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Investors are racing to own previously-beaten up stocks in the hope that a Covid vaccine will improve corporate earnings prospects
Thursday 03 Dec 2020 Author: Ian Conway

With markets jumping last month on a combination of clarity over US politics and hopes of a vaccine-led economic recovery, unloved value stocks have rallied more than most.

Many, like banks, energy and travel stocks, still face major headwinds even if their businesses are ever to return to anything resembling normal.

Meanwhile, there are a handful of stocks which are just as cheap and unloved, but which have worked hard during the pandemic to improve their businesses yet aren’t feeling the same amount of love.

Here are three which we believe are worth buying as high-risk but potentially high reward trades. They are not suitable stocks for anyone who cannot afford to lose money.

CAPITA’S COMEBACK?

Companies don’t come much more unloved than Capita (CPI), whose shares are still down 70% this year and more than 90% below their 2015 highs, even though they have doubled from their October lows.

The firm’s dramatic fall from grace came after repeated profit warnings due to provisions for poorly performing contracts and write-downs on assets and disposals. In retrospect, the inflated levels of accrued income and prepayments on the balance sheet should have been a warning that asset quality was deteriorating.

After a £700 million rights issue in 2018 and a thorough review of underperforming contracts, the firm has made good progress although there is still more work to do.

This year was set to be a pivotal period for Capita when it expected to see revenue growth and sustainable cash flow. Instead, the firm has had to manage its way through the crisis, although the pandemic has forced it to accelerate certain strategic decisions such as the sale of its Education Software Solutions business.

Covid is likely to continue to negatively impact revenues and transaction levels, and the inflection to sustainable cash flow generation has been delayed by one to two years, but the firm continues to win local and central government contracts and a stronger balance sheet will improve market confidence.

It’s clearly not a stock for widows and orphans but having made it through the pandemic Capita isn’t going bust, yet it trades on just six times 2022 earnings forecasts. It meets the definition of a value stock and could see further share price appreciation in the coming weeks and months if value remains in fashion, but this is one for brave investors only.

BABCOCK’S APPEAL

Engineering services and support firm Babcock (BAB) isn’t a stock for widows and orphans either – nor will it feature on any ESG lists given its heavy reliance on UK and US defence spending. But like Capita it has had to take a hefty dose of self-help to see it though Covid.

While customer demand held up in most businesses due to the mission critical nature of its services, the civil aerospace market was predictably weak and the UK Government’s decision to insource management of the Magnox and Dounreay nuclear facilities was an unexpected hindrance.

Higher health and safety costs during the pandemic impacted margins and led to a 55% drop in reported operating profits for the half to the end of September, but cost cuts and disposals allowed the firm to keep gearing around two times, out of the danger zone.

In addition, orders continued to roll in with wins including the Dreadnought submarine programme, the Nuclear Technical Support contract at the Clyde naval base and an extension to the Met Police fleet management contract. There is also potential for growth in new markets, with the firm having received considerable overseas interest in its Type 31 frigate platform.

Shore Capital sees the first half representing the low point in performance, while further restructuring, balance sheet strengthening, and contract news should stoke investor interest. On eight times 2022 earnings, expectations seem sufficiently low to make it a worthwhile bet.

M&S LOOKS THE MOST APPEALING OF THE THREE

Finally, Marks & Spencer (MKS) should be on investors’ shopping list. Like Capita and Babcock, its shares have popped since the news of a vaccine but considering where they were 18 months ago and given how much the business has improved, they are still a bargain.

Were it not for lockdown, earnings per share for the year to March 2020 would have been around 15% higher than reported (19p vs actual 16.7p). At the current share price of 130p, the shares are trading on less than seven times ‘normal’ earnings.

Analysts at Morgan Stanley and Shore Capital value M&S’s 50% stake in the retail joint venture with Ocado (OCDO) at more than £1 billion. As Morgan Stanley points out, strip out the Ocado stake and M&S trades on four times ‘normal’ earnings.

As important, the pandemic has energised M&S management to deliver three years’ change in one. The clothing and home division, which was shut in-store during both periods of lockdown, has grown its market share online and new head Richard Price – a former M&S man before he ran the F+F clothing brand for Tesco (TSCO) – is accelerating its transformation.

With shopping likely to be frantic online and in-store this Christmas, and with the possibility of life returning to ‘almost normal’ next year, M&S shares have significant upside potential.

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