Galliford Try: From Style Neutral to Super Stock

Investors are more likely to outperform the market by investing in profitable, financially stable companies that have rising share prices and are still cheap – at least according to finance academics. For instance, Professor Robert Novy-Marx explains that ‘tilts towards value, momentum and profitability have outperformed the market’. In terms of Stockopedia’s StockRank framework for classifying shares, companies with this profile are called ‘Super Stocks’. They often have strong Value, Quality and Momentum Ranks (see here).

On 12 September, the house builder Galliford Try (LON:GFRD) published its annual financial statements and the company’s StockRank Style changed from ‘neutral’ to Super Stock. In this piece we take a closer look at Galliford Try’s respective Quality, Value and Momentum Ranks in order to discover why it has become a ‘Super Stock’ and explore what this means for the firm’s future prospects…

What does Galliford Try do?

Galliford Try is one of the UK’s largest housebuilding and construction companies. The company has three divisions: Linden Homes develops private homes for sale; the ‘Partnerships amp; Regeneration’ division works with local authorities to supply mixed-tenure housing; while the ‘Construction’ division tenders for construction contracts in the public and regulated sectors. The firm has a market cap of £1.2bn and is currently a constituent of the FTSE 250 Index.

Breaking down Galliford Try’s StockRank

We can see from the top of Galliford’s StockReport that the company has a strong StockRank (99 out of 100) and the firm is classified as a ‘Super Stock’. At the start of September, the StockRank was just 69 and the company was ‘Style Neutral’ (see here). The StockRank changed around 12 September, when the company published its financial statement for the year ending June 2018. When this happened, the respective Quality and Momentum Ranks improved, while the ValueRank remained stable. Indeed, in the image below we can see that the Quality and Momentum Ranks have little green triangles next to them, indicating that the rank has improved by 5 points or more over the last 30 days (see here). The ValueRank does not have a triangle. Let’s explore why the ValueRank remained static…

Galliford’s ValueRank

Galliford Try’s current ValueRank is 82. Before the company produced its annual results, the rank was 86. Based on this measure, it has been, and continues to be, relatively cheap – but why? Some financial academics argue cheap stocks outperform expensive stocks because value investors are effectively compensated for holding risky cheap stocks. You could certainly argue that Galliford Try is exposed to both business risk and country risk, which may account for its apparently cheap valuation.

• Business risk is the uncertainty of income flows caused by the nature of a firm’s business.
• Macroeconomic risk is the uncertainty of returns caused by the possibility of a major change in the macroeconomic environment of a country.

Let’s take a look at business risk first. Galliford Try is a cyclical company, meaning that revenues and profits tend to rise and fall in line with the business cycle. When the business cycle hits a recession, the profits and also share prices of cyclical companies tend to fall hard. Galliford operates in the house construction industry, and it is easy to anticipate that people may cancel plans to buy a new home when the economy slows down. Indeed, we can see from the chart that Galliford’s share price collapsed during the 2008 credit crunch.

Galliford is also exposed to macroeconomic risk. Housebuilders have generally benefited from the low interest rates, which make mortgage payments easier to afford. However, the Bank of England raised interests rates to 0.75% in August 2018 and warned that there would likely be further ‘gradual’ and ‘limited’ rate rises as we go forward. Britain’s withdrawal from the EU is also likely to impact interest rate levels. Back in July, Mark Carney explained that no-deal Brexit would have ‘big’ economic consequences and prompt a review of interest rates. It is plausible that a no-deal situation could place upwards pressure on interest rates. A weaker pound could make imports more expensive and the Bank of England may raise interest rates to control inflation.

So these business and macroeconomic risks help to explain why the firm is so cheap with, for example, a PE ratio of just 6.2 – well below the market median of 15.2. The company’s yield is also 7%, while the market median yield is just 2.9%. It may well be that the market has priced Galliford’s riskiness into the firm’s valuation.

It is plausible that the company has been consistently cheap because Galliford’s exposure to business and macroeconomic risks has not changed since the company produced its annual results on 12 September. The company has always operated in a cyclical industry and the firm’s exposure to interest rate risk is not something new.

The publication of annual results is more likely to have a direct impact on the QualityRank because ‘quality’ metrics (eg. profit margins) are constructed predominantly using fundamental data, while the Value and Momentum Rank also incorporate price data. So let’s examine the firm’s QualityRank.

Galliford’s QualityRank

Readers can find out why a company has a high QualityRank by clicking on the QualityRank value in the Portfolio Holdings tab. (See this video for further details).

The breakdown of Galliford’s QualityRank is shown on the right. We can see that company’s high rank is supported by a strong Piotroski F-Score and a solid Long Term Average ROCE.

Analysts can use the DuPont formula to break the ROCE into two parts (see below) and identify the source of superior (or inferior) returns.

Generally speaking, a high ROCE can come from two sources:

• High Operating Profit Margins: The Operating Margin is calculated as Operating Margin divided by Revenue. Margins could be high if companies are able to command high pricing power, control operating expenses, or do both.
• High Capital Turnover: Capital Turnover is calculated as Revenues divided by Capital Employed (where Capital Employed is defined as Fixed Assets plus Working Capital). As such, investors can use Capital Turnover to ascertain how effective a company is at using Fixed Assets and Working Capital to generate sales.

