Five contrarian value plays

Source: Datastream

The theory behind targeting companies which are lowly valued compared with sales is that while profitability can slump at companies from time to time, if sales hold up and grow, profit levels can generally be restored. But when a slump in profitability happens, the market’s obsession with short-term earnings means any top line progress is ignored and the shares are sold off sharply. That creates the potential for substantial upside when things do start to improve.

Another highly-regarded proponent of this valuation method is James O'Shaughnessy, who did extensive statistical work studying what metrics were the best predictors of US share price movements, which formed the basis of his best-selling book: "What Works on Wall Street". He found the price-to-sales ratio (similar to EV/Sales but not taking account of a company's cash or debt position) was the most effective indicator of value.

While all the top five stocks in last year's portfolio produced positive returns (see table), this is a high risk strategy, which can be seen from looking at the performance of individual shares in the full 20-stock portfolio. While we highlight the top five shares from the screen below, we also provide a list of the rest of the 20 "cheapest" (lowest EV/Sales) stocks that passed the screen this time around. It should be noted that a number of the stocks in our list have an EV/Sales ratio that is actually above the market's median average of 1.49.

FIVE CONTRARIAN VALUE PLAYS:

MDM Engineering

It is not hard to see why the shares of mineral engineering and project management group MDM (MDM) are currently out of favour. The group's main clients are African miners which have been hit by negative sentiment towards the resources sector and additional worker-related problems in the region - particularly South Africa. What's more, a proposed merger with Australian firm Sedgman, which put a 181p valuation on the shares, was canned after client project delays meant MDM would be unable to satisfy the merger conditions.

That said, the company's full-year results earlier this month were knock out, with the group reporting a 54 per cent leap in sales to $137m and a 162 per cent surge in pre-tax profit to $20.4m, boosted by completion bonus payments. And while house broker Canaccord Genuity expects a 30 per cent earnings slip this year before - at odds with the CapitalIQ consensus data in our table - edging north in 2015, the order book and potential for jobs from extension work at existing mines provides some comfort and supports management's view that there are still organic growth opportunities. The cash pile will also be used to pursue new growth possibilities. MDM is committed to paying out half of its post-tax profits as dividends and sought to sweeten shareholders following the collapse of the merger with a special dividend worth 6¢ per share on top of the 24.1¢ regular payment. So while MDM is definitely a contrarian play due to the trouble in its end markets, if it can keep the ship steady, there are certainly grounds to believe there's plenty of value on offer.

*Consensus forecasts for the next 12 months

Source: S&P CapitalIQ

Last IC view: Sell, 180p, 28 November 2012

SDL

SDL (SDL) became a decidedly more contrarian bet at the end of last month when it released a stonker of a profits warning saying that underlying profits were likely to be between £15m and £20m compared with £35.5m in 2012. The City’s central concern with SDL is that recent acquisitions have caused the business spiral away from its traditional translation market and left it without a clear strategy and poorly integrated. Indeed, some analysts are struggling to understand what market its new focus on "customer experience management" is actually meant to serve.

At the time of its full-year results in March the company announced it would be funnelling £9m into improving its sales and marketing following a period of under investment, which came as something of an unwelcome surprise to investors. But this investment did not come in time to prevent a slide in first-half license sales, and shareholders will have to hope the group is spending its £9m wisely. SDL's translation services business has also been hit by the tough economic climate. That said, the group did report it was "seeing pipeline improvement on both the technology and services side with licence bookings expected to increase significantly in the second half." Fingers crossed there is light at the end of the tunnel. With the shares now 60 per cent below their March 2012 highs, there is room for upside should a convincing turnaround story emerge.

*Consensus forecasts for the next 12 months

Last IC view: Sell, 440p, 12 March 2013

M&C Saatchi

Despite its low rating compared with peers, advertising group M&C Saatchi (SAA) has been delivering industry beating growth for a number of years and has earmarked 2013 to be a year when it expects to achieve at least double the average of its peer group. The group's success is based on its focus on high-growth areas in media, such as customer relationship management, as well as pushing into fast-growing developing markets. What’s more, the bottom line should be aided this year by a fall off in set up costs relative to 2012 and there are hopes of a pick up at the group's Clear brand consultancy.

The company's cash pile provides comfort and supports a worthwhile, although not exceptional, dividend which is forecast to grow at a rate of about 10 per cent a year for the next two years by broker Numis. While Saatchi's strong track record means it is hard to describe it as a contrarian play, the shares nevertheless look cheap, especially considering its industry-beating growth prospects. Its forecast enterprise-value-to-operating-profit ratio of 8.4 times (based on Bloomberg consensus numbers for the next 12 months) compares with a peer group average of 9.1 times.

*Consensus forecasts for the next 12 months

Last IC view: Buy, 204p, 18 March 2013

ACM Shipping

The shipping industry has been in a mire for nigh on half a decade. The business is notoriously cyclical, a characteristic that is exaggerated by the long build time on new ships that mean a downturn can be like watching a slow-motion car wreck. While few are brave enough to start popping champagne corks at the moment (that kind of behaviour is normally reserved for just before the bubble bursts), there is growing confidence that things are slowly but surely getting better.

ACM Shipping (ACMG) looks like it should be well prepared to take advantage of any upturn following investment in new staff after a spat of defections by key sales people. What's more, ACM has shown resilience during recent tough years. For instance, the dividend has been maintained at 10.15p and despite thin cover this is expected to be maintained in the future. Indeed, the payment is supported by the cash generative nature of the ship broking business and last year the group's cash pile grew £1.2m to £4.3m at the year end. A decent share price rise over the last year is in part recognition of this resilience as well as a sign that the market may be getting interested in the potential for a recovery after so many years in the doldrums. That said, this remains a contrarian play, but one with plenty of potential upside should the cycle finally turn.

*Consensus forecasts for the next 12 months

Last IC view: na

Drax

Forecasts of gradual earnings advances coupled with Drax's (DRX) hearty PE and enterprise-value-to-cash-profits ratio hardly suggest it’s a classic contrarian play. But, as far as utilities go, the stock does boast some contrarian credentials. Indeed, the company's plans to covert power-generation units to use biomass are a strategy that embodies a lot of implementation risk but also a lot of potential reward. The strategy got a boost last month when the government unveiled a new feed in tariff proposal for biomass which has been judged by analysts to look very attractive. Broker JP Morgan believes the government support could prompt Drax to increase its target for unit conversion from three to four.

But while there is plenty of long-term potential from the biomass conversion strategy it is hard to see more immediate signs of value from the shares beyond the enterprise-value-to-sales ratio. Even the historic yield listed in our table isn't a reason for buying the stock on valuation grounds as it is expected to be cut this year. Based on JP Morgan's forecasts of a 12.35p payment in the current year the shares would yield 2 per cent. Nevertheless a compelling long-term story could emerge as more certainty is established around biomass and if Drax can make good progress with its mammoth retrofit project.

*Consensus forecasts for the next 12 months

Last IC View: Hold, 630p, 20 Feb 2013

15 more contrarian value plays

*Consensus forecasts for the next 12 months

Source: S&P CapitalIQ