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5 unloved stocks that could spring a surprise in 2016

David Smith of Henderson High Income and Alastair Mundy of Temple Bar pick five companies they think could surprise this year.

by Gavin Lumsden on Jan 07, 2016 at 12:51

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Smith looks for surprises

David Smith, manager of the Henderson High Income (HHI) investment trust, is looking for companies that can deliver extra earnings growth despite the slowdown in the global economy caused by China’s deceleration.

His £231 million fund seeks to provide a high level of investment income and some capital growth. It invests mainly in shares but can hold up to 10% in bonds to boost the dividends it pays shareholders. It yields 4.9%, has returned 43% over three years and last year charged investors 1.59%, including a performance fee (its ongoing charge excluding the performance fee was 0.73%).

Next: the M&S margin story
Key stats
Market capitalisation£7,159m
No. of shares out1,631m
No. of shares floating1,613m
No. of common shareholdersnot stated
No. of employees83069
Trading volume (10 day avg.)5m
Profit before tax£487m
Earnings per share29.54p
Cashflow per share62.65p
Cash per share13.20p

*Correct as at 4 Jan 2016

The M&S margin story

The UK retail sector is tough at the moment but Smith believes the turnaround at Marks & Spencer (MKS) is finally gaining momentum, even if chief executive Marc Bolland is leaving the group under a bit of a cloud following a tough Christmas trading period.

Smith said Bolland had sought to revive M&S’ general merchandise division by modernising its warehouses and increasing profit margins through improved buying of the clothing, footwear and homeware products it sells to shoppers.

In 2014 he lured sourcing specialists Mark and Neal Lindsey back from retirement. The Hong-Kong based brothers are famous for their achievements at Next where they boosted the fashion retailer’s profits by streamlining its supply chain and buying goods directly from factories.

A trading statement released today showed merchandise sales fell 5.8% over Christmas, although margins were up and the food division enjoyed its best ever season.

Speaking to investors at an event organised by broker Cantor Fitzgerald at the end of last year, Smith was confident. ‘It will be the start of a multi-year phase. They could do 7% earnings per share growth just driven by margin improvements.’

Add the 4% dividend yield and the fact that M&S’ capital expenditure had peaked and it could return another 4% in cash or special dividends, Smith reckoned the shares could generate a 15% total return, ‘which is not bad,’ he said.

Next: Pearson is not a pariah
Key stats
Market capitalisation£5,942m
No. of shares out821m
No. of shares floating812m
No. of common shareholdersnot stated
No. of employees40876
Trading volume (10 day avg.)2m
Profit before tax£243m
Earnings per share29.93p
Cashflow per share79.20p
Cash per share67.18p

*Correct as at 4 Jan 2016

Pearson is not a pariah

Educational publisher Pearson (PSON) was one of the worst performing shares of 2015, down 38% after a third quarter profits warning.

‘Clearly profitability has been pretty weak. Some say it suffers structural problems from online rivals and lower margins. Others say it’s more cyclical – US unemployment is at a 40-year low so people don’t need to go to college,’ said Smith.

Although investor concern has focused on the dividend, Smith believed the group could avoid cutting shareholder payouts. It has raised £1.4 billion in disposals, such as the sale of the Financial Times, and could receive another £1 billion from a joint venture with German publisher Bertelsman.

‘Fundamentally, I think it’s a good business. It’s a global market leader, it’s well invested and education is a growth market longer term,’ the manager said.

Smith holds 1.6% of Henderson High Income in Pearson. Analysts are broadly positive on the stock, according to Thomson Reuters, with eight rating it a ‘buy’, five a ‘sell’ and nine a ‘hold’. The shares yield 7% and trade at 12.6 times forecast earnings, which is lower than the 15.4 average of publishers such as Relx (RELX), Informa (INF) and Daily Mail and General Trust (DMGOa).

Next: ‘Unsexy’ Hilton
Key stats
Market capitalisation£388m
No. of shares out73m
No. of shares floating48m
No. of common shareholdersnot stated
No. of employees2447
Trading volume (10 day avg.)m
Profit before tax£18m
Earnings per share24.72p
Cashflow per share48.14p
Cash per share49.03p

*Correct as at 4 Jan 2016

'Unsexy' Hilton

Hilton Food Group (HFG) is not a supplier to a famous hotel chain, as its name suggests, but is in fact a packager of meat products for supermarkets including Tesco in the UK and Woolworths in Australia.

‘It’s a fantastically unsexy business,’ said Smith, describing it as an ‘investment led growth opportunity’. He said the company generated a great return on invested capital and that ‘as contracts ramp up cash flow will ramp up.'

