Shares digital

If you can keep your head while all about you are losing theirs, there are profits to be had. Russ Mould trawls for the stocks which look oversold after July’s heavy sell-off

It is the goal of every investor: unearth an unloved, forgotten or simply oversold stock, snap up some shares while no one else is looking and then watch them fly once the market suddenly wakes up and spots the same story. The current equity bear market environment may not appear ideal for such a contrarian strategy but the day-to-day volatility can in fact be a terrific help.

Just one week’s frenetic trading – from Wednesday 16 July to Wednesday 23 July – shows how it can be done, as a bagful of FTSE 350 stocks yielded terrific returns. Newspaper publisher Trinity Mirror soared 40% after chief executive Sly Bailey fiercely rebutted analyst reports the company was on the verge of breaching its debt covenants and forced funds who had shorted the stock to run for cover and buy it back. Quintain Estates & Development shot up 27% after small cap peer Minerva became the subject of a bid approach and highlighted low valuations in the bombed-out real estate sector. Pubs group JD Wetherspoon’s shares rose 17% as investors continued to digest a trading update from earlier in the month, which had shown trading to be better than market expectations.

These are returns worth having in any market, let alone a bear one, and they even helped stimulate a broad rally in the headlines indices, as the FTSE 100 and the FTSE 350 each ripped up by 4% in just four days. In all three examples, the stocks had been among the worst performers in the FTSE 350 before their rally: Trinity Mirror had plunged by 89%, Quintain 87% and JD Wetherspoon 69% respectively. Shares has therefore sifted through the bottom 10% of the FTSE 350 index to help investors identify both those stocks to buy for an overdue – and profitable – bounce and the lost causes which must still be avoided.

Tales of woe

Over the past year the FTSE 350 index has fallen by 20%, slightly underperforming the headline FTSE 100’s 19% slide and matching the broader FTSE All-Share. As illustrated by the table (see table below left) the bottom 10% of the FTSE 350 has fallen by at least 60% over the past 12 months, providing investors with some gruesome returns.

Even a brief glance down this list of 35 waifs and strays reveals some clear trends.

• Exposure to the mortgage, construction and real estate melt down. After a massive boom which stretches back all the way to the early 1990s, the UK property bubble has well and truly burst. It is little wonder names such as real estate agent Savills, commercial property developer Mapeley, house builders Barratt Development and Taylor Wimpey and

mortgage lender HBOS are down among the FTSE 350’s dead men.

• Exposure to the consumer. Consumer stocks have collapsed as consumer spending has begun to flag. The UK’s population faces a savage squeeze on real incomes as house prices fall and the costs of food and fuel rise. Retailers such as Marks and Spencer, pub group JD Wetherspoon and lenders such as Bradford & Bingley have all caught the backlash, and the situation could get worse yet as the number of companies cutting staffing levels continues to rise.

• Structural challenges. Whereas the woes of tool hire firm Speedy Hire and vehicle hire expert Northgate are related to a cyclical downturn in construction activity, in the UK or abroad, some firms have even bigger challenges to face. The media sector has been an appalling underperformer since 2000 as advertising spend and content have moved online. Media groups such as Trinity Mirror and Johnston Press have found growth hard to generate and suffered a grinding de-rating.

• Balance sheet, cashflow and dividend worries. Royal Bank of Scotland, HBOS and Bradford & Bingley have all approached the market to repair shattered balance sheets. Financial worries have also hammered sentiment towards Punch Taverns whose market valuation has collapsed 82% to just £668 million under a £4.8 billion debt burden. Dividend cuts to preserve cash flow and bolster balance sheets have also hit home. Wolseley’s shares suffered ahead of last week’s axing of the final dividend payment.

Enough is enough

Despite these lurid tales of woe, a number of the FTSE 350’s bottom decile have already enjoyed sharp rallies. In the past fortnight alone, Barratt Developments, Northgate and Taylor Wimpey have all enjoyed one-day upward moves of at least 10%. Since market volatility is unlikely to subside over the summer, further trading opportunities are sure to present themselves. A bear market may not seem the most helpful environment for making a fast buck, but it does open up several potential avenues for profit.

