -8.7% 379m GBP 8 /Fwd EPS grth/ LSE:BWY £3,390m 2,754p 6 5.2% 3.4% 0.7% -11.6% -27m GBP 8 /RoE grth/ Redrow LSE:RDW £1,881m 547p 6 5.6% 2.0% 2.4% -18.3% 101m GBP 8 /RoE grth/ The Sage Group LSE:SGE £8,375m 771p 24 2.1% -5.5% 6.7% 14.3% -422m GBP 7 /PEG/Fwd EPS grth/ Aptitude Software Group LSE:APTD £267m 432p 27 1.5% -25.6% 20.9% 11.4% 17m GBP 7 /PEG/Fwd EPS grth/ Group LSE:KNOS £775m 640p 36 1.5% 26.3% 11.0% 22.3% 42m GBP 7 /Int Cov/PE/ GlaxoSmithKline LSE:GSK £78,581m 1,588p 14 5.0% -6.4% 4.4% 6.1% -27,544m GBP 7 /Fwd EPS grth/FCF/ NEXT LSE:NXT £7,138m 5,542p 12 3.0% 2.6% 3.5% 5.1% -1,135m GBP 7 /RoE grth/Marg grth/ LSE:FXPO £1,530m 261p 4 8.1% 45.5% -25.9% -3.2% -339m USD 7 /RoE grth/Fwd EPS grth/ Howden Joinery LSE:HWDN £3,034m 505p 15 2.3% 5.5% 7.9% 0.5% 231m GBP 7 /RoE grth/Int Cov/ IMI LSE:IMI £2,633m 973p 13 4.2% -0.4% 6.5% -3.6% -401m GBP 7 /Marg grth/Fwd EPS grth/ Renishaw LSE:RSW £2,738m 3,762p 25 1.6% -21.3% 20.3% -9.9% 101m GBP 7 /PEG/Fwd EPS grth/ Persimmon LSE:PSN £6,126m 1,937p 7 12.1% -1.5% 1.7% -15.6% 1,048m GBP 7 /PEG/Fwd EPS grth/ BT Group LSE:BT.A £20,396m 207p 8 7.4% -7.3% 4.1% -8.2% -11,996m GBP 7 /Marg grth/Fwd EPS grth/ Taylor Wimpey plc LSE:TW. £5,114m 157p 8 11.7% -3.6% 1.7% -15.0% 617m GBP 7 /RoE grth/Fwd EPS grth/ NMC Health LSE:NMC £4,841m 2,319p 19 0.8% 29.5% 19.1% -13.0% -1,552m USD 7 /RoE grth/Int Cov/ Alfa Financial Software LSE:ALFA £354m 118p 19 - 3.8% 9.5% -29.0% 45m GBP 7 /Marg grth/Int Cov/ Holdings LSE:CRST £925m 360p 8 9.2% -13.3% -1.7% -11.1% -66m GBP 7 /RoE grth/Fwd EPS grth/ Source: S&P CapitalIQ, 18 June 2019

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4 Alpha Quality screen: small-cap results

Market Fwd NTM Fwd EPS grth Fwd EPS grth 3-month Net Cash/ Tests passed Test Name TIDM cap Price PE DY FY+1 FY+2 momentum Debt(-) Cur (out of 9) failed PayPoint LSE:PAY £723m 1,070p 16 6.5% 5.3% 6.0% 22.5% 37m GBP 9 na MJ Gleeson LSE:GLE £422m 774p 13 4.1% 8.8% 9.7% -2.3% 28m GBP 9 na Treatt LSE:TET £262m 448p 25 1.1% 1.1% 5.5% 10.4% 9m GBP 8 /RoE grth/ Photo-Me International LSE:PHTM £353m 94p 10 9.0% -4.7% 10.7% 5.6% 31m GBP 8 /Fwd EPS grth/ On the Beach LSE:OTB £609m 464p 18 0.8% 10.5% 18.7% 3.7% -1m GBP 8 /FCF/ Ten Entertainment LSE:TEG £150m 230p 11 4.8% 26.1% 11.9% 3.5% -11m GBP 8 /RoE grth/ Sirius Real Estate Ltd LSE:SRE £663m 65p 15 4.5% 5.3% 2.5% 2.4% -295m EUR 8 /FCF/ Medica Group LSE:MGP £159m 143p 17 1.6% 8.3% 10.9% 0.8% 1m GBP 8 /RoE grth/ Henry Boot LSE:BOOT £333m 251p 9 3.6% -0.2% 2.3% -2.7% -18m GBP 8 /Fwd EPS grth/ XP Power LSE:XPP £423m 2,210p 13 3.8% 1.2% 7.6% -6.6% -52m GBP 8 /FCF/ Kainos LSE:KNOS £775m 640p 36 1.5% 26.3% 11.0% 22.3% 42m GBP 7 /Int Cov/PE/ Aptitude Software LSE:APTD £267m 432p 27 1.5% -25.6% 20.9% 11.4% 17m GBP 7 /PEG/Fwd EPS grth/ LSE:AVON £421m 1,380p 18 1.2% -1.4% 4.8% 7.9% 47m GBP 7 /RoE grth/Fwd EPS grth/ Alfa Financial Software LSE:ALFA £354m 118p 19 - 3.8% 9.5% -29.0% 45m GBP 7 /Marg grth/Int Cov/ Source: S&P CapitalIQ, 18 June 2019

