Bargain shares update

However, I am far from happy even though the total return on my portfolio is 6.6 per cent on an offer price-to-bid price basis. That's because two of the 10 holdings I selected back in early February, Polo Resources (POL: 22.75p) and Heritage Oil (HOIL: 148p), are both under water and have taken some of the gloss off the performance. In fact, they have wiped 3.6 per cent off that total return and both need updating.

How Simon Thompson's 2013 Bargain Share Portfolio has performed

Unloved, but significantly undervalued

Shares in Polo Resources are currently down around 10 per cent on an offer-to-bid basis on my buy recommendation, having fallen since a first-quarter trading update one month ago.

True, a $5m (£3.3m) write-down on the value of the company's 15 per cent stake in Ironstone Resources, the Canadian resource company behind the Clear Hills iron ore and vanadium project in Alberta, has hardly helped. However, the carrying value on Polo's holding - around £5m - only represents 5 per cent of the company's investment portfolio and the likely catalysts for share price gains were always elsewhere.

Polo on track to make golden returns

Of far greater importance is the progress being made on the Nimini's Komahun Gold Project in Sierra Leone, in which Polo holds a 90 per cent stake. This holding has a carrying value of £29.4m, or the equivalent of almost 11p per Polo share, and accounts for 30 per cent of Polo's net asset value of £96.6m, or 35.9p a share at the end of March 2013. The news here is very positive.

Following completion of the 29,100 metre drill, which uncovered further extensions of mineralisation at depth and along strike, a drill programme targeting near-surface strike extensions was completed in March. This comprised 52 holes and a total of 20,132 metres of resource and exploratory diamond-core drilling. A revised business plan for Komahun has been produced which eliminates the need for immediate funding from shareholders, and the project is on track to deliver a new Mineral Resource Estimate in June, shortly followed by a Preliminary Economic Assessment. Polo is now considering a fast-tracked Definitive Feasibility Study, which would allow Nimini to move to an early decision for mine development.

The last independent resource estimate by SGS Canada showed an indicated gold resource at the site of 521,000 ounces and another 263,000 inferred ounces of gold, bringing the total potential resource to 784,000 ounces. On that basis, the £29.4m carrying value on Polo's 90 per cent stake values the project at only $50m (£32m), or the equivalent of $63 an ounce. That's a 25 per cent discount to sector peers, so it's hardly being overvalued. Moreover, there is scope for upgrades to the project's value when the new Mineral Resource Estimate is published next month.

Admittedly, the weak gold price has taken some of the shine off gold stocks; the gold price has dropped by $300 an ounce to $1,457 an ounce in the past six months. However, Nimini is still a very valuable asset and one with clear scope for valuation upside.

Polo Resource's investment portfolio at 31 March 2013

Africa to pay dirt for Polo

Polo's other major interest is a 48.2 per cent stake, worth £28.2m, in African oil and gas explorer Signet Petroleum, a company that has four prospective assets in Benin, Burundi, Namibia and Tanzania. Signet holds an 80 per cent interest in Hydrotanz, a company that has a production-sharing agreement with the United Republic of Tanzania and the Tanzania Petroleum Development Corporation on the offshore North Mnazi Bay Block. This prospect is adjacent to BG and Ophir Energy's offshore Chaza 1 gas discovery well, which is targeting an eye-catching 12 trillion cubic feet of gas.

2D seismic analysis previously indicated a possible extension of Chaza 1 through to Mnazi Bay North. It's therefore reassuring that evaluation of 3D seismic data (carried out in 2012) has now identified "a potentially substantial extension of the BG/Ophir Chaza 1 discovery", according to Polo's executive chairman. He points out that the license area is located "in close proximity to the Maurel et Prom Mnazi Bay facility and the new gas pipeline being constructed from Mnazi Bay to Dar es Salaam, which offers early domestic market development potential".

Interestingly, First Energy Capital Corporation has been appointed by Signet to assess strategic alternatives for Mnazi Bay, including potential farm-out opportunities. This could have major implications for Polo's share price as it would highlight the hidden value in the company's investment in Signet.

