Today I’m looking at two FTSE 250 stocks that I believe could power ahead of the FTSE 100 over the coming years.

A turnaround in progress

Back in January, I tipped defence firm Chemring Group (LSE: CHG) as a potential buy. The shares rose by about 30% after that, until a serious fire at its Countermeasures factory in Salisbury caused the shares to crash in mid-August.

The group’s shares fell from 236p to under 195p following this incident, in which one person was killed and one seriously injured. However, Chemring shares have risen by more than 10% already this week, after the firm announced a major new contract win and issued an update on trading.

Work is going to gradually restart at the Salisbury factory, starting with shipments of finished orders. As the factory is rebuilt, it’s likely to be more heavily automated than it was previously. I’d expect this to result in higher profit margins over the long term.

In the meantime, Chemring has won a long-term contract to supply chemical agent detectors to the US Department of Defense. The company says this is the result of several years’ research and development. No information was provided about the value of the deal, but it was enough to send the shares up by 5%. This suggests to me that it’s expected to make a meaningful contribution to future profits.

A buying opportunity?

The fire is expected to cut Chemring’s underlying operating profit by about £15m this year. Aside from this, management says that trading is in line with expectations.

Analysts’ forecasts are for earnings per share to drop by around 18% in 2018, before bouncing back next year. This puts the stock on a 2018 forecast P/E of 20, falling to a P/E of 16 in 2019.  The group’s dividend yield is expected to rise from 1.6% in 2018 to 2% in 2019, as profits and cash flow improve.

I believe Chemring could be a good buy at this level, for long-term investors.

A safer option?

If you’re concerned about investing in a firm that’s facing significant operational disruption, you might want to consider my second choice. FTSE 250 engineer Vesuvius (LSE: VSVS) specialises in “molten metal flow engineering”.

This company makes equipment used in foundries and in the steel industry. The group’s shares have risen by 11% over the last year, compared to a gain of just 2% for the FTSE 100. Although profits dipped in 2015 and 2016, last year saw Vesuvius return to profit growth.

Further progress is expected this year. Analysts expect adjusted earnings to rise by about 15% to 47p per share in 2018. A dividend of 19.3p per share is expected, an increase of 7.2% versus last year’s distribution.

These forecasts put Vesuvius on an undemanding forecast P/E of 13.4, with a prospective dividend yield of 3.1%. In my view this could be a good example of a boring business that makes a good long-term investment. I’d consider buying this stock at current levels.

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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.

In-line performance

After a number of profit warnings and a vast decline in its valuation, defence company Chemring (LSE: CHG) seems to be making encouraging progress. It reported a positive trading update on Tuesday which showed it is performing in line with expectations. Revenue in the last four months has increased by 13.4% versus the comparable period from last year. Its order book of £541.8m was 2.6% lower than it was at the end of April 2017, but recent orders provide the company with confidence about its prospects over the medium term.

Of particular note for investors is the improving performance of the company’s countermeasures segment. Orders totalling £56.6m were received during the period, with operational performance improving and the second Philadelphia plant having been successfully closed. Similarly, there has been a robust performance from its energetics and sensors segments.

Looking ahead, Chemring is forecast to post a rise in its bottom line of 10% in the current year, followed by further growth of 9% next year. Despite this upbeat outlook, it trades on a price-to-earnings growth (PEG) ratio of just 1.6. This suggests that it could deliver a rising share price over the long run.

High growth/low valuation

Also offering recovery potential is online advertising company RhythmOne (LSE: RTHM). It announced news of an acquisition on Tuesday which could see it become a complete end-to-end platform in one of the fastest-growing segments of its industry. It has agreed to acquire YuMe for a total consideration of $185m based on current exchange rates. The deal will be funded through a mix of cash and shares (one-third cash, two-thirds shares) and is expected to close in the first calendar quarter of 2018.

The acquisition fits with RhythmOne’s strategy to create a unified marketplace that is efficient and effective for advertisers. YuMe offers innovation within the video advertising segment and this could complement the programmatic platform that RhythmOne has built over the last three years. During that time, the company has been transformed and is now expected to deliver a positive bottom line for the first time since 2014 in the current year.

Despite its clear recovery prospects, the stock trades on a low valuation. Next year it is expected to report a rise in its earnings of 168%, which puts it on a PEG ratio of only 0.1. As such, now could be the perfect time to buy it.

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Peter Stephens 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.

Our Chemring romance

All hail British export success Chemring Group (LSE: CHG), which generates a whopping 96% of its revenues outside of the UK. The country is going to need a lot more companies like this one if it is going to improve the nation’s current account deficit and make a go of Brexit.

