Five shares to watch in 2023

Source: Refinitiv Eikon, correct to 14/11/22. *estimated values

Today’s geopolitical climate means threat levels have increased. We think governments are less likely to rein in defence spending. It also means other countries are likely to move to bolster their own fleets and systems, which is a potential benefit for BAE.

There are some risks that come from investing in a defence company. Some institutional investors exclude investments in the sector, which can cap returns. At the same time, defence companies like BAE are at a higher risk of controversial events than others. There would be downward pressure on the valuation if something like this were to occur. A broader risk is that government defence budgets tend to wax and wane, and we expect BAE’s order intakes to broadly follow these trends.

Cash flow has historically been a thorn in BAE's side. Working capital management coupled with strong profits means this is the second year running that cashflow is in the black.

Costs are facing pressure from supply chain disruption, but for now BAE says it's offsetting the worst of the financial impact.

As a critical defence supplier in today’s uncertain world, we think BAE is in a strong position, and has long-term potential. Those perceived strengths do come with some extra risk though. The shares change hands for 12.6 times expected earnings, slightly above the ten-year average.

A member of the Share Research Team holds shares in BAE Systems.

Source: Refinitiv Eikon, correct to 16/11/22

If we look at cash conversion, BATS has been a consistently high cash generator for years. That’s helped support a dividend that’s grown at an annualised rate of 8% over the last 10 years and £4.5bn of share buybacks over that time. No returns are guaranteed.

Paying down the debt pile is a draw on cash. In 2017, BATS bought US-based Reynolds in a cash and stock deal worth $49.4bn. Debt’s reduced by more than £8bn since then and BATS expects the ratio of net debt to cash profit (EBITDA) to be within the group’s target range of 2-3 times at the full year.

New products are the main future growth prospects. BATS has 3 global, market leading, brands in categories like e-vapour and heated tobacco. It’s early days for this division, but losses are reining in and profits are expected to flow in 2025.

There are social risks associated with investing in tobacco, not least that the sector is excluded from some institutional products. The risk of regulators cracking down on new products is also worth being aware of.

BATS trades on a valuation some way below its longer-term average and a re-rate looks unlikely given the declining volumes in traditional tobacco – still the core performance driver. Instead, the investment case lies on strong cash generation and the prospective dividend yield of 7.8% (variable and not a reliable indicator of future income).

Source: Refinitiv Eikon correct to 15/11/22

There’s a modest 2.2% prospective dividend yield on offer, which has an impressive history of growing at an annualised rate of 10% since 1992. No dividends are guaranteed.

Bunzl may not be a household name, but underlying performance is impressive. A track record of doing well during tough times and steady growth are attractive qualities as economic uncertainty lingers. That hasn’t gone unnoticed though, with the group trading on a forward price to earnings ratio of 18.4, ahead of the wider sector.

Source: PayPal Q2 2022 Investor Update

A robust balance sheet and free cash flow that's expected to exceed $5bn this year gives options. PayPal’s in a strong position to make acquisitions to reach new customers or distribute cash to shareholders.

We’ve been pleased to see PayPal working closely with other enablers of eCommerce, rather than going head-to-head. Apple’s an example where work’s being done to help iPhones become a payment terminal for vendors. Moves like this reduce dependence on revenues from PayPal’s former parent, eBay.

There are also plans to enable both PayPal and Venmo (owned by the group) credit cards to be added to Apple Wallets. This gives users further opportunities to choose PayPal as their preferred payment option, both online and in-store.

The main risk to PayPal is a prolonged economic downturn that impacts spending. We see a lot of pain already priced into PayPal’s valuation, which is a good chunk below its long-term average. But the risk of further challenges for the shares remains very real. For those willing to accept the risks, PayPal could present an opportunity to invest in a leader in the electronic payment arena.

Remember, to invest in US shares you’ll need to complete a W-8BEN form.

Source: Volvo Group annual report, 2021

The group’s also benefiting from booming e-commerce (those extra online orders mean increased need for logistics). Volvo is also a leader in the electrification of heavy-duty vehicles. Volvo wants over 35% of its vehicle sales to be electric by 2030. We view being a front-runner of sustainable haulage a real plus point.

In the medium term, cost inflation and wider supply chain issues are problematic. We think taking a more cautious approach to new orders is the prudent thing to do. Volvo is an expensive business to run at the best of times, so underlying operating margins of close to 10% are the norm.

The steadier style of Volvo’s revenue means it’s able to pay dividends, supporting a 5.1% dividend yield. The proportion of the group’s earnings paid as a dividend is low, which can make these payments more resilient in a downturn and provide scope for dividend growth. Please remember nothing is guaranteed. Overseas dividends can be subject to withholding tax which might not be reclaimable.

We view Volvo as a steady-Eddie with longer-term growth and income potential. There are some immediate challenges around supply chains and inflation, which the market has priced in with the price to earnings ratio of 10.5 some way below the longer-term average.