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The UK shares managers love and loathe for 2017

UK equity managers reveal which shares they are buying and ditching to prepare for 2017
December 8, 2016

It has been a tumultuous year for equity markets, not least in the UK, and with elections in Europe and the formal start of Donald Trump's presidency, 2017 might be even more fraught. For this reason active stock selection has never been more important, both to seize opportunities for gain and mitigate downside by avoiding certain areas and companies. So we have asked a number of UK equity fund managers what shares they have been buying and selling ahead of an uncertain 2017.

Equity income champions

Job Curtis, who runs IC Top 100 Fund City of London Investment Trust (CTY), a UK equity income fund, likes Pendragon (PDG). He thinks this FTSE 250 car retailer could shake off Brexit fears and that the market is rating it too lowly.

"This is the biggest motor retailer in the UK, with a £446m market cap," says Mr Curtis. "It is on a price-earnings (PE) ratio of eight times 2015-16 earnings, has a dividend yield of 4.5 per cent and has reported like-for-like sales increase of 5.7 per cent for the last three months to the end of September 2016, so this is a very lowly-rated share doing very well."

Mr Curtis also highlights the tripartite nature of this business, which generates profit from new car sales, used cars and aftercare.

"The risk here is a downturn in the economy and this is ultimately a cyclical sector, which could be an issue," he says. "In theory, the company could struggle with higher import prices from overseas, however the potential of tariff-free trade agreements for overseas car dealers following Brexit makes this sector appealing."

His other favoured share is Diageo (DGE), a company that has benefited from the vote for Brexit due to a high slug of overseas earnings with added growth from emerging markets. However, the market has grown suspicious of it due to its reputation as a 'bond proxy' - a stock perceived to pay safe and predictable dividends that equate to higher yields than those offered by much of the bond market.

"Diageo has come back about 15 per cent as bond yields have risen in recent months," says Mr Curtis. "I like it because it is one of Britain's biggest exporters, so a key beneficiary of the fall in the pound. It makes 34 per cent of its sales in the US, so a boost to US growth under Trump would be a benefit."

However, Diageo also has strong sales growth from emerging markets - 13 per cent of Guinness sales are in Africa. "It is not as cheap as I would like at 19 times earnings, with a dividend yield of 3.02 per cent, but in recent months it has traded on a PE ratio of as high as 25 times earnings. There is growth coming from emerging markets although the growth in western markets is slower."

 

Pendragon (PDG)

Price 31.44p
Dividend yield4.54%
Market cap£446.08m
IC view: Buy (10 Nov 2016) 

 

Diageo (DGE)

Price 1,972p
Dividend yield3.02%
Market cap £49.25bn
IC view: Buy (28 Jul 2016)

Source: Investors Chronicle & Thomson Reuters

 

Less loved large-caps

Jeremy Lang, manager of MGTS Ardevora UK Income (GB00B4RL9738), is bearish on Whitbread (WTB), which owns Costa Coffee, Beefeater Grill and Premier Inn, and whose shares have recently been pummelled after reaching a ten-year peak in 2015. Its shares trade at about 3,410p - around 14 times broker Numis' expected 2017 earnings. The company is suffering due to a spate of cost increases affecting UK consumer businesses and new chief executive Alison Brittain has undertaken a £150m cost-cutting drive in a bid to drive efficiency.

Mr Lang says: "The company has had an easy time expanding over the past few years as it rolled out locations of Costa Coffee and Premier Inn all over the country. However, we have seen signs of change recently with growth becoming harder and harder to achieve, meaning the company is having to take more risks to keep this growth going. According to its chief executive Alison Brittain, the company's savings in coming years should offset some investments in its business as well as the pressure of foreign exchange and rising business rates, among other things. But Brexit-related fears could hit the business in the coming months, as could competition from Airbnb and artisan coffee shops. In its most recent results, the company reported half-year like-for-like sales up 2.3 per cent, down on the 4.4 per cent increase reported for the previous year.

 

Whitbread (WTB)

Price3404p
Dividend yield2.69%
Market cap£6.24bn
IC view: Buy (30 Nov 2016)

 

Alex Wright, manager of funds including Fidelity Special Situations (GB00B88V3X40) and Fidelity Special Values (FSV), invests in the UK but can put up to 20 per cent of his funds' assets into overseas shares. He looks for stocks that are undervalued by the market and says he is currently avoiding consumer staples such as Unilever (ULVR) and Reckitt Benckiser (RB.), which are trading at high valuations due to what he says is "an extremely bifurcated equity market. Unilever shares have come down in price in the past month and now sit at 3,120p while Reckitt Benckiser shares are trading at 6,545p."

He adds that this has been created by "low and negative rates and inflation, meaning stocks that boast predictable bond-like cash flows are trading at very high valuations, while stocks that have more volatile cash flows are trading at low relative valuations. "As a point of example, tobacco stocks currently trade at around 12 times book value, with banks trading at 0.7 times book value," he says.

 

Reckitt Benckiser (RB.)