Chemring manufactures and exports high technology electronics to over 60 countries around the world. Products include countermeasures against guided missiles, sensors and electronics to detect improvised explosive devices and combat chemical and biological threats, plus components for aircraft, missiles and space technology. It’s a growing market in today’s anxious world.

Defence investment

Chemring’s share price came under fire after the financial crisis, when austerity was the order of the day, and governments were cracking down on military spending. Business picked up last year, and Brexit played a key role. In the run-up to the referendum its shares traded at around 130p but they started climbing the moment the pound crashed. Today they trade at 197p, a rise of 50%.

Revenues  for 2016 rose 26.5% to £477.1m, but the growth rate is still positive even if you strip out the sterling booster, up 16.7% at 2015 currency rates. Underlying profit before tax rose whopping 71.7% to £34m, and again, growth of 47% at 2015 currency rates is impressive.

The future also looks promising, with earnings per share forecast to grow 12% this year and 8% next. However, trading at 18 times earnings and with the pound apparently finding a floor, growth rates could slow unless President Donald Trump’s military spending blitz rides to the rescue.

Sure of Renishaw

Global engineering company Renishaw (LSE: RSW), which specialises in measurement, motion control, healthcare and spectroscopy, has also has a good Brexit so far. Its share price rose 58%, from around 2,000p in the days beforehand to today’s 3167p. However, unlike Chemring it was doing pretty well before the referendum, with its share price up a total of 136% over five years.

Renishaw earns 95% of its revenues overseas, so a weak pound is the icing on the cake. But as sterling picks up, rising from a low of $1.20 in mid-January to $1.25 today, the sugar won’t be spread quite as thickly in future. Revenues for the six months to 31 December 2016 rose 21% to £240.4m, which reflected an underlying growth of 12% and a currency boost of 9%. That’s attractive growth even if you strip out the exchange rate effect, although it’s vulnerable if sterling starts strengthening.

Pound for pound 

Exchange rate movements aren’t all good news, as they have also boosted Renishaw’s overseas operating costs in sterling terms, a factor to consider with Chemring as well. The good news is that this should offset any downside from a stronger pound. Renishaw is growing strongly, with forecast EPS growth of 19% this year and 13% next, but at more than 32 times earnings there is a price to pay for its attractive prospects.

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

An improving business

As well as the potential growth opportunities resulting from higher spending in the defence sector, Rolls-Royce (LSE: RR) could be positively catalysed by a new strategy. It is focused on reducing costs over the medium term, which should create a more efficient and profitable business.

In fact, the company’s bottom line is expected to increase by 7% in the current year and by a further 17% next year. Beyond 2018, faster growth could be achieved due to the impact of additional cost cutting as well as rising demand for the company’s products.

In addition to reducing costs, Rolls-Royce is also investing in new products. For example, its aerospace division’s performance could gain a boost from the introduction of new Trent engines, while higher production volumes could mean sales growth moves higher. As such, its turnaround programme appears to be far from complete.

Trading on a price-to-earnings growth (PEG) ratio of 1.1, Rolls-Royce appears to have a relatively wide margin of safety. Certainly, there is scope for more disappointment if demand growth fails to reach expected levels, or if its transformation programme stalls. However, in the long run the company’s outlook and valuation suggest it could be a strong performer.

Strong momentum

Another defence stock with turnaround potential is Chemring (LSE: CHG). It reported upbeat results on Friday which showed that the momentum from the second half of the prior year has continued into the current year. Order intake in the first four months of the year was in line with the company’s expectations.

This is excellent news for the company’s investors, since Chemring has endured an exceptionally difficult period which has seen several profit warnings released. Its outlook for the next two years is relatively positive, with earnings growth of 11% and 8% forecast for 2017 and 2018 respectively. And since debt levels are now stabilising and its trading is more consistent than in recent years, it would be unsurprising for investor sentiment to improve over the medium term.

Chemring trades on a PEG ratio of 1.5. While significantly higher than that of Rolls-Royce, Chemring arguably has more turnaround potential than its sector peer. Therefore, while its shares may be a relatively risky proposition, they could also record higher levels of growth. That’s especially the case if currency translation continues to be positive during the remainder of the year. An increase to the company’s guidance could be on the horizon if sterling moves lower as Brexit talks commence.

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Shareholders will be desperate for signs that the firm’s decline has bottomed out. Potential buyers — including me — will be trying to decide whether this latest round of bad news is likely to be the last.

What’s new?

Thursday’s update contained bad news on almost all fronts. Higher costs and bad debt charges mean that underlying trading profit for last year will be £225m, £20m less than the firm’s January guidance.

