Shift in inflation expectations is driving a new cycle of ‘value rotation’
One way to screen for value investment opportunities is to look at companies whose share prices are trading considerably below lofty highs enjoyed before stock markets around the world crashed in 2008. Most bombed-out stocks will be trading on a low level for a reason but careful research can help you sift out a few golden nuggets.
Our in-depth analysis has unearthed six interesting turnaround stocks from this market filter including aspiring metals producer North River Resources (NRRP:AIM). We highlight the upside possibilities at drug delivery specialist SkyePharma (SKP) and crops-to-cattle counter Agriterra (AGTA:AIM). The market has yet to appreciate how Accsys Technologies (AXS:AIM) has matured from an early stage start-up to a business with rapid revenue growth. We also examine the bounce back potential at resources duo Oilex (OEX:AIM) and Victoria Oil & Gas (VOG:AIM).
Investors who don’t have an appetite for the risk of buying individual equities that have displayed a poor share price performance over the past seven years can still play the turnaround theme through investment collectives. We highlight five funds that specialise in buying out-of-favour companies with the hope they will soon turn good. Our selection includes Investec UK Special Situations (GB00B1XFJS91), M&G Recovery (GB00B4X1L373), Rathbone Recovery (GB00B7FQM503), MFM Slater Recovery (GB00B90KTC71) and Fidelity Special Values (FSV).
Tumbling down
We’ve screened the Main Market and AIM for those companies whose shares have lost 90% or more of their value since the FTSE All-Share peaked on 15 June 2007, shortly before the Great Financial Crisis decimated so many market valuations. Our list, adjusting for share splits, reveals approximately 230 companies have jettisoned 90% of their valuation or more over the past seven and a bit years.
Though the ranks of stocks that have shed 90% of their value contain their fair share of corporate disasters, investors shouldn’t automatically dismiss this collective. Time your entry into an unloved stock to perfection and the share price could rocket, though the challenge is separating out the recovery candidates from so-called ‘falling knives’.
Yes, the 90% club is littered with the detritus of many an entrepreneurial dream, there’s still numerous companies that have the right traits to be compelling recovery plays, particularly if they have been successfully refinanced, restructured or reoriented and now await wider investor recognition.
The very mention of the phrase ‘90% club’ conjures up a certain unique dread in the minds of investors, since its constituents have burned big holes in the wallets of their backers. Members of the 90% club operate across many industry sectors and sport varying market capitalisations, ranging from industry heavyweights that have fallen on tough times to micro caps whose business models have either failed or remain untested and high risk.
These names include credit crunch casualty Royal Bank of Scotland (RBS), the part-nationalised lender bailed out by the taxpayer six years ago. Battling back to health, RBS’ finances are on a firmer footing, yet clouds still hover over the bank as scandals emerge pertaining to past misdemeanours.
Another conspicuous 90% club member is Premier Foods (PFD), the Mr. Kipling cakes-to-Bisto gravy maker, long encumbered by a crippling debt pile which was amassed under the acquisitive hubris of previous management. A major £1.1 billion refinancing package earlier this year included a £353 million equity raise, made up of a £100 million placing at 130p and a £253 million rights issue at 50p, as well as a £475 million bond issue and a £300 million revolving credit facility. Investors need to note that an increase in the number of shares in issue plays its part in Premier’s presence in this list, yet its gearing levels, past history of profits disappointment and what appeared to be an uncertain future have all weighed on sentiment.
The good news is the refinancing has liberated the food producer from its fiscal constrictions and is enabling boss Gavin Darby to invest in growing sales of Premier’s ‘Power Brands’. The bad news is Premier faces the headwinds of still-weak grocery market conditions and downwards margin pressure from an intensifying supermarkets price war.
Other members of the 90% club are a rather eclectic bunch, either with chequered financial histories, uncertain future prospects or recovery narratives which have yet to win a wider audience. They range from Global Brands (GBR:AIM), the pizza business-turned oil and gas investor to Green Compliance (GCO:AIM), the restructured water hygiene and treatment minnow in the process of being bought by clean energy and electronic components business APC Technology (APC:AIM) for £4.8 million. A particularly interesting name is WYG (WYG:AIM), formerly White Young Green, the infrastructure and environmental consultant that has successfully emerged from a long period of financial distress.
