Bargain shares updates

As part of the process I screen every single listed company on the London market using specific balance sheet criteria based on the writings of Benjamin Graham, who favoured looking for companies that were "out of favour because of unsatisfactory developments of a temporary nature". I then apply my own fundamental analysis to a short list of 50 mainly small cap shares in order to whittle the number down to a motley crew of 10 companies which I believe will reward the followers of this form of investing.

It is the very essence of stock-picking, and whatever fans of passive investment might say, it works: our portfolios have beaten the FTSE All-Share index in 13 out of the 15 years in which we have run them. And last year's portfolio has continued the strong recent performance, returning more than 37 per cent in the past 11 months and outperforming the FTSE All-Share, FTSE SmallCap and Aim indices handsomely. In light of recent announcements, some of the portfolio constituents require updating.

Follow the money

I was intrigued to see that Neil Woodford, the star fund manager at Invesco Perpetual, will be running a fund for Oakley Capital Management when he leaves his employer in April after 25 years of service. This is a real coup for Peter Dubens, the founder of Oakley.

It should also be good news for shares in Oakley Capital Investments (OCL: 187p), the closed-end Aim-traded investment company and one of my 2013 Bargain shares. The company makes its money by taking stakes in private equity ventures established by its associated limited partnership, Oakley Capital Private Equity, and provides mezzanine debt finance. It has been clearly doing well, as the company's book value per share rose 9 per cent to 195p in the first half of last year. Net asset value (NAV) is made up of cash of 49p a share, the investment in Limited Partnership and loans provided to Limited Partnership and a number of portfolio companies.

Moreover, with ample cash resources, and access to the Limited Partnership, shareholders in Aim-traded Oakley Capital should be ideally placed to take advantage of the investment opportunities arising from the funds and strategies Mr Woodford will be implementing for the new funds he will be running.

So, although shares in Oakley have been significantly rerated since I spotted their investment potential 11 months ago, I would continue to run your profits if you followed my earlier advice.

Primed for earnings upgrades

Brownfield regeneration specialist and housebuilder Inland Homes (INL: 47p) looks ideally placed to take advantage of the favourable housing market conditions and positive sentiment that habitually leads to the sector rising in the first quarter each year.

That's because the board's decision to ramp up the company's housebuilding operation means that the company is set to see profits rise sharply over the next few years. The government's Help to Buy mortgage guarantee scheme is clearly supportive of the housing market and it's obvious from the trading statements from larger rivals that this is benefiting both prices and the margins earned on new build properties. It's also fair to assume that the benign conditions in the mortgage market will remain unchanged for most of this year, if not into next year before new Bank of England governor Mark Carney contemplates tightening monetary policy. This can only boost the confidence of home buyers and transaction levels, evidence of which was obvious to see in last month's mortgage lending data and recent house price surveys. It makes Inland's decision to ramp up output well-timed.

These positive trends will become obvious to a wider audience once the company starts issuing trading updates in the first half of this year. At this stage, analyst Duncan Hall at broking house finnCap expects Inland's pre-tax profits to surge almost 40 per cent from £5.1m to £7m in the year to end-June 2014, reflecting a 18 per cent rise in sales to £38.8m. The respective figures for the following financial year are sales of almost £60m and pre-tax profits of £9m. On this basis, expect EPS to rise 40 per cent to 2.8p this year, rising to 3.6p in the financial year to June 2015. This means that Inland’s shares are priced on 13 times next year's earnings estimates, a valuation that doesn't seem too punchy to me considering the scope for the company to beat expectations. That's because as house prices rise further the extra profit on house sales will largely drop straight through to the bottom line and boost margins and profits significantly.

In addition, higher house prices will have a major impact on the open market value of the company's 2,500 plot land bank, the vast majority of which is situated in the prosperous south of England including sites in Beaconsfield, Poole, Chelmsford and Drayton Gardens Village (DGV) in west London. To put this into some perspective every 10 per cent move in land prices could add 14p a share to Inland's current net asset value of 34p (this figure includes the 5p a share of profits embedded in DGV and which will largely be realised in the coming year).

So, with the sector enjoying a favourable tailwind, and Inland shares trading on a modest 1.4 times book value - a significant discount to larger rivals - I have no hesitation repeating my earlier buy advice. My target price is 60p, or almost a third above the current share price.