Mr Herbert also notes that Signet has been following up on the initial analysis of 2D seismic data for its Namibian acreage (Block 2914B), over which the company has a 75 per cent working interest. Having identified a potentially major structure in the final quarter of last year, Signet has since undertaken further processing of the 2D seismic data and has identified "a number of highly prospective targets with potential to host commercial hydrocarbon deposits".

In other words, there is obvious potential for further positive newsflow from Signet's two major African prospects this year.

A compelling valuation

To put Polo's current low valuation into some perspective, the shares are priced on a 38 per cent discount to net asset value of 35.9p a share. However, the company is also sitting on short-term investments, cash and receivables of 8.5p a share. Strip those out and assets worth 27.4p a share are in effect being valued at only 13.75p with the shares currently priced on a bid-offer spread of 22.5p to 22.75p. So Polo's investment portfolio is being valued at only 50 per cent of the carrying value of its assets even though there is clear potential for valuation uplifts from the investments in Nimini and Signet, which account for a combined 60 per cent of the company's portfolio.

Importantly, positive news from the Polo's interests in Tanzania, Namibia or Sierra Leone would be the catalyst to spark a well overdue re-rating in the months ahead. I would use the current price weakness as a buying opportunity.

Heritage Oil share plunge overdone

Shares in independent upstream exploration and production Heritage Oil (HOIL:148p) have been hit by a double-whammy of negative news, prompting a painful share price slide. However, although shares in the FTSE 250-listed company are unlikely to bounce back in the near term, the investment case I outlined in February is still intact and there is scope for medium-term gains.

Tax dispute

The first issue spooking investors concerns a dispute over a potential tax liability to the Ugandan government following the sale of Heritage's interests in Uganda to Tullow Oil three years ago. The Ugandan Revenue Authority (URA) contends that income tax is due on the capital gain arising on the $1.4bn disposal and it raised assessments of $404m at the time. These were disputed by Heritage but, pending a resolution between the Ugandan government and Heritage, the company deposited $121m with the URA once the deal closed; and placed a further $283m in escrow with Standard Chartered Bank in London, pending resolution between the Ugandan government and Heritage Oil of the tax dispute.

To complicate matters Tullow now wants $313m to be returned to the company for alleged breach of contract by Heritage in relation to a tax payment made by Tullow to the URA in April 2011. Heritage is counter-claiming that the $283m held in escrow be released to Tullow. The case is being heard in the High Court and a first instance decision is expected to be received later this year. Heritage believes that the claim has no merit and is robustly defending it.

Clearly, this dispute raises uncertainty and will ultimately be decided by the courts. Heritage's board believe that the monies on deposit and held in escrow will ultimately be recovered by Heritage and points out that it has the cash to pay the disputed tax liability. In fact, net of restricted cash of $509m, the company had cash of $90m at the end of 2012 and total borrowings of $561m. Net debt of $471m was less than 50 per cent of shareholders' funds.

Production shortfall

To compound matters, the company has revealed a production shortfall from its interests in OML 30, one of the largest of Shell's onshore Nigerian assets sold in the past couple of years. Following a series of complex transactions to fund the $850m (£531m) acquisition last November, Heritage Oil ended up with a 31.5 per cent equity holding in the investment vehicle controlling OML 30. The balance is held by its Nigerian energy partner, Shoreline Energy.

When Heritage released full-year results at the end of April, gross production for the licence averaged 20,350 barrels of oil per day (bopd) in November and December, a hefty decline from an average of 35,000 bopd before the acquisition closed. The lower than expected production was due to a manifold in a gas lift compressions system failing, and a strike by local workers. These issues have been addressed and the manifold is expected to be repaired by the end of this month.

The majority of the fields are also operating again after the operator held a series of successful meetings with workers. The remaining fields should be back in production shortly. Heritage notes that good progress has been made to boost production in the second half of 2013, primarily through improved gas lift with new compressors being ordered.

