SIF Folio: Can Severfield build on strong results?

My SIF portfolio delivered a gain of around 20% during the first half of 2021 – double the 10% increase delivered by the FTSE All-Share Index. While I’m happy with this result, I’m aware that the market conditions we’ve seen over the last year are not exactly typical. 

For example, two weeks ago I sold Volex for a gain of 170% after just 10 months. 

Of the 16 stocks which remain in the SIF portfolio, five have risen by between 50% and 100% in less than nine months. 

Making money from shares isn’t always this easy, at least not in my experience. While I’d like to take all the credit, in reality I think I’ve simply profited from a broader re-rating of good companies which looked cheap in autumn 2020.

I wouldn’t be surprised to see a more mixed performance from the market over the next 6-12 months. In this context, I’m a little concerned about the portfolio’s lack of exposure to defensive stocks:

Being underweight defensive stocks has been a recurring problem throughout the portfolio’s life. Put simply, they’ve usually been too expensive – and sometimes too slow growing – to pass my screening tests.

That remains the case today. Ahead of writing this, I hunted through a number of FTSE 100 and FTSE 250 consumer defensive stocks I’d be happy to own. None came close enough to qualifying for my screen for me to consider buying without breaking my rules.

All of which led me back to reconsider the handful of stocks which do currently qualify for my buying screen.

Of these, the only one I might consider buying today is UK structural steel specialist Severfield (LON:SFR). This business provides the steelwork for a wide range of non-residential property. Past projects have included many well-known UK landmarks, such as the Wimbledon No. 1 Court and the London Shard. The company is also active in markets such as data centres and transport infrastructure.

Severfield has made regular appearances in my screening results, but the last time I looked at the company was in November 2019. At the time, I noted that the company was promising growth despite an uncertain outlook for the UK economy. I didn’t buy the shares in 2019, for several reasons:

• I noted an “apparent contraction in the core UK business” 

• My analysis suggested that recent earnings growth may have come from acquisitions, not organic growth.

• I was wary about management’s intention to seek growth in Europe through acquisitions

However, it seems I was wrong. Or at least the market disagreed with me. Severfield’s share price has risen by 45% since November 2019, as the company has continued to deliver strong revenue growth. 

This week I want to ask whether the good news is in the price – or whether there’s still time for me to build a winner with Severfield.

A mixed picture

As Jack commented in an SCVR in April, Sevefield is a cyclical business that has suffered some setbacks in the past. Although the one-year share price chart is very impressive, the three-year chart is much less so. 

Looking further back, the picture is even more sorry:

Severfield suffered something of a blowup after the financial crisis and had to resort to a large, discounted rights issue in 2013 to steady the ship. 

Recent performance has been more favourable, though. Although profits dipped during the year to 31 March, revenue rose by 11% to £363m. The shortfall in profits was blamed on Covid-19 disruption and delays to cost recoveries, which seems reasonable to me.

What concerns me slightly more is the lack of progress with the group’s order book. Although the order backlog rose by £14m to £301m between November 2020 and June 2021, this included an £18m contribution from February’s acquisition of rail and piling specialist DAM Structures. 

Without this bolt-on deal, it looks like the order book would have contracted. This isn’t necessarily a serious concern during such a short (and difficult) period. But it does seem to be an echo of my worry in 2019 that the company was relying heavily on acquisitions to drive growth.

In fairness, DAM does seem like a sensible fit and should be small enough to be easily digested. I’m further encouraged that Severfield still ended the year with a modest net cash position, despite the DAM deal.

Stokopedia’s algorithms have a favourable impression of the business too. Severfield boasts a StockRank of 92 and Super Stock status. 

Severfield shares comfortably pass all of my screening tests. This suggests they could offer an attractive combination of value and growth. Let’s take a closer look.

Value: reasonably priced

A ValueRank of 86 suggests to me that Severfield shares are likely to be reasonably valued. On the whole, I agree with this.

