10 superb stocks for 2018

Discover our top equity picks for the year ahead
Thursday 21 Dec 2017 Author: Daniel Coatsworth

Welcome to our top share picks for the year ahead. Keep reading to discover 10 companies which we believe will enjoy decent share price gains over the coming 12 months. You will find a mixture of growth, value and recovery situations; all have an exciting investment proposition.



An excellent way to play the thriving electric vehicles industry

We believe AB Dynamics (ABDP:AIM) is at a major turning point in its life and could see significant share price gains for several reasons.

It is slap bang in the middle of the electric vehicle revolution. The company has a growing portfolio of unique testing products critical to developing and launching increasingly sophisticated vehicles.

Its order book is at an all-time high and we believe its services will be in very strong demand over the coming years. As such, it justifies a premium valuation.

The automotive industry is undergoing a radical change with both traditional players and tech firms developing electric vehicles. They all need to be tested for safety and efficiency, either in a live environment or using a simulator.

AB Dynamics not only has the necessary solutions but it also has relationships with the top 25 automotive companies in the world who are already using its products and services.

Car makers want to do repeat tests to check everything works and AB Dynamics’ robots can do anything a test driver can do and repeat it with great accuracy. It generates a huge amount of data which can then be analysed to help produce the optimal driving machine.

‘If you look at the top 20 companies in the world in terms of research and development spend; six of those are car companies,’ said outgoing chief executive Tim Rogers at a recent investor event.

The company is forecast by stockbroker Panmure Gordon to secure its first order for a new vehicle driving simulator developed in partnership with Williams F1 in the current financial year.

‘More work is now done on a computer but there comes to a point where you need a prototype,’ said Rogers. ‘Wouldn’t it be nice if the driver could get in at an earlier stage and drive a model?’ That’s where its simulator comes in.

AB Dynamics raised £5.4m in 2016 to recapitalise the company, finish a new manufacturing facility and support its R&D functions. It has grown its software capabilities and created new roles internally.

It is now close to appointing a new chief executive to drive corporate development. Rogers recently said at an investor conference that the candidates are ‘extremely high calibre’ and that he wouldn’t have got the job had he applied. ‘The company needs someone familiar with larger revenue and the M&A process,’ he commented.

The group is forecast to grow pre-tax profit from £5.9m in 2017 to £8.9m in 2018. It ended the 2017 financial year with close to a £10m net cash position. (DC)

Alliance Pharma is a lower risk pharmaceutical play with potential to deliver strong growth.

Chippenham-based Alliance Pharma (APH:AIM) is ideal for investors who want exposure to the pharmaceutical industry without the risks of developing new drugs.

The company acquires and licenses pharmaceutical and healthcare products and delivers these to patients.

The shares look cheap against its forecast growth. Based on consensus forecasts the company trades on a price-to-earnings to growth ratio for 2018 of just 0.58 times. Anything below 1.0 can imply good value on this metric.

Alliance Pharma sells its products to over 100 countries through direct channels, joint ventures and a large distribution network. Half of its sales are generated in the UK, with a quarter in Europe and the remaining 25% generated elsewhere in the world.

It drives growth through targeted marketing for what it describes as its ‘bedrock’ products. These typically require modest promotion to maintain meaningful sales due to limited competition.

Examples include Haemopressin to treat extremely dilated sub-mucosal veins and Flamma, a product that soothes skin after sunburn.

‘Bedrock’ products comprise half of overall sales and provide a reliable source of cash flow to invest in acquisitions or marketing. Additional growth comes from bolt-on acquisitions where it can take drugs being produced by smaller firms and channel them through the company’s wider distribution footprint.

The company recently acquired rights to topical anaesthetic gel Ametop from Smith & Nephew (SN.) for $7.5m and worldwide rights for TyraTech’s (TYR:AIM) head lice treatment Vamousse for $13m.

The deals are expected to boost earnings immediately, with Numis analyst Sally Taylor having nudged anticipated earnings per share for the year to 31 December 2018 up 3% and by another 4% for the following year.

There is the odd fly in the ointment. Nausea treatment Diclectin failed to get marketing approval from the UK’s regulator, the Medicine and Healthcare Products Regulatory Agency (MHRA) in August. This is unlikely to have any impact on financial forecasts in the near term.

