Time to buy for recovery

Companies that have been particularly badly hammered in the worst UK bear market since 1974 but remain strong enough to take part in a sustained recovery, when that occurs, are coming under increasing scrutiny from fund managers prepared to look beyond current financial and economic traumas. Standard Life Investments, one of the UK’s leading fund management groups, has launched a new UK Equity Recovery Fund, which it says is ‘specifically positioned to capitalise on a potential recovery in market sentiment and any improvement in the economic backdrop’.

Lately approaching the 4,000-point level, the FTSE 100 Share Index is still nearly 40 per cent off its 52-week high, despite a recent rally of nearly 500 points, and more than 40 per cent down from its all-time peak of 6,930.2 at the end of 1999. The more spectacular victims of the financial meltdown, from Royal Bank of Scotland (RBS) – which helped cause it – to Punch Taverns, have shed more than 90 per cent of their market value in less than two years.

In these circumstances, Standard Life’s head of UK equities, David Cumming, and his team are taking a medium-term view. They will eschew hitherto favourite bear market defensive sectors, such as tobacco, pharmaceuticals, utilities and consumer staples, in favour of those market groups poised for recovery, in particular general industrials, support services, general retailers, media, travel and leisure and financials.

Property opportunities
Commercial property is another area of interest to Cumming and his colleagues, who have chosen the venerable British Land group as one of the new fund’s favourites. This company, whose shares plunged from more than £14 to 301.35p between the end of 2006 and early February, has perked up to 373.75p in the wake of a £740 million rights issue at a lowly 225p to strengthen its balance sheet.

Another Cumming favourite is leading European electrical retailer DSG International, which lost £41 million on falling sales in the six months to October and saw its shares collapse from 222p in 2006 to 9.49p in December. They have rallied to 19.75p as the company, with a £400 million committed credit facility, seeks to take £95 million out of annual costs under a plan for ‘renewal and transformation’.

Looking good on paper
Standard Life also sees worthwhile recovery prospects in South African packaging and paper concern Mondi, quoted in London and Johannesburg, whose shares have fallen from £5 to 166.5p in two years after turning a £347 million pre-tax profit into a £93 million loss last year. The group, which was de-merged from South Africa’s giant Anglo American mining and industrial combine two years ago and operates in Europe and Russia as well, is rationalising its business through cost cutting, divestments and closures.

Ben Whitmore, manager of Jupiter UK Special Situations Fund, argues that prospects for recovery shares are ‘a lot better than two years ago. Company profits and values have both come down a lot’.

He adopts the value investment approach originally pioneered by US market analysts Graham and Dodd in the last century and looks at the moving averages of companies’ earnings over ten years. If the stock market’s present valuations of them look historically low on that basis, they are candidates for consideration.

Companies selected in this way must have a quoted life of at least ten years ‘or you would have no feel for how they cope in good and bad times’. Whitmore does not go for sectors as such, but sees potential in companies with good franchises and strong balance sheets whose earnings are down for cyclical reasons.

‘You’ve got to get earnings below trend,’ he explains, ‘otherwise you can get into danger.’ Although Whitmore’s selections are not driven by sector analysis, he says his methods of identifying recovery shares have revealed potential bargains among major oil companies, pharmaceuticals, media ventures, industrials and technology enterprises.

He has not found any mining companies that fit his bill. Of the battered banks, Whitmore comments, ‘They look to be natural recovery candidates, but you can’t as yet get a firm picture of what their balance sheets are going to look like’.

Others suggest the increased role of the government, as bailer-out, guarantor and shareholder of several banks, could also be a complicating factor. For those with nerves to take the plunge, sector watchers rate HSBC, less than half its 895p high at 417.75p, with its finances strengthened by a near £13 billion rights issue, and Barclays, down from 769p to 121.5p, which reported a £6 billion annual pre-tax profit and has been considering significant disposals, with bombed-out RBS at 27p for gamblers only.

