Bargain shares update

Primarily, I target companies trading on deep discounts to net asset value, but also carefully stock pick those that have realistic chances of trading at decent premiums to book value as, and when, investor sentiment improves. Ideally, I prefer to buy shares in companies where I am getting all the fixed assets for free to create the ‘margin of safety’ that Mr Graham preferred.

As I noted in last week’s updates, this year’s Bargain shares portfolio is absolutely flying and has now racked up a 36.6 per cent total return in just eight months. This follows on from the 31.9 per cent return my 2012 portfolio made and which outperformed all bar three of the 55 small cap funds in the UK according to data from Trustnet. I have now updated the majority of the constituent companies I selected back in February, but as always news flow is constant and a further two companies require updates.

How Simon Thompson's 2013 Bargain Shares Portfolio has performed

Buy backs to drive Cairn Energy’s share price

The third quarter trading update from Edinburgh-based oil exploration and production company Cairn Energy (CNE: 286p) prompted a decent rise in the share price and one that, in my view, is highly likely to gain further momentum in the coming months. There are several reasons for my optimism.

For one, the company has announced a share buyback programme worth $300m, or around £188m, which is a significant sum for a company with a market value of £1.7bn. The board was given authority to repurchase up to 14.99 per cent of the issued share capital at May’s annual general meeting, so there is scope to increase the buyback further. A share repurchase programme also makes a lot of sense because the shares are trading on a huge 22 per cent discount to book value of 355p. Or put it another way, Cairn Energy’s market value is a thumping £443m less than its net asset value.

So not only is a buy back supportive of the share price as stock is removed from the market, but it also enhances net asset value per share given the share price is trading at a discount to book value. Moreover, it’s worth noting that at the end of September Cairn Energy was sitting on net cash of around £875m at current exchange rates, and it’s 10 per cent residual stake in Cairn India was worth a further £675m. Combined these liquid resources account for £1.5bn, or the equivalent of 90 per cent of Cairn's current market value.

And it’s not as if the other operating assets are overvalued as they include the acquisitions of Agora Oil & Gas in May 2012 (for £283m in a cash and shares deal) and the purchase of Nautical Petroleum 12 months ago for £414m. Agora is a Norwegian company with non-operated exploration, appraisal and development assets in the UK and Norwegian North Sea. The company’s portfolio is made up of interests in 11 licenses in the North Sea basin and it is pursuing an active drilling programme. This provides Cairn with additional growth potential through an active near-term exploration and appraisal programme in the UK North Sea.

Upside in Catcher and Krachen

The acquisition of Nautical Petroleum made sense too as it increased Cairn's working interest in the Catcher area of the North Sea to 30 per cent including the Catcher, Burgman, Carnaby and Varadero oil discoveries; and gave Cairn a 25 per cent interest in Kraken, another large, North Sea oil development project. Enquest (ENQ: 131p) is the operator for Kraken and Premier Oil (PMO: 336p) is the operator for Catcher, so there are some major oil explorers with a decent track record leading the development of these fields.

The 6 per cent interest in the Mariner oil field, acquired as part of the Nautical Petroleum transaction, is being sold for $46m, or £30m, which will bolster Cairn’s cash pile further.

The plan is to use the £1.5bn of capital held in cash and the stake in Cairn India to first bring on Kraken and Catcher, and to fund an ongoing exploration and appraisal programme worth $700m post tax (£437m) by the end of next year. Of this sum, $235m, or £147m, has already been spent. In terms of the drilling campaign outside the North Sea margin, the first well, Prospect A, offshore Morocco, is expected to spud the next 60 days. This will then be followed by two proposed wells offshore Senegal in the first quarter of 2014; the Spanish Point appraisal well offshore Ireland in the second quarter of 2014, and further drilling in Greenland in the second half of next year. Cairn also has interests in Mauritania and the Mediterranean.

So, with Cairn about to commence a 12-month multi-well high impact exploration programme shareholders have exposure to potentially material growth in the company's asset base. Moreover, with the shares trading at little over cash and liquid resources on the balance sheet, any success from the drilling and exploration campaign could send the share price rocketing.

Needless to say, I continue to rate Cairn shares a strong buy trading on a bid-offer spread of 284.5p to 285p.

Accept Stanley Gibbons offer for Noble Investments

Over the years, many of the companies I have highlighted in my annual Bargain share portfolios have succumbed to takeover bids. That’s hardly surprising given the whole point of this particular investment technique is to highlight companies that are fundamentally undervalued based on the assets held on the balance sheet. In some cases, the market value attributed to the companies is significantly less than the replacement value.

There is also potential for rivals to see the potential of merging operations too, and this is exactly what has happened with two of my Bargain share companies: Stanley Gibbons (SGI: 325p), the most famous name in stamps and a company that has been around for 156 years, and Noble Investments (NBL: 254p), the international rare coin, banknote, medal and stamp dealer and auction house operator. A tie-up makes a lot of sense as these niche segments of the alternative investment world are attracting increasing amounts of interest. In fact, there are around 30m stamp enthusiasts worldwide and over 10m rare coin collectors.

