Moreover, when a company's operational performance starts to gain momentum, it also pays to monitor key indicators, an area I discuss in quite some depth in my new book, Stock Picking for Profit. That's because substantial gains can be made by riding on the coat-tails of a company in an upgrade cycle. And for good measure, one of the companies on my watchlist has clear potential to enter such a cycle.
Gaining momentum
Investors are starting to warm to the merits of specialist engineer Molins (MLIN: 182p) and with good reason. The shares are also delivering the hefty gains I anticipated when I included them in my 2012 Bargain shares portfolio in early February last year when the price was 107p. Since then we have banked four dividends totalling 10.75p a share to give a total return of 78 per cent. To put that performance into some perspective, in the same 20-month period the FTSE All-Share index has produced a total return of 26 per cent and the FTSE Small-Cap index has returned 49 per cent.
The technical set-up is certainly supportive of further upside in the company's share price and a rally back to the August 2007 bull market high around 220p. In fact, the price is on the verge of taking out the mid-July high of 181p, and giving a swing buy signal in the process. If this happens, as I strongly feel will be the case, there is no technical resistance at all to overcome before that August 2007 high.
True, the 14-day relative strength index (RSI) is starting to become overbought, but this need not stop the price momentum continuing. Moreover, the price is not overextended above its moving averages with the long-term 200-day moving average around 165p, the 50-day moving average at 169p and the short-term 20-day moving average around 171p. These will provide strong support on any pull-back.
Interestingly, the long-term trend line has acted as support for the share price since the bull run started in December 2010 and each time it has been tested, or come close to be tested, this has been the precursor to a major rally. And since the share price has peaked out between 20 and 25 per cent above its rising 200-day moving average on the last two occasions, there is ample scope for the ongoing rally to continue.
The fundamental case for investing is also very supportive of further share price upside.
Understanding the business
To recap, about 60 per cent of the company's sales come from the tobacco industry, where Molins specialises in improving the effectiveness of existing customer plant, monitoring and testing product quality and conducting the analysis of cigarette smoke. This is the high-end part of the business, accounting for a quarter of revenues, and a likely source of some exciting news by the year-end if, as I expect, Molins' tobacco testing business, Arista Laboratories, receives a boost in demand for its services resulting from tighter US regulations that are expected to be implemented by the Food & Drug Administration (FDA).
The US regulator has already heard representations from cigarette manufacturers in advance of issuing guidance on testing requirements with a view to tightening up the testing regime for harmful compounds found in tobacco smoke. The new regulations were scheduled to be published in April, but have been delayed and the latest indication from the FDA is that guidance will be published in December.
True, the timescale and nature of the FDA testing regime is uncertain, but what is not in doubt is that Molins is well-placed to capitalise on the opportunities, especially as Arista has a significant logistical and marketing advantage to attract new business for its onshore US testing services. The unit is fully operational from its new laboratory facility in Richmond, Virginia, where it services all the tobacco industry's tobacco and smoke testing requirements, and from where non-tobacco testing will be carried out as the business extends its activities into other end markets.
Analyst Michael O'Brien at broking house Canaccord Genuity believes that several major tobacco manufacturers, which currently do the testing of these compounds in-house, will have to outsource much of it in future if the FDA dramatically expands the number of harmful compounds on its consultation list. In my opinion, any forthcoming FDA-related newsflow will be a key share price driver for Molins if, as expected, the regulator does indeed extend the list of harmful compounds that tobacco companies need to test. It would also prompt analysts to upgrade their earnings estimates for future years.
Anomalous valuation
But even without upside from a change in US legislation, Molins is performing well enough. Half-year results revealed that sales increased by 20 per cent to £47.8m and underlying pre-tax profits almost doubled from £0.8m to £1.5m. This was driven by double digit top-line growth in Molins' packaging and machinery businesses, both of which are benefiting from robust order books.
For the full year, Canaccord forecasts that Molins will raise operating profits by 10 per cent to £5.5m, mainly reflecting the heavy second-half bias to the reported numbers. Analysts Paul Hill and Gilbert Ellacombe at research house Equity Development are looking for a 9.2 per cent rise in operating profit and note that the half-year numbers comprehensively beat their profit forecasts. Latest guidance today from Molins management is that the business is trading in line with these forecasts.
True, a higher tax charge means underlying EPS is likely to flat at 22p, but this is unlikely to hold back the dividend, which is expected to rise to 5.7p a share, having been raised from 5.3p to 5.5p last year. On that basis, the shares trade on only 8.3 times forward earnings - less than half the sector average - and yield about 3.1 per cent.
The price is also well underpinned by a rising dividend as analysts at Equity Development predict a payout of 6p next year, rising to 6.25p in 2015. On that basis, the prospective yield rises to 3.3 per cent and 3.6 per cent, respectively. The pay-out is also covered almost four times by post tax earnings so there is scope for a more progressive dividend policy if Molins does indeed benefit from the change in US tobacco testing legislation. Equity Development predicts that the "US testing market alone could be worth $100m (£63m) in five years time, and similar initiatives might also be implemented in other countries".
Strong balance sheet
Furthermore, the attractive rating becomes even more compelling once you consider that Molins had net funds of £5.6m, worth 28p a share, at the end of June. Strip this cash out from the current share price and the forward multiple drops to a bargain basement rating of less than seven times earnings. For good measure, the shares trade on a 15 per cent discount to net asset value of 211p, so we are still able to buy the shares well below book value.
Needless to say, I remain a firm buyer of Molins' shares and my target price remains 220p - equating to 8.7 times earnings estimates net of cash - which I still believe could be achieved by the year-end, assuming of course the FDA releases its guidance by then. Analysts at Equity Development have a more aggressive fair value target of 260p, while Canaccord has a target of 200p. Offering a further 23 per cent potential upside to my very realistic target price, I continue to rate Molins' shares a value buy trading on a bid-offer spread of 177p to 182p.
■ 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'.
MORE FROM SIMON THOMPSON ONLINE....
I have published five other articles this week on the following eight companies:
■ Trifast ('A timely bolt on purchase', 21 Oct 2013)
■ Noble Investments ('Bargain shares update', 21 Oct 2013)
■ Stanley Gibbons ('Bargain shares update', 21 Oct 2013)
■ Cairn Energy ('Bargain shares update', 21 Oct 2013)
■ Eros ('Time for some price action', 22 Oct 2013)
■ PV Crystalox Solar ('Time for some price action', 22 Oct 2013)
■ BP Marsh & Partners ('BP Marsh cashed up to invest', 23 Oct 2013)
■ Moss Bros ('New highs beckon', 23 Oct 2013)
■ Bloomsbury Publishing ('Decision time', 24 Oct 2013)
