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Why these value stocks could be contrarian buys in 2017

Big mining stocks delivered huge profits last year for investors who were willing to buy when everyone was selling. But that trade has passed, and I believe the big wins are now in the bank.

If you want to follow Warren Buffett’s advice to “be greedy when others are fearful”, you’ll probably have to look elsewhere in 2017.

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One option is the retail sector. Big retailers are out of favour and struggling with weak footfall and falling sales. I suspect some companies may end up in serious trouble. But I believe there are some quality operators who will survive this slowdown and adapt successfully.

In this article I’ll consider two possible choices, one of which I’ve recently added to my own portfolio.

A homely stock for investors

Homewares retailer Dunelm Group (LSE: DNLM) delivered a mixed set of half-year results on Wednesday, triggering a 9% fall in the group’s share price.

Like-for-like sales fell by 1.6% during the six months to 31 December. Pre-tax profit fell by 11% to £67m during the same period, excluding the Worldstores acquisition at the end of last year.

The problem is that Worldstores was bought out of administration and is currently lossmaking. During the first five weeks of Dunelm’s ownership, the acquired business lost £1.8m. And management expects this business to lose nearly £10m during the current financial year.

However, integrating the new buy into Dunelm is expected to deliver cost savings of £10m per year in the “short-to-medium term”. And chief executive John Browett is confident that Worldstores can be returned to profit.

Dunelm’s track record suggests that the group could be worth a closer look. Return on capital employed has averaged 50% over the last five years, and the group’s operating margin is about 15%. Cash generation has always been strong.

Consensus profit forecasts for 2016/17 put Dunelm shares on a forecast P/E of about 14, with a prospective yield of 4.6%. This could be a contrarian opportunity. But I believe there are other, cheaper, opportunities that might be worth considering first.

Has this unpopular stock bottomed out?

Fashion retailer Next (LSE: NXT) has long enjoyed a reputation for under-promising and over-delivering on profits. But the group’s share price has now fallen by 41% over the last year.

Next stock currently trades on a forecast P/E of just nine and offers a yield of 4.6%. That’s unusually cheap for such a high quality business. After all, Next doesn’t have much debt and has delivered an average return on capital of 61% over the last five years.

One reason for this is that Next’s customers owe the firm about £1bn through its store card scheme. Customers are charged an interest rate of 22%, making this loan book a significant cash cow for the firm.

Looking ahead, Next should eventually start to benefit from falling retail rents in many areas of the UK. The group would also see its costs fall if the pound gains strength against the dollar.

I believe Next offers decent value at under £40 and could deliver a solid recovery over the next few years. In the meantime, the shares are backed by an attractive yield and a strong balance sheet, so downside risks should be limited.

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Roland Head owns shares of Next. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.