The core valuation metrics I use all look reasonable, if not overly cheap:

• Trailing P/E: 13.6

• Trailing price/free cash flow: 13.5

• Trailing dividend yield: 3.5%

• Price/book ratio: 1.3

• Earnings yield (EBIT/EV): 8.4%

I’ve no issue with any of these numbers. Indeed, I’d note that free cash flow improved last year, despite money spent on acquisitions. This is reflected in the StockReport cash flow stats:

The company ended last year with net cash of £4.3m, excluding IFRS 16 lease liabilities. Even when these are included, net debt looks modest to me at £6.7m. That’s very modest compared to annual profits of c.£20m. 

I don’t see any particular concerns here, assuming a stable outlook.

Quality: solid

The nature of its business means that Severfield is quite capital intensive. It must buy bulky raw materials and invest in factories and costly machinery. I would not expect a company of this kind to generate high returns on capital. Instead, what I’d look for are stable margins and returns, supported by solid cash flow.

A QualityRank of 72 suggests that Severfield may score quite well on these metrics. A closer look at the numbers appears to confirm this view. Since 2017, margins and ROCE have been pretty consistent:

I’d be happy with an average ROCE of 8% or more through the cycle from Severfield. Can the company deliver on this? It’s hard to be sure, as we haven’t really seen a major downturn since the company’s 2013 refinancing. Although the pandemic was initially expected to trigger such an event, so far it hasn’t materialised.

I don’t have any serious concerns about Severfield’s quality factors. So everything hinges on whether the outlook – represented by momentum factors – is likely to remain positive.

Momentum: Looks good to me

Despite my best intentions, I fear that my decision not to add Severfield to SIF in 2019 was influenced by my cautious view on the outlook for the economy. This runs counter to the ethos of the rules-based SIF folio, so I’ve made a conscious effort to avoid this subject in this review.

Instead, I’ve tried to focus purely on the numbers. In terms of momentum, this means looking at technical share price activity and broker forecasts. These are – broadly speaking – the factors that lie behind Severfield’s healthy MomentumRank of 71.

Price momentum: Initial impressions are fairly positive. The stock has outperformed the market over the last year and appears to have seen strong buying activity recently:

One comment: I wonder whether the recent surge in volume flagged by the 10d/3m indicator is linked to the recent issue of 1.5m shares by the company in connection with share awards to staff. This is a significant number of shares, when compared to the three-month average daily volume of c.300k. If a percentage of staff cashed in their share awards, I’d guess this could create a short-lived surge in volume.

Of course, the other (more conventional) explanation for a sudden increase in average daily volumes is that institutional investors are buying the stock in size. That would potentially be a bullish signal.

Earnings estimates: City analysts have taken an increasingly positive view on the outlook for Severfield over the next 18 months. Earnings forecasts for both FY22 and FY23 have been upgraded on multiple occasions since February:

These forecasts price the stock on a rolling forecast P/E of 10.8, with a dividend yield of 3.8%. That seems a reasonable entry valuation to me.

Taken at face value, Severfield’s momentum metrics look fairly attractive, in my view.

My decision

Should I add Severfield to SIF? Looked at in isolation, I don’t really have any reason to reject Severfield. Despite my concerns about the group’s underlying growth, the shares pass all of my screening tests comfortably.

However, I also need to consider the impact of any new stocks on the portfolio’s diversification. In this context, I’m not sure Severfield is a good fit. As we saw in the portfolio allocation graphic earlier in this piece, SIF already has significant levels of exposure to cyclical stocks. 

As things stand at the time of writing, almost 40% of the portfolio is invested in Industrial stocks and UK-centric consumer cyclicals. I’m not sure that adding a further UK-focused industrial stock makes sense at this time.

It’s possible that I’m being too cautious (again). But I’m not going to pull the trigger on Severfield at this time. As always, please let me know what you think. Am I underestimating the growth potential of this business?

Disclosure: At the time of publication, Roland owned all the stocks held in the SIF portfolio.

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