Buying shares that have fallen over the past year is usually not considered to be a wise investment strategy. Shares that have performed badly in the past generally continue to under-perform the market for some time. This phenomenon is called the “momentum effect”, and it is well documented in financial markets worldwide.
Occasionally, though, some shares do make a spectacular recovery after a steep fall in their share price. To name one example, McBride (LSE: MCB), the manufacturer of private label household and personal care products, has seen the value of its shares more than double since the start of this year, after having lost 41% of its value over the previous two years.
The “reversal” in the trend of McBride’s share price is well justified too. Pricing in the market is stabilising and the green shoots of recovery are already evident in the company’s financial performance.
McBride’s latest financial results for the year ending 30 June 2015 showed adjusted pre-tax profits rise 46.6% to £28.5m. Most significantly, the improvement in earnings was primarily down to the improvement in operating margins. Adjusted operating margins rose 1 percentage point in 2015, to 4%, as management focussed on reducing manufacturing complexity and upgrading its production assets.
It is also important to understand that the transformation is only half finished, and there remain many opportunities for the company to become more efficient and grow into new markets. Management is confident that it can deliver continued margin improvement and has a set a medium term target for adjusted operating margins of 7.5% within the next three to five years.
If the company does indeed achieve that target, and if we assume that revenues grow by 2% annually, we could expect McBride to earn net profit of around £38m–£40m by 2018–2020. This would imply its shares trade at a multiple of 7.4–7.7 on its earnings after restructuring. So, although shares in McBride have already rebounded so strongly since the start of the year, they could still rise further.
Like McBride, Burberry (LSE: BRBY) has seen structural and cyclical factors affect its recent financial performance. Growth is slowing as fashion tastes change, and sales of luxury goods have been hit by China’s anti-graft measures and slowing emerging market growth.
The company is also renewing its focus on productivity and efficiency. It has plans to take a firmer grip on cost management, too, by tackling hiring, rent, travel and other discretionary costs. In addition, it has begun to unify its three labels — Prorsum, London and Brit — under a single Burberry label, to provide a more consistent experience for customers and reduce internal complexity.
These measures will not solve all the problems it is facing, but they will at least alleviate some of the pressures on its bottom line. City analysts seem to be too pessimistic on their outlook for the group’s earnings. They expect underlying earnings to fall 6% this year, even though pre-tax earnings rose 9% in the first half of 2015. For me, this means Burberry’s shares could be a great contrarian pick.
Glencore’s (LSE: GLEN) woes are also down to a combination of cyclical and structural problems. Falling commodity prices have hit Glencore particularly hard because the company failed to cut high cost production early enough and allowed debt to climb to uncomfortable levels.
The company is finally responding to these issues, with plans to raise fresh capital, sell non-core assets and suspend production from two of its loss making copper mines in Africa. Unfortunately, though, commodity prices continue to deteriorate. So, unless there are signs that commodity prices are finally bottoming, I would still prefer to avoid Glencore’s shares.
These five large-cap shares have been selected for their combination of income and growth prospects. They generate stable cash flows from their dominant market positions and broad global exposure.
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Jack Tang has no position in any shares mentioned. The Motley Fool UK has recommended Burberry. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.