Turkey of the week: the dangers of momentum trading

Paul Hill picks a share whose price has rocketed in the past few years without an improvement in the company's underlying value. Beware - you could be throwing money down the drain.

This share is a marvellous example of irrational exuberance. The share price has rocketed by 150% over the past three years, as supposedly rational fund managers have decided that they do not want to miss out on the price action. Momentum trading is dangerous at best, unless it is supported by a corresponding improvement in the company's underlying value. Without this support, a substantial price/value gap can be created. Then when reality finally sets in and a sharp correction occurs, retail investors are usually the ones left nursing the heaviest losses.

Turkey of the week: AWG (AWG: £12.90) tipped as a BUY by Lehman Bros

AWG owns Anglian Water and also has non-regulated interests in infrastructure services and property management. Ofwat regulates the UK water sector to protect consumers and improve the overall quality of the industry. Every five years it calculates a fair value (Regulatory Capital Value, or RCV) for each water company and specifies the price that each entity can charge, how much it should invest, and what level of return shareholders can receive.

Consequently, this RCV figure rather than the p/e ratio is the prime indicator of underlying value for a water business. If actual returns are greater than specified, then water bills will be reduced by Ofwat at the next pricing review (due in 2010) in order to ensure that the consumer obtains value for money.

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In terms of figures, how does this apply to AWG? Well, Ofwat has set a 2006 RCV for Anglia Water of £4.5bn. Additionally, AWG's non-regulated

assets are worth around £300m, which together with net debt of £3.4bn and a pension deficit of £100m, generates a sum-of-the-parts valuation for the shares of approximately 905p. Worryingly, this is around 40% below the current

share price.

So what is driving investors to buy at these inflated levels? As well as the "herd mentality" of fund managers and the defensive qualities of the sector, rumours are rife in the City that many water companies are takeover targets. Interest in the sector has been raised by hedge funds hoping to profit from any corporate action. In May, Aguas de Barcelona purchased Bristol Water at roughly a 40% premium to its RCV. Last weekend, there was press comment that a group of private-equity firms were planning to bid £5bn for Severn Trent. After stripping out its non-regulated assets worth about £1.5bn, this would imply a bid premium to RCV of around 30% for the company's water business.

Although at 4% AWG's dividend yield is attractive for income seekers, at £12.92 the share price already includes a significant takeover premium.

If speculation subsides, then clearly there is a danger that the price will crash back down towards its underlying value.

However, as a word of warning before you think of shorting the stock, not only does short selling require that a price is overvalued as it is for AWG it also needs an upcoming trigger event, such as a profits warning, that will change the City's view. Remember, markets can remain irrational for many years and it is difficult to second-guess what will actually happen in the very near term.

Recommendation: TAKE PROFITS at £12.90

Paul Hill's personal portfolio has gone up by 483% over the last five years. To find out more about his own specialist share-tipping service, Precision Guided Investments', click on the link below:

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.