Cobham has also booked an additional £150m charge relating to an airborne tanker project it’s working on with Boeing.

The firm’s balance sheet review has unearthed more problems. Cobham will write off a total of £574m in goodwill and intangible fixed assets. These are non-cash charges and mostly relate to acquisitions made between 2009 and 2014. The biggest culprit is the 2014 Aeroflex acquisition, which was probably the trigger for the firm’s current problems.

Although these are non-cash charges, they are bad news for shareholders because they mean that previous management has effectively wasted more than half a billion pounds of company cash.

Unsurprisingly, this has left Cobham with a debt problem. The firm admits that at £1bn, net debt is too high and that action will be required to strengthen the balance sheet. I’d expect a rights issue to be the most likely outcome, but further guidance will be provided with the firm’s results at the start of March.

The good news

The good news is that this update has been issued after the firm’s new chief executive and chief financial officer — David Lockwood and David Mellors — have had time to review the firm’s balance sheet, contracts and funding position.

In my opinion, this update is a proper kitchen sink job. All of the firm’s problems should now be out in the open. Unless Cobham’s core businesses have fundamental issues, the group should now be able to work towards a recovery.

Cobham has gone onto my watch list. I’ll be studying its results carefully in March for signs of value.

This is how it should be done

Cobham isn’t the only defence firm with problems. Smaller peer Chemring (LSE: CHG) raised £80.8m in a rights issue last year, after profits slumped and debt levels became unsustainable.

Shareholders had endured a decline that saw the value of their stock fall from 722p in 2011 to just 90p last year. However, Chemring’s turnaround appears to have been successful. The firm’s recent results suggest to me that this stock could be an attractive buy at current levels.

Underlying earnings rose by 45% to 10.3p per share last year, putting the stock on a P/E of 18. Although this may not seem cheap, earnings are expected to rise by about 10% in both 2016/17 and 2017/18. Dividends should also rise now that debt levels are under control.

Although a partial recovery is already priced into Chemring stock, I think there’s a good chance that it will outperform expectations. I’d remain a buyer at under 200p.

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Today’s figures are likely to be a relief for shareholders, who stumped up £80m in a rights issue last year. The good news is that this cash influx seems to have been successful. Net debt fell by 43% to £87.6m last year, while underlying pre-tax profits rose by 71.7% to £34m.

Does Chemring now offer a buying opportunity for investors, or is the firm’s recovery already priced into the shares?

More to come?

It’s worth putting Chemring’s turnaround in context. The group’s share price is still 60% lower than it was five years ago. This year’s underlying pre-tax profit of £34m is 73% lower than the figure of £125.6m reported in 2011.

Although Chemring’s profits may not return to historical levels for the foreseeable future, I believe that profits are likely to continue recovering for some time yet.

Alongside that recovery, cash generation also improved last year. Cash flows from operating activities rose by 115% to £76.4m, while underlying free cash flow was £44.4m, broadly in line with underlying operating profit of £48.5m. These figures suggest to me that Chemring will be able to continue managing debt and gradually rebuilding its dividend.

Analysts expect its dividend payout to rise to 3p this year, giving a prospective yield of 1.8%. Alongside this, underlying earnings are expected to rise by 15% to 11.2p, putting the stock on a forecast P/E of 15.

Although currency effects gave a boost to Chemring’s recovery last year, I believe the shares look reasonable value at current levels, and are likely to deliver further gains.

A bigger and better choice?

If you want to avoid the uncertainty of a turnaround situation, then one alternative to Chemring is sector heavyweight BAE Systems (LSE: BA).

The firm’s shares have risen by 20% over the last 12 months, partly because the weaker pound has provided a significant boost to the value of BAE’s US dollar revenues. Management guidance is for underlying earnings growth of 5%-10% this year, which gives a figure of about 40p per share. Analysts expect the group’s dividend to rise to 21.3p.

At the current share price of 600p, these forecasts give BAE a 2016 forecast P/E of 15 and a prospective yield of 3.5%. A similar level of earnings growth is expected for 2017.

Is BAE a buy?

BAE made good progress on a number of fronts last year, signing a £2.1bn Typhoon support contract and beginning work on a major submarine project for the Royal Navy. But it’s worth noting that the group’s order backlog fell slightly during the first half of last year, while net debt rose to more than £2bn.

As a shareholder myself, I’ve no plans to sell. But I paid much less for my shares, which gives me a higher dividend yield. At current levels, the stock looks fully priced to me. I plan to wait for a better buying opportunity before adding to my holding.

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Roland Head owns shares of BAE Systems. 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.