Firstly, panic selling can create the perfect opportunity for a contrarian punt on a stock which has been flattened by the herd. It only took a trading statement from JD Wetherspoon to reveal a meagre 0.4% rise in 11 week like-for-like sales to drive the firm’s shares up by 34% in early July. If a firm’s business fundamentals remain sound, it could have been oversold by now.

Secondly, short covering and sharp market rallies can drive the shares up and help the shrewd investor close out to lock in a welcome profit. Despite their woeful performance over the past 12 months, no fewer than nine of our 35 FTSE 350 laggards still feature in the Euroclear data for most borrowed shares. Since short sellers have to borrow a stock before they pull the trigger, this is a guide (though not a perfect one) to which stocks have been most aggressively shorted. Any glimmer of good news from a stock, or news simply less bad than feared, could prompt the shorts to panic and close out, creating a technical wave of buying. This was in evidence not just in the UK during last week’s broad market rally, but also in the USA, where the Securities and Exchange Commission (SEC) last week introduced new restrictions of short selling, particularly on financial stocks. As US markets rallied by nearly 5% in three days (16 to 18 July) and the SEC edict last Thursday (17 July), American weekly financial journal Barrons notes the 150 stocks with the heaviest short interest rallied 15%, while those with with the smallest short positions eked out average gains of just 2%.

Thirdly, such has been the weight of selling, a firm’s valuation may prove sufficiently compelling to tempt out a buyer and help the contrarian investor really hit the jackpot. Alliance & Leicester soared 53% on the day (14 July) Banco Santander’s £1.3 billion bid went public. Shares in Moneysupermarket.com jumped 22% last week (23 July) when the firm announced chief executive officer, and majority shareholder, Simon Nixon, had received and rejected an unsolicited bid approach.

Finally, broader bear market rallies can also help all boats rise with the tide. During such spikes it is often the stocks which have been sold off hardest during the downturn – usually the ones with the biggest problems – which rally the hardest. This was certainly the case during the 2001 to 2003 bear market. Although technology stocks crashed out of favour and took the markets down, when investors decided the bad news was all priced in, at least short term, it was those same downtrodden techs which helped drive the markets back up, at least temporarily.

The most startling example of this came in early 2001 when then US Federal Reserve chairman Alan Greenspan unexpectedly cut interest rates and the tech-laden NASDAQ tore up by 14% in one day (3 January 2001). The FTSE 100 also enjoyed its rallies. Even though the last bear market bit hard in 2001, when the FTSE 100 fell by 16%, the UK’s headline index still enjoyed rallies of 12% between March and May, and 21% between September and December. That second tear took the FTSE 100 to 5,370 and enabled nimble traders to make big gains, even if the index did not trough until 15 months later at 3,287 in March 2003.

Money money money

Just one week of wild trading has proved careful analysis and a cool head can turn contrarian investments which go against the current market wisdom into quick profits. Nor is it too late to get involved. Just one of the worst 35 FTSE 350 performers over the past 12 months – Mitchells & Butler – has made it into the list of the best 35 performers over the past month (see table page 15). Shares has therefore drawn up a list of five criteria to help investors spot which depressed, unloved stocks will be the next to rally.

1. Sound business model

Many of the woes suffered by the 35 market laggards are cyclical in nature, even if the lax credit conditions which did so much to bolster banks, real estate, construction and consumer-facing firms during the earlier part of this decade are unlikely to be repeated for many years to come.

However, media stocks such as Yell and Johnston Press do face severe structural challenges as the internet mulches up their business models. Tech stock CSR faces rising competition from US giants such as Broadcom and could lose further share in the Bluetooth chip design arena.

