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One Neil Woodford mid-cap growth stock I’d ditch today

Fund manager Neil Woodford has made some great stock picks over the years, but few have been more successful than litigation financing group Burford Capital (LSE: BUR).

Mr Woodford is a long-time investor in this firm, whose shares have risen by an astonishing 1,000% since 2013. There’s no doubt it’s been a good buy, but my concern is that the risks facing ordinary shareholders may be rising rapidly.

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Unsustainable growth?

Burford has paid a dividend each year since 2011, but it’s not the kind of income stock which attracts me.

The reason for this is that while profits rose from $31.5m to $115.1m between 2012 and 2016, this firm doesn’t really generate any surplus cash. All the cash generated by litigation wins — plus much more — is reinvested into new claims, fuelling further growth.

This has been a successful strategy so far. Annual profits have risen by an average of 47% per year since 2011, and are expected to have climbed 80% to $207m in 2017.

Why I’m worried

Payouts from successful cases can take years to receive, so Guernsey-based Burford appears to be using increasing levels of debt and private funding to fuel its expansion, rather than accept slower growth.

Although this is a valid strategy, I think it’s worth noting that repaying these funders is likely to take priority over shareholder returns if cash ever becomes tight.

My second concern is that this complex business is pretty much a black box for most investors. In its 2016 annual report, Burford said that its (then) 64 ongoing ‘investments’ involved “hundreds of separate claims”.

In my opinion, there’s no way any of us can really understand the quality or type of cases being undertaken by the firm. So any shifts in future earnings could catch the market by surprise.

Turning point?

Analysts’ consensus forecasts suggest that after a bumper 2017, Burford profits could fall by 26% this year. I’d expect profits to be lumpy over time, but I’m not sure the current share price reflects this. I don’t see any reason to invest at current levels.

One stock I might buy

If you’re looking for a mid-cap growth stock for your portfolio, I believe that FTSE 250-listed recruitment group Hays (LSE: HAS) could be worthy of your attention.

Shares in the firm rose by 3% this morning after it said that net fee income had risen by 12% during the three months to 31 December, maintaining the momentum seen in Q1. The strong growth in Q2 was described as “broad based”, with 24 of the group’s 33 operating countries delivering growth of more than 10%.

Ironically, the only real area of concern was the UK & Ireland, where net fee income rose by just 1% due to an 8% fall in public sector net fees.

Why I’m interested

Unlike Burford, Hays generates a lot of surplus cash that it’s able to return to shareholders. Even after paying out £94.3m in dividends in November, the group still ended the quarter with net cash of £35m.

Analysts expect Hays to report earnings growth of 15% in 2017/18. This puts the stock on a forecast P/E of 17, with a prospective yield of 2.7%. In my view this could still be a profitable entry point.

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Roland Head has no position in any of the shares mentioned. 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.

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