A portfolio with 24% upside and nice yield
16th December 2016 14:13
by Harriet Mann from interactive investor
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Shrugging off concerns over the election of Donald Trump and the Italian referendum, the European STOXX 600 index has rallied 12% from post-Brexit lows. Volatility is here to stay, but higher valuations should be supported by earnings momentum and their attractiveness against bonds in 2017, argues one heavyweight analyst.
The rotation from "low volatility" stocks into "value" has been more pronounced as 2016 draws to a close, boosted by a changing macro backdrop. As inflation picks up and the Trump presidency beds in, Barclays' European equity strategist Dennis Jose believes this rotation has further to run.
Investors should buy value stocks where earnings growth outperforms the market, he says. Staples look expensive compared to banks, while other value hot spots like autos, insurance and mining continue to look cheap.
Barclays has updated its 28-strong portfolio of European top picks to best play this theme, revealing a portfolio with 24% upside and a 3.2% yield. Rounding up the best of the best, profiling the seven London-listed companies with at least 30% upside, gives an average potential return of 40%.
Other gems, tipped by Barclays, but with less forecast upside, are , , and , each with predicted upside of 20%.
Imperial Brands
Target price: 4,500p
Potential upside: 33%
Weighed down by competition in the UK, the loss of its Philip Morris distribution contract and EU regulation costs, shares have fallen 15% over the last two months.
Although UK pressures will remain in 2017, the company is only half way through its programme to streamline the business and another £360 million of savings should be made in the next three years.
Management has also just outlined £300 million of investment next year, which should drive revenue higher. This investment will hold back margins, of course, but foreign exchange tailwinds should keep earnings growth around 13% per share.
It's these moving parts that should underpin annual double-digit dividend growth for the next three-four years.
"The shares having already de-rated to a c.36% discount to Staples, (CY 2017E price/earnings [PE] multiple of 11.9x) and given the group's ongoing commitment to 10% annual dividend growth, investors are now being paid to wait and see if an acceleration in growth is achievable," says Barclays analyst Simon Hales.
BP
Target price: 625p
Potential upside: 32%
The blue-chip oil giant should reach a sweet spot in 2017, as annual production volumes increase by 3-4% up to 2020 and with new production expected to generate 35% higher cash flow per barrel.
That means an extra $5 billion (£4 billion) of cash should flow from the 800,000 barrels (bbl) due on stream over the next three years, a fifth higher than 2015 cash flow.
With that extra cash sloshing about, should be able to grow its dividend over the next few years, especially as it breaks even after dividends at $50-$55/bbl in 2017.
Expecting Brent crude to trade around $60 from 2017, Barclays analyst Lydia Rainforth reckons BP shares are worth 625p, although a recovery to $85/bbl by 2019 means they could be worth 741p.
"As a result we see the 6.2% yield and 32% potential upside to our 625p per share price target as compelling and we rate the stock 'overweight'," says Rainforth.
Ophir Energy
Target price: 125p
Upside: 42%
Ever since announcing its development deal with OneLNG over its Fortuna project, has traded at a 40% discount to net asset value (NAV) compared to a 20% discount for European peers. Clearly, the firm needs to show it's hitting near-term milestone targets before it can unlock decent upside.
Ophir has now reduced its equity exposure to the liquefied natural gas (LNG) project in Equatorial Guinea before first gas to $150 million, as it wanted. The partners are now trying to finalise terms on a $1.2 billion financing and align gas sales and government approvals before the project is given the go-ahead next year.
With LNG prices at $6 per million British thermal units (mmbtu), the project should generate around $140 million cash after tax for Ophir each year.
Its exploration portfolio also looks interesting, with attractive returns with oil priced below $50/bbl. Management could start drilling in Myanmar and Cote d'Ivoire in early 2017, taking advantage of low drilling costs.
Petrofac
Target price: 827
Potential upside: 51%
Fitted out with three divisions, it was development IES business that has been plagued with issues since 2014, related largely to its Laggan-Tormore project to the west of the Shetland Islands. Higher capital costs and a surprise exit from its head financial honcho didn't help.
Management is focusing on its core Engineering & Construction (E&C) arm and Engineering & Production business, and should soon explain how they will release capital from its IES business.
Operating in the Middle East and North Africa, the core E&C business mostly works with large and established national oil companies on large-scale developments. These projects are usually steady investment programmes, as the national oil companies look for income for their countries instead of shareholder returns.
A full bidding pipeline should be converted into proper orders next year, says Barclays, which will reduce concerns for 2018, and project execution will boost earnings momentum.
Derwent London
Target price: 3,500p
Potential upside: 37%
This UK Real Estate Investment Trust (REIT) has delivered market-beating returns for investors. Brexit concerns have weighed on the closed-ended fund, which provides a rare compelling entry point, argues Barclays.
Of course, uncertainty could feed into the rental market, but low vacancy rates and limited supply should mean rates fall much less than the market has priced in.
But if business does get tougher, can turn off its medium-term pipeline and use assets previously earmarked for redevelopment as a source of income until conditions improve.
"With what we consider to be the most experienced management team in the sector owning a predominantly West End portfolio valued at £830 per sq ft and trading on a c.25%+ discount to spot NAV, we see Derwent's current valuation as very attractive," says analyst David Prescott.
Oxford Instruments
Target price: 970p
Potential upside: 47%
A high-risk but potentially high reward opportunity comes in the form of research company , claims Barclays.
Granted, the latest interims were disappointing and the balance sheet looks risky, with year-end net debt tipped to exceed £135 million. However, Barclays thinks most of this is priced in already.
The order book looked promising at the interims, up 19% to £162 million, and the outlook for research projects is getting brighter, especially in the US.
Currency movements will be a tailwind, anyway, and should add £7 million to cash profit in 2018 if the backdrop stays as it is.
Paddy Power Betfair
Target price: 115p
Potential upside: 40%
A multi-year growth story, gambling group is a high-growth stock with the potential for strong capital returns underpinned by its robust free cash flow generation.
No wonder it's Barclays' top pick in the European leisure sector. Strong earnings momentum can be unlocked through its high operational gearing and free balance sheet.
Expecting Paddy Power Betfair to smash expectations this year, Barclays is as "upbeat as ever", pencilling in cash profit of £411 million, growing to £507 million in 2017. Regulation risk is real, but the group has multiple levers for growth and its experienced management team are ready to build on its market-leading position.
"We view Paddy Power and Betfair as two of the highest-quality gaming brands in the sector," writes Barclays analyst Patrick Coffey.
"Scale is key and the business operates in structurally growing markets, with a strong management team and leading technology platform that can benefit from centralised technology and resources to develop new products to segment and target consumers in order to take market share."
This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.