Price6545p
Dividend yield2.23%
Market cap£46.17bn
IC view: Hold (2 Nov 2016)

 

Unilever (ULVR)

Price3122p
Dividend yield3.35%
Market cap£92.85bn
IC view: Hold (21 July 2016) 

 

Digging deeper for returns?

Jeremy Lang, manager of MGTS Ardevora UK Income Fund, has been buying miner Anglo American (AAL) and says a period of crisis at the company will force management to overhaul the business and deliver value. "Only one area of the market is currently exhibiting severe stress - natural resources," he says. "Management language was excuse, excuse, excuse - until about a year ago. Recently, though, some companies have changed. Only in companies facing the most acute stress have managements accepted the need for radical change.

"Hence, despite superficial similarities, stocks such as Rio Tinto (RIO) and Anglo American look completely different to us. Rio Tinto, for example, looks like a value trap - its management still looks to be in denial, believing current difficulties are transient and that little needs to change from its side. However, Anglo American looks like a value opportunity. Crucially, its management know changes need to be made, or the company will face extinction. This means offloading assets and becoming smaller. Anglo American may feel the riskier of the two, but its management is behaving in the least risky way."

Since plummeting commodity prices in 2015 caused Anglo American severe pain, the miner has cut its dividend and started disposing of assets. Its divestment programme has resulted in a rebound in the company's fortunes this year and, in October, the miner hit is debt reduction target for the year. With the outlook for commodity prices improving, the streamlined business could see a better 2017. Its shares now trade at around 1,211.5p, up from below 250p at the start of the year.

However, Job Curtis, manager of City of London Investment Trust, is avoiding miners. "The mining sector has had a strong run and is ultimately very dependent on Chinese growth. [Avoiding this area] has cost me a bit against the index, but given that all the companies in the sector cut their dividends, I feel okay with that. I don't hold Glencore (GLEN) or Anglo American."

Anglo American (AAL)

Price 1,209p
Dividend yield na
Market cap £16.78bn
IC view: Hold (27 Oct 2016)

Source: Investors Chronicle & Thomson Reuters

  

Small- and mid-cap companies

Keith Ashworth-Lord manages CFP SDL UK Buffettology (GB00BKJ9C676) fund, which uses famed US investor Warren Buffett's investment style to pick companies with high barriers to entry, healthy balance sheets and cash flow, and strong pricing power at good valuations. He is betting on a turnaround at troubled company Restaurant Group (RTN) - the owner of American Italian-themed restaurant chain Frankie and Benny's - which has experienced a substantial decline in its share price since the start of the year for a number of reasons, including overpricing its food and drink and changing its menu.

However, the company has since overhauled its board and set itself on a new path. "The new management have held their hands up to the issues, including a new menu. I was interested from day one in this company, but it was always priced too highly for me to buy. It used to sell on 25 times earnings and then, following three profit warnings - the first in November 2015 and last in April 2016 - the shares rerated from 15 times to 10 times earnings, and suddenly this was a business priced at around £3 per share, which was pricing in no growth, when free cash flow last year should put it on a valuation closer to £4 to £5 a share."

Restaurant Group's shares yield about 4.95 per cent, with a well-covered dividend, and Mr Ashworth-Lord adds: "I think this turnaround could take 18 months but these were company-specific, not market-specific issues and it could also be a great private equity takeover target."

He also likes FTSE 250 cyber security and technology company NCC (NCC), which manages highly lucrative contracts for a large swath of FTSE 100 companies. Its share price experienced a steep fall following an October trading statement in which the group revealed three of its large contracts had been cancelled. But according to Mr Ashworth-Lord, the market in which it operates has high barriers to entry and the company remains on a compelling valuation. NCC's shares lost almost half of their value between 19 October 2016 and the end of the month, and are now trading at around 190p. But Mr Ashworth-Lord says the issues were inherited through acquired businesses, while its core operation is solid.

"Group revenues had increased by 36 per cent (over the four months to September 2016) with organic growth of 21 per cent," he says. "The business is divided into two parts, an escrow division and an assurance division, and those showed organic growth of 25 and 4 per cent respectively. The underlying business is fine, but even if it doesn't manage to turn around those problems, it could be a sitting duck for an American takeover, given where the dollar is sitting against the pound. NCC is on about 16 times historic earnings and has a yield of around 2.5 per cent."

A company with similar benefits is CML Microsystems (CML), which designs and sells semiconductor products to communications and storage businesses. The company needs to import components from overseas, so when sterling is weak it is more expensive to do this. But Victoria Stevens, co-manager of Liontrust UK Smaller Companies Fund (GB00B57TMD12), says the embedded nature of CML Microsystems' contracts means it is able to pass on increased costs to customers.

"We like this company because of the intellectual property in the design of its chips and the fact it has an embedded distribution network," she says. "That means that when a customer says it will use one of its chips, the customer then goes through a lengthy process of designing that chip into its end-product, meaning it is very hard to move supplier."

CML Microsystems is trading on 18.8 times price-earnings.

"We have seen recently significant pockets of value even with companies forecast to generate impressive growth," says Ms Stevens. "At the upper end of the small-cap spectrum, though, investors who've been used to fishing in the mid-cap area and upwards have started dipping down into the upper end of the small-cap area, and some of those have become quite stretched in terms of valuation."

