Join our community of smart investors
OPINION

Seeking safety and income at a reasonable price

Seeking safety and income at a reasonable price
December 17, 2013
Seeking safety and income at a reasonable price
IC TIP: Buy at 47p

By focusing primarily on yield and value investing, there is no doubt this strategy has served me well over the years. However, I have had to adapt my investment approach and my asset allocations to take into account the reflationary policies, or 'Zirp' - zero interest-rate policy - that have been employed by the major global central banks for the past five years.

That's one reason why I maintained a strategy all this year of targeting small caps, the one segment of the market that benefits most from the ultra easy and unorthodox monetary policy that central banks have been employing to try to boost economies suffering from low levels of growth. It is also the main reason why I have been sanguine about general market sell-offs since virtually all of the equity investments I have recommended have been focused on niche plays at the smaller end of the market.

That's not to say that my recommendations are completely immune from a general rise in risk aversion, no equity investment can possibly be. However, by targeting undervalued special situations priced at discounts to intrinsic value of a company's assets, I have managed to build in a safety net into my stock selections and one that is more likely to attract similar like-minded investors.

It is a fundamental-based approach that will ultimately attract other medium and long-term investors who are more concerned with generating decent returns over a reasonable time horizon rather than trying to make quick-fire gains. Another benefit of this specific approach is that general market corrections generally have had less of an impact on my stock selections. That’s because, day traders aside, readers who are following my advice are basing their decisions on sound fundamental analysis and, importantly, most of my special situations have a visible exit strategy worth holding out for or have a realistic target price in mind which is attainable if you have the patience and discipline to ride short-term volatility.

I have also made a concerted attempt to target companies where there will be positive news flow in the weeks and months ahead in order to benefit from a positive tailwind irrespective of general market conditions. This is precisely the reason why my 2013 Bargain Share Portfolio has performed so incredibly well even after accounting for the drag from the three resource stocks I selected.

 

Taking a market overview

It's worth pointing out that as part of my stock picking process I try to take a general market overview to understand the overall macroeconomic backdrop, and then apply my findings to individual sectors to decide which segments of the market I should be targeting at any one given time. I outline my latest overview of the equity market in an indepth feature in this week’s issue. It also explains why I have made multiple recommendations in the real estate sector this year, and some hugely profitable ones too, as I strongly believed the benign monetary policies being followed by the major central banks are designed to inflate a whole host of asset prices, of which property is a major beneficiary.

It’s fair to say that it has almost been a one-way street by adopting this strategy with shares in both land bank specialist and housebuilder Inland (INL: 47.5p) and property company Terrace Hill (THG: 32p) doubling in value since I included both in my 2013 Bargain share portfolio February. I maintain a buy recommendation on Inland with a 60p target price, but I would bank the 100 per cent plus profit on Terrace Hill now as the shares now trade at a premium to book value.

They were not isolated cases as shares in both Daejan (DJAN: 4450p) and Mountview (MTVW: 7050p) are now up 35 per cent on my buy in prices, and that excludes some pretty hefty cash returns (‘Buy the break-out’, 14 February 2013 and ‘Chart break-out for solid income play’, 11 February 2013). The advice to buy Eastern European property company and asset manager First Property Group (FPO: 25.25p) at the end of last year also paid dividends, quite literally (‘Hidden value’, 20 November 2013). Not only would you have locked into a safe looking 6 per cent dividend yield at the time, but the 40 per cent share price gain in the past 12 months has outperformed both the FTSE Aim and FTSE SmallCap indices handsomely.

Other property winners this year include Town Centre Securities (TCSC: 235p - ‘A high yield play in the north’, 18 February 2013); Raven Russia (RUS: 81p - ‘A major buy signal beckons’, 11 March 2013); Conygar (CIC: 154p -‘Shrewd insider buying at property play’, 30 September 2013) and Macau Property Opportunities (MPO: 210p -‘Far eastern delight’, 6 September 2013). Gains on these shares range between 15 to 19 per cent, excluding dividends, after I highlighted the investment cases. I remain positive on the shares of all four companies.

And of course, the first-quarter housebuilder effect worked a treat too, delivering a near 25 per cent gain in the three-month period. For good measure, I also highlighted Bellway (BWY: 1488p) twice as a short-term trading opportunity at the end of January ('Profit from the London property boom', 30 January 2013) and in mid-February ('Seeking alpha amongst the housebuilders', 11 February 2013). We were richly rewarded with the shares rising by 26 per cent and 20 per cent, by the end of March when I advised closing out the positions. I see little reason why the shares should not make headway in the first quarter next year either given the positive seasonal tailwind and the real possibility of earnings upgrades, as I pointed out last month (‘As safe as houses’, 27 November 2013).