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5 Alpha Quality screen: Aim results

Market Fwd NTM Fwd EPS grth Fwd EPS grth 3-month Net Cash/ Tests passed Test Name TIDM cap Price PE DY FY+1 FY+2 momentum Debt(-) Cur (out of 9) failed Gamma Communications AIM:GAMA £1,098m 1,165p 33 0.8% 17.1% 11.9% 23.7% 31m GBP 9 na Churchill China AIM:CHH £168m 1,525p 21 1.9% 4.8% 10.0% 17.3% 17m GBP 9 na Johnson Service AIM:JSG £599m 163p 16 1.9% 6.4% 4.5% 21.4% -99m GBP 9 na Billington AIM:BILN £39m 322p 9 4.0% 1.5% 3.7% 20.4% 8m GBP 9 na Water Intelligence AIM:WATR £50m 338p 28 - 28.8% 9.0% 14.4% 3m USD 9 na The Character Group AIM:CCT £121m 568p 12 4.6% 6.6% 10.9% 9.6% 20m GBP 9 na Tracsis AIM:TRCS £193m 673p 25 0.2% 5.0% 7.5% 1.5% 18m GBP 9 na Bioventix AIM:BVXP £191m 3,720p 33 3.3% 4.4% 12.0% -8.2% 5m GBP 9 na Fevertree Drinks AIM:FEVR £2,817m 2,426p 39 0.6% 13.7% 13.7% -13.3% 84m GBP 9 na The Property Franchise AIM:TPFG £45m 176p 13 4.8% 0.8% 5.1% 48.7% 2m GBP 8 /RoE grth/ Arcontech Group AIM:ARC £23m 172p 26 0.8% 54.8% 3.4% 27.7% 3m GBP 8 /Int Cov/ Belvoir Lettings AIM:BLV £40m 115p 9 6.3% 6.8% 13.4% 16.1% -10m GBP 8 /FCF/ dotdigital Group AIM:DOTD £333m 112p 28 0.6% 18.8% 10.9% 21.5% 17m GBP 8 /Int Cov/ Nichols AIM:NICL £664m 1,800p 25 2.1% 4.8% 4.9% 14.0% 39m GBP 8 /RoE grth/ D4t4 Solutions AIM:D4T4 £105m 267p 20 0.9% 20.8% -0.1% 9.5% 12m GBP 8 /Fwd EPS grth/ Serica Energy AIM:SQZ £338m 128p 3 - 297.5% -20.2% 5.1% 35m USD 8 /Fwd EPS grth/ AdEPT Telecom AIM:ADT £88m 370p 12 2.6% 7.3% 7.8% 13.8% -31m GBP 8 /Int Cov/ Inspiration Healthcare AIM:IHC £20m 67p 19 - 2.9% 19.2% 4.7% 3m GBP 8 /Int Cov/ Scientific Digital Imaging AIM:SDI £49m 51p 20 - 3.9% 29.2% -2.0% 1m GBP 8 /RoE grth/ Elecosoft AIM:ELCO £62m 76p 17 0.9% 14.7% 10.9% -3.3% -2m GBP 8 /RoE grth/ Central Asia Metals AIM:CAML £375m 219p 8 6.6% 10.5% 15.0% -12.3% -110m USD 8 /RoE grth/ iomart Group AIM:IOM £354m 326p 16 2.3% 7.0% 10.2% -8.0% -39m GBP 8 /RoE grth/ Hotel Chocolat AIM:HOTC £367m 325p 35 0.7% 3.6% 14.0% -9.8% 22m GBP 8 /RoE grth/ Somero Enterprises AIM:SOM £166m 295p 10 5.1% -1.0% 2.7% -23.1% 28m USD 8 /Fwd EPS