Discussions between the drug’s licensor Duchesnay and the MHRA are expected to continue into 2018.

We are reassured by the group’s strong cash flow generation, which is forecast to increase by more than 10% in 2018 to £23.7m based on FinnCap’s forecasts. (LMJ)

Biffa looks undervalued given decent profit growth expectations and operating in a defensive market

We’re perplexed as to why waste management group Biffa (BIFF) trades on such a low valuation given the relatively defensive nature of its business and expectations for sustained profit growth.

Many investors at the moment seem happy to pay price to earnings multiples in excess of 20 for any company that is showing decent growth. It therefore seems bizarre that a company like Biffa is left behind, trading on a mere 13.5 times earnings.

Biffa operates in a structural growth market. An expanding population living longer and in a greater number of houses (and working in a greater number of offices or other business premises) all equates to a greater volume of waste being created.

Exacerbating that situation is increased legislation on the waste industry, such as pressure to reduce items being sent to landfill and ensure more items are recycled.

Biffa is well placed to capitalise on this situation as it collects, processes and recycles waste and it also produces energy, all from the UK.

Stockbroker Numis forecasts pre-tax profit rising by 30% in the current financial year to £58.7m, before reaching £64.9m the year after.

The biggest contributor to Biffa’s group profit is its Industrial & Commercial (I&C) division which provides services to 72,000 customers including retailers John Lewis and Next (NXT). It continues to buy small rival I&C businesses to boost its scale and capacity.

The division enjoyed a 7.4% underlying operating margin in 2017, up from 5.7% in 2016. Margins are improving thanks in part to maximising route density. This involves winning extra work so its trucks are picking up from a greater number of addresses per street which means extra income without lots of extra cost.

Next year should see Biffa decide whether it will build energy-from-waste plants in the UK, in partnership with US specialist Covanta. It believes the UK needs to expand its current infrastructure to convert more rubbish into fuel or energy.

Biffa insists it would only use proven technology should it decide the economics stack up on the projects. It says it won’t delve into the more radical energy-from-waste techniques which have dogged various third party schemes in the UK over the past few years.

The last reported net debt position was £272.2m and its net debt to EBITDA (earnings before interest, tax, depreciation and amortisation) ratio was a comfortable 1.9 times. (DC)

Robust buy-to-let mortgage lending market bodes for Charter Court which is trading on a bargain valuation

We think recent float Charter Court Financial Services (CCFS), which joined the stock market on 29 September 2017, has the ability to hit the ground running as a public company.

It is a highly specialised bank, focusing mainly on the professional buy-to-let market. This sector has traditionally been dominated by private investors. Tax and regulatory changes to buy-to-let rules announced last year now make it less appealing to amateur private landlords and shifting focus to more serious professional operators.

Charter Court fits neatly into the ‘challenger’ end of the market and its closest peer in terms of business model is OneSavings Bank (OSB). Charter Court has some impressive past performance to help it stand out from the crowd; it doubled its loan book in 2015 and again in 2016 with impairments (or bad loans) running at zero.

Aside from buy-to-let mortgages, it also provides second charge mortgages and bridging loans. It has the capacity to grow in this space as more mainstream lenders tend to steer clear of the complex underwriting criteria put in place by the Prudential Regulation Authority.

The company has targeted 20% loan book growth and a return on equity of around 25% in the medium term. If it can hit these numbers then the current valuation looks way too low.

The Wolverhampton-based lender has a higher risk appetite than some of its peers according to Ian Gordon, an analyst at Investec. While banking and risk-taking are not considered a good combination in today’s market, the success in keeping a lid on impairments to date suggests the company is good at managing these risks.

Charter Court is a well-capitalised bank. It has a common equity tier one ratio of around 13% to protect against economic shocks. It operates in a niche part of the market which the large incumbents are not active in, so it has more limited competition.

Although the UK economic outlook is somewhat uncertain, the company is well used to navigating a volatile backdrop having been set up in the teeth of the financial crisis back in 2008.

Investec forecasts pre-tax profit of £109.1m in 2017, £130.6m in 2018 and £159.4m in 2019, demonstrating the impressive growth potential for Charter Court.

