Stockwatch: Odds favour long-term upside for this stock

Among potential value discrepancies, one area is cyclicals being beaten hard last year. It can offer trading, even investment situations where the company need only give a weak update that isn't so bad as feared for the shares to rise. Mind this may be significantly due to short sellers closing out positions and/or active traders chasing a turn.

Know your objectives as this area, while potentially profitable, can involve value traps - the proverbial "investments that are short-term trades gone wrong." More positively, these stocks will become genuine investment situations; it could even be now. The future hinges largely on whether deflationary forces intensify or abate.

RPS and Foxtons are prime examples; there will be more

One example last week was Foxtons (FOXT), the London estate agency that on Tuesday gave an overall weak trading update yet saw its shares bounce 25% over subsequent days. It has been a short-selling favourite, down from 400p in March 2014 to a 150p-160p range since last November. The broad sense is that Foxtons, having floated at the top of a London housing market boom, is now exposed to any future Labour government "mansion tax". But the stock's ravaging has provoked an argument as to what is priced in already, perhaps overly so.

Similarly the Mid 250 shares in RPS Group have halved from 360p a year ago and the five-year chart shows them at the lower end of their range. A jagged pattern is typical of the risk-on/risk-off, sentiment swings in this kind of cyclical. RPS provides advice for development of land, property, infrastructure, oil & gas exploration and the environment, with "energy" contributing 51% of 2013 profit.

Naturally, fears have arisen that the company will suffer lower demand as a result of the fall in oil prices. Also, the stock did rocket in the second half of 2013 (like so many amid QE-driven exuberance) and necessarily had to de-rate from a price/earnings multiple in the mid-twenties.

Unexciting interims have emphasised second-half 2014

The interim results highlighted like-for-like, normalised pre-tax profit up 11% to £31.4 million on a constant currencies basis, with bottom line growth in earnings per share of 5-8% depending on an adjusted or basic view. With 10.3p adjusted EPS made in the first half, this appeared to put the second half-year outcome at risk as oil prices slumped, versus market forecasts of over 21p for 2014 as a whole. The chairman alluded to "some softness in parts of the oil & gas sector" as some clients began to tighten spending and a 30 October update said: "Currency volatility, as well as the uncertainty affecting the oil & gas sector, make it difficult to anticipate the full-year out-turn with precision." Such words may have been enough to keep the stock in a downtrend despite his assurance that trading implied meeting market expectations.

Declared sound prospects hint at upside potential

RPS has indicated meeting the top end of market expectations in a pre-results update saying its energy-related business grew profits significantly in the second half of 2014 compared with the first half. "This was without the benefit of acquisitions and reflects the resilience and long-term nature of this business resulting from its broad range of clients and services, as well as its geographical diversity."

The prospect is entertained of "another successful year in 2015" with "further growth." Yet the stock has responded only modestly, up 6p to 188p, on a forward price/earnings multiple of about 9 times and yielding about 4.5%, possibly 2.5 times covered by earnings and with a strong cash flow profile also (see table). At this level the risk/reward profile has become interesting: the economic risks may be priced in and the stock also offers a useful dividend yield to compensate. Further downside assumes deflation can only get worse.

Relegation from the FTSE 250 index in early March?

The market may be remaining cautious because RPS is exposed to demotion from the Mid 250 index at the next review; also it being prone to adverse sentiment towards oil services generally. But these are aspects of market bias, genuine investors should exploit. Key uncertainties are any lag-effect of the oil price plunge on RPS's clients, especially if prices stay low, and wider economic slowdown affecting other group business.

Mind also, this company has a strong priority for acquisitions - involving some £62 million in the 10 months to end-October 2014 - which can cut both ways. It should help bolster earnings against potentially weaker trading, but also inherently raises business risks (e.g. of integration). It helps explain why net assets are wholly based on intangibles, typical also of a "people industry". At end-June RPS had £82.9 million borrowings although the net interest charge clipped only 7.3% of interim operating profit; and there was £13.7 million deferred consideration. While the acquisition strategy appears to have commercial rationale it can expose strains in a downturn; more positively targets become cheaper.

Overall, there is a good financial track record here, if prone to the wider business cycle and exceptional events - e.g. weather and BP's 2010 Macondo disaster. Henceforth the odds favour long-term upside; it is mainly a matter of timing. Barring a serious recession, RPS is not a "value trap." Prelims are due 26 February.

For more information see rpsgroup.com.