Valuation

Analysts at Canaccord Genuity note that: "This is a 'show me' story for the market, with plenty of upside, but progress over the rest of this year will be crucial in confirming the quality of the OML 30 acquisition". I would agree with that. So, although Heritage's shares, at 148p, are trading almost 40 per cent below book value of 242p a share and way below Canaccord's 350p target price, the valuation gap will only narrow on a successful ramp up of production - and the cash flow that generates for Heritage - and a resolution of the above tax dispute.

On both counts, we will have to wait until later this year for hopefully positive news to reinvigorate the share price. I am prepared to wait and, if you followed my earlier advice, I would hold on for a medium-term share price recovery even though there could be further short-term weakness.

SMALL CAP UPDATES

A lowly rated chip designer

Shares in IQE (IQE: 23.25p), a global supplier of advanced wafer products to the semiconductor industry, have been marked down sharply in the past three months and undeservedly so.

When the company announced results in late March, chief executive Drew Nelson noted: "Financially, our record second-half performance in 2012 has provided a glimpse of what's to come. The road ahead has never been clearer. The advanced properties of compound semiconductors are central to addressing the challenges and performance expectations facing the electronics industry."

Mr Nelson added: "The next wave of growth for the electronics industry will be enabled by combining the properties of advanced compound semiconductors with the cost advantages of silicon. This is already beginning to happen and will accelerate in the next few years."

However, investors have yet to buy into the growth story. This is perhaps because they are still nervous after Qualcomm, a leading broadband and applications processor vendor in the wireless market, launched a front-end silicon-based radio frequency (RF) module to support 3G and 4G phones in February. I believe the caution is misplaced for three reasons.

First, the Qualcomm product is an off-the-shelf solution, limiting the ability for smartphone manufacturers to differentiate, whereas the products from IQE's customers are customised to the requirements of handset makers. Second, Qualcomm's product is based on silicon, which has inherent physical limitations (consumes higher power at higher frequencies) in comparison to compound semiconductors. Third, the market Qualcomm is targeting accounts for only 5-6 per cent of IQE's revenues, and even then the US giant is unable to offer the same solutions to customers as IQE, given the differences in the technology used.

Shares are undervalued

Analyst Pia Tapley at broking house N+1 Singer agrees, advising clients a few weeks ago: "The shares have fallen 15 per cent since the start of the year. This appears to be driven by fears over the competitive landscape in the wireless end markets, in particular the recent launch by Qualcomm of a silicon-based RF front-end module for mobile handsets. We believe that these fears are overdone. In the near term, Qualcomm's first-generation product is likely to make only slow inroads into handset manufacturers, which should not have too much impact on IQE's wireless customers."

The broker estimates that IQE will make EPS of 2p this year, up from 1.6p in 2012, based on adjusted pre-tax profits of £13.5m on revenues of £142m. These are bottom of the range forecasts as Peel Hunt is looking for EPS of 2.5p and Canaccord Genuity is forecasting EPS of 2.1p. On that basis, the shares are trading on around 10 to 11 times current year earnings estimates. N+1 Singer also notes that these forecasts are "before the impact of £7m of expected costs savings (following the Kopin acquisition earlier this year) which are entirely in the company's hands".

But what we really need is a share price catalyst to spark a re-rating to make up the lost ground this year. The obvious one would be a positive pre-close trading statement for the first half of this year, which is scheduled to be released in mid to late July. Ahead of the trading update, I remain a buyer of the shares at 23.25p.

MORE FROM SIMON THOMPSON ONLINE...

My next article will appear online on Monday 6 May. I have also written five other online articles this week, all of which are on my homepage and include the following companies or sector trades:

Housebuilders ('Seasonal stock picking strategies', 30 Apr 2013)

Daejan Holdings, Moutview Estates ('Hot property', 1 May 2013)

Aurora Russia, Thalassa ('Small-cap stock picks', 1 May 2013)

Town Centre Securities, Terrace Hill ('Hot property: take two', 2 May 2013)

Netplay TV ('A golden nugget', 2 May 2013)