Add Some Risk Via Emerging Turnaround Stories

This story features HILLS LIMITED, and other companies. For more info SHARE ANALYSIS: HIL

By Rudi Filapek-Vandyck, Editor FNArena

Within the general context of a share market that is trading above its long term average Price-Earnings (PE) ratio, with many of the outperformers since mid-2012 now trading on premium valuations, there is a good argument to be made for investors to start looking to add more risk to their portfolios. In particular now that experts' confidence is rising about further upside potential for equities.

Adding more risk does not necessarily equate to adding micro-caps or midget mining stocks few have ever heard of. The local share market contains various emerging turnaround stories in the industrials space -outside of the mining services sector- that have the potential for significant gains over the next two-three years, if everything goes to plan.

Investors should always bear in mind the latter is never guaranteed and wasn't it Warren Buffett himself who once said: [the problem with turnaround stories is] Turnarounds seldom turn.

Nevertheless, I believe the following three potential turnaround stories deserve investors' attention today.

CSG Limited ((CSV))

IT business company CSG is one of many that simply lost its way a few years ago and shareholders have had a really tough time since. This probably explains as to why investors have been reluctant to revisit this emerging turnaround story.

Regardless, the February reporting season even surprised new management at the helm of the company, triggering upgraded guidance for this financial year. CSG is transforming itself from a mere hardware seller into a more active provider of services and consultancy and the first 18 months of the five year transformation plan have provided sufficient evidence that new management is showing all the right moves, and early achievements, to make this a success story in the years ahead. CSG recently won a few sizeable contracts, with Bank of New Zealand and the New Zealand Police, further fueling analysts' confidence.

What should provide investors with an easy point of focus is management's promise to pay out 9c each year to shareholders, either in the form of regular dividends or via a special one, until FY17. Consensus estimate is the company will pay out 4.5c this year and the shares are consequently trading on an implied 4.7% yield. But if management keeps its promise, annual yield is about to double to beyond 9%.

The two brokers in the FNArena universe that still cover the stock have set price targets for this year of $1.00 and $1.05 respectively, which is still above the $0.95 registered on Monday, but the gap is narrowing rapidly. Late last year, the shares temporarily spiked well above $1, which is one obvious risk that comes with investing into such recovering small caps stories: greater volatility comes with the small size and low volumes.

Analysts at Macquarie recently stated: "The new management team continue to make good progress on their business transformation project and executing on their strategy to sell more products and services to the same customer. Maintaining top-line growth and improving cash conversion will be key to further rerating".

There's another way of looking at this proposition: the promise to pay out 9c each year between FY15-FY17, at the current share price, represents nearly 30% in returns, ignoring everything else.

Hills Industries ((HIL))

Industrial conglomerate Hills Industries used to be a dividend investor's favourite, before the GFC, but it too has given shareholders many headaches since Lehman Brothers went under. Now that the proposed sale of its legacy steel operations has received regulatory approval, however, analysts are all of a sudden talking about "transformational divestment".

As a matter of fact, Hills' recovery story already started in the August reporting season last year and price charts clearly show that's when the share price came to life again, but now that a second six month period has been added to the transformation narrative, overall confidence is rising.

The emerging story at Hills is one that leaves the old economy behind (steel products) and focuses on tomorrow's trends instead (healthcare, technology and communications). The report published in February looks impressive at face value with ongoing EBIT jumping 74%, thanks to margins expanding 280bps from 6.1% to 8.9%. But these numbers of significant improvement merely illustrate what troubled state the company has been in. Nevertheless, once the payment has been received for the steel divestment, Hills should be in a net cash position to the tune of $38m by mid-2014 on Citi's projections, with a healthy balance sheet and reinvigorated management that will be looking for further efficiency improvements and for acquisitions.

Assuming everything develops according to plan, this company should be looking forward to multiple years of double digit growth post FY14. Achieving this should trigger a re-rating, while a changing profile into healthcare, technology and communications might further re-rate the PE multiple.

Investors clearly remain on the cautious side, given the share price remains well below the $2.10-$2.15 level where analysts think the price should be. CIMB is clearly supportive of the new Hills and provides three focal points as to why investors should back its judgment on this transformation story:

1.) HIL’s remaining (core) businesses are still at or close to bottom-of-cycle earnings levels;

2. CIMB believes a further (and significant) level of corporate costs can be removed once the divestment of the capital/people-heavy steel businesses is completed; and

3. The balance sheet is in excellent shape and opens up a range of "opportunities".

Hills Industries is expected to lift its dividend in each of the coming years, which further supports its investment proposition.

Transpacific ((TPI))

If you lost track of Transpacific's fortunes in years past, you are far from the only one. I have no qualms in admitting that I too have completely ignored everything that has happened at Transpacific post the GFC. Too much debt. Too many acquisitions. This should have been a relatively safe haven throughout turbulent times, as waste management is supposed to be, but too much debt at the wrong time pretty much ruined everything. And Transpacific had mountains of debt.

Now that the New Zealand operations are about to be sold, the company will finally be debt free. It has made analysts and investors enthusiastic about what the future might possibly look like now that management can finally focus on sweating and expanding its Australian operations. CIMB, for example, sees "multiple angles for further earnings growth and multiple re-rating".

Potential remains for further cost outs, while acquisitions will be back on the agenda, analysts believe. At some point, shareholders should see the return of dividend payouts. UBS, for example, forecasts the company will introduce a dividend in FY15 of 4.7cps, which equates to a yield of circa 4.0% today. At Monday's closing price, the gap between share price and consensus target is 7.3%, indicating investors have remained reluctant to price in future potential just yet.