Small-cap snips
Other professional investors are looking at companies whose share price declines have taken them out of the FTSE 250 Share Index and into the Small Cap Index, thus automatically taking them out of consideration for some institutions and, in some cases, exacerbating their fall. A striking example in the latest cull was Punch Taverns, Britain’s largest pub company, already an émigré from the elite FTSE 100, as poor fundamental trends in the business combined with a punishing level of debt to wipe away shareholder value.

Punch has managed to hold on so far, though there is little equity left, and the shares, down from £14 two years ago to 41.5p now, still look risky as recovery candidates and might best be viewed as option money. A less risky small-cap newcomer, insulation and construction products specialist SIG, is strengthening its finances with a £341 million placing at a heavily discounted 75p, after a 75 per cent annual pre-tax profits fall to £33 million on turnover up 24 per cent to £598 million.

Analysts at broker J.P. Morgan Cazenove expect SIG to outperform the stock market at 114.25p. The company is paying down debt with the placing proceeds and striving to cut annual costs by £50 million.

A weakness in gas trading dealt a savage blow to the stock market rating of utility support services company Spice, and sent its shares clattering out of the FTSE 250 and into the Small Cap and their value, once more than 130p in 2007, down below 30p. However, overall profits are benefiting from a continuing shift in the company’s business mix towards faster-growing billing and energy operations and, at 55p, City believers think there is scope for further improvement here.

Shares in logistics group Wincanton, another outcast from the FTSE 250 index, have already rallied more than 30 per cent from February’s low, but they are still little more than a third of 2007’s 435.5p high. The company has been cutting costs and reducing capacity in the face of accelerating weakness in areas such as construction, home delivery and recycling.

Wincanton is faring better in other fields, with new business wins in France, Germany and Poland, and from BAE Systems and others in the UK. The company says it expects its 2009 financial performance to be ‘broadly similar to last year’, when it made an underlying £21.4 million pre-tax profit.

Up, up and away
Aerospace and precision engineering concern Hampson Industries continues to show signs of life despite its ejection from the FTSE 250. The company, which more than doubled pre-tax profits to £12.5 million in the six months to September, disturbed the market in February by warning of a subsequent ‘steep reduction’ in its automotive business. Looking ahead, however, Hampson has been building up its higher-margin aerospace composite tooling side and recently spoke of an expanding ‘visible pipeline of potential new business’.

The group, which ended the third quarter of its financial year with £137 million of net debt, continues to make money. Hampson shares, which fell from 207p to 78.5p between 2007 and last month, have perked up to 91p and look a safer bet than many.

European waste management concern Shanks Group, yet another FTSE Small Cap newcomer, is spending £1.5 million on a UK restructuring to save £2 million a year after November’s sharp fall in the value of recyclable materials and a consequent slowdown in business. However, the company, which recently reported ‘satisfactory progress’ on refinancing a £250 million banking facility due to expire in a year, sees
fair progress in its Dutch and Belgian operations, while its shares, though at 67.25p only a fraction of the 281p reached two years ago, have at least bounced somewhat from a recent 46.5p low.

Resource punts
Junior resource exploration and development companies have been among the hardest hit by the stock market fall, wobbling raw material prices and problems in financing their projects. Those that are managing to raise funds and be around for the next upturn could offer interesting speculative recovery possibilities for the brave.

Former AIM darling and Russian gold producer Peter Hambro Mining could fit that bill, after plunging from £17.10 three years ago to 169p last October. With gold production set to rise and short-term indebtedness eased with a recent equity issue, the shares have rallied to nearly 473.75p, helped by the recent strength of gold.

Among the minnows, another fallen AIM star, Victoria Oil & Gas, whose shares collapsed from 263p three years ago to 2.68p a few months back, has bounced to 4p on success in its court battle to uphold its licence to Kazakhstan’s Kemerkol oil field. The rally could go significantly further if the company is able to resume progress.

Down from 63p two years ago to 7.8p now, European Nickel is seeking to raise £4.3 million bridging finance at 6p for its Caldag project in Turkey, having signed a £250 million agreement for funding arrangements with its Chinese partners, Jiangxi Rare Earth and Rare Metals Tungsten Group and China Tianchen Engineering Corporation. This by no means guarantees success, but it is a step in the right direction.