The UK economy is facing the most challenging outlook in decades, and, unsurprisingly, the growing wave of bad news is spooking investors. While the FTSE 100 is flat year-to-date, mainly thanks to the index’s international diversification and large weighing of oil and mining stocks, the FTSE 250 is off by 16%.
However, as investors flee to safe havens, bargains are starting to emerge.
Searching for bargains amid the carnage
The headline performance of the FTSE 100 year-to-date masks the large dispersion in returns among its individual constituents. While some constituents such as BAE Systems (LSE: BA), Pearson (LSE: PSON) and Glencore (LSE: GLEN) have each returned more than 30%, others such as Hargreaves Lansdown (LSE: HL), ITV (LSE: ITV) and Ocado (LSE: OCDO) have all lost as much as 50%.
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There has been a shift away from expensive growth stocks to cheaper defensives such as materials and resources. However, some high-quality businesses have also seen their value collapse as investors have thrown the baby out with the bathwater.
Borrowing a strategy pioneered by US investor Joel Greenblatt, the author of You Can Be A Stock Market Genius and the Little Book that Beats the Market, I have identified nine high-quality, cheap stocks in the FTSE 100.
The strategy, conservatively named the Magic Formula, is based around return on capital, which can be an indication of a quality business.
The return on capital figure used in the Magic Formula is calculated using the company’s earnings before interest and tax divided by capital employed (net working capital + net fixed assets). As this figure can be distorted by one year of good performance, my model uses a five-year average return on capital.
Along with this quality metric, I’m also looking for businesses that appear cheap. To screen for these companies I’m using the price-to-free cash flow (p/fcf) multiple. The combination of these two factors should help me to find FTSE 100 equities that are both high quality, and look cheap compared to the value of their cash flows.
Three cheap high-quality FTSE 100 equities Nine blue-chip stocks make it through my screen of companies with a return on capital of more than 20% a p/fcf ratio of less than ten. Two are resource stocks, which I’m going to exclude as their earnings can be volatile.
Two are tobacco stocks which I’m excluding for ethical reasons, and another two are housebuilders. While I like the housebuilding sector, earnings and returns on capital can also be cyclical, and for that reason I’m also excluding these businesses.
That leaves me with three companies: Airtel Africa (LSE: AAF), JD Sports Fashion (LSE: JD) and B&M European Value Retail (LSE: BME).
Airtel Africa: a huge growth opportunity
Airtel is the cheapest of the three, trading at a p/fcf ratio of 5.3 and has achieved a five-year average return on capital of 28.4.
Airtel operates as a telecoms and mobile money services provider in 14 countries across Africa, and is one of the best ways for investors to play the growth of the continent’s digital economy. Last year, customer numbers grew 8.7% to 128.4 million and average revenue per customer jumped 15%. Revenue expanded 21% to $4.7bn.
Airtel has been investing heavily in 4G connectivity across the continent, and has just launched its payment service in Nigeria. This could be a huge growth opportunity for Airtel as it expands to reach the tens of millions of consumers in the country that don’t have access to regular banking facilities. Looking at the stock’s current valuation, it does not seem as if the market appreciates this potential.
JD Sports: doubled down on growth
The second-cheapest stock on the list with a p/fcf ratio of 7.9 and a five-year average return on capital of 39.6% is JD Sports.
Shares in the FTSE 100 fashion retailer have been hit by the shift away from highly-valued growth stocks. Concerns about the effect high inflation will have on consumers’ discretionary income are also weighing on the retail sector more generally.
Despite these concerns, Refinitiv analyst estimates for JD Sports’ growth over the next two years have not changed. In fact, since the beginning of the year they’ve increased.
JD Sports has doubled down on its growth strategy over the past few years, setting the business apart from its competitors. It is building its presence in the US and constructing two new logistics centres in the UK and the Netherlands to meet growing demand and improve customer service.
The FTSE 100 company also stands out from the competition due to its unique agreements with big brands, JD is one of Nike’s top customers globally, giving the business leverage over this key supplier. In a competitive market like retail, these advantages and growth investments can make all the difference.
B&M: fortunes could be about to pick up
Shares in B&M European Value Retail are off more than 30% this year. After these declines the stock is trading at a p/fcf figure ratio of 8.3. It has earned a five-year average return on capital of 32.9%.
Even though investors have been dumping the stock this year, the company has historically achieved its best performance when consumer confidence is weak. The group, which sells a mix of groceries and homewares in over 700 stores, reported average quarterly like-for-like sales growth of 10.4% in 2008 to 2011.
Growth slowed over the following nine years but ramped up again during the coronavirus pandemic when B&M was classed as an essential retailer. Like-for-like sales growth averaged around 20% per quarter in 2020, before consumer confidence bounced back in 2021.
Based on these figures, as dark clouds build over the economy, B&M’s fortunes could be about to pick up, suggesting the market’s view of the enterprise is far too pessimistic.
Disclosure: Rupert Hargeaves owns shares in ITV.
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