One rule of thumb which I learned from a seasoned investor in small cap stocks is that a typical opportunity should have the potential to generate at least 50% in returns over the next three years. This sounds like a high barrier, but one must account for the higher risk profile that comes with investing in small caps. Even so, 50% return over three years amounts to 16.66% per annum compared with the share market's long term trend return of circa 10%. I believe all of three turnaround stories mentioned have such potential, with the notion that "potential" does not equal 'guarantee".

Australian Equities: Not Cheap, But Going Higher

Always funny to see commentators, in particular those linked to brokerages, argue the share market is "fair value" or even "not expensive", if only to try to emphasise the point there are still enough opportunities around to invest in. On simple Price-Earnings metrics the share market is slightly above long term trend, as I have pointed out a few times now. Which is exactly what valuation models at Credit Suisse are suggesting. CS' chart below shows the share market is trading just about one standard deviation from its long term average to the upside.

This is just the plain vanilla observation. And probably giving investors the wrong message. The correct view is that at this point of the share market cycle, when earnings growth follows re-rating, the present slight over-valuation is perfectly normal and in tune with past experiences. Investors better ignore doomsayers that look solely at the present over-valuation without putting it in the right context (see also "Harry Dent" below).

The latest update by market strategists at Macquarie provides further support to the view that Australian equities are no longer "cheap", but they remain poised to post another positive performance this year. On Macquarie's updated calculations, post a supportive February reporting season, the ASX200 will narrowly miss the 6000 level by year-end, for a total investment return of nearly 17%. This is less than the 20.2% achieved in 2013, but a whole lot better than the negative outlooks from the scarecrows.

Harry Dent; Even A Broken Clock Is Right Twice A Day

It is amazing what a well-oiled marketing apparatus can achieve, in particular in the financial sector. I have expressed my amazement about Harry Dent's popularity and media attention in the past, so enough said from me. Recently, however, I came across an analysis by Raymond James Chief Investment Strategist, Jeffrey D. Saut, and for wider enjoyment, and financial education in general, I repeat a few paragraphs below. Enjoy.

"It was 5:00 a.m. on Monday, March 2, 2009, when I warped in from my trading turret trying to get ready for a Bloomberg TV appearance on my friend Carol Massar's show. The environment was pretty glum following the Dow Dive that had lopped off some 7700 points (~54%) from the D-J industrial Average (INDU/16421.89) since the Dow Theory "sell signal" of November 2007. However, my message on March 2nd was that the bottoming process that began on October 10, 2008, when 92.6% of all stocks traded on the NYSE made new annual lows, was complete and the equity markets were going to bottom.

"Clearly, investors remain worried as reflected by the 1929 analog chart that went viral on the Internet a few weeks ago, which when corrected to compare apples-to-apples showed there is no correlation between now and the 1929 crash. Similarly, Mr. Dent's salacious claim that the SPX is in a bubble at 15.3x this year's earnings estimate is, and remains, very questionable. I would also note that the SPX's earnings have climbed from $49.50 in 2008 to this year's estimate of ~$122; and Harry Dent has been bearish during that entire climb. So for all of you who questioned me about Harry Dent's appearance on CNBC yesterday, yes . . . Harry Dent is bearish. And if we get an upside blow-off above 1900, Harry Dent may be right again for a few days . . ."

Peak In The Cycle For Insurers

Analysts have been warning for months that positive momentum seems to be near a peak for general insurers in Australia. Now sector analysts are in a frenzy in trying to determine what this means, exactly, for the insurance companies in question. Recent updates by the likes of Deutsche Bank and Morgan Stanley show growing question marks with regard earnings growth potential for Suncorp ((SUN)) and Insurance Australia Group ((IAG)), even though each still appears to have its own in-house trump cards that might please shareholders in the year ahead.

For Suncorp, there's potential for extra dividend payout. For IAG, the acquisition of Wesfarmers' operations should provide a short term boost. The two other insurance companies in Australia, AMP ((AMP)) and QBE ((QBE)) both look cheaply priced after prolonged de-ratings.

China's First Corporate Bond Default

Seldom witnessed how the next "left field" event from China was soooooo telegraphed and widely anticipated as the first corporate bond default in the country on Friday, and still the result was for freakish price weakness in base metals and spot iron ore. Yet another experience that proves: the market wants to be told?

I had been warning about such event. I was far from the only one. Two weeks ago I mentioned it on Switzer TV. The response I received was: but Rudi, this is pure speculation. Investors can view the video HERE

Bottom line: both investors and regulators in China are now learning and accumulating insights while this process unfolds. There will be many more of such defaults in China. And we will all have to find out how exactly this is going to impact on volatility and on price formation in the Chinese share market and its derivatives outside the country, like AUD and resources stocks.

Also, I happily repeat what I wrote last week: "China is not about to experience its own Lehman-moment. The most convincing argument against such claims is the fact that China is still very much a financial island that has yet to be fully integrated into the global finance network, wherein Lehman's collapse was able to cause so much harm."

(This story was written on Monday, 10th March, 2014. It was published on the day in the form of an email to paying subscribers).

(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions. All views are mine and not by association FNArena's – see disclaimer on the website)

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THE AUD AND THE AUSTRALIAN SHARE MARKET

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MAKE RISK YOUR FRIEND – ALL-WEATHER PERFORMERS

Things might look a lot different today than they have between 2008-2012, but that doesn't mean there are no lessons and conclusions to be drawn for the years ahead. "Making Risk Your Friend. Finding All-Weather Performers", was published in January this year and identifies three categories of stocks that should be part of every long term portfolio; sustainable yield, All-Weather Performers and Sweetspot Stocks.

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