Three promising undervalued stocks

Rod Sleath, fund manager at Collins Stewart Continental Europe Focus Fund, tells MoneyWeek where he'd put his money now.

Our aim is to invest in companies that are trading at considerable discounts to what we consider to be their true value. Our portfolio is therefore built on a stock-specific basis and we limit it to a maximum of 30 investments.

We always assess stocks on a medium-term basis and, as such, try to look through short-term issues. When we look at businesses, our primary questions are: What do we think this business is worth? What upside is there from the current market price? What do we think will lead to a stock price rise to fair valuation? And finally, what risk is there?

One of our favoured stocks at the moment is Michelin (ML.PA). Despite its excellent share-price performance, we still believe it represents outstanding value. Michelin is benefiting from the trend toward higher-value tyres. Overall, the global tyre market grows by 3%-4% a year, but high-end tyres, such as those for SUVs, are growing at nearer 10%. If you have ever bought these tyres, you will know that theyre not cheap ­ something that is reflected in Michelin's gross margins on these products.

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But there is more to Michelin than SUV tyres. It also represents an ongoing restructuring story. Every year, the group announces large cost-cutting plans in different areas of the group and there is plenty of potential for this to continue.

On the downside, Michelin has recently been the victim of higher raw materials prices, but the industry has so far been successful in passing costs on to consumers via higher prices. Michelin trades on ten times historic earnings, is not unduly leveraged and pays a 2.4% dividend yield. This seems cheap, given its structural earnings growth.

Another business we believe is extremely undervalued is IT services company Cap Gemini (CAP.PA). The IT services industry has suffered four years of declining volumes and prices, but the evidence suggests that the market bottomed in mid-2004. Through the downturn, Cap has suffered more than most of its competitors ­ partly due to the Ernst & Young acquisition it made at the peak of the market and the integration costs it incurred as a result of this.

Today, Cap is re-establishing cost discipline and has improved internal project controls. In the US, which accounts for 22% of Cap's sales, the group lost money last year, but a dramatic restructuring is now underway with reductions in the numbers of senior managers and support staff.

Additionally, Cap trades on an enterprise value to sales ratio of 50%. This is very low compared to its peer group: Atos Origin trades on 90% of sales, EDS on 57%, IBM 145% and Accenture 123%. This valuation suggests the market does not yet believe that Cap will be able to reach normal industry operating margins or its own historic average margins.

When we look at a firm, we don't look at it in isolation. We also consider the industry as a whole. Looking at Cap Gemini led us to take note of a small-cap IT services firm called GFI Informatique (GFI.PA). GFI has a core French business that generates reasonable and improving margins. Outside France, the group has small operations, most of which generate large losses. Through the course of this year we expect GFI will close, sell, or deeply restructure these loss-making operations. As a result, earnings should recover dramatically over the next two years. The group trades on 18 times historic earnings, but less than 10 times 2007 earnings.