How Simon Thompson's Bargain share portfolio has performed

Heritage ramping up production

Fourth-quarter results from oil and gas independent upstream exploration and production company Heritage Oil (HOIL: 166p) confirmed that the company is clearly delivering on its Nigerian interests, while making progress in both Tanzania and Papua New Guinea on exploration activities.

To recap, following a complex series of transactions to fund the $850m (£531m) acquisition of OML 30, one of the largest of Shell's onshore Nigerian assets sold in the past couple of years, Heritage Oil ended up with a 30.7 per cent working interest in the investment vehicle controlling OML 30. The balance is held by its Nigerian energy partner, Shoreline Energy. After a blip in the second quarter, when production missed targets due to a manifold in a gas lift compression system failing and a strike by local workers, production has recovered strongly in the second half and gross production ended the year at over 50,000 bopd. The net daily production attributable to Heritage averaged 13,300 bopd in the fourth quarter, up from around 8,150 bopd in the first nine months of last year, which meant the resource delivered total revenues of $465m net to Heritage, including $170m from four liftings in the final quarter.

The increase in production from OML 30 has been achieved by the installation of new equipment, working over existing wells and commencing production from the Uzere West field, which has been shut-in for nearly two years. The plan now is to ramp up output from OML 30 to between 60,000 and 65,000 bopd in 2014, of which the net production to Heritage will be in the range 16,000 to 21,000 bopd. If achieved analysts expect OML to produce around $500m of revenues this year, pre-tax profits of around $300m and EPS of 67c. On that basis, the shares, at 166p, are trading on a miserly four times earnings forecasts.

Untapped resources

True, any investment in Nigeria carries geopolitical risk and given the nature of Heritage's business, there is a fair amount of execution risk, too. This is one reason why the shares are lowly rated. However, with eight producing fields and associated infrastructure and gross proved and probable reserves of 1,114bn barrels of oil, there is obvious potential to generate substantial returns from OML, one of the largest onshore licences in the country. And this is what Heritage plans to do by ramping up output to 100,000 bopd in 2015 and close to 150,000 bopd the following year.

In turn, this sharp increase in production should generate the bumper cash flow needed to pay down the $500m of net borrowings Heritage took on to fund the purchase of its interest in OML. And this is exactly what is happening as unrestricted cash on Heritage's balance sheet has risen from $113m at the end of September to $190m at the financial year-end. It is likely to increase even further this year as output is ramped up and around 60 wells that were vandalised in the period 2006 to 2009 are returned to production.

Exploration upside

It's also worth noting that Heritage has ongoing exploration work programmes in Tanzania and Papua New Guinea, in particular. Expect results of a geochemical survey to be released this quarter on the Rukwa South Licence area in Tanzania. Several prospects have been identified, geologically analogous to the Kingfisher discovery in Uganda, for which detailed prospect mapping and evaluation is currently ongoing. This will be followed by a drilling programme across the licences later this year and next.

In Papua New Guinea, processing of new seismic data, combined with the reprocessing of around 300 kilometres of legacy seismic data over licences PPL 319 and PRL 13 is now complete and expect delivery of the data later this month. Further seismic data acquisition over leads within the licences will be ongoing this first quarter with a view to firming-up these leads as additional prospects for drilling. Well and logistical planning continues to enable drilling of the Tuyuwopi prospect in 2014.

Undervalued

True, Heritage Oil has proved the laggard in my 2013 Bargain shares portfolio, but no matter which way I look at it the shares are very undervalued.

For instance, analysts calculate that the company has an unrisked net present value (NPV) of around £1bn on all its assets, or more than double the company's current market capitalisation. This valuation uses a 12.5 per cent discount rate on future cash flows, factors in a 2015 Brent Oil price of $102 a barrel and 2 per cent growth in the oil price thereafter. Those look sensible assumptions to me.

However, being ultra cautious, and applying a massive 15 per cent discount rate to Heritage's future cash flows, the NPV still comes out at around 263p a share, or almost 100p more than the current share price. So, not only are Heritage's shares lowly rated on an earnings basis, they are also trading on a huge discount to sum-of-the-parts valuations using very conservative valuation metrics.

From a technical perspective the set-up is starting to look interesting once again with the share price rising above the 200-day moving average and approaching a resistance level around 170p. In my view, a break above this technical resistance is key and would be undoubtedly bullish. If this happens expect a rally back to the autumn highs just below 200p. Beyond that the 12-month high from early last year around 224p is the next target.

So, although Heritage shares have underperformed in the past 11 months, I am maintaining my buy stance ahead of full-year results in April and exploration news in the interim. Medium-term buy.