Gordon at Investec says he believes investors should at least double their money on a three-year view and he says Charter Court is a ‘shockingly cheap bank’. (DS)

The funeral services group has the expertise to deal with competitive threats

Reports of the demise of Dignity (DTY) are exaggerated and a fierce share price sell-off of the UK’s second biggest funeral services and biggest private cremations provider is a buying opportunity.

We believe the share price weakness in this high quality, cash generative company, renowned for an unrelenting focus on customer service, is overdone.

A dependably solid third quarter update on 13 November revealed 5% underlying operating profit growth to £79.4m year-to-date. It also left full year guidance intact.

However, the statement confirmed the UK’s only listed funerals play continues to see rising competition in funerals and pre-arranged funeral plans.

These are high margin yet unregulated industries attracting new entrants. This is impacting Dignity’s funeral services pricing power, one of the key tenets of the industry consolidator’s bull case.

But under chief executive Mike McCollum, Dignity is pushing for the regulation of the funeral and pre-arranged funeral plan markets.

Hopefully, incoming regulation would stop funeral parlour operators that fail to provide minimum care standards from entering or participating in the market, while also squeezing out those who pursue aggressive funeral plan sales tactics.

Dignity still has attractive medium-to-long term opportunities to consolidate fragmented markets. Highly cash generative, Dignity is able to leverage its strong balance sheet to fund further acquisitions of established funeral businesses, or additional returns of capital to shareholders.

Crucially, it can reinvest the cash generated by the underlying business to regain market share.

Investment in its digital strategy is expected to cost £1m in full year 2017 and could rise in future years, though this looks a sensible spend to develop Dignity’s competitive position online. Dignity is also introducing new, more affordable services to appeal to more price sensitive customers.

As such, we believe Dignity, whose long-run track record of meeting or beating expectations is exceptional, can successfully fight back.

Dignity is still on course to deliver around 8% annual earnings per share (EPS) growth over the medium term, assuming normal mortality trends, despite the fact competition is intensifying.

Broker Panmure Gordon is a buyer with a £27.50 price target for Dignity implying 63% upside. For 2018 it forecasts £83.4m pre-tax profit (2017: £77.4m), rising to £89.9m in 2019.

Estimated 2018 EPS of 135.1p (2017: 123p) is forecast to rise to 145.7p in 2019, with the dividend progressing from 28.5p next year to 31.4p in 2019. (JC)

We think Dixons Carphone has the right skills to bounce back after a troublesome year

We don’t believe specialist electrical and telecoms retail business Dixons Carphone (DC.) will stay in the doldrums for long.

The shares have been hit by a combination of an August 2017 profit warning, signs of fragile consumer confidence and a squeeze on discretionary big ticket spend.

Nevertheless, we think the risk versus reward ratio has improved post half year results on 13 December. Chief executive Sebastian James announced plans to revive the UK mobile business and flagged strong festive sales momentum.

The £2.2bn cap is best known for its Carphone Warehouse and Currys PC World brands, though it also provides an array of business-to-business (B2B) services.

Competitive strengths include enviable electricals and mobile market shares, a leading specialist multi-channel position and deep supplier relationships, which hold the key to clinching market share across the UK and Ireland, Nordics and Greece.

Admittedly, half year results showed a slump in pre-tax profit to £61m (2016: £154m), struck after £58m of UK & Ireland write-downs. There was also a downgrade to the top end of full year pre-tax profit guidance, narrowed to a £360m-to-£400m range, although free cash flow was significantly improved to £169m (2016: £64m).

More encouragingly, Dixons Carphone highlighted market share gains across consumer electronics and white goods and a record Black Friday in all geographies. Cyber weekend best sellers included large TVs, headphones and smart tech products.

James believes ‘we can, over time, reduce the complexity and capital intensity of our mobile business model, and increase the simplicity and profitability of what we do’, potentially implying store closures. Actions to improve profitability while retaining market dominance offer a positive New Year catalyst for the shares.

Carphone Warehouse faces rising competition and handset prices as well as changing customer habits. First-half like-for-like UK & Ireland mobile sales fell 3%, impacted by the delayed launch of
the iPhone X and consumers holding on to handsets for longer.

Numis forecasts a sharp drop in pre-tax profit to £370m (2017: £489m) for the year to April 2018, ahead of a small recovery to £375m in 2019.

Dixons now trades on a low price-to-earnings ratio of 7.6 times with a generous 6% yield. We think the bad news is more than priced in and just meeting these conservative estimates could provide a catalyst for the shares to move much higher in 2018.

