Four high-quality stocks that the market has ignored
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Associate Editor
David Stevenson Sep 14, 2009
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E.ON - looking particularly good
Stock markets just keep climbing. The FTSE 100 closed on Friday at its highest point in nearly a year.
We're still not convinced that this stellar rally is justified. There are too many reasons to believe that it won't last, as we point out below.
But the good news is that despite the 40%-odd rally since March, there are still opportunities around for investors. Alongside the mad 'dash for trash' that has driven up all the stocks most exposed to the economic rebound, some of the highest-quality stocks, each paying decent dividend yields, have been virtually ignored by investors.
Here are four of the best…
The rally can't last
Six months ago, many shares had fallen to levels that were 'pricing in' a near-Armageddon scenario, which we now know didn't happen – well, not yet at least. And stocks had fallen so far that a bear market rally was bound to happen at some point.
But the latest stock market moves feel very artificial. That's because they've not been based on a genuine recovery in industrial production (i.e. where real demand from consumers for goods drives companies to make more products). Instead, the recovery is based pretty much entirely on what governments have dredged up to try to stop the world's economy falling off a cliff.
As we said in Money Morning last week: (It's time to sell copper miners), without governments around the world spending bucket loads of money that they don't actually have, there wouldn't be much extra economic activity at all right now.
But that sort of boost can't last forever. Governments, particularly flat-broke ones like ours – can't keep spending indefinitely; they have to pay it back sometime. And when the penny drops, we suspect that investors will get jittery very quickly. The trouble is that the latest rally has been based on what several critics have called a 'dash for trash'. The market is pricing in a perfect 'V-shaped' recovery. If that doesn't happen, there will be a lot of disappointed investors out there.
But just because the market as a whole looks vulnerable to any economic upsets, that doesn't mean there's nothing worth buying. Several good quality companies, that don't depend on a temporary, government-funded economic fillip to make money, have been almost completely ignored by investors.
How to find good investment opportunities
Generally, when you're looking for decent investment opportunities, a good plan is to trawl through a list of stocks that have done relatively badly over time. Stocks and sectors go in and out of fashion for reasons that don't always reflect the economic fundamentals, so yesterday's poor performers often turn out to be tomorrow's top dogs as fund managers rotate their portfolios. Right now, defensive stocks are out of favour. And one specific defensive sector is particularly despised.
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Utilities, such as power and water suppliers, have been shunned by investors. There are fears – justified in some cases – about falling demand and possible rights issues. But the same fears also threaten the profits of many of the cyclical companies whose shares have surged in recent months.
Yet while other stocks have taken off, utilities have been "beaten up", says Alberto Ponti at Citigroup. They have been the poorest-performing market sector so far this year, seeing their worst underperformance (compared to the wider market) in five years.
But this could be about to change. "We think the process should now reverse", says Ponti. "Balance sheets are now stronger, and the sector valuation looks attractive on a 14% price/earnings discount to the overall market which compares with a 9% premium over 35 years". In other words, utility stocks are now looking unusually cheap. What's more, utilities' dividend yields are the second-highest in the market and "we could see earnings upgrades in coming months".
Four high quality stocks to buy now
Sounds good. But what should you buy? Earlier this month we suggested a French stock, GDF Suez (FP: GSZ), which is the world's second biggest utility. Although the price has started to creep up, it still looks a good bet.
Two other utilities also look good. German power generator E.ON (GY: EOAN) is Ponti's top pick on a current year p/e of 10.5x, dropping to 9.5x next year, while the 2009 prospective yield is 5.2%, rising to 5.6% in 2010. The shares are no higher than at the start of 2000. Citi has a price target almost 15% up on the current €28.90.
In the UK, shares in water supplier Severn Trent (LSE: SVT) have been hit by fears that water regulator Ofwat will give the firm a tough time in its November 'returns review'. That could hurt the company's ability to maintain its dividend, and is why the stock is standing only a little above its four-year low on a 7%-plus yield. But even if the payout were cut by a third, which is now probably factored into the share price, the yield would still be a decent 5%.
Further, Severn Trent Services is booking bigger and bigger deals in China, including building and supplying a customised water treatment operation to serve more than 3.3m residents in Zhejiang Province. This is a bombed-out stock, with limited downside risk, which looks well worth snapping up while it's in the doldrums.
And finally we have global telecoms company Cable & Wireless (LSE: CW). It's not exactly a utility, but it's similar. It's another stock which is still languishing at a lower price than at the start of 2009. It's been out of favour due to investor worries about how much money it'll need to spend on upgrading its network.
But Cazenove's Paul Howard expects "strong growth" in full year profits and cash flow, which should do the trick. On a p/e of 11.8x for the year to March 2010, dropping to 10.3x in the following 12 months, and a prospective yield of 6.2%, Cable & Wireless looks cheap – and that's not something you can say for many stocks right now.
Our recommended article for today
Commodities should offer some of the best investment opportunities of the future. And with its price at a seven and a half year low, now could be the time to buy natural gas.
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