A conundrum to solve

In fact, of the 26 recommendations and trades I made in the last three months of 2012 no fewer than 23 are in profit and the average gain is currently 17.9 per cent on an offer-to-bid basis even after factoring in the paper losses from three losers.

How Simon Thompson's recommendations from the fourth quarter of 2012 have performed

One of the holdings under water is Plymouth marina and property company Sutton Harbour (SUH: 26p) which I updated in detail last month and maintained my medium-term buy recommendation. However, I am now faced with a dilemma on another one of those stock recommendations: packaging materials group API (API: 57p).

Amber alert for a bid

I first noted the upside potential in API shares when I revisited the investment case for Aim-traded investment company, Crystal Amber (CRS: 104p), a couple of months ago (Small caps to buy now, 3 December 2012). The fund’s holding in API constitutes around 6.5 per cent of Crystal Amber’s investment portfolio and on the basis that the board of API had put the company up for sale following pressure from major shareholders, and the sale process was ongoing, a takeover of API looked likely. In fact, US activist fund and 32 per cent shareholder Steel Partners and 28 per cent shareholder Wynnefield Capital had announced they wanted to sell out, so it looked odds on that a deal would be agreed with the most likely bidders being trade buyers in Germany and the Middle East, foil-makers in Asia or even Illinois Tool Works which had an offer of around 100p a share turned down several years ago.

I was also attracted by the fact that API had a hidden and valuable asset in its New Jersey site which "covers 20 acres within the Manhattan commuter belt and is potentially worth a significant part of its market capitalisation" according to Crystal Amber, adding that even without a bid "reorganisation, investment and marketing initiatives combine to offer share price upside well in excess of 100p". I agreed and advised buying shares in the packaging materials group at 70p Small caps to buy now, 3 December 2012). Indeed, I was so convinced that the company would be taken out that I reiterated that advice when the shares were priced at 83p (More upside to come, 22 January 2013) noting “speculative upside in API shares to 100p a share in the event of a bid."

Bids fall shy of expectations

It therefore came as a shock when API’s board stated in late January that indicative proposals from bidders were below 90p a share. To put that into some perspective, the company was forecast by analysts to make underlying EPS of 8.8p in the 12 months to March 2013, so the indicative offers didn’t even equate to an exit multiple of 10 times earnings estimates. The shares duly slumped back to 70p on that news, but I still believed it was worth holding on as any bid would have to be north of 80p to win the approval of the major shareholders. But that clearly hasn’t happened and bid talk with all parties terminated this week, prompting API's share price to slump once more, to 59p. To compound matters, the management of API also warned that results for the financial year to 31 March 2013 "will be marginally below previous management expectations." True, the board is still confident that "results for the current financial year will demonstrate substantial year-on-year improvement", but with investors positioning themselves for a bid, the latest news prompted a wave of selling as some headed for the exit.

Strong earnings growth

That said, having seen API’s share price slump by a third in the past few weeks from 90p to 57p, the shares are now rated on a miserly 6.4 times forward earnings of 8.9p for the financial year to 31 March 2013, according to analyst Charles Pick at broking house Numis Securities, which still represents a significant uplift from the 6.4p of earnings reported in the financial year to March 2012. These estimates are based on flat revenues of £112m, down slightly on the £113.9m in the prior year. For the 12 months to March 2014, Mr Pick is now predicting revenues of £116m and pre-tax profits of £8m (versus £9.6m previously) which would represent 14 per cent growth on the £7m forecast for the year to March 2013. On this basis, Numis is pencilling in EPS of 10p, down slightly from the 10.8p previous estimate. It's worth noting that the "utilisation of tax losses has been far better than expected", so the downgrade to EPS figures are proportionately less than to pre-tax profits.

The company is soundly financed and at the end of September net debt had been cut to only £5.2m, half the level of 12 months earlier, which means that balance sheet gearing is only 21 per cent of shareholders funds. True, API has a defined benefit pension deficit of £9.3m, which is significant in the context of shareholders funds of £24.1m and one reason why bidders were less keen to offer a take-out price acceptable to the major shareholders. That's because financial buyers could not use as much leverage on the acquisition. But this does not detract from the overall positive operational performance of API's business which lifted operating profits by a third to £5m in the six months to end September and is expected to lift the full-year figure by even more.

Sensible advice

So, although the outlook for API's laminates and holographics businesses are less favourable than six months ago, and the foils business has only offset some of this weakness, I am loathe to bail out when the shares are priced on a miserly 6.4 times earnings estimates for the year to March 2013. True, bid support has disappeared and so has any bid premium embedded in the share price, but I am willing to hold on for the share price to recover back to my 70p buy-in price driven by the operational performance of the company.