Defence engineering firm Chemring Group (LSE: CHG) has lost 62% of its value since November 2011. Chemring is finally expected to return to profit this year, after three consecutive years of losses.

In this article, I’ll ask whether either company deserves a buy rating after today’s news.

Low costs and rising production

Enquest says production has now started from its ‘small pool’ Scolty/Crathes project in the North Sea. Initial operating costs are expected to be just $15/bbl., and production is expected to continue until 2025.

The firm’s much larger Kraken project is moving towards completion. The Floating, Production, Storage and Offloading (FPSO) vessel commissioned for Kraken will shortly set sail from Singapore. It is expected to arrive in the North Sea in January, on-track for production to start during the first half of next year.

Refinancing complete

Enquest also announced the completion of its recent financial restructuring today. The firm’s loans have been extended until at least 2021, and interest payments on some debt will be rolled over until oil reaches $65 per barrel. Enquest has also raised £82m by issuing new shares. This cash will be used to complete the development of the Kraken field, ahead of next year’s production start date.

This refinancing should mean that Enquest avoids defaulting on its debts. But I’m not sure it makes the stock any more attractive for equity investors. Enquest’s net debt was $1,681m at the end of June. The group is only expected to report a profit of $83m in 2017. Unless the oil market stages a stunning recovery, it will take a long time for Enquest to repay its debts. In the meantime, the firm is unlikely to be able to pay dividends or invest in major new projects. In my view, Enquest’s debt burden means that shareholder returns are likely to remain poor.

A brighter outlook?

The situation at Chemring may be more appealing. The company confirmed today that full-year profits should be in line with expectations. Net debt fell from £154m to £88m during the year to 31 October, putting it well within Chemring’s target range of less than 1.5 times earnings before interest, tax, depreciation and amortisation (EBITDA).

Chemring’s revenue rose by 26% to £477m last year, up from £377m in 2015. Even if exchange rate effects are excluded, revenue would still have been higher, at £440m. Expected earnings of 9.5p per share for the year just ended give Chemring a forecast P/E of 16.5. This seems reasonable, at this early stage in Chemring’s recovery.

We don’t yet know if Chemring will pay a final dividend this year. The interim dividend was passed, but consensus forecasts do show a payout of 2.05p for the current year. If paid, this would give a forecast yield of 1.3%.

I’m encouraged by the reduction in Chemring’s debt levels and the stabilisation of its revenue levels. I believe now could be a good time to consider investing in the group’s medium-term recovery.

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As a result of the difficult outlook for Flexonics, first-half margins are likely to be lower than expected and are due to be in the range of 8% to 9%. Clearly, this is disappointing and is a key reason why investor sentiment has taken a hit today.

With Senior forecast to report a fall in earnings of 8% this year, it wouldn’t be surprising if its shares continue to come under pressure in the short run. However, with a focus on cost management, its outlook for next year is much more positive and it’s expected to record a rise in its bottom line of 8%. Trading on a price-to-earnings growth (PEG) ratio of 1.6 indicates that for long-term investors, Senior could be a sound buy although it’s likely to be volatile over the short-to-medium term.

Investing for growth

Also reporting today was Saga (LSE: SAGA), with the over-50s product specialist releasing an encouraging update. It has experienced solid trading across the core insurance and travel businesses, with it investing for future growth through development opportunities across the emerging world.

Furthermore, it remains on track to meet full-year expectations and with it expected to increase its bottom line by 4% in the current year and by 10% next year, it seems to be performing well as a business. This strong growth rate puts Saga on a PEG ratio of only 1.3, which indicates that there’s significant upside potential following its 6% share price fall in the last year. And with it having a yield of 4%, it remains a sound income play for the long term too.

Shares plunge

Meanwhile, shares in Chemring (LSE: CHG) have fallen by 22% today after the defence specialist announced a widening of losses in the first half of the year. Underlying pre-tax losses increased from £1.3m in the first half of last year to £4m in the first half of the current year. The reasons for this are the slightly later than expected commencement of a 40mm ammunition contract together with a lower margin sales mix, the phasing of revenue within the current year and contract-specific issues resolved in the period.

Looking ahead, Chemring expects its full-year result to now undercut previous expectations. Despite its sales rising by 11.4% and the business being in a stronger financial position following its recent fundraising, it would be of little surprise for the shares to come under further pressure in the short run. Therefore, it may be prudent to await further evidence of a turnaround before buying a slice of Chemring.

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Peter Stephens owns shares of Saga. 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.