Risk-tolerant investors seeking high-octane recovery bets should tread carefully with internet advertising specialist Phorm (PHRM:AIM), a loss-maker with a track record of requiring funds, ditto Eco City Vehicles (ECV:AIM), the Mercedes Vito taxi supplier which has launched a strategic review and flagged a funding crunch.
We’re not surprised to see bombed-out Redhall (RHL:AIM) on the list. The nuclear engineer has been beset by profit warnings and contract timing delays in recent troubled years. New cash has been raised, yet the group’s market backcloth remains difficult, recovery prospects uncertain and Redhall is no recovery bet for widows and orphans.
Turnaround temptations
The reason investors might trawl for opportunities among the great unloved of the 90% club is that turnaround tales can prove particularly rewarding, hence the reason why they are highly-prized by investors. The problem is that spotting a sustainable recovery and avoiding a share that will head into the ground like a dart - a fabled ‘falling knife’ - is no mean feat.
Yet investors who set about doing their homework diligently can be handsomely rewarded. A useful starting point is to look for signs of improvements or stabilisation in what have been poor trading patterns, or for improvements in a company’s cash generation, or the falling debt levels that signify financial risk is diminishing.
Narrowing losses or improving profitability offer powerful catalysts for upside. New management coming in with a clear strategy for turning around the business offers another positive catalyst for a recovery story, since new leaders bring fresh ideas and the energy to make the cultural and operational changes required to turn around the business. (Cont...)
Thomas Cook’s turnaround bonanza
While a rare breed, companies with structurally-challenged business models, stretched balance sheets, difficult trading backdrops and bombed-out share prices can be revived and then some, rewarding investors handsomely in the process. One terrific exemplar is travel agent Thomas Cook (TCG), whose share price went from 333p in June 2007 to 13p in February 2012 after a succession of profit warnings and which was also forced to scrap the dividend to help cut a debt pile north of £1 billion.
Essentially, the tour operator was almost brought to its knees by a toxic combination of a general fall in tourism numbers caused by the global recession and Euro Zone debt crisis, the impact of political turmoil in Egypt and Tunisia on its package holidays as well as rising fuel costs.
The tour operator has subsequently been revived under the leadership of former Premier Farnell (PFL) boss Harriet Green, who took over the business in the summer of 2012 with no experience of the industry, but a conviction she could revive the company. The holiday group in 2013 underwent a major £1.6 billion refinancing to remove a debt wall looming in 2015 when previous bonds were due to mature.
Thomas Cook has been successfully turned around through self-help measures including job cuts and other cost measures, physical branch closures, a focus on internet sales, and non-core asset disposals to simplify the business. In November 2013, full-year figures revealed the business back on a firm profitable growth trajectory - it made a first operating profit for three years - a near-halving of net debt to £421 million, as well as gathering operational cash flow momentum, while interim figures this year (15 May) showed further strong progress. Just before Green joined Thomas Cook, the shares were hovering at 21p, though they’ve since recovered to 124.5p having been higher than 180p earlier this year. (JC)
Harriet Green, chief executive officer of Thomas Cook
(Cont...)
One well-followed and expert proponent of catching ‘falling knives’ with compelling recovery potential is renowned contrarian investor Alastair Mundy, manager of the Investec UK Special Situations fund as well as Temple Bar Investment Trust (TMPL) in the closed-ended funds space. In his book - ‘You Say Tomayto... Contrarian Investing in Bitesize Pieces’ - Mundy writes provides numerous pearls of wisdom on both the huge returns and downside risks of backing bombed-out shares or buying into stocks on a sharp downwards trajectory.
Mundy writes: ‘While we have always argued that it is correct, in general, to catch falling knives, we know that some knives can do serious damage. Over the long term, however, a strategy of buying underperforming shares
has typically paid dividends, as investors have overestimated the default risk in individual companies.’
