Stockwatch: An alluring speculative buy

Although price/earnings (PE) multiples are already looking stretched and dividend yields are scant, cyclical stocks have been upgraded on the back of bullish updates this New Year. Typically, the bulls claim that operational gearing is kicking in and the businesses have scope for more positive surprises, but to what extent is this actually supported by evidence?

Examples include FTSE-250 engineer Rotork, which has recovered to a 2015 level of 280p after plunging to 153p. It trades on a forward PE of 26x and its 2% yield is covered less than twice by earnings.

Goldman Sachs recommends investors 'buy' Rotork on the basis that 2016 marks a trough and earnings should surge 54% by 2020 - a radical change of view from the secular stagnation that has plagued cyclicals since 2014/15.

Goldman also recommends FTSE 100 listed industrial group Smiths at 1,450p, which is trading near a three-year high of 1,525p on a forward PE of 16 and 3.0% yield, covered twice. The analysts argue that growth prospects are improving and the weak sterling has not only made it more attractive in the eyes of overseas buys, but also boost the value of its US earnings.

Then there is Fenner, which supplies belting for the mining industries. The stock has nearly trebled from an early 2016 trough to about 270p on a forward PE of 22 and yielding 1.3%, 3-4 times covered. The rebound assumes the Chinese economy will remain strong, sustaining commodity prices.

Bullish trading in the shade?

A fourth and much more intriguing example is small-cap Cape. Providing critical industrial services for miners, the shares have grown modestly from a long-term low of 141p at the end of 2016 to about 177p after a 5 January update cited 2016 results were "materially ahead of market expectations".

All three of its regional businesses performed strongly during the last two months of the year, particularly in the Asia Pacific.

Coupled with strong cash generation, this better performance has had a "consequent impact" on net debt, the company said. The £43 million pre-tax profit consensus in the table below was calculated before upgrades.

Litigation over Cape's previous activity in asbestos, if successful, could hit the dividendAll this is combining for an inflection point in the stock, which is still trading at around half its 2014 level due to ongoing health claims as a result of Cape's past activity in asbestos.

Towards the end of an otherwise positive 18 November update, Cape cautioned about "the emerging complexity" of litigation surrounding liability claims - already known about, and contested.

Although the board did not see fit to create a provision, if the litigation were to succeed then it could end up compromising "the implementation of the group's strategic plans, potentially including the company's capacity to pay a dividend", the group warns.

That was some sting in the update's tail. Matters are in focus as a six-week trial is due to start on 16 January.

Should investors take this seriously?

How seriously should a diversified investor take this? Litigation-related stocks tend to show a knee-jerk reaction to the worst-case scenario. Tobacco stocks proved a 'buy' at the height of litigation fears, as was BP over its Gulf of Mexico spillage.

In a situation like Cape's, the directors have to manifest a worst-case scenario otherwise they become liable to shareholder actions if it ever materialised.

Be aware of their high risk/reward profile; litigation clashes with improved prospectsThere is a long history of asbestos-related health litigation and indeed, the largest-ever US bankruptcy was Johns-Manville Corporation in 1982 after it was forced to settle so many claims.

A trust was set up to pay out hundreds of millions of dollars. It still does.

Currently there are at least sixty asbestos trust funds established by companies that have gone bankrupt due to legal actions brought against them by victims of asbestos exposure.

So although some brokers are recommending Cape shares on the basis that litigation risks are more than priced in, be aware of their high risk/reward profile as litigation clashes with improved prospects.

It does however make the stock intriguing to follow in early 2017 for diversified investors.

Liabilities for industrial disease claims

At 3 July 2016, Cape's balance sheet cited £93.0 million of non-current liabilities for industrial disease claims and £11.2 million of similar current liabilities - up from £5.3 million. A 19 July court judgment found in favour of Cape in some aspects and others against, which required a further £9.7 million provision.

Cape explains: "The group continues to receive claims, from both individuals and insurance companies, in connection with historical alleged exposure to asbestos...new developments and new types of claims give rise to inherent uncertainty in both the future level of claims and legal costs...which may result in significant liability over and above that recognise under the current provision."

Gearing is high, considering £190.3 million of longer-term debtSo the matter won't get resolved by the January/February trial, indeed the wider context of asbestos claims implies Cape and its investors will have to live with such for years to come.

This would leave net assets at £132.0 million albeit with £146.1 million of intangibles, therefore net tangible assets per share of minus 11.7p, similar to the recent context (see table).

Gearing is therefore high, considering £190.3 million of longer-term debt, which meant a net interest charge of £5.4 million versus £6.8 million of operating profit. This partly explains why Cape shares are sensitive to trading updates.

Henderson boosts stake

Henderson increased its stake in Cape to above 5% after the January update, showing how fund managers see the rewards of markedly improving trading for Cape as outweighing the litigation risks.

The Far East is driving progress - Cape makes a quarter of its revenues here. Ongoing sterling weakness in response to a potential hard Brexit is helping counter margin pressure in the UK - just over half of revenue - and lower demand in the Middle East - about a third of revenues - as low oil prices limited new projects and maintenance.

However, the latest update cites 2016 results materially ahead of recent expectations, as if the OPEC-driven recovery in oil prices is already spurring activity. If OPEC production cuts hold without much cheating, oil prices should be supported in a $60 range and this should continue to improve demand for services, with Cape's operational gearing also kicking in.

Its litigation context makes a 'speculative buy' tag wise, but versus cyclical stocks now on high ratings, Cape is the more alluring.

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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.