Looking beyond the FTSE100

Friday, 12th October 2012 12:27 - by David Harbage

By popular demand, more on individual stocks..

In the previous two blogs we highlighted ten individual UK listed company shares which the writer considered to be cautious (featuring defensive, economically-resilient business activities, accompanied by undemanding valuations), followed by ten which were perceived to be more aggressive - by reference to cyclical businesses apparently exhibiting higher inherent growth and, as might be expected, priced accordingly via a premium rating to the wider market.  All represented leaders, be it domestically or more commonly on a global basis, in their respective niches or industries.

Looking beyond the FTSE100

The case for smaller sized businesses has already been made in earlier educational articles, and the writer appreciates that many readers have an interest in companies which offer the potential of being the industry leaders – if not ‘blue chips’ in quality terms - of the future. Less well researched by the major investment institutions (both ‘Sell side’ and by fund management houses), often because their clients wish to takes stakes (of meaningful influence) or invest minimum sums (typically north of £10 million), or are otherwise inhibited because of listing or particular index membership, this provides an opportunity for private client investors.

10 interesting businesses

Accordingly, this week’s blog features ten company stocks which the writer believes (and, in some cases, incidentally, owns) merits further investigation. As frequently advised, every investor should carry out their own due diligence; these stocks are not intended to be a suitable recommendation to any one reader but rather are ‘for interest only’ which may prompt further debate – as is evident from looking at the Share Chat on LSE.co.uk – and personal research. A lack of space and time allows mention of only ten companies, whereas the writer would recommend that vital diversification should begin with a collective (such as Exchange Traded Funds) before extending – where a segregated portfolio of individual company names is sought - to a minimum of at least twenty businesses, across a broad range of industry segments and geographic regions.

Valuing immature growth businesses

The key to having confidence in highly valued or rated (apparent because they may be in start-up, investment rather than dividend paying, mode), smaller or medium sized company stocks is a belief that above average growth is maintained to eventually drive the valuation metrics (such as PE ratio and dividend yield) into more attractive, and share price supportive, territory. Investors should always ensure that smaller companies have sufficient finance in place (ideally evident on the Balance Sheet, rather than promises from banks), to deliver the logical business plan of reaching critical self-funding profitability.

Justifying a fair valuation of future potential

Although the PEG (comparison of PE ratio to earnings growth) is useful when studying higher growth businesses, this ratio only provides a ‘snapshot’ of a very short term prognosis. Assessing businesses by reference to their longer term potential naturally requires an estimation of future revenue, profit or distributed profit (dividend) growth. Professional investors typically create mathematical models of such projected income, and then discount the numbers back (by using an anticipated long term interest rate) to arrive at today’s (or to a present) worth of such future cash flows. When the overall economic climate is more difficult, then clearly a higher degree of belief – that the specific individual selection possesses especial business merit, or perhaps economically-contrarian characteristics - is required to justify a fair valuation. The smaller or more risky the business venture, so capital becomes more expensive and the need to discount future revenue or profits more deeply therefore applies.  

Aggressive Portfolio of UK equities

easyJet – Often described as a budget airline, this provider of short haul flights has an impressive growth record and, despite a dull economic UK and European landscape, its business model appears resilient. DIY holidaymakers increasingly make their own plans (rather than buy a package), and cuts in corporate travel budgets have seen bookings migrate from the leading higher-cost airlines (appreciating that easyJet typically flies to prime city airports). The £2.4 billion equity market capitalisation company has proven itself to be innovative (most recently a link with Nectar points and allocated seating), but will always face volatile fuel prices as well as currency risks. Consensus views of equity industry analysts (16 rate the shares as a Buy, 5 consider it as a Hold and 3 say Sell) anticipate:

Berkeley Group – a builder of upmarket houses and apartments, with a strong bias to London, the management weathered the housing downturn that accompanied the financial crisis and the economic stagnation that has afflicted much of the UK by showing foresight in managing its land bank. Sensitive to maximising shareholder returns, the company is returning excess cash rather than compromise its returns on capital by investing in sub-optimal projects. Buoyed by recent publicity afforded by the Olympics, London’s popularity with overseas investors – as well as visitors – suggests its detachment from the remainder of the domestic housing market is set to continue. Capitalised at £1.9 billion, the consensus views of equity analysts (currently 9 rate the shares as a Buy, 4 consider it as a Hold and 0 say Sell) anticipate:

Premier Oil – an upstream natural resources company, producing oil and gas in the UK’s North Sea, Indonesia, Pakistan and Vietnam, it also has major exploration and development interests in Norway, the Philippines, South Asia and West Africa. To the latter can be added the Falkland Islands, post the acquisition of a 60% stake in Rockhopper – which has received a mixed response from investors. Characterised by having a particularly high drilling programme (offering prospect of significant news flow), and strong growth in production (likely to be up 49% at 60,000 boepd this year), the group is set to commence dividend payments in 2012. Capitalised at £2.0 billion, the consensus views of equity analysts (currently 17 rate the shares as a Buy, 7 consider it as a Hold and 1 say Sell) anticipate:

For investors looking for something higher risk-reward amongst oil and gas explorers, the following two relative newcomers with strong management track records may be of interest:

Genel - is a £1.6 billion market cap business which is the largest oil producer and owner of reserves in the Kurdistan region of Iraq. Granted a full listing in November 2011, a highly regarded management team under the leadership of CEO Tony Hayward (ex-BP chief) raised a significant ‘fighting fund’ (of which US$900m remains) to procure attractive exploration assets. Genel has made numerous acquisitions over the past year, doubling its core Kurdistan oil business and focusing on gas assets (targeted to supply a rapidly growing Turkish market); the company have also targeted Morocco, Somaliland, the Ivory Coast and Malta. Clearly political, cum business regime, risk represents a prime concern (as Iraq resists Kurds’ wish for independence) for investors. The consensus views of equity analysts (currently 10 rate the shares as a Buy, 4 consider it as a Hold and 0 say Sell) anticipate:

Fastnet Oil & Gas - is a much smaller, and even ‘newer’ business: a £50 million market cap company which is searching for oil and gas in offshore Ireland (awarded licenses in Celtic Sea’s Molly Malone and Mizzen Basins) and Africa (via a significant interest in Morocco). Listed on the AIM exchange in June 2012, the company has sufficient funds (via £10 million IPO) to reach first drilling in mid 2013. The management’s history is impressive (notably John Craven, previously at Cove Energy, who oversaw its worth rise 20-fold in three years) and independent analysts speak encouragingly of the prospects for the Celtic Sea fields. However, investors should be mindful of the inherently high risk-reward nature of such unprofitable junior businesses – with history littered with far more failures than successes. The company’s website indicates that there are only three analysts (two of which are broker to Fastnet) covering the business. There are probably others, but fundamental valuation metrics (such as profitability, to deliver EPS or dividend) cannot be expected in the foreseeable future. Share price progress will depend on asset trading and sentiment surrounding its fields (notably based on the success of other operators’ drilling in the same fields, ahead of its own bit use in 2013).

Five interesting businesses

Each has appeal for particular reasons – be it on demographic developments: easyJet enjoys economies of scale as it flies more routes, Berkeley continues to see overseas and domestic buy-to-let investor demand in London, or on other expectations: Premier Oil’s discovery and production provides a constant pipeline of interest, or the prospect of Genel and Fastnet’s respective management team’s delivering similar success in the future. Often “travelling can be better than arriving” in terms of stock market performance, so it is important to identify the prospective beneficiaries of secular or structural change in society or the economy sooner rather than later.

And we will have five more next week

Clearly the writer is featuring industries or businesses which have attracted his attention – both on fundamental considerations and because the valuation appears anomalous. With the notable exception of Fastnet, all the companies mentioned in this blog possess attractive valuations (based on the consensual views of industry analysts). This suggests that the market lacks confidence in the longer term prospects (beyond the two year forecasts, mentioned above) or has particular stock-specific concerns. However it ‘takes two to make a market’ and it is important that investors carry out their own due diligence and form their own views about the prospects for any industry or company – as the descriptors above are far too brief to represent anything approaching a recommendation. Next week, we will conclude our search for interesting non-FTSE100 sized businesses with another five companies.

Finally, on a personal note

Sad to report that John Cotter, a market commentator, former colleague and good friend, passed away last month. A ‘larger than life’ character, with a great sense of humour, John shared his love of stock market and investment matters with a large, varied and appreciative audience over more than 30 years. Many readers will have heard or met John at one of these public events, or read his book – they will know that he cared passionately about people first and investment second. Rest in peace, John.