Three contrarian plays for 2008

There's little sign of the outlook clearing in 2008 but don't panic, says Paul Hill. He picks three stocks that should still offer substantial upside over the next two to three years.

Investing in 2007 was very much a game of two halves. Until June, liquidity was plentiful and several global stockmarkets hit all-time highs. Then came the credit crunch. By December, most of the gains seen in the first half had been wiped out as fear swept markets and the financial sector in particular. As we enter the New Year, there's no sign of the outlook clearing. So what should investors do?

First things first: don't panic. Yes, there are major potential hazards, including a US recession, slowing corporate profits, rising commodity prices and a meltdown in the banking sector.

But even so, this year the global economy is still expected to grow at a 4.8% clip, while the Bank of England seems likely to cut interest rates to around 4.5% to prop up the UK economy. Assuming that a severe slowdown can be avoided, I have chosen three contrarian stock picks that offer substantial upside over the next two to three years.

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An opportunity in engineering

Charter ( LSE:CHTR )

Engineering group Charter is one example of a firm that has been unfairly punished during the market turmoil. Charter's share price has fallen by more than 35% in the past three months, despite a record first half, and in December it confirmed it remains upbeat on its trading prospects. The City's pessimism looks overdone, making this a great buying opportunity.

Charter has two core units. ESAB makes welding and cutting equipment and accounts for 66% of sales; the other unit, Howden, is the world leader in industrial fans, and also produces heat exchangers and compressors. ESAB sells to the shipbuilding, transport, construction and oil and gas industries. The growing popularity of cruises has meant healthy demand for new liners, while higher shipping costs and the need for many operators to replace ageing fleets should keep demand solid until 2010 at least.

Howden's main market is power generation and emissions control systems. It supplies machines that help to generate electricity and cut the associated pollution. Howden also derives around 25% of its revenues from the aftermarket (for example, providing servicing and parts), providing consistent recurring revenues from its large customer base.

The outlook for both units is positive. ESAB should continue to benefit from ongoing global demand for steel and other metals, such as aluminium, which is being led by increased consumption in Asia and China. Meanwhile, Howden's growth is being driven by the construction of new coal-fired power stations and the implementation of stricter environmental legislation.

The City expects turnover and earnings per share of £1.4bn and 83.1p respectively this year, rising to £1.5bn and 91.5p in 2008. That puts the stock on undemanding p/e ratios of 9.3 and 8.4 for this year and next. This looks good value, particularly as Charter has positive net funds and is about to pay a maiden dividend.

So what are the risks? Charter operates in cyclical markets and will undoubtedly be hurt if demand for steel subsides. Fears on this count have been fuelled by recent weak results from one of ESAB's competitors, US welding group Lincoln Electric, which missed third-quarter profit targets and indicated slower future growth. On top of this, both divisions are exposed to adverse currency movements.

But with an ungeared balance sheet, strong positions in robust markets and recent director buying, I think the shares are a solid long-term buy. In fact, at the current down-trodden levels, I would not be surprised if a bid materialised from a large industrial company in China or India who I'm sure would love to acquire Charter's leading technology.

Recommendation: LONG-TERM BUY at 786p

A compelling catalogue retailer

Home Retail Group ( LSE:HOME )

The next contrarian play is the UK's top catalogue retailer, Home Retail Group, which has recently seen its share price hit an all-time low. Around three-quarters of its business is generated via the Argos chain, which sells a broad mix of general merchandise through its 670 stores, website and telesales. Homebase, the UK's number-two DIY outlet, contributes the other 25% of turnover and focuses on the softer end of the consumer market or "decorative and style-based" offerings rather than the more price-sensitive trade sector. The group also has an active financial services unit, with the bulk of its credit derived from divisional sales.