That should support the dividend which has grown at 7.5% in recent years. ‘It should be rewarded by high multiple by the market,’ said Smith.

HFG has expanded its contract with Tesco to cover beef as well as pork products. In November it reported trading had slightly exceeded its expectations and its financial position was strong. This followed half-year results in September which showed profits before tax had risen to 10.3 million pounds from 10.2 million on turnover down to 579.2 million from 592.3 million a year earlier.

According to Thomson Reuters, two analysts rate HFG as a 'strong buy' and four as a 'buy' with none saying 'hold' or 'sell'.

Next: Alastair Mundy’s ‘Value Hell’

Alastair Mundy’s ‘Value Hell’

Value investing, or buying companies when they are out of favour, is a style that has itself been unfashionable as central banks have pumped up stock markets with electronically printed money.

No one knows this better than Alastair Mundy, whose Temple Bar (TMPL) investment trust trails the FTSE All Share index over one, three and five years.

Mundy told investors at the Cantor Fitzgerald meeting that he was ‘in Value Hell’, explaining there were periods like 1999 and 2006-08 when the approach didn’t work.

Not that he planned to change spots. ‘I’m afraid it’s what happens when you’re a dyed-in-the-wool value investor,’ he said.

Mundy warned against assuming that equities, or shares, looked value just because bonds were expensive. ‘The relative yield argument of equities versus bonds doesn’t work. If you think about zero inflation and 2% coupons, that’s a pretty difficult backdrop and you might want to revisit your earnings forecasts on those equities.’

‘It’s a straw man comparison. It’s a very dangerous comparison,’ he said.

Next: Tesco: the only way is up
Key stats
Market capitalisation£11,684m
No. of shares out8,141m
No. of shares floating8,080m
No. of common shareholdersnot stated
No. of employees506984
Trading volume (10 day avg.)19m
Profit before tax£-5,694m
Earnings per share-70.24p
Cashflow per share-51.43p
Cash per share33.95p

*Correct as at 4 Jan 2016

Tesco: the only way is up

Shares in Tesco (TSCO) have lost nearly two thirds of their value since the summer of 2013, with the stock down 30% over three months as fears about its trading position have intensified.

It’s not all doom and gloom for the nation’s biggest supermarket group, which has ill prepared for the onslaught from discount rivals Aldi and Lidl and which has struggled since an accounting scandal broke in 2014.

Last month second quarter figures showed the pressure on the group might be easing with underlying sales at its 250 ‘Extra’ stores down 1.1% year on year, compared to a 6.3% slump the previous year.

‘I wonder if this is a point of maximum bearishness just as they’re getting their house in order and getting on the front foot,’ mused Mundy, who last year held 1.4% of Temple Bar in Tesco shares.

Mundy argued that the threat from Aldi and Lidl was receding, pointing out that only 5% of their customers did half of their shopping at their stores. While they would respond with bigger carparks, more food and tills, this would bring its own problem.

‘As soon as they start to grow they will struggle,’ he predicted.

Next: is RBS really ‘risky’?
Key stats
Market capitalisation£33,911m
No. of shares out11,574m
No. of shares floating3,184m
No. of common shareholdersnot stated
No. of employees92400
Trading volume (10 day avg.)8m
Profit before tax£-25m
Earnings per share-0.22p
Cashflow per share10.07p
Cash per share653.00p

*Correct as at 4 Jan 2016

Is RBS really ‘risky’?

Temple Bar has a top 10 position in Royal Bank of Scotland (RBS) and Mundy is bemused why the shares in the taxpayer-backed bank have fallen 22% in the past year.

Although the global economic backdrop has not been helpful to big financial stocks, the local backdrop to RBS’s recovery from the 2008 financial crisis has been positive. Last month the Bank of England said UK banks were sufficiently capitalised while there has been a surge in consumer lending by RBS and its rivals.

‘I wonder if we’re making the banks story too difficult?’ said Mundy. ‘Investors learned to be shy of big, opaque, lightly regulated complex banks. Now they’re small, transparent, heavily regulated and simple and people still don’t like them!’

Temple Bar held 3.9% of its assets in RBS in October. Among analysts seven rate the bank a ‘buy’, 15 a ‘hold' and three a ‘sell’.

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Look up the shares

  • Marks and Spencer Group PLC (MKS.L)
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  • Pearson PLC (PSON.L)
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  • Hilton Food Group PLC (HFG.L)
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  • Tesco PLC (TSCO.L)
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  • Royal Bank of Scotland Group PLC (RBS.L)
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Look up the investment trusts

  • Temple Bar (Ordinary Share)
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  • Henderson High Income (Ordinary Share)
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