If they stay low for too long, we wouldn’t be surprised to see the company become a takeover target. (JC)

A fast-growing technology business with high-quality profit and paying a dividend

People are increasingly shopping online; that means retailers have to find clever ways in which to connect with consumers digitally and drive traffic to their websites. AIM-quoted DotDigital (DOTD:AIM) plays a vital role in this task and we believe 2018 will be another strong year for the company.

DotDigital’s core technology platform, Dotmailer, provides marketers with a cloud- based single solution to design, create, personalise and monitor campaigns. Mainly using email, it has also built extra functionality to include text messaging and social media, such as live chat, Facebook messenger and Apple business messenger.

Importantly, Dotmailer can be easily integrated into a client’s customer relationship management software, plus other third party e-commerce tools. Customers include well-known brands such as Superdry, CNBC, Converse and Fred Perry.

The company is enjoying very strong growth. Revenues have jumped from £12.2m to £32m in five years, but not at the expense of profit. Pre-tax profit has more than doubled to £8.1m over the same spell. Importantly, DotDigital enjoys consistently great cash generation and even pays a modest dividend.

Debt-free, the company had £20m of net cash on the books before its recent £11m acquisition of Cheltenham-based Comapi, which added technology functionality and a bigger footprint in the Far East.

Investors can expect growth, particularly in the US, to accelerate now the company has set up a New York base, and strengthened its existing partner reseller network.

Last year US revenues were £3.9m, just 12% of the group total, which shows the scale of that opportunity, while the Far and Middle East are great target markets.

Recurring income equal to 81% of overall sales last year bolsters reliability of future revenue, while a long trend of driving existing clients to spend more on Dotmailer provides security on tomorrow’s profits.

If there is a potential sticking point it’s the already racy rating. A year-end 30 June 2018 price-to-earnings multiple of 32.3 suggests that a fair bit of excitement is already in the price.

But we can think of many UK-quoted technology companies trading on far heftier ratings, many of them without the growth profile, cash generation or dividends of DotDigital.

In 2017 rankings from research consultancy Megabuyte, DotDigital came in the top 10 of all UK-quoted technology businesses.

We could see the shares hitting levels around 150p over the coming 12 months. (SF)

Potential dividend resumption illustrates how the publisher has regained strength

Investors should back Future’s (FUTR) continuing transition from old fashioned operator in the structurally challenged publishing industry to an innovative global platform for specialist media.

Interest in the story is picking up, helped by the company saying in November that it may restart dividends in the current financial year.

The shares have already responded well in 2017 as the company has got better at making its content pay and we think there is further upside to come.

Future is split into two divisions – Media and Magazine. The Media division, currently around 40% of the business but growing fast, has three revenue streams: e-commerce, display advertising and events.

The Magazine division derives revenue from news trade, subscriptions and advertising. Among the better-known titles in its portfolio are Techradar and Total Film.

Newspaper and magazine publishers continue to struggle with falling sales and have struggled to get readers to pay for their relatively generic content, but consumers have shown a greater willingness to pay for specialist and niche content which they are unable to get elsewhere.

In a recent report on trends in the media sector, consultant PwC noted ‘fans’ spend more and show greater loyalty. Future’s titles, covering topics from films to computer games and photography, are often a conduit between fans and their enthusiasm or hobby.

Taking advantage of this situation, the company aims to monetise a single article through several avenues including e-commerce, licensing and digital advertising.

As well as growing organically the company is looking to buy other publishing assets and applying this same model to them.

Home Interest, a portfolio of home improvement events and magazines, was acquired from Centaur Media (CAU) for £32m in July 2017, part-funded by a share placing at 250p per share. Its integration should help demonstrate to the market Future’s ability to maximise returns from content assets.

Free cash flow increased from just £100,000 in the 12 months to 30 September 2016 to £8.2m in the year just gone and the strong cash generation has helped keep a lid on net debt, which is less than one times earnings. This leaves plenty of scope to pursue further deals and pay a dividend. (TS)

We are backing underdog Johnson Matthey for its potential electric vehicle breakthrough and underappreciated business resilience

Chemicals firm Johnson Matthey (JMAT) is a misunderstood business offering plenty of value to investors bold enough to own a share experiencing waves of negative market sentiment.

