Of course, some shares may get cheaper before they bottom out. You have to take that as a given. However, unless you have the Midas touch, and only the select few of us are able to regularly call the bottom with unerring accuracy, then a far better strategy is to focus on shares in companies where the risk-reward ratio is skewed in your favour for upside potential, as and when the market turns. My own view has always been that it's better to forsake a few per cent of short-term pain on an equity holding when the long-term potential rewards offer substantial compensation. That's something well worth considering right now.
It's also worth pointing out that being out of the market entirely is a trade in itself. So unless you believe that this five-year long bull market is over, a view I don't concur with, then it pays to capitalise on short-term sell-offs by picking up attractively priced shares on your watchlists. It also pays to distance yourself from the herd mentality of trigger-happy investors that are all too willing to press the sell button on any spike in risk aversion in the market. As I have pointed out repeatedly in the past, the best returns are made by those who have the patience and discipline to ride out short-term fluctuations with a view to generating long-term gains.
It's for this reason that I have never hesitated to recommend a technically oversold share when the fundamental case for investing underpins the investment case. In the end if the rationale behind making an investment holds true, then it's only reasonable to expect the market to recognise the value on offer as and when sentiment turns. That factor also helps to explain why my annual bargain shares portfolios have outperformed all the UK market indices with such regularity. In effect, many of the shares I highlight are out of favour for one reason or another and as a result the risk premium embedded in the current valuation is elevated. However, as soon as newsflow improves, and a greater number of investors recognise the undervaluation, the scope for a significant re-rating improves, too. With this thought in mind I have been reviewing one of the companies in my 2013 Bargain Shares Portfolio, which released financial results last week and needs reviewing in light of this.
Making a fair point
Shares in Aim-traded debt management specialist Fairpoint (FRP: 128p) have risen by a third in the past 12 months as the company continues to successfully execute its strategy of diversifying revenue streams by using robust cash generation to grow its debt management plan (DMP) and claims management businesses. For example, the company acquired 3,400 plans last year and since the start of January has spent a further £4m on 9,000 plans to take the total to 24,000, up from less than 15,000 only 15 months ago. Moreover, with margins holding steady, this underpins future profitability from this business segment.
Claims management services are also now contributing strongly. Pre-tax profits from this activity rose 44 per cent to £2.3m last year on revenues of £6.4m, up from £5m in 2012. This segment has benefitted from PPI claims from both the company's core individual voluntary arrangements (IVA) and DMP portfolios. As a result, debt management and claims management services segments now account for 42 per cent of Fairpoint's total revenues, up from 36 per cent in 2012. That's just as well because market conditions in the company's core IVA activities remain subdued, a situation that is unlikely to change until more stretched consumers with higher disposable incomes enter into these arrangements.
Indeed, the near 5 per cent rise in new IVAs across the UK last year (around 49,000 according to the Insolvency Service) was mainly driven by lower income tenants in financial difficulty. This group generate lower fees for companies operating these arrangements. As a result, an upturn in more profitable activity is only likely to happen when bank base rate starts to rise again and adversely impact the financial circumstances of overstretched and heavily indebted home owners who have been benefiting from record low variable rate mortgages.
The good news for Fairpoint is that with unemployment falling rapidly, and UK economic growth rates being revised upwards, the point at which the economy hits escape velocity, and is strong enough to withstand base rate rises, could feasibly be as early as the first quarter of next year. That's bad news for heavily indebted homeowners who could be tipped over the edge, but it's rather good news for Fairpoint.
Value on offer
In any case, even without factoring in a pick up in IVA activity, analysts John Borgars and Hannah Crowe at Equity Development still predict Fairpoint will increase pre-tax profits from £8.05m to £8.5m in the current financial year, having grown profits by around £500,000 in 2013, buoyed by an increased contribution from its DMP and claims management businesses. On this basis, expect underlying EPS of 15.5p, up marginally on the 15p reported last year, which means the shares are very modestly priced on a little over eight times earnings estimates.
Importantly, with the benefit of a cash-rich balance sheet - Fairpoint had net funds of £2.8m at the end of December - and an asset-based revolving credit facility of £13m, the company has ample cash available to make further bolt-on purchases to its DMP and claims management businesses.
The board also has the flexibility to increase the dividend further, having lifted the payout by 9 per cent to 6p a share last year. The final dividend of 3.85p a share is paid on 19 June and has an ex-dividend date of 21 May. For the current financial year, analysts forecast a dividend of 6.3p a share, implying a healthy 4.85 per cent yield. For good measure, the shares are only rated on a 25 per cent premium to book value, so they also offer value on this metric.
Encouraging technical set-up
As I noted at the start of this article, the time to buy shares in a bull run is when they pull back to their 200-day moving average. In the case of Fairpoint, this long-term trend has offered massive support over the past couple of years, with the share price bouncing off this line no fewer than four times, the last successful retest was last August. The share price then surged by almost 40 per cent in the subsequent three months to a multi-year high of 138p in early November, since when it has consolidated the gains as the 200-day moving average has played catch up. Interestingly, the trend line is now around 122p, only slightly below the current share price.
For good measure, with the 14-day relative strength indicator (RSI) showing a massively oversold reading well below 30, I believe we are pretty close to the point where the sideways consolidation in Fairpoint's share price is coming to an end and the next leg-up in the bull run can start. A move above November's high of 138.5p would give a swing-chart and point-of-figure buy signal and confirm the consolidation is over.
However, I am prepared to buy in before then because on a risk-reward basis the risk looks skewed to the upside on a medium-term basis. In my opinion, from both a technical perspective and based on fundamentals, a target price range between 165p to 170p seems achievable. So offering around 30 per cent upside to this target, it goes without saying that I rate Fairpoint's shares a buy on a bid offer spread of 125p to 128p.
Please note that having already published seven columns this week I am still working my way through a large number of announcements from companies on my watchlist, which I plan to update. These include: LMS Capital (LMS), BP Marsh Partners (BPM), Eros (NYSE: EROS), First Property (FPO), Trading Emissions (TRE), and Polo Resources (POL). My next column will appear tomorrow morning.
