3 contrarian stock picks for 2017

I know Foolish readers are generally keen to find unloved, undervalued stock picks with strong upside potential, so I’ve found three that may warrant a closer look this year.

Investor uncertainty

First up is outsourcing firm Capita (LSE: CPI), which faces an uncertain outlook due in part to the Brexit vote. The stock is down 57% over the past 52 weeks, and with a current market capitalisation of under £3.5bn, Capita is at risk of being demoted from the FTSE 100 Index.

The company announced a series of profit warnings last year, as clients delayed making big investment decisions amid the Brexit uncertainty, which caused a slowdown in contract volumes for some of its more cyclical businesses. As a result, Capita expects underlying pre-tax profits for 2016 to fall short of its earlier guidance by up to £100m, with a current guidance of at least £515m.

But, although the company faces some strong medium-term headwinds, longer-term fundamentals remain hugely attractive. The outlook for growth in the outsourcing sector continues to be promising as governments and companies alike are keen to gain efficiencies in service delivery, while consolidation in the sector could lead to improved margins and profitability. Moreover, valuations are cheap as things stand, with Capita valued at just 8.4 times its 2016 expected earnings, and the dividend currently yielding 6.1%.

I’m not the only one who thinks the stock is oversold — prominent fund manager Neil Woodford seems to agree. “The share price now profoundly undervalues the fundamental long-term attractions of this business,” he said in his fund’s 2016 year in review. He also said that although it will “take time to rebuild credibility and value at Capita”, he’s “prepared to be patient”.

Falling margins

Sports Direct International (LSE: SPD), the scandal-hit sports retailer, is in a similar position. The company, which is Britain’s largest sports goods retailer, said underlying margins declined by around a third as a result of the devaluation of the pound since the Brexit vote.

Looking forward, city analysts expect underlying EPS for the current year to fall by more than half, to around 16p. The stock has lost 32% of its value over the past 52 weeks, but valuations for Sports Direct aren’t nearly as attractive as they are for Capita. The stock currently trades at a forward P/E of 17.4 and shareholders continue to forego dividend payments.

That said, Sports Direct could bounce back when the current headwinds subside. The retailer benefits from a wide economic moat due to its low cost structure, and despite the recent employment practices scandal, it has a skilful and well-motivated management team in place.

Shrinking sales

Another retail stock stuck in the doldrums is Next (LSE: NXT). Last week’s trading statement was hardly reassuring, as the company announced that after a difficult pre-Christmas trading period, it now expects pre-tax profits for the current year to fall at the lower end of its previous guided figure of between £785m-£825m. What’s worse is that it expects profits in 2017 to drop further as the falling pound and rising inflation could hurt household disposable incomes.

But despite these cyclical headwinds, Next remains highly cash generative. With a current share price of 4,051p, Next yields 3.9%. Moreover, valuations are tempting, with the stock trading at an undemanding 9.4 times expected earnings this year.

Before you decide for yourself...

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Jack Tang has a position in Capita plc. The Motley Fool UK has recommended Sports Direct International. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.