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Time to buy: 4 value stocks that won’t stay cheap for long
With ‘value’ investing still in the ascendancy in global markets, and with UK stocks still trading at a hefty discount to their international peers, we have screened the FTSE All-Share index for cheap stocks which we believe offer significant upside potential.
As well as looking at straightforward price to earnings ratios for the next 12 months, we have included returns on capital – in order to weed out stocks which make perpetually low returns – and gearing, or net debt to earnings, to make sure that we aren’t including stocks which may look cheap on earnings but have lots of debt (and debt servicing costs) hanging over them.
UK ‘HISTORICALLY CHEAP’
By way of background, according to data compiled by Fidelity from MSCI and IBES, the UK is not only outstandingly cheap relative to other markets using forward price to earnings multiples but it is well within its 10-year range whereas global stocks are trading at a significant premium and US stocks are trading at one of their highest premiums in history.
In our last scan for value stocks in mid-February – when global markets were hitting all-time highs, as they are again this month – we flagged the worst-performing stocks and sectors and picked three companies we thought were being mispriced by the markets, Beazley (BEZ), Bellway (BWY) and Micro Focus (MCRO).
So far two of those ideas, Bellway and Micro Focus – which we put at the more ‘risky’ end of the spectrum – have played out well, gaining 22% and 19% respectively compared with a rise of just 3.5% in the FTSE All-Share index. Ironically our ‘safe’ recommendation at the time, insurer Beazley, has lagged the index, which says a great deal about the market’s mood.
With investors seemingly in ‘risk-on’ mode therefore, we have steered clear of traditional large-cap value stocks like tobacco-maker Imperial Brands (IMB) and grocery chain Morrisons (MRW), which are cheap on our measures but lack a clear catalyst for a re-rating. Moreover, in the case of Imperial there are obvious ESG concerns and we would rather choose a stock with tailwinds than one with headwinds.
The importance of a catalyst is key – without a reason for other investors to change their mind about a stock it could remain undervalued almost indefinitely.
What follows is a selection of names which genuinely look ready to re-rate but which come with varying degrees of execution risk.
FOUR TOP VALUE PICKS TO BUY TODAY
DFS Furniture (DFS) 270.5p
While shares in DFS Furniture (DFS) have rallied from their pandemic lows, the cash-generative sofa seller is inexpensive on a forward price to earnings ratio of eight times with a 6.3% yield based on broker Numis’ current year estimates.
The key re-rating catalyst for the UK’s clear living room furniture leader is the reopening of non-essential retail in England (12 April), which should see sofa buyers return to its showrooms in droves, as well as a hoped-for pick-up in orders deferred by extended lockdowns.
DFS did enjoy a surge in online sales during the pandemic, yet management also observed strong levels of pent-up demand on reopening stores after previous lockdowns and expects to benefit from the release of pent-up demand once showrooms reopen.
DFS should also profit from positive market conditions during the rest of 2021 thanks to the continued shift to spending on the home caused by the pandemic. Numis forecasts a swing from losses to pre-tax profit of £110 million in the year to July 2021 for earnings of 33.9p and a near-17p dividend, with profit of £80 million, earnings per share of 24.4p and a 20.7p dividend pencilled in for 2022. (JC)
Smiths News (SNWS) 36.5p
Smiths News (SNWS) is the UK’s largest wholesale distributor of newspapers and magazines, with 24,000 customers nationally and a 55% market share.
The firm maintained a full service during the second lockdown in November, and has operated without a hitch in the recent UK-wide restrictions as its markets haven’t experienced the same big drop in demand as during the first wave of the virus.
Therefore, the company expects earnings before interest, tax, depreciation and amortisation for the first half to the end of February to be around £20.5 million, and the board is even contemplating reinstating dividends. This doesn’t look to be reflected in a forward price-to-earnings ratio of just 4.1.
As footfall returns to high streets and people start travelling again, sales should see a significant increase, coupled with publishers planning to raise prices to make up for lost sales, which feeds through to Smiths’ revenues.
