Unloved stocks with healthy prospects

Sebastian Lyon, CEO of Troy Asset Management and manager of the Trojan Fund tells MoneyWeek where he'd put his money now.

Last year was an unusual one for the markets. Every year, almost without exception, the consensus expectation of strategists for the following year is for the equity market to rise about 10%. More often than not, they are wrong. Markets don't move in straight lines and, although we expect low returns over the medium term, there will inevitably be years of sharp rises and falls. The market is an emotional beast.

In 2004, the FTSE All Share index rose by 12.8% - truly a consensus year. The last time the market gave a similar return was 1998, when it rose 13.7%. We have to look back as far as 1988 to see anything similar - then the UK market rose 8.7%. In fact, in the last 20 years there have been only three years (1988, 1998 and 2004) when the return was between 5% and 15%: 2004 was the exception, not the rule. You're usually better off ignoring the consensus opinion, such as this year's, which, funnily enough, is for an 8% rise in equities.

At Troy, we look for unloved stocks the market has ignored. Nine months ago, we recommended BT (BT/A). Since then, the shares have risen 9.5%, including dividends - not stunning, but respectable. The market remains sceptical of the stock, but to us the valuation looks as compelling as ever. A starting yield of 5% and a p/e ratio of 11 times provide downside protection, and as contrarian investors we are pleased that most analysts are holders or sellers of the stock.

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Institutional investors yawn with boredom over BT - it hardly gives the sugar rush of the oil exploration stocks they find so exciting - and tend to dismiss it as a wasting asset. But for us, it's a defensive, cash-generative business focused on stabilising revenues and removing costs. Its 21st Century Network investment is targeting £1bn of annual cost savings. Growth will come from broadband and the global services business. The balance sheet is undergeared, and we think the market has overlooked the benefits of lower interest costs to be derived from refinancing debt in the next two years.

The recent publication of the 2004 Berkshire Hathaway annual report reminds us, if it were needed, that risks remain in the financial sector. Warren Buffett continues to warn investors of the potential risk of a financial meltdown. The high level of financials in index weightings tells us more about past success than the future prospects and, at Troy, our weighting in the financials sector is likely to stay low. But if there is a period when financial markets do poorly, investment companies with strong balance sheets should do well: they are able to invest in distressed assets at attractive levels of return, and could even gear up.

One such investment company is Rutland Trust (RUT), which specialises in investing in companies with commercial and financial challenges. Its recent investments in Carron Energy (a coal-fired power station in Wales) and Harvey & Thompson (the chain of pawnbrokers) demonstrate an ability to unearth forgotten assets at attractive prices. Realisations last year leave the balance sheet in a strong position, with net cash at the year end amounting to £36m out of net assets of £100m. This gives comfort that the shares have limited downside risk. The management has hinted of further profitable realisations in 2005. These should generate upside potential for the shares, which trade at a discount to net assets of 17%.