Interactive Investor

This is what the ideal share for 2023 looks like

30th December 2022 09:04

by Ben Hobson from interactive investor

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These 11 companies could be winning shares in 2023 after passing stock screen expert Ben Hobson’s rules to build a strategy for the unknown.

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2022 saw some of the biggest shifts in the performance of stock market investment strategies that we’ve seen since the global financial crisis.

Styles that have been serving investors well for over a decade were turned on their heads as new themes began to influence which shares and sectors did well, and which did not.

The good news is that lessons learned from experiences this year could help shape your approach to the market in 2023.

How markets trends changed in 2022

This time 12 months ago, few were predicting that equities would sell off quite as sharply as they have in parts of the market this year.

Rising inflation was already a nagging concern at the turn of the year - and it became a dominant theme in 2022. With both consumers and businesses facing rising prices, central banks responded with a series of interest rate hikes.

This change of policy marked a move away from the easy monetary conditions in place since the great recession of 2008. But it coincided with the outbreak of war in Ukraine, international supply chain disruption and a global energy shock.

Together, these factors have set the scene for a likely recession in 2023 and caused a radical shift in investor expectations. This showed up in a number of themes:

Theme #1. Growth strategies fall from grace

One of the symbolic features of markets in 2022 was the falling share prices of some of the world’s largest technology and high-growth companies. Shares in Meta Platforms Inc Class A (NASDAQ:META) (Facebook) fell 66%, shares in Alphabet Inc Class A (NASDAQ:GOOGL) (Google) fell 40% and Tesla Inc (NASDAQ:TSLA) slumped 70%.

Not only did the bubble pop in US tech valuations, growth investing strategies completely fell out of favour.

Growth companies (which often include pre-profit firms) can have strong upside in the kind of stable conditions we have enjoyed over the past decade. But they become riskier in a downturn.

Growth shares are often valued on the cash flows investors think they will achieve in the years ahead. But inflation and recession can make these assumptions difficult because the future value of cash (and the strength of the economy) become uncertain.

This theme resulted in a major reassessment of expectations and a move away from speculative growth shares. Small and mid-cap companies were some of the worst performers, with the UK’s junior AIM market losing 30% of its value.

With no clear sense of a return to more upbeat conditions, it seems likely that growth strategies will remain out of favour for now.

Theme #2. Quality factors come to the fore

Faced with rising input prices and a squeeze on consumer spending, profits came under pressure in 2022. Firms that were best placed to resist these issues were those with pricing power, which allowed them to quickly pass on higher costs to customers.

Strong, efficient profitability and good margins became highly desirable factors. Companies with costs under control, low debt and healthy cash flows were a much more appealing option than those for which economic headwinds could blow them off course.

With inflation expected to ease in 2023, all eyes are now on just how debilitating any recession will be. That is likely to mean that good quality firms with strong finances and solid competitive strengths will remain in demand.

Theme #3. Value shows signs of life among the large-caps

With growth strategies on the ropes, some commentators expected value strategies to take a lead in 2022. To an extent that proved to be the case, and there is a consensus view that the UK stock market now looks relatively cheap in places - so value strategies are arguably well placed to perform well.

What we saw in 2022 was a few previously unloved stocks and sectors finding themselves in the right place at the right time. Oil and gas was one of very few clear winners as a result of bumper profits caused by supply shocks in energy markets. Rising energy prices also boosted utilities and fuel suppliers.

Meanwhile, rising interest rates were a boon for banking shares, which were suddenly much more profitable. It’s worth remembering though that recessions are hardly kind to banks, which often face higher defaults on loans when consumers are stretched.

While value strategies may flourish in 2023, ongoing uncertainty suggests that it might be worth focusing on reasonably priced quality shares rather than outright value.

Theme #4. Cyclical sectors suffer while defensives hold firm

Cyclical sectors like retail, entertainment, car sales and house construction have all done well in recent years. These areas have been the source of strong performance for many shares, particularly in the rebound from Covid. However, faced with dark clouds on the economic horizon, some have suffered badly in 2022. It seems unlikely that will improve until a recovery from recession is more visible.

By contrast, defensive sectors have performed much better over the past year. Consumer staples, including tobacco and beverages, healthcare, utilities and a number of industrials have resisted the worst drawdowns. Several are already showing signs of improving momentum - and it’s possible we’ll see more of this as the new year progresses.

