Forecasting is a perilous game. At the end of 2009, I predicted that equities would start 2010 well – which they did – and end poorly – which they didn’t. I felt that by the summer most Western governments would be in strict belt-tightening mode, and that this would hit growth. What I didn’t count on was Ben Bernanke, the US Federal Reserve chairman, opening the monetary sluicegates again. A second round of quantitative easing (or ‘QE2’) propelled the FTSE up 20% from its mid-year lows of 4,800. But what happens when QE2 runs dry in June 2011?
Wall Street is betting on QE3, and possibly even QE4. This suggests the markets will probably stay strong for the moment, as investors rotate out of bonds into assets that offer inflation protection. Looking ahead, my advice would be to stick with undervalued plays, as this strategy continues to outperform.
For example, in 2010 our buys and gambles saw absolute gains of 23% and 13% respectively, compared to 6% for the FTSE 100. (Note: this is as at 12 December, and assumes that equal amounts of cash were invested in each stock, returns are time-adjusted and dividends, transaction costs and foreign exchange are ignored). Notable successes included OMG (up 90%), Renold (up 87%) and ICAP (up 63%). Admittedly, these were offset by a few horror stories, such as Southern Cross Healthcare (down 90%) and EAGA (down 52%). And my “turkeys” struggled against the rising tide – albeit many, such as ASOS and Supergroup, are still raging sells. So, which companies are still worth buying now?
Tip of the year number one:
Epiq systems is an excellent counter-cyclical play that should perform well, regardless of what Mr Bernanke decides to do. QE2 is already pushing up US Treasuries, bond yields and borrowing costs, which could soon tip more corporations into administration. But if there’s no QE3, and the economy stays as dead as the proverbial parrot, it’s game over for a number of overstretched businesses.
Either way, Epiq should clean up. That’s because it is the world’s largest provider of IT and back-office support to the legal profession and liquidators. The firm is working on hundreds of bankruptcies, and has been involved in front-line defaults with banks such as Lehman Bros, the two Icelandic banks Glitnir and Kaupthing, Chrysler and Nortel Networks.
EPIQ Systems’ first-class software significantly improves the speed, efficiency and quality of insolvency, litigation, forensic accounting and other regulatory work. But that’s not all. The organisation offers complementary applications in the rapidly expanding areas of electronic discovery (up 64% in the third quarter of 2010) and claims management. Finally, it also generates full documentary evidence backed up by recorded audit trails in order that work can be submitted to the courts for scrutiny.
EPIQ Systems (Nasdaq: EPIQ), rated OUTPERFORM by Wells Fargo
Analysts are predicting 2010 turnover and underlying earnings per share (EPS) of $241m and 74 cents respectively, rising to $268m and 85 cents in 2011. That puts the shares on price-to-earnings (p/e) ratios of 18.2 and 15.8. Better still, I suspect these estimates will be beaten next year as China cools down. We’ll see another round of destocking, bad debt write-offs and property foreclosures, with corporate cash flows grinding to a halt.
So I would value EPIQ Systems on a ten-times 2011 earnings before interest, tax, depreciation and amortisation (Ebitda) multiple. After adjusting for the pro-forma $75m of net debt, that delivers an intrinsic worth of more than $18 per share. Fine, but what are the possible snags?
EPIQ Systems is exposed to the usual risks (such as lumpy orders) related to large projects. Those risks are coupled with the generic issues tied to working on high-profile legal cases. All the same, with its eDiscovery arm going gangbusters, the shares offer excellent downside insurance – regardless of how the QE cookie crumbles. Preliminary results are due out on 22 February 2011.
Recommendation: BUY at $13.50 (first tipped in January 2010 at $13.10)
Tip of the year number two:
One of the major fault lines in the global recovery is the scope for another European sovereign debt crisis following hot on the heels of Ireland and Greece. If that happens, the euro would surely tank. But provided there is no all-out currency disintegration, that would be good news for Germany, thanks to its vibrant export economy. Indeed, the country is my number-one pick for 2011, because it will remain the most competitive economy in Europe. And one way to play this strength is via power utility RWE.