He also outlines some of the prime reasons why share prices can languish at lowly levels. ‘Typically, the companies that enter our universe (usually extreme underperformers) have up to four problems - cyclical risk, structural risk (perceived or real), balance sheet risk, and specific risk (for example, a company that is struggling even if its industry is not). Usually, the greater the number of problems, the higher the risk the company represents.’
In addition, he writes about the importance of the balance sheet in assessing the viability of potential turnarounds. ‘One approach that can work, even in markets where information is disseminated widely, is to emphasise the importance of a company’s balance sheet in preference to the market’s focus on the profit and loss account. Sometimes the long-term future of a company may appear bright, but the company’s balance sheet might be too weak to guarantee its future. Short-term investors are so fixated on earnings trends rather than balance sheet risk that they may underestimate bankruptcy risk.’ A key lesson from Mundy therefore is that value investors who prefer not to sell on the way down need to factor in bankruptcy risk to their investment horizon and analysis.
Red flags
With the odd exception, most constituents of the 90% club will be high-risk fare, yet there are a number of quick and simple checks investors can run in order to weight the odds in their favour and avoid the all-out disasters.
• Do not be dazzled by headline stories of glorious sales growth in the profit and loss account. Instead, turn to the balance sheet, where companies have to confront harsh financial reality and you’ll find out how much the group has borrowed and when it needs to be repaid.
• Keep a close eye on the cash flow statement, which shows what money has flowed in or out of the company over the whole accounting period rather than the snapshot picture provided by the balance sheet on one half-year or year-end accounting date.
• Declining operating margins, signalling product markdowns or rising costs without an additional boost to profits, or selling by directors at a 90% club stock that has enjoyed a rebound, are further red flags to watch out for.
• Be aware that if a company’s share price has already collapsed, banks and creditors will be unwilling to lend the company more money if its value has slumped.
THE FUND MANAGER’S VIEW
What stocks look like recovery stocks now?
‘We seek companies with either self-help and (or) that are set to benefit from an improving industry backdrop. For instance, we hold Clarkson (CKN), a global, leading shipbroker. Management have improved the quality of the business greatly since the credit crisis - they are now able to engage with clients in multiple markets and become more embedded in the clients’ day-to-day operations. In addition, they are yet to benefit from an upturn in their end markets.’
Are there any specific qualities you look for, or is it different for each equity?
‘Whilst there will be differences to be aware of, especially when assessing companies across industries, there are also similar factors that we seek. For instance, management change can be an important trigger for a recovery story. A stronger management team can often improve the returns of a business, through generating higher profits or bringing about a more efficient capital base, or a combination of the two. Such companies will often see a justified re-rating of their equity, as well as improved earnings momentum. We are also drawn to companies that operate in attractive industry backdrops, but might have had short-term business specific issues, which look set to revert.
In addition, we stay clear of companies that are financially stretched and (or) fail to generate cash.’
What should retail investors be wary of?
‘One of the big no-nos for us is companies that are both operationally and financially-geared. This caught out many companies (and investors) over the recent recession, when profits fell sharply and meeting interest payments became a struggle.’
What are the pros and cons of recovery stocks?
‘When recovery stocks work, they can offer huge shareholder returns, and often for a number of years. Sometimes the recovery can take much longer than expected due to external factors (e.g. tougher economic times) or company specific issues (e.g. cultural change required to improve a company can take years).’
Julian Chillingworth, chief investment officer and co-manager, Rathbone Recovery Fund
North River Resources (NRRP:AIM) 0.82p
Market cap: £13 million
Namibia-based junior miner North River Resources (NRRP:AIM) is our standout pick of turnaround stocks due to a quick payback on its lead/zinc project, Namib. There’s lots of near-term news catalysts for the share price and some very interesting people have stepped in to help finance Namib’s development. We believe North River is in the early stages of a major re-rating.
The business floated in December 2006 at 5p with a polymetallic exploration project in Australia. This was at a time when mining stocks were riding waves of investor euphoria amid the commodities boom. North River saw its share price nearly treble to 13.25p by September 2007. Unfortunately the stock market soon experienced its first market correction towards the end of that year, leading to a full-blown sell-off during 2008, obliterating investors’ risk appetite and resulting in the decimation of mining stocks.
