Twelve 'Late Bloomer' stocks that can beat the FTSE

Since we started tracking it a decade ago, its headline total return (that is, including reinvested dividends) has been 47 per cent, equal to a compound annual growth rate of 3.9 per cent. An investor who had simply stuck with the often-disappointing FTSE All-Share index would, by contrast, be up 72 per cent on the same measure.

Note the word ‘headline’, there. Factor in a 1.5 per cent annual charge to reflect real-world transactional charges and the wide bid-offer spreads that can sometimes crop up, and the return drops to a frankly woeful 26 per cent.

A year ago, I was lamenting not only the screen’s results, but its structure. Designed to highlight cyclical stocks that were late to enjoy the fruits of improving economic conditions, it provided little in the way of market alpha in its first seven years. Then, in mid-2021, it began to badly misfire, just at the point one might expect to see a gap between valuations and underlying business momentum.

By the autumn of 2023, with little sign of improvement, I had more or less concluded that the Late Bloomers would never bloom, and that its convoluted share-vetting process had failed to adapt to a new market paradigm. Its continued heavy backing of a rebound in commercial property, despite a huge shift in the fundamentals of the asset class and a total re-pricing of debt, seemed like a sign that its performance would continue to wither.

So it was more than a pleasant surprise, upon refreshing the screen for what I thought would be the last time, to discover that after a very long rainy season, bloom the screen has.

Over the past 12 months, just two of 2023’s nine selections posted a negative total return, while two – UK Commercial Property (UKCM) and Pinewood Technologies (PINE) – were on the receiving end of major corporate activity. UKCM, which is in the process of finalising a merger with Tritax Big Box (BBOX), will see shareholders issued stock in the combined group, while Pinewood (the software business remaining from the spinout of Pendragon’s car retail business to US-based Lithia (US:LAD)) has just made a £358mn return to shareholders following the transaction.

Together with good outings for blue-chips BAE Systems (BA.) and GSK (GSK), this pushed the screen’s total return for the year to 24 per cent, almost 16 percentage points ahead of the FTSE All-Share index.

So while the long-term performance remains dismal, there remains room for hope. After all, the real damage to the Late Bloomers occurred in a two-year period. Is it too much to assume repair can’t happen over a similar timeframe?

While anything’s possible, we should never forget that share prices must rise a lot more than they fall to properly ‘recover’. More analytically, we need to be confident that the past year’s rally wasn’t simply a fluke, and that either the Late Bloomers screen is now more functional following the tweaks I have made to it (details of which are below), or that market and economic conditions should favour the screen’s contrarian bias toward undervalued stocks.

The methodology

The Late Bloomers screen looks for shares that appear cheap against their own long-term valuation range, by looking at the “ultimate source” of their earnings. This is based on the idea that stocks often rebound after profits have been hit. In theory, by looking at a company’s future earnings potential (rather than current earnings), investors can get a better read of the prospect of recovery.

The screen assumes the source of earnings for most companies is sales, while for property firms, housebuilders and financials it is net assets. Turning this into a valuation metric involves the use of Z-scores, which allow us to compare how cheap or expensive a valuation looks relative to its 12-year history. If a full history does not exist, the reference is a minimum of six years.

From this, we get the neat (or tortured) acronym of the ZEUS ratio (the Z-score of earnings’ ultimate source). The screen looks for a ZEUS ratio of -1 or less, suggesting the valuation is toward the bottom of the historic range. The other tests used by the screen are there to see if the balance sheet looks in a serviceable state and whether the company has been more profitable in the past than it is now. 

The full criteria are:

■ Value: ZEUS ratio of -1 or less. 

■ Recovery potential: Real estate companies get a free pass on this test. For financials, return on equity needs to be at least one-third below its 10-year peak. For other sectors, operating margin at least a third below 10-year peak.

■ Balance sheet: (i) For financials, equity representing at least 5 per cent of assets and return on assets of at least 1 per cent. This is a test suggested by the great Peter Lynch, the former star manager of Fidelity’s flagship Magellan fund. (ii) For utilities, which have very defensive earnings streams well suited to supporting high levels of debt, net debt to book value (gearing) of less than 150 per cent. (iii) For real estate companies, gearing of 75 per cent or less. (iv) For housebuilders, gearing of 25 per cent or less. (v) For all other sectors, net debt of 1.5 times cash profits or less.

■ Growth: Growth in earnings' ultimate source (the EUS in ZEUS) over the past 12 months. 

■ Positive free cash flow: Free pass for financials and real estate

(NB investment trusts are excluded from this screen but not Reits)

This year, six stocks passed all tests. Yet again, there was a heavy weighting to Reits, which for my money are given an easy ride by the balance sheet, recovery potential and cash flow tests.

In 2023, in the interests of broadening the range of stocks, I made the decision to dilute the overall criteria to admit companies that pass just one of the recovery tests. This time around, while the screen’s real estate names hold more promise than many peers, I’ve again used the diluted criteria to avoid placing two-thirds of our eggs in the basket marked “sudden commercial property rally”.

This gets us six more stocks: ITV (ITV), Capital Limited (CAPD), Croda International (CRDA), BAE Systems, Next (NXT) and Compass (CPG). While the first three have recovery potential, it feels wrong to describe BAE (up 80 per cent in two years) or Next (up 36 per cent in one) as late bloomers. Both appear to be well-understood businesses with the winds at their backs. It’s also notable that a third of this year’s stocks – ITV, Croda, BAE and UKCM – were also on last year’s ticket, suggesting that the screen (or rather, its latest incarnation) sees ‘recovery’ as a multi-year process.  

So, am I happy with the adapted version? In truth, not especially. To me, the screen’s criteria remain overly prescriptive and too generous towards a beaten-up property sector. By allowing stocks to fail one of the recovery tests in the interests of greater diversification, I’ve at best put a sticking plaster on things, at worst added stocks that are simply in a new business cycle.

And herein lies my big issue with the Late Bloomers. The screen's checks and balances tests – positive free cash flow in some instances, some balance sheet resilience, and the presence of earnings growth – might not be tough enough. Throw in some decade-long reference points that remain badly skewed by the pandemic and the output is, well, a bit random.

That’s my feeling as of May 2024. Perhaps, in a few months’ time, I’ll be feeling a bit more confident about whatever this method now is. The Late Bloomers screen has bought itself another year.