Bargain shares flying high

That's not to say that I am complacent - far from it. Having had first-hand experience of the stock market's rollercoaster ride for the best part of a quarter of a century, I know all too well how Mr Market is more than happy to relieve you of your hard-fought gains. That said, I am comfortable holding all 10 companies I started this year's portfolio with and, if you followed my advice, I would do the same for a number of reasons. There are also some repeat buying opportunities in some of the companies.

How Simon Thompson's 2013 Bargain Shares Portfolio has performed

True, past performance is no guide to future success as every fund manager will tell you, but in terms of stock-picking I have been making hay in this bull market, which certainly makes life easier. Last year was truly exceptional, as my 2012 motley crew of Bargain Shares managed to beat all bar three of the 55 small-cap funds in the UK. More important was the excess return over both the FTSE All-Share and Small Cap indices: the 31.9 per cent total return on my 2012 portfolio was a hefty 18 percentage points more than the FTSE All-Share achieved and nine points more than the return on the SmallCap index. So, not only did I select the right segment of the market to focus on - micro and small caps - but I managed to beat the benchmarks too.

Indeed, the 'alpha' my Bargain Shares portfolios have created over the years - that is the excess return over and above what the market would have returned - has done us proud. Since 2003, my Bargain Shares portfolios have posted an average annual return of 17 per cent - a hefty 7 percentage points each year more than the FTSE All-Share index. And this is in no small part down to the excess return I have been able to make by stock-picking wisely in the small-cap segment of the market.

It was not by chance that the best of the returns from this year's portfolio have been from small-cap shares. In fact, I made a conscious decision to focus on the smaller end of the stock market once again since my overriding view at the end of last year was that the minnows would be a major beneficiary of any improvement in investor risk appetite, and any economic upturn even if it proved modest. I set my stall for 2013 when I predicted a very bullish outlook for the UK equity market at Christmas ('Reasons to be cheerful', 21 December 2012). As it happens both of these factors are creating a pleasant tailwind for my undervalued small companies. In fact, all bar one - Polo Resources (POL:23p) - of the eight small-caps I chose are showing very decent gains at the half-year stage. The same cannot be said for the two mid-caps: FTSE 250 constituents Cairn Energy (CNE: 271p) and Heritage Oil (HOIL: 187p).

Oil plays to pay dirt

That said, I expect both companies to come good, and with good reason. For instance, Cairn Energy is still only capitalised at a modest £1.6bn, little more than the total of the $1.5bn cash (£967m) on the group's balance sheet and the stake in Cairn India, which is worth a further $1.5bn. That leaves an aggressive drilling campaign - and one where the odds are one in four of hitting a strike, according to analysts in the know - in the price for free. If only one of those wells pays dirt, then Cairn's share price could surge. Expect the first well, Prospect A, offshore Morocco, to spud by the end of September. This will then be followed by another well in Morocco in the first quarter of next year, two proposed wells offshore Senegal in the first half of 2014, the Spanish Point appraisal well offshore Ireland in the second quarter of 2014, and further drilling in Greenland and the UK in the second half of next year. I see the current undervaluation as a buying opportunity.

Not before time, shares in independent upstream exploration and production company Heritage Oil are enjoying a re-rating as investors slowly start to appreciate the investment case, 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 in Nigeria. Both issues have been rectified and output is now above 35,000 barrels of oil per day, which puts Heritage back on course to generate the bumper cash flow it needs to pay down debt, and generate healthy profits for shareholders. I fully expect us to recoup our losses and show decent gains by the year-end. The shares continue to rate a buy.

Prospects for further small-cap gains

Earlier this month, I updated the investment case on homebuilder and land developer Inland (INL) ('Profit from the property boom', 14 August 2013); coin dealer and auction house Noble Investment (TRI) ('Taking profits', 6 August 2013); and distributor Trifast (TRI) ('Happy Anniversary', 19 August 2013). I remain upbeat on prospects for all three. I also gave an extensive update on Polo Resources (POL) last week, reiterating the obvious undervaluation ('Golden Nugget', 22 August 2013).