One regret is that I didn’t include Bellway shares in my 2013 Bargain share portfolio as I had originally intended. I chose Heritage Oil (HOIL: 152.5p) instead – the laggard in the portfolio! That said the two property plays I selected, Inland and Terrace Hill, did me proud. Moreover, it highlights the importance of running a balanced portfolio of a decent number of shares in order to mitigate the risk of one underperforming.

These bumper share price gains also reflect the stock picking process I go through in order to screen companies within my preferred sectors in order to whittle down the number of potential investment opportunities which I apply my fundamental analysis to. Having done my research, I can then weigh up how the technical situation looks for my short-list of potential investment opportunities. Only when I can tick all the right boxes do I advise readers to buy into these special situations. I apply the same methodical approach when revisiting past recommendations too, hence the large number of repeat buy recommendations I make on the vast majority of my share recommendations.

 

Riding earnings upgrade cycles

As part of my analysis I also estimate what a realistic target price for a share is based on both my fundamental analysis and also the chart set-up. I believe this is an important process to follow as I can then reassess the investment case and revisit the target price as and when new information comes to light. In some cases, this can lead to multiple price upgrades especially when companies are firmly in the grip of an earnings upgrade cycle.

For instance, shares in Aim-traded stock broker Jarvis Securities (JIM: 415p) are now up 89 per cent on my recommended buy in price of 220p in late February (‘A solid income buy’, 25 February 2013). When I initiated coverage I had a fair value estimate of 260p based on analyst estimates at the time. If achieved this would have priced the shares on 13 times 2014 earnings estimates, a rating supported by a forward dividend yield of 5.3 per cent. However, the company kept on issuing bumper trading updates which in turn led to substantial earnings upgrades from analysts. As a result my target prices were repeatedly smashed and, having acknowledged the fact that Jarvis was clearly in an earnings upgrade cycle, I raised my fair value estimates accordingly.

In fact, I have written no fewer than six articles on Jarvis this year! If you followed that advice I would continue to run your bumper profits ahead of the full-year results in February. That’s because the shares are trading on 15 times earnings estimates net of a cash pile worth 82p a share, but that rating could drop again if, as seems highly likely, the company beats even the upgraded earnings expectations. For good measure, Jarvis has a stated policy of paying out two-thirds of its net earnings as a quarterly dividend so expect a full-year payout of 14p this year. On this basis the prospective yield remains attractive at 3.5 per cent.

Jarvis was not an isolated example either of a company in an earnings upgrade cycle as shares in Thalassa (THAL: 278p) have more than doubled after I initiated coverage at 138p in March (‘Potential for seismic gains’, 19 March 2013). The company provides marine seismic equipment and, in particular, a technology called Portable Modular Source System (PMSS™). This equipment is installed on vessels to provide a seismic source to enable oil and gas exploration and production companies to perform life of field seismic studies or permanent reservoir monitoring. My interest in Thalassa was piqued when I noted the company had received a letter of intent with Statoil ASA (NO: STL), the Norwegian energy giant, to provide long-term seismic acquisition services for permanent reservoir monitoring of the Snorre and Grane oil fields in the Norwegian sector of the North Sea. It was huge contract for the Aim-traded minnow and, after I had taken the time to extensively research the company, I realised that there was clear potential for further contract wins as the technology gained traction.

 

Identifying the right signs

Moreover, I was more than prepared to recommend the shares on the basis Thalassa was about to enter an steep earnings upgrade cycle, a subject matter I cover in great depth in a dedicated chapter in my new book, Stock Picking for Profit. The company was certainly showing all the right characteristics I look out for when trying to identify businesses in the early stages of an upgrade cycle. At the time of my initial buy recommendation, Thalassa was being valued on 15 times earnings estimates before substantial upgrades to factor in the Statoil contract. However, with the benefit of further contract wins, brokerage WH Ireland now expects Thalassa to more than double revenues from $14m last year to $30.6m in 2013. And with gross margins rising sharply, this should be enough to treble pre-tax profits to $3.6m. That was enough to drive the share price skywards. However, the company still offers around 20 per cent upside to my upgraded target price of 350p.

That’s because if you strip out the company’s cash pile of 120p a share from Thalassa's share price, then a business forecast to post pre-tax profits of $5m in 2014 is being rated on a prospective multiple of 16 times earnings estimates. That rating is not that much higher than when I initiated coverage in March and that’s after a doubling in the share price. For a company that is set to treble profits this year, and conservatively raise them by almost 40 per cent in 2014, and potentially more if more contracts are won as seems highly likely, that is hardly an exacting valuation. Furthermore, the risk to earnings remains skewed to the upside, given the conservative assumptions for the conversion of the company’s bid pipeline into contract wins. Clearly, the institutions buying equity at 250p a share - in a recent placing that raised £18m to fund these contracts - are thinking the same way. I am too and Thalassa's shares continue to rate a buy.