Galliford’s operating profit margins (5.2%) are slightly below the market median (6.9%). Indeed, operating margins in the construction amp; engineering industry stand at 3.4% – so Galliford operates in a relatively low margin industry. We can see from Galliford’s annual report that the Linton Homes division has very solid margins (19.5%) although the firm’s overall operating margins are brought down by the ‘Partnerships amp; Regeneration’ and ‘Construction’ segments, which have margins around 6% and 1% respectively (see below).

The firm’s strong ROCE is more likely the result of high capital turnover. Indeed, Galliford’s Capital Turnover was 2.7 in 2018, while the market median Turnover was around 0.5. As such, Galliford’s Sales are high compared to Capital Employed. The firm’s latest annual report indicates that sales have benefited from the ‘government’s commitment to the housing market, combined with the relaxation of stamp duty for first-time buyers, good mortgage availability and historically low interest rates…despite the ongoing macroeconomic uncertainty.’

Improving Fundamentals

When Galliford produced it’s annual report, the firm’s Piotroski F-Score jumped from 4 to 7. The F-Score is a useful metric which investors can use to ascertain whether a company has improving fundamentals. The F-Score system scores companies on a ‘pass’ / ‘fail’ basis on 9 signals. Companies would have a positive, or ‘pass’ signal if the company is:

1. Making a profit;

2. Generating cash;

3. Making more cash than profits;

4. Making more profit than the previous year;

5. Reducing long term debt;

6. Increasing its ability to pay short term debts;

7. Operating without having to raise funds from shareholders;

8. Improving pricing power (in terms of profit margins);

9. Becoming more productive (in terms of asset turnover).

We can see that Galliford has 7 out of a possible 9 positive signals. Most companies only have 5 out of 9.

With regards to operating efficiencies, we can see that Galliford gets a ‘pass’ for improvements in pricing power/reductions in costs (ie. stronger profit margins). Two factors have driven this trend. The company has recently prioritised cost reduction. Back in February 2017 it set out a ‘three-part strategy for sustainable growth’. The first part of this strategy aimed to ‘drive operating efficiencies by streamlining our operations to increase margins’. Galliford has also been able to sell houses at higher prices. For example, in 2018 the Linden Homes division was able sell ‘private’ houses 4% higher than the previous year, while the selling price for ‘affordable homes’ increased by 11% (see here).

Galliford also gets a ‘pass’ for improvements in productivity. As such, the firm has a stronger Asset Turnover (ie. Sales / Assets). We can see here that the value of assets on Galliford’s balance sheet declined from £3,044m (2017) to £2,900 (2018). Furthermore, sales have been driven higher, supported by the Help to Buy scheme, mortgage affordability and the cut in stamp duty for first-time buyers (see here). Higher revenues coupled with a smaller asset base would of course support a higher Asset Turnover. In turn, stronger revenues coupled with higher profit margins would translate into larger profits (given that profits are equal to revenue multiplied by profit margin). Galliford’s net profits increased from £48.7 (2017) to £118.3 (2018) and we can indeed see that the company gets a ‘pass’ for improvements in profitability.

Galliford’s MomentumRank

Momentum is perhaps one of the most counter-intuitive factors that drives share prices. Most investors like to buy low, sell high. Momentum investors typically buy high and sell even higher, because shares that have gone up historically tended to keep on going up.

According to academic finance, this happens because investors underreact to new information which would otherwise drive share prices higher. For example, a company may produce bullish financial statements which suggest a that stock’s ‘intrinsic value’ (or true worth) has increased from say 100p to 150p. Initially, the share price may spike higher, to 120p, but the price would then very slowly drift from 120p to 150p because new investors remain reluctant to buy a stock that has already risen by 20% or more. Investors may feel they have ‘missed the bus’ and so the stock could keep going up and the price would reach ‘intrinsic value’ very slowly.

Galliford Try has a strong MomentumRank (90 of out 100). Interestingly, when the firm produced it’s bullish annual report earlier this month, the price did spike from 999p to 1104p (see chart). If the market determines that the ‘intrinsic value’ is higher than 1104p, the momentum effect would suggest that the price may adjust very slowly because buying shares at new highs is scary, as we can see from the chart. So where will Galliford’s price go from here?

Where will Galliford go next?

There is a distinct possibility that interest rates will rise. It is difficult to predict the impact this will have on Galliford Try. If inflation -and thereby interest rates- rise as a result of wage growth and higher levels of employment, then it is possible that the negative effects of tighter mortgages could be offset by the positive effects of wider economic growth.

A less favourable scenario would be as follows: the British economy slows down while the UK fails to negotiate a favourable withdrawal from the EU. European imports become expensive, due to tariffs and a weaker pound, while inflation and therefore interest rates rise. This scenario may never be realised, but if it is, Galliford Try would be hit by the double whammy of an economic recession plus higher interest rates.

At the same time, one may expect Super Stocks to be exposed to these kind of risks. Super Stocks tend to be cheap and cheap stocks tend to have apparent problems and/or be considered risky investments. Many academics believe that this is why cheap stocks tend to outperform. If Galliford was not risky, then perhaps the company would have the profile of a High Flyer (ie. an expensive company with strong quality and high momentum). Cyclical stocks are inherently risky, but that doesn’t necessarily make them bad investments. Investors can use sector diversification to manage risk. So perhaps the question is not ‘should I invest in Galliford Try?’. Instead, investors could consider whether they have a role in their portfolio for cyclical stocks. My colleague Ben answers this question here.

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