By 2009, resources stocks were in the doldrums. North River struck a deal to buy gold and uranium assets, quickly followed by taking on assets from a fellow AIM-quoted miner. Kalahari Minerals was a rare bright spot in the mining sector thanks to its investment in an Australian company that owned one of the biggest undeveloped uranium projects in the world. Investors only cared about this asset so Kalahari flipped its non-core interests into North River.
For the next three years North River limped along with a Chinese controlling shareholder who failed to engage with the business. The management eventually left at the end of 2012 after all the money had been spent and Martin French took over at the top with the intention of focusing on a single asset sitting unloved in the portfolio, being Namib.
Over the past few years, North River has quietly rebuilt its business. Having hit an all-time low of 0.35p in July 2013, the shares have since more than doubled, but clearly stand significantly below its 2007 heights, even after accounting for a one-for-two stock share consolidation in 2009.
Namib has a relatively low construction cost at $25 million because it used to be an operating mine and still benefits from good local infrastructure. Studies suggest it will only take 1.4 years’ operation to pay back the cost of construction. Yet French reckons he can get the capital expenditure bill reduced quite a bit which would further enhance the asset’s appeal. Zinc and lead are back in favour and Namib is expected to have high operating margins.
The project has recently suffered delays due to an equipment problem, so it didn’t have enough drill data to publish a feasibility study as expected earlier this year. Instead, it published a mine development plan that had economic figures but lacked official resource and reserve data. It meant the company could guide the market on Namib’s potential but won’t be taken seriously until the resource and reserve data is officially done. That’s about to come.
First will be a resource update, potentially by early September, followed a month later by the reserve number and then a full feasibility study can be published. In parallel, it is undertaking detailed implementation planning with the intention of being in production in 12 months’ time.
The equity portion of the construction bill has already been raised via a $12 million deal in July from private equity group Greenstone which will come in stages including a slug of cash at a premium to the current share price.
French says Greenstone, founded in 2013, analysed 300 projects and that North River is the only one to have got funding. Even more interesting is that Greenstone is run by two highly experienced individuals. Mark Sawyer, who now has a seat on North River’s board, used to head up the acquisitions team at Xstrata, the former FTSE 100 mining giant gobbled up by Glencore (GLEN) last year. His business partner is Michael Haworth who ran JP Morgan’s mining team.
North River wants to use Namib as a cash-generating platform from which to grow through acquisitions; having the Greenstone team on board is clearly a priceless relationship.
VSA Capital has a 2p price target for North River, more than double its present trading level. With lots of news on the horizon and a big communications push scheduled for the fourth quarter of 2014, get ahead of the crowd with this turnaround story now. (DC)
Accsys Technologies (AXS) 0.19p
Market Cap: £67.4 million
While Accsys Technologies (AXS) continues to close in steadily on profitability, the company’s progress against the backdrop of a global economic crisis - which hit the construction sector particularly hard - has not always been brisk enough for the markets and, by mid-August 2014, shares in the £67.4 million cap were still 95% off their level when the market peaked in 2007.
Sustainability, performance and cost efficiency are key considerations in the construction business and Accsys certainly seems to tick all three boxes. It transforms softwoods to give them the strength, finish and durability of hardwood products. The group’s showcase product is Accoya Wood, created by its own proprietary acetylation process.
One of the major concerns investors may have had regarding Accsys over the past couple of years has been the Damoclean presence of ongoing litigation with its first major licensee, Diamond Wood China and this plunged Accsys into a €52.2 million loss in 2010. To date, this legal wrangling has cost Accsys €0.7 million and the (albeit faint) prospect of Diamond Wood succeeding in a counter claim for up to €140 million must have weighed on investors. On 25 July, some certainty at least was restored to the situation. The arbitration tribunal ruled that the Diamond Wood licence agreement was to continue in full force and effect but that Diamond Wood could only claim for limited damages (if any) up to a maximum of €250,000.
(Click on chart to enlarge)
But legal vicissitudes aside, the group’s full-year results on 3 July showed a pre-tax loss of €8.2 million which was marginally better than the €8.5 million expected by the likes of stockbroker Numis which maintains the company ‘has matured: it is no longer an early stage start-up. Instead it now has a proven Accoya plant, greatly strengthened intellectual property, powerful future/current partners and increasingly well-recognised brand names.’