It was a similar story with Aim-traded Pilat Media Global (PGB: 80p), a supplier of business management software to the media industry. Shares in the company have surged 60 per cent since I initiated coverage at 49p six months ago ('Buy the break-out', 3 Jun 2013) and now look well on their way to hitting my upgraded target price and a return to the all-time high of 88p. It’s more than justified on fundamentals: Pilat is a company winning major new contracts; generating bumper cash flow; has potential to return excess cash to shareholders; looks nailed on to increase EPS by 35 per cent this year and by at least 17 per cent in 2014; and is now in an earnings upgrade cycle.

Buoyed by a raft of contract wins, analysts have been hiking forecasts steeply since the summer and now expect the company to report adjusted pre-tax profit of £2.5m and EPS of 2.95p in 2013, up from £1.78m and 2.15p, respectively, in 2012. Furthermore, with the business now enjoying clear momentum, Shore Capital has recently upgraded its 2014 numbers and now predicts EPS of 3.45p, well ahead of the 3.15p previously forecast and miles ahead of the 2.9p estimate ahead of interim results in August. In other words, Pilat is firmly in an earnings upgrade cycle, and one that looks to have some way to run.

I was also attracted by the company’s rock solid balance sheet and robust cash position: net funds of £12.6m equates to 20p a share, but if Pilat hits Shore Capital's numbers for 2014, that cash pile is predicted to rise to £14.7m, or 23.5p a share, by the end of next year. Strip this cash pile out, and the shares are now rated on a more reasonable 17 times 2014 earnings estimates, but with the risk to earnings skewed to the upside, a return to those record highs, and possibly beyond, looks in order.

 

Cash is king

My focus on value shares offering decent dividends has clearly proved an attractive combination in a low interest rate environment, and across a number of sectors. By adopting a balance sheet approach to investing and focus on the cash generation of a business, I have been able to pick out undervalued shares of companies in a large number of sectors that offer the compelling combination of a cash rich balance sheet, rising dividends, low earnings multiples and a good news story to drive a higher rating.

For instance, at the start of the year I highlighted the investment case of Air Partner (AIP: 560p - ‘A share ready to take off’, 7 January 2013). As I noted at the time, it's not often you get the opportunity to buy shares in a company offering a solid 6 per cent dividend yield and trading on a modest 6.5 times earnings estimates net of cash. However, that's exactly what I was on offer here and, to add to the attraction, this was a business in recovery mode with analysts predicting that pre-tax profits would rise by almost a fifth in the year to July 2013. The share price was at an interesting juncture too, as it looked to be on the verge of a major break-out. That in itself warranted a closer look at the investment case and one that led me to make a strong buy recommendation when the shares were priced at a bargain basement 310p. In the event, Air Partner’s underlying pre-tax profits rose 31 per cent to £4.2m in the 12-month period to end July, adjusted EPS rose by over a quarter and with the cash pile soaring by almost a third to £20.7m, the payout was raised by 10 per cent to 20p a share. So, if you followed the advice you will have locked into a healthy 6.6 per cent yield. You have also benefited from an 80 per cent rise in the share price too.

However, even after such a healthy gain, the rating still doesn’t look too expensive. That’s because, once you strip out that 200p a share cash pile, Air Partner is being valued on an earnings multiple of 12.8. Or, put it another way, a business conservatively forecast to make £4.4m of profit in the current financial year is being attributed a value of only £36m after factoring in that £20.7m cash pile. My target price of 640p is not unrealistic.

I underwent a similar exercise when I selected two Aim-traded shares in the online gaming sector: 32Red (TTR: 68p - ‘Game on’, 8 July 2013) and NetPlay TV (NPT: 20.5p - ‘A share set to hit the jackpot’ 11 February 2013). Both companies had similar characteristics: strong balances sheets, substantial and rising net cash positions, robust cash generation from operating activities, rising dividends, low earnings multiples, healthy dividend cover, and importantly the risk to earnings expectations was firmly to the upside. The two businesses were also growing their user base at quite some pace, which given their higher than average operational gearing, meant the outlook for earnings growth rates was equally robust. Despite these positives, the shares were both rated on bargain basement earnings multiples.