I also remain very upbeat on the high-yielding Aim-traded shares of Randall & Quilter (RQIH), a specialist in the run-off of insurance companies. The company releases results later this week, which we will cover in the magazine and online. Aim-traded debt management specialist Fairpoint (FRP: 117p) also issues its half-year results shortly, on Tuesday, 12 September, and ahead of those figures I can only reiterate my previous bullish stance.

Fairpoint's cash generation remains robust and net cash increased to £2.8m in the six months to end-June, reflecting £3.6m of cash generated from operating activities. That should augur well for the dividend after the board "committed to a long-term progressive dividend policy, which takes into account the underlying growth in earnings and strong cash generation". Analysts are pencilling in a dividend of 6p a share this year, up from 5.5p in 2012, implying a prospective yield of 5.5 per cent.

The shares are also attractively rated on an earnings basis. In fact, assuming Fairpoint raises full-year adjusted pre-tax profits from £7.5m to £8m, as analysts predict, that lifts EPS from 13.4p to 14.5p. On that basis, the shares are being rated on a forward PE ratio of 8. It's worth noting, too, that the payout is more than twice covered by earnings and I would not be surprised to see the board announce a larger-than-expected boost to the dividend. So ahead of half-year results, I continue to rate Fairpoint's shares a value buy on a bid-offer spread of 115p to 117p.

Oakley well worth buying

There is also obvious scope for upside in the shares of Oakley Capital Investments (OCL: 149p), a closed-end Aim-traded investment company. 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 doing rather well, a point that investors seem to have overlooked but will be reminded of when Oakley reports its half-year results in mid-September. According to Oakley's investment adviser, the company's book value per share will "be in the range of 193p to 195p at the end of June, up from 181p at the start of the year and 174p in June last year". Net asset value is made up of cash, the investment in the Limited Partnership and loans provided to the Limited Partnership and a number of the portfolio companies.

So with Oakley's shares marking time at 149p, the share price discount to net asset value is a hefty 24 per cent. Now a discount of that magnitude would be in order if Oakley's investments were underperforming. But that is clearly not the case. In fact, to date the Limited Partnership has exited four of its portfolio investments, achieving an internal rate of return of 43 per cent on invested capital and an eye-catching 14 per cent uplift in realisation proceeds above the previous book value of those investments. In other words, Oakley shares are not only trading on an unwarranted share price discount to net asset value, but the book value of its investments look very conservative. It also has a sizeable cash pile, which mitigates risk. A value buy.

On solid foundations

Shares in Aim-traded property developer and investor Terrace Hill (THG: 23p) have surged this year, but it is only realistic to expect further gains. That's because, following a site sale and forward funding agreement for the company's 1,104-unit student accommodation scheme in Southampton, and the disposal of the majority of its remaining residential assets, the company's balance sheet gearing has been slashed to 30 per cent. This mitigates financial risk, which was the major reason the shares had been previously shunned by investors.

Moreover, there is scope for further debt reductions as Terrace Hill has bought out a joint venture partner to take ownership of 47 residential assets worth £5.3m, all of which will be sold off on a piecemeal basis. The focus will be on commercial property developments and food stores in particular. Prospects here look well underpinned. The company has completed two pre-sold and pre-let Sainsbury's food store developments in the north-east of England and a 41,800 sq ft Asda supermarket in Skelton. Importantly, Terrace Hill's chief executive Philip Leech points out that his company is still experiencing good demand from retailers for the right type of store in the right location. The company has close relationships with several large retailers and the pipeline of development projects is "progressing well".

This has not been completely lost on investors, since Terrace Hill's shares are up 42 per cent since I advised buying in February at 15.4p. However, trading 25 per cent below Oriel Securities' end-September 2013 net asset value estimate of 31p, the share price discount to book value is still far too wide. Buy.

Please note that in response to requests from dozens of readers, I have published an article outlining the content of my new book, Stock Picking for Profit: 'Secrets to successful stock picking'