RWE is the leading power producer in Germany (representing two thirds of the company’s Ebitda), and it is rated second in the Netherlands and third in Britain. The firm owns coal, nuclear and gas-fired power stations. It is also a leading supplier of renewable energy, investing heavily in solar, tidal and wind power. For instance, as part of a £2bn consortium, RWE bagged a prestigious contract to build and run a 160 turbine wind farm ten miles off the coast of North Wales. The project is expected to be completed in 2014 and the company should be able to provide enough electricity for 400,000 houses and prevent the release of 1.7 million tons of carbon dioxide per year.
Ongoing concerns about the state of the environment spell opportunity for RWE. The EU plans to slash its greenhouse gas emissions by up to 95% by 2050. In order to meet his goal by 2025, RWE aims to have turned 75% of its generating assets into “zero or low-carbon” ones – up from 40% today. This would boost profitability, as RWE would be able to close its least-efficient plants and reduce the number of carbon credits that it currently purchases. The firm is also likely to charge more as more of us switch to electrically driven vehicles and electric heating systems.
RWE AG (DAX: RWE), rated a BUY by Equinet
The City is predicting the 2010 turnover, underlying earnings per share (EPS) and the dividend to be €52.3bn, €6.9, and €3.5 respectively. That puts the shares on a miserly p/e ratio of 7.3, paying a generous 7% yield. The balance sheet is secure too, with net debt (€11bn) equating to a comfortable 1.2 times Ebitda. However, there is €17bn of non-interest-bearing legacy costs relating to future pension, nuclear decommissioning and mining obligations that needs to be kept an eye on. All in all, I’d rate the stock on a through-cycle Ebitda multiple of seven. After adjusting for the firm’s liabilities, that delivers an intrinsic worth of roughly e60 per share.
But it’s not all going to be plain sailing. Recently the Budestag, Germany’s Lower House, voted to introduce a levy on nuclear fuel. From 2011, I estimate that the tax will reduce RWE’s operating profit by €600m to €700m per year – that’s equivalent to around a €1 fall in EPS. Lastly, RWE is exposed to the usual commodity/power and foreign-exchange market risks. But I’m not put off. I believe it’s a good long-term buy. Full-year figures are scheduled for 24 February. Equinet has a target of €70.
Recommendation: Buy at €50 (first tipped in June 2010 at €57)
Gamble of the year
Irish fruit importer Fyffes has been hit by a triple whammy of weaker selling prices, a stronger dollar, and escalating fuel costs. But the fruit industry has now stabilised. After the recent $5.6bn takeover of Del Monte Foods (DLM) by private-equity outfit KKR, the sun could be about to shine down on shareholders.
Indeed, I suspect Fyffes will be an acquisition target because it is one of the cheapest plays in the sector. The group offers the whole shebang: it sources, cultivates, ripens, ships and distributes fresh fruit across the world. In fact, it is the second-largest banana supplier in Europe behind leader Chiquita.
Fyffes (Aim: FFY)
The board is forecasting an underlying 2010 Ebita figure of between €14m and €18m. I estimate that this will deliver adjusted earnings per share of approximately five cents. As a result, the stocks trades on a skinny p/e ratio 7.2, while also paying a healthy 4.5% dividend yield.
I would value the business on a 6.5 times Ebitda multiple. After adjusting for net cash of €36.3m, the €18m pension deficit and its 40% stake in property group Blackrock International Land (worth around €7.5m), this delivers an intrinsic value of about 45p per share. Better still, if it was ac-quired on an eight-times Ebitda multiple, Fyffes could even be worth more than 53p. Reassuringly, the shares are supported by net tangible assets of 42.7 cents per share (or 36p).
The main wild cards are volatile prices, crop damage owing to poor weather, foreign exchange, trade wars, shipping costs and cut-throat competition. But, given the heritage of the brand and the banana’s traditional resilience, Fyffes should continue to prosper from greater consumption and healthier eating trends.
Recommendation: BUY at 30p (first tipped in March 2010 at 35.25p)
Disclosure: I own shares in RWE.