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December’s contrarian stock ideas

Tony Featherstone shares his seven rules for choosing out-of-favour stocks and his three favourites.

I have 7 rules with contrarian investing and buying badly-out-of-favour stocks:

  1. Focus on the company’s future rather than its past. That sounds obvious, but too many investors succumb to “anchoring bias”. They anchor their value assessment to past prices and believe a stock that falls from $5 to 50 cents must be cheap, when it is a trap.
  2. Identify a re-rating catalyst within the next 12 months. It’s no good holding an undervalued company for years, hoping the market will re-rate it. You must have a view on what the market is overlooking and what will spark the stock’s recovery.
  3. Ignore bullish recommendations from house brokers. As the company’s share price falls, the likelihood of an equity capital raising (and broker fees) increases. I’ve seen too many broking firms act as cheerleaders for stocks that sink lower, to earn capital-raising fees.
  4. Watch the smart money for clues. Company “insiders”, such as directors, buying stock in a fallen company is usually a good sign. So too is a savvy fund manager who has a knack for picking contrarian stocks appearing on the share register.
  5. This relates to the balance sheet. Contrarian investing is hard enough without choosing companies that need a (potentially dilutive) equity capital raising to survive, or are close to breaching their debt covenants. Stick to those with a solid capital position.
  6. Buy contrarian stocks that have formed a share-price base and are turning higher. Few stocks have v-shaped recoveries after they nose-dive. Survivors often serve their penance through a period of sideways price consolidation that forms the base for recovery. It’s usually here where the market loses patience and frustrated investors throw in their chips.
  7. Understand risk. Deep contrarian investing suits experienced active investors who have high risk tolerance. Most investors are better off sticking with large-cap equities or high-quality mid- and small-cap companies that are rising.

Caveats aside, here are 3 deep contrarian ideas worth consideration:

 

1. Myer Holdings (MYR:ASX)

The troubled department store is about as contrarian as it gets. Myer has been crunched by poor consumer sentiment, weak retail sales growth and other cyclical forces. And also by structural factors, notably intense competition, falling margins and the steep decline of department stores.

None of these factors will ease anytime soon. Australia’s economy is likely to worsen next year before it improves, forcing the Reserve Bank to cut interest rates twice and employ quantitative easing. It’s hard to see consumers opening their wallets with so much doom and gloom.

Pressure on the department-store model will intensify as e-commerce grows, niche retailers expand, foreign entrants boost competition and profit margins fall. I cannot see consumers rushing back to department stores when there are other, more compelling, retail options.

These are terrible trends for Myer. But the company’s decline is also of its own making over the years: dreary stores, a confused product mix, poor service, inadequate online penetration and too much floor space. The good news is Myer finally has the management to fix these problems.

I like Myer’s strategy under CEO John King and the work to cut costs and shrink stores – a move that led to Myer’s first profit growth in nine years (for FY19) and a short-lived price rally.

It may not seem like it, but there is a lot of fat still to be cut at Myer. Too many of its stores are too big and several should close. Aggressively shrinking Myer’s floor footprint could slash rental costs and, if done well, create a more attractive retail concept, in my view.

Growth in private-label brands and digital sales – a feature of the latest result – are other potential upsides. So too is better leverage of Myer’s database of millions of customers.

The market remains unconvinced of Myer’s turnaround potential, principally because of macro fears. These fears are well founded, but Myer’s re-rating over the next 18 months will be a micro story: management doing a good job to get the department store firing again.

 

Myer

Source: ASX

 

2. Ardent Leisure Group (ALG:ASX)

Few stocks have been more out of favour in the past few years than Ardent Leisure, operator of Dreamworld and other theme parks and US entertainment centre chain Main Event.

Ardent shares plunged after the 2016 accident at Dreamworld that killed four people. Attendance at Dreamworld and other Gold Coast theme parks suffered as concerns grew about the maintenance and safety of rides, and consumers chose other entertainment.

The market also worried that growth in Main Event, one of Ardent’s best-performing businesses, was slowing. Ardent had one bad news event after another.

I wrote favourably about Ardent for The Switzer Report in September 2019 at 95 cents a share, nominating it as one of “five neglected small- and mid-cap stocks”. Ardent has since rallied to $1.19 and can continue a slow turnaround over the next 12-18 months.

Ardent is a simpler business these days after the sale of its marina and bowling business. About four fifths of revenue comes from Main Event, its United States family entertainment business.

Main Event should continue to grow through centre openings and is being valued on lower earnings multiples than comparable US businesses.

The theme parks have long-term issues: my main concern is kids losing interest in entertainment parks as they become glued to phones and other devices. But so much bad news is already factored into the theme-park business, judging by Ardent’s valuation.

Chairman Gary Weiss, a noted shareholder activist, is overseeing the rationalisation of what was an unwieldly business. Perhaps it’s time to split the theme parks into a standalone company through a demerger and focus on the faster-growing Main Event.

Either way, Ardent looks undervalued. Morningstar values it at $2 a share.

 

Ardent Leisure

Source: ASX

 

3. Japara Healthcare (JHC:ASX)

Who would want to invest in the aged-care sector after the shocking revelations of the Aged Care Royal Commission? Contrarian investors who sniff out value, that’s who.

With Regis Healthcare and Estia Health, Japara shares were pummelled this year after disappointing earnings and gloom towards the sector. Having watched the banking Royal Commission’s effect on financial services companies, investors were right to be wary.

The market feared greater regulation in aged care, higher operating costs, falling profits and a lower return on assets across the sector. Understandably, investor sentiment towards aged-care stocks was horrible given the regulatory uncertainty.

The upside is the Royal Commission will bring much-needed structural change and reform, and hopefully improve confidence in the sector. Smaller players might struggle with the extra costs from reforms, enhancing the competitive position of Japara and other larger players.

I suspect we’ll see more mergers and acquisitions in the sector as private equity firms run their ruler over aged-care stocks trading at “doghouse” valuations. Or large aged care-companies snapping up smaller ones that struggle to compete at a higher cost base.

For all the problems, aged care is a long-term growth industry given the ageing population. The supply of aged-care beds available is not keeping up with the growth of people aged 85 plus. That should underpin higher occupancy rates for better-quality aged-care centres.

As the Aged Care Royal Commission winds down, and there is greater clarity on regulatory reforms, the market will feel more confident to buy beaten-up aged-care stocks. The recovery will take time, but the sector’s valuations and long-term prospects are favourable.

Japara appeals on valuation grounds, having lagged the gains (off a low base) in Estia Health and Regis Healthcare this year.

 

Japara Healthcare

Source: ASX


About the Author
Tony Featherstone , Switzer Group

Tony is a former managing editor of BRW, Shares, Personal Investor, Asset and CFO magazines and currently an author at Switzer Report. He specialises in small listed companies, IPOs, entrepreneurship and innovation and writes a weekly blog for The Sydney Morning Herald/The Age on small companies and entrepreneurs.