She highlights Aim stock Accesso (ACSO), a ticketing technology company used by theme parks such as Merlin Entertainments which has soared from just over 400p a share in July 2014 to over 1,577.2p today. "It is a fantastic, high-growth business and people are justifiably excited about it, but it is trading on over 50 times price-earnings," she says.

A fund that does hold Accesso is IC Top 100 Fund Henderson Smaller Companies Investment Trust (HSL). The fund invests in mid- and small-caps as well as Aim-traded stocks, depending on where its managers see growth opportunities, and they are willing to pay for companies with a long-term growth profile.

Indriatti van Hien, deputy manager of Henderson Smaller Companies, likes litigation funder Burford Capital (BUR), which is benefiting from an increased demand for third-party litigation finance. Recent changes in the way law firms can charge to undertake expensive and time consuming cases means more lawyers are seeking to outsource the financial liability via companies such as Burford.

"The benefit of this stock is that its returns are completely uncorrelated with the market cycle," she says. "It is trading on a price of around two times book, which is consistent with a 20 per cent return on equity, which it should deliver, so it is fairly valued. You are paying for quality with this business."

Burford's share price is trading on around 18.6 times earnings. The risk with this stock is in its hard-to-value portfolio. There is also the risk it will lose the cash it has invested if a case is unsuccessful. However, Ms Van Hien adds: "Burford only accepts 10 per cent of cases offered to it because it only wants ones that will meet its hurdle rate and provide decent upsides."

Ms Van Hien also likes John Laing (JLG), an infrastructure company with growing earnings and a strong pipeline of future projects. The company operates a primary and secondary portfolio and has a wide range of assets outside the UK, as well as a UK portfolio which could be in line for a boost from an increase in UK government infrastructure spend mooted by Chancellor of the Exchequer Philip Hammond.

Ms Van Hien says: "In this uncertain climate we are really focusing on structural growth stories and not taking bets on cyclical plays. John Laing Group is an infrastructure play and we like it because it feeds into the trends of growing demographics and urbanisation - the need for more roads and waste management. It runs an integrated business model, which means it's the originator, asset owner and asset manager. The company is also globally diversified - 90 per cent of its assets are in the UK, but 70 per cent of its pipeline is outside the UK.

"This is a very visible business that pays a dividend but is trading at a discount that's out of kilter with other infrastructure plays trading at 20 per cent premiums to book."

The group's net asset value (NAV) has increased in the past year but according to Ms Van Hien, the market is discounting its shares due to a lack of certainty over its overseas expansion, something she is not worried about. "The company is trading on a 5 per cent discount to NAV (at 0.95 times 2016 NAV) and a 13 per cent discount to forward NAV assuming 13 per cent a year NAV growth," she says.

John Laing's portfolio also benefits from lower risk due its infrastructure assets paying on an availability rather than volume basis. This means it is paid the same amount regardless of how many cars travel on its toll roads, for example.

 

John Laing (JLG)

Price275.6p
Dividend yield1.84%
Market cap£1.01bn
IC view: Hold (29 Sep '16)

 

Mr Lang likes online retailer Asos (ASC), which has been one of the best performers on the London market since the UK's referendum to leave the European Union. The company's full-year results in October revealed a 37 per cent increase in pre-tax profit to £63.7m and retail sales growth of 26 per cent. Mr Lang says: "Asos is different to most retailers. And it is very different to the UK retailers that still dominate our high streets - Asos is an online fast-fashion retailer that increasingly has global reach.

"In 2014, the business struggled to cope with its rapid growth. That, and a combination of factors, resulted in a couple of profit warnings and the share price fell by more than 70 per cent. Since then, management has focused on execution first, and growth second. An efficient delivery service has helped drive rapid sales growth, which has enabled the business to invest further in customer service and increase the brands on offer. This in turn has driven further sales growth. Today, the company is going through a phase of high growth and this makes it a rare beast in the UK equity market."

That puts Asos on a high PE multiple of 117 times, but Mr Lang says it is a price he is willing to pay.

  

Restaurant Group (RTN)

Price325.2p
Dividend yield  5.37%
Market cap £651.44m
IC view: Buy (20 Aug 2016)

 

NCC (NCC)

Price 190.8p
Dividend yield2.45%
Market cap£525.46m
IC view: Hold (20 Oct 2016)

 

CML Microsystems (CML)

Price375p
Dividend yield3.71%
Market cap£63.68m
IC view: Hold (20 Nov 2013) 

 

Accesso (ACSO)

Price1,570p
Dividend yield na
Market cap£349.27m
IC view: Hold (15 Sep 2015)

 

Burford Capital (BUR)

Price464.45p
Dividend yield1.42%
Market cap£941.57m
IC view: Buy (6 Oct 2016) 

 

Asos (ASC)

Price4,936p
Dividend yieldna
Market cap£4.1bn
IC view: Buy (18 Oct 2016)

Source: Investors Chronicle & Thomson Reuters