(Click on chart to enlarge)
Overall the past financial year, Accsys achieved a dramatic change in its rate of revenue growth with the 78% advance comparing with an increase of mere 25.5% in the previous year. A trading update on 13 August points to a strong start to the first quarter of the new financial year with total revenue increased by 29% to €10.1 million with significant progress on the group’s joint venture with Belgian chemical giant Solvay (SOLB:BR) being the main takeaway. Accoya has been boosted by 19 extra distribution and agency agreements secured, boosting the total to 61, with comprehensive coverage now in place across Europe, the Americas and Asia Pacific. It’s worth bearing in mind that there were only three distributors for the product at the end of the 2008/9 financial year. (SFl)
Agriterra (AGTA:AIM) 1.13p
Market Cap: £13.5 million
Skittishness regarding frontier markets, nervousness surrounding the Ebola outbreak and impatience with losses racked up during a prolonged capital expenditure drive account for the drift at pan-African crops-to-cattle counter Agriterra (AGTA:AIM).
A lack of recent news flow hasn’t helped either, though an eventual move into profits driven by market share gains and the achievement of critical mass could reverse the negative trend. The £13.5 million cap is a play on rising beef demand in Mozambique and a global cocoa shortage. Key divisions carry out everything from cattle ranching to cocoa trading and plantation development to maize farming and milling. In Mozambique, its expanding ‘field to fork’ beef operation integrates ranching, feedlot, abattoir and beef retail operations, a model designed to maximise margins.
Adding extra spice to the story is Agriterra’s brownfield agricultural land suitable for palm oil production in Sierra Leone. Encouragingly, asset-rich Agriterra reported (26 Feb) a 50% decrease in pre-tax losses to $2.1 million for the half-year to November and forthcoming finals could offer reassuring updates on its operations. While a risky recovery bet, Agriterra offers exposure to Africa’s compelling consumer spending theme. (JC)
Skyepharma (SKP) 248p
Market cap: £265.1 million
Momentum is building at inhalation drug delivery specialist Skyepharma (SKP). Higher sales in the first half of the year, milestone payments from the launch of its Flutiform fixed-dose inhaler in eight countries and securing approval in a further four helped push operating profit up 187% year-on-year to £13.2 million.
The company’s success has been hard fought. Since June 2007, 90.8% has been wiped off the value of its shares due to concerns over the size of its debt and Flutiform being dumped by licensing partner Abbott Laboratories (ABT:NYSE) after regulator the Food & Drug Administration wanted more evidence before clearing its sale in the lucrative US market.
This includes developing a new technology, the nature of which could be disclosed at the end of this year, while acquisitions are also playing a part. Skyepharma has bought the rights to an inhaled therapy platform that could produce the world’s first anti-inflammatory treatment for chronic obstructive pulmonary disease, a condition affecting the lungs. Analysts at N+1 Singer forecast £13.7 million pre-tax profit this year, versus a £1 million loss in 2013. (MD)
Oilex (OEX:AIM) 9p
Market cap: £55 million
Net cash: £4.2 million
Shares in Indian tight gas play Oilex (OEX:AIM) may have almost trebled year-to-date but the company is still comfortably a member of our 90% club thanks, in part, to previous disappointments on its Cambay field. The proof of concept Cambay 76H well drilled in 2011 involved the first hydraulic fracturing operation ever carried out in India and encountered a number of problems.
A piece of equipment became stuck down the hole and this complicated a flow rate test. The well was finally suspended in May 2012 and did not generate a definitive result. An independent audit by consultant Netherland Sewell in 2011 identified contingent resources of 37 million barrels of oil and 222 billion cubic feet (bcf) of gas net to Oilex’s 45% interest.