This leaves a select handful of firms, including JD Wetherspoon, where its price-competitive beer and food offering is perfect for these cash-strapped times, and property developers such as Quintain and Mapeley, whose woes are ones of cyclical timing rather than anything worse.

2. Solid balance sheet, cashflow and dividend cover

Panic surrounding Trinity Mirror’s debt covenants may have been overdone, but a lot of the bottom 35 performers have done so badly because they are perceived to be financially weak. Mitchells & Butlers did not help itself here when it came a cropper trying to embrace the ‘operating company-property company’, or ‘Opco-Propco’ fad which obsessed the market last year as investors insisted companies make their balance sheet ‘more efficient’. In January the managed pub chain unveiled £274 million in losses related to a failed property venture.

High levels of net debt and financial gearing are not a problem on their own, so long as cashflow is good and interest cover healthy. Solid cashflow would also boost confidence in some of the dividend yields on offer from the 35 unloved stocks, which on the basis of last year’s payouts run into double digits at Cattles, Debenhams and DSG International to name just three.

3. Valuation

Even after the crunching 60%-plus falls all of these stocks have suffered, not all of them are guaranteed to be cheap. Banking stocks may look cheap on 2009 earnings forecasts, but that assumes the forecasts are accurate. Royal Bank of Scotland does look appealing on a price/earnings ratio (PE) of 5.2 times for 2009, but that assumes a 35% rebound in 2009 earnings per share (EPS). At least consensus forecasts for Bradford & Bingley – a 35% plunge this year and a further 32% drop in 2009 – look more sensible.

After all, the UK is probably a year behind where the US economy is and non-performing loan ratios are starting to rise sharply over the pond, particularly among the regional banks. Low PE ratios based on sensible forecasts, low double-digit market capitalisation to sales ratios and price to book ratios below one times are the ideal, as all suggest valuations are near rock bottom.

4. Bid candidate

A corollary of any valuation which is seen to be unduly depressed for whatever reason – the economic cycle, poor market sentiment or even hedge funds shorting – is a predator could appear. Alliance & Leicester has already fallen prey to Spain’s Banco Santander, which had tried to bid for the mortgage lender last year at much higher prices. Even HBOS’s name was put in the frame by the market rumour mill last week.

5. Heavily shorted

HBOS might not quite feature in Euroclear’s list of most heavily borrowed stocks but the Financial Services Authority’s (FSA) feeble rules on shorting do at least mean major short positions – above 0.25% of the shares outstanding – can be tracked more easily. According to releases on the Reuters News Service, as of 23 July, nine hedge funds had declared short positions, equivalent to 5.7% of the share count. It is little wonder the shares shot higher as bid talk emerged last week, as a so-called ‘short squeeze’ on the stock could have easily puffed it higher as the shorts bought back their positions.

High octane, high risk

Bottom-fishing the market can be high-risk game. While some of the worst performers within the FTSE 350 do look oversold, some have done badly for a very good reason – and that is before the now nationalised Northern Rock, a former FTSE 100 stock, gets a mention. Some of the bottom 35 will continue to flounder, as a deteriorating economy and poor balance sheets depress both operational performance and sentiment towards them.

The old market saying ‘never catch a falling knife’ has stood the test of time so in addition to highlighting three stocks which look ripe for a bounce, Shares has also picked out three which investors should continue to shun. After all, it is very hard to argue with the logic of another market adage: ‘What is the definition of a stock which has fallen by 90%? One which has dropped by 80% – and then halved again.’

BUYS

HBOS 271p

2009 PE: 4.9

2009 EPS growth: -2%

2009 yield: 9.02%

Price/NAV: 0.7

HBOS is an unloved, heavily shorted stock operating in a sector ripe for cross-border consolidation. It is therefore an ideal candidate for a contrarian rally, not least as the US banking sector soared by nearly 50% in a week after results from Wells Fargo. This is not to say HBOS operates in a good market or has healthy trading prospects, since the picture for the UK mortgage market is grim. But HBOS could still be primed for a ‘short squeeze’. After all, surely all the rights issue underwriters, Morgan Stanley and Dresdner Kleinwort, have to do is withdraw the borrow to prevent hedge funds from shorting and force them to buy back their positions.

