Every now and then, the market throws up genuine bargains for investors who are prepared to take a contrarian view and ride out short-term uncertainty.
Bargain stocks like this are more common among smaller companies, where analyst coverage is patchy. Today, I’m going to look at two small cap stocks with 7% yields and — in my view — the potential for big gains.
This sell-off has gone too far
Shares of recruitment group Gattaca (LSE: GATC) — formerly known as MatchTech — have fallen by 34% over the last year. Investors have stayed away from this sector since the referendum due to fears that Brexit could trigger a recession.
There’s no way to know what might happen in two years. But the evidence so far suggests that demand from the engineering and technology sectors in which Gattaca specialises remains strong.
In its latest trading update, the company said that “vacancy flow is increasing” after a slow period following the referendum. Although the group’s net fee income fell by 5% to £35.1m during the first half, this was apparently due to “elongated hiring decisions”, not a slump in demand.
The board expects profits for the year ending 31 July to be in line with expectations. Forecasts from the firm’s house broker suggest that this will mean earnings of 39.9p per share, together with a dividend of 23.3p per share. That puts the stock on a tempting P/E of 7.9, with a prospective yield of 7.4%.
For what it’s worth, forecasts for 2017/18 show further growth. But a lot could change before then. I’m more attracted to Gattaca’s low debt levels and its historically strong free cash flow.
These, plus the stock’s modest valuation, suggest to me that the dividend should be sustainable. If I’m right, I’d expect the shares to move significantly higher at some point.
An alternative property stock
If you’re not sure about UK property stocks, Barbados-focused luxury hotel group Elegant Hotels Group (LSE: EHG) could be an interesting alternative.
The group’s shares currently trade at a 15% discount to book value and offer a dividend yield of 7%. This payout is expected to be covered about 1.3 times by earnings this year, and debt levels look comfortable to me.
Elegant Hotels’ share price is up by 5% so far in 2017, having slumped last year in the wake of the referendum. However, although the weaker pound has made staying in Elegant’s four and five-star hotels more expensive, customer demand seems to have remained strong. The group’s latest trading update reported bookings in line with expectations so far this year.
The group has recently acquired a new hotel, Treasure Beach, which will cement its hold on a prime beachfront area in Paynes Bay, Barbados. The group plans to spend $10.5m refurbishing this before launching Treasure Beach back onto the market in November.
This is clearly a growth opportunity, but it also flags up my main concern about Elegant Hotels. Although the company’s financial situation looks strong enough, I suspect its cash flow could be strained by the costs of keeping its hotels freshly updated.
I haven’t yet made a decision about Elegant Hotels, but I’m leaning towards a buy at the moment.
Can you afford to ignore this opportunity?
I'm bullish about Elegant Hotels and Gattaca, but I believe it's essential to diversify your portfolio to protect against unforeseen events.
Our top analysts have identified another small-cap stock which they believe could be worth up to 40% more at current prices.
The company concerned is a UK business with a solid record of growth. If you'd like to know more, then download our exclusive new report 1 Top Small-Cap Stock From The Motley Fool today.
This must-read report is FREE and carries no obligation. To get your copy, click here now.
Roland Head owns shares of Gattaca. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.