grth/ Redde AIM:REDD £312m 102p 7 11.4% 10.2% -4.7% -11.9% -41m GBP 8 /Fwd EPS grth/ Pennant Int’l AIM:PEN £32m 88p 9 - 3.0% 8.3% -30.6% 2m GBP 8 /Marg grth/ Quixant AIM:QXT £149m 225p 11 1.4% 1.8% 11.7% -28.6% 10m USD 8 /RoE grth/ SafeCharge Int’l AIM:SCH £658m 432p 27 3.4% 21.2% 13.3% 48.9% 93m USD 7 /RoE grth/Int Cov/ Craneware AIM:CRW £836m 3,175p 59 0.8% 14.9% 16.9% 32.1% 39m USD 7 /Int Cov/PE/ AB Dynamics AIM:ABDP £562m 2,560p 48 0.1% 41.4% 11.6% 31.8% 19m GBP 7 /Int Cov/PE/ ULS Technology AIM:ULS £51m 79p 12 3.0% -11.1% 0.1% 18.2% -3m GBP 7 /PEG/Fwd EPS grth/ James Halstead AIM:JHD £1,061m 510p 27 2.6% 7.6% 2.7% 14.4% 63m GBP 7 /RoE grth/Int Cov/ M Winkworth AIM:WINK £15m 119p 12 6.4% 4.9% 6.1% 11.2% 3m GBP 7 /Marg grth/Int Cov/ Boohoo AIM:BOO £2,590m 223p 45 - 19.2% 20.9% 21.1% 191m GBP 7 /RoE grth/PE/ Gateley (Holdings) AIM:GTLY £181m 163p 13 4.3% 23.8% 6.4% 7.3% -8m GBP 7 /RoE grth/Marg grth/ Keystone Law AIM:KEYS £165m 527p 37 1.7% 7.5% 14.1% 10.2% 6m GBP 7 /RoE grth/Marg grth/ Secure Income REIT AIM:SIR £1,301m 403p 24 3.2% 13.2% 3.8% -1.0% -1,007m GBP 7 /RoE grth/Int Cov/ Tristel AIM:TSTL £135m 303p 30 1.5% 39.2% 12.0% -1.8% 4m GBP 7 /RoE grth/Int Cov/ Dart Group AIM:DTG £1,318m 886p 9 0.8% 51.8% -14.4% 2.7% 460m GBP 7 /Fwd EPS grth/FCF/ Prime People AIM:PRP £10m 82p - 6.1% - - -1.2% 2m GBP 7 /Fwd EPS grth/Int Cov/ Portmeirion AIM:PMP £108m 1,015p 15 3.7% -8.1% 9.5% -6.2% 2m GBP 7 /RoE grth/Fwd EPS grth/ Watkin Jones AIM:WJG £529m 208p 13 3.7% 2.0% 10.4% -9.2% 18m GBP 7 /RoE grth/FCF/ Shoe Zone AIM:SHOE £94m 189p 11 6.1% -7.5% 0.4% -11.7% 3m GBP 7 /Fwd EPS grth/Int Cov/ Fulcrum Utility Services AIM:FCRM £59m 27p 7 7.9% 1.5% -8.2% -37.6% 10m GBP 7 /RoE grth/Fwd EPS grth/ Source: S&P CapitalIQ, 18 June 2019

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www.investorschronicle.co.uk telephone: +44 (0)20 7873 3000 email: [email protected] © The Financial Times Limited 2019. Investors Chronicle is a trademark of The Financial Times Limited. Registered office: Bracken House, 1 Friday Street, London, EC4M 9BT

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