I am also happy to hold shares in Crystal Amber which now trade on a 16 per cent discount to end January net asset value of 124p especially as 23p of that figure is in cash, so in effect the share price discount widens to 20 per cent net of cash even though the fund has been outperforming its benchmarks since the end of 2011.

On solid foundations

I reviewed my first-quarter housebuilder trade earlier this week and maintained buy ratings on all eight FTSE 350 players (Seeking Alpha, Monday, 11 February 2013). However, I should have also pointed out that if you followed the advice to buy shares in all eight and simultaneously buy a Deutsche Bank short ETF on the FTSE 100 index (XUKS), then I would continue to run your long-short pair trade.

So far, this pair trade has produced a net return of 5.4 per cent since start of trading on Wednesday, 2 January, and as I noted in my article on Monday, this is still significantly below the average 13.5 per cent outperformance this strategy has generated in the 20 years when the sector has produced a return above 7.5 per cent in the first quarter.

FTSE 350 Housebuilders' performance table in 2013

■ Please note that I have released six online articles since Monday: 'A share set to hit the jackpot','A highly profitable arbitrage play, 'Seeking Alpha among the housebuilders','Chart break out for a solid income play', Time to dial into profit' and 'Buy the break-out'.

Finally, I will be taking a four-week break during April to complete a book on 'Profitable stockpicking', my follow-up to Trading Secrets: 20 Hard and Fast Rules to Help You Beat the Stock Market. The book will be published in early summer.

MORE FROM SIMON THOMPSON ONLINE...

Since the start of this year I have written no fewer than 29 online articles, all of which are available on my homepage. These include articles on the following companies or investment strategies:

Daejan Holdings (Buy the break-out, 14 February 2013)

IQE (Time to dial into profit, 13 February 2013)

Mountview Estates ('Chart break out for a solid income play', 12 February 2013)

Bellway (Seeking Alpha, 11 February 2013)

Marwyn Value Investors (A highly profitable arbitrage play, 11 February 2013)

Netplay TV (A share set to hit the jackpot, 11 February 2013)

Oakley Capital, Randall & Quilter, Inland, Terrace Hill, Heritage Oil, Cairn Energy, Polo Resources, Trifast, Noble Investments, Fairpoint (Bargain Shares for 2013, 8 February 2013)

Telford Homes, MJ Gleeson, Stanley Gibbons, Molins, Indigovision, Trading Emissions, Mallett, Bloomsbury Publishing, Rugby Estates, Eurovestech (How the 2012 Bargain Shares fared, 8 February 2013)

Future (Decision time after a bright start, 5 February 2013)

Sanderson (An 'app' online investment, 5 February 2013)

Aurora Russia ('Time to play Russian Roulette', 4 Feb 2013)

BP Marsh & Partners ('Hyper value gains', 31 Jan 2013)

Bellway ('Profit from the London property boom', 30 Jan 2013)

Telford Homes, MJ Gleeson, Mallett, Rugby Estates ('Taking profits after a winning streak', 28 Jan 2013)

Market timing ('Lessons to learn', 24 Jan 2013)

Communisis, Netcall ('Bumper trading gains', 23 Jan 2013)

Crystal Amber, API, Sutton Harbour ('More upside to come', 22 Jan 2013)

PV Crystalox Solar ('Seeing the light', 21 Jan 2013)

Bloomsbury Publishing ('A publisher for the digital age', 18 Jan 2013)

Housebuilders first-quarter effect and performance table on all my recommendations from the final quarter of 2012 ('Stockpicking Marvels, 16 Jan 2013)

Eros ('A share firmly in the picture', 15 Jan 2013)

Netcall ('Jumping the gun: take two', 15 Jan 2013)

Moss Bros, Communisis ('Jumping the gun', 14 Jan 2013)

Stanley Gibbons, MJ Gleeson, Spark Ventures ('Small cap wonders', 11 Jan 2013)

IQE, Trading Emissions ('A tech share worth buying now', 10 Jan 2013)

S&P 500 portfolio of dog shares ('Dog shares barking back', 8 Jan 2013)

Air Partner ('A share ready to take off', 7 Jan 2012)

FTSE 100 traded options strategy ('Highly profitable options', 3 Jan 2012)

Telford Homes, MJ Gleeson, Molins, Noble Investments ('Rampant bargain shares', 31 Dec 2012)