In fact, when I initiated coverage on 32Red in the summer, the company was being valued on just 8.4 times this year's earnings forecasts, dropping to a bargain basement 6.6 times 2014 estimates. Other investors clearly noted the value on offer too as the shareholding has produced a total return of 35 per cent in the past five months including special dividends. There should be more upside to come too. That’s because even if 32Red share price rises a further 32 per cent to my newly upgraded target price of 90p, the shares would still only be rated on 10 times 2014 earnings estimates net of cash. The risk is firmly to the upside here as I noted in my update last month (‘Hitting the jackpot’, 11 November 2013).

It’s a similar story with NetPlay TV which has produced a 64 per cent total return since I highlighted the compelling valuation in February when the price was only 12.5p. As I noted at the time, it's not often you get the opportunity to buy shares in a company for three times next year's earnings estimates, net of a substantial cash pile, when the business is in a strong upgrade cycle and where brokers have lifted their earnings estimates not once, but twice in the previous six months. Even after the subsequent rerating, the shares are hardly over rated on 6.5 times prospective earnings net of cash. I am not the only one thinking along these lines as brokerage Daniel Stewart has an upgraded price target of 27p and N+1 Singer has a valuation range between 28p to 32p for 2014. With profits from the mobile and tablet segment soaring, the benefits of the Vernon acquisition to come through, the company’s share of the UK online casino market rising, and EPS set to rise by 25 per cent in 2013 and a further 40 per cent in 2014, I am more than comfortable with my 28p target price (‘Strong buy signal’ 31 October 2013).

 

Risk assessment

The bumper gains made on a large number of companies I have recommended this year also reflects the attitude I have to risk as it is critical to be fully aware of the risk embedded in a company's valuation as any two companies will have a different risk profile. My aim is ultimately to maximise the return available by taking as little risk as possible. Personally, I carry out 16 different risk assessments on every company I analyse to get a picture of the level of investment risk and whether this is appropriate for the upside potential on offer. It's not an exact science, but this process has served me well, which is why I have dedicated a whole chapter in my book to the subject of understanding risk.

As part of this risk assessment I also look at seasonal investing patterns. That’s because a company may appear undervalued based on fundamental investment analysis, and the chart set up may be relatively positive, but investing in the wrong sector at the wrong time of the year is like running up a down escalator. To avoid the pitfalls, it's best to know which segments of the market perform best and at which points of the year. Unfortunately, this is one risk some investors overlook.

But even when an investment is under water, and clearly some of my recommendations this year are, I always ask myself the question whether I would still put fresh capital into a company’s shares. If the rationale behind the investment decision still holds, and the valuation is attractive based on a fundamental approach, then I am not only prepared to ride out the short-term downside, but more often than not use it as a further buying opportunity. In my experience, the greatest gains are made by those who have the discipline and patience to be invested for when the upside finally materialises, even if it takes longer than you initially anticipated. That’s something that is likely to be highly relevant in 2014 when riding off the market’s coat-tails is likely to bring far less rich rewards than it has this year. As I discuss in my 2014 equity market outlook, stock pickers are likely to come into their own next year, a challenge I am relishing already.

Finally, due to unprecedented demand, my new book, Stock Picking for Profit, has sold out and is being reprinted for delivery the week beginning Monday, 6 January 2014. As a special promotion to IC readers, the first 100 pre-orders for the book placed online with YPD Books and quoting offer code ICOFFER will receive complimentary postage and packaging. The book can be purchased online at www.ypdbooks.com, or by telephoning YPDBooks on 01904 431 213. The book is only being sold through YPDBooks and no other source. It is priced at £14.99, plus £2.75 postage and packaging. Telephone orders will continue to incur the £2.75 charge.

 

MORE FROM SIMON THOMPSON ONLINE...

In the past fortnight, I have published articles on the following 14 companies or trading strategies:

PV Crystalox Solar ('Cash rich and undervalued', 2 Dec 2013)

Pilat Media Global ('Bumper upgrades for software maestro', 2 Dec 2013)

Housing market ('Allaying fears of housing myths', 3 Dec 2013)

Dragon Ukrainian Properties ('Ukrainian nigntmare tames the dragon', 4 Dec 2013)

Conygar ('A smart regional property play', 4 Dec 2013)

Sutton Harbour ('Small cap value plays', 5 Dec 2013)

Crystal Amber ('Small cap value plays', 5 Dec 2013)

API ('Small cap value plays', 5 Dec 2013)

Greenko('Fair wind', 6 Dec 2013)

Bezant Resources ('High risk, high reward resource play', 9 Dec 2013)

Thorntons ('A rating too sweet?', 10 Dec 2013)

KBC Advanced Technologies ('Fuelled for more growth', 11 December 2013)

Terrace Hill (‘Property play fully valued’, 13 December 2013)

Moss Bros (‘Dressed for success, 16 December 2013)