Today I’m looking at two situations where investing against the trend could help you lock-in a tasty long-term income and some exciting growth.
The housing sector is generally out of favour with the market at the moment. But a closer look suggests to me that there may be buying opportunities among these unloved stocks. I believe the two companies I’m examining today both have the potential to deliver market-beating returns.
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2 years’ dividends in cash
My first company is a FTSE 100 firm which recently reported a £687m net cash balance — that’s enough to cover forecast dividends and share buybacks for the next two years.
Berkeley Group Holdings (LSE: BKG) is focused on upmarket homes in London and the South East. Chairman and founder Tony Pidgley is one of the most highly-respected operators in the property market.
Mr Pidgley’s decision to purchase large amounts of cheap land during the financial crisis has led to several years of bumper profits for the firm. The strong financial management which made these purchases possible has allowed the company to run without debt and provide generous cash returns for shareholders.
Time to buy again?
The problem is that Berkeley’s hoard of cheap land is running low. Recently purchased land has cost more and the market for London property has slowed somewhat. Because of this, the company expects profits “to return to more normal levels from 2018/19”. Management guidance is for profits to fall by about 30% this year.
The good news is that the group’s profit margins should remain attractive. Mr Pidgley is targeting a “pre-tax return on equity of 20% over the cycle”. I estimate that next year’s sales are likely to generate an operating profit margin of more than 20%.
Looking ahead, Berkeley expects to return £840m to shareholders over the three years to September 2021. The company ended last year with cash due from forward sales of £2.2bn and a net cash balance of £687m. Even without the forward sales, the firm’s existing cash is enough to cover two-thirds of planned shareholder returns, which equates to around 209p per share each year.
Some of this cash may be returned through share buybacks instead of dividends, but analysts’ forecasts suggest the majority will be paid out as cash, giving the stock a forward yield of about 5.5%.
At this level I think the shares could be worth considering for income, or perhaps to top up a long-term position.
One big risk
In my view, the big risk with Berkeley Group is that its profits are forecast to fall this year, and again in 2019/20. During that period we could see Brexit, a general election and rising interest rates. Conditions in the housing market could change dramatically.
I’m concerned about the risk of investing in a company with falling profits. After such a long housing boom, it could be several years before profits start to rise again. The shares could get cheaper still before they start to recover.
A growth opportunity
Not all housebuilders expect profits to fall. A number of companies focusing on affordable housing and the rental sector are reporting strong demand and expect continued growth.
One example is AIM-listed Inland Homes (LSE: INL), which has just reported a 66% increase in full-year revenue. This £131m company has previously caught my eye due to the stock’s attractive discount to its net asset value. The firm’s shares hit a 52-week high of 73.7p earlier this year but have since slipped to 66p in line with the fall in housing stocks.
I think this sell-off my have gone too far. In today’s year-end trading update, Inland’s management said the number of houses it sold into the open market rose by 46% to 275 last year. The group also inked major deals to build houses for top 10 housing association A2 Dominion and rental fund KCR Residential REIT.
Another source of profit for the company is its land bank, which is larger than you might expect for a £131m firm. That’s because a significant part of the business is focused on acquiring land to which it can add value, for example by gaining planning permission. The land is then sold on to developers.
The group sold 837 land plots last year and ended the year with 6,808, of which 1,547 had planning consent. So Inland has a significant pipeline of potential profit from land sales if it can continue to gain planning permission for new plots.
Discount to fair value?
The Buckinghamshire-based firm expects to report revenue of £150m for the year ended 30 June. That’s a 66.7% increase from last year’s total of £90m. Analysts expect the group’s adjusted earnings per share to be broadly unchanged from last year, at 7.13p (2017: 7.09p).
However, I think this flattish picture doesn’t give full credit to the earning potential of the company’s assets. The City seems to agree — analysts covering the company are forecasting earnings growth of 10% to 7.87p per share next year, which is equivalent to a P/E ratio of just 8.3 at the current share price.
A second source of potential upside is the group’s net asset value. Using the industry-standard EPRA NAV measure, Inland’s net assets were worth 92.8p per share at the half-year point of 31 December. This valuation formula is designed to give a realistic view of the current market value of a property firm’s assets, excluding various non-cash financing and debt items.
At 66p, the shares trade at a 28% discount to their EPRA NAV. In my view, this is a large enough discount to be worth a closer look. If the company can to continue to perform well across a range of markets, then I think it’s fair to expect further gains over the next year.
In the meantime, the shares offer a forecast dividend yield of 2.8% to reward patient shareholders.