One of the most obvious companies to benefit would be oil supermajor BP (LSE: BP). In 2015 BP brought in $74bn of its $222bn in revenue from the US, refined over 700,000 barrels of oil a day at its three refineries and operated 7,000 retail outlets in the country. Trump’s proposal to cut the headline corporate tax rate from 39% to 15% would be a huge boon for BP. Likewise, any increased tensions in the Middle East resulting from Trump’s often bellicose foreign policy positions would likely drive up crude prices to BP’s benefit. Even without Trump in the White House, BP is in good shape as downstream assets bring in record profits, operating costs come down and expenses related to the Gulf of Mexico spill slowly tail off.

Security drive

One of the most notorious of Trump’s mooted policies, the deportation of many of the 11m undocumented workers in the US could end up benefitting private security companies such as G4S (LSE: GFS). G4S brought in 24% of 2015 revenue from North America and already has contracts in America for border protection, running prisons and repatriating deportees, all of which would see spending increases in a Trump presidency. However, with £1.7bn in net debt at year-end, a series of controversies following the company in several jurisdictions and continuing restructuring charges, I would look elsewhere to profit from Trump’s proposals.

Building bridges

Trump’s plan for a $1trn infrastructure investment would certainly benefit CRH (LSE: CRH), the largest building materials provider in the US. CRH produces and sells concrete, asphalt and other materials that would be put to use in the roads, bridges and airports Trump intends to build. CRH already brought in 19% of operating profits from the US last year and will be in good shape no matter who the next president is, as each of the three remaining candidates have pledged major infrastructure projects. Although net debt stood at three times EBITDA at year end, this was due to the wise €6.5bn purchase of assets being divested by Lafarge and Holcim in order to meet regulatory approval for their merger.

A risk too far?

Defence spending is supposedly set to decrease under Trump as he talks of weeding out bloated contracts, which would hurt the major contractors that provide large, multi-year projects. But one company that could benefit is Chemring (LSE: CHG), a maker of countermeasures and other defence products that are mainly used in combat situations. The end of the Iraq and Afghanistan wars has hit Chemring hard, but if Trump’s aggressive policy statements come to fruition and a slimmed-down US military sees more combat, Chemring would undoubtedly sell more missile defence flares and IED detectors. However, even a Trump presidency sending more contracts to Chemring wouldn’t be enough for me to buy shares. The main culprit is £154m in net debt that the company raised £80.8m in a rights issue to help pay down. Even with net debt down to a manageable 1.5 times EBITDA after this share dilution, the company is facing slow growth for the foreseeable future that will constrain shareholder returns.

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That’s at least partly why the likes of Rolls-Royce (LSE: RR) and Chemring (LSE: CHG) have posted disappointing results. In the case of Rolls-Royce, its bottom line declined by 10% last year and is due to fall by a further 57% in the current year. This has the potential to cause the company’s shares to come under pressure in the near term – especially since Rolls-Royce has a new management team and an uncertain long-term outlook.

Similarly, Chemring has made a loss in each of the last two years and has recently conducted a fundraising. This has sent the company’s share price lower by 80% in the last five years, but with Chemring due to return to profitability in the current year there’s light at the end of the tunnel. In fact, Chemring trades on a price-to-earnings-growth (PEG) ratio of just 0.8 and this indicates that it could be worth buying for the long haul. Meanwhile, Rolls-Royce is due to return to profit growth next year, with its PEG ratio of 0.6 indicating that it could prove to be a sound turnaround play as well.

Better buy?

Despite their potential as turnaround stocks, BAE (LSE: BA) seems to be a better buy than both Rolls-Royce and Chemring. It has been able to more successfully navigate the difficulties within the global defence sector better than its two sector peers and this has helped its share price to outperform the FTSE 100 by 48% in the last five years. And with great uncertainty regarding the outcome of the US election, holding a more secure and stable defence play could prove to be a sound move in future months and years.

Furthermore, with BAE trading on a price-to-earnings (P/E) ratio of just 13.2 there’s plenty of scope for an upward rerating. Certainly, BAE’s PEG ratio of 1.9 is higher than the equivalent figures for Rolls-Royce and Chemring, but with BAE having a more stable outlook and better revenue visibility, it comes with less risk. Plus, BAE’s dividend yield of 4.2% is well-covered and shareholder payouts could be set to rise at a brisk pace over the medium-to-long term.

So, while all three stocks have appeal, BAE seems to have the most enticing risk/reward ratio – especially with the future for the defence sector being highly uncertain.

The post Why I’d Buy BAE Systems plc Over Rolls-Royce Holding PLC & Chemring Group plc appeared first on The Motley Fool UK.

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Peter Stephens owns shares of BAE Systems. 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.