Meanwhile, the firm is a bona fide ‘green’ story since as well as delivering supplies, Smiths collects and recycles returns making it part of the ‘circular economy’. (IC)
TI Fluid Systems (TIFS) 290.5p
This automotive industry supplier has seen its stock jump nearly 20% in 2021 as investors bet on a rapid Covid recovery for car makers and their supply chain partners.
Providing crucial components for vehicle fuel systems, TI Fluid Systems (TIFS) is held in high regard across the industry and is widely considered to be among the leaders in its field, with customers reading like a who’s who of global vehicle manufacturers, including Ford, Volkswagen, BMW, Mercedes-Benz, Toyota and more.
Its shares trade at an unfair discount to the wider sector on many metrics, such as price to cash flow, price to book and price to earnings. The latter’s rolling 12-month figure of 12.7 stands against the sector’s 13.2, according to Refinitiv data, while the five-times enterprise value to earnings before interest, tax, depreciation and amortisation is less than half its peers.
We believe these valuation ratings will play catch-up as TI Fluid continues to spell out its move into electric vehicles, which represented half of new contracts wins in 2020. (SF)
WPP (WPP) 943.8p
Advertising giant WPP (WPP) may have recovered the majority of its pandemic losses but the shares still look inexpensive as chief executive Mark Read continues the turnaround of a business he took over in 2018 following the acrimonious departure of founder Martin Sorrell.
Based on consensus forecasts the shares trade on a price to earnings ratio of 13.6 for 2021, falling to 11.8 for 2022 and it yields 3%.
The catalyst to unlock this value is continuing self-help and the reopening of the global economy which should be accompanied by an uptick in advertising spend. Structural challenges, whereby the big social media giants like Google and Facebook cut out the middlemen agencies like WPP, will likely be tempered by the importance of issues such as ensuring advertisements don’t appear alongside extremist or offensive content.
The focus has been on simplifying what had become a rather unwieldy business with lots of moving parts, improving co-operation between different bits of the wider group as well as reducing debt and investing in technology. (TS)
Where are fund managers finding value?
Alex Wright, lead manager of Fidelity Special Values (FSV), is a self-confessed contrarian who likes finding unloved companies with potential for positive change.
‘Positive change is key, otherwise cheap stocks will stay cheap,’ says Wright, citing telecoms, utilities and oil as sectors where valuations are undemanding but the long-term growth outlook is at best for zero growth or at worst for negative growth.
Meanwhile, where others might argue mining and personal goods are attractive, Wright finds no value in either sector and is underweight both relative to the benchmark.
Included in his portfolio are insurers Aviva (AV.) and Legal & General (LGEN), support services firms such as Serco (SRP) and DCC (DCC) and specialty retailers such as Dixons Carphone (DC.) and Inchcape (INCH).
Signs of change are already clear at Aviva, under new chief executive Amanda Blanc, but Wright believes the market has yet to appreciate the changes under way at Dixons Carphone and Inchcape.
Nick Purves and Ian Lance of RWC Partners, who recently took over the management of Temple Bar Investment Trust (TMPL), are firm believers in the excess returns value investing can produce over the long term and look for good-quality companies with strong cash flows which are temporarily mispriced by the market.
As of the end of February the fund’s top 10 holdings included energy stocks BP (BP.A) and Royal Dutch Shell (RDSB), banks NatWest (NWG) and Standard Chartered (STAN), media firm ITV (ITV) and general retailer Marks & Spencer (MKS).
Simon Gergel, manager of The Merchants Trust (MRCH), says he is finding value in general financials, certain industrials, media, tobacco and companies linked to the home environment such as housebuilders and furniture suppliers.
‘We’re trying to buy good businesses that are lowly rated for their own prospects, so we’re not totally dependent on the whole value/growth cycle turning,’ he adds.
While the portfolio also includes the oil and gas majors in its top 10 holdings, Gergel admits the value case for energy stocks is ‘not as compelling as it was a few month ago’.