In October, Home Retail Group reported a 36% rise in first-half operating profit, beating City hopes. The group has been able to leverage its scale to keep supplier costs down and source more of its products from overseas, boosting profit margins. About 30% of the company's merchandise is now sourced from Asia. Although the wet summer hit demand at Homebase, leaving garden furniture and barbecues stuck on the shelves, Argos was able to shift larger numbers of flat-panel televisions and video games as consumers opted for indoor entertainment. Argos also launched its biggest-ever catalogue in July, expanding its range by 9% or 5,000 items while at the same time trimming prices by around 5%.

That resulted in a 1.4% rise in like-for-like first-half sales at Argos, compensating for the 2.5% fall suffered at Homebase. Chief executive Terry Duddy said he was "looking forward to a good Christmas", despite fears of a slowing economy. He added that Argos had yet to feel any impact of competition from Tesco, which introduced its own catalogue in 2007.

So what are the potential pitfalls? Well, if there's a severe recession, the DIY sector is likely to be hit, although Argos's low-cost model should be more resistant. Profit margins could also be squeezed if cost inflation continues to rise faster than selling prices, and competition grows.

However, despite these worries, the stock now trades on an attractive 2007/2008 p/e multiple of 10.2 and pays a 4.7% dividend yield, covered 2.2 times. This is too cheap for two such leading brands and could even trigger a takeover bid from an aggressive predator looking to expand into these sectors.

Finally, Home Retail Group had £223m of net cash at 1 September. While the stores are leased under long-term contracts, rental payments are 2.5 times covered. Third-quarter results, together with figures on the all-important Christmas trading period, are due out on 17 January.

Recommendation: HIGH-RISK BUY at 324p

Gamble of the week

Straight ( Aim:STT )

Last year was a bad one for Straight, Europe's leading provider of recycling containers, including wheelie bins, kerb­side collection boxes and home composters. First its share price was hit by one-off costs, then sales of its leading water butts were hurt by the dreary summer. On 21 December it warned that 2007 results are likely to be "materially below City forecasts" due to contract delays and softer trading in its retail and gardening operations, which account for about 20% of turnover.

As a result, the stock has dived to all-time lows, around 75% below the 310p achieved back in June 2006. So why do I think Straight is an interesting turn-around play?

Well, on a more encouraging note, the balance sheet looks secure with £2.5m (or 23p per share) of net cash as at 30 June. Secondly, sales of recycling containers are at record levels as the Government's vision of more household waste being separated at source continues to drive demand (Straight is one of the main suppliers of recycling bins to local authorities). Meanwhile, leading retailers such as Tesco and Marks & Spencer have indicated that they wish to sell more "environmentally-friendly" household products, such as water butts and composters.

On top of this, the UK rainwater-collection market should return to growth next year as a result of global warming and ever-growing domestic water consumption. And even after the setbacks of the second half, the company "continues to be cash generative".

Indeed, the "order book for 2008 is strong and is expected to be further boosted by major contract wins", and the "board has also made a number of changes, which will reduce operating overheads going forward". All of this leads me to believe that the existing problems can be resolved in the fullness of time.

Housebroker Panmure Gordon is waiting until January's trading statement before updating its forecasts. But in the absence of such revised City forecasts, and assuming that the turnaround plan proves successful, then in two years' time I could see Straight achieving turnover of around £33m, while generating sustainable earnings before interest and tax margins of 6%, giving adjusted earnings per share of about 12p. Even though it's still early days, these ball-park figures do suggest that the recent sell-off has been somewhat overdone.

Recommendation: SPECULATIVE BUY at 74p (market capitalisation £8.5m)

Paul Hill also writes a weekly share-tipping newsletter, Precision Guided Investments

Paul gained a degree in electrical engineering and went on to qualify as a chartered management accountant. He has extensive corporate finance and investment experience and is a member of the Securities Institute.

Over the past 16 years Paul has held top-level financial management and M&A roles for blue-chip companies such as O2, GKN and Unilever. He is now director of his own capital investment and consultancy firm, PMH Capital Limited.

Paul is an expert at analysing companies in new, fast-growing markets, and is an extremely shrewd stock-picker.