It's highly profitable business, too, as I estimate that the two companies will report combined pre-tax profits of £9m this financial year, rising to £10.3m in 2014. Clearly, the boards of both companies had the same thought as Stanley Gibbons’ has bid to acquire Noble Investments in a cash-and-shares offer currently values the shares at 261p apiece, a decent premium to the 199p price I advised buying at back in February. Of this consideration, 192.5p will be paid in cash and a further 0.21186 shares in Stanley Gibbons.

The acquisition looks nailed on to go through as certain Noble shareholders, controlling 42.2 per cent of the issued share capital, have already indicated they will vote in favour at the general meeting on 30 October. The scheme of arrangement is expected to become effective on 21 November. My advice is to accept the offer as I can see definite upside in Stanley Gibbons shares.

For starters, the merged entity will have a market value of around £134m, making it one of the top 100 companies on London's Alternative Investment Market (Aim). It will also have a rock-solid balance sheet with pro-forma almost £80m of net assets, including net cash of £17m, factoring in Stanley Gibbons' share placing last month which raised a net £38.1m in order to fund the £34.3m consideration of the cash part of the offer for Noble shares. But that's a conservative figure as Stanley Gibbons' holdings of stamps, coins and memorabilia were only in the books for £21.5m at the half-year stage. However, mark these to market value and this adds over £23m to net asset value.

There is also hidden value in Noble's accounts too. For instance, the company's London headquarters are in the books for £1.1m, whereas the market value of the property is nearer £3m. Inventories of coins acquired as part of the takeover of AH Baldwin seven years ago are significantly undervalued, too. Factor in annual price appreciation of 10 per cent since the acquisition and, if these stocks are marked to market value, this adds a further £1.8m to the company's book value. In other words, I reckon the true net asset value of the two companies is well over £100m, of which £17m is in cash.

Lowly rated

Analysts are currently unable to release their earnings estimates until the takeover completes, but by my calculations, the merged entity is likely to generate post-tax profits of £8.4m and adjusted EPS of between 19p to 20p next year. The cash pile on completion of the deal will equate to around 38p a share which means that Stanley Gibbons' shares are currently being priced on a forward PE ratio of 14 net of cash factoring in the acquisition of Noble. That rating doesn't seem expensive to me given the growth opportunities in the alternative investment market. In the circumstances, I have no hesitation in recommending Noble shareholders accept the offer and maintain my buy advice on Stanley Gibbons shares.

Finally, as a pre-Christmas offer exclusive to Investors Chronicle readers, all telephone orders placed with YPDBooks for my new book Stock Picking for Profit will receive complimentary postage and packaging. This offer is strictly for a limited period, is subject to stock availability and applies to only telephone orders placed until Friday 15 November 2013.

Please note the book is only being sold through YPDBooks and no other source. Full details of the content of the book is available online at www.ypdbooks.com. If you would like to take advantage of this offer, please contact YPDBooks on 01904 431 213 and quote reference ‘ICOFFER’. The book is priced at £14.99. Internet orders will continue to incur the normal postage and packaging cost of £2.75. I have also published an article outlining the content of the book: 'Secrets to successful stock picking'. The book also includes a dedicated chapter on how I select my annual Bargain shares with case study analysis.

MORE FROM SIMON THOMPSON ONLINE....

In the past fortnight, I have published 12 other articles on the following 16 companies or trading strategies:

■ Inland ('Property plays with foundations, 7 Oct 2013)

■ Terrace Hill ('Property plays with foundations, 7 Oct 2013)

■ Sanderson ('A smart tech share', 9 Oct 2013)

■ Pure Wafer ('Time to chip in', 10 Oct 2013)

■ US debt ceiling deadline looms ('Debt ceiling dilemma', 11 Oct 2013)

■ Air Partner ('Gaining altitude', 14 Oct 2013)

■ Polo Resources ('Targeting special situations', 14 Oct 2013)

■ Greenko ('Targeting special situations', 14 Oct 2013)

■ Randall & Quilter ('Bargain shares flying', 15 Oct 2013)

■ Oakley Capital Investments ('Bargain shares flying', 15 Oct 2013)

■ Marwyn Value Investors ('Exploiting an arbitrage opportunity', 16 Oct 2013).

■ Entertainment One ('Exploiting an arbitrage opportunity', 16 Oct 2013).

■ NetPlay TV ('Punting on new highs', 16 Oct 2013)

■ Global Energy Development ('Pay dirt beckons', 17 Oct 2013)

■ Bezant Resources ('Binary bet', 17 October 2013)

■ Trifast ('A timely bolt on purchase', 21 October 2013)