JD Wetherspoon 208p

2009 PE: 8.2

2009 EPS growth: 1%

2009 yield: 6.5%

Net debt/equity: 278%

Wetherspoon’s shares shot up by 34% after July’s trading update unexpectedly revealed like-for-like sales growth but there should be more to go for, as the firm’s low-priced beer and food offerings are perfectly positioned for a slowing UK economy. A prospective PE of barely eight for 2008 prices in a lot of bad news, especially as earnings estimates look sensible, calling for an 11% drop this year and a 1% rise in 2009. A prospective 6.5% yield looks secure and, better still, the stock is also heavily shorted, with 21.6% of shares traded through CREST on loan.

Quintain Estates & Development 162p

2009 PE: n/a

Price/NAV: 0.3

2009 yield: 7.7%

Net debt/equity: 69%

The property firm’s net asset value fell 12% last year to 584p and although further falls are likely as the market softens further a price/net asset value (P/NAV) ratio of 0.3 times looks to account for this risk. Quintain’s exposure to less cyclical sub-sectors, such as student accommodation and healthcare, should help insulate the £242 million cap from the worst of the downturn. Nor is a net debt figure of £516 million an undue burden since Quintain successfully refinanced in March, when it obtained £620 million in new facilities, a figure it subsequently topped up by a further £95 million. The 160p per share bid for Minerva by Limitless valued the target at 0.5 times its last stated NAV of 306.2p and focused attention on depressed property stock valuations. Quintain was itself the subject of a takeover speculation last summer.

SELLS

DSG International 43.5p

2009 PE: 8.3

2009 EPS growth: 0%

2009 yield: 9.7%

Net cash/equity: 6%

The specialist electrical retailer has to combat not only weak consumer spending but also the rampant threat of the internet. Chief executive John Browett’s five-point turnaround plan was widely regarded by analysts as a damp squib when it was unveiled a month ago (26 June) and despite cost-cutting programmes, consensus estimates of flat earnings in 2009 look optimistic. A yield of 9.7% is an attraction but the dividend was cut from 8.8p to 5.5p last year and is expected to fall at best to 4.2p this year. Even then cover is thin at 1.3 times, although the balance sheet is net cash.

Marks & Spencer 252.3p

2009 PE: 8.6

2009 EPS growth: -11%

2009 yield: 8.4%

Net debt/equity:157%

Stuart Rose may have coaxed the high street chain into achieving £1 billion in profits last year but this figure does not look likely to be repeated for some time. Consensus estimates call for a 24% drop in EPS this year and 11% next, but M&S faces a terrible squeeze as consumers trade down. A bid cannot be ruled out entirely, as Philip Green has coveted the group since 2004 but M&S’s £4.3 billion market cap means it will not be easy to raise the required finance. The yield looks enticing but cover of 1.4 times is skinny and any talk of a dividend cut would badly puncture the share price.

Northgate 381.5p

2009 PE: 4.8

2009 EPS growth: -3%

2009 yield: 8.1%

Net debt/equity: 224%

If even mobile telecoms giant Vodafone has to blame the slumping Spanish economy for a disappointing trading update, then Northgate really does have its work cut out. The van rental operator derives a large chunk of its revenues from Spanish construction firms and a casual glance at the share prices of Madrid-quoted construction, materials and real estates firms such as Sacyr Vallehermoso, Cementos Portland Valderrivas and Metrovacesa (see chart opposite) confirms this is trouble, as Spain suffers its own property bubble bust. The UK is hardly likely to see trade improving either and earnings forecasts for 2009 look too optimistic. The balance sheet is heavily indebted, and the rising value of the euro against sterling has exacerbated this, although there is more funding headroom and interest cover exceeded three times last year.