We’ve picked the FTSE 100 business for its underappreciated play on electric vehicles (EVs) and significant growth potential from its Health arm. Underpinning this bullish view is the belief that its core emission controls business will be strong enough to cope with any downturn in the diesel market.

Approximately 60% of its sales in 2017 came from catalysts used to reduce emissions from vehicles and industry. There is some concern in the market that a switch to electric vehicles puts this division in terminal decline.

We think that’s being too pessimistic, particularly as the diesel industry is unlikely to disappear completely. Investment bank Morgan Stanley actually believes that Johnson Matthey’s auto catalyst sales will keep growing for at least the next 10 years. It forecasts 4.8% compound annual growth rate over this period. A key sales driver will be stricter emissions regulations in Asia.

Against this backdrop of a potentially more stable business than some investors expect, we’re really excited by the company’s electric vehicle battery technology.

It has developed enhanced lithium nickel oxide (eLNO) cathode material which could disrupt the market. According to Morgan Stanley, the material offers 20% to 25% more energy density and less cobalt compared to nickel manganese cobalt (NMC) cathode materials used in other electric vehicle batteries.

A predicted shortfall in cobalt supply versus demand is likely to push up the price of the commodity. Therefore vehicle manufacturers may favour a battery using technology such as Johnson Matthey’s given the reduced cobalt requirement.

It is worth noting that eLNO is still at the concept stage. Johnson Matthey has patented the technology and is in the process of building a pilot plant. Positive progress will be important to winning the market over and convincing sceptics that it can play a major role in the EV industry.

The Health division could deliver double-digit growth beyond 2020, according to Morgan Stanley. Johnson Matthey is a global supplier of active pharmaceutical ingredients and custom pharma services such as toxicological studies, development and commercial manufacturing of drugs. It has invested over the last couple of years in its European and US manufacturing capacity.

For the group as a whole, pre-tax profit is forecast to rise by 3.2% to £477m in the year to March 2018. (LMJ)

Sage is a reliable FTSE 100 company with accelerating growth and income upside

FTSE 100 constituent Sage (SGE) is just the sort of relatively safe, cash generative, dividend paying company we think investors will chase through an uncertain 2018.

Sage has become one of the UK’s leading software and enterprise tools suppliers. While it is best known for accounting services like payroll and tax processing, it can also bolt on extra functions like human resources and customer relationship management. That might sound dull but these are business critical applications.

That means the company’s typical smaller and medium-sized enterprise customers are sticky, making future revenues very predictable. The Sage model also throws off lots of cash, with surplus funds funnelled into growing dividends likely to yield a respectable 2.2% over the year.

For the year to 30 September 2017 Sage reported £1.31bn of recurring revenue, or 76% of its £1.72bn total.

Now at the end of a three year transition phase, designed to embrace cloud software functionality and bolster recurring revenues, Sage is ready to accelerate growth. The company is aiming for high single-digit organic revenue expansion after several years of low to mid-single digit rates.

Organic growth may be bolstered by bolt-on acquisitions, such as those of Fairsail, Compass and Intacct last year, which helped add clever technology and extend its global footprint.

Margin improvements should mean profit grows faster than revenue. Activities like selling surplus office space and streamlining sales and marketing teams have been done but much of the benefit has yet to shine through in reported figures.

Cross and upselling extra functionality is another avenue, one that should be helped by plans for a single business cloud platform.

The biggest challenge facing Sage is competition. QuickBooks-owner Intuit and MYOB are established while relative newcomers such as Xero and KashFlow are growing fast. Yet the global market is vast with plenty of opportunity to sell to businesses.

Sage’s shares had a decent run in 2017 but we believe there is more upside through 2018 as the market wakes up to the growth story gear change.

With more questions than answers facing investors as we enter 2018 we believe trusted company shares will earn premium valuations. A 25-times price-to-earnings multiple, assuming modest earnings outperformance, could imply a £10 share price before 2018 is over. (SF)


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The Shares team

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The value of your investments can go down as well as up and you may get back less than you originally invested. We don't offer advice, so it's important you understand the risks, if you're unsure please consult a suitably qualified financial adviser. Tax treatment depends on your individual circumstances and rules may change. Past performance is not a guide to future performance and some investments need to be held for the long term.