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3 Undervalued UK Stocks

THE VALUE INVESTOR: Threadneedle UK equity fund manager Chris Kinder names three UK stocks he thinks are trading at less than their intrinsic value

Emma Wall 20 August, 2014 | 9:52AM



Emma Wall: Hello, and welcome to Morningstar. I'm Emma Wall and here with me today to give his three U.K. stock picks is, Chris Kinder, Manager of the Threadneedle UK Absolute Alpha Fund.

Hello, Chris.

Chris Kinder: Hi.

Wall: So, what's your first stock?

Kinder: I think the first stock that I'd like to talk about is Wood Group (WG.), which is a FTSE 250 oil services company headquartered in Scotland. Interestingly, they just had the results today, so it's quite topical for the viewers.

I think it's a really interesting time to have a look at the stock. Primarily, again, valuation is very important to us. It's on 12 times earnings. I don't think their earnings are at a peak. In many ways, they are suffering a little bit at the hands of the oil majors who are cutting back their expenditure. But actually, what you see with Wood Group is very strong profitability improvement in certain geographical regions, particularly in the North of America where they've got a fantastic shale business they have been developing. And also, I think in the next year or so we should start to see a recovery in some of the bigger projects in deepwater where they've got a great market position. The business model is very sound. They allocate capital incredibly well. And as I say, fundamentally, the stock has significant valuation attractions.

Wall: I mean, there's two red flags there. Number one, the oil and gas companies, commodity companies in general, have not done very well over the last couple of years. And also, secondly, that it's based in Scotland. I mean, we've got the yes or no vote coming up next month. How much are those two things a concern for you?

Kinder: Yeah, I think, first of all, when I say, based in Scotland, it's where the corporate HQ is. The vast majority of the activity is clearly in North America. They are global. They've got business in Australia, in Africa, all around the world. Finally, they do have quite a big exposure in the North Sea.

And clearly, we don't know the result of the referendum. You wouldn't ask me to predict that. Well, I think one thing that is happening there is that there is a real will to revitalize North Sea production, which has been coming down now for a number of years and Wood Group with their strong position out there, should be a beneficiary of that actually. And I think strangely their business is performing quite well for them and actually could do even better than it is currently. So, I'm not so worried about that.

There's always been this thing in the market about the oil majors suffer because they pay too much to the service companies of which Wood is clearly a beneficiary. I think the truth is, the oil majors can't – they'll cut back on CapEx at the margin. The new fields are becoming – they are increasingly more complex to access. A lot of them have taken out their in-house expertise themselves.

Wall: They need these innovators.

Kinder: They need these people. Wood Group don't charge too much. They charge a fair value for their services. So, at the margin – that's why I read, it is a pressure, but I think it comes through and I think most importantly, it's reflected in the price.

Wall: What's your second stock today then?

Kinder: Another one that is sort of under a bit of pressure at the moment is Rolls-Royce (RR.) which has been a long-term favorite of mine and my company's. And in the first performance, as you probably know, it's a number two in a global duopoly on aircraft engines, has a marvelous business model whereby the engine goes on the wing. They don't make much money upfront, but then the engine generates revenue for the next 25 years that airplane stays in the air and that revenue is the aftermarket revenue which is very high margin. So, it's a great long-term business model.

At the moment, they are struggling as they build new facilities and they're putting the cost in to facilitate the production of the next-generation of engines and that's why the profitability is a little bit depressed at the moment. But as these engines get up in the air, I can see really, really strong cash flow coming through from that business and again, the valuation is quite compelling at this point.

Wall: How much of these aviation companies are affected by fuel duty and et cetera? Is it just the service airlines that get hit by these or do the manufacturers do as well?

Kinder: Yeah, I mean, the airline – interestingly, I would differentiate my investment view between the airlines and the equipment suppliers. Personally, I wouldn't invest in airline companies. Those are the people who have to wear the fuel bills. Recently, they've been able to put prices up to compensate themselves for that, but they have a far more volatile income stream and that obviously is a risk to Rolls-Royce of whom they are the end customer ultimately. But I think – I mean, an interesting dynamic what we're seeing in the market is that the order book of Rolls-Royce is predicated on new planes which are far more fuel efficient as these airlines really try and get their fuel bills down over time. So, strangely the high fuel is sort of counterintuitively quite a positive impact for Rolls-Royce.

Wall: And what's then your third and final stock?

Kinder: Again, another stock quite topical at the moment is Persimmon (PSN) where we've had a holding now for a number of years. It's performed extremely well. So, one is always quite uncomfortable recommending a share that's gone up a lot as we talked about earlier. But strongly, looking at the outlook for the Company, it's amazingly strong.

People I think perhaps have failed to appreciate is how much land these guys have and how the prices at which it's been bought which basically guarantees very high future margins and very high future returns on capital and because they have so much land, the need to buy more land is relatively limited which means the cash in the business can be returned to shareholders. So, Persimmon are really leading the way in getting the money back to shareholders.

Wall: Persimmon have been hugely boosted by low interest rates and is helped by schemes from the government, but even the government themselves and certainly the Bank of England are almost turning their back on their own plans because they are raising red flags about the housing bubble. I mean, if this implodes, surely that means stocks like Persimmon will impact.

Kinder: Oh, yeah. If you were to tell me factually that house prices were to fall 10% compound next three years, I don't think you'd own Persimmon. And I think I love the sort of the rhetoric of a bubble. For those of us sitting here in London, I think we see it every day. If you go out to the regions, you will see house prices not having moved for seven or eight years now. And obviously, the house builders, certainly Persimmon, have far bigger exposure in the regions than they do in the U.K. – than they do in London. So, I would really differentiate between the London-focused house builders who I think are going to find it really hard to put prices up and those in the regions where prices should, I don't know, match inflation a couple of percent. But the key is the land and the margins and the cash.

Wall: Chris, thank you very much.

Kinder: It's a pleasure. Thank you.

Wall: This is Emma Wall for Morningstar. Thank you for watching.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

Securities Mentioned in Article

Security NamePriceChange (%)Morningstar
Persimmon PLC2,120.00 GBX4.43
Rolls-Royce Holdings PLC792.80 GBX-2.10
Wood Group (John) PLC431.40 GBX1.15

About Author

Emma Wall  is former Senior International Editor for Morningstar

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