So far the Cambay 77-H well, the company’s latest effort to tap this potential, has been far more successful. RFC Ambrian’s risked net present value per share for Cambay is 7.6p. A successful outcome from upcoming production tests could see that valuation revised upwards rapidly. It is also worth noting that RFC Ambrian’s valuation attributes nothing for the group’s early-stage unconventional assets in Australia’s Canning basin or the deeper potential on Cambay to which Netherland Sewell ascribes prospective resources of 63 million barrels and 421 bcf. (TS)
Victoria Oil & Gas (VOG:AIM) 1.57p
Market cap: £68.7 million
Net cash: $1.1 million
The depressed valuation endured by Victoria Oil & Gas (VOG:AIM) more than reflects the ongoing execution risks associated with its effort to sell gas from its Logbaba project in Cameroon. Over-promising and under-delivering on Logbaba and legacy projects in Russia contributed to a significant fall from grace for the company.
The good news is investors now have a good entry opportunity to a potentially compelling proposition. Logbaba is a gas and condensate field located in close proximity to Douala, Cameroon’s largest city. An independent audit in October 2010 estimated it contained proved and probable (2P) reserves of 212 billion cubic feet.
The fundamentals behind the development look sound since Victoria, as the sole onshore gas producer in Cameroon, is able to charge its industrial customers between $12 and $16 per million cubic feet (mmcf) of gas. At the beginning of August the company completed a borehole under the Wouri River in Douala opening up the Bonaberi district of the city as a potential new market.
Northland Capital identifies three so-called ‘big bang’ events which could transform the economics of the Cameroon business: the commissioning of a nearby cement plant; supply to local power stations and conversion to compressed natural gas. (TS)
Trading a recovery via investing in funds
Investors can scour the market’s legion of fallen firms for recovery stocks and trust their own investment acumen. However, less experienced, risk-averse investors could instead look to invest in professionally-managed funds, whose managers have pedigree in making contrarian calls. Key advantages of investing in recovery stocks via funds is that they enable you to spread your risk and not be reliant on any one company.
The £1.3 billion Investec UK Special Situations (GB00B1XFJS91) fund is heavily weighted towards large firms, so it would be fair to say that the risks are much lower than investing in a basket of troubled micro caps. Key holdings include GlaxoSmithKline (GSK) and Direct Line Insurance (DLG).
M&G Recovery (GB00B4X1L373), a £6.4 billion open-ended investment company (Oeic), is managed by bargain hunter Tom Dobell who seeks capital growth from companies that are out of favour, in difficulty, or whose future prospects aren’t yet recognised by the market. As at 31 July, its top 10 included the likes of oil giant BP (BP.) and banking behemoth HSBC (HSBA), as well as Solero ice cream-to-Flora margarine maker Unilever (ULVR) and low-cost carrier EasyJet (EZJ).
Rathbone Recovery (GB00B7FQM503) is an £81 million unit trust whose manager Julian Chillingworth looks to buys stocks where he believes recovery potential isn’t appreciated by the market. He looks to sell once that potential has indeed been recognised. Key holdings include Synergy Health (SYR), engineering service group Renew (RNWH:AIM) and media giant WPP (WPP).
Other vehicles through which to obtain exposure to recovery stocks include MFM Slater Recovery (GB00B90KTC71), the £32.7 million UK unit trust managed by well-followed stockpicker Mark Slater. Leading portfolio positions include the likes of document storage play Restore (RST:AIM), aircraft leasing business Avation (AVAP:AIM) and international photo booth operator Photo-Me International (PHTM). The fund has returned a cumulative 22.9%, 29.1% and 96.7% over the past one, three and five years in an environment where recovery investing hasn’t been flavour of the month.
In the investment trust universe, Fidelity Special Values (FSV) is one all-cap collective which enables investors to tap into a portfolio of companies which are unloved at the time of purchase. Its manager is value investor Alex Wright, also in charge of the near-legendary Fidelity Special Situations (GB00B88V3X40) fund.
Wright looks for companies where he sees limited downside risk. He seeks to invest in businesses which are either exceptionally cheap or boast an asset such as intellectual property, or inventory, which should stop the share price falling to below a certain level. Wright also wants to buy into unrecognised growth potential, constantly scouring the market for events that could boost a company’s earning power but aren’t as yet reflected in the share price.
Key holdings in Fidelity Special Values include stockbroker Brewin Dolphin (BRW), Irish logistics group DCC (DCC) and niche retailer Games Workshop (GAW).
