Bargain or cheap for a reason? The 23 ‘fallen stars’ a leading broker is backing to bounce back

Research has found that 150 companies in the FTSE All-Share and AIM 100 indices have seen their share prices fall by more than 40% year-to-date. Leading broker Peel Hunt picks out 23 ‘fallen stars’ it believes are best placed to bounce back.

The past decade has been a painful time for investors who follow the value style of investing, and the coronavirus sell-off did not buck the trend, with fund managers that focus their sights on quality companies outperforming those that place greater importance on shares with cheap price tags.

This marked the continuation of a trend that has played out over the past couple of years, with two of the key drivers being sluggish economic growth and an acceptance among investors that, over a decade on from the global financial crisis, the business cycle was in its latter stages.

As a result, high-quality businesses with reliable earnings regardless of the economic backdrop have been highly prized by investors. In contrast, there’s been a notable shortage of takers for bombed-out value stocks that are typically more cyclical (economically sensitive) in nature.

Following the steep market falls in response to the coronavirus pandemic, quality growth companies will continue to be in high demand, owing to their defensive characteristics. To assess whether a company is superior compared to its competitors, quality growth investors look for certain attributes that help give the business an edge, such as intellectual property, recurring revenues from repeat sales, or strong pricing power.

As James Thomson, manager of the Rathbone Global Opportunities fund, points out, such quality characteristics include “offering a service that their customers rave about or can’t do without.” In a recession – which the world is currently heading towards – such businesses are relatively immune, as all things being equal a large proportion of customers will be retained.  

The predicament for investors, though, is that high-quality growth stocks were already in high demand before the sell-off, and were carrying expensive price tags. Given this part of the market held up well in the sell-off and value stocks tanked, the valuation gap between the two investment styles has grown even wider.

Research by Peel Hunt, a leading broker, points out that following the market sell-off there are plenty of opportunities for investors to pick up bargains. Its research found that 150 companies in the FTSE All-Share and AIM 100 indices have seen their share prices fall by more than 40% year-to-date, versus -24% and -20% respectively for the indices. Therefore, from a value investing perspective there is a wide choice on the bombed-out discount aisle for investors to peruse.

Peel Hunt picks out 23 ‘fallen stars’ it expects to bounce back from a range of more cyclically geared industries – with its choices listed in the table below. Its stock selections were made against a number of assumptions, including that a loosening of lockdown conditions will be in place by the end of June, and that there will be no renewed outbreaks of coronavirus later this year that would lead to a second spell of lockdown conditions being imposed. It has also assumed the shape of the economic recovery would resemble a “Nike swoosh whereby the economy stopped abruptly and will recover steadily, but gradually.”

A number of Peel Hunt’s choices are described as being leading players in their respective industries: Bakkavor (leading chilled food supplier in UK), McCarthy & Stone (market leader in the UK retirement market), Melrose (world leader in driveline), RHI Magnestia (world number one in steel refractories), Halfords (the market leader in cycling), Mears (the UK’s market leader in housing management and maintenance) and Whitbread (leading player in the UK budget hotel market).

Peel Hunt’s stock selections seeks to “identify where we think the market is ignoring the recovery potential or overestimating the long-term threat to the business”.

But, as ever the trade-off in buying cheap stocks is the risk of catching the proverbial falling knife. Therefore, private investors need to do their own analysis, including scrutinising return on capital in good and bad times. 

Moreover, Terry Smith, manager of the Fundsmith Equity fund, cautions it is important to bear in mind that: “Shares in companies that are lowly rated are so mostly for good reasons – because their businesses are heavily cyclical, highly leveraged, they have poor returns on capital and/or they face other structural or management issues.

Peel Hunt’s ‘fallen stars’