A strategy for 2023

Given the experiences of the past 12 months, there is a case for believing that the new themes of inflation and recession and a preference for higher quality, more defensive positioning will continue for some time yet.

So what would the ideal share look like in 2023?

It’s obviously a very personal choice - and doing your own research is more important than ever - but this is my effort at building a strategy for the unknown in the year ahead. It includes:

  • Pricing power: companies with above average profit margins
  • Cash flow: companies that are good at turning sales into actual cash
  • Strong profitability: Return on Capital Employed and Return on Equity both above 10% now and on average over five years
  • Not too expensive: an Earnings Yield of greater than 5%

Here are some of the companies that pass these rules:

Name

Mkt Cap (£m)

Operating Margin % 5y Average

ROCE % 5y Average

Earnings Yield (%)

Forecast Dividend Yield

Sector

Rightmove (LSE:RMV)

4,263.0

72.2

517.0

5.5

1.6

Technology

Serica Energy (LSE:SQZ)

748.9

42.5

18.3

89.0

6.0

Energy

Games Workshop Group (LSE:GAW)

2,788.9

36.4

67.1

5.7

3.0

Consumer Cyclicals

Auto Trader Group (LSE:AUTO)

4,813.5

68.0

55.0

6.2

1.7

Technology

Central Asia Metals (LSE:CAML)

444.1

45.9

16.3

27.7

6.3

Basic Materials

Sylvania Platinum Ltd (LSE:SLP)

273.5

45.4

29.6

38.6

7.2

Basic Materials

Rio Tinto Registered Shares (LSE:RIO)

94,139.2

37.7

21.1

20.7

6.4

Basic Materials

Andrews Sykes Group (LSE:ASY)

198.1

25.4

27.6

11.7

0.0

Industrials

Airtel Africa Ordinary Shares (LSE:AAF)

4,239.2

26.0

15.6

21.5

4.9

Telecoms

Segro (LSE:SGRO)

9,191.2

402.5

14.9

34.9

3.8

Financials

Safestore Holdings Ordinary Shares (LSE:SAFE)

2,044.0

134.1

13.8

19.9

3.3

Financials

Data: Stockopedia

This focus on high-quality profitability picks up some well-known names, including property website Rightmove (LSE:RMV), fantasy wargame retailer Games Workshop Group (LSE:GAW) and auto sales website Auto Trader Group (LSE:AUTO). These shares are among the priciest based on Earnings Yield, but they are still all trading at lower prices than they were a year ago. Any pick up in the outlook could see them start to re-rate quickly.

Among the miners making the list are Central Asia Metals (LSE:CAML), Rio Tinto Registered Shares (LSE:RIO) and Sylvania Platinum Ltd (LSE:SLP). Meanwhile, the financial stocks here are both real estate investment trusts: Segro (LSE:SGRO) and Safestore (LSE:SAFE). Their potential exposure to economic headwinds has dragged on their prices this year, but they still appear to be in robust financial shape.

The main screening rules didn’t specify a minimum dividend yield, but the table does show them. Note that there are some strong yields on offer, including 6.0% at oil and gas producer Serica Energy (LSE:SQZ), 7.2% at Sylvania Platinum and 4.9% at telecom operator Airtel Africa Ordinary Shares (LSE:AAF).

Opportunities in the year ahead

After a challenging year in markets in 2022, we’re not yet past all of the potentially damaging economic turmoil. Fears of a recession still hang in the air, and that is reflecting in depressed share prices. Uncertainty still dominates.

However, there are signs of improving momentum in parts of the market, and a focus on good quality firms with solid profitability does suggest that they can be had for much more reasonable prices than just a year ago. For investors with a longer-term horizon, this year’s sell-off is presenting some high quality companies at valuations you haven’t seen very often in recent years.

Whatever strategy you use and whatever your approach to the stock market, I wish you all the best for the new year!

Ben Hobson is a freelance contributor and not a direct employee of interactive investor.

Disclosure

We use a combination of fundamental and technical analysis in forming our view as to the valuation and prospects of an investment. Where relevant we have set out those particular matters we think are important in the above article, but further detail can be found here.

Please note that our article on this investment should not be considered to be a regular publication.

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